The most complicated--and misunderstood--of market imperfections is monopoly. For our purposes, we will state that a "monopoly problem" exists whenever a firm can significantly increase the price it can charge by restricting the quantity of goods it sells. Economists call this ability MARKET POWER. To illustrate the monopoly problem, we are going to analyze one of the most egregious and ubiquitous examples of monopoly to be found anywhere in the economy: the neighborhood lemonade stand.

In particular, we will consider the case of one John D. Rockefeller, Jr., "J.D." as he is known to his friends. From 7:30 a.m. to 3:00 p.m. on Mondays through Fridays, J.D. lives a life similar to most 10 year-olds. He goes to school, does his classwork, looks forward to recess, and is in most respects a strikingly unremarkable kid. However, every day after the school bus lets J.D. off at the stop near his home, he does something unusual. He races home in front of his two school chums, Sammy and Susie, and opens up his lemonade stand. For you see, J.D. is the neighborhood entrepreneur. He earns his lunch money by selling lemonade to his two friends as they walk home from school. Oh yeah. There's one more thing you should know about J.D.: his is the only lemonade stand in this section of town. J.D. is a monopolist.

Because J.D. sells the same lemonade to the same two kids everyday, he has learned a lot about the preferences of his two school chums. Sammy derives intense pleasure from lemonade and is willing to pay 80¢ for a first glass of lemonade, though he never has any interest in purchasing a second glass. Susie likes lemonade too, but not as much as Sammy. She is willing to pay 50¢ for a glass of lemonade; and, like Sammy, never wants more than one. We summarize the willingness to pay of J.D.'s two customers in the table below.

Given the preferences of his customers, we see that the quantity J.D. sells affects the price he can charge. If J.D. wants to sell 2 cups of lemonade, the highest price he can charge is 50¢ a cup. Any amount above this price and Susie will refuse to buy any.¹ However, if he limits his "production" to only 1 cup of lemonade, he can raise his price to 80¢ a cup. In other words, J.D. can significantly increase the price he charges by restricting the quantity of lemonade he sells. He has "market power."

Based upon his experience as CEO, Chairman of the Board, and majority stockholder of Rockefeller's Lemonade Stand, J.D. has calculated the following revenue table with respect to his lemonade sales. Pay particular attention to the change in Total Revenue as Quantity increases from 1 to 2.

Like all great entrepreneurs, J.D. is a profit maximizer. He has calculated that it costs about 25¢ to "produce" a cup of lemonade (this includes the cost of the lemonade mix, plus the value of the paper cup, etc.). So what quantity of lemonade will maximize J.D.'s profits? To answer that question, J.D. has expanded the table above to identify the profit he makes for differing levels of lemonade "production."

Column (5) reports the Total Profit that J.D. earns for each level of output. As the table clearly shows, J.D. maximizes Total Profit when he produces and sells 1 cup of lemonade. By restricting output to 1 cup, he can charge a price of 80¢ a cup. This yields him a Total Revenue of $0.80, versus a Total Cost of production of only $0.25. The bottom line is a Total Profit of $0.55, which is higher than at any other level of sales.

Now things start to get interesting. We are about to see what monopolies do wrong. What Quantity of lemonade production maximizes society's happiness? From the information we have concerning Sammy's and Susie's preferences, we know that when only 1 cup of lemonade gets produced, it goes to Sammy, who receives 80¢ of happiness. In contrast, society loses 25¢ in happiness from withdrawing resources from other activities in order to produce that cup. Thus, the Total Net Happiness received by society from the first cup of lemonade is 80¢ - 25¢ = 55¢.

When J.D. produces 2 cups of lemonade, the second cup goes to Susie. She receives 50¢ of happiness from her cup. However, society loses another 25¢ of happiness in producing this cup. Thus, the increase in Total Net Happiness from the second cup is 50¢ - 25¢ = 25¢. If we add this to the happiness from the first cup, we see that the production of 2 cups of lemonade results in 55¢ + 25¢ = 80¢ of Total Net Happiness. Column (6) reports Total Net Happiness for each level of output. Clearly, society's happiness is maximized when J.D. produces 2 cups of lemonade.

Anybody remember how many cups of lemonade maximize J.D.'s profits? As demonstrated above, the profit-maximizing level of lemonade production is 1 cup. Did you catch that? One cup! The happiness-maximizing quantity is 2, while the profit-maximizing quantity is 1! Herein lies the great sin of monopolies. Left to their own devices, MONOPOLIES PRODUCE TOO LITTLE OUTPUT. In the case of John D. Rockefeller, Jr., society would like him to produce and sell 2 cups of lemonade. Instead, young Mr. Rockefeller chooses to sell only 1 cup of lemonade, since that is what maximizes his profits.

Why does J.D. produce too little? As a result of the market power that J.D. possesses, a decrease in lemonade production increases the price he can charge. For example, if J.D. were to produce 2 cups of lemonade, he could only charge 50¢ a cup. By decreasing production from 2 cups to 1, J.D. is able to raise the price he can charge to 80¢ a cup. As a result, when J.D. sells one less cup of lemonade, he doesn't lose 50¢ in Revenue. The decrease in sales only costs him 20¢ in Revenue (check out Column (3) in the table above).² However, producing one less cup of lemonade saves J.D. 25¢ in Cost. As a result, decreasing production from 2 cups to 1 cup increases his Total Profit by 5¢, even though it lowers society's happiness (check out Columns (5) and (6)).³

All of this can be illustrated in the context of our familiar Profit Table. The Profit Table below represents J.D.'s decision to produce a second cup of lemonade. As discussed above, the extra Revenue associated with increasing production to 2 cups is 20¢. However, the Cost of producing a second cup of lemonade is 25¢. Increasing production from 1 cup to 2 would thus lower J.D.'s Profit by 5¢.

Now this is a fine pickle indeed! Here we have a resource transfer that would make society better off by approximately 25¢. Unfortunately, J.D. loses 5¢ in profit if he makes this resource transfer. This keeps him from producing any more than 1 cup of lemonade. And that is a shame. Because society is a little less happy than it could be if only J.D. would think of the happiness of others, as opposed to selfishly maximizing his own profits.

What makes J.D.'s situation unique? J.D.'s firm is different from the firms we previously analyzed because we assumed that J.D. has market power, while the other firms did not. When a firm doesn't have market power, an increase in production will have little effect on the Price the firm can charge. If the Price is 50¢, and the firm sells another unit, then the extra Revenue it receives will also equal 50¢. And we get a Profit Table just like the ones earlier in the book. However, when a firm has market power, selling more output means the firm has to charge a lower price. In this case, if the Price is 50¢ and the firm sells another unit, then the extra Revenue it receives will be significantly less than 50¢.

In conclusion, it's important to remember that even when a firm is a monopoly, prices still send the right information. The price still approximates the additional happiness that society would receive from consuming one more unit of the output good. The problem isn't with the prices. The problem lies with the Revenue incentives facing the firm. Even so, it should never be forgotten that monopolies are good. They transfer resources from lower-valued to higher-valued activities. They increase society's happiness. They just don't increase society's happiness as much as we would like them to.