Economics of Social Issues 21st Edition Register Solutions Manual 1

Chapter 08 - The Economics of Monopoly Power
Economics of Social Issues 21st

Edition by Registe Grimes ISBN
007802191X 9780078021916
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CHAPTER 8
THE ECONOMICS OF MONOPOLY POWER
CAN MARKETS BE CONTROLLED?
Since much of the nation’s business is carried on by large corporations, the issue of monopoly power
provides a basis for examining the relationships between market structure and performance in a
predominantly private enterprise economy. The general public witnesses daily governmental
invectives against “big business” and “obscene profits.” How much of what we hear and see is
posturing and rhetoric? How much of it is a real problem of economic performance?
We try to first define and classify market structures paying particular attention to the limiting cases of
pure competition and pure monopoly. We present a simple picture of how price and output are
determined in competitive markets and then we show how monopolization brings about output
restrictions and higher prices than would prevail in competitive markets that become monopolized.
At this point, we bring in the concept of the dead-weight welfare loss due to monopoly along with
empirical estimates of the loss. Next, we examine the forces giving rise to monopoly and stress that
any serious anti-monopoly measures must be directed against its causes. With the basic analysis of
monopoly complete, we consider the peculiar case of natural monopoly. This is not intended as a
justification for existing levels of industry concentration, but rather as a means of introducing
government regulation of business. We present the Capture Theory of Regulation. We emphasize the
difference between bigness and monopoly on the performance of the United States economy. Finally,
we discuss issues of corporate responsibility and their relationship to regulation of business.
TEACHING OUTLINE
I. Monopoly Power
A. Definition
1. Concentration ratios
2. Limitations of concentration ratios
a. Geographic area of market (e.g. local and international)
II. Impact of Monopoly on Performance
A. Firms
1. Demand
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B. Profit and profit maximization
C. Price and output with competition
8-4
1. MR
2. Supply curve
D. Price and output with monopoly
1. MC = MR
2. MR < P
E. Deadweight loss
F. Entry restrictions
1. Private
a. Ownership of raw materials
b. Predatory pricing
c. Differentiated product
d. Network economies
2. Government
a. Regulated industries
b. Occupational licensing
c. Import/export barriers
d. Patents and copyrights
G. Non-price competition
1. Advertising
2. Changing design and quality
III. Should We Fear Monopoly Power?
A. Estimates of DWL
1. Putting estimates in perspectives
8-5
B. Loss due to private barriers
8-6
C. Loss due to laws
D. Loss due to non-price competition
E. What is bigness?
1. Too big to fail?
IV. Natural Monopoly
A. Average costs
1. Economies of scale
2. Diseconomies of scale
B. DWL weighed against increasing average costs
C. Government regulation
1. Natural monopoly
2. Lack of information
3. Poorly defined property rights
4. Costs-benefit analysis of regulation
a. Capture theory of regulation
5. Deregulation movement
D. Corporate Responsibility
1. Corporation
2. Agency problem
3. Stock options
8-7
CORE ECONOMIC PRINCIPLES

 Perfect Competition Model - This chapter presents the core microeconomic models of market
structures in the context of the debate on the appropriate size of businesses.
 Monopoly Model - The monopoly model is presented in comparison with the model of competition
in order to discuss the welfare loss associated with monopoly.
 Deadweight Loss - A key purpose of the discussion of market structures in this chapter is to provide
a framework for the discussion of the welfare effects of “big business” in the economy.
 Economies of Scale - The important concept of economies of scale, which is used through as well
as outside economics, is presented in the context of the existence and regulation of natural
monopolies.
RESOURCES
Curriculum Ideas
For a classroom experiment on costs and production, see Expernomics, Vol. 2, #1. For a classroom
experiment on marginal costs and sunk costs, see Vol. 3, #1.
http://www.marietta.edu/~delemeeg/expernom.html
DATA SOURCES
The following data sources may be used to update and refine the statistics found in this chapter:
• A good source for the latest news on existing antitrust cases can be found in the Department of
Justice’s regular press releases. These are available on the Department’s web site at
http://www.usdoj.gov.
• The Bureau of Competition of the Federal Trade Commission (http://www.ftc.gov/bc/index.shtml)

