Chapter 10 - Pure Monopoly

Chapter 10 Pure Monopoly

QUESTIONS

1. “No firm is completely sheltered from rivals; all firms compete for consumer dollars. If that is
so, then pure monopoly does not exist.” Do you agree? Explain. How might you use Chapter 4’s
concept of cross elasticity of demand to judge whether monopoly exists? LO1

Answer: Though it is true that “all firms compete for the dollars of consumers,” it is
playing on words to hold that pure monopoly does not exist. If you wish to send a
first-class letter, it is the postal service or nothing. Of course, if the postal service raises
its rate to $10 to get a letter across town in two days, you will use a courier, or the phone,
or you will fax it. But within sensible limits, say a doubling of the postal rate, there is no
alternative to the postal service at anything like it at a comparable price.
The same case can be made concerning the pure monopoly enjoyed by the local
electricity company in any town. If you want electric lights, you have to deal with a
single company. It is a pure monopoly in that regard, even though you can switch to oil
or natural gas for heating. Of course, you can use oil, natural gas, or kerosene for
lighting too—but these are hardly convenient options.
The concept of cross elasticity of demand can be used to measure the presence of close
substitutes for the product of a monopoly firm. If the cross elasticity of demand is greater
than one, then the demand that the monopoly faces is elastic with respect to substitute
products, and the firm has less control over its product price than if the cross elasticity of
demand were inelastic. In other words, the monopoly faces competition from producers
of substitute products.

2. Discuss the major barriers to entry into an industry. Explain how each barrier can foster either
monopoly or oligopoly. Which barriers, if any, do you feel give rise to monopoly that is socially
justifiable? LO1

Answer: Economies of scale are a barrier to entry because of the need for new firms to
start big to achieve the low production costs of those already in the industry. However,
not all industries need techniques of production that require large scale. In many
industries the minimum efficient scale is only a small percentage of domestic
consumption.
Natural monopolies give rise to monopoly that is socially justifiable. The economies of
scale are sometimes such that having two or more firms serving the market would
increase costs unreasonably. Two telephone companies, or gas companies, or water
companies, or electricity companies in the same city would be highly inconvenient and
costly as long as transmission requires wires and pipes. In such instances, it makes sense
for government to grant exclusive franchises and then regulate the resulting monopoly to
ensure the public interest is protected.
Patents and licenses are legal barriers to entry that also, to some extent, are justifiable. If
inventions were not protected at all from immediate copying by those who bore none of
the costs, the urge to invent and innovate would be lessened and the costly secrecy that is
enforced already would have to be much greater and more costly. However, this does not
mean that abuses do not exist in the present system and a case can be made for reducing
the present seventeen years for which patents are granted.

10-1
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Ownership of essential raw materials is another barrier to entry. It has little social
justification except to the extent that the hope of gaining a monopoly in the supply of an
essential raw material leads to more prospecting. The Last Word on De Beers is an
example.
Unfair competition is the last of the barriers and has no social justification at all, which is
why price-cutting to bankrupt a rival is illegal. The problem here, though, is to prove that
cutthroat competition truly is what it appears to be.

3. How does the demand curve faced by a purely monopolistic seller differ from that confronting
a purely competitive firm? Why does it differ? Of what significance is the difference? Why is the
pure monopolist’s demand curve not perfectly inelastic? LO1

Answer: The demand curve facing a pure monopolist is downward sloping; that facing
the purely competitive firm is horizontal, perfectly elastic. This is so for the pure
competitor because the firm faces a multitude of competitors, all producing perfect
substitutes. In these circumstances, the purely competitive firm may sell all that it wishes
at the equilibrium price, but it can sell nothing for even so little as one cent higher. The
individual firm’s supply is so small a part of the total industry supply that it cannot affect
the price.
The monopolist, on the other hand, is the industry and therefore is faced by a normal
downward sloping industry demand curve. Being the entire industry, the monopolist’s
supply is big enough to affect prices. By decreasing output, the monopolist can force the
price up. Increasing output will drive it down.
Part of the demand curve facing a pure monopolist could be perfectly inelastic; if the
monopolist put only a very few items on the market, it is possible the firm could sell
them all at, say, $1, or $2, or $3. But it is the very fact that the monopolist could sell the
same amount at higher and higher prices that would ensure that the profit-maximizing
monopolist would not, in fact, sell in this perfectly inelastic range of the demand curve.
Indeed, the monopolist would not sell in even the still slightly inelastic range of the
demand curve. The reason is that so long as the demand curve is inelastic, MR must be
negative, but since the MC of any item can hardly be negative also, the monopolist’s
profit must decrease if it produces here. To equate a positive MR with MC, the
monopolist must produce in the elastic range of its demand curve.

