Mircoeconomics Ch. 8

EXAMPLE 8.1 Economies of Scale—Small Fixed Cost Two video game producers, Nintendo and Sony Computer Entertainment, each have fixed costs of $200,000 and marginal costs of $0.80 per game. If Nintendo produces 1 million units per year and Sony produces 1.2 million, how much lower will Sony's average total production cost be? Table 8.1 summarizes the relevant cost categories for the two firms. Note in the bottom row that Sony enjoys only a 3-cent average cost advantage over Nintendo. Even though Nintendo produces 20 percent fewer copies of its video game than Sony, it does not suffer a significant cost disadvantage because fixed cost is a relatively small part of total production cost.

EXAMPLE 8.2 Economies of Scale—Large Fixed Cost Two video game producers, Nintendo and Sony Computer Entertainment, each have fixed costs of $10,000,000 and marginal costs of $0.20 per video game. If Nintendo produces 1 million units per year and Sony produces 1.2 million, how much lower will Sony's average total cost be? The relevant cost categories for the two firms are now summarized in Table 8.2. The bottom row shows that Sony enjoys a $1.67 average total cost advantage over Nintendo, substantially larger than in the previous example.

In each submarket, Carla must charge the same price to every buyer, just like an ordinary monopolist. She should therefore keep expanding output in each submarket as long as marginal revenue in that market exceeds her marginal cost. The relevant data for the two submarkets are displayed in Table 8.6. On the basis of the entries in the marginal revenue column for the list price submarket, we see that Carla should serve all three students (A, B, and C) since marginal revenue for each exceeds $29. Her profit-maximizing price in the list price submarket is $36, the highest price she can charge in that market and still sell her services to students A, B, and C. For the discount price submarket, marginal revenue exceeds $29 only for the first two students (D and E). So the profit-maximizing price in this submarket is $32, the highest price Carla can charge and still sell her services to D and E. (A discount price of $32 means that students who mail in the coupon will receive a rebate of $4 on the $36 list price.) Note that the rebate offer enables Carla to serve a total of five students per week, compared to only three without the offer. Carla's combined total revenue for the two markets is (3)($36) + 2($32) = $172 per week. Since her opportunity cost is $29 per paper, or a total of (5)($29) = $145 per week, her economic profit is $172 per week − $145 per week = $27 per week, $6 more than when she edited three papers and did not offer the rebate. CONCEPT CHECK 8.4 In Example 8.7, how much should Carla charge in each submarket if she knows that only those students whose reservation prices are below $34 will use rebate coupons?

IS PRICE DISCRIMINATION A BAD THING? We are so conditioned to think of discrimination as bad that we may be tempted to conclude that price discrimination must run counter to the public interest. In Example 8.7, however, both consumer surplus and producer surplus were actually enhanced by the monopolist's use of the hurdle method of price discrimination. To show this, let's compare consumer and producer surplus when Carla employs the hurdle method to the corresponding values when she charges the same price to all buyers. When Carla had to charge the same price to every customer, she edited only the papers of students A, B, and C, each of whom paid a price of $36. We can tell at a glance that the total surplus must be larger under the hurdle method because not only are students A, B, and C served at the same price ($36), but also students D and E are now served at a price of $32. To confirm this intuition, we can calculate the exact amount of the surplus. For any student who hires Carla to edit her paper, consumer surplus is the difference between her reservation price and the price actually paid. In both the single price and discount price examples, student A's consumer surplus is thus $40 − $36 = $4; student B's consumer surplus is $38 − $36 = $2; and student C's consumer surplus is $36 − $36 = 0. Total consumer surplus in the list price submarket is thus $4 + $2 = $6 per week, which is Page 225the same as total consumer surplus in the original situation. But now the discount price submarket generates additional consumer surplus. Specifically, student D receives $2 per week of consumer surplus since this student's reservation price of $34 is $2 more than the discount price of $32. So total consumer surplus is now $6 + $2 = $8 per week, or $2 per week more than before. Carla's producer surplus also increases under the hurdle method. For each paper she edits, her producer surplus is the price she charges minus her reservation price ($29). In the single-price case, Carla's surplus was (3)($36 − $29) = $21 per week. When she offers a rebate coupon, she earns the same producer surplus as before from students A, B, and C and an additional (2)($32 − $29) = $6 per week from students D and E. Total producer surplus with the discount is thus $21 + $6 = $27 per week. Adding that amount to the total consumer surplus of $8 per week, we get a total economic surplus of $35 per week with the rebate coupons, $8 per week more than without the rebate. Note, however, that even with the rebate, the final outcome is not socially efficient because Carla does not serve student F, even though this student's reservation price of $30 exceeds her opportunity cost of $29. But though the hurdle method is not perfectly efficient, it's still more efficient than charging a single price to all buyers.

ECONOMIES OF SCALE AND THE IMPORTANCE OF START-UP COSTS As we saw in Chapter 6, Perfectly Competitive Supply, variable costs are those that vary with the level of output produced, while fixed costs are independent of output. Strictly speaking, there are no fixed costs in the long run because all inputs can be varied. But as a practical matter, start-up costs often loom large for the duration of a product's useful life. Most of the costs involved in the production of computer software, for example, are start-up costs of this sort, one-time costs incurred in writing and testing the software. Once those tasks are done, additional copies of the software can be produced at a very low marginal cost. A good such as software, whose production entails large fixed start-up costs and low variable costs, will be subject to significant economies of scale. Because, by definition, fixed costs don't increase as output increases, the average total cost of production for such goods will decline sharply as output increases. To illustrate, consider a production process for which total cost is given by the equation TC = F + M×Q, where F is fixed cost, M is marginal cost (assumed constant in this illustration), and Q is the level of output produced. For the production process with this simple total cost function, variable cost is simply M×Q, the product of marginal cost and quantity. Average total cost (ATC), TC/Q, is equal to F/Q + M. As Q increases, average cost declines steadily because the fixed costs are spread out over more and more units of output. Figure 8.2 shows the total production cost (a) and average total cost (b) for a firm with the total cost curve TC = F + M×Q and the corresponding average total cost curve ATC = F/Q + M. The average total cost curve (b) shows the decline in per-unit cost as output grows. Though average total cost is always higher than marginal cost for this firm, the difference between the two diminishes as output grows. At extremely high levels of output, average total cost becomes very close to marginal cost (M). Because the firm is spreading out its fixed cost over an extremely large volume of output, fixed cost per unit becomes almost insignificant.

(FIGURE 8.2 Total and Average Total Costs for a Production Process with Economies of Scale. For a firm whose total cost curve of producing Q units of output per year is TC = F + M×Q, total cost (a) rises at a constant rate as output grows, while average total cost (b) declines. Average total cost is always higher than marginal cost for this firm, but the difference becomes less significant at high output levels.) As the following examples illustrate, the importance of economies of scale depends on how large fixed cost is in relation to marginal cost.

PROFIT MAXIMIZATION FOR THE MONOPOLIST Cost-Benefit Regardless of whether a firm is a price taker or a price setter, economists assume that its basic goal is to maximize its profit. In both cases, the firm expands output as long as the benefit of doing so exceeds the cost. Further, the calculation of marginal cost is also the same for the monopolist as for the perfectly competitive firm. The profit-maximizing decision for a monopolist differs from that of a perfectly competitive firm when we look at the benefits of expanding output. For both the perfectly competitive firm and the monopolist, the marginal benefit of expanding output is the additional revenue the firm will receive if it sells one additional unit of output. In both cases, this marginal benefit is called the firm's marginal revenue. For the perfectly competitive firm, marginal revenue is exactly equal to the market price of the product. If that price is $6, for example, then the marginal benefit of selling an extra unit is exactly $6. MARGINAL REVENUE FOR THE MONOPOLIST The situation is different for a monopolist. To a monopolist, the marginal benefit of selling an additional unit is strictly less than the market price. As the following discussion will make clear, the reason is that while the perfectly competitive firm can sell as many units as it wishes at the market price, the monopolist can sell an additional unit only if it cuts the price—and it must do so not just for the additional unit but for the units it is currently selling. Suppose, for example, that a monopolist with the demand curve shown in Figure 8.3 is currently selling 2 units of output at a price of $6 per unit. What would be its marginal revenue from selling an additional unit?

