Microeconomics 2

Chapter 11
Massimiliano Landi
 Outline
• Definition of Monopolist.

• Profit Maximisation for a Single Price Monopolist.

• The Inverse Price Elasticity Rule.

• Multi-Plant Monopoly.

• Welfare Implications.

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 Outline

• Definition of Monopsony

• Profit maximisation of a monopsony

• Welfare implications

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 Monopolist
• Monopolist: A single firm that has market power:

• Must have a large share of the market (dominant firm).

• Cross price elasticity must be close to zero (no substitutes).

• Causes for a Monopolist:

A. Exclusive control of natural resources.

B. Natural Monopoly.

C. Network Externalities.

D. Legal Barriers to Entry (Patents).

E. Government Contracting.

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 Profit Maximisation
• The monopolist faces no competition.

• Therefore the monopolist can do what they want to

maximise their profits.

• The only constraint coming from the Market

Demand.

• Profit Maximisation: Q must solve MC(Q) = MR(Q).

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 Profit Maximisation

• And P is obtained from the Market Demand

(Vertical Interpretation.)

[Refer to Interactive Figure 1]

• Remark that MR(Q) < Demand curve = P(Q).

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Explain P′(Q)Q + P(Q)
P
Initial TR

Final TR
P
ΔTR = ΔQ(P + ΔP) + QΔP
P + ΔP
ΔTR ΔP
= P + ΔP + Q
ΔQ ΔQ

Q Q + ΔQ Q
 Profit Maximisation
• A single price monopolist with non zero marginal
costs chooses a point on the elastic portion of the
demand curve.

• Suppose it is on the inelastic portion: Verify that

your profits increase if you reduce Q and increase
P.

• Answer: Costs decrease. Revenue increases.

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 Profit Maximisation

Remember the
definition of PED
which I denote
here by ϵ

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 Optimal price
• The profit maximising price is therefore a multiple of
MC(Q), as follows (from MR(Q) = MC(Q))
|ϵ|
P= MC(Q)
|ϵ| − 1
• Common practice is to set a price that is a multiple
of MC(Q) but the multiplying factor is not estimated
from the demand (and probably the marginal cost
is computed differently)

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 Markup
• Markup: Difference between P and MC(Q) relative
to P.
P − MC(Q)
Markup =
P

• It shows the severeness of the Monopolist, since

P=MC(Q) is our benchmark for efficiency.
1
Lerner Index =
|ϵ|

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 Comparative Statics (Meta
learning moment)
Discuss with your classmates what happens to the
monopolist best price and best quantity when

1. Demand increases

2. Marginal cost increases

Suppose linear demand. For case 1 tackle two cases:

marginal cost is increasing or constant in Q; marginal
cost is decreasing in Q.

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 Cartels (Collusion)

• Cartels are groups of firms that collude so as to act

as a monopolist.

• Therefore the Cartel's problem is equivalent to the

multi-plant monopolist (See next.)

• Still, the analysis just done can also be used as a

benchmark to test for collusive behaviours.

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 Cartels (Collusion)

• Example from textbook: Breakfast cereal (or Beer)

industry

• Increase in excise tax induces an increase in MC

• Investigate the impact on total revenues. If total

revenues in the industry go up, then firms are not
acting as a monopolist.

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 TR
As MC ↑, TR ↓

P, MR, MC

MC+T
MC

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Q
 Multi Plant Monopolist

• Monopolist producing in two plants

• What is the optimal rule for allocating production

across two plants?

MC1(Q1) = MC2(Q2) = MR(Q1 + Q2)

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 Multi Plant Monopolist
• Logic: Suppose for given total output marginal costs in the
two plants differ. Say MC1(Q1) > MC2(Q2)

• Reducing production in plant 1 and increasing it in plant 2 by

the same amount,ΔQ generates no change in revenues

• But a reduction of costs in plant 1 of, roughly, ΔQMC1(Q1)

and an increase in costs in plant 2 of, roughly, ΔQMC2(Q2).
Hence the total effect on costs is
ΔQ [MC2(Q2) − MC1(Q1)] < 0

• Suppose now that marginal revenues exceed (fail below)

marginal costs. Total output should increase (decrease).

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 Multi Plant Monopolist
Profit maximisation shows the result too

π = P(Q1 + Q2)(Q1 + Q2) − TC1(Q1) − TC(Q2)

First order conditions

MR(Q1 + Q2) = MC1(Q1)

MR(Q1 + Q2) = MC2(Q2)

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 Back to Cartels

• A Cartel is like a multi-plant monopolist.

• Hence the collusive outcome is the one obtained

by solving the profit maximising problem of the
multi-plant monopolist

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Multi Market Monopolist

• Monopolist selling in two different markets

• What is the optimal rule for choosing production

and price when selling two different markets?

MR1(Q1) = MR2(Q2) = MC(Q1 + Q2)

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Multi Market Monopolist
• Logic: suppose at the current production marginal revenue in
one market is greater. Example, MR1(Q1) > MR2(Q2)

• Consider decrease the quantity sold in market 2 and increase

the quantity sold in market 1 by ΔQ

• Total costs do not change, since total production remains the

same. Revenues in market 2 decrease by ΔQMR2(Q2) while
revenues in market 1 increase by ΔQMR1(Q1) and so overall
revenues change by ΔQ [MR1(Q1) − MR2(Q2)] > 0.

• Suppose that marginal revenues exceed (fail below) marginal

costs. Total output should increase (decrease).

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Multi Market Monopolist
Profit maximisation shows the result too

π = P1(Q1)Q1 + P2(Q2)Q2 − TC(Q1 + Q2)

Taking the first order conditions

MR1(Q1) = MC(Q1 + Q2)

MR2(Q2) = MC(Q1 + Q2)

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 Welfare Analysis
• As anticipated, a Single Price Monopolist is
inefficient.

• Inefficiency is due to the the fact that profit

maximisation requires under production relative to
the efficiency benchmark.

• In fact, MC(Q) = MR(Q) < P

[Refer to Interactive Figure 2]

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 Monopsony

• A single buyer that can purchase from many sellers

• Example: government purchasing military uniforms

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 Monopsony
• Labor market application: one big firm hiring workers

• Analogous to a monopolist, a monopsony has market

power

• In our case, the monopsony faces the entire supply of

labor

• Discuss with your classmates the implications for profit

maximisation (assume competitive market for the
output). Just assume production happens only via units
of labor L to economise on notation.
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 Profit maximisation

max Pf(L) − w(L)L − FC

L

The first term is total revenues, which depend on

quantity produced f(L) times price. The second term
is the cost of labor, which depends on labor supply
w(L) and the quantity of labor employed L. The third
term is the fixed cost.

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 Profit maximisation
max Pf(L) − w(L)L − FC
L

First order conditions for profit maximisation

Pf′(L) = w(L) + w′(L)L

Left hand side: Marginal revenue product of labor;
Right hand side: Marginal expenditure on labor (MEL)

As labor supply w(L) slopes upward, MEL > Labor supply

Therefore, less than efficient output is demanded and lower than

efficient wage is paid

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Profit maximisation
w w(L) + w′(L)L
w(L)

we DWL
w*

pf′(L)

L* Le 28 L
 Monopsony

Market power by one firm in the labor market means

that

Workers are paid less than in a competitive market

Fewer workers are hired than in a competitive market

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