Hill – Mankiw 9th Edn Chapter 15 – Monopoly
Mankiw, N. G. (2021) Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
Rod Hill
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
email: rhill@unb.ca
Chapter 15 – Monopoly
Here are some things to consider when reading this chapter.
- The inefficiency of monopoly compared with perfect competition
The previous chapter stated that one of the uses of the perfectly competitive model was as “a benchmark against which we can compare other market structures” (p. 264). In the case of monopoly, Mankiw describes how a benevolent social planner could set a price equal to marginal cost to maximize total surplus, paralleling how total surplus is maximized in a perfectly competitive market. However, the monopolistic firm chooses a price that exceeds marginal cost, creating a deadweight loss (pp. 299-301).
(i) The problem of cost curves
One practical problem with this prescription is that the cost curves illustrated in Figure 5 are not supported by the evidence, as explained in the Commentary on Chapter 13. Like other firms, the monopolistic firm’s costs are much more likely to look like those in Mankiw’s Figures 6 and 10, where marginal costs are constant. Marginal costs could also be illustrated as decreasing, which is consistent with decreasing average costs. In these cases, setting price equal to marginal cost would result in a loss, as shown in Figure 10.
If price can’t be set at marginal cost, the benevolent social planner faces the same problems that the regulators of a monopoly must deal with (described on p. 310). Either the price is set equal to marginal cost with the resulting losses paid for through taxes, which may create their own inefficiencies, or price is set above marginal cost to eliminate the loss.
(ii) Comparing monopoly with perfect competition: demand and costs
A student might think that the monopolist’s demand and marginal cost curves in Figure 5 and Figure 8 are the same as the demand and supply curves would be if the industry were perfectly competitive. While many textbook authors make this assumption explicitly, Mankiw seems to assume this implicitly.
Unlike monopolists, perfectly-competitive firms have no incentive to advertise to influence demand for their product. All firms sell identical products, so advertising by any one firm would raise its costs while any effect on market demand would almost entirely benefit other sellers. In Mankiw’s account of monopoly, the firm’s marketing department just tries to determine the location of the demand curve so that price can be set appropriately, rather than attempting to influence demand (p. 302). While this is consistent with the standard textbook assumption of consumers with given preferences and perfect information, in reality monopolists could have an incentive to advertise. In general, the monopolistic industry’s demand curve differs from what it would be if the industry were perfectly competitive.
Economists have long recognized that a monopoly’s costs would differ from that of a perfectly competitive industry. For example, Alfred Marshall, in his classic text Principles of Economics wrote:
when the production is all in the hands of one person or company, the total expenses involved are generally less than would have to be incurred if the same aggregate production were distributed among a multitude of comparatively small rival producers.… they would be less able to avail themselves of the many various economies which result from production on a large scale. In particular they could not afford to spend as much on improving methods of production and the machinery used in it, as a single large firm which knew that it was certain itself to reap the whole benefit of any advance it made (1920: Book V, Chapter 15, Section 5).
If the monopoly’s costs were sufficiently low compared with a perfectly competitive industry, a monopolized industry could even sell a greater quantity at a lower price compared with the perfectly competitive market. Mankiw’s claim that “[m]onopolies produce less than the socially desirable quantity of output” (p. 308), i.e. less than under perfect competition, is not correct as a general conclusion.
This example illustrates the limitations of a narrow ceteris paribus (‘all else unchanged’) assumption in a theoretical model when applying it to the real world. As Alfred Marshall realized, understanding the effects of monopolizing an industry requires recognizing the subsequent changes in firm behaviour that would occur (marketing, changes in production methods, research and development and so on).
(iii) Comparing monopoly with perfect competition: the ‘second-best’ problem
Mankiw’s benevolent social planner eliminates the deadweight loss due to monopoly, illustrated in Figure 8, by setting price equal to the monopolist’s marginal cost. The assumption is that total surplus in this market and in the economy as a whole will increase. Here, and throughout the text, it’s implicitly assumed that policies in individual markets that move the equilibrium closer to the perfectly competitive equilibrium always increase overall economic welfare or total surplus.