(FIGURE 8.3 The Monopolist's Benefit from Selling an Additional Unit. The monopolist shown receives $12 per week in total revenue by selling 2 units per week at a price of $6 each. This monopolist could earn $15 per week by selling 3 units per week at a price of $5 each. In that case, the benefit from selling the third unit would be $15 − $12 = $3, less than its selling price of $5.) This monopolist's total revenue from the sale of 2 units per week is ($6 per unit) (2 units per week) = $12 per week. Its total revenue from the sale of 3 units per week would be $15 per week. The difference—$3 per week—is the marginal revenue from the sale of the third unit each week. Note that this amount is not only smaller than the original price ($6) but smaller than the new price ($5) as well. CONCEPT CHECK 8.2 Calculate marginal revenue for the monopolist in Figure 8.3 as it expands output from 3 to 4 units per week, and then from 4 to 5 units per week.

For the monopolist whose demand curve is shown in Figure 8.3, a sequence of increases in output—from 2 to 3, from 3 to 4, and from 4 to 5—will yield marginal revenue of $3, $1, and −$1, respectively. We display these results in tabular form in Table 8.4. Note in the table that the marginal revenue values are displayed between the two quantity figures to which they correspond. For example, when the firm expanded its output from 2 units per week to 3, its marginal revenue was $3 per unit. Strictly speaking, this marginal revenue corresponds to neither quantity but to the movement between those quantities, hence its placement in the table. Likewise, in moving from 3 to 4 units per week, the firm earned marginal revenue of $1 per unit, so that figure is placed midway between the quantities of 3 and 4, and so on. To graph marginal revenue as a function of quantity, we would plot the marginal revenue for the movement from 2 to 3 units of output per week ($3) at a quantity value of 2.5, because 2.5 lies midway between 2 and 3. Similarly, we would plot the marginal revenue for the movement from 3 to 4 units per week ($1) at a quantity of 3.5 units per week, and the marginal revenue for the movement from 4 to 5 units per week (−$1) at a quantity of 4.5. The resulting marginal revenue curve, MR, is shown in Figure 8.4.

(FIGURE 8.4 Marginal Revenue in Graphical Form. Because a monopolist must cut price to sell an extra unit, not only for the extra unit sold but also for all existing units, marginal revenue from the sale of the extra unit is less than its selling price.) More generally, consider a monopolist with a straight-line demand curve whose vertical intercept is a and whose horizontal intercept is Q0, as shown in Figure 8.5. This monopolist's marginal revenue curve also will have a vertical intercept of a, and it will be twice as steep as the demand curve. Thus, its horizontal intercept will be not Q0, but Q0/2, as shown in Figure 8.5. (FIGURE 8.5 The Marginal Revenue Curve for a Monopolist with a Straight-Line Demand Curve. For a monopolist with the demand curve shown, the corresponding marginal revenue curve has the same vertical intercept as the demand curve, and a horizontal intercept only half as large as that of the demand curve.) Marginal revenue curves also can be expressed algebraically. If the formula for the monopolist's demand curve is P = a − bQ, then the formula for its marginal revenue curve will be MR = a − 2bQ. If you have had calculus, this relationship is easy to derive,2 but even without calculus you can verify it by working through a few numerical examples. First, translate the formula for the demand curve into a diagram, and then construct the corresponding marginal revenue curve graphically. Reading from the graph, write the formula for that marginal revenue curve.

WHY THE INVISIBLE HAND BREAKS DOWN UNDER MONOPOLY In our discussion of equilibrium in perfectly competitive markets in Chapter 7, Efficiency, Exchange, and the Invisible Hand in Action, we saw conditions under which the self-serving pursuits of consumers and firms were consistent with the broader interests of society as a whole. Let's explore whether the same conclusion holds true for the case of imperfectly competitive firms. Consider the monopolist in Figures 8.6 and 8.7. Is this firm's profit-maximizing output level efficient from society's point of view? For any given level of output, the corresponding price on the demand curve indicates the amount buyers would be willing to pay for an additional unit of output. When the monopolist is producing 8 units per week, the marginal benefit to society of an additional unit of output is thus $4 (see Figure 8.7). And since the marginal cost of an additional unit at that output level is only $2 (again, see Figure 8.7), society would gain a net benefit of $2 per unit if the monopolist were to expand production by 1 unit above the profit-maximizing level. Because this economic surplus is not realized, the profit-maximizing monopolist is socially inefficient. Recall that the existence of inefficiency means that the economic pie is smaller than it might be. If that is so, why doesn't the monopolist simply expand production? The answer is that the monopolist would gladly do so, if only there were some way to maintain the price of existing units and cut the price of only the extra units. As a practical matter, however, that is not always possible. Now, let's look at this situation from a different angle. For the market served by this monopolist, what is the socially efficient level of output? At any output level, the cost to society of an additional unit of output is the same as the cost to the monopolist, namely, the amount shown on the monopolist's marginal cost curve. The marginal benefit to society (not to the monopolist) of an extra unit of output is simply the amount people are willing to pay for it, which is the amount shown on the monopolist's demand curve. To achieve social efficiency, the monopolist should expand production until the marginal benefit to society equals the marginal cost, which in this case occurs at a level of 12 units per week. Social efficiency is thus achieved at the output level at which the market demand curve intersects the monopolist's marginal cost curve. The fact that marginal revenue is less than price for the monopolist results in a deadweight loss. For the monopolist just discussed, the size of this deadweight loss is equal to the area of the pale blue triangle in Figure 8.9, which is (½)($2 per unit) (4 units per week) = $4 per week. That is the amount by which total economic surplus is reduced because the monopolist produces too little.

(FIGURE 8.9 The Deadweight Loss from Monopoly. A loss in economic surplus results because the profit-maximizing level of output (8 units per week) is less than the socially optimal level of output (12 units per week). This deadweight loss is the area of the pale blue triangle, $4 per week.) For a monopolist, profit maximization occurs when marginal cost equals marginal revenue. Since the monopolist's marginal revenue is always less than price, the monopolist's profit-maximizing output level is always below the socially efficient level. Under perfect competition, by contrast, profit maximization occurs when marginal cost equals the market price—the same criterion that must be satisfied for social efficiency. This difference explains why the invisible hand of the market is less evident in monopoly markets than in perfectly competitive markets. If perfect competition is socially efficient and monopoly is not, why isn't monopoly against the law? Congress has, in fact, tried to limit the extent of monopoly through antitrust laws. But even the most enthusiastic proponents of those laws recognize the limited usefulness of the legislative approach since the alternatives to monopoly often entail problems of their own. Suppose, for example, that a monopoly results from a patent that prevents all but one firm from manufacturing some highly valued product. Would society be better off without patents? Probably not because eliminating such protection would discourage innovation. Virtually all successful industrial nations grant some form of patent protection, which gives firms a chance to recover the research and development costs without which new products would seldom reach the market. Or suppose that the market in question is a natural monopoly—one that, because of economies of scale, is most cheaply served by a single firm. Would society do better to require this market to be served by many small firms, each with significantly higher average costs of production? Such a requirement would merely replace one form of inefficiency with another. In short, we live in an imperfect world. Monopoly is socially inefficient, and that, needless to say, is bad. But the alternatives to monopoly aren't perfect either. RECAP WHY THE INVISIBLE HAND BREAKS DOWN UNDER MONOPOLY The monopolist maximizes profit at the output level for which marginal revenue equals marginal cost. Because its profit-maximizing price exceeds marginal revenue, and hence also marginal cost, the benefit to society of the last unit produced (the market price) must be greater than the cost of the last unit produced (the marginal cost). So the output level for an industry served by a profit-maximizing monopolist is smaller than the socially optimal level of output.

