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Principles of Microeconomics Textbook

Principles of Microeconomics Textbook

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Firms that confront downward-sloping demand curves are said to enjoy market
power,a term that refers to their ability to set the prices of their products. A com-
mon misconception is that a firm with market power can sell any quantity at any
price it wishes. It cannot. All it can do is pick a price–quantity combination on its
demand curve. If the firm chooses to raise its price, it must settle for reduced sales.
Why do some firms have market power while others do not? Since market power
often carries with it the ability to charge a price above the cost of production, such
power tends to arise from factors that limit competition. In practice, the following five
factors often confer such power: exclusive control over inputs, patents and copyrights,
government licenses or franchises, economies of scale, and network economies.

EXCLUSIVE CONTROL OVER IMPORTANT INPUTS

If a single firm controls an input essential to the production of a given product, that
firm will have market power. For example, to the extent that some tenants are will-
ing to pay a premium for office space in the country’s tallest building, the Sears
Tower, the owner of that building has market power.

PATENTS AND COPYRIGHTS

Patents give the inventors or developers of new products the exclusive right to sell
those products for a specified period of time. By insulating sellers from competition
for an interval, patents enable innovators to charge higher prices to recoup their
product’s development costs. Pharmaceutical companies, for example, spend mil-
lions of dollars on research in the hope of discovering new drug therapies for seri-
ous illnesses. The drugs they discover are insulated from competition for an
interval—currently 20 years in the United States—by government patents. For the
life of the patent, only the patent holder may legally sell the drug. This protection
enables the patent holder to set a price above the marginal cost of production to re-
coup the cost of the research on the drug. In the same way, copyrights protect the
authors of movies, software, music, books, and other published works.

GOVERNMENT LICENSES OR FRANCHISES

The Yosemite Concession Services Corporation has an exclusive license from the
U.S. government to run the lodging and concession operations at Yosemite National
Park. One of the government’s goals in granting this monopoly was to preserve the
wilderness character of the area to the greatest degree possible. And indeed, the inns

FIVE SOURCES OF MARKET POWER

237

FIGURE 9.1
The Demand Curves
Facing Perfectly
and Imperfectly
Competitive Firms.

(a) The demand curve
confronting a perfectly
competitive firm is perfectly
elastic at the market price.
(b) The demand curve
confronting an imperfectly
competitive firm is
downward-sloping.

$/unit of output

Quantity
(a)

Price

Quantity
(b)

Market
price

Perfectly competitive firm

Imperfectly competitive firm

D

D

0

0

market powera firm’s ability to
raise the price of a good without
losing all its sales

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and cabins offered by the Yosemite Concession Services Company blend nicely with
the valley’s scenery. No garish neon signs mar the national park as they do in places
where rivals compete for the tourist’s dollars.

ECONOMIES OF SCALE AND NATURAL MONOPOLIES

When a firm doubles all its factors of production, what happens to its output? If
output exactly doubles, the firm’s production process is said to exhibit constant re-
turns to scale.If output more than doubles, the production process is said to exhibit
increasing returns to scale,or economies of scale.When production is subject to
economies of scale, the average cost of production declines as the number of units
produced increases. For example, in the generation of electricity, the use of larger
generators lowers the unit cost of production. The markets for such products tend
to be served by a single seller, or perhaps only a few sellers, because having a large
number of sellers would result in significantly higher costs. A monopoly that results
from economies of scale is called a natural monopoly.

NETWORK ECONOMIES

Although most of us don’t care what brand of dental floss others use, many prod-
ucts do become much more valuable to us as more people use them. In the case of
home videotape recorders, for instance, the VHS format’s defeat of the competing
Beta format was explained not by its superior picture quality—indeed, on most im-
portant technical dimensions, Beta was regarded by experts as superior to VHS.
Rather, VHS won simply because it managed to gain a slight sales edge on the ini-
tial version of Beta, which could not record programs longer than one hour. Al-
though Beta later corrected this deficiency, the VHS lead proved insuperable. Once
the fraction of consumers owning VHS passed a critical threshold, the reasons for
choosing it became compelling—variety and availability of tape rental, access to re-
pair facilities, the capability to exchange tapes with friends, and so on.
A similar network economy helps to account for the dominant position of
Microsoft’s Windows operating system, which, as noted earlier, is currently in-
stalled in more than 90 percent of all personal computers. Because Microsoft’s
initial sales advantage gave software developers a strong incentive to write for the
Windows format, the inventory of available software in the Windows format is
now vastly larger than that for any competing operating system. And although gen-
eral-purpose software such as word processors and spreadsheets continues to be
available for multiple operating systems, specialized professional software and
games usually appear first—and often only—in the Windows format. This software
gap and the desire to achieve compatibility for file sharing gave people a good
reason for choosing Windows, even if, as in the case of many Apple Macintosh
users, they believed a competing system was otherwise superior.

