Micro Economics

MICROECONOMICS
by Robert S. Pindyck
Daniel Rubinfeld
Ninth Edition
Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved
Part Three
Market Structure and Competitive Strategy
Part 3 examines a broad range of markets and explains how the pricing, investment, and
output decisions of firms depend on market structure and the behavior of competitors.
CHAPTERS
10. Market Power: Monopoly and Monopsony
11. Monopolistic Competition and Oligopoly
12. Game Theory and Competitive Strategy
13. Pricing with Market Power
14. Markets for Factor Inputs
15. Investment, Time, and Capital Markets
Chapter 10
Market Power: Monopoly and Monopsony (1 of 2)
CHAPTER OUTLINE LIST OF EXAMPLES
10.1 Monopoly 10.1 Astra-Merck Prices Prilosec
10.2 Monopoly Power 10.2 Elasticities of Demand for Soft Drinks
10.3 Sources of Monopoly Power 10.3 Markup Pricing: Supermarkets to Designer

Jeans
10.4 The Social Costs of Monopoly Power
10.4 The Pricing of Videos
10.5 Monopsony
10.5 Monopsony Power in U.S. Manufacturing
10.6 Monopsony Power
10.6 A Phone Call about Prices
10.7 Limiting Market Power: The Antitrust Laws
10.7 Go Directly to Jail. Don’t Pass Go.
10.8 The United States and the European

Union versus Microsoft
10.9 The Authors Debate Merger Policy
Market Power: Monopoly and Monopsony (2 of 2)
monopoly Market with only one seller.
monopsony Market with only one buyer.
market power Ability of a seller or buyer to affect the price of a good.
10.1 Monopoly (1 of 15)
Average Revenue and Marginal Revenue
marginal revenue Change in revenue resulting from a one-unit increase in output.
Consider a firm facing the following demand curve: P = 6 - Q
TABLE 10.1 TOTAL, MARGINAL, AND AVERAGE REVENUE
TOTAL MARGINAL AVERAGE

PRICE (P) QUANTITY (Q) REVENUE (R) REVENUE (MR) REVENUE (AR)
$6 0 $0 — —
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
FIGURE 10.1
AVERAGE AND MARGINAL

REVENUE
Average and marginal revenue are

shown for the demand curve
P = 6 − Q.
The Monopolist’s Output Decision
FIGURE 10.2
PROFIT IS MAXIMIZED WHEN
MARGINAL REVENUE EQUALS
MARGINAL COST
Q* is the output level at which MR = MC.
If the firm produces a smaller output—

say, Q1—it sacrifices some profit
because the extra revenue that could be
earned from producing and selling the
units between Q1 and Q* exceeds the
cost of producing them.
Similarly, expanding output from Q* to

Q2 would reduce profit because the
additional cost would exceed the
additional revenue.
We can also see algebraically that Q* maximizes profit. Profit π is the difference between
revenue and cost, both of which depend on Q:
Π(Q) R(Q) C(Q)
As Q is increased from zero, profit will increase until it reaches a maximum and then begin
to decrease. Thus the profit-maximizing Q is such that the incremental profit resulting from
a small increase in Q is just zero (i.e., Δπ /ΔQ = 0). Then
ΔΠ ΔQ ΔR ΔQ ΔC ΔQ 0
But ΔR/ΔQ is marginal revenue and ΔC/ΔQ is marginal cost. Thus the profit-maximizing
condition is that
MR − MC = 0, or MR = MC
An Example
Cost of production : C(Q ) 50 Q2

Demand : P (Q ) 40 Q
FIGURE 10.3
EXAMPLE OF PROFIT MAXIMIZATION
Part (a) shows total revenue R, total cost C, and profit, the difference
between the two.
Part (b) shows average and marginal revenue and average and
marginal cost.
Marginal revenue is the slope of the total revenue curve, and

marginal cost is the slope of the total cost curve.
The profit-maximizing output is Q* = 10, the point where marginal

revenue equals marginal cost.
At this output level, the slope of the profit curve is zero, and the
slopes of the total revenue and total cost curves are equal.
The profit per unit is $15, the difference between average revenue
and average cost. Because 10 units are produced, total profit is $150.
A Rule of Thumb for Pricing
With limited knowledge of average and marginal revenue, we can derive a rule of thump
that can be more easily applied in practice. First, write the expression for marginal revenue:
MR ΔR Δ(PQ )
ΔQ ΔQ
Note that the extra revenue from an incremental unit of quantity, Δ(PQ)/ΔQ, has two
components:
1. Producing one extra unit and selling it at price P brings in revenue (1)(P) = P.
2. But because the firm faces a downward-sloping demand curve, producing and selling
this extra unit also results in a small drop in price ΔP/ΔQ, which reduces the revenue
from all units sold (i.e., a change in revenue Q[ΔP/ΔQ]).
Thus MR P Q ΔP P P Q ΔP
ΔQ P ΔQ
(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand, 1/Ed, measured at the profit-
maximizing output, and
MR P P (1 Ed )
Now, because the firm’s objective is to maximize profit, we can set marginal revenue equal
to marginal cost:
P P (1 Ed ) MC
which can be rearranged to give us