EXAMPLE 8.6 Price Discrimination If Carla can price-discriminate, how many papers should she edit? Suppose Carla is a shrewd judge of human nature. After a moment's conversation with a student, she can discern that student's reservation price. The reservation prices of her potential customers are again as given in the following table. If Carla confronts the same market as before, but can charge students their respective reservation prices, how many papers should she edit, and how much economic and accounting profit will she make? Carla will edit papers for students A to F and charge each exactly his or her reservation price. Because students G and H have reservation prices below $29, Carla will not edit their papers. Carla's total revenue will be $40 + $38 + $36 + $34 + $32 + $30 = $210 per week, which is also her accounting profit. Her total opportunity cost of editing 6 papers is (6)($29) = $174 per week, so her economic profit will be $210 − $174 = $36 per week, $30 per week more than when she edited 6 papers but was constrained to charge each customer the same price.

A monopolist who can charge each buyer exactly his or her reservation price is called a perfectly discriminating monopolist. Notice that, when Carla was discriminating among customers in this way, her profit-maximizing level of output was exactly the same as the socially efficient level of output: 6 papers per week. With a perfectly discriminating monopoly, there is no loss of efficiency. All buyers who are willing to pay a price high enough to cover marginal cost will be served. Note that although total economic surplus is maximized by a perfectly discriminating monopolist, consumers would have little reason to celebrate if they found themselves dealing with such a firm. After all, consumer surplus is exactly zero for the perfectly discriminating monopolist. In this instance, total economic surplus and producer surplus are one and the same. In practice, of course, perfect price discrimination can never occur because no seller knows each and every buyer's precise reservation price. But even if some sellers did know, practical difficulties would stand in the way of their charging a separate price to each buyer. For example, in many markets the seller could not prevent buyers who bought at low prices from reselling to other buyers at higher prices, capturing some of the seller's business in the process. Despite these difficulties, price discrimination is widespread. But it is generally imperfect price discrimination—that is, price discrimination in which at least some buyers are charged less than their reservation prices.

VIGOROUS ENFORCEMENT OF ANTITRUST LAWS The nineteenth century witnessed the accumulation of massive private fortunes, the likes of which had never been seen in the industrialized world. Public sentiment ran high against the so-called robber barons of the period—the Carnegies, Rockefellers, Mellons, and others. In 1890, Congress passed the Sherman Act, which declared illegal any conspiracy "to monopolize, or attempt to monopolize . . . any part of the trade or commerce among the several States." And in 1914, Congress passed the Clayton Act, whose aim was to prevent corporations from acquiring shares in a competitor if the transaction would "substantially lessen competition or create a monopoly." Antitrust laws have helped to prevent the formation of cartels, or coalitions of firms that collude to raise prices above competitive levels. But they also have caused some harm. For example, federal antitrust officials spent more than a decade trying to break up IBM Corporation in the belief that it had achieved an unhealthy dominance in the computer industry. That view was proved comically wrong by IBM's subsequent failure to foresee and profit from the rise of the personal computer. By breaking up large companies and discouraging mergers between companies in the same industry, antitrust laws may help to promote competition, but they also may prevent companies from achieving economies of scale. A final possibility is simply to ignore the problem of natural monopoly: to let the monopolist choose the quantity to produce and sell it at whatever price the market will bear. The obvious objections to this policy are the two we began with, namely, that a natural monopoly is not only inefficient but also unfair. But just as the hurdle method of price discrimination mitigates efficiency losses, it also lessens the concern about taking unfair advantage of buyers. Consider first the source of the natural monopolist's economic profit. This firm, recall, is one with economies of scale, which means that its average production cost declines as output increases. Efficiency requires that price be set at marginal cost, but because the natural monopolist's marginal cost is lower than its average cost, it cannot charge all buyers the marginal cost without suffering an economic loss. The depth and prevalence of discount pricing suggest that whatever economic profit a natural monopolist earns generally will not come out of the discount buyer's pocket. Although discount prices are higher than the monopolist's marginal cost of production, in most cases they are lower than the average cost. Thus, the monopolist's economic profit, if any, must come from buyers who pay list price. And since those buyers have the option, in most cases, of jumping a hurdle and paying a discount price, their contribution, if not completely voluntary, is at least not strongly coerced. So much for the source of the monopolist's economic profit. What about its disposition? Who gets it? A large chunk—some 35 percent, in many cases—goes to the federal government via the corporate income tax. The remainder is paid out to shareholders, some of whom are wealthy and some of whom are not. These shareholder profits are also taxed by state and even local governments. In the end, two-thirds or more of a monopolist's economic profit may fund services provided by governments of various levels.

Cost-Benefit Both the source of the monopolist's economic profit (the list-price buyer) and the disposition of that profit (largely, to fund public services) cast doubt on the claim that monopoly profit constitutes a social injustice on any grand scale. Nevertheless, the hurdle method of differential pricing cannot completely eliminate the fairness and efficiency problems that result from monopoly pricing. In the end, then, we are left with a choice among imperfect alternatives. As the Cost-Benefit Principle emphasizes, the best choice is the one for which the balance of benefits over costs is largest. But which choice that is will depend on the circumstances at hand. RECAP PUBLIC POLICY TOWARD NATURAL MONOPOLY The natural monopolist sets price above marginal cost, resulting in too little output from society's point of view (the efficiency problem). The natural monopolist also may earn an economic profit at buyers' expense (the fairness problem). Policies for dealing with the efficiency and fairness problems include state ownership and management, state regulation, exclusive contracting, and vigorous enforcement of antitrust laws. Each of these remedies entails problems of its own.

THE MONOPOLIST'S PROFIT-MAXIMIZING DECISION RULE Cost-Benefit Having derived the monopolist's marginal revenue curve, we're now in a position to describe how the monopolist chooses the output level that maximizes profit. As in the case of the perfectly competitive firm, the Cost-Benefit Principle says that the monopolist should continue to expand output as long as the gain from doing so exceeds the cost. At the current level of output, the benefit from expanding output is the marginal revenue value that corresponds to that output level. The cost of expanding output is the marginal cost at that level of output. Whenever marginal revenue exceeds marginal cost, the firm should expand. Conversely, whenever marginal revenue falls short of marginal cost, the firm should reduce its output. Profit is maximized at the level of output for which marginal revenue precisely equals marginal cost. When the monopolist's profit-maximizing rule is stated in this way, we can see that the perfectly competitive firm's rule is actually a special case of the monopolist's rule. When the perfectly competitive firm expands output by one unit, its marginal revenue exactly equals the product's market price (because the perfectly competitive firm can expand sales by a unit without having to cut the price of existing units). So when the perfectly competitive firm equates price with marginal cost, it is also equating marginal revenue with marginal cost. Thus, the only significant difference between the two cases concerns the calculation of marginal revenue.