By far the most important and enduring of these sources of market power are
economies of scale and network economies. Lured by economic profit, firms almost
always find substitutes for exclusive inputs. Thus, real estate developer Donald Trump
has proposed a building taller than the Sears Tower, to be built in Chicago. Likewise,
firms can often evade patent laws by making slight changes in design of products.
Patent protection is only temporary, in any case. Finally, governments grant very few
franchises each year. But economies of scale are both widespread and enduring.
Firmly entrenched network economies can be as persistent a source of natural
monopoly as economies of scale. Indeed, network economies are essentially similar
to economies of scale. When network economies are of value to the consumer, a
product’s quality increases as the number of users increases, so we can say that any
given quality level can be produced at lower cost as sales volume increases. Thus
network economies may be viewed as just another form of economies of scale in
production, and that’s how we’ll treat them here.

238

CHAPTER 9MONOPOLY,OLIGOPOLY,AND MONOPOLISTIC COMPETITION

increasing returns to scalea
production process is said to
have increasing returns to scale
if,when all inputs are changed
by a given proportion,output
changes by more than that
proportion;also called

economies of scale

natural monopolya monopoly
that results from economies of
scale

constant returns to scalea
production process is said to
have constant returns to scale
if,when all inputs are changed
by a given proportion,output
changes by the same proportion

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ECONOMIES OF SCALE AND THE IMPORTANCE
OF START-UP COSTS

As we saw in the previous chapter, variable costs are those that vary with the level of
output produced, while fixed costs are independent of output. Strictly speaking, there
are no fixed costs in the long run because all inputs can be varied. But as a practical
matter, start-up costs often loom large for the duration of a product’s useful life.
Most of the costs involved in the production of computer software, for example, are
start-up costs of this sort, one-time costs incurred in writing and testing the software.
Once those tasks are done, additional copies of the software can be produced at a
very low marginal cost. A good such as software, whose production entails large
fixed start-up costs and low variable costs, will be subject to significant economies of
scale. Because by definition fixed costs don’t increase as output increases, the average
total cost of production for such goods will decline sharply as output increases.
To illustrate, consider a production process for which total cost is given by the
equation TC F M*Q,where Fis fixed cost, Mis marginal cost (assumed con-
stant in this illustration), and Qis the level of output produced. For the production
process with this simple total cost function, variable cost is simply M*Q,the prod-
uct of marginal cost and quantity. Average total cost, TC Q,is equal to F Q M.
As Qincreases, average cost declines steadily because the fixed costs are spread out
over more and more units of output.
Figure 9.2 shows the total production cost [part (a)] and average total cost [part
(b)] for a firm with the total cost curve TC F M*Qand the corresponding aver-
age total cost curve ATC F Q M. The average total cost curve [part (b)] shows
the decline in per-unit cost as output grows. Though average total cost is always
higher than marginal cost for this firm, the difference between the two diminishes as

ECONOMIES OF SCALE AND THE IMPORTANCE OF START-UP COSTS

239

RECAP

FIVE SOURCES OF MARKET POWER

A firm’s power to raise its price without losing its entire market stems from
exclusive control of important inputs, patents and copyrights, government li-
censes, economies of scale, or network economies. By far the most important
and enduring of these are economies of scale and network economies.

FIGURE 9.2
Total and Average Total
Costs for a Production
Process with Economies
of Scale.

For a firm whose total cost
curve of producing Qunits of
output per year is TC F
M*Q,total cost (a) rises at a
constant rate as output
grows,while average total
cost (b) declines.Average
total cost is always higher
than marginal cost for this
firm,but the difference
becomes less significant at
high output levels.

TC F M *Q

ATC F/Q M

Total cost ($/year)

Average cost ($/unit)

F

F M *Q0

Q0

Q

(a)

M

Q

(b)

0

0

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output grows. At extremely high levels of output, average total cost becomes very
close to marginal cost (M). Because the firm is spreading out its fixed cost over an ex-
tremely large volume of output, fixed cost per unit becomes almost insignificant.
As the following examples illustrate, the importance of economies of scale de-
pends on how large fixed cost is in relation to marginal cost.