P MC 1 (10.1)
P Ed
Equivalently, we can rearrange this equation to express price directly as a markup over
marginal cost:
P MC
(10.2)
1 (1 Ed )
EXAMPLE 10.1
ASTRA-MERCK PRICES PRILOSEC
In 1995, Prilosec, represented a new generation of

antiulcer medication. Prilosec was based on a very
different biochemical mechanism and was much more
effective than earlier drugs.
By 1996, it had become the best-selling drug in the

world and faced no major competitor.
Astra-Merck was pricing Prilosec at about $3.50 per

daily dose.
The marginal cost of producing and packaging Prilosec

is only about 30 to 40 cents per daily dose.
The price elasticity of demand, ED, should be in the

range of roughly −1.0 to −1.2.
Setting the price at a markup exceeding 400 percent

over marginal cost is consistent with our rule of thumb
for pricing.
Shifts in Demand
A monopolistic market has no supply curve. In other words, there is no one-to-one

relationship between price and the quantity produced.
The reason is that the monopolist’s output decision depends not only on marginal cost but
also on the shape of the demand curve.
As a result, shifts in demand do not trace out the series of prices and quantities that
correspond to a competitive supply curve. Instead, shifts in demand can lead to changes in
price with no change in output, changes in output with no change in price, or changes in
both price and output.
Shifts in demand usually cause changes in both price and quantity. A competitive industry
supplies a specific quantity at every price. No such relationship exists for a monopolist,
which, depending on how demand shifts, might supply several different quantities at the
same price, or the same quantity at different prices.
FIGURE 10.4
SHIFTS IN DEMAND
Shifting the demand curve shows that a
monopolistic market has no supply curve—i.e.,
there is no one-to-one relationship between
price and quantity produced.
In (a), the demand curve D1 shifts to new
demand curve D2.
But the new marginal revenue curve MR2
intersects marginal cost at the same point as
the old marginal revenue curve MR1.
The profit-maximizing output therefore remains
the same, although price falls from P1 to P2.
In (b), the new marginal revenue curve MR2
intersects marginal cost at a higher output level
Q2.
But because demand is now more elastic, price
remains the same.
The Effect of a Tax
Suppose a specific tax of t dollars per unit is
levied, so that the monopolist must remit t
dollars to the government for every unit it
sells. If MC was the firm’s original marginal
cost, its optimal production decision is now
given by
MR ΜC t
FIGURE 10.5
EFFECT OF EXCISE TAX ON

MONOPOLIST
With a tax t per unit, the firm’s effective
marginal cost is increased by the amount t to
MC + t.
In this example, the increase in price ΔP is
larger than the tax t.
• The Multiplant Firm
Suppose a firm has two plants. What should its total output be, and how much of that
output should each plant produce? We can find the answer intuitively in two steps.
• Step 1. Whatever the total output, it should be divided between the two plants so that
marginal cost is the same in each plant. Otherwise, the firm could reduce its costs and
increase its profit by reallocating production.
• Step 2. We know that total output must be such that marginal revenue equals marginal
cost. Otherwise, the firm could increase its profit by raising or lowering total output.
We can also derive this result algebraically. Let Q1 and C1 be the output and cost of
production for Plant 1, Q2 and C2 be the output and cost of production for Plant 2, and
QT = Q1 + Q2 be total output. Then profit is
Π PQT C1(Q1) C 2(Q 2)
The firm should increase output from each plant until the incremental profit from the last
unit produced is zero. Start by setting incremental profit from output at Plant 1 to zero:
ΔΠ Δ(PQT ) ΔC1 0
ΔQ1 ΔQ1 ΔQ1
Here Δ(PQT)/ΔQ1 is the revenue from producing and selling one more unit—i.e.,
marginal revenue, MR, for all of the firm’s output.
The next term, ΔC1/ΔQ1, is marginal cost at Plant 1, MC1. We thus have
MR − MC1 = 0, or
MR = MC!
Similarly, we can set incremental profit from output at Plant 2 to zero,

