MSci 607: Applied economics for management

Managerial Economics and Strategy (2017) by Perloff and Brander

Topic 4 (Monopoly)
Chapter 9 Solutions

1.3. When Q = 10, p = 500 − 10(10) = $400. The demand function is Q = 50 − 0.10p. The slope
of the demand function is dQ/dp = –0.1. Therefore, the elasticity of demand is
400
ε=
−0.1 ( )
10
=−4
.

1.5. Revenue is maximized when the change in revenue (or marginal revenue) is zero, which is at
Q = 12 units. A monopoly maximizes profit by producing the quantity where marginal revenue
equals marginal cost. Revenue is maximized at the quantity where marginal revenue equals zero.
Because marginal revenue is decreasing with output and marginal costs are positive, marginal
revenue equals marginal cost at a smaller quantity than when marginal revenue equals zero.
Revenue equals price multiplied by quantity. Revenue is zero when price is zero and when the
quantity demanded is zero and is maximized when quantity equals 12 units.

1.8. A competitive firm operates at the lowest point of its long-run average cost curve due to
competition. If it raises its price above the lowest possible long-run average cost, then it will sell
no output (because other firms would be able to sell output for less). Thus, the firm would not
lower its price below the lowest possible long-run average cost because it would incur losses. A
monopoly faces no competition, so it is able to maximize profit by producing where marginal
revenue equals marginal cost without other firms charging lower prices until price equals the
lowest possible long-run average cost. That is, even if a monopoly is not operating where long-
run average costs are minimized, no other firms are present in the market to profitably charge
lower prices.

1.10. From MC = MR:

100 – 2Q = 5  Q = 47.5 and p = 52.5

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If C(Q) = 100 + 5Q, the answer does not change because marginal cost is still MC = 5. The
profit-maximizing condition is still the same.

1.11. From MC = MR:

25Q–1/2 = 5  Q = 25 and p = 100

2.5. Apple’s price/marginal cost ratio was $349/84 = 4.155. The Lerner Index or price markup is
the ratio of the difference between price and marginal cost to the price:
p  MC 349  84
L   0.76
p 349 .
Finally, a monopoly operates optimally where

MR = MC or
( 1ε )
p 1+
= MC.
With a marginal cost of $84 and a profit-maximizing price of $349, the elasticity of demand is
ε = –1.317.

2.6. Amazon’s Lerner Index was (p – MC)/p = (359 – 159)/359  0.557. Using Equation 11.11,
we know that (p – MC)/p  0.557 = –1/, so   –1.795.

2.7. Given that Apple’s marginal cost was constant, its average variable cost equals its marginal
cost, $200. Its average fixed cost was its fixed cost divided by the quantity produced, 736/Q.
Thus, its average cost was AC = 200 + 736/Q. Because the inverse demand function was p = 600
– 25Q, Apple’s revenue function was R = 600Q – 25Q2, so MR = dR/dQ = 600 – 50Q. Apple
maximized its profit where MR = 600 – 50Q = 200 = MC. Solving this equation for the profit-
maximizing output, we find that Q = 8 million units. By substituting this quantity into the inverse
demand equation, we determine that the profit-maximizing price was p = $400 per unit, as the
figure shows. The firm’s profit was  = (p – AC)Q = [400 – (200 + 736/8)]8 = $864 million.
Apple’s Lerner Index was (p – MC)/p = [400 – 200]/400 = ½. According to Equation 9.10, a
profit-maximizing monopoly operates where (p – MC)/p = –1/. Combining that equation with
the Lerner Index from the previous step, we learn that ½ = –1/, or  = –2.

3.2. The monopoly’s profit-maximizing condition leads to 480 – 8Q = 40  Q = 55, p = 260.

The competitive market price is $40 (= MC), and quantity is 110. Deadweight loss is equal to a
triangle with a base equal to the difference in the monopoly quantity and the competitive
quantity (110 – 55 = 55) and a height equal to the difference in them monopoly price and the
competitive price (260 – 40 = 220): DWL = 0.5 × 55 × 220 = $6,050.