4. Use the demand schedule below to calculate total revenue and marginal revenue at each
quantity. Plot the demand, total‐revenue, and marginal-revenue curves, and explain the
relationships between them. Explain why the marginal revenue of the fourth unit of output is
$3.50, even though its price is $5. Use Chapter 4’s total‐revenue test for price elasticity to
designate the elastic and inelastic segments of your graphed demand curve. What generalization
can you make as to the relationship between marginal revenue and elasticity of demand? Suppose
the marginal cost of successive units of output was zero. What output would the profit‐seeking
firm produce? Finally, use your analysis to explain why a monopolist would never produce in the
inelastic region of demand. LO1

10-2
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Answer: To calculate Total Revenue multiply price (P) by Quantity Demanded (Q): TR
= P x Q.
To calculate Marginal Revenue find the change in total revenue for each unit demanded:
MR = Δ TR = TR (i+1) - TR(i).
See table below.

Price (P) Quantity Total Marginal

Demanded Revenue Revenue
(Q) (TR) (MR)
$7.00 0 $0 NA
6.50 1 6.50 $6.50
6.00 2 12.00 5.50
5.50 3 16.50 4.50
5.00 4 20.00 3.50
4.50 5 22.50 2.50
4.00 6 24.00 1.50
3.50 7 24.50 0.50
3.00 8 24.00 -0.50
2.50 9 22.50 -1.50

Because TR is increasing at a diminishing rate, MR is declining. When TR turns

downward (starts decreasing), MR becomes negative.
Marginal revenue is below D because to sell an extra unit, the monopolist must lower the
price on the marginal unit as well as on each of the preceding units sold. Four units sell
for $5.00 each, but three of these four could have been sold for $5.50 had the monopolist
been satisfied to sell only three. Having decided to sell four, the monopolist had to lower
the price of the first three from $5.50 to $5.00, sacrificing $.50 on each for a total of
$1.50. This “loss” of $1.50 explains the difference between the $5.00 price obtained on
the fourth unit of output and its marginal revenue of $3.50.
Demand is elastic from P = $6.50 to P = $3.50, a range where TR is rising. The curve is
of unitary elasticity at P = $3.50, where TR is at its maximum. The curve is inelastic
from then on as the price continues to decrease and TR is falling. When MR is positive,
demand is elastic. When MR is zero, demand is of unitary elasticity. When MR is
negative, demand is inelastic.
If MC is zero, the monopolist should produce 7 units where MR is also zero. It would
never produce where demand is inelastic because MR is negative there while MC is
positive.

10-3
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

The graph below summarizes the analysis discussed above.

5. Assume that a pure monopolist and a purely competitive firm have the same unit costs.
Contrast the two with respect to (a) price, (b) output, (c) profits, (d) allocation of resources, and
(e) impact on income transfers. Since both monopolists and competitive firms follow the MC =
MR rule in maximizing profits, how do you account for the different results? Why might the costs
of a purely competitive firm and those of a monopolist be different? What are the implications of
such a cost difference? LO3

Answer: With the same costs, the pure monopolist will charge a higher price, have a
smaller output, and have higher economic profits in both the short run and the long run
than the pure competitor. As a matter of fact, the pure competitor will have no economic
profits in the long run even though it might have some in the short run. Because the
monopolist does not produce at the point of minimum ATC and does not equate price and
MC, its allocation of resources is inferior to that of the pure competitor. Specifically,
resources are underallocated to monopolistic industries. Since a pure monopolist is more
likely than the pure competitor to make economic profits in the short run and is,
moreover, the only one of the two able to make economic profits in the long run, the
distribution of income is more unequal with monopoly than with pure competition.
In pure competition, MR = P because the firm’s supply is so insignificant a part of
industry supply that its output has no effect on price. It can sell all that it wishes at the
price established by demand and the total industry supply. The firm cannot force the
price up by holding back part or all of its supply.