MR = MC"
Putting these relations together, we see that the firm should produce so that
MR = MC! = MC" (10.3)
FIGURE 10.6
PRODUCING WITH TWO

PLANTS
A firm with two plants maximizes

profits by choosing output levels
Q1 and Q2 so that marginal
revenue MR (which depends on
total output) equals marginal costs
for each plant, MC1 and MC2.
FIGURE 10.7
THE DEMAND FOR
TOOTHBRUSHES
Part (a) shows the market demand
for toothbrushes.
Part (b) shows the demand for

toothbrushes as seen by Firm A.
At a market price of $1.50, elasticity

of market demand is −1.5.
Firm A, however, sees a much more

elastic demand curve DA because of
competition from other firms.
At a price of $1.50, Firm A’s demand

elasticity is −6.
Still, Firm A has some monopoly

power: Its profit-maximizing price is
$1.50, which exceeds marginal cost.
EXAMPLE 10.2
ELASTICITIES OF DEMAND FOR SOFT DRINKS
Soft drinks provide a good example of the difference between a market elasticity of demand and a firm’s
elasticity of demand.
In addition, soft drinks are important because their consumption has been linked to childhood obesity;
there could be health benefits from taxing them.
A recent review of several statistical studies found that the market elasticity of demand for soft drinks is
between −0.8 and −1.0.6 That means that if all soft drink producers increased the prices of all of their
brands by 1 percent, the quantity of soft drinks demanded would fall by 0.8 to 1.0 percent.
The demand for any individual soft drink, however, will be much more elastic, because consumers can
readily substitute one drink for another.
Although elasticities will differ across different brands, studies have shown that the elasticity of demand
for, say, Coca Cola is around −5. In other words, if the price of Coke were increased by 1 percent but the
prices of all other soft drinks remained unchanged, the quantity of Coke demanded would fall by about 5
percent.
Students—and business people—sometimes confuse the market elasticity of demand with the firm
(or brand) elasticity of demand. Make sure you understand the difference.
10.2 Monopoly Power (1 of 3)
Production, Price, and Monopoly Power
In figure 10.7, although Firm A is not a pure monopolist, it does have monopoly power—
it can profitably charge a price greater than marginal cost. Of course, its monopoly power is
less than it would be if it had driven away the competition and monopolized the market, but
it might still be substantial.
This raises two questions.
1. How can we measure monopoly power in order to compare one firm with another?
(So far we have been talking about monopoly power only in qualitative terms.)
2. What are the sources of monopoly power, and why do some firms have more monopoly
power than others?
We address both these questions below, although a more complete answer to the second
question will be provided in Chapters 12 and 13.
Measuring Monopoly Power
Remember the important distinction between a perfectly competitive firm and a firm with
monopoly power: For the competitive firm, price equals marginal cost; for the firm with
monopoly power, price exceeds marginal cost.
Lerner Index of Monopoly Power Measure of monopoly power calculated as excess of

price over marginal cost as a fraction of price.
Mathematically:
L (P MC) P
This index of monopoly power can also be expressed in terms of the elasticity of demand
facing the firm.
L (P MC ) P 1 Ed (10.4)
The Rule of Thumb for Pricing
P MC
1 (1 Ed )
FIGURE 10.8
ELASTICITY OF DEMAND AND

PRICE MARKUP
The markup (P − MC)/P is equal to

minus the inverse of the elasticity
of demand.
If the firm’s demand is elastic, as in

(a), the markup is small and the
firm has little monopoly power.
The opposite is true if demand is

relatively inelastic, as in (b).
EXAMPLE 10.3
MARKUP PRICING: SUPERMARKETS TO DESIGNER JEANS
Although the elasticity of market demand for food is small (about

−1), no single supermarket can raise its prices very much without
losing customers to other stores.
The elasticity of demand for any one supermarket is often as large

as −10. We find P = MC/(1 − 0.1) = MC/(0.9) = (1.11)MC.
The manager of a typical supermarket should set prices about 11

percent above marginal cost.
Small convenience stores typically charge higher prices because its

customers are generally less price sensitive.
Because the elasticity of demand for a convenience store is about

−5, the markup equation implies that its prices should be about 25
percent above marginal cost.
With designer jeans, demand elasticities in the range of −2 to −3

are typical. This means that price should be 50 to 100 percent
higher than marginal cost.
EXAMPLE 10.4 (1 of 2)
THE PRICING OF VIDEOS
When the market for videos was young, producers had no good estimates of the elasticity
of demand. As the market matured, however, sales data and market research studies put
pricing decisions on firmer ground. By the 1990s, most producers had lowered prices
across the board.
TABLE 10.2: RETAIL PRICES OF VIDEOS IN 1985 AND 2011

