Why Monopolies Often Earn Zero Economic Profit

The title of this section might puzzle you. We've just seen that in the long run a monopoly can earn economic profit and should never stay in business if it suffers a loss. Then how can it be that monopolies often earn zero profit in the real world? Is it just a coincidence? The answer is no. There are two forces tending to cut monopoly profits.

1. Government regulation. As discussed earlier, in many cases of natural monopoly, a firm is granted a government franchise to be the sole seller in a market. This has been true of monopolies that provide water service, electricity, and natural gas. In exchange for its franchise, the monopoly must accept government regulation, often including the requirement that it submit its prices to a public commission for approval. The government will want to keep prices high enough to keep the monopoly in business, but no higher. Since the monopoly will stay in business unless it suffers a long-run loss, the ideal pricing strategy for the regulatory commission would be to keep the monopoly's economic profit at zero. Remember, though, that economic profit includes the opportunity cost of the funds invested by the monopoly's owners. If the public commission succeeds, the monopoly's accounting profit will be just enough to match what the owners could earn by investing their funds elsewhere—that is, the monopoly will earn zero economic profit. Government regulation of monopoly will be discussed further in Chapter 15, on market failures.

2. Rent-seeking activity. Another factor that reduces a monopoly's profit comes from the interplay between politics and economics. As we've seen, many monopolies achieve and maintain their monopoly status due to government barriers to entry. Even when a monopoly is regulated by government, the regulation may be imperfect, resulting in a higher-than-ideal price. More importantly, many monopolies created through government barriers are completely unregulated. For example, a movie theater or miniature golf course may enjoy a monopoly in an area because zoning regulations prevent entry by competitors. Or, in less developed countries, a single firm may be granted the exclusive right to sell or produce a particular good. In all of these cases, the monopoly is left free to set its price as it wishes. When regulation is imperfect or when a monopoly is free of regulation, don't we expect it to earn economic profit for its owners?

Typically, no. Government barriers to entry—for example, zoning laws—are often controversial because, as you've learned, a monopoly may charge a higher price and produce less output than would a competitive market. Thus, government will be tempted to pull the plug on a monopoly's exclusive status and allow competitors into the market. The monopoly, in turn, will often take action to preserve government barriers to entry. Economists call such actions rent-seeking activity.

Any costly action a firm undertakes to establish or maintain its monopoly status is called rent-seeking activity.

In countries with corrupt bureaucracies, rent-seeking activity includes bribes to government officials; in less corrupt governments, it includes the time and money spent lobbying legislators and the public for favorable policies. For example, in 1999, AT&T acquired several cable companies, giving the firm a monopoly on cable television and cable Internet service in millions of homes across the United States. Except for one problem: City governments—before they would approve AT&T as the new operator of their cities' cable service—were demanding that AT&T permit competing Internet service providers, such as AOL and Bell Atlantic, to use their new cable lines. This, of course, would have cut into AT&T's monopoly profits in these cities. As we would predict, AT&T launched a war against these "open access" policies. It spent millions of dollars on lawyers, lobbyists, and public relations firms. It even tried to sway public opinion by helping to fund a lobbying group, "Hands Off the Internet." In Miami for example, AT&T was able to convince 11 of 13 city council members to change their minds and vote against "open access." But as you might guess, AT&T's expenses cut into its monopoly profit.5

What is the maximum amount of rent-seeking expenditure a monopoly would be willing to undertake? The answer, as you might guess, is an amount equal to the profit the firm is trying to protect. For example, if a firm can preserve $100 million in profit through the passage of a pending bill, it would be willing to pay up to $100 million in lobbying expenses. Of course, it may or may not be necessary to pay this much, depending on the nature of the bill and the difficulty in persuading legislators. But we can say this:

5 Source: Wall Street Journal, "ATT Used Carrot and Stick Lobbying Efforts in Local Debates over Access to Cable TV Lines," November 24, 1999, p. A20.

Rent-seeking activity Any costly action a firm undertakes to establish or maintain its monopoly status.

Rent-seeking activity that helps establish or maintain a firm's monopoly position is part of the firm's costs. As a result, rent-seeking activity tends to reduce the economic profit of the firm and may even reduce it to zero.

What Happens When WHAT HAPPENS WHEN THINGS CHANGE?_

Things Change?

Once a monopoly is maximizing profit, it has no incentive to change either its quantity of output or its price . . . unless something that affects these decisions changes. In this section, we'll consider how a change in demand for the monopolist's product affects the equilibrium in a monopoly market.

Back in Chapter 8, we saw how a competitive market adjusted to a change in demand. In particular, we saw that an increase in demand caused an increase in both market price and market quantity. Does the same general conclusion hold for a monopolist? Let's see.

Panel (a) of Figure 5 shows Zillion-Channel Cable earning a positive profit in the short run. As before, it is producing 10,000 units per month, charging $40 per unit,

FIGURE 5

A CHANGE IN DEMAND (a)

FIGURE 5

Panel (a) shows Zillion-Channel in equilibrium. It is providing 10,000 units of cable TV service at a price of $40 per month and earning a monthly profit of $80,000. Panel (b) shows the same firm following an increase in demand from D, to D2. With the increased demand, MR is higher at each level of output. In the new equilibrium, Zillion-Channel is charging a higher price ($47), providing more TV service (11,000 units), and earning a larger profit.

and earning a monthly profit of $80,000 (not shown). The fact that Zillion-Channel is a monopolist, however, does not mean that it is immune to shifts in demand.

What might cause a monopolist to experience a shift in demand? The list of possible causes is the same as for perfect competition. If you need a reminder of these causes, look back at Figure 3 in Chapter 8. For example, an increase in consumer tastes for the monopolist's good will shift its demand curve rightward, just as it shifts the market demand curve rightward in a competitive market.

Suppose that the demand for local cable service increases because a sitcom shown on one of Zillion-Channel's premium services attracts an enthusiastic follow-ing—an increase in tastes for cable services. In panel (b) of Figure 5, this is shown by a rightward shift of the demand curve from D1 to D2. Notice that the marginal revenue curve shifts as well—from MR1 to MR2. With an unchanged cost structure, the new short-run equilibrium will occur where MR2 intersects the unchanged MC curve. As you can see, the result is an increase in quantity from 10,000 to 11,000, and a higher price—$47 per month rather than the original $40. In this sense, monopoly markets behave very much like competitive markets (although the extent of the rise in price and quantity will generally not be the same as in a competitive market. What about the monopolist's profit, though? With both price and quantity now higher, total revenue has clearly increased. But cost is higher as well. So it seems as if profit could either rise or fall.

It turns out, however, that profit must be higher in the new equilibrium at point B. We know that because Zillion-Channel has the option of continuing to sell its original quantity, 10,000, at a price higher than before. If, as we assume, it started out earning a profit at that output level, then the higher price would certainly give it an even higher profit. But the logic of MR = MC tells us that the greatest profit of all occurs at 11,000 units. We can conclude that:

A monopolist will react to an increase in demand by producing more output, charging a higher price, and earning a larger profit. It will react to a decrease in demand by reducing output, lowering price, and suffering a reduction in profit.

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  • tuulikki
    Why Monopolies often earn zero Economic profits?
    2 years ago
  • scolastica
    Why don't monopolies produce large economic profits?
    10 months ago
  • aida
    Can a monopoly set its own pricing and still earn a profit?
    8 months ago
  • myla
    Why are economic profits zero in the long run in a monopoly?
    3 months ago
  • arcangelo
    How much would a firm pay to keep a monopoly?
    2 months ago
  • berenice arcuri
    How monopolies makes profit at expenses of consumer?
    1 month ago

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