is another government agency with responsibilities in the antitrust arena.
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• Homepage of the American Antitrust Institutute (http://www.antitrustinstitute.org/), AAI is a

nonprofit organization devoted to the study of antitrust issues.
DISCUSSION QUESTIONS
1. Explain what a concentration ratio measures and how it can be used to indicate whether a firm is
operating in a competitive industry or an industry that is close to the monopolistic model. What
shortcomings do concentration ratios have?
Solution:
A concentration ratio takes a few (usually four or eight) largest firms in an industry to see what
percentage of industry sales they account for. It’s a measure of monopoly power. The larger
percentage of industry sales they account for, the more concentrated the industry is, and the more
monopoly power these few firms have. In general an industry is considered competitive if the
concentration ratio is below 10 or 20 percent, close to monopolistic if it’s above 70 or 80 percent.
However, Concentration ratios do have some limitations. For example, they don’t take the sales of
imported goods into consideration, the degree of concentration for an industry could be overstated if
imports are not counted. Also, some industries are best estimated in a specific region. Concentration
ratios do not take the geographic factor into consideration, thus may understate the degree of
concentration in an industry.
2. The profit-maximizing condition for a competitive firm requires production to be carried to the
point where marginal revenue is equal to marginal cost. Explain why. Is this condition the same for
firms with monopoly power?
Solution:
Profit = Total Revenue – Total Cost. As a firm produces one more unit of output, both total revenue
and total cost increase. Whether profit increases or not depends on which of the two increases more. If
TR increases more than TC, profit will rise, otherwise it will fall. The firm should keep producing as
long as the increase in TR per unit increase in output (marginal revenue) is greater than the increase
in TC (marginal cost). In other words, the firm should keep producing as long as marginal revenue is
greater than marginal cost, because profit can be increased. Since MR falls and MC rises with output,
the firm will reach a point where MR=MC, beyond which MC will be greater than MR, profit will fall.
So profit is maximized at the output level where MR=MC. This condition holds for firms with
monopoly power.
3. What are barriers to entry, and how do they inhibit the proper functioning of a market?
Solution:
Barriers to entry are restrictions for new firms to enter a market. There are private barriers, such as
ownership of some key raw materials, predatory pricing, product differentiation and network
economies. Other barriers to entry are created by government, called government barriers. For
example, government regulations could block the entry to a particular industry, as it’s done in
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railroads, trucking, airlines, and communications industries. Other government barriers include
occupation licensing, import tariffs and quotas, patent and copyright laws, exclusive franchises,
zoning ordinances and building codes, etc. These barriers tend to block the entry of new firms and
investment in an industry, thus may lead to inefficient allocation of economic resources. Barriers tend
to provide some firms with monopolistic power, causing lower outputs, higher prices in the market,
but more profits for these firms.
4. A merger of formerly competing firms forming a monopoly invariably leads to a fall in industry
output. Why?
Solution:
Under competitive market, each individual firm is facing a horizontal demand curve, which is also its
marginal revenue curve. Then each firm is trying to maximizing its profit at the output level (7,000 in
the following diagram) where marginal revenue curve intersects marginal cost curve (MR=MC). As
the market becomes a monopoly, the firm is now the whole market supply. The monopolistic firm now
faces a downward sloping market demand curve, its marginal revenue curve is now downward sloping
under the market demand curve. As the monopoly is trying to maximize its profit at MR=MC, the
marginal revenue curve now intersects marginal cost curve at a lower output level (5,000 in the
following diagram). At the same time, the monopolist now can charge a higher price than under
competitive market and make a monopolistic profit.
5. Using the deadweight welfare loss diagram, compare and contrast the outcomes of competition and
monopoly.
Solution:
Refer to the solution to discussion question #4. In the diagram supply curve represents MC and
demand curve represents MB. They also represent MSC and MSB respectively if no externalities are
generated. When the market is competitive, buyers and sellers reach equilibrium at output level 7,000
where S=D and MSC=MSB. No deadweight loss. Now if the market becomes a monopoly, monopolist
