MARKETS WITH MARKET POWER - Tufts University

Chapter 12
MARKETS WITH MARKET POWER
Microeconomics in Context (Goodwin, et al.), 2 nd Edition
Overview and Objectives
This chapter covers traditional models of monopoly, monopolistic competition, and oligopoly.
An important complement to this chapter is Chapter 16, which goes beyond these traditional
analytical models to discuss contemporary issues of globalization and corporate power.
As in earlier chapters, graphs that include the average total cost curve are presented in an
appendix.
After reading and reviewing this chapter, the student should be able to:
1. Define a monopoly and describe how a monopolist maximizes profits.
2. Understand why a monopoly may or may not be efficient.
3. Define monopolistic competition and describe how profits are maximized in these
markets.
4. Define oligopoly and discuss firm behavior under conditions of oligopoly.
Key Term Review
barriers to entry
exclusionary practices
dumping
regulated monopoly
rent-seeking behavior
nonprice competition
duopoly
price war
tacit collusion
price leadership
natural monopoly
predatory pricing
local monopoly
price-maker
price discrimination
concentration ratio
payoff matrix
collusion
price-fixing
Lecture Outline
1. The Three Models
• The three idealized market structures where sellers have some market power are pure
monopoly (only one seller), monopolistic competition (many sellers selling slightly
Chapter 12 − Markets with Power 1