RETAIL RETAIL PRICE
TITLE TITLE
PRICE ($) ($)
Blank Cell VHS Blank Cell DVD
Purple Rain $29.98 The Divergent Series: Allegiant $29.95
Raiders of the Lost Ark $24.95 The Revenant $17.99
Jane Fonda Workout $59.95 Inside Out $19.96
The Empire Strikes Back $79.98 Star Wars: The Force Awakens $29.99
An Officer and a Gentleman $24.95 Minions $12.96
Star Trek: The Motion Picture $24.95 The Hunger Games: Mockingjay, Part 2 $14.99
Star Wars $39.98 13 Hours: The Secret Soldiers of Benghazi $29.99
THE PRICING OF VIDEOS
FIGURE 10.9
VIDEO SALES
Between 1990 and 2004, lower prices

induced consumers to buy many more
videos.
By 2001, sales of DVDs overtook sales of

VHS videocassettes.
High-definition DVDs were introduced in

2006, and were expected to eventually
displace sales of conventional DVDs. By
2008, however, sales of all DVDs,
conventional and high-definition, began
falling rapidly as they were displaced by
streaming video.
10.3 Sources of Monopoly Power (1 of 4)
As equation (10.4) shows, the less elastic its demand curve, the more monopoly power a
firm has. The ultimate determinant of monopoly power is therefore the firm’s elasticity of
demand.
Three factors determine a firm’s elasticity of demand.
1. The elasticity of market demand. Because the firm’s own demand will be at least as
elastic as market demand, the elasticity of market demand limits the potential for
monopoly power.
2. The number of firms in the market. If there are many firms, it is unlikely that any one
firm will be able to affect price significantly.
3. The interaction among firms. Even if only two or three firms are in the market, each
firm will be unable to profitably raise price very much if the rivalry among them is
aggressive, with each firm trying to capture as much of the market as it can.
The Elasticity of Market Demand
If there is only one firm—a pure monopolist—its demand curve is the market demand
curve. In this case, the firm’s degree of monopoly power depends completely on the
elasticity of market demand.
When several firms compete with one another, the elasticity of market demand sets a lower
limit on the magnitude of the elasticity of demand for each firm.
A particular firm’s elasticity depends on how the firms compete with one another, and the
elasticity of market demand limits the potential monopoly power of individual producers.
Because the demand for oil is fairly inelastic (at least in the short run), OPEC could raise oil
prices far above marginal production cost during the 1970s and early 1980s. Because the
demands for such commodities as coffee, cocoa, tin, and copper are much more elastic,
attempts by producers to cartelize these markets and raise prices have largely failed. In
each case, the elasticity of market demand limits the potential monopoly power of individual
producers.
The Number of Firms
Other things being equal, the monopoly power of each firm will fall as the number of firms
increases.
When only a few firms account for most of the sales in a market, we say that the market is
highly concentrated.
barrier to entry Condition that impedes entry by new competitors.
Sometimes there are natural barriers to entry:
Patents, copyrights, and licenses
Economies of scale may make it too costly for more than a few firms to supply the entire
market. In some cases, economies of scale may be so large that it is most efficient for a
single firm—a natural monopoly—to supply the entire market.
The Interaction Among Firms
Firms might compete aggressively, undercutting one another’s prices to capture more
market share, or they might not compete much. They might even collude (in violation of the
antitrust laws), agreeing to limit output and raise prices.
Other things being equal, monopoly power is smaller when firms compete aggressively and
is larger when they cooperate. Because raising prices in concert rather than individually is
more likely to be profitable, collusion can generate substantial monopoly power.
Remember that a firm’s monopoly power often changes over time, as its operating
conditions (market demand and cost), its behavior, and the behavior of its competitors
change. Monopoly power must therefore be thought of in a dynamic context.
Furthermore, real or potential monopoly power in the short run can make an industry more
competitive in the long run: Large short-run profits can induce new firms to enter an
industry, thereby reducing monopoly power over the longer term.
10.4 The Social Costs of Monopoly Power
(1 of 5)
FIGURE 10.10
DEADWEIGHT LOSS FROM MONOPOLY