10-4
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

The monopolist, on the other hand, is the industry. When it increases the quantity it
produces, price drops. When it decreases the quantity it produces, price rises. In these
circumstances, MR is always less than price for the monopolist; to sell more it must
lower the price on all units, including those it could have sold at the higher price had it
not put more on the market. When the monopolist equates MR and MC, it is not selling
at that price: The monopolist’s selling price is on the demand curve, vertically above the
point of intersection of MR and MC. Thus, the monopolist’s price will be higher than the
pure competitor’s.
Economies of scale may be such as to ensure that one large firm can produce at lower
cost than a multitude of small firms. This is certainly the case with most public utilities.
And in such industries as basic steel-making and car manufacturing, pure competition
would involve a very high cost. On the other hand, monopolies may suffer from
X-inefficiency, the inefficiency that a lack of competition allows. Monopolies may also
incur nonproductive costs through “rent-seeking” expenditures. For example, they may
try to influence legislation that protects their monopoly powers.

6. Critically evaluate and explain each statement: LO3

a. Because they can control product price, monopolists are always assured of profitable
production by simply charging the highest price consumers will pay.
b. The pure monopolist seeks the output that will yield the greatest per‐unit profit.
c. An excess of price over marginal cost is the market’s way of signaling the need for more
production of a good.
d. The more profitable a firm, the greater its monopoly power.
e. The monopolist has a pricing policy; the competitive producer does not.
f. With respect to resource allocation, the interests of the seller and of society coincide in a purely
competitive market but conflict in a monopolized market.

Answer:
(a) The statement is false. If the monopolist charged the highest price consumers would
pay, it would sell precisely one unit! (Conceivably, it might sell a little more than
one if more than one consumer made matching bids for the first unit offered.) It is
highly unlikely that the sale of one unit (or a very few) would cover the very high
AFC of one or a very few units. And even a monopolist that does produce sensibly
where MR = MC may still suffer a loss: P can be below ATC at all levels.
(b) The statement is false. The monopolist seeks the output that will yield the greatest
profit. The profit equation is Q(P - ATC). It is not (P - ATC). If the monopolist sells
one unit for $100 when ATC is $60, then its profit per unit and total profit is $40 (=
$100 - $60). Nice, but if the same monopolist can sell 1,000 units for $40 when ATC
is $39, then, though its per unit profit is a mere $1 (= $40 - $39), its total profit is
$1,000 [= 1,000($40 - $39)]. This is much better than $40.
(c) The statement is true. Price is the value society sets on the last item produced.
Marginal cost is the value to society of the alternative production forgone when the
last item is produced. When P>MC, society is willing to pay more than the
opportunity cost of the last item’s production.

10-5
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

(d) This statement can be true and probably is in many cases. Large profits allow
expansion to gain economies of scale and thus prevent the late entry of smaller rivals.
Large profits also enable the firm to price below cost, to engage (illegally) in a price
war. Moreover, large profits in the short run are often associated with monopoly
power. In the long run, only a firm with monopoly power can gain economic profits;
in pure competition such profits would invariably be competed away by new entry.
(e) The statement is true. The monopolist must equate MR and MC. Having determined
at what quantity this equality occurs, the monopolist simultaneously sets price. This
price differs at each output because the demand curve is downsloping. The pure
competitor accepts the price given by total industry supply and demand. Knowing
this externally given price, the competitor then equates it with the firm’s MC and
produces the amount determined by this equality.
(f) The statement is true. In pure competition, P = MC. This means that the value
society sets on the last item produced (its price) is equal to the cost of the alternative
commodities that are not produced. This is because producing the last item of the
commodity in question is its MC. In monopoly, P>MC. This means that society
values the last item produced more than its cost.

7. Assume a monopolistic publisher has agreed to pay an author 10 percent of the total revenue
from the sales of a text. Will the author and the publisher want to charge the same price for the
text? Explain. LO3

Answer: The publisher is a monopolist seeking to maximize profits. This will occur at
the quantity of output where MC = MR. (See Figure 10.4)

The author who will receive 10% of the total revenue will maximize his payment if the
book is priced where MR = 0. This will occur where the price elasticity of demand is
equal to 1 and total revenue is maximum. (See Figure 10.3)

10-6
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

The author would prefer a lower price than the publisher. Consult Key Graph 10.4 and
compare the price charged where MC = MR and the price that would be necessary to
maximize total revenue when MR = 0. This is a highly unlikely outcome since the
publisher, whether economically literate or not, is certain to recognize the revenue
maximizing price as disadvantageous.

