Chapter 12 MONOPOLY AND MONOPSONY QUESTIONS ...

Chapter 12 

MONOPOLY AND MONOPSONY 

QUESTIONS & ANSWERS 

Q12.1 Describe the monopoly market structure and provide some examples. 

Q12.1 ANSWER 

Monopoly is a market structure characterized by a single seller of a highly 

differentiated product. Because a monopolist is the sole provider of a desired 

commodity, the monopolist is the industry. Although the producer of every 

product faces at least some competition in the sense of competing for a share 

of the consumer's overall market basket of goods, monopolists face no 

effective competition from either established or potential rivals able to offer 

the same product. This allows the monopolist to simultaneously determine 

price and output levels for the firm (and the industry). Substantial barriers to 

entry or exit are often present, thereby deterring potential entrants and 

offering both efficient and inefficient monopolists the opportunity for excess 

profits, even in the long-run. 

Examples of monopoly markets include: local telephone service (or 

basic hook-up); municipal bus companies; and gas, water and electric utilities, 

among others. 

Q12.2 From a social standpoint, what is the problem with monopoly? 


The problem with monopoly from a social standpoint is that it leads to an 

inefficient allocation of productive resources and an inequitable allocation of 

income. From an efficiency perspective, monopolies produce too little output 

at too high a price. As a result, the demands of consumers are only partially 

met. Because P > MC, the marginal value of output (P) exceeds marginal 

production costs, and social welfare would rise with an increase in production. 

From an equity perspective, the excess profits that can arise due to 

unregulated monopoly are often criticized as unwarranted and thus unfair. 

Q12.3 Why are both industry and firm demand curves downward sloping in 

monopoly markets? 


Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance. 

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In monopoly, the firm is the industry. Thus, firm and industry demand and 

supply curves are identical. The monopoly demand curve will be downward 

sloping, like all industry demand curves, because this output must, to a 

greater or lesser degree, compete with all goods and services for a share in the 

consumer's market basket. The diminishing marginal utility associated with 

the consumption of all goods and services will ensure that the industry 

demand curve is downward sloping for all products. 

Q12.4 Give an example of monopoly in the labor market. Discuss such a 

monopoly's effect on wage rates and on inflation. 


With industrialization came a growing concentration on the purchase of labor 

services, and in some instances, this growing concentration was sufficient to 

create buyer (monopsony) power. Labor laws in the United States granted 

workers the right to unionize in order to create countervailing seller 

(monopoly) power in the market for labor services. The advantage of 

countervailing power is that markets characterized by monopsony-monopoly 

confrontation can sometimes lead to more efficient price-output combinations 

than markets characterized by uncontested buyer or seller power. 

Q12.5 Given the difficulties encountered with utility regulation, it has been 

suggested that nationalization might lead to a more socially optimal 

allocation of resources. Do you agree? Why or why not? 


This question is, of course, very subjective. However, experience suggests 

that economic efficiency is best served by vigorous competition in the 

marketplace. With utilities such competition is certainly limited, but private 

utilities must still compete for capital resources. This no doubt aids in the 

efficient allocation of scarce economic resources. With nationalization, even 

this role of competition in determining efficient resource use would be 

removed, and it seems unlikely that a nationalized firm with no profit 

incentive would operate at either an optimal output level, or facilitate an 

efficient allocation of resources. 

Q12.6 Antitrust statutes in the United States have been used to attack 

monopolization by big business. Does labor monopolization by giant unions 

have the same potential for the misallocation of economic resources? 


Economically speaking, the monopolization of labor can be as harmful as is 

the monopolization of big business. Both lead to a misallocation of economic 


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esources. From an efficiency standpoint, monopolization of both labor and 

business should be vigorously prosecuted. 

Q12.7 When will an increase in the minimum wage increase employment income for 

unskilled laborers? When will it cause this income to fall? Based on your 

experience, which is more likely? 


Demand analysis indicates that an increase in price will increase total revenue 

so long as demand is inelastic (|εP| < 1). Similarly, an increase in the 

minimum wage will increase employment income for unskilled workers so 

long as the demand for unskilled labor is inelastic. Unfortunately, the 

demand for unskilled labor may be quite elastic, given the propensity of 

consumers to substitute self-service labor for high-priced unskilled labor. 

Declining job opportunities for unskilled workers such as bus boys, caddies, 

gas station attendants, movie theater ushers, waitresses, and so on, suggest 

that increasing the minimum wage can hurt, rather than help, unskilled 

workers. 

Q12.8 Explain why state tax rates on personal income vary more on a state-by-state 

basis than do corresponding tax rates on corporate income. 


In considering state tax rates, it is interesting to note a greater variance from 

state to state in personal as opposed to corporate tax rates. This phenomena 

can be explained by the fact that corporations, more so than individuals, are 

willing to relocate to take advantage of state tax rate differentials. Individuals 

become attached to geographic locations and value geographic proximity to 

family and friends. As a result, individuals are often reluctant to move; the 

coal miners stayed in West Virginia long after the mines shut down. 

Corporations, on the other hand, exhibit few such ties to geographic location. 

This implies a higher tax revenue elasticity for corporate tax rate schedules 

than for personal tax rate schedules. 

Q12.9 Do the U.S. antitrust statutes protect competition or competitors? What is the 

difference? 


U.S. antitrust statutes are meant to protect competition (the fight), rather than 

currently active competitors (the fighters). Vigorous competition sometimes 

results in bankruptcy and exit for previously viable competitors. Moreover, 

there is not necessarily a close link between fewness in the number of 

competitors and the lack of competition. This point is sometimes overlooked 

in antitrust analysis. The important point to consider is that competition 


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equires viable competitors. With substantial economies of scale in an 

industry, for example, viable firms are going to be large. However, even a 

handful of firms can still be, and often are, vigorous competitors. 

Q12.10 Describe the economic effects of countervailing power, and cite examples of 

markets in which countervailing power is observed. 


Countervailing power exists in a market when buyer market power is used to 

offset the effects of seller market power, and vice versa. The effect of 

countervailing power is to reduce market prices and/or expand output in the 

case of new monopsony (buyer) power created to challenge established 

monopoly (seller) power. Similarly, new seller power created to challenge 

established buyer power has the effect of raising market prices and/or 

expanding output. 

In defense procurement, the monopsony (buyer) power of the federal 

government is often used to offset the monopoly (seller) power of singlesource 

defense contractors. Similarly, local governments use their buyer 

power to offset the seller power of local road and building contractors. The 

effects of countervailing power are also sometimes observed when large retail 

chains buy major appliances, car rental companies buy automobiles, and in 

several labor markets. 

SELF-TEST PROBLEMS & SOLUTIONS 

ST12.1 Capture Problem. It remains a widely held belief that regulation is in the 

public interest and influences firm behavior toward socially desirable ends. 

However, in the early 1970s, Nobel laureate George Stigler and his colleague 

Sam Peltzman at the University of Chicago introduced an alternative capture 

theory of economic regulation. According to Stigler and Peltzman, the 

machinery and power of the state are a potential resource to every industry. 

With its power to prohibit or compel, to take or give money, the state can and 

does selectively help or hurt a vast number of industries. Because of this, 

regulation may be actively sought by industry. They contended that 

regulation is typically acquired by industry and is designed and operated 

primarily for industry's benefit. 

Types of state favors commonly sought by regulated industries include 

direct money subsidies, control over entry by new rivals, control over 

substitutes and complements, and price fixing. Domestic "air mail" subsidies, 

Federal Deposit Insurance Corporation (FDIC) regulation that reduces the 

rate of entry into commercial banking, suppression of margarine sales by 

butter producers, price fixing in motor carrier (trucking) regulation, and 

American Medical Association control of medical training and licensing can 

be interpreted as historical examples of control by regulated industries. 