POWER
The shaded rectangle and triangles show
changes in consumer and producer surplus when
moving from competitive price and quantity, Pc
and Qc, to a monopolist’s price and quantity, Pm
and Qm.
Because of the higher price, consumers lose A +
B and producer gains A − C. The deadweight
loss is B + C.
Rent Seeking
rent seeking Spending money in socially unproductive efforts to acquire, maintain, or exercise
monopoly.
We would expect the economic incentive to incur rent-seeking costs to bear a direct relation to the gains
from monopoly power (i.e., rectangle A minus triangle C.)
10.4 The Social Costs of Monopoly Power (2 of 5)
Price Regulation
FIGURE 10.11 (1 of 2)
PRICE REGULATION
If left alone, a monopolist produces Qm

and charges Pm.
When the government imposes a price

ceiling of P1 the firm’s average and
marginal revenue are constant and equal
to P1 for output levels up to Q1.
For larger output levels, the original

average and marginal revenue curves
apply.
The new marginal revenue curve is,

therefore, the dark purple line, which
intersects the marginal cost curve at Q1.
FIGURE 10.11 (2 of 2)
PRICE REGULATION
When price is lowered to Pc, at the

point where marginal cost intersects
average revenue, output increases to
its maximum Qc. This is the output
that would be produced by a
competitive industry.
Lowering price further, to P3, reduces

output to Q3 and causes a shortage,
Q’3 − Q3.
Natural Monopoly
natural monopoly Firm that can produce the
entire output of the market at a cost lower than
what it would be if there were several firms.
FIGURE 10.12
REGULATING THE PRICE OF A NATURAL

MONOPOLY
A firm is a natural monopoly because it has

economies of scale (declining average and
marginal costs) over its entire output range.
If price were regulated to be Pc the firm would lose

money and go out of business.
Setting the price at Pr yields the largest possible

output consistent with the firm’s remaining in
business; excess profit is zero.
Regulation in Practice
The regulation of a monopoly is sometimes based on the rate of return

that it earns on its capital. The regulatory agency determines an allowed price, so that this
rate of return is in some sense “competitive” or “fair.”
rate-of-return regulation Maximum price allowed by a regulatory agency is based on the

(expected) rate of return that a firm will earn.
Although it is a key element in determining the firm’s rate of return, a firm’s capital stock is
difficult to value.
Regulatory lag is a term associated with delays in changing regulated prices.
Another approach to regulation is setting price caps based on the firm’s variable costs. A
price cap can allow for more flexibility. For example, a firm could raise its prices each year
(without having to get approval from the regulatory agency) by an amount equal to the
actual rate of inflation, minus expected productivity growth.
10.5 Monopsony (1 of 4)
monopsony power Buyer’s ability to affect the price of a good.
oligopsony Market with only a few buyers.
marginal value Additional benefit derived from purchasing one more unit of a good.
marginal expenditure Additional cost of buying one more unit of a good.
average expenditure Price paid per unit of a good.
FIGURE 10.13
COMPETITIVE BUYER COMPARED TO

COMPETITIVE SELLER
In (a), the competitive buyer takes

market price P* as given. Therefore,
marginal expenditure and average
expenditure are constant and equal;
quantity purchased is found by equating

price to marginal value (demand).
In (b), the competitive seller also takes

price as given. Marginal revenue and
average revenue are constant and equal;
quantity sold is found by equating price

to marginal cost.
FIGURE 10.14
MONOPSONIST BUYER
The market supply curve is monopsonist’s average

expenditure curve AE.
Because average expenditure is rising, marginal

expenditure lies above it.
The monopsonist purchases quantity Q*m, where

marginal expenditure and marginal value (demand)
intersect.
The price paid per unit P*m is then found from the
average expenditure (supply) curve.
In a competitive market, price and quantity, Pc and Qc,

are both higher.
They are found at the point where average expenditure

(supply) and marginal value (demand) intersect.
Monopsony and Monopoly Compared
FIGURE 10.15
MONOPOLY AND MONOPSONY
These diagrams show the close analogy

between monopoly and monopsony.
(a) The monopolist produces where marginal

revenue intersects marginal cost.
Average revenue exceeds marginal revenue,

so that price exceeds marginal cost.
(b) The monopsonist purchases up to the

point where marginal expenditure intersects
marginal value.
Marginal expenditure exceeds average

expenditure, so that marginal value exceeds
price.
10.6 Monopsony Power (1 of 4)
FIGURE 10.16
MONOPSONY POWER: ELASTIC