EXAMPLE 8.3 Marginal Revenue What is the monopolist's profit-maximizing output level? Consider a monopolist with the demand and marginal cost curves shown in Figure 8.6. If this firm is currently producing 12 units per week, should it expand or contract production? What is the profit-maximizing level of output?Page 215 (FIGURE 8.6 The Demand and Marginal Cost Curves for a Monopolist. At the current output level of 12 units per week, price equals marginal cost. Because the monopolist's price is always greater than marginal revenue, marginal revenue must be less than marginal cost, which means this monopolist should produce less.) In Figure 8.7, we begin by constructing the marginal revenue curve that corresponds to the monopolist's demand curve. It has the same vertical intercept as the demand curve, and its horizontal intercept is half as large. Note that the monopolist's marginal revenue at 12 units per week is zero, which is clearly less than its marginal cost of $3 per unit. This monopolist will therefore earn a higher profit by contracting production until marginal revenue equals marginal cost, which occurs at an output level of 8 units per week. At this profit-maximizing output level, the firm will charge $4 per unit, the price that corresponds to 8 units per week on the demand curve. (FIGURE 8.7 The Monopolist's Profit-Maximizing Output Level. This monopolist maximizes profit by selling 8 units per week, the output level at which marginal revenue equals marginal cost. The profit-maximizing price is $4 per unit, the price that corresponds to the profit-maximizing quantity on the demand curve.) For the monopolist with the demand and marginal cost curves shown, find the profit-maximizing price and level of output.

EXAMPLE 8.4 Profit Maximization and Opportunity Cost How many manuscripts should Carla edit? Carla supplements her income as a teaching assistant by editing term papers for undergraduates. There are eight students per week for whom she might edit, each with a reservation price as given in the following table. Carla is a profit maximizer. If the opportunity cost of her time to edit each paper is $29 and she must charge the same price to each student, how many papers should she edit? How much economic profit will she make? How much accounting profit? Table 8.5 summarizes Carla's total and marginal revenue at various output levels. To generate the amounts in the total revenue column, we simply multiplied the corresponding reservation price by the number of students whose reservation prices were at least that high. For example, to edit 4 papers per week (for students A, B, C, and D), Carla must charge a price no higher than D's reservation price ($34). So her total revenue when she edits 4 papers per week is (4)($34) = $136 per week. Carla should keep expanding the number of students she serves as long as her marginal revenue exceeds the opportunity cost of her time. Marginal revenue, or the difference in total revenue that results from adding another student, is shown in the last column of Table 8.5. Note that if Carla were editing 2 papers per week, her marginal revenue from editing a third paper would be $32. Since that amount exceeds her $29 opportunity cost, she should take on the third paper. But since the marginal revenue of taking on a fourth paper would be only $28, Carla should stop at 3 papers per week. The total opportunity cost of the time required to edit the 3 papers is (3)($29) = $87, so Carla's economic profit is $108 − $87 = $21 per week. Since Carla incurs no explicit costs, her accounting profit will be $108 per week.

EXAMPLE 8.5 Social Efficiency What is the socially efficient number of papers for Carla to edit? Again, suppose that Carla's opportunity cost of editing is $29 per paper and that she could edit as many as 8 papers per week for students whose reservation prices are again as listed in the following table. What is the socially efficient number of papers for Carla to edit? If she must charge the same price to each student, what will her economic and accounting profits be if she edits the socially efficient number of papers? Students A to F are willing to pay more than Carla's opportunity cost, so serving these students is socially efficient. But students G and H are unwilling to pay at least $29 for Carla's services. The socially efficient outcome, therefore, is for Carla to edit 6 papers per week. To attract that number, she must charge a price no higher than $30 per paper. Her total revenue will be (6)($30) = $180 per week, slightly more than her total opportunity cost of (6)($29) = $174 per week. Her economic profit will thus be only $6 per week. Again, because Carla incurs no explicit costs, her accounting profit will be the same as her total revenue, $180 per week.

THE HURDLE METHOD OF PRICE DISCRIMINATION The profit-maximizing seller's goal is to charge each buyer the highest price that buyer is willing to pay. Two primary obstacles prevent sellers from achieving this goal. First, sellers don't know exactly how much each buyer is willing to pay. And second, they need some means of excluding those who are willing to pay a high price from buying at a low price. These are formidable problems, which no seller can hope to solve completely. One common method by which sellers achieve a crude solution to both problems is to require buyers to overcome some obstacle to be eligible for a discount price. This method is called the hurdle method of price discrimination. For example, the seller might sell a product at a standard list price and offer a rebate to any buyer who takes the trouble to mail in a rebate coupon. Cost-Benefit The hurdle method solves both of the seller's problems, provided that buyers with low reservation prices are more willing than others to jump the hurdle. Because a decision to jump the hurdle must satisfy the Cost-Benefit Principle, such a link seems to exist. As noted earlier, buyers with low incomes are more likely than others to have low reservation prices (at least in the case of normal goods). Because of the low opportunity cost of their time, they are more likely than others to take the trouble to send in rebate coupons. Rebate coupons thus target a discount toward those buyers whose reservation prices are low and who therefore might not buy the product otherwise. A perfect hurdle is one that separates buyers precisely according to their reservation prices, and in the process imposes no cost on those who jump the hurdle. With a perfect hurdle, the highest reservation price among buyers who jump the hurdle will be lower than the lowest reservation price among buyers who choose not to jump the hurdle. In practice, perfect hurdles do not exist. Some buyers will always jump the hurdle, even though their reservation prices are high. And hurdles will always exclude at least some buyers with low reservation prices. Even so, many commonly used hurdles do a remarkably good job of targeting discounts to buyers with low reservation prices. In the example that follows, we will assume for convenience that the seller is using a perfect hurdle.

EXAMPLE 8.7 Perfect Hurdle How much should Carla charge for editing if she uses a perfect hurdle? Suppose Carla again has the opportunity to edit as many as 8 papers per week for the students whose reservation prices are as given in the following table. This time she can offer a rebate coupon that gives a discount to any student who takes the trouble to mail it back to her. Suppose further that students whose reservation prices are at least $36 never mail in the rebate coupons, while those whose reservation prices are below $36 always do so. If Carla's opportunity cost of editing each paper is again $29, what should her list price be, and what amount should she offer as a rebate? Will her economic profit be larger or smaller than when she lacked the discount option? The rebate coupon allows Carla to divide her original market into two submarkets in which she can charge two different prices. The first submarket consists of students A, B, and C, whose reservation prices are at least $36 and who therefore will not bother to mail in a rebate coupon. The second submarket consists of students D through H, whose lower reservation prices indicate a willingness to use rebate coupons.