8. U.S. pharmaceutical companies charge different prices for prescription drugs to buyers in
different nations, depending on elasticity of demand and government-imposed price ceilings.
Explain why these companies, for profit reasons, oppose laws allowing reimportation of drugs to
the United States. LO4

Answer: U.S. pharmaceutical companies are price discriminating based in part on the
different elasticities of demand in different nations. Reimportation allows reselling of the
goods, making it more difficult to price discriminate. To the extent they could still charge
different prices, the difference in prices would have to be small enough so that
reimportation was not profitable. Prohibition of reimportation would allow
pharmaceutical companies to charge the profit-maximizing price in each nation, without
fear of being undercut back in the U.S. by those in nations where the drugs are cheaper.

9. Explain verbally and graphically how price (rate) regulation may improve the performance of
monopolies. In your answer distinguish between (a) socially optimal (marginal‐cost) pricing and
(b) fair‐return (average‐total‐cost) pricing. What is the “dilemma of regulation”? LO5

10-7
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Answer: Monopolies that are natural monopolies are normally subject to regulation.
Because of extensive economies of scale, marginal cost is less than average total cost
throughout the range of output. An unregulated monopolist would produce at Q m when
MC = MR and enjoy an economic profit. Society would be better off with a larger
quantity. Output level Qr would be socially optimal because MC = Price and allocative
efficiency would be achieved. However, the firm would lose money producing at Q r
since ATC exceeds the price. In order for the firm to survive, public subsidies out of tax
revenue would be necessary. Another option for regulators is to allow a fair-return price
that would allow the firm to break even economically (cover all costs including a normal
profit). Setting price equal to ATC would deliver Q f output and only partially solve the
underallocation of resources. Despite this dilemma regulation can improve on the results
of monopoly from the social point of view. Price regulation (even at the fair -return price)
can simultaneously reduce price, increase output, and reduce the economic profits of
monopolies.

10. It has been proposed that natural monopolists should be allowed to determine their profit‐
maximizing outputs and prices and then government should tax their profits away and distribute
them to consumers in proportion to their purchases from the monopoly. Is this proposal as
socially desirable as requiring monopolists to equate price with marginal cost or average total
cost? LO5

Answer: No, the proposal does not consider that the output of the natural monopolist
would still be at the suboptimal level where P > MC. Too little would be produced and
there would be an underallocation of resources. Theoretically, it would be more desirable
to force the natural monopolist to charge a price equal to marginal cost and subsidize any
losses. Even setting price equal to ATC would be an improvement over this proposal.
This fair-return pricing would allow for a normal profit and ensure greater production
than the proposal would.

11. LAST WORD How was De Beers able to control the world price of diamonds even though it
produced only 45 percent of the diamonds? What factors ended its monopoly? What is its new
strategy for earning economic profit, rather than just normal profit?

10-8
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Answer: De Beers produces 50 percent of all rough-cut diamonds, but buys a large
portion of the diamonds produced by other mines. As a result, it marketed over 80
percent of the world’s diamonds.
New diamonds were discovered and mined in Angola, Canada, and Australia and some of
these diamonds were leaking into the world market. In addition, Russia was allowed to
sell a portion of its diamond stock directly into the world market.
De Beers’ new strategy is to transform itself into a firm selling premium diamonds and
other luxury goods. This new image will be portrayed in an advertising campaign.

PROBLEMS

1. Suppose a pure monopolist is faced with the demand schedule shown below and the same cost
data as the competitive producer discussed in problem 4 at the end of Chapter 8. Calculate the
missing total‐revenue and marginal‐revenue amounts, and determine the profit‐maximizing price
and profit‐maximizing output for this monopolist. What is the monopolist’s profit? Verify your
answer graphically and by comparing total revenue and total cost. LO2

10-9
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Answer:
Price (P) Quantity Total Marginal
Demanded Revenue Revenue
(Q) (TR) (MR)
$115 0 $0 NA
100 1 100 100
83 2 166 66
71 3 213 47
63 4 252 39
55 5 275 23
48 6 288 13
42 7 294 6
37 8 296 2
33 9 297 1
29 10 290 -7

Profit-maximizing price = $63; profit-maximizing quantity = 4 units; monopolist’s

profit = $42.
The graph should have the general shape of Figure 10.4.