VERSUS INELASTIC SUPPLY
Monopsony power depends on the

elasticity of supply.
When supply is elastic, as in (a),

marginal expenditure and average
expenditure do not differ by much, so
price is close to what it would be in a
competitive market.
The opposite is true when supply is

inelastic, as in (b).
Sources of Monopsony Power
ELASTICITY OF MARKET SUPPLY
If only one buyer is in the market—a pure monopsonist—its monopsony power is

completely determined by the elasticity of market supply. If supply is highly elastic,
monopsony power is small and there is little gain in being the only buyer.
NUMBER OF BUYERS
When the number of buyers is very large, no single buyer can have much influence over
price. Thus each buyer faces an extremely elastic supply curve, so that the market is
almost completely competitive.
INTERACTION AMONG BUYERS
If four buyers in a market compete aggressively, they will bid up the price close to their
marginal value of the product, and will thus have little monopsony power. On the other
hand, if those buyers compete less aggressively, or even collude, prices will not be bid up
very much, and the buyers’ degree of monopsony power might be nearly as high as if there
were only one buyer.
The Social Costs of Monopsony Power
FIGURE 10.17
DEADWEIGHT LOSS FROM MONOPSONY

POWER
The shaded rectangle and triangles show changes

in buyer and seller surplus when moving from
competitive price and quantity, Pc and Qc,
to the monopsonist’s price and quantity, Pm and Qm.
Because both price and quantity are lower, there is

an increase in buyer (consumer) surplus given by
A − B.
Producer surplus falls by A + C, so there is a

deadweight loss given by triangles B and C.
Bilateral Monopoly
bilateral monopoly Market with only one seller and one buyer.
It is difficult to predict the price and quantity in a bilateral monopoly. Both the buyer and the
seller are in a bargaining situation.
Bilateral monopoly is rare. Although bargaining may still be involved, we can apply a rough
principle here: Monopsony power and monopoly power will tend to counteract each other.
In other words, the monopsony power of buyers will reduce the effective monopoly power
of sellers, and vice versa.
This tendency does not mean that the market will end up looking perfectly competitive, but
in general, monopsony power will push price closer to marginal cost, and monopoly power
will push price closer to marginal value.
EXAMPLE 10.5
MONOPSONY POWER IN U.S. MANUFACTURING
The role of monopsony power was investigated to

determine the extent to which variations in price-cost
margins could be attributed to variations in monopsony
power.
The study found that buyers’ monopsony power had an

important effect on the price-cost margins of sellers.
In industries where only four or five buyers account for

all or nearly all sales, the price-cost margins of sellers
would on average be as much as 10 percentage points
lower than in comparable industries with hundreds of
buyers accounting for sales.
Each major car producer in the United States typically buys an individual part from at least three, and
often as many as a dozen, suppliers.
For a specialized part, a single auto company may be the only buyer.
As a result, the automobile companies have considerable monopsony power. Not surprisingly, producers
of parts and components usually have little or no monopoly power.
10.7 Limiting Market Power: The Antitrust
Laws (1 of 3)
Excessive market power harms potential purchasers and raises problems of equity and
fairness. In addition, market power reduces output, which leads to a deadweight loss.
In theory, a firm’s excess profits could be taxed away, but redistribution of the firm’s profits
is often impractical.
To limit the market power of a natural monopoly, such as an electric utility company, direct
price regulation is the answer.
antitrust laws Rules and regulations prohibiting actions that restrain, or are likely to
restrain, competition.
It is important to stress that, while there are limitations (such as colluding with other firms),
in general, it is not illegal to be a monopolist or to have market power. On the contrary,
we have seen that patent and copyright laws protect the monopoly positions of firms that
developed unique innovations.
(2 of 3)
Restricting what Firms can do
parallel conduct Form of implicit collusion in which one firm consistently follows actions of
another.
predatory pricing Practice of pricing to drive current competitors out of business and to
discourage new entrants in a market so that a firm can enjoy higher future profits.
Enforcement of the Antitrust Laws
The antitrust laws are enforced in three ways:
1. Through the Antitrust Division of the Department of Justice.
2. Through the administrative procedures of the Federal Trade Commission.
3. Through private proceedings.
(3 of 3)
Antitrust in Europe
Antitrust laws of the European Union are quite similar to those of the United States.
Article 101 of the Treaty of the European Community is much like Section 1 of the Sherman
Act.
Article 102, which focuses on abuses of market power by dominant firms, is similar in many
ways to Section 2 of the Sherman Act.
The European Merger Control Act is similar in spirit to Section 7 of the Clayton Act.
Merger evaluations typically are conducted more quickly in Europe.
Antitrust enforcement has grown rapidly through the world in the past decade.
All enforcement agencies meet at least once each year through the auspices of the
International Competition Network.
A PHONE CALL ABOUT PRICES
Robert Crandall, president and CEO of American, made a phone call to Howard Putnam,
president and chief executive of Braniff. It went like this:
Crandall: I think it’s dumb as hell for Christ’s sake, all right, to sit here and pound the
@!#$%&! out of each other and neither one of us making a @!#$%&! dime.
Putnam: Well . . .
Crandall: I mean, you know, @!#$%&!, what the hell is the point of it?
Putnam: But if you’re going to overlay every route of American’s on top of every route that
Braniff has—I just can’t sit here and allow you to bury us without giving our best effort.
Crandall: Oh sure, but Eastern and Delta do the same thing in Atlanta and have for years.
Putnam: Do you have a suggestion for me?
A PHONE CALL ABOUT PRICES
Crandall: Yes, I have a suggestion for you. Raise your @!#$%&! fares 20 percent. I’ll raise
mine the next morning.
Putnam: Robert, we. . .
Crandall: You’ll make more money and I will, too.
Putnam: We can’t talk about pricing!
Crandall: Oh @!#$%&!, Howard. We can talk about any @!#$%&! thing we want to talk
about.
Crandall was wrong. Talking about prices and agreeing to fix them is a clear violation of
Section 1 of the Sherman Act.
However, proposing to fix prices is not enough to violate Section 1 of the Sherman Act: For
the law to be violated, the two parties must agree to collude.
Therefore, because Putnam had rejected Crandall’s proposal, Section 1 was not violated.
GO DIRECTLY TO JAIL. DON’T PASS GO
If you become a successful business executive, think twice