It has long been known that this is not true except in the very special case that the rest of the economy consists only of perfectly competitive markets, including any markets in which international trade takes place. There can be no other market failures of any kind. Note that this abstract model of a perfectly competitive market economy leaves no room for a government that produces goods and services and that raises revenues through taxes.
In real-world economies, policy makers determine policy in what is termed this ‘second-best’ situation. (The terminology originates in a famous 1956 paper by Richard Lipsey and Kelvin Lancaster.) The problem is that widespread market failures (imperfect competition in many markets, externalities, etc.) have complex effects, so that eliminating one source of market failure in one market could have detrimental effects elsewhere and worsen overall resource allocation.
In one of the earliest papers exploring this concept, John Hicks (1941) showed that a policy of setting price equal to marginal cost in one monopolized industry would not maximize the overall efficiency in resource allocation if other industries were not perfectly competitive. As Figure 8 shows, this policy expands output in the monopolized industry, which must draw inputs from other industries, whose production declines. (Recall the Production Possibilities Frontier, illustrated on p. 22; if resources are fully employed, one industry can only expand if some others get smaller.)
Equilibrium in each of the other imperfectly competitive industries is similar to that in Figure 8: output is produced at a value (or price) which is greater than marginal cost. When those other industries reduce their output, this results in a loss of surplus there. (If all those industries were perfectly competitive and price equaled marginal cost in equilibrium, the marginal unit yields no surplus, neither to producers nor to consumers. As a result, marginal changes in output would involve no loss of surplus.)
Hicks concluded that “the social cost (the opportunity cost) of employing factors in the first industry [the monopoly his case] is greater than it appears at first sight. The surplus [from expanding monopoly output by setting price equal to marginal cost], accruing not merely to the producers and consumers in the original industry, but to society in general, is less that appears at first” (p. 114).
The monopolist’s marginal cost curve does not reflect the social cost of using resources in this industry because it does not consider the reduction in surplus in other industries. Taking this into account, Hicks explained that the social marginal cost curve lies above the monopolist’s private marginal cost curve, as shown in the Figure. (Hicks’s paper has a similar diagram.) As a result, the marginal cost curve shown in Figure 5 is not an appropriate benchmark to use in setting the optimal price in this industry.
Paralleling the example in Chapter 10 of a Pigouvian tax on an external cost, Hicks wrote that a tax would be needed to reduce output to the socially optimal level (850 units per week in this example). The tax increases total social surplus by raising price to equal marginal social cost. This is the price that Mankiw’s omniscient benevolent social planner should set.
- Do firms try to maximize profits? (revisited)
The first section in the Commentary on Chapter 13 set out some reasons why many firms may be managed in a way that does not achieve or intend profit maximization. There is empirical evidence inconsistent with profit maximization that can be described here, now that the logic of profit maximization for a firm with market power has been explained.
Consider Mankiw’s Figure 4 in Chapter 15 (p. 295), which illustrates the numbers set out in Table 1 (p. 293). (The costs of production are the same as those described in Chapter 13, which were critiqued as empirically dubious in that chapter’s Commentary.)
Unless marginal costs are zero, which is a special case, marginal revenue must be positive if profits are maximized. The same reasoning applies to any firm that has the ability to set its own price, not just to monopolies.
But in his text on Post-Keynesian economics, Marc Lavoie (2014: 170-171) reports that estimates of the demand facing individual oligopolistic firms suggest that they are operating at a point where marginal revenue is negative. Compared with the profit maximizing price and quantity shown in Figure 4 (p.295), the quantity would be greater and the price lower. Lavoie also notes that in the survey of firms undertaken by Allan Blinder and co-authors (1999) more than 80 percent of firms’ responses were consistent with negative marginal revenue. This is consistent with Lavoie’s claim that management is willing to sacrifice some profit to achieve greater growth.
- Monopoly through patents and copyright: are the benefits worth the costs?
Mankiw writes: “Sometimes a would-be monopolist receives the right out of sheer political clout… At other times, the government grants a monopoly because doing so is viewed to be in the public interest” (p. 289). He offers no opinion about whether the degree of protection is appropriate in balancing incentives for innovation with the reductions in economic welfare from monopoly.