different things), and oligopoly (so few sellers that each needs to watch what the others
are doing).
• The cases of monopoly and monopolistic competition can be analyzed using the
traditional economic model. That model is not applicable to oligopoly because oligopoly
markets are evolving social institutions.
Teaching strategy: See the Extension “Competition and Concentration” (below) for more
discussion of how these two forces interact, and why competition does not always win out.
2. Pure Monopoly: One Seller
2.1 The Conditions of Monopoly
• The three conditions of monopoly are: only one seller, the good being sold has no close
substitutes, and barriers exist to prevent new firms from entering the market.
• One reason new firms may be prevented from entering monopoly markets is economic.
The fixed costs to enter the market may be very high. A natural monopoly means that the
minimum efficient scale of production is large relative to the market demand.
• Barriers to entry may also be legal, such as through copyrights, patents, and trademarks.
• Barriers to entry may also be deliberate. Through exclusionary practices a firm may get
its suppliers to agree to not sell to competitors. Through predatory pricing a firm may
temporarily sell at a price below its costs to drive competitors out of business.
2.2 Examples of Monopoly
• Examples of local monopolies (limited to a specific geographical region) are relatively
common, such as the only theatre in a small town.
• A regulated monopoly is a private company that is run under government supervision,
such as AT&T in the past.
2.3 Profit Maximization for a Monopolist
• A monopolist will choose to produce where marginal cost equals marginal revenue.
• Unlike a firm in a perfectly competitive market, a monopolist faces the entire demand
curve and can adjust its selling price.
• As a price-maker, a monopolist faces a downward-sloping marginal revenue curve.
• Rather than setting price equal to marginal cost, a monopolist will set price at the
maximum willingness to pay (the point on the demand curve).
• A monopolist can make a sustained economic profit because new firms cannot enter the
market to drive down prices.
Teaching strategy: See the Extensions section (below) for additional numerical examples.
2.4 Monopoly and Inefficiency
• A deadweight loss exists in a monopoly market. Because the monopolist produces at an
output level at which price exceeds marginal cost, society could gain from increased
output of the product.
• Graphical analysis illustrates that a monopoly market, as compared to the case of perfect
competition, results in a transfer of benefits from consumers to the monopolist, as well as
a deadweight loss.
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• Monopolists may also use their market power to create other inefficiencies, such as
engaging in rent-seeking behavior to obtain transfers or favors.
2.5 Can Monopoly be Efficient?
• In the case of a natural monopoly, multiple firms would have higher per-unit production
costs than a monopolist. A firm operating under conditions of natural monopoly is
normally regulated to produce at higher levels and sell at a lower price than the firm
would on its own.
• The granting of a monopoly through copyrights and patents can be a way to encourage
research and innovation.
• Monopolists may behave more like a competitive firm if they fear potential competitors
or government regulation.
• In the case of price discrimination, a firm can sell its product to different buyers at
different prices. Buyers that are less responsive to price are charged a higher price. This
allows the firm to capture more of potential consumer surplus as profits.
3. Monopolist Competition
3.1 The Conditions of Monopolist Competition
• The four conditions of monopolistic competition are: numerous small buyers and sellers,
the sellers produce goods that are similar but differentiated, producers can freely enter or
exit the market, and buyers and sellers have perfect information.
3.2 Examples of Monopolistic Competition
• Examples of monopolistic competition are very common, such as fast-food restaurants
and different types of bookstores.
3.3 Profit Maximization with Monopolistic Competition
• Monopolistically competitive firms face a downward-sloping demand curve. Their
marginal revenue curve will lie below their demand curve.
• Profit maximization occurs at the point where marginal revenue equals marginal cost.
• If monopolistically competitive firms are making positive economic profits, then new
firms will enter the market. This will increase supply, drive down prices, and eventually
result in all firms earning zero economic profits.
3.4 Monopolistic Competition and Long-Run Efficiency
• Monopolistically competitive firms produce below the level where the social benefits of
production are equal to the social costs. Thus, they operate inefficiently.
• Monopolistically competitive firms may engage in non-price competition, such as
through advertising or being open for long hours.
4. Oligopoly
4.1 The Conditions of Oligopoly
• Oligopoly markets are characterized by containing only a few sellers (at least some of
which are large enough to influence the market price); and conditions exist which make
entry into such market difficult.
• In making decisions, an oligopolist must anticipate the likely reaction of its rivals.
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4.2 Examples of Oligopoly
• Automobile manufacturing is a classic example of an oligopoly. There are only a handful
of major automobile manufacturers.
• The concentration ratio is the proportion of total market sales that go to the largest firms
in the industry. The concentration ratio for the four largest firms in some oligopoly
markets is above 0.80.
4.3 Oligopoly and the Behavior of Firms
• One model for analyzing the behavior of oligopolists is game theory, where firms plot
their moves as if engaged in a competitive game.
• A payoff matrix shows the benefits of one seller as a function of the behavior of another
seller. While each firm would benefit by selling at a lower price than its competitor, if
they engage in a price war they will both end up making relatively low profits.
• A payoff matrix illustrates that two such firms could do better if they were able to
cooperate. Through collusion, the firms could both agree not to lower their prices.
Collusion is difficult to sustain because each firm has an incentive to lower its prices and,
at least temporarily, increase its own profits.
Teaching Strategy: The analysis of oligopoly in the text is mostly static. You might want to
discuss that oligopoly and payoff matrices are dynamic. If one firm gains a temporary
advantage, the other will likely respond quickly by cutting its own price. Thus, the
cooperative equilibrium is very unstable. It is like being on the top of a steep hill – a small
move away from the top can result in a big fall. If one firm “cheats,” it may be able to
cooperate again but the other firm will likely be very suspicious.
Teaching Strategy: See the Extensions section (below) for two in-class “games” illustrating
the behavior of cartels.
4.4 Is Oligopoly Rampant?
• The key feature of oligopoly is the degree of interdependence among the firms. In
reality, most any real-world firm will consider the actions of its rivals. A more complete
analysis of oligopoly must consider more than just economic factors – it must also
consider social factors in the firms’ response.
5. Summary and a Final Note
• In the real world, markets may not easily be categorized into just one of the four basic
structures.
• Arguments in favor of “free” markets rely on the perfectly competitive model which
maximizes efficiency. But examples of markets with some degree of market power are
much more common than markets with perfect competition.
Appendix: A Formal Analysis of Market Structures with Market Power
• The profit levels achieved by monopolists and by firms in monopolistic competition can
be illustrated using the demand, MC, MR and ATC curves.
Chapter 12 − Markets with Power 4