before picking up the phone. And if your company happens to
be located in Europe or Asia, don’t think that will keep you out
of a U.S. jail.
For example:
In 1996 Archer Daniels Midland (ADM) and two other
producers of lysine (an animal feed additive) pled guilty to
charges of price fixing. In 1999 three ADM executives were
sentenced to prison terms of two to three years.
In 1999 four of the world’s largest drug and chemical
companies—Hoffman-La Roche of Switzerland, BASF of
Germany, Rhone Poulenc of France, and Takeda of Japan—
pled guilty to fixing the prices of vitamins sold in the U.S. and
Europe. The companies paid about $1.5 billion in penalties to
the U.S. Department of Justice (DOJ), $1 billion to the
European Commission, and over $4 billion to settle civil suits.
Executives from each of the companies did prison time in the
U.S.
of a U.S. jail.
For example:
During 2002 to 2009, Horizon Lines engaged in price fixing
with Sea Star Lines (Puerto Rico-based shipping companies).
Five executives got prison terms ranging from one to four
years.
Eight companies, mostly in Korea and Japan, fixed DRAM
(memory chip) prices from 1998 to 2002. In 2007, 18
executives from these companies were sentenced to prison
terms in the United States.
In 2009, five companies pled guilty to fixing prices of LCD
displays during 2001 to 2006. 22 executives received prison
sentences in the United States (on top of $1 billion in fines).
In 2011, two companies were convicted of fixing prices and
rigging bids for ready-mix concrete in Iowa. One executive was
sentenced to one year in prison, another to four years.

of a U.S. jail.
For example:
In 2013, an Army Corp of Engineers contractor received a 4-
year prison sentence for bid-rigging. The individual who led the
bid-rigging conspiracy had previously received a 19-year
sentence.
During 2014–2015, a total of 29 executives pleaded guilty and
were sentenced to an average of nearly 15 months in jail in the
U.S. for fixing the prices of auto parts in a worldwide
conspiracy.
Get the idea? Don’t make the mistake of doing what these
business people did. Stay out of jail.
EXAMPLE 10.8
THE UNITED STATES AND THE EUROPEAN UNION VERSUS MICROSOFT
Over the past three decades Microsoft has dominated the

software market for personal computers, having
maintained over a 90-percent market share for operating
systems and for office suites.
In 1998, the Antitrust Division of the U.S. DOJ filed suit,

