Data, Economics, and Development Policy MicroMasters Program 14.

100x

Handout 7: Monopoly
1 Introduction

In this handout we will explore a market under the control of a monopolist. In Handout 7, we

discussed how to get from the problem of the firm to the supply in a competitive market. Now, we

will do the same, but in a situation where firms do not take the price as given. In particular, we

assume that there is only one firm in the market, which internalizes that it can increase market price

if it reduces quantity. We first do an example where the monopolist cannot discriminate prices and

compute equilibrium outcomes and surpluses of consumers and producers. Second, we discuss price

discrimination and how the equilibrium price is related to the elasticity of demand.

2 Monopoly

Consider a monopolist that faces the market demand Q = (40 − P )/3. The cost of Q to produce

the good is given by is given by C(Q) = Q2 . The monopolist can charge only one price (no price

discrimination).

1. Find the marginal revenue and the marginal cost as a function of Q. Draw them along with the

demand curve.

2. Find the profit-maximizing price and quantity. What is the marginal cost at the profit-maximizing

quantity?

3. How much profits does the monopolist make?

4. Calculate the producer surplus, consumer surplus and total surplus in the market. Illustrate

them in a graph.

5. What is the price elasticity of demand at the equilibrium point? What is the markup of the

monopolist, defined by (P − M C)/P (this is known as the Lerner index)?

Solution.

1. The Marginal cost (MC) is given by

dC(Q)
MC = ⇒ M C = 2Q
dQ

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Data, Economics, and Development Policy MicroMasters Program 14.100x

and marginal revenue is

d(P (Q)Q) d(40Q − 3Q2 )

MR = = ⇒ M R = 40 − 6Q
dQ dQ

We first invert the market demand to get P = 40−3Q, multiply this by Q, and finally differentiate

w.r.t. Q. We show all curves in Figure 1.

Figure 1: Demand, MR and MC

P

MC
40

MR D
O Q
20/3 40/3

2. Setting M R = M C (the profit maximizing condition of the firm) implies profit-maximizing

quantity

40 − 6Q∗ = 2Q∗ ⇒ Q∗ = 5

To find the price, we replace this quantity in the demand to recover: P ∗ = 40 − 3Q = 25.

Finally, the marginal cost at this quantity equals M C(5) = 10.

3. The profit level of the monopolist is given by total revenue (price times quantity) minus total

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Data, Economics, and Development Policy MicroMasters Program 14.100x

cost, that is

π = P ∗ Q∗ − C(Q∗ ) = 25 × 5 − 25 ⇒ π = 100

4. The consumer surplus (CS) is the are above the equilibrium price and below the demand.

Recall that the equilibrium quantity is where M C = M R, but the equilibrium price is that on

the demand at the equilibrium quantity, as shown in Figure 2. The consumer surplus is the are

of the blue triangle:

(40 − 25) × 5 75
CS = =
2 2

The producer surplus is the area of the trapeze, which can be computed as

(25 + (25 − 10)) × 5

PS = = 100
2

The total surplus is the sum of CS and P S, thus: T S = 275/2.

Figure 2: Consumer, Producer and Total Surplus

P

MC
40

CS

P ∗ = 25

10

PS

MR D
O Q
Q∗ = 5 20/3 40/3

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Data, Economics, and Development Policy MicroMasters Program 14.100x

5. The elasticity of demand at any point is given by

dQ P P
D = =−
dP Q 40 − P

Therefore, at the equilibrium price, the elasticity is −25/15 = −5/3. Remembering the formula
P −M C
for markup: P = − 1D , we get the markup 3/5. If you don’t remember the formula for

markup, here is a derivation. Consider the maximization problem of any monopolist that faces

inverse demand P (Q) and has a marginal cost c:

max (P (Q) − c)Q

Q

where P (Q) is the inverse demand function. Taking the FOC:

dP (Q)
P (Q) + Q =c
dQ

Therefore:
dP Q c
1+ =
dQ P P

Note that
dP (Q) Q 1
=
dQ P D

since the derivative of the inverse of a function is the inverse of the derivative. Therefore:

P −c 1
=−
P D

3 Price Discrimination

A price discriminating monopolist sells a good for two types of consumers: young and old. Old

consumers have an aggregate demand given by:

p
QOLD
D = 110 −
4

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Data, Economics, and Development Policy MicroMasters Program 14.100x

While young consumers have an aggregate demand given by

p
QYDoung = 100 −
2

The cost of production is C(Q) = Q2 .

1. Find the equilibrium price, quantity and aggregate demand elasticity if the monopolist does not

distinguish between Old and Young Consumers.