Notes on Text Discussion Questions
2.1. This would represent a case of a local monopoly because students could still travel to a
different university bookstore to buy their books. However, they would most likely find that
the prices of books across different university bookstores are very similar. You might ask
them why several university bookstores in a small geographical area (such as when several
colleges are found in a metropolitan area) all have similar prices, when one bookstore could
potentially capture a large share of the market by lowering their prices. This could
foreshadow the discussion of oligopoly later in the chapter. Most students will be aware of
some alternatives to buying textbooks at their college bookstore, such as a student-run
cooperative or the Internet. Still, these alternatives haven’t driven down the price of texts at
university bookstores much, if at all. Perceptive students might realize that monopoly power
also resides with publishers who set prices for their books and continually revise books to
limit the impact of the used book market. They may also note that professors, who don’t
have to pay for their books, have little incentive to try to reduce students’ book costs by
possibly using older editions or encouraging students to share books.
2.2. This question should help reinforce the efficiency/inefficiency issues related to monopolies.
Having just one company make all electronic goods would clearly improve compatibility.
Other potential benefits include greater availability of repair choices and lower production
costs through economies of scale. But there would be several disadvantages of having just
one electronics company, including the potential for higher monopoly prices, reduced
innovation, and fewer consumer choices. If students believe that having just one company is
a good idea, you can ask them why this hasn’t happened. Electronics is not an industry
where market forces have produced a natural monopoly. A discussion about why this is not
the case can focus on production costs, consumer preferences, and innovation.
3.1. This question is best used for discussion, where students could compare the prices they pay
for certain goods. Coffee is a good that likely varies significantly in price across firms.
While some of the difference can be attributed to quality differences, ask students to consider
other differences as well (convenience, status, atmosphere, etc.). Gas, on the other hand, is a
good that varies less in quality. Ask students why gas prices often vary in a region and why
everyone doesn’t simply buy gas from the cheapest station in the area. Note that, even after
considering many factors, some slight differences in price might remain puzzling. This could
be explained by using the “thick curves” that were described in the Extension to Chapter 4
notes in the IRM, where equilibrium is represented by a range of outcomes rather than a
single point.
3.2. Students are most likely faced with a tremendous variety of goods and services. Hopefully,
an interesting discussion could be structured around whether this variety is “too much.” For
example, would five brands of toothpaste be enough for society or is society better off with
fifteen choices? Ask students to consider the resources devoted to developing and promoting
many different brands, and the benefits consumers receive from additional choices. Some
students might offer a situation of declining marginal benefits – the first few choices
significantly benefit consumers but eventually more choices yield few benefits. Non-price
competition can provide consumers with benefits such as improved quality, greater
Chapter 12 − Markets with Power 5

convenience, etc., but it can also reduce social well-being. Students should recognize that
advertising can impose costs on society by increasing prices, encouraging irresponsible
spending, and targeting children. Some non-price competition, such as disposable products
and single-serve portions can increase environmental impacts.
4.1. a) In a prisoner’s dilemma situation, each firm would benefit from having the lower price.
However, with both firms taking a low-price strategy and no cooperation, neither firm will
gain a price advantage. The result will likely be lower profits for both due to a price war.
b) If the two firms collude to set price, they can both maintain high profits. Note, however,
that each firm also has an incentive to lower price and capture a larger market share and
higher profits.
4.2. The payoff matrix with revised labels is given below. The “Low Price” labels are replaced
with “Spend a lot” and “High Price” is replaced with “Spend a little.” Firms undertake
advertising because they want to increase sales and revenues (and raise profits), but
advertising also costs money (an expense which reduces profits). In this case, each firm
perceives a benefit from a lot of advertising because, if its rival doesn’t advertise as much, it
will be able to steal the other’s customers and make high profits. If one chooses not to spend
much while its rival spends a lot, the situation is reversed, and the first firm will make losses.
However, if both spend a lot, they have to split the customer base while having high
expenses, yielding low profits. If both spend only a little, they will again split the customer
base, but their expenses (for ads that essentially cancel each other out) aren’t as high, so their
profits will be moderate. Each one will realize that the worst they can do if they spend a lot is
get a low profit, while if they only spend a little they could end up making losses. As a
result, the noncooperative outcome is for both firms to spend a lot of money on advertising,
and make low profits (the upper left cell in the figure below). If advertising were severely
limited by law, each firm would save on ineffective advertising costs and the moderate profit
(lower right cell) payoff could be reached instead. Thus, the companies’ profits would
increase if they are both forced to cut back. While the government has limited advertising of
cigarettes and alcohol for public health reasons, this could have the somewhat perverse result
of increasing profits to the cigarette and alcohol manufacturers!
Firm 2’s Options
Firm 1’s Options
Spend a
lot
Spend a
little
Spend a lot
low profit
low profit
high profit
loss
Spend a little
loss
high profit
moderate profit
moderate profit
5.1. Recall from Chapter 5 that Braeburn does have a monopoly on the particular book of
poetry they are selling, but they compete with many other publishing firms. Thus, the market
structure of monopolistic competition corresponds most with Braeburn’s position. As they
increase the price of the book, they will lose some (but not all) customers. Braeburn will
Chapter 12 − Markets with Power 6