claiming that Microsoft had illegally bundled its Internet
browser with its operating system for the purpose of
maintaining its dominant operating system monopoly. The
court found that Microsoft did have monopoly power in the
market for PC operating systems, which it had maintained
illegally in violation of Section 2 of the Sherman Act.
In 2004, the European Commission claimed that by bundling the Windows Media Player with the
operating system, Microsoft would monopolize the market for media players. Microsoft agreed to offer
customers a choice of browsers when first booting up their new operating system, and the case came to
a close in 2012.
By 2016, the locus of competition had moved to the smartphone industry, where Microsoft faces strong
competition from Google’s (Android) and Apple’s (iOS) operating systems.
THE AUTHORS DEBATE MERGER POLICY
Should the U.S. Department of Justice and Federal Trade Commission as well as the
European Commission be more skeptical about claims that mergers will lead to cost-saving
efficiencies, and put more emphasis on possible harm to consumers?
“Yes,” claims Pindyck. The firms that want to merge typically claim that the merger will lead
to efficiencies that will reduce costs and thereby benefit consumers, but those claims are
usually speculative and, post-merger, often fail to materialize.”
“No. Hold a minute,” responds Rubinfeld. “The vast majority of mergers (well over 95
percent) do not increase the market power of the acquiring firms and don’t need major
public investigations. Some mergers actually do result in cost-saving efficiencies. And in
most cases, mergers have not led to significant price increases.”
“I’ll grant that,” replies Pindyck, “but you should also note that the number of mega-mergers
(those valued at more than $500 million) has steadily increased in recent years. In fact,
look at Figure 10.18, which shows how several industries have become much more
concentrated during the 15-year period 1992 to 2007.
THE AUTHORS DEBATE MERGER POLICY
FIGURE 10.18
CHANGE IN CONCENTRATION
IN SEVERAL INDUSTRIES
The figure shows the share of

industry revenue in the United
States that went to the top four
firms in each industry, for 1992
and 2007.
“The question,” replies Rubinfeld, “is whether these mergers have resulted in greater
consumer benefits and efficiencies that can lead to lower costs, and thus in the long run,
lower prices. Some—though not all—clearly have.” Which is what makes merger policy so
complex, the two authors conclude.
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MICROECONOMICS

10. Market Power: Monopoly and Monopsony

11. Monopolistic Competition and Oligopoly

12. Game Theory and Competitive Strategy

13. Pricing with Market Power

14. Markets for Factor Inputs

15. Investment, Time, and Capital Markets

10.2 Monopoly Power 10.2 Elasticities of Demand for Soft Drinks

10.3 Sources of Monopoly Power 10.3 Markup Pricing: Supermarkets to Designer

10.8 The United States and the European

10.9 The Authors Debate Merger Policy

monopsony Market with only one buyer.

market power Ability of a seller or buyer to affect the price of a good.

marginal revenue Change in revenue resulting from a one-unit increase in output.

Consider a firm facing the following demand curve: P = 6 - Q

TABLE 10.1 TOTAL, MARGINAL, AND AVERAGE REVENUE

TOTAL MARGINAL AVERAGE

AVERAGE AND MARGINAL

Average and marginal revenue are

If the firm produces a smaller output—

Similarly, expanding output from Q* to

Π(Q) R(Q) C(Q)

Cost of production : C(Q ) 50 Q2

EXAMPLE OF PROFIT MAXIMIZATION

Marginal revenue is the slope of the total revenue curve, and

The profit-maximizing output is Q* = 10, the point where marginal

which can be rearranged to give us

In 1995, Prilosec, represented a new generation of

By 1996, it had become the best-selling drug in the

Astra-Merck was pricing Prilosec at about $3.50 per

The marginal cost of producing and packaging Prilosec

The price elasticity of demand, ED, should be in the

Setting the price at a markup exceeding 400 percent

A monopolistic market has no supply curve. In other words, there is no one-to-one

EFFECT OF EXCISE TAX ON

Π PQT C1(Q1) C 2(Q 2)

Similarly, we can set incremental profit from output at Plant 2 to zero,

MR = MC! = MC" (10.3)

PRODUCING WITH TWO

A firm with two plants maximizes

Part (b) shows the demand for

At a market price of $1.50, elasticity

Firm A, however, sees a much more

At a price of $1.50, Firm A’s demand

Still, Firm A has some monopoly

This raises two questions.

Lerner Index of Monopoly Power Measure of monopoly power calculated as excess of

ELASTICITY OF DEMAND AND

The markup (P − MC)/P is equal to

If the firm’s demand is elastic, as in

The opposite is true if demand is

Although the elasticity of market demand for food is small (about

The elasticity of demand for any one supermarket is often as large

The manager of a typical supermarket should set prices about 11

Small convenience stores typically charge higher prices because its

Because the elasticity of demand for a convenience store is about

With designer jeans, demand elasticities in the range of −2 to −3

TABLE 10.2: RETAIL PRICES OF VIDEOS IN 1985 AND 2011

Between 1990 and 2004, lower prices

By 2001, sales of DVDs overtook sales of