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will maximize its profit at the level of output 5,000. From 5,000 to the last unit before 7,000,
MSB>MSC. Social welfare could be gained by increasing output up to 7,000. But the monopolist stops
at 5,000, thus causing deadweight welfare loss as indicated by the triangular area ABC.
6. Explain why bigness and monopoly power are not necessarily the same.
Solution:
Being big in size is not necessarily the same as monopoly power. Monopoly power doesn’t have to
come from a firm with large absolute size. Monopoly power can come from the firm’s size relative to
the industry’s output and market characteristics, like the lack of substitutes. For example, GM and
Ford are very big firms in absolute terms in the U.S. But they cannot exercise much monopoly power
because they face strong competition from foreign imports in the auto market. On the other hand,
local cable companies like Comcast is not as big in size as GM and Ford, but they can exercise a
stronger monopoly power because there are few substitutes or competitions for cable service.
7. What is natural monopoly, and what dilemma does it pose for public policy? Give examples of
natural monopoly.
Solution:
Natural monopoly refers to an industry where the economies of scale is exhausted with only one firm
providing for the whole market. It’s also the point at which this firm’s average cost of production is
minimized. Public utilities industry like electricity, water, and subway system in New York city are
some examples of natural monopoly. Natural monopoly implies that it’s more cost efficient for one
firm to operate in the industry. Given the market size, more than one firms will lead to each firm’s
scale of operation to be smaller than what’s needed to enjoy the full benefits of economies of scale,
thus facing a higher average cost of production. On the other hand, allowing one firm to dominate the
industry gives rise to monopoly and its negative consequences. Lower output level, higher price and
misallocation of resources that are associated with monopoly will result in the deadweight loss of
social welfare. To address this dilemma, government has to regulate the natural monopoly.
8. The typical firm’s long-run average cost curve is U-shaped. Why?
Solution:
The U-shaped long run average cost curve is due to economies of scale and diseconomies of scale the
firm experiences in different phases of its expansion. As the firm starts to expand, in the beginning, it
tends to enjoy a declining average cost of production, or economies of scale. This benefit is brought
about by division of labor and specialization. However, as the firm’s size keeps expanding, it will
become too large to be effectively monitored and managed. The cost of bureaucracy starts to rise.
Workers get bored with the specialized job. All these lead to the benefits of division of labor and
specialization to be gradually exhausted. After a point, the firm will experience diseconomies of scale
and its average cost of production will start to rise.
9. List and discuss the three economic justifications for government regulation. If one of these exists,
does that mean that regulation should be imposed?
Solution
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Three situations exist that may justify government regulation. One is natural monopoly. As discussed
in solution to discussion question #7, government regulation has to allow for the existence of natural
monopoly, but at the same time monitor and alleviate the negative impact of monopoly on the social
welfare. Another is the situation where consumers lack important information to make appropriate
decision to maximize social well-being. Government regulation such as the requirement for labeling of
specific product ingredients, health and safety codes for products and workplaces, or banning certain
items deemed too dangerous would be necessary. The third situation is when property rights are
poorly defined in the market place that leads to externalities. For example, government could use
regulation tools such as taxes, direct controls on emissions, prohibitions on the use of particular
substances, and “cap and trade” to deal with pollution problem. When market fails in these situations,
it doesn’t mean government regulation should be imposed. This is because government regulation has
a cost. It also costs the market to comply with new regulation. We should look at the costs and
benefits. Only if the benefits of regulation overweigh the costs associated with new regulation should
we impose new regulation.
10. Define and explain the capture theory of regulation.
Solution:
The capture theory of regulation believes that government regulatory agencies are actually serving
the interests of the firms being regulated, instead of serving the interests of the general public. The
theory believes that industries under regulation devote lots of resources to lobby and influence policy