most likely engage in non-price competition to differentiate themselves from other
publishers. They may advertise to specific markets, sponsor books signings, and use other
tactics to promote their books.
5.2. This question is designed to tap into the real-world knowledge that some students might
have about market structure. It may be best run as a full-class exercise, taking the
experience of one or a few students, and having a full-class discussion of each case.
Students should be encouraged not just to tell stories, but rather use the stories to unravel
and illustrate (and even critique) the “conditions” for the various market structures
described in the text. For less experienced classes, you might substitute a general call for
examples, with an example of your own of a well-known consumer-good manufacturer that
has been in the news.
Answers to End-of-Chapter Review Questions
1. The three idealized market structures with market power are: pure monopoly (only one
seller), monopolistic competition (many sellers, but they sell slightly different things),
and oligopoly (so few sellers that they each need to watch what the others are doing).
2. Pure monopoly is characterized by: only one seller, the good being sold has no close
substitutes, and barriers of entry exist.
3. Three types of barriers to entry are: economic barriers (high fixed costs, network
externalities, economies of scale), legal barriers (copyrights, franchises, patents,
trademarks), and deliberate barriers (exclusionary practices, predatory pricing, dumping).
4. A pure monopolist is imagined to maximize profits by producing where marginal revenue
equals marginal cost but charging as high a price as it can on the market demand curve.
5. Monopolists are inefficient because: deadweight loss is created (the price level exceeds
marginal cost), innovations may be reduced, costs may be spent to maintain barriers to
entry, and rent-seeking behavior.
6. Monopoly market power generally leads to inefficiencies in the form of deadweight loss.
The monopolist produces at an output level at which price exceeds marginal cost and
society could gain from increased output of the product. See Figure 12.2.
7. Four cases in which a monopoly might be efficient are: natural monopolies (economies of
scale dictate that one firm can produce at the minimum per-unit cost), intellectual
property (the potential benefits of patents, trademarks, etc. actually encourage
innovations), pressure to appear competitive (firms worry that too-high monopoly profits
will attract too much attention so they operate more like a competitive firm), and perfect
price discrimination (the monopolist is able to charge every buyer his or her maximum
willingness to pay).
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8. A price-discriminating seller charges different prices to different buyers, reducing or
eliminating consumer surplus. See Figure 12.3.
9. Monopolistic competition is characterized by: numerous small buyers and sellers, each
seller’s product is somewhat different from that offered by the other sellers, producers of
the good or service can freely enter or exit the industry, and buyers and sellers have
perfect information.
10. A monopolistically competitive firm is expected to maximize profits by producing where
marginal revenue equals marginal cost, charging a price set by the demand curve for its
product, and trying to engage in non-price competition.
11. Monopolistically competitive markets are not efficient because firms, compared to
perfectly competitive firms, will produce lower levels of output and charge higher prices.
12. Oligopoly is characterized by a market dominated by only a few sellers and difficult
entry.
13. Two theories used to describe the behavior of oligopolists are: strategic interaction and
game theory (firms plot their moves while considering other firms’ behavior), and
collusion, cartels and price leadership (firms cooperate and form a monopoly for pricing
purposes).
Answers to End-of-Chapter Exercises
1. a) The demand curve is given below.
b) The completed cost table is given below. See the graph above for the marginal revenue
curve.
Chapter 12 − Markets with Power 8