In summarizing their views on regulation, Stigler and Peltzman suggest that 


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egulators should be criticized for pro-industry policies no more than 

politicians for seeking popular support. Current methods of enacting and 

carrying out regulations only make the pro-industry stance of regulatory 

bodies more likely. The only way to get different results from regulation is to 

change the political process of regulator selection and to provide economic 

rewards to regulators who serve the public interest effectively. 

Capture theory is in stark contrast to more traditional public interest theory, 

which sees regulation as a government-imposed means of private-market 

control. Rather than viewing regulation as a "good" to be obtained, controlled, 

and manipulated, public interest theory views regulation as a method for 

improving economic performance by limiting the harmful effects of market 

failure. Public interest theory is silent on the need to provide regulators with 

economic incentives to improve regulatory performance. Unlike capture 

theory, a traditional view has been that the public can trust regulators to make 

a good-faith effort to establish regulatory policy in the public interest. 

A. The aim of antitrust and regulatory policy is to protect competition, not 

to protect competitors. Explain the difference. 

B. Starting in the 1970s, growing dissatisfaction with traditional 

approaches to government regulation led to a global deregulation 

movement that spurred competition, lowered prices, and resulted in 

more efficient production. Explain how this experience is consistent 

with the capture theory of regulation. 

C. Discuss how regulatory efficiency could be improved by focusing on 

output objectives like low prices for cable or telephone services rather 

than production methods or rates of return. 

ST12.1 SOLUTION 

A. Entry and exit are common facts of life in competitive markets. Firms that 

efficiently produce goods and services that consumers crave are able to boost 

market share and enjoy growing revenues and profits. Firms that fail to 

measure up in the eyes of consumers will lose market share and suffer 

declining revenues and profits. The disciplining role of competitive markets 

can be swift and harsh, even for the largest and most formidable corporations. 

For example, in August, 2000, Enron Corp. traded in the stock market at an 

all-time high and was ranked among the 10 most valuable corporations in 

America. Nevertheless, Enron filed for bankruptcy just 16 months later as 

evidence emerged of a failed diversification strategy, misguided energy 

trading, and financial corruption. Similarly, once powerful telecom giant 

WorldCom quickly stumbled into bankruptcy as evidence came to light 

concerning the companys abuse of accounting rules and regulations. In both 

cases, once powerful corporations were brought to their knees by competitive 


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capital and product markets that simply refused to tolerate inefficiency and 

corporate malfeasance. 

In evaluating the effects of deregulation, and in gauging the competitive 

implications of market exit by previously regulated firms, it is important to 

remember that protecting competition is not the same as protecting 

competitors. Without regulation, it is inevitable that some competitors will 

fall by the wayside and that concentration will rise in some previously 

regulated markets. Although such trends must be watched closely for anticompetitive 

effects, they are characteristics of a vigorously competitive 

environment. Bankruptcy and exit are the regrettable costs of remedying 

economic dislocation in competitive markets. Though such costs are 

regrettable, experience shows that they are much less onerous than the costs 

of indefinitely maintaining inefficient production methods in a tightly 

regulated environment. 

B. Although it is difficult to pinpoint a single catalyst for the deregulation 

movement, it is hard to overlook the role played by George Stigler, Sam 

Peltzman, Alfred E. Kahn, and other economists who documented how 

government regulation can sometimes harm consumer interests. A study by 

the Brookings Institution documented important benefits of deregulation in 

five major industries--natural gas, telecommunications, airlines, trucking, and 

railroads. It was found that prices fell 4-15% within the first two years after 

deregulation; within 10 years, prices were 25-50% lower. Deregulation also 

leads to service quality improvements. Crucial social goals like airline safety, 

reliability of gas service, and reliability of the telecommunications network 

were maintained or improved by deregulation. Regulatory reform also tends 

to confer benefits on most consumers. Although it is possible to find 

narrowly defined groups of customers in special circumstances who paid 

somewhat higher prices after deregulation, the gains to the vast majority of 

consumers far outweighed negative effects on small groups. Finally, 

deregulation offers benefits in the sense of permitting greater customer choice. 

Although many industries have felt the effects of changing state and 

local regulation, changing federal regulation has been most pronounced in the 

financial, telecommunications, and transportation sectors. Since 1975, for 

example, it has been illegal for securities dealers to fix commission rates. 

This broke a 182-year tradition under which the New York Stock Exchange 

(NYSE) set minimum rates for each 100-share ("round lot") purchase. Until 

1975, everyone charged the minimum rate approved by the NYSE. Purchase 

of 1,000 shares cost a commission of ten times the minimum, even though the 

overhead and work involved are roughly the same for small and large stock 

transactions. Following deregulation, commission rates tumbled, and, 

predictably, some of the least efficient brokerage firms merged or otherwise 

went out of business. Today, commission rates have fallen by 90% or more, 

and the industry is noteworthy for increasing productivity and innovative new 

product introductions. It is also worth mentioning that since brokerage rates 

were deregulated, the number of sales offices in the industry, trading volume, 


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employment, and profits have skyrocketed. This has lead some observers to 

conclude that deregulation can benefit consumers without causing any lasting 

damage to industry. In fact, a leaner, more efficient industry may be one of 

the greatest benefits of deregulation. 

In Canada, the deregulation movement led to privatization of governmentowned 

Air Canada. Trucking, historically a regulated industry, also was 

deregulated. Specialized telecommunications services industries were 

deregulated and thrown open to competition. In other areas where the 

government considered continued regulation desirable and necessary, 

regulatory agencies were pressured to reform and improve the regulatory 

decision-making process to reduce inefficiencies, bureaucratic delays, and 

administrative red tape. 

C. A significant problem with regulation is that regulators seldom have the 

information or expertise to specify, for example, the correct level of utility investment, 

minimum transportation costs, or the optimum method of pollution control. Because 

technology changes rapidly in most regulated industries, only industry personnel working 

at the frontier of current technology have such specialized knowledge. One method for 

dealing with this technical expertise problem is to have regulators focus on the preferred 

outcomes of regulatory processes, rather than on the technical means that industry adopts 

to achieve those ends. The FCC's decision to adopt downward-adjusting price caps for 

long-distance telephone service is an example of this developing trend toward incentivebased 

regulation. If providers of long-distance telephone service are able to reduce costs 

faster than the FCC-mandated decline in prices, they will enjoy an increase in 

profitability. By setting price caps that fall over time, the FCC ensures that consumers 

share in expected cost savings while companies enjoy a positive incentive to innovate. 

This approach to regulation focuses on the objectives of regulation while allowing 

industry to meet those goals in new and unique ways. Tying regulator rewards and 

regulated industry profits to objective, output-oriented performance criteria has the 

potential to create a desirable win/win situation for regulators, utilities, and the general 

public. For example, the public has a real interest in safe, reliable, and low-cost electric 

power. State and federal regulators who oversee the operations of utilities could develop 

objective standards for measuring utility safety, reliability, and cost efficiency. Tying 

firm profit rates to such performance-oriented criteria could stimulate real improvements 

in utility and regulator performance. 

Although some think that there is simply a question of regulation versus 

deregulation, this is seldom the case. On grounds of economic and political 

feasibility, it is often most fruitful to consider approaches to improving 

existing methods of regulation. Competitive forces provide a persistent and 

socially desirable constraining influence on firm behavior. When vigorous 

competition is absent, government regulation can be justified through both 

efficiency and equity criteria. When regulation is warranted, business, 

government, and the public must work together to ensure that regulatory 

processes represent the public interest. The unnecessary costs of antiquated 

regulations dictate that regulatory reform is likely to remain a significant 

social concern. 