Feedback: Consider the following example. Suppose a pure monopolist is faced with
the demand schedule shown below and the same cost data as the competitive producer
discussed in problem 4 at the end of Chapter 8. Calculate the missing total‐revenue and
marginal‐revenue amounts, and determine the profit‐maximizing price and profit‐
maximizing output for this monopolist. What is the monopolist’s profit? Verify your
answer graphically and by comparing total revenue and total cost.

10-10
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

To calculate Total Revenue multiply price (P) by Quantity Demanded (Q): TR = P x Q

To calculate Marginal Revenue find the change in total revenue for each unit demanded:
MR = Δ TR = TR (i+1) – TR (i).

See table below.

Price (P) Quantity Total Marginal

Demanded Revenue Revenue
(Q) (TR) (MR)
$115 0 $0 NA
100 1 100 100
83 2 166 66
71 3 213 47
63 4 252 39
55 5 275 23
48 6 288 13
42 7 294 6
37 8 296 2
33 9 297 1
29 10 290 -7

To determine profit‐maximizing price and profit‐maximizing output for this monopolist

use the cost data in problem 4 at the end of Chapter 8 (see table below).

10-11
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

To find the profit maximizing quantity compare marginal revenue from the first table
above with the marginal cost from second table.

Price (P) Quantity Marginal Marginal

Demanded Revenue Cost
(Q) (MR) (MC)
$115 0 NA NA
100 1 $100 $45
83 2 66 40
71 3 47 35
63 4 39 30
55 5 23 35
48 6 13 40
42 7 6 45
37 8 2 55
33 9 1 65
29 10 -7 75

Starting with the first unit MR=$100 > MC=$45, produce this unit. The same logic
applies to units 2, 3, and 4. However, for the fifth unit MR=$23 < MC=$35. Thus, the
firm does NOT produce this unit. (NOTE: We have modified the MR=MC rule to
MR>MC, which is more general. Produce all units where MR>MC.)

The profit maximizing quantity produced is 4 units.

The profit maximizing price is the price associated with the profit maximizing quantity, 4
units. Thus, the profit maximizing price is $63.

10-12
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

The monopolist's profit equals total revenue minus total cost. Total revenue equals $252
at 4 units of output. We still need total cost. From the 'cost data' table we see that average
total cost (ATC) equals $52.50. Since ATC equals total cost divided by quantity we can
determine total cost from the ATC cost data.

ATC = Total Cost / Quantity

or
Total Cost = Quantity x ATC = 4 x $52.50 = $210

Profit = $252 - $210 = $42

Another approach is to use the following relationship.

Profit = TR -TC

Divide through by Q

Profit/Q = TR/Q -TC/Q

Since TR/Q = Average Revenue = P and TC/Q = ATC, we have:

Profit/Q = P -ATC

Rearranging,

Profit = Q (P - ATC) = 4($63 - $52.50) = 4 x $10.5 = $42.

Either approach above will work.

The graph should have the general shape of Figure 10.4.

10-13
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

2. Suppose that a price‐discriminating monopolist has segregated its market into two groups of
buyers. The first group described by the demand and revenue data that you developed for
problem 1. The demand and revenue data for the second group of buyers is shown in the
accompanying table. Assume that MC is $13 in both markets and MC = ATC at all output levels.
What price will the firm charge in each market? Based solely on these two prices, which market
has the higher price elasticity of demand? What will be this monopolist’s total economic profit?
LO4

Answer: Price in market 1 = $48; price in market 2 = $33; the second market has the higher
price elasticity of demand; total economic profit = $330.

Feedback: Consider the following example. Suppose that a price‐discriminating

monopolist has segregated its market into two groups of buyers, the first group described
by the demand and revenue data that you developed for problem 1. The demand and
revenue data for the second group of buyers is shown in the accompanying table. Assume
that MC is $13 in both markets and MC = ATC at all output levels. What price will the
firm charge in each market? Based solely on these two prices, which market has the
higher price elasticity of demand? What will be this monopolist’s total economic profit?

