The theory of monopoly originated with Antoine Augustin Cournot (1801-1877). A French mathematician, Cournot published writings on philosophy and mathematics, as well as economics. He was a predecessor to what economists call the marginalist school of economics, meaning he emphasized marginal analysis in decision-making. As part of his marginal analysis, Cournot was the first economist to apply mathematics to economic theory. In addition to this work on the monopoly model, Cournot developed the first theory of duopoly (a two-firm industry). In developing his theory of monopoly, Cournot was also the first to articulate the familiar MR=MC rule for profit-maximizing firms. To illustrate his theory, Cournot used the example of a mineral spring, from which the owner can sell the water. Because the water flows naturally from the earth, Cournot assumed that marginal costs were zero. From there Cournot explained: Suppose that a man finds himself proprietor of a mineral spring which has just been found to possess salutary properties possessed by no other. He could doubtless fix the price of a liter of water at 100 francs; but he would soon see by the scant demand [quantity demanded], that this is not the way to make the most of his property. He will therefore successively reduce the price of the liter to the point which will have him the greatest possible profit, i.e. if F(p) denotes the law of demand [quantity demanded], he will end, after various trials, by adopting the value of p [price] which renders the product pF(p) [total revenue] a maximum.In short, the seller will charge some price above its marginal cost to maximize profit. Modern monopoly theory incorporates increasing marginal costs in the standard model, but Cournot’s mathematical specifications of demand and marginal revenue are precisely those reflected in the textbook’s model.

Photograph courtesy of: (c)Nance Trueworthy;

24.2 Minimum Efficient Scale and Natural Monopoly

Piero Sraffa (1898-1983), an Italian born economist, developed the idea of natural monopoly. He migrated to England, where he became a student of Alfred Marshall (1842-1924), and later a teacher, at Cambridge. In 1940, when Germany began the blitzkrieg into France, Sraffa was interned by the British as an enemy alien. John Maynard Keynes denounced the ill treatment of distinguished refugee scholars such as Sraffa, writing, "If there are any Nazi sympathizers still at large in this country, we should look in the War Office and our Secret Service, not in the internment camps. Sraffa observed that in some production processes, average costs fall as output expands. He wrote: Everyday experience shows that a very large number of undertakings—and the majority of those which produce manufactured consumers’ goods—work under conditions of individual diminishing costs. Almost any producer of such goods, if he could rely upon the market in which he sells his products being prepared to take any quantity of them from him at the current price, without any trouble on his part except that of producing them, would extend his business enormously. It is not easy, in times of normal activity, to find an undertaking which systematically restricts its own production to an amount less that which it could sell at the current price, and which is at the same time prevented by competition from exceeding that price. Business men, who regard themselves as being subject to competitive conditions, would consider absurd the assertion that the limit to their production is to be found in the internal conditions of production in their firm, which do not permit of the production of a greater quantity without an increase in cost. The chief obstacle against which they have to contend when they want gradually to increase their production does not lie in the cost of production— which, indeed generally favours them in that direction—but in the difficulty of selling the larger quantity of goods without reducing the price, or without having to face increased marketing expenses.(1) Given a limited market demand for output, Sraffa concluded that efficiency concerns would lead to a decreasing number of firms in the industry, with the extreme possibility of a natural monopoly. This idea ran contrary to the popular belief that markets operated more in accord with perfect competition. In perfect competition, rising marginal and average costs limit how much output one firm can profitably sell in the market. With a natural monopoly, the firm is limited only by the size of the market, which is in part a function of the prices set by the monopoly. Sraffa’s work on natural monopolies was consistent with neoclassical economics, the conservative mainstream in economics. Later years would see a dramatic shift in Sraffa’s thinking, as he became a leading figure of the more radical post-Keynesian school of economic thought. Piero Sraffa, "The Laws of Returns under Competitive Conditions," Economic Journal 36 (December 1926) p. 543.

24.3 X-inefficiency

Harvey Leibenstein (1922-1993) is credited with developing the theory of X- inefficiency. In his June 1966 American Economic Review article, Leibenstein distinguishes between allocative inefficiency and X-inefficiency. Allocative efficiency, as explained in the text, results when price equals marginal cost. When firms produce a level of output where price (P) exceeds marginal cost (MC), resources are misallocated based on society’s valuation of the resources. With allocative inefficiency, firms face the lowest average total cost (ATC) curve, but do not produce at the minimum point on the curve where P = MC = ATC. In contrast, X-inefficiency occurs when the average cost of producing any particular level of output exceeds the lowest possible average cost of producing that output. That is, the firm produces at an average cost above the ATC curve. Firms in highly competitive industries will be forced out of business if they are X-inefficient. Monopoly and oligopoly firms, however, can be X-inefficient, at least for some time, if barriers to entry are significant. As the text observes, X-inefficiency sometimes occurs because managerial goals conflict with cost-minimization. This is an example of the principal-agent problem. Principals, the corporate owners, for example, want profits maximized. The agents, managers hired to run the firm, may be more interested in maximizing their salaries, power, expense accounts, and so forth. These excessive costs are the source of X-inefficiency.

24.4 Price Discrimination

Price discrimination, also known as monopoly price discrimination, was a notion first developed by Jules Dupuit (1804-1866]. Born in Fossano, Piedmont, Italy (then part of the French empire), Dupuit moved to Paris with his parents in 1814. He studied in Versailles, Louis-le-Grand and Saint Louis, eventually earning his degree in engineering from Ecole des Ponts et Chaussees. Dupuit became a prominent engineer in France, receiving the French Legion of Honor in 1843, becoming the chief engineer in Paris in 1850, and earning the position of inspector-general of the French Corps of Civil Engineers in 1855. From 1844 to 1853, Dupuit published numerous works in economics, his "hobby," contributing to the theories of utility and consumer surplus. In France, many of the infrastructure projects (roads, bridges, waterworks, etc.) that Dupuit engineered were government owned and operated monopolies. Dupuit involved himself in the question of how much government should charge for these public goods and services, especially if they were to be self-supporting. One obvious solution was to set a fixed price per unit that would cover the costs. Dupuit argued that the government could extract additional revenue, without reducing the amount consumed, by charging people according to the different utilities they received from consuming the good or service. A more formal articulation of the theory of price discrimination came later, from Arthur Cecil Pigou (1877-1959). Pigou, a British welfare economist (meaning that his economic theories focuses on maximizing the well-being of society), studied at King’s College in Cambridge and later served as the chair of political economy at Cambridge from 1908 to 1943. The previous chair, Alfred Marshall, significantly influenced Pigou’s thinking, as both were concerned about how to use economic theory to promote social well-being. Pigou distinguished between first, second, and third degree price discrimination. First degree price discrimination is the most complete, charging each customer the exact maximum price they are willing to pay. It corresponds with the model of the perfectly discriminating monopolist that appears in the text. Second degree, also known as block price discrimination, uses declining prices for successive blocks of units of output purchased. The first units are priced high; the successive blocks of output, lower, to encourage consumers to buy more than they would at a single, higher price. For example, some pizza restaurants offer discounted prices for a second pizza if the first is purchased at the regular (higher) price. Third degree price discrimination separates buyers by elasticity, with those with a more price elastic demand paying lower prices. The textbook examples of movie theaters and airlines provide good illustrations of third degree price discimination. The next time you get your student discount at a theater or sporting event, be sure to thank Jules Dupuit and A.C. Pigou.