The problem of inefficiency for monopolies

The problem of inefficiency for monopolies often runs even deeper than these issues, and also involves incentives for efficiency over longer periods of time. There are counterbalancing incentives here. On one side, firms may strive for new inventions and new intellectual property because they want to become monopolies and earn high profits—at least for a few years until the competition catches up. In this way, monopolies may come to exist because of competitive pressures on firms. However, once a barrier to entry is in place, a monopoly that does not need to fear competition can just produce the same old products in the same old way—while still ringing up a healthy rate of profit. John Hicks, who won the Nobel Prize for economics in 1972, wrote in 1935: “The best of all monopoly profits is a quiet life.” He did not mean the comment in a complimentary way. He meant that monopolies may bank their profits and slack off on trying to please their customers.

When AT&T provided all of the local and long-distance phone service in the United States, along with manufacturing most of the phone equipment, the payment plans and types of phones did not change much. The old joke was that you could have any color phone you wanted, as long as it was black. But in 1982, AT&T was split up by government litigation into a number of local phone companies, a long-distance phone company, and a phone equipment manufacturer. An explosion of innovation followed. Services like call waiting, caller ID, three-way calling, voice mail though the phone company, mobile phones, and wireless connections to the Internet all became available. A wide range of payment plans was offered, as well. It was no longer true that all phones were black; instead, phones came in a wide variety of shapes and colors. The end of the telephone monopoly brought lower prices, a greater quantity of services, and also a wave of innovation aimed at attracting and pleasing customers.

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The Rest is History In the opening case, the East India Company and the Confederate States were presented as a monopoly or near monopoly provider of a good. Nearly every American schoolchild knows the result of the ‘unwelcome visit’ the ‘Mohawks’ bestowed upon Boston Harbor’s tea-bearing ships—the Boston Tea Party. Regarding the cotton industry, we also know Great Britain remained neutral during the Civil War, taking neither side during the conflict.

Did the monopoly nature of these business have unintended and historical consequences? Might the American Revolution have been deterred, if the East India Company had sailed the tea-bearing ships back to England? Might the southern states have made different decisions had they not been so confident “King Cotton” would force diplomatic recognition of the Confederate States of America? Of course, it is not possible to definitively answer these questions; after all we cannot roll back the clock and try a different scenario. We can, however, consider the monopoly nature of these businesses and the roles they played and hypothesize about what might have occurred under different circumstances.

Perhaps if there had been legal free tea trade, the colonists would have seen things differently; there was smuggled Dutch tea in the colonial market. If the colonists had been able to freely purchase Dutch tea, they would have paid lower prices and avoided the tax.

What about the cotton monopoly? With one in five jobs in Great Britain depending on Southern cotton and the Confederate States nearly the sole provider of that cotton, why did Great Britain remain neutral during the Civil War? At the beginning of the war, Britain simply drew down massive stores of cotton. These stockpiles lasted until near the end of 1862. Why did Britain not recognize the Confederacy at that point? Two reasons: The Emancipation Proclamation and new sources of cotton. Having outlawed slavery throughout the United Kingdom in 1833, it was politically impossible for Great Britain, empty cotton warehouses or not, to recognize, diplomatically, the Confederate States. In addition, during the two years it took to draw down the stockpiles, Britain expanded cotton imports from India, Egypt, and Brazil.

Monopoly sellers often see no threats to their superior marketplace position. In these examples did the power of the monopoly blind the decision makers to other possibilities? Perhaps. But, as they say, the rest is history.

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allocative efficiency

barriers to entry



intellectual property

legal monopoly

marginal profit


natural monopoly


predatory pricing

trade secrets



producing the optimal quantity of some output; the quantity where the marginal benefit to society of one more unit just equals the marginal cost

the legal, technological, or market forces that may discourage or prevent potential competitors from entering a market

a form of legal protection to prevent copying, for commercial purposes, original works of authorship, including books and music

removing government controls over setting prices and quantities in certain industries

the body of law including patents, trademarks, copyrights, and trade secret law that protect the right of inventors to produce and sell their inventions

legal prohibitions against competition, such as regulated monopolies and intellectual property protection

profit of one more unit of output, computed as marginal revenue minus marginal cost

a situation in which one firm produces all of the output in a market

economic conditions in the industry, for example, economies of scale or control of a critical resource, that limit effective competition

a government rule that gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time

when an existing firm uses sharp but temporary price cuts to discourage new competition

methods of production kept secret by the producing firm

an identifying symbol or name for a particular good and can only be used by the firm that registered that trademark


9.1 How Monopolies Form: Barriers to Entry Barriers to entry prevent or discourage competitors from entering the market. These barriers include: economies of scale that lead to natural monopoly; control of a physical resource; legal restrictions on competition; patent, trademark and copyright protection; and practices to intimidate the competition like predatory pricing. Intellectual property refers to legally guaranteed ownership of an idea, rather than a physical item. The laws that protect intellectual property include patents, copyrights, trademarks, and trade secrets. A natural monopoly arises when economies of scale persist over a large enough range of output that if one firm supplies the entire market, no other firm can enter without facing a cost disadvantage.

9.2 How a Profit-Maximizing Monopoly Chooses Output and Price A monopolist is not a price taker, because when it decides what quantity to produce, it also determines the market price. For a monopolist, total revenue is relatively low at low quantities of output, because not much is being sold. Total revenue is also relatively low at very high quantities of output, because a very high quantity will sell only at a low price. Thus, total revenue for a monopolist will start low, rise, and then decline. The marginal revenue for a monopolist from selling additional units will decline. Each additional unit sold by a monopolist will push down the overall market price, and as more units are sold, this lower price applies to more and more units.