Quantity of Output
(Demanded)
Selling Price
($)
Total Revenue
($)
Marginal Revenue
($)
1 17 17 17
2 14 28 11
3 11 33 5
4 8 32 -1
5 5 25 -7
c) The selling price of $8 cannot be profit maximizing because the marginal revenue is
negative – Braeburn decreases its revenue by producing and selling the fourth book.
d) See the graph above for the horizontal marginal cost curve.
e) Profit maximization occurs where marginal revenue equals marginal cost. In the graph
above, this occurs at a production level of three books and a price of $11.
f) At a price of $8, Braeburn would sell four books for a total revenue of $32. Total cost
would be $20 (4*$5) and profits would be $12. At the profit maximizing price of $11,
Braeburn’s revenues are $33, their costs are $15, and their profits are $18.
2. a) Firm 1 will make high (additional) profit; Firm 2 will make no (additional) profit--as
shown in the upper right cell in the payoff matrix.
b) The worst that can happen to Firm 1 if it opens a new outlet is that it could make moderate
profit. If it doesn’t open one, the worst that can happen is that it could make no profit. So it
will open the new outlet.
c) The outcome will be that each firm will open a new outlet. The end result will be that each
firm will make a moderate profit.
d) This situation is not like the prisoner’s dilemma because the firms could not both clearly
achieve a better outcome through cooperation.
e) Given the potential to open outlets in multiple towns, the firms do have potential gains
through collusion. Suppose there are two potential towns. If both firms open an outlet in
each town, each firm will make only a moderate profit in each town. However, if one firm
opens an exclusive outlet in one town and the other firm opens an exclusive outlet in the
other town, each firm would make a high profit. Thus (if “high” is greater than two
“moderates”) an agreement that gives each firm exclusive access to each town has the
potential to benefit both firms.
3. The correct matches are a-2, b-5, c-1, d-7, e-4, f-6, g-3.
Extensions
1. Discussion of “Competition and Concentration” (suitable for lecture preparation or handout).
(1 page)
2. Extra numerical example of Monopoly. NOTE: Table 1 refers only to material covered in the
text, but uses the notation “Δ” for “change in.” Table 2 includes material (average variable costs
and average total costs) covered in the appendix, and also includes average fixed costs (not
Chapter 12 − Markets with Power 9

covered in the appendix). Table 2 and the graph use the notation “AR=Demand” which is not
used in the text. (3 pages)
3. Extra exercise on “Monopoly Profit-Maximization” (suitable for in-class use or homework).
and answer key. NOTE: The calculation of profit involves material covered in the appendix. (2
pages)
4. Question on Monopoly Profit Maximization, suitable for use on an exam, and answer key.
NOTE: The calculation of profit involves material covered in the appendix. (1 page)
5. A handout on the “Cartel Game” and answer sheet NOTE: THIS EXERCISE HAS BEEN
WRITTEN FOR A CLASS OF 36 STUDENTS. (3 pages)
6. Handout on the “Grading Game” (1 page)
Chapter 12 − Markets with Power 10

Competition and Concentration
There is a perpetual struggle between the forces of competition and the forces that tend toward
concentration. (This will be discussed further in Chapter 16.) In one sense almost everyone is
engaged in a “pan-human conspiracy” against competition: firm owners and managers don’t like
it because it reduces profits, while workers don’t like it because firms that are being squeezed by
competition become cost-cutters – and that usually includes making life less pleasant for the
workers: faster pace of work, more supervision, and often reduced benefits, even reduced pay.
(We have seen a great deal of this in the last decade, as global competition made more firms
more “lean and mean.”) Most people, during most of their lives, share this
owner/manager/worker point of view. At the same time, everyone is a consumer – and it’s
consumers (and economists) who see competition as highly desirable, precisely because it gets
firms to lower the prices of their products (which is why they are obliged to lower production
costs.)
Note that the advantages of bigness do not always produce high concentration, or allow firms to
escape from the whip of competition. If the market for the product is large enough, or is growing
fast enough, it may not produce monopoly or oligopoly. The monopolizing trend is most likely
to win over the forces of competition when the market is not too big to overwhelm the
advantages of large firm size.
In any case, competition is not a stable situation: when it heats up, it tends to lead to shake-outs
that encourage bigness and monopoly. That’s part of the explanation for the confusing picture
we see when we look at global markets today. Competition seems to be increasing in many
ways, as virtually all firms are competing against producers throughout the whole world; yet, at
the same time, many firms have attained such enormous size that they have achieved significant
power, even in the global market.
Why and how do they attain such power? First of all, the motivations to escape the constraints
of severe competition are very strong; corporate leaders work extremely hard, and can employ
teams of very able people to help them, to figure out strategies that will give them market power.
Given these strong motivations, corporate leaders also reach out to government officials who can
help them, as well as to international bodies. While we see the big firms competing against one
another for customers, at another level they recognize, and act on, a joint interest in reducing
competition, and are often able to create and maintain local, national and international laws and
regulations that can give them special advantages, or protections against would-be competitors or
against constraints on their growth.
Chapter 12 − Markets with Power 11