makers’ decision. Government officials serving in the regulatory agencies often times are the people
coming from the industry, or having close ties with the industry. Governmental agencies sometimes
have to rely on the industry to provide necessary information in order to regulate. Because of all
these, regulatory agencies have been “taken captive” by the industry under regulation.
11. Explain how agency problems contribute to the abuse of market power by managers of large
corporations. Can regulation prevent agency problems? Discuss.
Solution:
Agency problem in the business world refers to the situation where managers entrusted to serve the
interests of shareholders use their power to benefit themselves. Top executives in big corporations are
hired by the board of directors to serve the best interests of stockholders. However, the interests of
these CEOs are not necessarily aligned with stockholders’. For example, instead of seeking long term
growth and profits for the company, CEOs could take some risky measures to boost the short term
stock price just to benefit themselves. Government regulation that holds CEOs more responsible to the
shareholders with serious penalty consequences if they’re not could be used to alleviate the agency
problem.
12. What are stock options? Stock option plans are often used as an incentive to hire top-level
managers, but do they always create the right incentives for managerial behavior? Explain.
Solution:
Stock options are a right to purchase or sell a certain shares of a stock at a fixed price (strike price).
Top managers in big companies are often given stock option plans as an incentive. But stock options
could encourage top managers to engage behaviors that seek short term interests for themselves. For
example, the long term development of the company may require a R&D investment that takes years to
8-12
see the return. However, top managers want to see higher stock price in the near future. As the stock
price rises above the strike price, they can exercise the stock option to rip the profits for themselves.
So top managers may just do whatever it takes to boost the short term stock price, instead of investing
in the long term growth of the company.
13. In Chapter 3, you learned the concept of diminishing returns. In this chapter, the concept of
diseconomies of scale was presented. Compare/contrast these two concepts.
Solution:
There are several differences between the concept of diminishing returns and the concept of
diseconomies of scale. Diminishing returns refer to the situation where there are some fixed inputs, as
we add more and more of a variable input to the production process, the marginal product of the last
unit of the variable input will eventually decline. As we increase one input while holding other inputs
fixed, sooner or later we will bypass the optimal match point between different inputs. Diminishing
returns will set in. Diseconomies of scale refers to a long run situation, where all inputs can be
increased. As firms expand the scale of operation by increasing all their inputs, the average costs will
decrease first due to the benefits of division of labor and specialization, but eventually average costs
will rise as these benefits are exhausted. Thus, diminishing returns is a short run concept that
measures the decline of marginal product of one input; while diseconomies of scale is a long run
concept that measures the rise of average cost as all inputs change.
14. Suppose two industries exist, A and B, both of which have concentration ratios of 80 percent. In A,
the four largest firms control the following shares of the market, respectively: 60 percent, 10 percent, 7
percent, and 3 percent. In B, the four largest each have a 20 percent share of the market. In which
would you expect more potential for monopoly power? What does this say about using concentration
ratios as a measure of the potential for monopoly power?
Solution:
In general, as four firms have equal shares of the market, there tends to be more competition than if
one firm has substantially greater share than the other three firms. In industry B, the four firms are
equals in terms of market share. No firm can dominate the others easily. However, in industry A, the
firm with 60% of market share could exercise more monopoly power than the other firms. This
example shows that concentration ratio misses many details as a measure of the monopoly power in
an industry. It’s only a first indication of the degree of concentration for an industry. We have to look
more closely into the industry to find more detailed information.
15. Suppose that the market for (extremely) high-end sports cars is such that no more than 100,000 can
be sold per year and that at this level of production, the industry’s long-run average cost curve is
declining. Why will this market most likely naturally gravitate to having only one producer?
Solution:
This market will be most likely to be a natural monopoly. Under appropriate conditions, one firm