Mankiw mentions pharmaceutical drugs which receive a 20-year patent giving exclusive rights to manufacture and sell them. For creative works, authors receive copyright protection (duration unmentioned), giving them rights over the production and use of their work.
Let’s fill in some of the gaps in his account.
Internationally, the World Trade Organization (WTO), established in 1995, oversees multilateral agreements that include the Trade-Related Aspects of Intellectual Property Rights (TRIPS) Agreement. This was also established in 1995 after extensive lobbying by the multinational corporations that would profit from strengthening of intellectual property protection worldwide. The 164 countries that are currently members of the WTO must enforce a minimum 20-year patent protection that applies to all industries. Before TRIPS, patents in the United States had a 17-year term. Many developing countries had no patent protection for pharmaceutical products (Lester and Zhu 2019: 794).
Patents are disproportionately held by multinational companies owned in high income countries. Although the lowest-income developing countries were allowed time to phase in the changes, the resulting increase in monopoly power led to large annual transfers of income from middle-and low-income countries to high-income countries (Stiglitz 2018, p. xxxv). Of particular concern is TRIPS’ restriction of access to generic pharmaceuticals (available at much lower cost than monopoly-protected drugs), with predictable effects on public health, especially in low-income countries.
TRIPS also requires a minimum copyright protection of the life of the author plus 50 years for creative work, including software. (If there is no author, as in the case of movies, for example, it’s 50 years from the date of publication or creation.) The North American Free Trade Agreement, renegotiated in 2019, required member countries to enforce a minimum copyright protection of 70 years. A similar provision exists in the Trans-Pacific Partnership.
Why was TRIPS created to be administered by the WTO and why are other trade agreements setting IP rules? A United Nations organization dealing with IP, the World Intellectual Property Organization, established in 1967 and headquartered in Geneva, already existed. However, it did not oversee negotiations to set uniform international rules; protection and enforcement of IP was up to individual countries.
Negotiating uniform rules for IP protection as part of trade negotiations allows room for trade-offs in negotiating – lower tariffs for a country’s exports in exchange for greater IP protection in that country, for example. As Joseph Stiglitz also explains, violations can now be punished by trade sanctions imposed by the large high-income countries who are its primary beneficiaries (2018: 41). These extensions of monopoly power provided by patents and copyrights have been the result of “sheer political clout” rather than changes in the view of what is in the “public interest”.
For example, in the United States before 1976, a copyright could last for a maximum of 56 years. In 1976 this was extended to 75 years, and was extended further in 1998 to 98 years. Both extensions were applied retroactively to existing works whose copyright was still in effect, providing a windfall benefit to those copyright holders (Baker 2016: 80). Perhaps not coincidentally, each of these extensions took place shortly before the expiry of the copyright on Disney’s 1928 cartoon where Mickey Mouse made his debut.
There is no evidence that these increases in copyright protection, beyond what was already available provided an effective incentive for new creative works. But they offered large windfall profits to current copyright owners, while impeding the use of copyright material (Stiglitz 2019: 74).
A predictable effect of stronger IP protection has been an upward redistribution of income from the general population to the shareholders in the corporations who owned the patents and copyrights. This has contributed to the growing inequality of income and wealth discussed in the Commentary on Chapter 20.
Do the greater incentives for innovation and creation of new products provided by the stronger patent protection offset the added economic welfare costs of temporary monopoly and the increase in inequality to which it contributes? This has been the official justification for strengthening monopoly power, but misses some important long-term negative effects of patent protection.
Increased patent protection reflects what Joseph Stiglitz describes as “power dynamics that prioritized corporate power and short-term gains at the expense of long-term innovation and growth” (2016: 2). He explains one reason why stronger patent protection doesn’t increase innovation and productivity (pp. 32-33):
Among the most important discoveries are those that are part of the advancement of science, from the discovery of DNA to the mathematical insights that led to the computer …, rather than those made for primarily financial gain. Strong IPRs [intellectual property rights], perversely, can actually impede innovation in the economy by limiting the spillover of knowledge critical to fueling additional innovations.
