©Bruce Domazlicky
REVENUES AND COSTS UNDER MONOPOLY
Since the monopolist is the sole seller of its product in the market, the demand curve that it faces is the market demand curve. This means if the monopolist wishes to increase its sales, it must lower price in order to move down its demand curve. It also means that marginal revenue will not be constant and equal to price but will decline as output increases and be less than price.
The first two columns in Table 7.1 comprise the demand curve for product X. Note that price and quantity demanded are inversely related as required by the Law of Demand. The third column gives total revenue, which is found by multiplying price times quantity. Note that total revenue increases to a maximum of $56.00, after which it starts to decline. The final column, marginal revenue, is the change in total revenue from selling one more unit of X. It declines and reaches zero and then becomes negative. Marginal revenue is also less than price as indicated earlier. Why is it, for example, that the third unit of X is sold for $12.00, but the marginal revenue of that third unit is only $10.00? The reason is that to sell the third unit of X, price must be lowered from $13.00 to $12.00. Therefore, the two units that were being sold for $13.00 each are now being sold for $12.00 each. Two dollars of revenue were lost from having to lower the prices of the first two units. The marginal revenue of the third unit is, therefore, $12.00 minus the $2.00 lost from lowering the price on the first two units to $12.00. That gives a marginal revenue of $10.00 as shown in Table 7.1. A graph of the demand curve and the marginal revenue curve is given in Figure 7.2.
Table 7.1
Price Quantity Total Rev. Marginal Rev.
$15 0 $ 0 --
14 1 14 14
13 2 26 12
12 3 36 10
11 4 44 8
10 5 50 6
9 6 54 4
8 7 56 2
7 8 56 0
6 9 54 -2
5 10 50 -4
The firm's costs are depicted in Table 7.2. The total cost (TC) column gives the total cost to the firm of producing the corresponding level of quantity. Therefore, if the firm produces 4 units of output, it will incur a cost of $24. The marginal cost column (MC) gives the additional cost to the firm of producing one more unit of output. In this example, the marginal cost is assumed to be constant such that when the firm increases its output by one unit, its total cost increases by $6.
Table 7.2
Quantity Total Cost Marginal Cost
0 0 --
1 6 6
2 12 6
3 18 6
4 24 6
5 30 6
6 36 6
7 42 6
8 48 6
9 54 6
10 60 6
Table 7.3 combines the information in Tables 7.1 and 7.2. The monopolist wants to produce the quantity of output that will maximize its profits. Profit is equal to total revenue (TR) minus total cost (TC). From Table 7.3, it is apparent that if the monopolist produces 4 or 5 units of output, its profit will be maximized at $20. The profit maximizing output can also be found by looking at marginal revenue and marginal cost. When the monopolist (or any firm, for that manner) increases its output, marginal revenue (MR) gives the changes in the monopolist's revenue while marginal cost (MC) is the change in the monopolist's costs. If MR exceeds MC, then the monopolist's profits will be increasing since more is added to revenue than to cost. If MR is less than MC, then adding one more unit of output will add more to cost than to revenue and the monopolist's profits will be decreasing. Consider the first unit of output in Table 7.3. Producing that first unit will add $6.00 to cost and $14 to revenue. Clearly, the monopolist should add the first unit of output. Similarly, the MR exceeds the MC for the second unit of output and so that unit should be produced. In general, the monopolist (or any firm) should expand output up to the point where marginal revenue equals marginal cost, or an output of 5 units in our example.
Table 7.3
Quant. Price TR MR TC MC Profit
0 $15 $0 --- $0 --- $ 0
1 14 14 14 6 6 8
2 13 26 12 12 6 14
3 12 36 10 18 6 18
4 11 44 8 24 6 20
5 10 50 6 30 6 20
6 9 54 4 36 6 18
7 8 56 2 42 6 14
8 7 56 0 48 6 8
9 6 54 -2 54 6 0
10 5 50 -4 60 6 -10
A graph of the above example is given in Figure 7.3. The MC is marginal cost, which is a horizontal line at $6 in this example. Marginal cost is equal to marginal revenue at an output level of 5. The monopolist charges a price of $10 and earns profits of $20.
If the industry were competitive, the level of production would occur where supply equals demand. Recall that the supply curve in a competitive market is equal to the marginal cost of producing one additional output. This means the competitive industry would produce where marginal cost (MC) crosses the demand curve (D) at an output level of 9. The competitive price would be $6, just equal to the constant marginal cost of production. Therefore, we can see that the monopolist will produce less than the competitive industry and charge a higher price. Also notice that at an output level of 5, the price someone is willing to pay fort he fifth unit is $10, which is greater than the $6 cost of producing the fifth unit. Efficiency demands that more of this good be produced since the benefits of additional units will exceed the marginal cost of producing additional units. But the monopolist will not choose to increase output, since to do so would cause the monopolist's profit to decrease. So once again, we see that the monopolist produces less than the efficient level of output.