could keep expanding its scale of operation, through merger and acquisition, to take the advantage of
economies of scale. The fact that its long run average cost curve is declining at the full market demand
level 100,000 implies that the firm can still enjoy the economies of scale after it has dominated the
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industry. Then any new firm that has not achieved that level faces a higher average cost, thus cannot
compete with the existing firm. Economies of scale in this industry serve as high natural barrier to
entry, helping one firm to establish monopolistic status.
16. Of the industries listed in Table 8.1, which has the highest concentration ratio? Based on your own
personal experiences, do you believe that American consumers are suffering significant welfare losses
due to monopoly power being exerted in this industry? Why or why not? Discuss.
Solution:
Based on the data in Table 8.1, the industry of household laundry equipment has the highest
concentration ratio, 98.3%. Students are encouraged to discuss the questions based on their own
personal experiences. No standard solution here.
17. Who would you expect to have lower costs of production, a monopolist or a competitive firm?
Explain.
Solution:
In a competitive market, a typical firm faces strong competition from other firms in the industry. It will
try its best to lower the cost of production below the current market price in order to make a profit in
the short run. Suppose the firm is making some profit by choosing the output level at MR=MC. New
firms will be attracted into the industry by the profit potential, market supply increases, causing the
market price to fall. This process will continue as long as the price is above average cost. Eventually
the market price falls to the level equal to the average cost and economic profit is zero in the long run.
Because MR =P for a competitive firm, MR curve is horizontal, the only way we have MR=MC and
P=ATC is at the minimum ATC curve. For a monopolist, MR curve is downward sloping and lies
below market demand curve. As the monopolist is maximizing its profit by choosing the level of output
at MR=MC, that level of output will still be in the declining portion of ATC. Since the monopolist
doesn’t have any competition, if the market price is above its ATC to generate some profit, it will get
to keep the monopolist profit in the long run. As a result, monopolist tends to have higher costs of
production than a competitive firm.
18. From an economic perspective, evaluate the U.S. federal government’s decision to bail out the
automobile industry in 2009. Given the state of the industry today, was this a good decision?
Solution:
Students may have various viewpoints on government’s bailing out the U.S. auto industry in the last
recession, but it’s important for students to realize the “too big to fail” problem. As the firm’s size gets
extremely large, the firm’s fall and survival could affect many workers’ life, the whole industry and
other businesses in the economy. Government and general public have been “taken hostage” by big
firms. Government had to bail out auto industry to avoid massive unemployment and collapse of the
industry. Because of the bailout, auto industry returned to profitability quickly, they have become more
competitive, its creation of jobs contributed significantly to the recovery of the U.S. manufacturing
industry. Most of the government bailout money was recovered later. Although there was still a net
cost of about $10 billion, it was a small cost to pay in comparison with the benefits it created. With
hindsight the bailout should be considered a success.
8-14

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Chapter 08 - The Economics of Monopoly Power

Economics of Social Issues 21st

Download full test bank at :

CAN MARKETS BE CONTROLLED?

2. Limitations of concentration ratios

a. Geographic area of market (e.g. local and international)

II. Impact of Monopoly on Performance

B. Profit and profit maximization

C. Price and output with competition

D. Price and output with monopoly

a. Ownership of raw materials

d. Patents and copyrights

2. Changing design and quality

III. Should We Fear Monopoly Power?

1. Putting estimates in perspectives

B. Loss due to private barriers

C. Loss due to laws

D. Loss due to non-price competition

1. Too big to fail?

IV. Natural Monopoly

B. DWL weighed against increasing average costs

3. Poorly defined property rights

4. Costs-benefit analysis of regulation

a. Capture theory of regulation

CORE ECONOMIC PRINCIPLES

• The Bureau of Competition of the Federal Trade Commission (http://www.ftc.gov/bc/index.shtml)

• Homepage of the American Antitrust Institutute (http://www.antitrustinstitute.org/), AAI is a

8. The typical firm’s long-run average cost curve is U-shaped. Why?

10. Define and explain the capture theory of regulation.

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