10-14
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Let's start with the second market (Table above). Marginal cost is $13 for all output
levels. The marginal revenue from producing the 6th unit is $13 (=$198- $185), so this is
the last unit produced by the firm for this market.

Thus, the marginal revenue equals marginal cost rule results in 6 units being produced in
this market (MR=MC=$13 at 6 units in this market).

The price the firm charges in this market is $33, which is the price associated with the 6 th
unit.

The firm’s profit in this market can be found using the following relationship (see
problem 1 in this chapter for derivation).

Profit Market 2 = Q (P - ATC) = 6($33 - $13) = 6 x $20 = $120.

The first market is found in problem 1 (Table reproduced below):

Price (P) Quantity Total Marginal

Demanded Revenue Revenue
(Q) (TR) (MR)
$115 0 $0 NA
100 1 100 100
83 2 166 66
71 3 213 47
63 4 252 39
55 5 275 23
48 6 288 13
42 7 294 6
37 8 296 2
33 9 297 1
29 10 290 -7

Again, marginal cost is $13 for all output levels.

The marginal revenue equals marginal cost rule results in 6 units being produced in this
market as well (MR=MC=$13 at 6 units in this market).

The price the firm charges in this market is $48, which is the price associated with the 6 th
unit.

The firm’s profit in this market can be found using the following relationship (see
problem 1 in this chapter for derivation).

Profit Market 1 = Q (P - ATC) = 6($48 - $13) = 6 x $35 = $210.

The combined profit from both markets gives us total profit.

Total Profit = Profit Market 1 + Profit Market 2 = $120 + $210 = $330

10-15
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Since the firm charges a lower price in the second market (a price of $48), this market has
the higher price elasticity of demand.

3. Assume that the most efficient production technology available for making vitamin pills has
the cost structure given in the following table. Note that output is measured as the number of
bottles of vitamins produced per day and that costs include a normal profit. LO4

a. What is ATC per unit for each level of output listed in the table?
b. Is this a decreasing‐cost industry? (Answer yes or no).
c. Suppose that the market price for a bottle of vitamins is $2.50 and that at that price the total
market quantity demanded is 75,000,000 bottles. How many firms will there be in this industry?
d. Suppose that instead the market quantity demanded at a price of $2.50 is only 75,000. How
many firms do you expect there to be in this industry?
e. Review your answers to parts b, c, and d. Does the level of demand determine this industry’s
market structure?

Answers: (a) ATC per bottle is $4 per bottle at 25,000 bottles, $3 per bottle at 50,000 bottles,
$2.50 per bottle at 75,000 units, and $2.76 per bottle at 100,000 units.
(b) No.
(c) There will be 1000 firms in this industry.
(d) There will be one firm in this industry.
(e) Yes.

Feedback: Consider the following example. Assume that the most efficient production
technology available for making vitamin pills has the cost structure given in the
following table. Note that output is measured as the number of bottles of vitamins
produced per day and that costs include a normal profit.

a. What is ATC per unit for each level of output listed in the table?

To find Average Total Cost (ATC) divide Total Cost by Output (Quantity).

ATC = Total Cost / Output

10-16
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

Output TC MC ATC
25,000 $100,000 $0.50 $4.00
50,000 150,000 1.00 $3.00
75,000 187,500 2.50 $2.50
100,000 275,500 3.00 $2.76

b. Is this a decreasing‐cost industry? (Answer yes or no).

No, the ATC cost does NOT decline for all levels of output.

c. Suppose that the market price for a bottle of vitamins is $2.50 and that at that price the
total market quantity demanded is 75,000,000 bottles. How many firms will there be in
this industry?

Since $2.50 is minimum ATC, firms will produce at this level of output. Any firm that
deviated from this level would incur a higher ATC and would be unprofitable at the
market price of $2.50.

The total number of firms can be found by dividing the market quantity demanded by
output produced by a firm at the ATC of $2.50, which is 75,000.

Number of Firms = Market Quantity Demanded / Output Minimum ATC =

75,000,000/75,000 =1000.

d. Suppose that instead the market quantity demanded at a price of $2.50 is only 75,000.
How many firms do you expect there to be in this industry?

The total number of firms under this assumption is:

Number of Firms = Market Quantity Demanded / Output Minimum ATC = 75,000/75,000
=1.

e. Review your answers to parts b, c, and d. Does the level of demand determine this
industry’s market structure?