This last point emphasizes that new ideas are built upon existing ones and that stronger intellectual property rights increase the price of using them, potentially reducing future innovation. Joseph Stiglitz and Bruce Greenwald describe the extreme case of ‘patent thickets’:
Today, most products are sufficiently complex that their production may require using many separate items of knowledge. If each piece of knowledge is protected by a patent, this engenders a complex bargaining problem. Unless the owners of these separate pieces of IPR can agree, the product cannot be produced. (2014: 434)
A further problem: in an area when there are so many patents that future innovators could not know the details of all of them, any innovation risks facing expensive litigation. Some firms, called patent trolls, buy patents solely to make money by suing other companies for allegedly infringing on their patents.
Given these and other drawbacks, some economists advocate the phasing out and ultimate abolition of the patent system. They would claim that competition and ‘first-mover advantage’ (i.e. the benefits to an innovator of being the first in the market) provide sufficient incentive to spur innovation. (For example, see Boldrin and Levine, 2013.)
In his critique of the existing patent and copyright system, Dean Baker concludes: “There is little reason to believe that the gain from the innovation and creative work that is induced by these forms of protection is remotely comparable to the costs, especially when considering the potential benefits of alternative mechanisms for providing incentives” (2016, p. 129). (Chapter 5 of Baker’s book describes an alternative system that he contends could provide large social benefits compared with the existing one.)
- Public Policy toward Monopolies
Mankiw’s discussion (pp. 308-11) covers both policy towards monopolies (e.g. regulation, public ownership, breaking them up into separate companies, or doing nothing) and antitrust policy concerning mergers in oligopolistic industries. Such mergers could either monopolize the market or increase its concentration significantly. (Chapter 17 on oligopoly discusses how antitrust policy deals with specific business practices. Section 3 of the Commentary on that chapter provides some brief background to the Chicago School approach to antitrust that is also relevant here.)
For a firm to be a monopoly, following Mankiw’s definition (p. 288), it must have an overwhelming share of the market for the good or service it sells and what it sells can’t have any close substitutes. For example, an airline might provide the only flights between two cities. To see if a train service between those cities is a close substitute, cross-price elasticities of demand (p. 96) could be estimated. These could show whether or not a change in the price of one has a significant effect on the demand for the other. If, for example, the cross-price elasticities are significant, the market for transportation services between the two cities could be considered a duopoly.
(i) Public Ownership. While acknowledging that different countries make different choices, Mankiw claims that economists “usually prefer private to public ownership of natural monopolies” (p. 310). Yet privatization gives up direct public input concerning what are often essential services (e.g. municipal water and sewage services); these are essential not only because of the importance of the service but because of the lack of close substitutes. The private firms’ managers would be accountable to shareholders, not the public. Public utility boards can try to regulate them to better align their behaviour with the public interest, but these attempts are costly. It’s not surprising that publicly owned utilities provide 87 percent of American households with piped water service, with the share of private for-profit utilities in steady decline (Food & Water Watch 2016: 2)
Mankiw asserts that managers of private firms have a greater incentive to minimize costs than do managers of publicly-owned firms, but offers no evidence. Comparing the two isn’t straightforward.
Hugh Stretton and Lionel Orchard ask: “If private ownership is thought to be better than public, is it better at what, for whom, by what criteria? If (for example) public bus services break even serving everybody, while private services have lower costs, make profits, but fail to serve some residents at awkward locations, which is more efficient?” (1994, p. 83). After reviewing the empirical studies, they remark: “Public and private enterprises rarely produce the same goods in the same conditions with the same purposes to make exact comparisons possible. Even when they do, the results vary widely enough to allow no knock-down conclusion” (p. 80).
Even the story about incentives is not so clear. The theory of profit maximization assumes that shareholders, through their Board of Directors, can structure contracts so that managers try to minimize costs. If cost minimization was also the goal of politicians, why couldn’t they also structure the contracts of the managers of public enterprises to give them the same cost-minimizing incentives? (Stretton and Orchard 1994, p. 92)
(ii) What about doing nothing?