STATE REGULATION OF PRIVATE MONOPOLIES In the United States, the most common method of curbing monopoly profits is for government to regulate the natural monopoly rather than own it. Most states, for example, take this approach with electric utilities, natural gas providers, local telephone companies, and cable television companies. The standard procedure in these cases is called cost-plus regulation: Government regulators gather data on the monopolist's explicit costs of production and then permit the monopolist to set prices that cover those costs, plus a markup to ensure a normal return on the firm's investment. While it may sound reasonable, cost-plus regulation has several pitfalls. First, it generates costly administrative proceedings in which regulators and firms quarrel over which of the firm's expenditures can properly be included in the costs it is allowed to recover. This question is difficult to answer even in theory. Consider a firm like AT&T, whose local telephone service is subject to cost-plus regulation but whose other products and services are unregulated. Many AT&T employees, from the president on down, are involved in both regulated and unregulated activities. How should their salaries be allocated between the two? The company has a strong incentive to argue for greater allocation to the regulated activities, which allows it to capture more revenue from captive customers in the local telephone market. A second problem with cost-plus regulation is that it blunts the firm's incentive to adopt cost-saving innovations for when it does, regulators require the firm to cut its rates. The firm gets to keep its cost savings in the current period, which is a stronger incentive to cut costs than the one facing a government-owned monopoly. But the incentive to cut costs would be stronger still if the firm could retain its cost savings indefinitely. Furthermore, in cases in which regulators set rates by allowing the monopolist to add a fixed markup to costs incurred, the regulated monopolist may actually have an incentive to increase costs rather than reduce them. Outrageous though the thought may be, the monopolist may earn a higher profit by installing gold-plated faucets in the company restrooms. Finally, cost-plus regulation does not solve the natural monopolist's basic problem: the inability to set price equal to marginal cost without losing money. Although these are all serious problems, governments seem to be in no hurry to abandon cost-plus regulation.

EXCLUSIVE CONTRACTING FOR NATURAL MONOPOLY One of the most promising methods for dealing with natural monopoly is for the government to invite private firms to bid for the natural monopolist's market. The government specifies in detail the service it wants—cable television, fire protection, garbage collection—and firms submit bids describing how much they will charge for the service. The low bidder wins the contract. The incentive to cut costs under such an arrangement is every bit as powerful as that facing ordinary competitive firms. Competition among bidders should also eliminate any concerns about the fairness of monopoly profits. And if the government is willing to provide a cash subsidy to the winning bidder, exclusive contracting even allows the monopolist to set price equal to marginal cost. Contracting has been employed with good results in municipal fire protection and garbage collection. Communities that employ private companies to provide these services often spend only half as much as adjacent communities served by municipal fire and sanitation departments. Despite these attractive features, however, exclusive contracting is not without problems, especially when the service to be provided is complex or requires a large fixed investment in capital equipment. In such cases, contract specifications may be so detailed and complicated that they become tantamount to regulating the firm directly. And in cases involving a large fixed investment—electric power generation and distribution, for example—officials face the question of how to transfer the assets if a new firm wins the contract. The winning firm naturally wants to acquire the assets as cheaply as possible, but the retiring firm is entitled to a fair price for them. What, in such cases, is a fair price?Page 229 Fire protection and garbage collection are simple enough that the costs of contracting out these functions are not prohibitive. But in other cases, such costs might easily outweigh any savings made possible by exclusive contracting.

IMPERFECT AND PERFECT COMPETITION Monopolistic competition is the industry structure in which a large number of small firms offer products that are similar in many respects, yet not perfect substitutes in the eyes of at least some consumers. Monopolistically competitive industries resemble perfectly competitive industries, in that entry and exit cause economic profits to tend toward zero in the long run. Oligopoly is the industry structure in which a small number of large firms supply the entire market. Cost advantages associated with large-scale operations tend to be important. Oligopolists may produce either standardized products or differentiated products. In contrast to each form of imperfect competition, in which all firms face downward-sloping demand curves, perfectly competitive firms face demand curves that are horizontal at the prevailing market price.

FIVE SOURCES OF MARKET POWER Firms that confront downward-sloping demand curves are said to enjoy market power, a term that refers to their ability to set the prices of their products. A common misconception is that a firm with market power can sell any quantity at any price it wishes. It cannot. All it can do is pick a price-quantity combination on its demand curve. If the firm chooses to raise its price, it must settle for reduced sales. Why do some firms have market power while others don't? Market power often carries with it the ability to charge a price above the cost of production, so such power tends to arise from factors that limit competition. In practice, the following five factors often confer such power: exclusive control over inputs, patents and copyrights, government licenses or franchises, economies of scale, and network economies.

Oligopoly

Further along the continuum between perfect competition and pure monopoly lies oligopoly, a structure in which the entire market is supplied by a small number of large firms. Cost advantages associated with large size are one of the primary reasons for pure monopoly, as we will discuss presently. Oligopoly is also typically a consequence of cost advantages that prevent small firms from being able to compete effectively. In some cases, oligopolists sell undifferentiated products. In the market for wireless phone service, for example, the offerings of AT&T, Verizon, and Sprint are very similar. The cement industry is another example of an oligopoly selling an essentially undifferentiated product. The most important strategic decisions facing firms in such cases are more likely to involve pricing and advertising than specific features of their product. Here, too, we leave a more detailed discussion of such decisions to Chapter 9, Games and Strategic Behavior. In other cases, such as the automobile and tobacco industries, oligopolists are more like monopolistic competitors than pure monopolists, in the sense that differences in their product features have significant effects on consumer demand. Many long-time Ford buyers, for example, would not even consider buying a Chevrolet, and very few smokers ever switch from Camels to Marlboros. As with oligopolists who produce undifferentiated products, pricing and advertising are important strategic decisions for firms in these industries, but so, too, are those related to specific product features. Because cost advantages associated with large size are usually so important in oligopolies, there is no presumption that entry and exit will push economic profit to zero. Consider, for example, an oligopoly served by two firms, each of which currently earns an economic profit. Should a new firm enter this market? Possibly, but it also might be Page 206that a third firm large enough to achieve the cost advantages of the two incumbents would effectively flood the market, driving price so low that all three firms would suffer economic losses. There is no guarantee, however, that an oligopolist will earn a positive economic profit. As we'll see in the next section, the essential characteristic that differentiates imperfectly competitive firms from perfectly competitive firms is the same in each of the three cases. So for the duration of this chapter, we'll use the term monopolist to refer to any of the three types of imperfectly competitive firms. In the next chapter, we'll consider the strategic decisions confronting oligopolists and monopolistically competitive firms in greater detail.

THE ESSENTIAL DIFFERENCE BETWEEN PERFECTLY AND IMPERFECTLY COMPETITIVE FIRMS In advanced economics courses, professors generally devote much attention to the analysis of subtle differences in the behavior of different types of imperfectly competitive firms. Far more important for our purposes, however, will be to focus on the single, common feature that differentiates all imperfectly competitive firms from their perfectly competitive counterparts—namely, that whereas the perfectly competitive firm faces a perfectly elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve. In the perfectly competitive industry, the supply and demand curves intersect to determine an equilibrium market price. At that price, the perfectly competitive firm can sell as many units as it wishes. It has no incentive to charge more than the market price because it won't sell anything if it does so. Nor does it have any incentive to charge less than the market price because it can sell as many units as it wants to at the market price. The perfectly competitive firm's demand curve is thus a horizontal line at the market price.

If the Sunoco station at State and Meadow Streets raised its gasoline prices by 3 cents per gallon, would all its customers shop elsewhere? By contrast, if a local gasoline retailer—an imperfect competitor—charges a few pennies more than its rivals for a gallon of gas, some of its customers may desert it. But others will remain, perhaps because they are willing to pay a little extra to continue stopping at their most convenient location. An imperfectly competitive firm thus faces a negatively sloped demand curve. Figure 8.1 summarizes this contrast between the demand curves facing perfectly competitive and imperfectly competitive firms. (FIGURE 8.1 The Demand Curves Facing Perfectly and Imperfectly Competitive Firms. (a) The demand curve confronting a perfectly competitive firm is perfectly elastic at the market price. (b) The demand curve confronting an imperfectly competitive firm is downward-sloping.)