THE "SPECIAL CASE" OF NATURAL MONOPOLY
While pure monopoly is clearly undesirable, it should be noted that monopoly may be necessary in markets where economies of scale in production are large relative to the size of the market. This would be the case of a natural monopoly that was mentioned above. As mentioned, when conditions of natural monopoly exist, it is most efficient to grant the firm a public utility franchise and then regulate that firm.
In applying the theory of natural monopoly, it becomes necessary, first, to identify which markets are characterized by pervasive economies of scale over the relevant range of market demand. Some cases are fairly obvious: electricity and natural gas at the municipal level. A city with more than one electric or natural gas company will experience wasteful duplication of facilities. For local phone service, at least at present, it would appear to be a natural monopoly. However, as cellular phones increase in use, it is not inconceivable that phone lines would no longer be necessary; only microwave transmission towers would be used to pick up and send calls. People would only need to have a cellular phone with no lines attached. If that should occur, then local phone service would become subject to intense competition as has happened with long distance service.
Other examples of government-sanctioned monopolies-the U.S. Postal Service and cable TV-don't necessarily fit the requirements of natural monopolies. Given the experience of overnight delivery and parcel post, it would appear that delivery of first-class mail could also be subjected to competition without negative effects on efficiency. In fact, many would maintain that a healthy dose of competition is just what the Postal Service needs to spur it to greater efficiency and power costs. One objection to allowing other mail carriers is that they would engage in cream-skimming. That is, new firms would deliver mail in the most lucrative routes (local delivery or between large cities) and leave the high-cost routes to the Postal Service (between small, rural cities as Tie Siding, Wyoming and Neelys Landing, Missouri). That objection could be easily met by requiring mail firms to provide universal service in order to enter the market. Further, evidence is that such a requirement may not be necessary since overnight delivery firms provide service to virtually anywhere in the U.S. (or even the world) Note also that technology is already starting to erode the Postal Service's markets in this area. The growing use of e-mail, the lowering of long-distance telephone rates, and the increasing use of fax machines all threaten the Postal Service's monopoly. Even with its exclusive monopoly, the Postal Service, apparently, is not safe from competition.
Once public utility franchises are granted, then regulation "in the public interest" becomes necessary. Such regulation usually centers around the allowable price the monopolist will be able to charge customers. A regulatory commission is established with the power to set the maximum price of the monopolist. The price must be set high enough so that the firm will be able to attract resources. If the price is set too low, then the firm will not make adequate profits and, therefore, will not be able to provide satisfactory service to its customers. On the other hand, the commission wants to set a maximum price which is below the profit-maximizing price of the monopolist. If the commission did not achieve the latter, then there is no reason for its existence since presumably, the monopolist could set the price at the profit-maximizing level on its own.
Most regulatory commissions appear to aim for a price that allows the firm to earn a rate of return that is commensurate with other firms in other markets. This would roughly correspond to setting a maximum price that would allow the firm to earn a normal profit. In the earlier example of this chapter, the maximum price would be set at $6.00. At such a price, the firm would produce 6 units of output to serve the entire demand (a requirement of regulation). Its price of $6.00 would just equal the average cost of production so the firm would earn normal profits. It would have enough profit, therefore, to attract resources and would earn a return similar to other firms in other markets. In general, the attractiveness of such an approach is evident. Consumers get lower prices and higher outputs while the firm is earning a normal profit.
However, the reality of regulation is that things do not always work out so smoothly. Allowable costs are sometimes difficult to determine. Since price depends on the level of costs, this is an important consideration. If a regulated firm is inefficient, costs will be too high. But frequently, this will just lead to higher allowable rates so that the firm itself experiences no real penalty from being inefficient. Its inefficiencies, in effect, are merely passed onto consumers in the form of higher rates.
The typical utility faces a variety of customers with differing levels and elasticities of demand. To what extent should price discrimination be allowed? As an example, the average residential customer has a very inelastic demand for electricity. There are just no viable alternatives for such a customer. A large industrial user of electricity, however, has alternatives. It may decide to buy from other suppliers or even generate electricity itself. Its demand for electricity, therefore, is much more elastic. Where demand is inelastic, much higher prices could be charged with little loss of business and significant increases in revenue. Where demand is more elastic, price must be kept lower to avoid loss of business and revenue. Will the commission require the utility to charge all customers the same price or will price discrimination be allowed? This is a question that requires an answer under regulation.
The process of regulation is also time-consuming and costly. Resources are being used up to support the process, resources that could be used in other markets to produce goods and services. This fact does not necessarily rule out regulation, but it does point out that there are resource costs to regulation. In summary, regulation is necessary whenever firms are granted exclusive franchises. In all cases, we need to be sure that the conditions of natural monopoly are present before setting up a firm with an exclusive franchise. Once that decision is made, regulation then needs to proceed as efficiently as possible.