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ST12.2 Deadweight Loss From Monopoly. The Las Vegas Valley Water District 

(LVVWD) is a not-for-profit agency that began providing water to the Las 

Vegas Valley in 1954. The District helped build the city's water delivery 

system and now provides water to more than one million people in Southern 

Nevada. District water rates are regulated by law and can cover only the 

costs of water delivery, maintenance, and facilities. District water rates are 

based on a four-tier system to encourage conservation. The first tier 

represents indoor usage for most residential customers. Rate for remaining 

tiers becomes increasingly higher with the amount of water usage. 

To document the deadweight loss from monopoly problem, allow the 

monthly market supply and demand conditions for water in the Las Vegas 

Water District to be: 

QS = 10P (Market Supply) 

QD = 120 - 40P (Market Demand) 

where Q is water and P is the market price of water. Water is sold in units of 

one thousand gallons, so a $2 price implies a user cost of 0 .2 cents per 

gallon. Water demand and supply relations are expressed in terms of 

millions of units. 

A. Graph and calculate the equilibrium price/output solution. How much 

consumer surplus, producer surplus, and social welfare is produced at 

this activity level? 

B. Use the graph to help you calculate the quantity demanded and quantity 

supplied if the market is run by a profit-maximizing monopolist. (Note: 

If monopoly market demand is P = $3 - $0.025Q, then the monopolists 

MR = $3 - $0.05Q) 

C. Use the graph to help you determine the deadweight loss for 

consumers and the producer if LVVWD is run as an unregulated 

profit-maximizing monopoly. 

D. Use the graph to help you ascertain the amount of consumer surplus 

transferred to producers following a change from a competitive 

market to a monopoly market. How much is the net gain in 

producer surplus? 

ST12.2 SOLUTION 

A. The market supply curve is given by the equation 

QS = 10P 


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or, solving for price, 

P = 0.1QS 

The market demand curve is given by the equation 

QD = 120 - 40P 


40P = 120 - QD 

P = $3 - $0.025QD 

To find the competitive market equilibrium price, equate the market 

demand and market supply curves where quantity is expressed as a function 

of price: 

Supply = Demand 


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10P = 120 - 40P 

50P = 120 

P = $2.40 

To find the competitive market equilibrium quantity, set equal the 

market supply and market demand curves where price is expressed as a 

function of quantity, and QS = QD: 


$0.1Q = $3 - $0.025Q 

0.125Q = 3 

Q = 24 (million) units per month 

Therefore, the competitive market equilibrium price-output combination 

is a market price of $2.40 with an equilibrium output of 24 (million) units. 

The value of consumer surplus is equal to the region under the market 

demand curve that lies above the market equilibrium price of $2.40. Because 

the area of such a triangle is one-half the value of the base times the height, 

the value of consumer surplus equals:

Consumer Surplus = [24 ($3 - $2.40)] 


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= $7.2 (million) per month 

In words, this means that at a unit price of $2.40, the quantity demanded is 24 

(million), resulting in total revenues of $57.6 (million). The fact that 

consumer surplus equals $7.2 (million) means that customers as a group 

would have been willing to pay an additional $7.2 (million) for this level of 

market output. This is an amount above and beyond the $57.6 (million) paid. 

Customers received a real bargain. 

The value of producer surplus is equal to the region above the market 

supply curve at the market equilibrium price of $2.40. Because the area of 

such a triangle is one-half the value of the base times the height, the value of 

producer surplus equals: 

Producer Surplus = [24 ($2.40 - $0)] 


At a water price of $2.40 per thousand gallons, producer surplus equals $28.8 

(million). Producers as a group received $28.8 (million) more than the 

absolute minimum required for them to produce the market equilibrium 

output of 24 (million) units of output. Producers received a real bargain. 

In competitive market equilibrium, social welfare is measured by the 

sum of net benefits derived by consumers and producers. Social welfare is 

the sum of consumer surplus and producer surplus: 

Social Welfare = Consumer Surplus + Producer Surplus 

= $7.2 (million) + $28.8 (million) 

= $36 (million) per month 

B. If the industry is run by a profit-maximizing monopolist, the optimal priceoutput 

combination can be determined by setting marginal revenue equal to 

marginal cost and solving for Q: 

MR = MC = Market Supply 

$3 - $0.05Q = $0.1Q 

$0.15Q = $3 

Q = 20 (million) units per month

At Q = 20, 


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P = $3 - $0.025Q 

= $3 - $0.025(20) 

= $2.50 per unit 

C. Under monopoly, the amount supplied falls to 20 (million) units and the 

market price jumps to $2.50 per thousand gallons of water. The amount of 

deadweight loss from monopoly suffered by consumers is given by the 

triangle bounded by ABD in the figure. Because the area of such a triangle is 

one-half the value of the base times the height, the value of lost consumer 

surplus due to monopoly equals: 

Consumer Deadweight Loss = [(24 - 20) ($2.50 - $2.40)] 


The amount of deadweight loss from monopoly suffered by producers is 

given by the triangle bounded by BCD. Because the area of a such a triangle 

is one-half the value of the base times the height, the value of lost producer 

surplus equals: 

Producer Deadweight Loss = [(24 - 20) ($2.40 - $2)] 


The total amount of deadweight loss from monopoly suffered by consumers 

and producers is given by the triangle bounded by ACD. The area of a such a 

triangle is simply the amount of consumer deadweight loss plus producer 

deadweight loss: 

Total Deadweight Loss = Consumer Loss + Producer Loss 

= $0.2 (million) + $0.8 (million) 


D. In addition to the deadweight loss from monopoly problem, there is a wealth 

transfer problem associated with monopoly. The creation of a monopoly 

results in a significant transfer from consumer surplus to producer surplus. In 

the figure, this amount is shown as the area in the rectangle bordered by 

PCMPMAB: 

Transfer to Producer Surplus = 20 ($2.50 - $2.40)


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Therefore, from the viewpoint of the producer, the change to monopoly 

results in a very favorable net increase in producer surplus: 

Net Change in Producer Surplus = Producer Deadweight Loss + Transfer 

= -$0.8 (million) + $2 (million) 

= $1. 2 (million) per month 

From the viewpoint of consumers, the problem with monopoly is 

twofold. Monopoly result in both a significant deadweight loss in consumer 

surplus ($0.2 million per month), and monopoly causes a significant transfer 

of consumer surplus to producer surplus ($2 million per month). In this 

example, the cost of monopoly to consumers is measured by a total loss in 

consumer surplus of $2.2 million per month. The wealth transfer problem 

associated with monopoly is seen as an issue of equity or fairness because it 

involves the distribution of income or wealth in the economy. Although 

economic profits serve the useful functions of providing incentives and 

helping allocate resources, it is difficult to justify monopoly profits that result 

from the raw exercise of market power rather than from exceptional 

performance. 

PROBLEMS & SOLUTIONS 

P12.1 Monopoly Concepts. Indicate whether each of the following statements is 

true or false, and explain why. 

A. The Justice Department generally concerns itself with significant or 

flagrant offenses under the Sherman Act, as well as with mergers for 

monopoly covered by Section 7 of the Clayton Act. 

B. When a single seller is confronted in a market by many small buyers, 

monopsony power enables the buyers to obtain lower prices than those 

that would prevail in a competitive markets. 

C. A natural monopoly results when the profit-maximizing output level 

occurs at a point where long-run average costs are declining. 

D. Downward-sloping industry demand curves characterize both perfectly 

competitive and monopoly markets. 

E. A decrease in the price elasticity of demand would follow an increase in 

monopoly power.

P12.1 SOLUTION 

A. True. Generally speaking, the Justice Department concerns itself with 

significant or flagrant offenses under the Sherman Act, as well as with 

mergers for monopoly covered by Section 7 of the Clayton Act. 