Mankiw writes that because none of the other policies for dealing with monopoly power are without some drawbacks or difficulties, “some economists argue that is often best for the government not to try to remedy the inefficiencies of monopoly pricing” (p. 311). Mankiw quotes the University of Chicago’s George Stigler, omitting the final sentence which is included here in italics:
A famous theorem in economics states that a competitive enterprise economy will produce the largest possible income from a given stock of resources. No real economy meets the exact conditions of the theorem, and all real economies will fall short of the ideal economy—a difference called “market failure.” In my view, however, the degree of “market failure” for the American economy is much smaller than the “political failure” arising from the imperfections of economic policies found in real political systems. The merits of laissez-faire rest less on its famous theoretical foundations than on its advantages over the actual performance of rival forms of economic organization. (Stigler 2007)
So, Stigler advocated that public policy should doing nothing about any market failures, not just those arising from monopoly and oligopoly.
Stigler’s judgement can be based on no empirical evidence. Mark Blaug’s comment (quoted in the Commentary on Chapter 14) applies here: “how can an idealized state of perfection [Stigler’s perfectly “competitive enterprise economy”] be a benchmark when we are never told how to measure the gap between it and real-world competition?” That’s real-world competition with public policies to address, however imperfectly, various market failures. What the modern American economy would look like with laissez-faire is impossible to say as it is so far from the existing state of affairs.
Stigler’s claim that the gap between perfect competition and a laissez-faire economy is “much smaller” than the gap between it and the current economy with its political failures is likely a reflection of his faith in libertarian political philosophy.
That said, the “do nothing” prescription does reflect the view of the Chicago School of which Stigler was a member. Joseph Stiglitz writes that “Chicago economists would argue – with little backing in either theory or evidence – that one shouldn’t even worry about monopoly: In an innovative economy, monopoly power would only be temporary, and the ensuing contest to become the monopolist maximized innovation and consumer welfare”. While this may have described the American economy in the past, he describes how firms invent new barriers to entry, while carrying out preemptive mergers, snapping up potential competitors before they become a threat. He writes: “today we live in an economy where a few firms can get for themselves massive amounts of profits and persist in their dominant position for years and years” (2017b).
Incidentally, the vast majority of American economists disagree with the Chicago position. A recent survey of members of the American Economic Association found that only 15 percent of those surveyed disagreed with the proposition “Corporate economic power has become too concentrated”. Just 7 percent disagreed with the statement “Antitrust laws should be enforced vigorously” (Geide-Stevenson and La Parra-Perez 2022).
- How prevalent are monopolies?
The chapter concludes with a section entitled “The Prevalence of Monopolies”, accompanied by Table 3 (p. 312) which describes the characteristics of a monopoly. However, this section is not really discussing monopoly; it’s discussing the extent of firms’ monopoly power. This is used as a synonym for ‘market power’ (the term used elsewhere in the book).
As Mankiw writes (p. 311), most firms have market power and therefore face downward sloping demand curves. He states that firms with “substantial” market power are “rare” because of the availability of sufficient substitute goods. This leaves most firms with “limited” market power. Hence his claim (discussed in the previous Commentary): “In such situations, we will not go far wrong assuming that firms operate in competitive markets, even if that is not precisely the case” (p. 312).
(a) How prevalent are firms that actually are monopolies?
Regulated privately- or publicly-owned monopolies such as water or electricity utilities are obvious examples. There are also local monopolies, firms protected from competition by distance. For example, most services need to be delivered locally, where there may be few or no competitors. For example, in many places in the United States, there are only one or two internet service providers (Stiglitz 2019: 147, n16).
As discussed above, the patent system has created many monopolies. Those created by patents for pharmaceuticals and medical equipment cause particularly large losses in economic welfare. Less visible are monopolists who produce products that are key components in making final products. This monopoly could result from a firm having a large technological lead, rather than from a patent per se. For example, the Dutch company ASML currently has an effective monopoly in the production of extreme ultraviolet (EUV) lithography machines which are essential in the production of cutting-edge semiconductor chips. If ASML’s monopoly results in a smaller number of machines compared with the situation where its technological know-how was more diffused, fewer advanced semiconductor chips would be produced, with effects on the output of many different products worldwide.
In short, monopolies are not rare.
(b) Has there been an increase in monopoly power more generally in the United States?