3.3. The monopolist originally produces where MR = MC or 160−4 Q=12 which implies
Q ¿ =37 and a price of $86. At this price/quantity combination, consumer surplus is
74∗37∗1
$ =$ 1369 and producer surplus is $ 74∗37=$ 2738. After the innovation (and the
2

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subsequent cost reduction), the firm maximizes profit by producing where 160−4 Q=4 which
implies Q ¿ =39 and a price of $82. This increase in output (and decrease in cost and price)
78∗39∗1
increases both consumer and producer surplus—consumer surplus rises to $ =$ 1521
2
and producer surplus increases to $ 78∗39=$ 3042. Total surplus increases by $456, and of this
increase, $152 (or 1/3) goes to consumers.

3.5. Prior to the imposition of the tax, the monopolist will produce where MR = MC which
implies 200−4 Q=20 or Q=45 and will sell at a price of p=$ 110. In this case, consumer
90∗45∗1
surplus is $2025 (calculated as $ ) and producer surplus is $4050 (calculated as
2
$ 90∗45). Total welfare is $6075. After the tax is imposed marginal cost rises to $40 and the
monopolist now produces Q=40 units at a price of $120. Since the price rises from $110 to $120
(a $10 increase from a $20 tax), the tax incidence falls equally on consumers and producers.
80∗40∗1
After the tax, consumer surplus falls to $1600 (because $ =$ 1600), producer surplus
2
falls to $3200, and tax revenue (society’s welfare) of $800 is generated. Overall welfare is $5600
—a decrease of $475 from the pre-tax scenario.

4.2. No. In order for a firm to be a natural monopoly, its production must exhibit economies of
scale; that is, firm’s average cost curve must be downward sloping. If the firm operates in the
upward-sloping region of its average cost curve, it is possible that two or more firms could
produce in the same industry more efficiently than one firm.

5.2. To maximize profit, the monopoly must set marginal revenue MR (= R/Q) equal to
marginal cost, MC and must set the marginal revenue of advertising, MRA (= Q/A) equal to the
marginal cost of advertising, which is 1. R = pQ = 100Q – Q2 + 5A – A2. Setting MR = MC
yields 100 – 2Q = 10 or Q = 45. Setting MRA = 1 yields 5 – 2A = 1 or A = 2.

5.3. The marginal revenue function (MR) is MR = 0.75Q–0.25A0.5.

Set marginal revenue from output equal to its marginal cost and solve for Q to find the profit-
maximizing output level:
Q = A2/4096. (1)
The change in profit given a small change in advertising is 0.5Q0.75A–0.5 – 0.25. Set marginal
revenue from advertising equal to its marginal cost and solve for A to find the profit-maximizing
level of advertising:
A = Q1.5/0.25. (2)
Substituting this expression for A into equation (1) above and solving for Q, Q = 16 units.
Substituting this value for Q into equation (2) above and solving for A, A = 256. Substitute the
profit-maximizing values for Q and A into the demand equation and solve for p to find the profit-
maximizing price (p = $8.00).

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6.2. Given that the demand curve is p = 10 – Q, its marginal revenue curve is MR = 10 – 2Q.
Thus the output that maximizes the monopoly’s profit is determined by MR = 10 – 2Q = 2 = MC,
or Q* = 4. At that output level, its price is p* = 6, and its profit is π* = 16. If the monopoly
chooses to sell 8 units in the first period (it has no incentive to sell more), its price is 2, and it
makes no profit. Given that the firm sells 8 units in the first period, its demand curve in the
second period is p = 10 – Q/β, so its marginal revenue function is MR = 10 – 2Q/ β. The output
that leads to its maximum profit is determined by MR = 10 – 2Q/ β = 2 = MC, or its output is 4 β.
Thus its price is 6, and its profit is 16 β. It pays for the firm to set a low price in the first period if
the lost profit, 16, is less than the extra profit in the second period, which is 16(β – 1). Thus it
pays to set a low price in the first period if 16 < 16(β – 1), or 2 < β.