PERFECT AND IMPERFECT COMPETITION The perfectly competitive market is an ideal; the actual markets we encounter in everyday life differ from the ideal in varying degrees. Economics texts usually distinguish among three types of imperfectly competitive market structures. The classifications are somewhat arbitrary, but they are quite useful in analyzing real-world markets. DIFFERENT FORMS OF IMPERFECT COMPETITION Farthest from the perfectly competitive ideal is the pure monopoly, a market in which a single firm is the lone seller of a unique product. The producer of Magic Cards is a pure monopolist, as are many providers of electric power. If the residents of Miami don't buy their electricity from Florida Power and Light Company, they simply do without. In between these two extremes are many different types of imperfect competition. We focus on two of them here: monopolistic competition and oligopoly.

Monopolistic Competition Oligopoly

EXCLUSIVE CONTROL OVER IMPORTANT INPUTS If a single firm controls an input essential to the production of a given product, that firm will have market power. For example, to the extent that some U.S. tenants are willing to pay a premium for office space in the country's tallest building, One World Trade Center, the owner of that building has market power. PATENTS AND COPYRIGHTS Patents give the inventors or developers of new products the exclusive right to sell those products for a specified period of time. By insulating sellers from competition for an interval, patents enable innovators to charge higher prices to recoup their product's development costs. Pharmaceutical companies, for example, spend millions of dollars on research in the hope of discovering new drug therapies for serious illnesses. The drugs they discover are insulated from competition for an interval—currently 20 years in the United States—by government patents. For the life of the patent, only the patent holder may legally sell the drug. This protection enables the patent holder to set a price above the marginal cost of production to recoup the cost of the research on the drug. In the same way, copyrights protect the authors of movies, software, music, books, and other published works. GOVERNMENT LICENSES OR FRANCHISES Yosemite Concession Services Corporation has an exclusive license from the U.S. government to run the lodging and concession operations at Yosemite National Park. One of the government's goals in granting this monopoly was to preserve the wilderness character of the area to the greatest degree possible. And indeed, the inns and cabins offered Page 208by Yosemite Concession Services Company blend nicely with the valley's scenery. No garish neon signs mar the national park as they do in places where rivals compete for the tourist's dollars. ECONOMIES OF SCALE AND NATURAL MONOPOLIES When a firm doubles all its factors of production, what happens to its output? If output exactly doubles, the firm's production process is said to exhibit constant returns to scale. If output more than doubles, the production process is said to exhibit increasing returns to scale, or economies of scale. When production is subject to economies of scale, the average cost of production declines as the number of units produced increases. For example, in the generation of electricity, the use of larger generators lowers the unit cost of production. The markets for such products tend to be served by a single seller, or perhaps only a few sellers, because having a large number of sellers would result in significantly higher costs. A monopoly that results from economies of scale is called a natural monopoly.

NETWORK ECONOMIES Although most of us don't care what brand of dental floss others use, many products do become much more valuable to us as more people use them. In the case of home videotape recorders, for instance, the VHS format's defeat of the competing Beta format was explained not by its superior picture quality—indeed, on most important technical dimensions, Beta was regarded by experts as superior to VHS. Rather, VHS won simply because it managed to gain a slight sales edge on the initial version of Beta, which could not record programs longer than one hour. Although Beta later corrected this deficiency, the VHS lead proved insuperable. Once the fraction of consumers owning VHS passed a critical threshold, the reasons for choosing it became compelling—variety and availability of tape rental, access to repair facilities, the capability to exchange tapes with friends, and so on. The VHS victory proved fleeting, however, since videotape players have now been all but completely displaced by DVD players and DVRs. A similar network economy helps to account for the dominant position of Microsoft's Windows operating system, which, as noted earlier, is currently installed in more than 80 percent of all personal computers. Because Microsoft's initial sales advantage gave software developers a strong incentive to write for the Windows format, the inventory of available software in the Windows format is now vastly larger than that for any competing operating system. And although general-purpose software such as word processors and spreadsheets continues to be available for multiple operating systems, specialized professional software and games usually appear first—and often only—in the Windows format. This software gap and the desire to achieve compatibility for file sharing gave people a good reason for choosing Windows, even if, as in the case of many Apple Macintosh users, they believed a competing system was otherwise superior. But, again, network dominance need not be permanent, as witnessed by Apple's dramatic resurgence in recent years. By far the most important and enduring of these sources of market power are economies of scale and network economies. Lured by economic profit, firms almost always find substitutes for exclusive inputs. If there's enough profit to be had by renting out space in this country's tallest building, some real estate developer will eventually build one taller than One World Trade Center in New York. Likewise, firms can often evade patent laws by making slight changes in design of products. Patent protection is only temporary, in any case. Finally, governments grant very few franchises each year. But economies of scale are both widespread and enduring, even if not completely insurmountable. Firmly entrenched network economies can be as persistent a source of natural monopoly as economies of scale. Indeed, network economies are essentially similar to economies of scale. When network economies are of value to the consumer, a product's quality increases as the number of users increases, so we can say that any given quality level can be produced at lower cost as sales volume increases. Thus network economies may be viewed as just another form of economies of scale in production, and that's how we'll treat them here.Page 209 (RECAP FIVE SOURCES OF MARKET POWER A firm's power to raise its price without losing its entire market stems from exclusive control of important inputs, patents and copyrights, government licenses, economies of scale, or network economies. By far the most important and enduring of these are economies of scale and network economies.)

Our concern in this chapter was the conduct and performance of the imperfectly competitive firm, a firm that has at least some latitude to set its own price. Economists often distinguish among three different types of imperfectly competitive firms: the pure monopolist, the lone seller of a product in a given market; the oligopolist, one of only a few sellers of a given product; and the monopolistic competitor, one of a relatively large number of firms that sell similar though slightly differentiated products. (LO1) Although advanced courses in economics devote much attention to differences in behavior among these three types of firms, our focus was on the common feature that differentiates them from perfectly competitive firms. Whereas the perfectly competitive firm faces an infinitely elastic demand curve for its product, the imperfectly competitive firm faces a downward-sloping demand curve. For convenience, we use the term monopolist to refer to any of the three types of imperfectly competitive firms. (LO1) Unlike the perfectly competitive firm, for which marginal revenue exactly equals market price, the monopolist realizes a marginal revenue that is always less than its price. This shortfall reflects the fact that to sell more output, the monopolist must cut the price not only to additional buyers but to existing buyers as well. For the monopolist with a straight-line demand curve, the marginal revenue curve has the same vertical intercept and a horizontal intercept that is half as large as the intercept for the demand curve. (LO1) Monopolists are sometimes said to enjoy market power, a term that refers to their power to set the price of their product. Market power stems from exclusive control over important inputs, from economies of scale, from patents and government licenses or franchises, and from network economies. The most important and enduring of these five sources of market power are economies of scale and network economies. (LO2)

Research, design, engineering, and other fixed costs account for an increasingly large share of all costs required to bring products successfully to market. For products with large fixed costs, marginal cost is lower, often substantially, than average total cost, and average total cost declines, often sharply, as output grows. This cost pattern explains why many industries are dominated by either a single firm or a small number of firms. (LO3) Whereas the perfectly competitive firm maximizes profit by producing at the level at which marginal cost equals the market price, the monopolist maximizes profit by equating marginal cost with marginal revenue, which is significantly lower than the market price. The result is an output level that is best for the monopolist but smaller than the level that would be best for society as a whole. At the profit-maximizing level of output, the benefit of an extra unit of output (the market price) is greater than its cost (the marginal cost). At the socially efficient level of output, where the monopolist's marginal cost curve intersects the demand curve, the benefit and cost of an extra unit are the same. (LO4, LO5) Both the monopolist and its potential customers can do better if the monopolist can grant discounts to price-sensitive buyers. The extreme example is the perfectly discriminating monopolist, who charges each buyer exactly his or her reservation price. Such producers are socially efficient because they sell to every buyer whose reservation price is at least as high as the marginal cost. (LO6) The various policies that governments employ to mitigate concerns about fairness and efficiency losses arising from natural monopoly include state ownership and management Page 231of natural monopolies, state regulation, private contracting, and vigorous enforcement of antitrust laws. Each of these remedies entails costs as well as benefits. In some cases, a combination of policies will produce a better outcome than simply allowing natural monopolists to do as they please. But in other cases, a hands-off policy may be the best available option. (LO7)