Monopoly
Table 1:
The Monopoly’s Demand Curve & its Total Revenue
the demand curve:
average
revenue = price
at each
quantity ($/bu)
q
quantity
of
output
total revenue (TR) =
p×q
marginal
revenue
ΔTR/Δq
(bu) ($) ($/bu)
AR = P q TR MR
23 5 115 23
22 10 220 21
21 15 315 19
20 20 400 17
19 25 475 15
18 30 540 13
17 35 595 11
16 40 640 9
15 45 675 7
14 50 700 5
13 55 715 3
12 60 720 1
11 65 715 -1
10 70 700 -3
9 75 675 -5
8 80 640 -7
7 85 595 -9
6 90 540 -11
5 95 475 -13
4 100 400 -15
3 105 315 -17
elastic demand: TR rises as P falls.
inelastic demand: TR
falls as P falls.
Chapter 12 − Markets with Power 12

Table 2:
Production and Costs under Monopoly.
The New Example: continued.
Fixed
Cost =
quantity
of
output
60 price varies with quantity profit schedule
average cost schedule
demand
curve: the
price at
average
fixed
costs
average average
variable total
costs costs
Marginal
Cost
ΔTC/Δq
(bu) ($/bu) ($/bu) ($/bu) ($/bu)
each
quantity
produced.
total
revenue =
p×q
marginal
revenue
= ΔTR/Δq
Total
profit =
(TR–TC)
extra
profit =
(MR –
MC)
($/bu) ($) ($/bu) ($) ($/bu)
q AFC AVC ATC MC AR TR MR
5 12.000 0.800 12.800 0.8 23 115 23 51 22.20
10 6.000 0.600 6.600 0.4 22 220 21 154 20.60
15 4.000 0.600 4.600 0.6 21 315 19 246 18.40
20 3.000 0.750 3.750 1.2 20 400 17 325 15.80
25 2.400 0.920 3.320 1.6 19 475 15 392 13.40
30 2.000 1.100 3.100 2.0 18 540 13 447 11.00
35 1.714 1.286 3.000 2.4 17 595 11 490 8.60
40 1.500 1.475 2.975 2.8 16 640 9 521 6.20
45 1.333 1.667 3.000 3.2 15 675 7 540 3.80
50 1.200 1.860 3.060 3.6 14 700 5 547 1.40
55 1.091 2.055 3.145 4.0 13 715 3 542 -1.00
60 1.000 2.250 3.250 4.4 12 720 1 525 -3.40
65 0.923 2.446 3.369 4.8 11 715 -1 496 -5.80
70 0.857 2.643 3.500 5.2 10 700 -3 455 -8.20
Chapter 12 − Markets with Power 13

Chapter 12 − Markets with Power 14

Exercise on Monopoly Profit-Maximization
Before World War II, the Alcoa corporation had a monopoly in the production of aluminum. Assume that its demand
and cost data are as follows:
demand curve
quantity, q
average
total cost,
ATC
price, p
11 93 10
12 91 11
13 89 13
14 87 15
15 85 17
16 83 20
17 81 24
18 79 28
A) Use the numbers above to fill in the following table:
quantity, q
total
revenue, TR
marginal
revenue,
MR
marginal
cost, MC
total cost,
TC total profit
11 _______ _______ _______ _______ _______
12 _______ _______ _______ _______ _______
13 _______ _______ _______ _______ _______
14 _______ _______ _______ _______ _______
15 _______ _______ _______ _______ _______
16 _______ _______ _______ _______ _______
17 _______ _______ _______ _______ _______
18 _______ _______ _______ _______ _______
B) What is the profit-maximizing level of output? ____________________
C) What is the profit-maximizing price? ________________________
D) Given the average total cost data, what profit is Alcoa making per unit of output?________
E) Assume that Alcoa acted as if it were perfectly competitive, setting price equal to MC, where
the price is determined by the demand curve. Then its short-run profit-maximizing output level = _______
F) In this case, its short-run profit-maximizing price = _______________
G) What would be the profits per unit of Alcoa in this case? ____________
H) Which is more profitable to Alcoa, to act as a competitive firm or as a monopolist?
Chapter 12 − Markets with Power 15