B. False. When a single buyer is confronted in a market by many smaller sellers, 

monopsony power enables the buyer to obtain lower prices than those that 

would prevail in a competitive markets. 

C. False. A natural monopoly occurs in a market when the market clearing price, 

or price where Demand (Price) = Supply (Marginal Cost), occurs at an output 

level where long-run average costs are declining. 

D. True. Downward sloping demand curves follow from the law of diminishing 

marginal utility and characterize both perfectly competitive and monopoly 

market structures. 

E. True. A decrease in the price elasticity of demand would result following an 

increase in monopoly power. 

P12.2 Natural Monopoly. On May 12, 2000, the two daily newspapers in Denver, 

Colorado, filed an application with the U.S. Department of Justice for 

approval of a joint operating agreement. The application was filed by The 

E.W. Scripps Company, whose subsidiary, the Denver Publishing Company, 

published the Rocky Mountain News, and the MediaNews Group, Inc., whose 

subsidiary, the Denver Post Corporation, published the Denver Post. Under 

the proposed arrangement, printing and commercial operations of both 

newspapers were to be handled by a new entity, the Denver Newspaper 

Agency, owned by the parties in equal shares. This type of joint operating 

agreement provides for the complete independence of the news and editorial 

departments of the two newspapers. The rationale for such an arrangement, 

as provided for under the Newspaper Preservation Act, is to preserve 

multiple independent editorial voices in towns and cities too small to support 

two or more newspapers. The Act requires joint operating arrangements, 

such as that proposed by the Denver newspapers, obtain the prior written 

consent of the Attorney General of the United States in order to qualify for 

the antitrust exemption provided by the Act. 

Scripps initiated discussions for a joint operating agreement after 

determining that the News would probably fail without such an arrangement. 

In their petition to the Justice department, the newspapers argued that the 

News had sustained $123 million in net operating losses while the financially 

stronger Post had reaped $200 million in profits during the 1990s. This was 

a crucial point in favor of the joint operating agreement application because 

the Attorney General must find that one of the publications is a failing 


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newspaper and that approval of the arrangement is necessary to maintain the 

independent editorial content of both newspapers. Like any business, 

newspapers cannot survive without a respectable bottom line. In commenting 

on the joint operating agreement application, Attorney General Janet Reno 

noted that Denver was one of only five major American cities still served by 

competing daily newspapers. The other four are Boston, Chicago, New York, 

and Washington, D.C. Of course these other four cities are not comparable 

in size to Denver; theyre much bigger. None of those four cities can lay claim 

to two newspapers that are more or less equally matched and strive after the 

same audience. 

A. Use the natural monopoly concept to explain why there is not a single 

city in the U.S. that still supports two independently owned and evenly 

matched, high-quality newspapers that vie for the same broad base of 

readership. 

B. On Friday January 5, 2001, Attorney General Reno gave the green light 

to a 50-year joint operating agreement between News and its longtime 

rival, the Post. Starting January 22, 2001, the publishing operations of 

the News and the Post were consolidated. At the time the joint 

operating agreement was formed, neither news organization would 

speculate on job losses or advertising and circulation rate increases 

from the deal. Based upon your knowledge of natural monopoly, would 

you predict an increase or decrease in prices following establishment of 

the joint operating agreement? Would you expect newspaper 

production (and employment) to rise or fall? Why? 


A. Economies of scale in production explain why few cities can support more 

than one local newspaper. Local newspapers are the classic example of 

natural monopoly. Almost all production and distribution costs are fixed. 

Marginal production and distribution costs are almost nil. Once the local 

news stories and local advertising copy are written, there is practically no 

additional cost involved with expanding production from, say, 200,000 to 

300,000 newspapers per day. Once a daily edition is produced, marginal 

costs may be as little as 5 per newspaper. When marginal production costs 

are minimal, price competition turns vicious. Whichever competitor is out in 

front in terms of total circulation simply keeps prices down until the 

competition goes out of business or is forced into accepting a joint operating 

agreement. This is exactly what happened in Denver. Until 2001, the cost of 

a daily newspaper in Denver was only 25 each weekday and 50 on Sunday at 

the newsstand, and even less when purchased on an annual subscription basis. 

The smaller News had much higher unit costs and simply couldnt afford to 

compete with the Post at such ruinously low prices. 


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B. Starting January 22, 2001, the publishing operations of the News and the Post 

were consolidated. The Denver Newspaper Agency, owned 50/50 by the 

owners of the News and Post, is now responsible for the advertising, 

circulation, production and other business departments of the newspapers. 

Newsrooms and editorial functions remain independent. Therefore, the 

owners of the News and Post are now working together to achieve financial 

success, but the newsroom operations remain competitors. Under terms of 

the agreement, E.W. Scripps Co., parent of the struggling News, agreed to pay 

owners of the Post $60 million. Both newspapers publish separately Monday 

through Friday. The News publishes the only Saturday paper and the Post the 

only Sunday paper. 

At the time the joint operating agreement was formed, neither news 

organization would speculate on job losses or advertising and circulation rate 

increases from the deal. Both proclaimed that neither job losses nor rate 

increases would be substantial. In fact, the company announced significant 

job cuts and steep advertising rate increases in the period following formation 

of the joint operating agreement. For example, Jake Jabs, who owns the 

American Furniture Warehouse chain in Denver, said his contract came up 

for renewal in February, 2001, and joint operating agreement executives said 

theyd keep his rates the same until they could negotiate a new agreement in 

March, 2001. However, in March, 2001, newspaper officials proposed a new 

fouryear contract for Jabs that required ads in both papers, with a 100% rate 

increase the first year, and 25% per year for the following three years. Jabs 

and other major local advertisers were so incensed that they sued in federal 

court. They lost. In early 2001, U. S. District Judge John Kane Jr. rejected a 

preliminary injunction sought by Jabs and a coalition of retailers called 

Coloradans Against Newspaper Monopolies. They wanted to roll back new 

ad rates at the News and the Post, and accused the papers of violating 

advertisers free speech rights by raising ad rates too high. Kane found no 

authority in support of the alleged constitutional violation, and the suit was 

dismissed. Kane said antitrust laws prohibiting business monopolies dont 

apply to newspapers in joint operating agreements. 

The circulations of the Post and the News fell sharply after the two 

newspapers dropped deep discounts on subscription rates. In the first two 

months after the two papers combined business operations and began sharing 

profits, the News lost 17.9 percent of its Monday through Saturday circulation 

and the Post lost 11.9 percent. The News Monday-through-Saturday 

circulation dropped from 446,465 to 366,499, and Post circulation dropped 

from 413,730 to 364,451. Sunday circulation for the News dropped from 

552,085 to 448,032, and the Posts Sunday circulation dropped from 558,560 

to 522,903. Despite the losses, both papers remain among the top 20 largest 

weekday papers in the nation. Combined circulation places the Sunday Post 

as the fifth-largest Sunday paper in the nation, with 970,935. The top four 

Sunday papers are The New York Times, The Washington Post, the Los 

Angeles Times and the Chicago Tribune. 


- 15 -

P12.3 Price Fixing. An antitrust case launched more than a decade ago sent 

tremors throughout the academic community. Over the 1989 -91 period, the 

Department of Justice (DOJ) investigated a number of highly selective 

private colleges for price fixing. The investigation focused on overlap group 

meetings comprised of about half of the most selective private colleges and 

universities in the United States. The group included 23 colleges, from small 

liberal arts schools like Colby, Vassar, and Middlebury to larger research 

universities like Princeton and MIT. DOJ found that when students applied 

to more than one of the 23 institutions, school officials met to coordinate the 

exact calculation of such students financial need. 