PUBLIC POLICY TOWARD NATURAL MONOPOLY Monopoly is problematic not only because of the loss in efficiency associated with restricted output, but also because the monopolist earns an economic profit at the buyer's expense. Many people are understandably uncomfortable about having to purchase from the sole provider of any good or service. For this reason, voters in many societies have empowered government to adopt policies aimed at controlling natural monopolists. There are several ways to achieve this aim. A government may assume ownership and control of a natural monopoly, or it may merely attempt to regulate the prices it charges. In some cases, government solicits competitive bids from private firms to produce natural monopoly services. In still other cases, governments attempt to dissolve natural monopolies into smaller entities that compete with one another. But many of these policies create economic problems of their own. In each case, the practical challenge is to come up with the solution that yields the greatest surplus of benefits over costs. Natural monopoly may be inefficient and unfair, but, as noted earlier, the alternatives to natural monopoly are far from perfect.

STATE OWNERSHIP AND MANAGEMENT Natural monopoly is inefficient because the monopolist's profit-maximizing price is greater than its marginal cost. But even if the natural monopolist wanted to set price equal to marginal cost, it could not do so and hope to remain in business. After all, the defining feature of a natural monopoly is economies of scale in production, which means that marginal cost will always be less than average total cost. Setting price equal to marginal cost would fail to cover average total cost, which implies an economic loss. Consider the case of a local cable television company. Once an area has been wired for cable television, the marginal cost of adding an additional subscriber is very low. For the sake of efficiency, all subscribers should pay a price equal to that marginal cost. Yet a cable company that priced in this manner would never be able to recover the fixed cost of setting up the network. This same problem applies not just to cable television companies but to all other natural monopolies. Even if such firms wanted to set price equal to marginal cost (which, of course, they do not since they will earn more by setting marginal revenue equal to marginal cost), they cannot do so without suffering an economic loss. One way to attack the efficiency and fairness problems is for the government to take over the industry, set price equal to marginal cost, and then absorb the resulting losses out of general tax revenues. This approach has been followed with good results in the state-owned electric utility industry in France, whose efficient pricing methods have set the standard for electricity pricing worldwide. Incentive But state ownership and efficient management do not always go hand in hand. Granted, the state-owned natural monopoly is free to charge marginal cost, while the private natural monopoly is not. Yet the Incentive Principle directs our attention to the fact that private natural monopolies often face a much stronger incentive to cut costs than their government-owned counterparts. When the private monopolist figures out a way to cut $1 from the cost of production, its profit goes up by $1. But when the government manager of a state-owned monopoly cuts $1 from the cost of production, the government typically cuts the monopoly's budget by $1. Think back to your last visit to the Department of Motor Vehicles. Did it strike you as an efficiently managed organization? Whether the efficiency that is gained by being able to set price equal to marginal cost outweighs the inefficiency that results from a weakened incentive to cut costs is an empirical question.

If the video games the two firms produce are essentially similar, the fact that Sony can charge significantly lower prices and still cover its costs should enable it to attract customers away from Nintendo. As more and more of the market goes to Sony, its cost advantage will become self-reinforcing. Table 8.3 shows how a shift of 500,000 units from Nintendo to Sony would cause Nintendo's average total cost to rise to $20.20 per unit, while Sony's average total cost would fall to $6.08 per unit. The fact that a firm cannot long survive at such a severe disadvantage explains why the video game market is served now by only a small number of firms. CONCEPT CHECK 8.1 How big will Sony's unit cost advantage be if it sells 2,000,000 units per year, while Nintendo sells only 200,000? An important worldwide economic trend during recent decades is that an increasing share of the value embodied in the goods and services we buy stems from fixed investment in research and development. For example, in 1984 some 80 percent of the cost of a computer was in its hardware (which has relatively high marginal cost); the remaining 20 percent was in its software. But by 1990 those proportions were reversed. Fixed cost now accounts for about 85 percent of total costs in the computer software industry, whose products are included in a growing share of ordinary manufactured goods.

The Economic Naturalist 8.1 Why does Intel sell the overwhelming majority of all microprocessors used in personal computers? The fixed investment required to produce a new leading-edge microprocessor such as the Intel Core i7 Extreme Mobile microprocessor runs upward of several billion dollars. But once the chip has been designed and the manufacturing facility built, the marginal cost of producing each chip is only pennies. This cost pattern explains why Intel currently sells more than 80 percent of all microprocessors. As fixed cost becomes more and more important, the perfectly competitive pattern of many small firms, each producing only a small share of its industry's total output, becomes less common. For this reason, we must develop a clear sense of how the behavior of firms with market power differs from that of the perfectly competitive firm. RECAP ECONOMIES OF SCALE AND THE IMPORTANCE OF START-UP COSTS Research, design, engineering, and other fixed costs account for an increasingly large share of all costs required to bring products successfully to market. For products with large fixed costs, marginal cost is lower, often substantially, than average total cost, and average total cost declines, often sharply, as output grows. This cost pattern explains why many industries are dominated by either a single firm or a small number of firms.

In a perfectly competitive market, entrepreneurs would see this economic profit as cash on the table. It would entice them to offer Magic Cards at slightly lower prices so that, eventually, the cards would sell for roughly their cost of production, just as ordinary playing cards do. But Magic Cards have been on the market for years now, and that hasn't happened. The reason is that the cards are copyrighted, which means the government has granted the creators of the game an exclusive license to sell them.

The holder of a copyright is an example of an imperfectly competitive firm, or price setter—that is, a firm with at least some latitude to set its own price. The competitive firm, by contrast, is a price taker, a firm with no influence over the price of its product. Our focus in this chapter will be on the ways in which markets served by imperfectly competitive firms differ from those served by perfectly competitive firms. One salient difference is the imperfectly competitive firm's ability, under certain circumstances, to charge more than its cost of production. But if the producer of Magic Cards could charge any price it wished, why does it charge only $10? Why not $100, or even $1,000? We'll see that even though such a company may be the only seller of its product, its pricing freedom is far from absolute. We'll also see how some imperfectly competitive firms manage to earn an economic profit, even in the long run, and even without government protections like copyright. And we'll explore why Adam Smith's invisible hand is less in evidence in a world served by imperfectly competitive firms.

BEING A MONOPOLIST DOESN'T GUARANTEE AN ECONOMIC PROFIT The fact that the profit-maximizing price for a monopolist will always be greater than marginal cost provides no assurance that the monopolist will earn an economic profit. Consider, for example, the long-distance telephone service provider whose demand, marginal revenue, marginal cost, and average total cost curves are shown in Figure 8.8(a). This monopolist maximizes its daily profit by selling 20 million minutes per day of calls at a price of $0.10 per minute. At that quantity, MR = MC, yet price is $0.02 per minute less than the company's average total cost of $0.12 per minute. As a result, the company sustains an economic loss of $0.02 per minute on all calls provided, or a total loss of ($0.02 per minute)(20,000,000 minutes per day) = $400,000 per day. (FIGURE 8.8 Even a Monopolist May Suffer an Economic Loss. The monopolist in (a) maximizes its profit by selling 20 million minutes per day of calls but suffers an economic loss of $400,000 per day in the process. Because the profit-maximizing price of the monopolist in (b) exceeds ATC, this monopolist earns an economic profit.)