Exercise on Monopoly Profit-Maximization—Answer Key
Before World War II, the Alcoa corporation had a monopoly in the production of aluminum. Assume that
its demand and cost data are as follows:
demand curve average total
quantity price cost
11 93 10
12 91 11
13 89 13
14 87 15
15 85 17
16 83 20
17 81 24
18 79 28
quantity,
q
11
12
13
14
15
16
17
18
A) Use the numbers above to fill in the following table: I added a column at the left, to represent prices.
from the
demand
curve:
price
total
revenue,
TR = p×q
marginal
revenue,
MR =
ΔTR/Δq
marginal
cost, MC
= ΔTC/Δq
total cost,
TC =
ATC×q
profit =
TR – TC
93 1023 n.a. n.a. 110 913
91 1092 69 22 132 960
89 1157 65 37 169 988
87 1218 61 41 210 1008
85 1275 57 45 255 1020
83 1328 53 65 320 1008
81 1377 49 88 408 969
79 1422 45 96 504 918
B) What is the profit-maximizing level of output? 15 (as close to MR = MC as possible, but not too far).
C) What is the profit-maximizing price? $85 (from the demand curve at q = 15).
D) Given the average total cost data, what profit is Alcoa making per unit of output? P – AC = $85 - $17 = $68.
E) Assume that Alcoa acted as if it were perfectly competitive, setting price equal to MC, where
the price is determined by the demand curve. Then its short-run profit-maximizing output level = 16
(this what we get if output is expanded as long as P > MC, to get as close as possible to P = MC without going too
far.)
F) If Alcoa acted as if it were perfectly competitive, its short-run profit-maximizing price = $83 (from the demand
curve at P = 15)
G) What would be the profits of Alcoa if it acts like a perfectly competitive firm? P – AC = $83 - $20 = $63 per
unit or $1008 total.
H) Which is more profitable to Alcoa, to act as a competitive firm or as a monopolist? It’s more profitable to
act as a monopolist.
Chapter 12 − Markets with Power 16

Question on Monopoly Profit Maximization
The graph below represents the average total cost and marginal cost curves (ATC & MC), and the
marginal revenue and demand curves (MR & D), for a monopoly, the BFC (the “Big Friggin’
Company”). FIRST, fill in the blanks below to indicate the name of each of the curves. (If you want, you
may use the initials.) THEN answer the questions below the graph.
A.__________________
B.__________________
C.__________________
D.__________________
E. If BFC acts as a profit-seeking monopoly, it would produce a quantity of about_____________
units per month, while the price would equal about ____________.
F. Is the company making an economic profit in this situation? _____________.
G. If the BFC is forced to act like a competitive firm, the quantity equals about ________
units per month while the price would equal about ___________________.
Question on Monopoly Profit Maximization—Answer Key
A. MC B. D C. ATC D. MR
E. If BFC acts as a profit-seeking monopoly, it would produce a quantity of about____13____
units per month, while the price would equal about _____50_______.
F. Is the company making an economic profit in this situation? Explain. ____Yes. At 13 units of output,
each unit on average costs about $30 (see the ATC) to produce, which is less than the selling price of
$50____.
G. If the BFC is forced to act like a competitive firm, the quantity equals about ___17_____
units per month while the price would equal about _________48__________.
Chapter 12 − Markets with Power 17