Although all of the overlap colleges attempted to use the same need 

formula, difficult-to-interpret information from students and parents 

introduced some variation into their actual need calculations. DOJ alleged 

that the meetings enabled the colleges to collude on higher tuition and to 

increase their tuition revenue. The colleges defended their meetings, saying 

that they needed coordination to fully cover the needs of students from lowincome 

families. Although colleges want able needy students to add diversity 

to their student body, no college can afford a disproportionate share of needy 

students simply because it makes relatively generous need calculations. 

Although the colleges denied DOJs price-fixing allegation, they discontinued 

their annual meetings in1991. 

A. How would you determine if the overlap college meetings resulted in 

price fixing? 

B. If price fixing did indeed occur at these meetings, which laws might be 

violated? 


A. The effects of the DOJ overlap group inquiry has become the subject of an 

interesting study by the National Bureau of Economic Research, Inc. The 

NBER study found no evidence that the overlap colleges were colluding to 

raise tuition, raise net tuition revenue, or to save expenditures on grants. Both 

the overlap colleges and the control colleges raised tuition about 4 percent a 

year both before and after the antitrust action. However, as a result of the suit, 

financial aid at the overlap colleges became less progressive with respect to 

parents income and more sensitive to the merit of individual students, as 

measured by standard aptitude tests. In other words, financial aid became 

less sensitive to parents income and more able students obtained more aid. 

As a consequence of the DOJ case, the apparent trend in overlap colleges is to 

have a student body with proportionately more well-off students and 

relatively fewer black and Hispanic students. 

Apparently, DOJ found it difficult to apply standard economic analysis 

to college education. Although students are consumers of education, they are 

also producers in sense that peers affect the student experience. Many 


- 16 -

students would like colleges to maintain need-based aid for others, but make 

exceptions for them if they fail to qualify. (Note: Founded in 1920, NBER 

is a private, nonprofit, nonpartisan research organization dedicated to 

promoting a greater understanding of how the economy works. NBER 

research is conducted by more than 600 university professors around the 

country.) 

B. If price-fixing is indeed the intent and logical result of the financial-aid 

overlap meetings, a violation of Section 1 of the Sherman Act could be 

involved. 

P12.4 Tying Contracts. In a celebrated case tried during 1998, The Department of 

Justice charged Microsoft Corporation with a wide range of anti-competitive 

behavior. Among the charges leveled by the DOJ was the allegation that 

Microsoft illegally bundled the sale of its Microsoft Explorer Internet 

browser software with its basic Windows operating system. DOJ alleged that 

by offering a free browser program Microsoft was able to extend its 

operating system monopoly and substantially lessen competition and tend to 

create a monopoly in the browser market by undercutting rival Netscape 

Communications, Inc. Microsoft retorted that it had the right to innovate and 

broaden the capability of its operating system software over time. Moreover, 

Microsoft noted that Netscape distributed its rival Internet browser software 

Netscape Navigator free to customers, and that it was merely meeting the 

competition by offering its own free browser program. 

A. Explain how Microsofts bundling of free Internet browser software with 

its Windows operating system could violate U.S. antitrust laws, and be 

sure to mention which laws in particular might be violated. 

B. Who was right in this case? In other words, did Microsofts bundling of 

Microsoft Explorer with Windows extend its operating system 

monopoly and substantially lessen competition and tend to create a 

monopoly in the browser market? 


A. Section 3 of the Clayton Act forbids tying contracts that reduce competition. 

A firm, particularly one with a patent on a vital process or a monopoly on a 

natural resource, could use licensing or other arrangements to restrict 

competition. One such method was the tying contract, whereby a firm tied 

the acquisition of one item to the purchase of another. For example, IBM 

once refused to sell its business machines. It only rented machines to 

customers and then required them to buy IBM punch cards, materials, and 

maintenance service. This had the effect of reducing competition in these 

related industries. The IBM lease agreement was declared illegal under the 

Clayton Act, and the company was forced to offer machines for sale and to 


- 17 -

separate leasing arrangements from agreements to purchase other IBM 

products. 

Clearly, in the 1998 case, The Department of Justice argued that 

Microsoft had engaged in a similar pattern of anticompetitive behavior. If the 

market for Internet browser software can indeed be seen as distinct from the 

market for desktop PC software, then DOJ would appear to have a case that 

Microsoft illegally bundled the sale of its Microsoft Explorer Internet browser 

software with its basic Windows operating system. If the market for Internet 

browser software is not distinct from the market for desktop PC software, 

then the DOJ case would appear to be meddling in software design, as critics 

allege. 

B. As stated in part A, if the market for Internet browser software can indeed be 

seen as distinct from the market for desktop PC software, then the DOJ would 

appear to have a case that Microsoft illegally bundled the sale of its Microsoft 

Explorer Internet browser software with its basic Windows operating system. 

On the other hand, if the market for Internet browser software is not distinct 

from the market for desktop PC software, then support would be gained for 

Microsofts contention that it has the right to innovate and broaden the 

capability of its operating system software over time. The governments case 

seems to have been weakened by Microsofts observation that Netscape 

distributed its rival Internet browser software Netscape Navigator free to 

customers. This suggests that Microsoft may indeed have merely moved to 

meet the competition in the browser market. It is also worth noting that 

Netscape Navigator continues to have an important share of the browser 

market, and the profits of Netscapes parent-company AOL-Time Warner 

continue to flourish. 

P12.5 Monopoly Price/Output Decision. The Hair Stylist, Ltd., has a monopoly in 

the College Park market because of restrictive licensing requirements, and 

not because of superior operating efficiency. As a monopoly, the Hair Stylist 

provides all industry output. For simplicity, assume that the Hair Stylist 

operates a chain of salons and that each shop has an average costminimizing 

activity level of 750 hair stylings per month, with Marginal Cost = Average 

Total Cost = $20 per styling. 

Assume that demand and marginal revenue curves for hair stylings in 

the College Park market are 

P = $80 - $0.0008Q 

MR = $80 - $0.0016Q 

Where P is price per unit, MR is marginal revenue, and Q is total firm output 

(stylings). 


- 18 -

A. Calculate the competitive market long-run equilibrium activity level, 

and the monopoly profitmaximizing price/output combination. 

B. Calculate monopoly profits, and discuss the monopoly problem from a 

social perspective in this instance. 


A. The competitive market long-run equilibrium activity level is obtained by 

setting marginal revenue equal to marginal cost at the average-cost 

minimizing output level. In this case, the competitive market long-run 

equilibrium price is where P = MC = ATC = $20. Setting P = MR = MC and 

solving for Q: 

P = MC 

$80 - $0.0008Q = $20 

$0.0008Q = $60 

Q = 75,000 hair stylings per month. 

The competitive market long-run equilibrium price is equal to marginal cost 

at the average-cost minimizing activity level 

P = $20 

The monopoly profitmaximizing activity level is obtained by setting marginal 

revenue equal to marginal cost, or marginal profit equal to zero (Mπ = 0), and 

solving for Q: 

MR = MC 

$80 - $0.0016Q = $20 

$0.0016Q = $60 

Under monopoly, the optimal market price is 

Q = 37,500 hair stylings per month. 

P = $80 - $0.0008(37,500) 

= $50 


- 19 -

B. At the Q = 37,500 monopoly activity level, the Hair Stylist will operate a 

chain of 50 salons (= 37,500/750). Although each outlet produces Q = 750 

hairstylings per month, a point of optimum efficiency, the benefits of this 

efficiency accrue to the company in the form of economic profits rather than 

to consumers in the form of lower prices. Economic profits from each shop 

are 

π = TR - TC 

= P Q - AC Q 

= $50(750) - $20(750) 

= $22,500 per month 

With 50 shops, the Hair Stylist earns total economic profits of $1,125,000 (= 

50 $22,500) per month. As a monopoly, the industry provides only 37,500 

units of output, down from the 75,000 units provided in the case of a perfectly 

competitive industry. The new price of $50 per hairstyling is up substantially 

from the perfectly competitive price of $20. The effects of monopoly power 

are reflected in terms of higher consumer prices, reduced levels of output, and 

substantial unwarranted economic profits for the Hair Stylist, Inc. 