The monopolist in Figure 8.8(a) suffered a loss because its profit-maximizing price was lower than its ATC. If the monopolist's profit-maximizing price exceeds its average total cost, however, the company will, of course, earn an economic profit. Consider, for example, the long-distance provider shown in Figure 8.8(b). This firm has the same demand, marginal revenue, and marginal cost curves as the firm shown in Figure 8.8(a). But because the firm in (b) has lower fixed costs, its ATC curve is lower at every level of output than the ATC curve in (a). At the profit-maximizing price of $0.10 per minute, the firm in Figure 8.8(b) earns an economic profit of $0.02 per minute, for a total economic profit of $400,000 per day. RECAP PROFIT MAXIMIZATION FOR THE MONOPOLIST Both the perfectly competitive firm and the monopolist maximize profit by choosing the output level at which marginal revenue equals marginal cost. But whereas marginal revenue equals the market price for the perfectly competitive firm, it is always less than the market price for the monopolist. A monopolist will earn an economic profit only if price exceeds average total cost at the profit-maximizing level of output.

USING DISCOUNTS TO EXPAND THE MARKET The source of inefficiency in monopoly markets is the fact that the benefit to the monopolist of expanding output is less than the corresponding benefit to society. From the monopolist's point of view, the price reduction the firm must grant existing buyers to expand output is a loss. But from the point of view of those buyers, each dollar of price reduction is a gain—one dollar more in their pockets. Efficiency Note the tension in this situation, which is similar to the tension that exists in all other situations in which the economic pie is smaller than it might otherwise be. As the Efficiency Principle reminds us, when the economic pie grows larger, everyone can have a larger slice. To say that monopoly is inefficient means that steps could be taken to make some people better off without harming others. If people have a healthy regard for their own self-interest, why doesn't someone take those steps? Why, for example, doesn't the monopolist from the earlier examples sell 8 units of output at a price of $4, and then once those buyers are out the door, cut the price for more price-sensitive buyers? PRICE DISCRIMINATION DEFINED Sometimes the monopolist does precisely that. Charging different buyers different prices for the same good or service is a practice known as price discrimination. Examples of price discrimination include senior citizens' and children's discounts on movie tickets, supersaver discounts on air travel, and rebate coupons on retail merchandise. Attempts at price discrimination seem to work effectively in some markets, but not in others. Buyers are not stupid, after all; if the monopolist periodically offered a 50 percent discount on the $8 list price, those who were paying $8 might anticipate the next price cut and postpone their purchases to take advantage of it. In some markets, however, buyers may not know, or simply may not take the trouble to find out, how the price they pay compares to the prices paid by other buyers. Alternatively, the monopolist may be in a position to prevent some groups from buying at the discount prices made available to others. In such cases, the monopolist can price-discriminate effectively.

Why do many movie theaters offer discount tickets to students? Whenever a firm offers a discount, the goal is to target that discount to buyers who would not purchase the product without it. People with low incomes generally have lower reservation prices for movie tickets than people with high incomes. Because students generally have lower disposable incomes than working adults, theater owners can expand their audiences by charging lower prices to students than to adults. Student discounts are one practical way of doing so. Offering student discounts also entails no risk of some people buying the product at a low price and then reselling it to others at a higher price. Why do students pay lower ticket prices at many movie theaters? HOW PRICE DISCRIMINATION AFFECTS OUTPUT In the following examples, we'll see how the ability to price-discriminate affects the monopolist's profit-maximizing level of output. First we'll consider a baseline case in which the monopolist must charge the same price to every buyer.

EXAMPLES OF PRICE DISCRIMINATION Once you grasp the principle behind the hurdle method of price discrimination, you'll begin to see examples of it all around you. Next time you visit a grocery, hardware, or appliance store, for instance, notice how many different product promotions include cash rebates. Temporary sales are another illustration of the hurdle method. Most of the time, stores sell most of their merchandise at the "regular" price but periodically offer special sales at a significant discount. The hurdle in this instance is taking the trouble to find out when and where the sales occur and then going to the store during that period. This technique works because buyers who care most about price (mainly, those with low reservation prices) are more likely to monitor advertisements carefully and buy only during sale periods. To give another example, book publishers typically launch a new book in hardcover at a price from $20 to $30, and a year later they bring out a paperback edition priced between $5 and $15. In this instance, the hurdle involves having to wait the extra year and accepting a slight reduction in the quality of the finished product. People who are strongly concerned about price end up waiting for the paperback edition, while those with high reservation prices usually spring for the hardback. Or take the example of automobile producers, who typically offer several different models with different trim and accessories. Although GM's actual cost of producing a Cadillac may be only $2,000 more than its cost of producing a Chevrolet, the Cadillac's selling price may be $10,000 to $15,000 higher than the Chevrolet's. Buyers with low reservation prices purchase the Chevrolet, while those with high reservation prices are more likely to choose the Cadillac. Commercial air carriers have perfected the hurdle method to an extent matched by almost no other seller. Their supersaver fares are often less than half their regular coach fares. To be eligible for these discounts, travelers must purchase their tickets 7 to 21 days in advance and their journey must include a Saturday night stayover. Vacation travelers can more easily satisfy these restrictions than business travelers, whose schedules often change at the last moment and whose trips seldom involve Saturday stayovers. And—no surprise—the business traveler's reservation price tends to be much higher than the vacation traveler's. Many sellers employ not just one hurdle but several by offering deeper discounts to buyers who jump successively more difficult hurdles. For example, movie producers release their major films to first-run theaters at premium prices and then, several months later, to neighborhood theaters at a few dollars less. Still later they make the films available on pay-per-view cable channels, then release them on DVD, and finally permit them to be shown on network television. Each successive hurdle involves waiting a little longer and, in the case of the televised versions, accepting lower quality. These hurdles are remarkably effective in segregating moviegoers according to their reservation prices. Recall that the efficiency loss from single-price monopoly occurs because, to the monopolist, the benefit of expanding output is smaller than the benefit to society as a whole. The hurdle method of price discrimination reduces this loss by giving the monopolist a practical means of cutting prices for price-sensitive buyers only. In general, the more finely the monopolist can partition a market using the hurdle method, the smaller the efficiency loss. Hurdles are not perfect, however, and some degree of efficiency will inevitably be lost.

Why might an appliance retailer instruct its clerks to hammer dents into the sides of its stoves and refrigerators? The Sears "Scratch 'n' Dent Sale" is another example of how retailers use quality differentials to segregate buyers according to their reservation prices. Many Sears stores hold an annual sale in which they display appliances with minor scratches and blemishes in the parking lot at deep discounts. People who don't care much about price are unlikely to turn out for these events, but those with very low reservation prices often get up early to be first in line. Indeed, these sales have proven so popular that it might even be in a retailer's interest to put dents in some of its sale items deliberately. Would a profit-maximizing appliance retailer ever deliberately damage its own merchandise? RECAP USING DISCOUNTS TO EXPAND THE MARKET A price-discriminating monopolist is one who charges different prices to different buyers for essentially the same good or service. A common method of price discrimination is the hurdle method, which involves granting a discount to buyers who jump over a hurdle such as mailing in a rebate coupon. An effective hurdle is one that is more easily cleared by buyers with low reservation prices than by buyers with high reservation prices. Such a hurdle enables the monopolist to expand output and thereby reduce the deadweight loss from monopoly pricing.