The Cartel Game
Each student in the class is the entrepreneur of a small firm producing widgets. Each firm has the
same conditions of production:
1. Each firm can choose to produce either 1 or 2 widgets per day. You must decide what level of
output to produce in order to maximize your profits.
2. The MC of producing a widget is $0.50 at all levels of output. This equals the AC (average or
per-unit costs) of producing widgets.
3. All of the firms earn the same price in selling widgets. The market price is set by the total of
all the firms' outputs (the total amount supplied) and the market demand curve. The demand
curve appears in the first two columns in the table on the next page.
4. The third column in the table shows the marginal revenue curve that would be seen if all
students united to form the Association of Widget Entrepreneurs (AWE), a cartel.
A. If the cartel acts to maximize profits of the group, what level of output will be produced?
B. What will the profits for all of the AWE be in this case? Are they AWEsome?
C. If the profits are distributed equally among the firms, what will the profits be per firm?
5. The government comes in and uses anti-trust laws to break up the AWE. Now each of you has
to decide how much to produce. Remember that your goal is to maximize your own profits.
We will play two rounds of the game, doing it two ways:
A. in the first round, hold up your hand if you want to produce two widgets; don't hold up your
hand if you want to produce one. (It’s not allowed for you to produce 0.)
B. in the second round, write whether you want to produce 2 or 1 widgets on a piece of paper.
Do not show the papers to other students.
On each we can calculate the market price (given the demand curve) and your profits (your
quantity*(p – AC)).
Chapter 12 − Markets with Power 18

industry demand
curve
AWE's
MR
q p
23 2.48 1.60
24 2.44 1.52
25 2.40 1.44
26 2.36 1.36
27 2.32 1.28
28 2.28 1.20
29 2.24 1.12
30 2.20 1.04
31 2.16 0.96
32 2.12 0.88
33 2.08 0.80
34 2.04 0.72
35 2.00 0.64
36 1.96 0.56
37 1.92 0.48
38 1.88 0.40
39 1.84 0.32
40 1.80 0.24
41 1.76 0.16
42 1.72 0.08
43 1.68 0.00
44 1.64 -0.08
45 1.60 -0.16
q p
AWE's
MR
45 1.60 -0.16
46 1.56 -0.24
47 1.52 -0.32
48 1.48 -0.40
49 1.44 -0.48
50 1.40 -0.56
51 1.36 -0.64
52 1.32 -0.72
53 1.28 -0.80
54 1.24 -0.88
55 1.20 -0.96
56 1.16 -1.04
57 1.12 -1.12
58 1.08 -1.20
59 1.04 -1.28
60 1.00 -1.36
61 0.96 -1.44
62 0.92 -1.52
63 0.88 -1.60
64 0.84 -1.68
65 0.80 -1.76
66 0.76 -1.84
67 0.72 -1.92
68 0.68 -2.00
69 0.64 -2.08
70 0.60 -2.16
71 0.56 -2.24
72 0.52 -2.32
73 0.48 -2.40
Chapter 12 − Markets with Power 19

Answers to the Cartel Game (class of 36 students):
4A: 36 (where MC ≈ MR, .50 ≈ .56)
4B: 36 × ($1.96 − $.50) = $52.56
4C: $ 52.56/36 = $1.46 (assuming each firm produces 1 unit)
5: (Will students maintain implicit collusion, and make profits? Or will individuals, especially when anonymous,
“defect” and produce 2 units, driving down the price? )
Chapter 12 − Markets with Power 20

The Grading Game
a) suppose that I graded using a hard-core curve. 1/10 of the students get an "A"; 2/10 get "B";
4/10 get "C"; 2/10 get "D"; and 1/10 get "F"
b) Suppose that one’s relative grade reflects both relative preexisting talent, luck, and relative
effort.
c) Since we don’t have any control over talent or luck, if people want higher grades, they need
to work harder.
d) the problem is that there’s a limited number of As and Bs, so that the students are all
competing over them. If I work hard and move up to an A, then someone else is pushed
down.
e) thus, there's an incentive for the students to restrict their efforts. If everyone colludes to not
work very hard, you'd still see pretty much the same distribution of grades as when
everybody works hard. The benefit is that less effort is needed, though less economics is
learned. If grades are all that's important to you, then the latter is unimportant.
f) the problem of free riders can undermine the attainment of the collective good. These are
students who either care about the grade enough that they are willing to take advantage of
their fellow students by working more than agreed upon, in order to rise in the ranks. Or
these students might really want to learn economics.
g) a well-organized cartel of students could make sure that free riders don't cheat. They could
throw big parties the night before the exam and make sure that everyone attends. Perhaps
punish the ones who "free ride" on the rest.
Chapter 12 − Markets with Power 21