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Chapter 11 Monopoly

 Monopoly Profit Maximization

 Market Power and Welfare
 Taxes and Monopoly
 Causes of Monopolies
 Government Actions that Reduce Market Power

Definitions:

 Monopoly: Market with only one seller.

 Monopsony: Market with only one buyer. A monopsony exercises its market
power by buying at a price below the price that competitive buyers would pay.
Our study will not focus on monopsony. Examples: professional baseball teams,
university in a college town, mining in a “company town”, a firm is the sole employer
in town and uses only one factor, L, to produce a final good.
 market power: Ability of a seller or buyer to affect the price of a good.

11.1 Monopoly Profit Maximization

 A monopoly is the only supplier of a good for which there is no close substitute.
 Monopolies are not price takers like competitive firms
 Monopoly output is the market output
 The monopoly demand curve is the market demand curve
 Monopolists can set their prices given market demand.
 Because demand is downward sloping, monopolists set prices above
marginal cost to maximize profit.

Marginal revenue function

 A firm’s MR curve depends on its demand curve.

 A monopoly's MR is also downward sloping and lies below demand.

Why?

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The teaching notes should be only used by students in Dr. Haozhen Zhang’s class of ECON2020.

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Quantity demanded, Q, is a function of price; the inverse demand function treats
price as a function of quantity demanded, and is also called the price function. If p(Q)
is the inverse demand function, which shows the price received for selling Q, then the
marginal revenue function is:

 Selling one more unit requires the monopolist to lower the price, i.e. dP(Q)/dQ < 0

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dP(Q)/dQ < 0 due to the inverse demand curve slope downward. Given a positive
value of Q, MR< p(Q), i.e. MR lies below inverse demand.

Examples:

Liner demand curve P ( Q )=a−bQ , where a and b are positive constants

Derive revenue R=p ( Q ) Q=aQ−b Q2

dR
then, MR ( Q ) = =a−2bQ
dQ

 If demand is linear, the MR function is linear.

 The slope of MR is -2b, which is twice the slope of the inverse demand curve, -
b.
 Both hit the vertical axis (price) at a: MR ( 0 )=P(0)=a
 MR hit the quantity axis at half the distance of the demand curve: MR=0=a-
2bQ, where Q=a/2b, and P=0=a-bQ, where Q=a/b

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Example: Relationship for inverse demand function of

and marginal revenue function of

When MR=0, Q=12, when P=0, Q=24

When Q=0, P=24=MR

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Necessary conditions for profit maximization

 Like all firms, monopolies maximize profits by setting price or output so that
marginal revenue (MR) equals marginal cost (MC).
 Profit function to be maximized by choosing output, Q:
 π (Q) = R(Q) – C(Q), where R(Q) is the revenue function, C(Q) is the cost
function
 The necessary condition for profit maximization:

i.e. MC=MR
 The sufficient condition for profit maximization:

i.e. the slope of marginal

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 revenue< the slope of the marginal cost curve. Typically, this condition is met
because the marginal cost curve is constant or increasing, i.e. d(MC)/dQ>=0, and
the monopoly's marginal revenue curve is downward sloping d(MR)/dQ<0.

Example:

Inverse demand function: Can be used to find the

marginal revenue function:

Quadratic SR cost function:

Can be used to find the marginal cost function:

The necessary condition

Profit-maximizing output is obtained by producing Q*:

Solving this expression reveals Q*=6

(The sufficient condition of profit maximization: slope of marginal revenue=-2< that
of marginal cost curve=2)

The inverse demand function indicates that people are willing to pay p = 24-6=$18 for
6 units of output.

Profit=p(Q)*Q-C(Q)=18*6-36-12=60

Maximizing profit Chart:

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The monopolist’s profit maximizing choice of output is found where MR=MC.
At the profit-maximizing output, set p according to inverse demand.

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Shut down decision

Should a profit-maximizing monopoly produce at Q* or shut down?

As with competitive firms, a monopoly should shut down if the monopolist’s price is
less than its AVC.
In our example, AVC at Q* of 6 is AVC=Q=$6.
Because p = $18 is clearly above $6, the monopoly in this example should produce in
the SR. Profit =(18-8)*6=60

2. Market power and welfare

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 Market power is the ability of a firm to charge a price above marginal cost and
earn a positive profit. Monopoly has market power; competitive firms do not.
 Market power is related to the price elasticity of demand

A Rule of Thumb for Pricing

 With limited knowledge of average and marginal revenue, we can derive a rule
that can be more easily applied in practice.
 First, write the expression for marginal revenue: R=p(Q)*Q
We can rewrite MR function so that it is stated in terms of elasticity epsilon (ϵ):

This makes the relationship between MR, p, and elasticity of demand quite clear.

We know that MR=MC, then •

Rewrite as

or
 Thus, the ratio of price to MC depends only on the elasticity of demand at the
profit maximizing quantity (why? Recall that MR=MC above).
The more elastic the demand curve (the size of ϵ is large), the less a monopoly can
raise its price without losing sales (and vice versa).

Lerner Index

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The Lerner Index (or price markup) is another way to examine the way in which
elasticity affects a monopoly’s price relative to its MC.

 can be rearranged to give us

 The Lerner Index (p-MC)/p ranges from 0 to 1 for a profit-maximizing firm.