Yes, high demand will result in a competitive industry while very low demand can result
in a monopoly industry.

4. A new production technology for making vitamins is invented by a college professor who
decides not to patent it. Thus, it is available for anybody to copy and put into use. The TC per
bottle for production up to 100,000 bottles per day is given in the following table.

Output TC
25,000 $50,000
50,000 70,000
75,000 75,000
100,000 80,000

10-17
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

a. What is ATC for each level of output listed in the table?

b. Suppose that for each 25,000‐bottle per day increase in production above
100,000 bottles per day, TC increases by $5000 (so that, for instance, 125,000 bottles per day
would generate total costs of $85,000 and 150,000 bottles per day would generate total costs of
$90,000). Is this a decreasing‐cost industry?
c. Suppose that the price of a bottle of vitamins is $1.33 and that at that price the total quantity
demanded by consumers is 75,000,000 bottles. How many firms will there be in this industry?
d. Suppose that instead the market quantity demanded at a price of $1.33 is only 75,000. How
many firms do you expect there to be in this industry?
e. Review your answers to parts b, c, and d. Does the level of demand determine this industry’s
market structure?
f. Compare your answer to part d of this question with your answer to part d of problem 3. Do
both production technologies show constant returns to scale?

Answers: (a) ATC per bottle is $2.00 per bottle for 25,000 bottles, $1.40 per bottle for 50,000
bottles, $1 per bottle for 75,000 bottles, and $0.80 per bottle for 100,000 bottles.
(b) Yes, this is a decreasing cost industry.
(c) Only one firm since this is a natural monopoly situation.
(d) Only one firm since this is a natural monopoly situation.
(e) No, the level of demand does not determine this market’s structure.
(f) No, the new technology of this problem shows economies of scale and this industry is
therefore a decreasing-cost industry.

Feedback: Consider the following example. The TC per bottle for production up to
100,000 bottles per day is given in the following table.

Output TC
25,000 $50,000
50,000 70,000
75,000 75,000
100,000 80,000

a. What is ATC for each level of output listed in the table?

To find Average Total Cost (ATC) divide Total Cost by Output (Quantity).
ATC = Total Cost / Output

Output TC ATC
25,000 $50,000 $2.00
50,000 70,000 $1.40
75,000 75,000 $1.00
100,000 80,000 $.0.80

b. Suppose that for each 25,000‐bottle per day increase in production above
100,000 bottles per day, TC increases by $5000 (so that, for instance, 125,000 bottles per
day would generate total costs of $85,000 and 150,000 bottles per day would generate
total costs of $90,000). Is this a decreasing‐cost industry?

10-18
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

The last two rows provide the additional cost and output information (you could continue
to add rows for additional output).

Output TC ATC
25,000 $50,000 $2.00
50,000 70,000 $1.40
75,000 75,000 $1.00
100,000 80,000 $.0.80
125,000 $85,000 $0.68
150,000 $90,000 $0.60

From this additional information we can conclude this is a decreasing cost industry
because ATC falls as output increases at all levels.

c. Suppose that the price of a bottle of vitamins is $2.50 and that at that price the total
quantity demanded by consumers is 75,000,000 bottles. How many firms will there be in
this industry?

Since this is a decreasing cost industry there will only be one firm.

d. Suppose that instead the market quantity demanded at a price of $2.50 is only 75,000.
How many firms do you expect there to be in this industry?

Again, since this is a decreasing cost industry there will only be one firm.

e. Review your answers to parts b, c, and d. Does the level of demand determine this
industry’s market structure?

No. Since this is a decreasing cost industry there will only be one firm regardless of
demand.

f. Compare your answer to part d of this question with your answer to part d of problem
3. Do both production technologies show constant returns to scale?

No, the second technology (this problem) has an increasing returns to scale technology.

5. Suppose you have been tasked with regulating a single monopoly firm that sells 50‐pound bags
of concrete. The firm has fixed costs of $10 million per year and a variable cost of $1 per bag no
matter how many bags are produced. LO5
a. If this firm kept on increasing its output level, would ATC per bag ever increase? Is this a
decreasing‐cost industry?
b. If you wished to regulate this monopoly by charging the socially optimal price, what price
would you charge? At that price, what would be the size of the firm’s profit or loss? Would the
firm want to exit the industry?
c. You find out that if you set the price at $2 per bag, consumers will demand 10 million bags.
How big will the firm’s profit or loss be at that price?
d. If consumers instead demanded 20 million bags at a price of $2 per bag, how big would the
firm’s profit or loss be?