P12.6 Deadweight Loss From Monopoly. The Onondaga County Resource 

Recovery (OCRRA) system assumed responsibility for solid waste 

management on November 1, 1990, for thirty-three of the thirty-five 

municipalities in Onondaga County, New York. OCRRA is a non-profit 

public benefit corporation similar to the New York State Thruway Authority. 

It is not an arm of county government. Its Board of Directors is comprised of 

volunteers who develop programs and policies for the management of solid 

waste. The OCRRA Board is responsible for adopting a budget that ensures 

there will be sufficient revenues to cover expenditures. It does not rely on 

county taxes. OCRRA has implemented an aggressive series of programs 

promoting waste reduction and recycling where markets exist to create new 

products. While a number of communities struggle to surpass the 20% 

recycling mark, Onondaga County's households and commercial outlets 

currently recycle more than 67% of the waste that once was buried in 

landfills. Converting non-recyclable waste into energy (electricity) is also a 

top priority. 

To show the deadweight loss from monopoly problem, assume that 

monthly OCRRAs market supply and demand conditions are: 

QS = -2,000,000 + 10,000P (Market Supply) 

QD = 1,750,000 - 5,000P (Market Demand) 


- 20 -

where Q is the number of customers served, and P is the market price of 

annual trash hauling and recycling service. 




B. Use the graph to help you determine the deadweight for consumers 

and the producer if the market is run by unregulated profitmaximizing 

monopoly. (Note: If monopoly market demand is P = 

$350 - $0.0002Q, then the monopolists MR = $350 - $0.0004Q.) 


A. The market supply curve is given by the equation 


QS = -2,000,000 + 10,000P 

10,000P = 2,000,000 + QS 

P = $200 + $0.0001QS 



QD = 1,750,000 - 5,000P 

5,000P = 1,750,000 - QD 

P = $350 - $0.0002QD 



of price: 


-2,000,000 + 10,000P = 1,750,000 - 5,000P 

15,000P = 3,750,000 


- 21 - 

P = $250





$200 + $0.0001QS = $350 - $0.0002QD 

$0.0003Q = $150 


- 22 - 

Q = 500,000 


is a market price of $250 with an equilibrium output of 500,000 customers 

served. 


demand curve that lies above the market equilibrium price of $250. Because 


the value of consumer surplus equals: 

Consumer Surplus = [500,000 ($350 - $250)] 

= $25 million 

In words, this means that at a competitive market price of $250 the quantity 

demanded is 500,000, resulting in total revenues of $125 million per year. 

The fact that consumer surplus equals $25 million means that customers as a 

group would have been willing to pay an additional $25 million per year for 

this amount of service. This is an amount above and beyond the $125 million 

paid per year. Customers received a real bargain. 


supply curve at the market equilibrium price of $250. Because the area of 

such a triangle is one-half the value of the base times the height, the value of 


Producer Surplus = [500,000 ($250 - $200)] 

= $12.5 million 

At a competitive market price for trash hauling and recycling service of $250, 

producer surplus equals $12.5 million per year. Producers as a group 

received $12.5 million per year more than the absolute minimum required for 

them to produce the market equilibrium output of 500,000 customers served. 

Producers received a real bargain. 



the sum of consumer surplus and producer surplus:



- 23 - 

= $25 million + $12.5 million 

= $37.5 million per year 

B. If the industry is run by a profit-maximizing monopolist, the optimal priceoutput 

combination can be determined by setting marginal revenue equal to 

marginal cost and solving for Q: 

At Q = 300,000, 

MR = MC = Market Supply 

$350 - $0.0004Q = $200 + 0.0001Q 

$0.0005Q = $150 

Q = 300,000 

P = $350 - $0.0002Q 

= $350 - $0.0002(300,000) 

= $290 per barrel 

Under monopoly, the amount supplied falls to 300,000 and the market price 

jumps to $290 per year for trash hauling and recycling service. The amount 

of deadweight loss from monopoly suffered by consumers is given by the 

triangle bounded by ABD in the figure. Because the area of such a triangle is 

one-half the value of the base times the height, the value of lost consumer 

surplus due to monopoly equals: 

Consumer Deadweight Loss = [(500,000 - 300,000) ($290 - $250)] 

= $4 million per year 

The amount of deadweight loss from monopoly suffered by producers is 

given by the triangle bounded by BCD. Because the area of a such a triangle 

is one-half the value of the base times the height, the value of lost producer 

surplus equals: 

Producer Deadweight Loss = [(500,000 - 300,000) ($250 - $230)]


- 24 - 


The total amount of deadweight loss from monopoly suffered by consumers 

and producers is given by the triangle bounded by ACD. The area of a such a 

triangle is simply the amount of consumer deadweight loss plus producer 

deadweight loss: 

Total Deadweight Loss = Consumer Loss + Producer Loss 

= $4 million + $2 million 


P12.7 Wealth Transfer Problem. The Organization of the Petroleum Exporting 

Countries (OPEC) was formed on September 14, 1960 in Baghdad, Iraq. The 

current membership is comprised of five founding members plus six others: 

Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, 

the United Arab Emirates and Venezuela. OPECs stated mission is to bring 

stability and harmony to the oil market by adjusting their oil output to help 

ensure a balance between supply and demand. At least twice a year, OPEC 

members meet to adjust OPECs output level in light of anticipated oil market 

developments. OPEC's eleven members collectively supply about 40 per cent 

of the world's oil output and possess more than three-quarters of the world's 

total proven crude oil reserves. 

To demonstrate the deadweight loss from monopoly problem, 

imagine that market supply and demand conditions for crude oil are: 

QS = 2P (Market Supply) 

QD = 180 - 4P (Market Demand) 

where Q is barrels of oil per day (in millions) and P is the market price of oil. 




B. Use the graph to help you ascertain the amount of consumer surplus 

transferred to the monopoly producer following a change from a 

competitive market to a monopoly market. How much is the net 

gain in producer surplus? 


A. The market supply curve is given by the equation


QS = 2P 

P = 0.5QS 



QD = 180 - 4P 

4P = 180 - QD 

P = $45 - $0.25QD 



of price: 



- 25 - 

2P = 180 - 4P 

6P = 180 

P = $30 





$0.5Q = $45 - $0.25Q 

$0.75Q = $45 

Q = 60 (million) barrels per day 


is a market price of $30 with an equilibrium output of 60 (million) barrels per 

day. 


demand curve that lies above the market equilibrium price of $30. Because


the value of consumer surplus equals: 

Consumer Surplus = [60 ($45 - $30)] 


- 26 - 

= $450 (million) per day 

In words, this means that at a competitive market price of $30 per barrel, the 

quantity demanded is 60 (million barrels per day), resulting in total revenues 

of $1,800 (million) per day. The fact that consumer surplus equals $450 

(million) per day means that customers as a group would have been willing to 

pay an additional $450 (million) per day for this level of market output. This 

is an amount above and beyond the $1,800 (million) paid per day. Customers 

received a real bargain. 


supply curve at the market equilibrium price of $30. Because the area of such 

a triangle is one-half the value of the base times the height, the value of 


Producer Surplus = [60 ($30 - $0)] 

= $900 (million) per day 

At a competitive market price for oil of $30 per barrel, producer surplus 

equals $900 (million) per day. Producers as a group received $900 (million) 

per day more than the absolute minimum required for them to produce the 

market equilibrium output of 60 (million) barrels of oil per day. Producers 

received a real bargain. 