Two video game producers,Nintendo and Playstation,each have fixed costs of
$200,000 and marginal costs of $0.80 per game.If Nintendo produces 1 mil-
lion units per year and Playstation produces 1.2 million,how much lower will
Playstation’s average total production cost be?

Table 9.1 summarizes the relevant cost categories for the two firms. Note in the bot-
tom row that Playstation enjoys only a 3-cent average cost advantage over Nin-
tendo. Even though Nintendo produces 20 percent fewer copies of its video game
than Playstation, it does not suffer a significant cost disadvantage because fixed cost
is a relatively small part of total production cost.

240

CHAPTER 9MONOPOLY,OLIGOPOLY,AND MONOPOLISTIC COMPETITION

TABLE 9.1

Costs for Two Computer Game Producers (1)

Nintendo

Playstation

Annual production

1,000,000

1,200,000

Fixed cost

$200,000

$200,000

Variable cost

$800,000

$960,000

Total cost

$1,000,000

$1,160,000

Average total cost per game

$1.00

$0.97

In the next example, note how the picture changes when fixed cost looms large
relative to marginal cost.

Two video game producers,Nintendo and Playstation,each have fixed costs of
$10,000,000 and marginal costs of $0.20 per video game.If Nintendo pro-
duces 1 million units per year and Playstation produces 1.2 million,how much
lower will Playstation’s average total cost be?

The relevant cost categories for the two firms are now summarized in Table 9.2.
The bottom row shows that Playstation enjoys a $1.67 average total cost advantage
over Nintendo, substantially larger than in the previous example.

TABLE 9.2

Costs for Two Computer Game Producers (2)

Nintendo

Playstation

Annual production

1,000,000

1,200,000

Fixed cost

$10,000,000

$10,000,000

Variable cost

$200,000

$240,000

Total cost

$10,200,000

$10,240,000

Average total cost per game

$10.20

$8.53

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If the video games the two firms produce are essentially similar, the fact that
Playstation can charge significantly lower prices and still cover its costs should en-
able it to attract customers away from Nintendo. As more and more of the market
goes to Playstation, its cost advantage will become self-reinforcing. Table 9.3 shows
how a shift of 500,000 units from Nintendo to Playstation would cause Nintendo’s
average total cost to rise to $20.20 per unit, while Playstation’s average total cost
would fall to $6.08 per unit. The fact that a firm cannot long survive at such a se-
vere disadvantage explains why the video game market is served now by only a
small number of firms.

EXERCISE 9.1

How big will Playstation’s unit cost advantage be if it sells 2,000,000 units
per year,while Nintendo sells only 200,000?

An important worldwide economic trend during recent decades is that an in-
creasing share of the value embodied in the goods and services we buy stems from
fixed investment in research and development. For example, in 1984 some 80 per-
cent of the cost of a computer was in its hardware (which has relatively high mar-
ginal cost); the remaining 20 percent was in its software. But by 1990 those
proportions were reversed. Fixed cost now accounts for about 85 percent of total
costs in the computer software industry, whose products are included in a growing
share of ordinary manufactured goods.

Why does Intel sell the overwhelming majority of all microprocessors used in
personal computers?

The fixed investment required to produce a new leading-edge microprocessor such as the
Intel Pentium chip currently runs upward of $2 billion.But once the chip has been de-
signed and the manufacturing facility built,the marginal cost of producing each chip is only
pennies.This cost pattern explains why Intel currently sells more than 80 percent of all
microprocessors.

As fixed cost becomes more and more important, the perfectly competitive pat-
tern of many small firms, each producing only a small share of its industry’s total
output, becomes less common. For this reason, we must develop a clear sense of
how the behavior of firms with market power differs from that of the perfectly
competitive firm.

ECONOMIES OF SCALE AND THE IMPORTANCE OF START-UP COSTS

241

TABLE 9.3

Costs for Two Computer Game Producers (3)

Nintendo

Playstation

Annual production

500,000

1,700,000

Fixed cost

$10,000,000

$10,000,000

Variable cost

$100,000

$340,000

Total cost

$10,100,000

$10,340,000

Average total cost per game

$20.20

$6.08

Why are most personal
computers equipped with Intel
microprocessors?

Example 9.1

The Economic Naturalist

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