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The monopolist will select the profit-maximizing level of output where MR = MC, and then charge the price for that quantity of output as determined by the market demand curve. If that price is above average cost, the monopolist earns positive profits.

Monopolists are not productively efficient, because they do not produce at the minimum of the average cost curve. Monopolists are not allocatively efficient, because they do not produce at the quantity where P = MC. As a result, monopolists produce less, at a higher average cost, and charge a higher price than would a combination of firms in a perfectly competitive industry. Monopolists also may lack incentives for innovation, because they need not fear entry.

SELF-CHECK QUESTIONS 1. Classify the following as a government-enforced barrier to entry, a barrier to entry that is not government- enforced, or a situation that does not involve a barrier to entry.

a. A patented invention b. A popular but easily copied restaurant recipe c. An industry where economies of scale are very small compared to the size of demand in the market d. A well-established reputation for slashing prices in response to new entry e. A well-respected brand name that has been carefully built up over many years

2. Classify the following as a government-enforced barrier to entry, a barrier to entry that is not government- enforced, or a situation that does not involve a barrier to entry.

a. A city passes a law on how many licenses it will issue for taxicabs b. A city passes a law that all taxicab drivers must pass a driving safety test and have insurance c. A well-known trademark d. Owning a spring that offers very pure water e. An industry where economies of scale are very large compared to the size of demand in the market

3. Suppose the local electrical utility, a legal monopoly based on economies of scale, was split into four firms of equal size, with the idea that eliminating the monopoly would promote competitive pricing of electricity. What do you anticipate would happen to prices?

4. If Congress reduced the period of patent protection from 20 years to 10 years, what would likely happen to the amount of private research and development?

5. Suppose demand for a monopoly’s product falls so that its profit-maximizing price is below average variable cost. How much output should the firm supply? Hint: Draw the graph.

6. Imagine a monopolist could charge a different price to every customer based on how much he or she were willing to pay. How would this affect monopoly profits?


7. How is monopoly different from perfect competition?

8. What is a barrier to entry? Give some examples.

9. What is a natural monopoly?

10. What is a legal monopoly?

11. What is predatory pricing?

12. How is intellectual property different from other property?

13. By what legal mechanisms is intellectual property protected?

14. In what sense is a natural monopoly “natural”?

15. How is the demand curve perceived by a perfectly competitive firm different from the demand curve perceived by a monopolist?

16. How does the demand curve perceived by a monopolist compare with the market demand curve?

17. Is a monopolist a price taker? Explain briefly.

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18. What is the usual shape of a total revenue curve for a monopolist? Why?

19. What is the usual shape of a marginal revenue curve for a monopolist? Why?

20. How can a monopolist identify the profit- maximizing level of output if it knows its total revenue and total cost curves?

21. How can a monopolist identify the profit- maximizing level of output if it knows its marginal revenue and marginal costs?

22. When a monopolist identifies its profit-maximizing quantity of output, how does it decide what price to charge?

23. Is a monopolist allocatively efficient? Why or why not?

24. How does the quantity produced and price charged by a monopolist compare to that of a perfectly competitive firm?


25. ALCOA does not have the monopoly power it once had. How do you suppose their barriers to entry were weakened?

26. Why are generic pharmaceuticals significantly cheaper than name brand ones?

27. For many years, the Justice Department has tried to break up large firms like IBM, Microsoft, and most recently Google, on the grounds that their large market share made them essentially monopolies. In a global market, where U.S. firms compete with firms from other countries, would this policy make the same sense as it might in a purely domestic context?

28. Intellectual property laws are intended to promote innovation, but some economists, such as Milton Friedman, have argued that such laws are not desirable. In the United States, there is no intellectual property

protection for food recipes or for fashion designs. Considering the state of these two industries, and bearing in mind the discussion of the inefficiency of monopolies, can you think of any reasons why intellectual property laws might hinder innovation in some cases?

29. Imagine that you are managing a small firm and thinking about entering the market of a monopolist. The monopolist is currently charging a high price, and you have calculated that you can make a nice profit charging 10% less than the monopolist. Before you go ahead and challenge the monopolist, what possibility should you consider for how the monopolist might react?

30. If a monopoly firm is earning profits, how much would you expect these profits to be diminished by entry in the long run?

PROBLEMS 31. Return to Figure 9.2. Suppose P0 is $10 and P1 is $11. Suppose a new firm with the same LRAC curve as the incumbent tries to break into the market by selling 4,000 units of output. Estimate from the graph what the new firm’s average cost of producing output would be. If the incumbent continues to produce 6,000 units, how much output would be supplied to the market by the two firms? Estimate what would happen to the market price as a result of the supply of both the incumbent firm and the new entrant. Approximately how much profit would each firm earn?

32. Draw the demand curve, marginal revenue, and marginal cost curves from Figure 9.6, and identify the quantity of output the monopoly wishes to supply

and the price it will charge. Suppose demand for the monopoly’s product increases dramatically. Draw the new demand curve. What happens to the marginal revenue as a result of the increase in demand? What happens to the marginal cost curve? Identify the new profit-maximizing quantity and price. Does the answer make sense to you?

33. Draw a monopolist’s demand curve, marginal revenue, and marginal cost curves. Identify the monopolist’s profit-maximizing output level. Now, think about a slightly higher level of output (say Q0 + 1). According to the graph, is there any consumer willing to pay more than the marginal cost of that new level of output? If so, what does this mean?

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  • Chapter 9. Monopoly
    • 9.1. How Monopolies Form: Barriers to Entry*
    • 9.2. How a Profit-Maximizing Monopoly Chooses Output and Price*
    • Glossary

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