2. Find the equilibrium prices, quantities and aggregate demand elasticities of Young and Old if

the monopolist can price discriminate between Old and Young consumers.

3. Are Young consumers better or worse off with price discrimination?

Solution.

1. We must first compute the aggegate demand curve. For 100 − p/2 ≥ 0, both Young and Old

consume positive amounts of the good - and we sum their demands. For 100 − p/2 ≤ 0, only Old

consumers demand the good. For 110 − p/4 ≤ 0, no consumer demands the good. Together:


210 − 43 p,




 if p ≤ 200


QD = 110 − p/4, if 200 < p ≤ 440





0,
 if p > 440

To find out what the price maximizing profit for the monopolist is, we must separate the three

cases above. Case 1: Sell to both Young and Old. p ≤ 200. If p < 200, the inverse demand

equation is given by
4
p = 280 − Q
3

Therefore, for the monopolist to maximize profits with M R = M C

d( (280 − 34 Q)Q
 
8 8
MR = = 280 − Q = 2Q = M C ⇒ 280 − Q = 2Q
dQ 3 3

Which implies Q1 = 60 (Q of the first case). Replacing at the demand, we get P1 = 280 − 43 Q =

200, which satisfies the condition that p ≤ 200 we started with. Therefore, profits in the first

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Data, Economics, and Development Policy MicroMasters Program 14.100x

case are

π1 = 200 × 60 − 602 = 8400

Note that as π1 > 0, we do not have to consider p > 440 as a case (the third case), since it

would yield zero profits. We have only to additionally consider case 2, where 200 < p ≤ 440.

Case 2: Sell to Old Only. 200 < p ≤ 440. IThe inverse demand equation is given by

p = 440 − 4Q

Therefore, for the monopolist to maximize profits with M R = M C

d([(440 − 4Q)Q]
MR = = 440 − 8Q = 2Q = M C ⇒ 440 − 8D = 2Q
dQ

Which implies Q2 = 44 (Q of the second case). Replacing at the demand, we get P2 = 264,

which satisfies the condition that 200 < p ≤ 440 we started with. Therefore, profits in the

second case are

π2 = 264 × 44 − 442 = 9680

Conclusion. The monopolist is better off in case 2, where it excludes young people from the

market to focus solely on the old. Old consumers are willing to pay more, and thus the monopolist

can decrease quantities (and costs) and increase prices to maximize its profits. Therefore, the

equilibrium price is p = 264, the equilibrium quantity is Q = 44 and the elasticity of demand at

this point is
1 264 3
εD = − =−
4 44 2

2. The Monopolist can now offer different prices for young and old consumers. The profit maximiza-

tion problem can be written as (already writing prices as their inverted demand counterparts):

max (200 − 2QY )QY + (440 − 4QO )QO − (QY + QO )2

QY ,QO

Note that we cannot solve the problem of the monopolist for young/old consumers separately.

The cost function C(Q) = Q2 is convex and, thus, the quantities produced in one market affect

the marginal cost of production in the other.

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Data, Economics, and Development Policy MicroMasters Program 14.100x

Taking the FOC with respet to QY and QO

200 − 4QY = 2(QY + QO )

440 − 8QO = 2(QY + QO ) (1)

Subtracting one from the other:

QY = 2QO − 60

Replacing it back:

440 − 10QO = 2(2QO − 60) ⇒ 14QO = 560

Which yields: QY = 20, QO = 40. Prices come from plugging into the inverse demand curves,

and yield

PY = 200 − 2QY ⇒ PY = 160

PO = 440 − 4QO ⇒ PO = 280

And the demand elasticities are

1 160
εD,Y = − × = −4
2 20

1 280 7
εD,O = − × =−
4 40 4

There are two noteworthy things in this example:

(a) Even though in Item 1 the monopolist was only producing for the old, the quantities were

larger there than they are here. Here, the convexity of the cost implies that the production

for the young will have an impact in price/quantity decisions for the old (and vice -versa).

(b) The old consumers, which are more inelastic (i.e., elasticity) close to zero, are the ones

charged the higher price. This is consistent with our derivation of the Lerner Index in Item

5 of the first section of this handout. As will be seen later on, demand elasticity and market

structure together are what generally determines equilibrium prices.

3. Young consumers are better off, because without price discrimination they would be excluded

from the market. This means that price discrimination can increase total welfare not only by

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Data, Economics, and Development Policy MicroMasters Program 14.100x

increasing the ability of the monopolist to extract rents from consumers, but also by allowing

more consumers to be in the market place.