the sum of consumer surplus and producer surplus: 


= $450 (million) + $900 (million) 

= $1,350 (million) per day 

B. The amount of deadweight loss from monopoly suffered by the monopoly 

producer is given by the triangle bounded by BCD. Because the area of such

a triangle is one-half the value of the base times the height, the value of lost 


Producer Deadweight Loss = [(60 - 45) ($30 - $22.50)] 


- 27 - 

= $56.25 (million) per day 

The creation of a monopoly also results in a significant transfer from 

consumer surplus to producer surplus. In the figure, this amount is shown as 

the area in the rectangle bordered by PCMPMAB: 

Transfer to Producer Surplus = 45 ($33.75 - $30) 

= $168.75 (million) per day 

Therefore, from the viewpoint of the producer, the change to monopoly 

results in a very favorable net increase in producer surplus: 

Net Change in Producer Surplus = Producer Deadweight Loss + Transfer 

= -$56.25 (million) + $168.75 (million) 

= $112.5 (million) per day 

The wealth transfer problem associated with monopoly is seen as an issue of 

equity or fairness because it involves the distribution of income or wealth in 

the economy. Although economic profits serve the useful functions of 

providing incentives and helping allocate resources, it is difficult to justify 

monopoly profits that result from the raw exercise of market power rather 

than from exceptional performance. 

P12.8 Monopoly Profits. Parvati Fluid Controls, Inc., (PFC) is a major supplier of 

reverse osmosis and ultrafiltration equipment, which helps industrial and 

commercial customers achieve improved production processes and a cleaner 

work environment. The company has recently introduced a new line of 

ceramic filters that enjoy patent protection. Relevant cost and revenue 

relations for this product are as follows: 

TR = $300Q - $0.001Q 2 

MR = TR/Q = $300 - $0.002Q 

TC = $9,000,000 + $20Q + $0.0004Q 2 

MC = TC/Q = $20 + $0.0008Q

where TR is total revenue, Q is output, MR is marginal revenue, TC is total 

cost, including a risk-adjusted normal rate of return on investment, and MC 

is marginal cost. 

A. As a monopoly, calculate PFCs optimal price/output combination. 

B. Calculate monopoly profits and the optimal profit margin at this profitmaximizing 

activity level. 


A. Set MR = MC to find the optimal price/output combination: 

MR = MC 

$300 - $0.002Q = $20 + $0.0008Q 

0.0028Q = 280 

Q = 100,000 

P = TR/Q 

= ($300Q - $0.001Q 2 )/Q 

= $300 - $0.001Q 

= $300 - $0.001(100,000) 

= $200 

B. Because the cost of capital is already included in the total cost function, any 

excess of revenues over total cost represents economic profits. 

π = TR - TC 

= $300Q - $0.001Q 2 - $9,000,000 - $20Q -$0.0004Q 2 

= -$0.0014Q 2 + $280Q -$9,000,000 

= -$0.0014(100,000 2 ) + $280(100,000) - $9,000,000 

= $5,000,000 

And finally, the optimal profit margin is: 


- 28 -

Profit Margin = π/TR 


- 29 - 

= $5,000,000/$200(100,000) 

= 0.25 or 25% 

P12.9 Monopoly versus Competitive Market Equilibrium. During recent years, 

MicroChips Corp. has enjoyed substantial economic profits derived from 

patents covering a wide range of inventions and innovations for 

microprocessors used in high-performance desktop computers. A recent 

introduction, the Penultimate, has proven especially profitable. Market 

demand and marginal revenue relations for the product are as follows: 

P = $5,500 - $0.005Q 

MR = TR/Q = $5,500 - $0.01Q 

Fixed costs are nil because research and development expenses have been 

fully amortized during previous periods. Average variable costs are constant 

at $4,500 per unit. 

A. Calculate the profit-maximizing price/output combination and 

economic profits if MicroChips enjoys an effective monopoly because of 

patent protection. 

B. Calculate the price/output combination and total economic profits that 

would result if competitors offer clones that make the market perfectly 

competitive. 


A. The profit-maximizing price/output combination is found by setting MR = 

MC. Because AVC is constant, MC = AVC = $4,500. Therefore: 

MR = MC 

$5,500 - $0.01Q = $4,500 

0.01Q = 1,000 

Q = 100,000 

P = $5,500 - $0.005(100,000) 

= $5,000 

Economic Profits = P Q - AVC Q

= $5,000(100,000) - $4,500(100,000) 

= $50,000,000 

(Note: As a monopolist, the company is the industry). 

B. In a competitive market, P = MC. In this instance, AVC is constant and, 

therefore, MC = AVC. Competitive market equilibrium occurs where: 

P = MC = AVC 

$5,500 - $0.005Q = $4,500 

0.005Q = 1,000 

Q = 200,000 

P = $5,500 - $0.005(200,000) 

= $4,500 

Economic Profits = P Q - AVC Q 

= $4,500(200,000) - $4,500(200,000) 

= $0 

In words, the transformation from monopoly to perfect competition has 

brought a $1,000 reduction in price and a 100,000 unit expansion in output. 

At the same time, economic profits have been eliminated. 

P12.10 Monopoly/Monopsony Confrontation. Safecard Corporation offers a unique 

service. The company notifies credit card issuers after being informed that a 

subscriber's credit card has been lost or stolen. The Safecard service is sold 

to card issuers on an annual subscription basis. Relevant revenue and cost 

relations for the service are as follows: 

TR = $5Q - $0.00001Q 2 

MR = TR/Q = $5 - $0.00002Q 

TC = $50,000 + $0.5Q + $0.000005Q 2 

MC = TC/Q = $0.5 + $0.00001Q 


- 30 -

where TR is total revenue, Q is output measured in terms of the number of 

subscriptions in force, MR is marginal revenue, TC is total cost, including a 

risk-adjusted normal rate of return on investment, and MC is marginal cost. 

A. If Safecard has a monopoly in this market, calculate the profitmaximizing 

price/output combination and optimal total profit. 

B. Calculate Safecard's optimal price, output, and profits if credit card 

issuers effectively exert monopsony power and force a perfectly 

competitive equilibrium in this market. 


A. The profit-maximizing monopoly price/output combination is found by 

setting MR = MC and solving for Q: 

$50,000 

MR = MC 

$5 - $0.00002Q = $0.5 + $0.00001Q, 

0.00003Q = 4.5 

Q = 150,000 

P = TR/Q = $5 - $0.00001Q 

= $5 - $0.00001(150,000) 

= $3.50 

π = TR - TC = -$0.000015(150,000 2 ) + $4.5(150,000) - 

= $287,500 

(Note: Profit is falling for Q > 150,000.) 

B. If credit card issuers effectively exert monopsony power and force a perfectly 

competitive equilibrium, P = MR and, therefore, P = MC at the average cost 

minimizing output level. To find the output level where average cost is 

minimized, set MC = AC and solve for Q: 

MC = AC 

$0.5 + $0.00001Q = ($50,000 + $0.5Q + $0.000005Q 2 )/Q 

$0.5 + $0.00001Q = $50,000Q 1 + $0.5 + $0.000005Q 


- 31 -

$0.000005(100,000) 

$0.000005(100,000 2 ) 

50,000Q -1 = 0.000005Q 

50,000Q -2 = 0.000005 

Q = 


- 32 - 

= 0.000005 

= 100,000 

AC = $50,000/100,000 + $0.5 + 

= $1.50 

At the average-cost minimizing output level, MC = AC = $1.50. Because P = 

MR in a perfectly competitive industry, at the profit-maximizing output level: 

P = MR = MC = AC = $1.50 

π = P Q - TC 

= $1.50(100,000) - $50,000 - $0.5(100,000) - 

= $0 

(Note: Average cost is rising for Q > 100,000.) 