 Competitive firms have a Lerner Index of 0 because P=MC.
 The Lerner Index gets closer to 1 as a firm has more market power (and
faces less elastic demand).

 The markup (P − MC)/P is equal to minus the inverse of the elasticity of demand.

 If the firm’s demand is elastic, as in (a), the markup is small and the firm
has little monopoly power.
 The opposite is true if demand is relatively inelastic, as in (b).

The Rule of Thumb for Pricing

•

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Example.

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When the iPad was introduced, MC=220, its fixed cost was $2000 million and its
inverse demand function is p=770-11Q, where Q is the millions of iPads sold.
1. MR?
demand p=770-11Q then R = pQ= 770Q-11Q^2, then MR=770-22Q

2. Profit-maximizing price?

MR=MC, then 770-22Q=220, Q=25 millions iPad

p=770-11Q=770-275=495

3. Lerner Index?

=(495-220)/495=0.56

4. Elasticity of demand?
Elasticity=-(1/0.56) = -1.79

What factors affect a monopoly's market power?

Elasticity of demand affects a monopoly’s price relative to its MC

 Elasticity of the market demand curve depends on consumers’ tastes and options.
 Demand becomes more elastic (which implies less market power for the firm):
 as better substitutes for the firm’s product are introduced
 as more firms enter the market selling a similar product
 as other firms that provide the same service locate closer to the firm
 As a profit-maximizing monopoly faces more elastic demand, it has to lower its
price.

The Social Costs of Monopoly Power / Deadweight loss from Monopoly

power
Definitions:
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  Consumer surplus (CS) is the monetary difference between the maximum
amount that a consumer is willing to pay for the quantity purchased and what
the good actually costs.
 Consumer surplus (CS) is the area under the inverse demand curve and above
the market price up to the quantity purchased by the consumer.
 Producer surplus (PS) is the difference between the amount for which a good
sells (market price) and the minimum amount necessary for sellers to be
willing to produce it (marginal cost).
 Producer surplus (PS) is the area above the inverse supply curve (MC) and
below the market price up to the quantity purchased by the consumer.
 Deadweight loss: the net reduction in welfare (consumer and producer surplus)

When moving from a competitive price and quantity to a monopolist’s price and
quantity, because of the higher price, consumers lose B+C and producer gains B−E.
The competitive equilibrium has no DWL, while the monopoly equilibrium has DWL
= C+E.

3. Taxes and Monopoly

 Taxes affect a monopoly differently than a competitive industry:

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 Suppose a specific tax of t dollars per unit is levied, so that the monopolist must
pay t dollars to the government for every unit it sells.
 With a tax t per unit, the firm’s effective marginal cost is increased by the amount
t to MC + t. Its optimal production decision is now given by MR=MC+t
 E.g. Before-tax cost function is C(Q)
The after-tax cost function is C(Q) + tQ
The necessary condition for maximizing after-tax profit:

 In the example below, the increase in price ΔP is larger than the tax t. That is, tax
incidence on consumers (the change in the consumers’ price divided by the change
in the tax) can exceed 100% in a monopoly market but not a competitive market.

In this example, the increase in price ΔP is larger than the tax t.

4. Causes of Monopolies
Why are some markets monopolized?
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Two key reasons:

 Cost advantage over other firms

 Government created monopoly

Cost Advantages of Monopoly: Sources of cost advantages:

 Control of an essential facility, a scarce resource that other firms need to use to
survive
For example: owning the only hot spring in a region generates monopoly power for
the water spa.

 Use of superior technology or a better way of organizing production

Example: Apple’s iPad during the first couple of years

 Protection from imitation through patents or informational secrets

Secrets are more common in new and improved processes, and patents are more
common with new products. For example, biologic drugs for cancer

 Natural monopoly: A market has a natural monopoly if one firm can produce
the market's total output at a lower cost than several firms could.

where Q = q1 + q2 +… + qn for n > 1 firms

Examples: public utilities such as water, gas, electricity, and mail delivery

A firm is a natural monopoly because it has economies of scale. For example, natural
monopolies may have high fixed costs, but low and constant marginal costs. It has a
strictly declining average cost.

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Government Actions that Create Monopolies
Governments typically create monopolies in the following ways:

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  Barriers to entry: new firms need to obtain a license to operate
Example: U.S. cities require new hospitals to secure a certificate of need to
demonstrate the need for a new facility
 By granting a firm the right to be a monopoly
Example: public utilities operated by a private company, e.g., Calgary`s Enmax
is a monopoly of electricity in South Alberta
 By auctioning the rights to be a monopoly
Example: selling government monopolies to private firms (privatization). For
example, the privatization of Air Canada
 Patents, copyrights, and licenses. For example, patented drugs vs generic drugs

Governments limit monopolies’ market power in various ways:

 Price regulation by imposing a price ceiling

o Optimal Price Regulation: government regulates the monopoly by
imposing a price ceiling that is equal to the competitive price, which
eliminates DWL.
o Nonoptimal Price Regulation: government-imposed price ceiling is not set
at the competitive level, which reduces but does not eliminate DWL.
 Increasing Competition: allowing/encouraging market entry by new domestic
firms and ending import bans that kept out international firms.

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