10-19
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

e. Suppose that demand is perfectly inelastic at 20 million bags, so that consumers demand 20
million bags no matter what the price is. What price should you charge if you want the firm to
earn only fair rate of return? Assume as always that TC includes a normal profit.

Answers: (a) ATC will never increase. This is a decreasing cost industry.
(b) Charge $1 per bag. At that price, the firm would lose its $10 million fixed costs. This
firm would be losing money and will want to exit the industry.
(c) The firm will break even (no profit or loss).
(d) The firm will make an economic profit of $10 million.
(e) You should charge $1.50 per bag if you want this firm to earn a fair rate of return.

Feedback: Consider the following example. Suppose you have been tasked with
regulating a single monopoly firm that sells 50‐pound bags of concrete. The firm has
fixed costs of $10 million per year and a variable cost of $1 per bag no matter how many
bags are produced.

a. If this firm kept on increasing its output level, would ATC per bag ever increase? Is this
a decreasing‐cost industry?
ATC will never increase. This is a decreasing cost industry. The intuition is that FC get
distributed over more and more units so that ATC will fall asymptotically towards the $1
per bag marginal cost.

b. If you wished to regulate this monopoly by charging the socially optimal price, what
price would you charge? At that price, what would be the size of the firm’s profit or loss?
Would the firm want to exit the industry?
Charge $1 per bag since the MC of all bags is $1 per bag. At that price, the firm would
lose its $10 million fixed costs (since the price is just enough to cover variable costs).
This firm would be losing money and will want to exit the industry.

c. You find out that if you set the price at $2 per bag, consumers will demand 10 million
bags. How big will the firm’s profit or loss be at that price?
The firm's revenue equals $20,000,000 ( = $2 (price) x 10,000,000 (quantity)).
The firm's Fixed Cost equals $10,000,000 (given above).
The firm's Total Variable Cost equals $10,000,000 ( = $1 (variable cost of producing each
bag) x 10,000,000 (quantity)).
The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost,
$20,000,000 (=$10,000,000 (Total Fixed Cost) + $10,000,000 (Total Variable Cost)).
The firm's profit equals $0 (= $20,000,000 (revenue) - $20,000,000 (total cost)). The firm
breaks even.

d. If consumers instead demanded 20 million bags at a price of $2 per bag, how big
would the firm’s profit or loss be?
The firm's revenue equals $40,000,000 ( = $2 (price) x 20,000,000 (quantity)).
The firm's Fixed Cost equals $10,000,000 (given above).
The firm's Total Variable Cost equals $20,000,000 ( = $1 (variable cost of producing each
bag) x 20,000,000 (quantity)).
The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost,
$30,000,000 (=$10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)).
The firm's profit equals $10,000,000 (= $40,000,000 (revenue) - $30,000,000 (total
cost)).

10-20
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
Chapter 10 - Pure Monopoly

e. Suppose that demand is perfectly inelastic at 20 million bags, so that consumers

demand 20 million bags no matter what the price is. What price should you charge if you
want the firm to earn only fair rate of return? Assume as always that TC includes a
normal profit.
The fair rate of return is where economic profit is zero (Total Cost above includes normal
profit).

The first step is to find Total Cost.

The firm's Fixed Cost equals $10,000,000 (given above).
The firm's Total Variable Cost equals $20,000,000 ( = $1 (variable cost of producing each
bag) x 20,000,000 (quantity)).
The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost,
$30,000,000 (=$10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)).

The second step is to find revenue (here the price is not known).
Revenue = Price (unknown) x 20,000,000.

The final step is to use the definition of profit to solve for the unknown price.
Profit = Revenue - Total Cost = Price x 20,000,000 - $30,000,000
We can also set profit to zero (fair rate of return requirement):
Price x 20,000,000 - $30,000,000 = 0
or
Price x 20,000,000 = $30,000,000 which gives us,
Price = $30,000,000 / 20,000,000 = $1.50.
Thus, the firm should charge $1.50 per bag to earn a fair rate of return.

10-21
© 2012 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.