CASE STUDY FOR CHAPTER 12 

Effect of R&D on Tobins q 

The idea of using the difference between the market value of the firm and accounting 

book values as an indicator of market power and/or valuable intangible assets stems 

from the pioneering work of Nobel laureate James Tobin. Tobin introduced the so-called 

q ratio, defined as the ratio of the market value of the firm divided by the replacement 

cost of tangible assets. For a competitive firm in a stable industry with no special 

capabilities, and no barriers to entry or exit, one would expect q to be close to one (q 1). 

In a perfectly competitive industry, any momentary propensity for q > 1 due to an 

unanticipated rise in demand or decrease in costs would be quickly erased by entry or 

established firm growth. In a perfectly competitive industry, any momentary propensity 

for q < 1 due to an unanticipated fall in demand or increase in costs would be quickly 

erased by exit or contraction among established firms. In the absence of barriers to entry 

and exit, the marginal value of q would trend towards unity (q 1) over time in perfectly

competitive industries. Similarly, a firm that is regulated so as to earn no monopoly rents 

would also have a q close to one. Only in the case of firms with monopoly power 

protected by significant barriers to entry or exit, or firms with superior profit-making 

capabilities, will Tobins q ratio rise above one, and stay there. In the limit, the 

theoretical maximum Tobins q ratio is observed in the case of a highly efficient monopoly. 

If q > 1 on a persistent basis, one can argue that the firm is in possession of market 

power or some hard-to-duplicate asset that typically escapes measurement using 

conventional accounting criteria. 

Tobins q ratio surged during the 1990s, and some made the simple conclusion 

that monopoly profits had soared during this period. In the early 1990s, however, the 

overall economy suffered a sharp recession that dramatically reduced corporate profits 

and stock prices. By the end of the 1990s, the economy had logged the longest peacetime 

expansion in history, and both corporate profits and stock prices soared to record levels. 

Corporate profits, stock and Tobins q ratios for major corporations took a sharp tumble 

over the 2000-03 period as the country entered a mild recession. Therefore, much of the 

year-to-year variation in Tobins q ratios for corporate giants can be explained by the 

business cycle. At any point in time, more fundamental changes are also at work. 

Leading firms today are characterized by growing reliance on what economists refer to 

as intangible assets, like advertising capital, brand names, customer goodwill, patents, 

and so on. Empirically, q > 1 if valuable intangible assets derived from R&D and other 

such expenditures with the potential for long-lived benefits are systematically excluded 

from consideration by accounting methodology. The theoretical argument that q 1 over 

time only holds when the economic values of both tangible and intangible assets are 

precisely measured. If q > 1 on a persistent basis, and Tobins q is closely tied to the 

level of R&D intensity, one might argue successfully for the presence of intangible R&D 

capital. 

Table 12.3 here 

In Table 12.3, q is approximated by the sum of the market value of common plus 

the book values of preferred stock and total liabilities, all divided by the book value of 

tangible assets, for a sample of corporate giants included in the Dow Jones Industrial 

Average (DJIA). To learn the role played by R&D intensity as a determinant of Tobins q, 

the effects of other important factors must be constrained, including: current profitability, 

growth, and risk. Current profitability is measured by the firms net profit margin, or net 

income divided by sales. Positive stock-price effects of net profit margins can be 

anticipated because historical profit margins are often the best available indicator of a 

firms ability to generate superior rates of return during future periods. Stock-price 

effects of profit margins include both the influences of superior efficiency and/or market 

power. Because effective R&D can be expected to enhance both current and future 

profitability, the marginal effect of R&D intensity on Tobins q becomes a very 

conservative estimate of the total short-term plus long-term value of R&D when such 

impacts are considered in conjunction with the stock-price effects of current net profit 

margins. Revenue growth will have a positive effect on market values if future 

investments are expected to earn abovenormal rates of return and if growth is an 

important determinant of these returns. While growth affects the magnitude of 

anticipated excess returns, a stock-price influence may also be associated with the degree 


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of return stability. Influences of risk are estimated here using stock-price beta. With an 

increase in risk, the market value of expected returns is anticipated to fall. 

A. Explain how any intangible capital effects of R&D intensity can reflect the 

effects of market power and/or superior efficiency. 

B. A multiple regression analysis based upon the data contained in Table 12.3 

revealed the following (t statistics in parentheses): 

9.046 R&D/S 

(3.10) 

q = 1.825 + 7.358 Profit Margin + 0.220 Growth - 0.711 Beta + 

(3.79) (2.77) (0.08) (-2.42) 

R 2 = 55.3%, F statistic = 7.73 

Are these results consistent with the idea that R&D gives rise to a type of 

intangible capital? 

CASE STUDY SOLUTION 

A. Intangible R&D capital can be derived from the value obtained from patents 

and other monopoly protections offered to firms making significant new 

discoveries and innovations. Alternatively, significant R&D capital can result 

from the nonpatented advantages gained from effective basic research and 

applied development. In economic terminology, superior rewards earned 

from exceptional productive capability or superior effort are called Ricardian 

rents after the early British economist David Ricardo. Monopoly rents which 

are usually regarded as unjust compensation for the antisocial exercise of 

market power through high prices. Richardian rents are conventionally 

regarded as fair compensation for superior productive capability that results 

in higher revenues or lower production costs. To the extent that the firm 

possesses factors which increase revenues or lower costs relative to the 

marginal firm, it will persistently display q > 1. To the extent that productive 

R&D allows the firm to increase revenues and/or lower costs, and thereby 

persistently display q > 1, the firm can be said to possess significant 

unmeasured intangible R&D capital. 

It is worth noting that this study compares a stock measure, the 

market value of the firm, with the flow of R&D expenditures. On a 

theoretical basis, it would seem more appropriate to compare market values 

with the stocks of intangible capital tied to R&D. However, if economic 

amortization of the exponential decay type can be assumed, along with 

constant percentage rates of growth in R&D expenditures, then the magnitude 

of intangible capital equals annual expenditures on R&D multiplied by a 

constant. Given these assumptions, the stock of intangible R&D capital is 

strictly proportional to the flow of R&D expenditures, and the net income and 


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stock-price effects of R&D expenditures can be taken as indicative of 

intangible capital influences. 

B. Yes, these results are consistent with the idea that R&D gives rise to a type of 

intangible capital. On an overall basis, the simple model estimated here 

explains more than one-half (55.3%) of the variation in Tobins q ratio seen 

for the giant corporations included in the DJIA. This is a statistically 

significant explanation ( F = 7.73) of a meaningful share of q variation. 

Positive and statistically significant stock-price effects of net profit 

margins reflect the effects of superior efficiency and/or market power. 

Because effective R&D can be expected to enhance both current and future 

profitability, the marginal effect of R&D intensity on Tobins q is a very 

conservative estimate of the total short-term plus long-term value of R&D 

when such impacts are considered in conjunction with the stock-price effects 

of current net profit margins. For this sample of firms, revenue growth fails 

to exhibit the expected positive effect on market values, but influences of risk 

are found using stock-price beta. With an increase in risk, the market value 

of expected returns appears to fall, as anticipated. 

Interestingly, R&D intensity appears to have a consistently positive effect on 

the Tobins q, even after allowing for the market value-effects of current 

profit margins. These results are consistent with the hypothesis that R&D 

makes an important contribution to the long-term profitability of the firm, and 

gives rise to a type of intangible capital with long-lived influences. In 

considering the economic determinants of Tobins q it is important that the 

effects of superior efficiency or capability be separated from the simple 

influences of market power. More detailed consideration of the favorable 

long-term effects of R&D is a small step in this direction. 


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Chapter 12 MONOPOLY AND MONOPSONY QUESTIONS ...

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