Joseph Stiglitz writes: “Over the past four decades, economic theory and evidence has laid waste to … the belief that some variant of the competitive equilibrium model provides a good, or even adequate, description of our economy.” instead, he suggests that if “we begin with the obvious, opposite hypothesis – that what we see in our daily life is true, that our economy is marked in industry after industry by large concentrations of market power – then we can begin to… understand much of what is going on” (2017b).
If industries become more concentrated, the resulting increase in market power leads to increases in prices relative to costs (i.e. markups), which lower living standards. Stiglitz reports that studies of manufacturing industries showed large increases in markups, consistent with increases in market power.
Market concentration in industries throughout the US economy have indeed been increasing. Why is this happening? Stiglitz (2017a: 49-50) attributes this to:
- i) decreased enforcement of anti-trust laws.
- ii) “an increase in the importance of sectors with large network externalities, in which naturally there will be one or a few dominant platforms”, e.g. Facebook and Twitter. (A network externality exists if the addition of one more users increases the value of the good to other users.)
iii) “an increase in the importance of sectors with high fixed costs and low marginal costs (much of the digital and knowledge economy), where again there is a tendency for there to be dominant firms”, e.g. Google’s search engine.
- iv) “an increase in knowledge about how to create, maintain, and extend market power” while also “learning about how to create entry barriers”.
- v) increased market power from greater protection of intellectual property rights.
- vi) an increase in the average degree of market power in locally provided services.
The talk by Stiglitz from which this is taken is entitled “America has a monopoly problem – and it’s huge”. The problem is not just increased monopoly/market power raising prices and squeezing living standards. Among its other effects are an increase in income and wealth inequality, which in turn increases political inequality “which can and has been used to create rules of the game that perpetuate economic inequality”.
None of these facts or ideas are to be found in Mankiw’s text, which downplays monopoly power, although Stiglitz’s views are shared by many economists and writers on current affairs.
References
Baker, Dean (2016) Rigged: How Globalization and the Rules of the Modern Economy Were Structured to Make the Rich Richer. Center for Economic and Policy Research. Kindle Edition.
Blinder, Allan, Elie Canetti, David E. Lebow and Jeremy B. Rudd (1998) Asking about Prices: A New Approach to Understanding Price Stickiness, Russell Sage Foundation.
Boldrin, Michele and David Levine (2013) “The case against patents”, Journal of Economic Perspectives, 27(1): 3-22.
Food & Water Watch (2016) “The State of Public Water in the United States”.
Geide-Stevenson, Doris and Alvaro La Parra-Perez (2021) “Consensus among economists 2020: A sharpening of the picture”, manuscript.
Hicks, J. R. (1941) “The rehabilitation of consumers’ surplus”, The Review of Economic Studies, 8(2): 108-16.
Lavoie, Marc (2014) Post-Keynesian Economics: New Foundations, Edward Elgar.
Lipsey, Richard G., & Lancaster, Kelvin (1956) “The General Theory of Second Best”, The Review of Economic Studies, 24(1), 11-32.
Marshall, Alfred (1920) Principles of Economics, eighth edition, Macmillan, available here.
Stigler, George J. (2007) “Monopoly” in David R. Henderson (ed.) The Concise Encyclopedia of Economics, second edition, Liberty Fund.
Stiglitz, Joseph E. (2016) Rewriting the Rules of the American Economy: An Agenda for Growth and Shared Prosperity, W. W. Norton, Kindle edition.
Stiglitz, Joseph E. (2017a) “Wealth and Income Inequality in the Twenty-First Century”, June 15.
Stiglitz, Joseph E. (2017b) “America Has a Monopoly Problem – and It’s Huge”, Roosevelt Institute, October 26.
Stiglitz, Joseph E. (2018) Globalization and Its Discontents Revisited: Anti-Globalization in the Age of Trump, W. W. Norton, Kindle edition.
Stiglitz, Joseph E. (2019) People, Power, and Profits: Progressive Capitalism for an Age of Discontent, W. W. Norton, Kindle edition.
Stiglitz, Joseph and Bruce Greenwald (2014) Creating A Learning Society: A New Approach to Growth, Development, and Social Progress, Columbia University Press.
Stretton, Hugh and Lionel Orchard (1994) Public Goods, Public Enterprise, Public Choice: Theoretical Foundations of the Contemporary Attack on Government, Macmillan.