24

Monopoly
 Pure Monopoly
• A monopolized market has a single seller.
• The monopolist’s demand curve is the
(downward sloping) market demand curve.
• So the monopolist can alter the market
price by adjusting its output level.
 Pure Monopoly
$/output unit
Higher output y causes a
p(y)
lower market price, p(y).

Output Level, y
 Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
 Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
 Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownership of a resource; e.g. a toll highway
 Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownership of a resource; e.g. a toll highway
– formation of a cartel; e.g. OPEC
 Why Monopolies?
• What causes monopolies?
– a legal fiat; e.g. US Postal Service
– a patent; e.g. a new drug
– sole ownership of a resource; e.g. a toll highway
– formation of a cartel; e.g. OPEC
– large economies of scale; e.g. local utility
companies.
 Pure Monopoly
• Suppose that the monopolist seeks to
maximize its economic profit,
( y)  p( y)y  c( y).
• What output level y* maximizes profit?
 Profit-Maximization
( y)  p( y)y  c( y).
At the profit-maximizing output level y*
d( y) d dc( y)
 p( y)y  0
dy dy dy
so, for y = y*,
d dc( y)
p( y)y  .
dy dy
 Profit-Maximization
$
R(y) = p(y)y

y
 Profit-Maximization
$
R(y) = p(y)y

c(y)

y
 Profit-Maximization
$
R(y) = p(y)y
c(y)

(y)
 Profit-Maximization
$
R(y) = p(y)y
c(y)

y* y

(y)
 Profit-Maximization
$
R(y) = p(y)y
c(y)

y* y

(y)
 Profit-Maximization
$
R(y) = p(y)y
c(y)

y* y

(y)
 Profit-Maximization
$
R(y) = p(y)y
c(y)

y* y
(y)

At the profit-maximizing
output level the slopes of
the revenue and total cost
curves are equal; MR(y*) = MC(y*).
 Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;
d dp( y)
MR( y)  p( y)y  p( y)  y .
dy dy
 Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;
d dp( y)
MR( y)  p( y)y  p( y)  y .
dy dy
dp(y)/dy is the slope of the market inverse
demand function so dp(y)/dy < 0. Therefore
dp( y)
MR( y)  p( y)  y  p( y)
dy
for y > 0.
 Marginal Revenue
E.g. if p(y) = a - by then
R(y) = p(y)y = ay - by2
and so
MR(y) = a - 2by < a - by = p(y) for y > 0.
 Marginal Revenue
E.g. if p(y) = a - by then
R(y) = p(y)y = ay - by2
and so
MR(y) = a - 2by < a - by = p(y) for y > 0.

a p(y) = a - by

a/2b a/b y
MR(y) = a - 2by
 Marginal Cost
Marginal cost is the rate-of-change of total
cost as the output level y increases;
dc( y)
MC( y)  .
dy
E.g. if c(y) = F + ay + by2 then
MC( y)  a  2by.
 $ Marginal Cost
c(y) = F + ay + by2

F
$/output unit y

MC(y) = a + 2by
a
y
 Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and
c(y) = F + ay + by2 then
MR( y*)  a  2by*  a  2by*  MC( y*)
 Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and if
c(y) = F + ay + by2 then
MR( y*)  a  2by*  a  2by*  MC( y*)
and the profit-maximizing output level is
aa
y* 
2(b  b )
 Profit-Maximization; An Example
At the profit-maximizing output level y*,
MR(y*) = MC(y*). So if p(y) = a - by and if
c(y) = F + ay + by2 then
MR( y*)  a  2by*  a  2by*  MC( y*)
and the profit-maximizing output level is
aa
y* 
2(b  b )
causing the market price to be
aa
p( y*)  a  by*  a  b .
2(b  b )
Profit-Maximization; An Example
$/output unit

a p(y) = a - by

MC(y) = a + 2by

a
y

MR(y) = a - 2by
Profit-Maximization; An Example
$/output unit

a p(y) = a - by

MC(y) = a + 2by

a
y*  y
aa
2(b  b ) MR(y) = a - 2by
 Profit-Maximization; An Example
$/output unit

a p(y) = a - by
p( y*) 
aa
ab
2(b  b ) MC(y) = a + 2by

a
y*  y
aa
2(b  b ) MR(y) = a - 2by
 Monopolistic Pricing & Own-Price
Elasticity of Demand
• Suppose that market demand becomes less
sensitive to changes in price (i.e. the own-
price elasticity of demand becomes less
negative). Does the monopolist exploit this by
causing the market price to rise?
 Monopolistic Pricing & Own-Price
Elasticity of Demand
d dp( y)
MR( y)  p( y)y  p( y)  y
dy dy
 y dp( y) 
 p( y) 1   .
 p( y) dy 
 Monopolistic Pricing & Own-Price
Elasticity of Demand
d dp( y)
MR( y)  p( y)y  p( y)  y
dy dy
 y dp( y) 
 p( y) 1   .
 p( y) dy 
Own-price elasticity of demand is
p( y) dy

y dp( y)
 Monopolistic Pricing & Own-Price
Elasticity of Demand
d dp( y)
MR( y)  p( y)y  p( y)  y
dy dy
 y dp( y) 
 p( y) 1   .
 p( y) dy 
Own-price elasticity of demand is


p( y) dy  1
so MR( y)  p( y) 1  .
y dp( y)   
 Monopolistic Pricing & Own-Price
Elasticity of Demand
 1
MR( y)  p( y) 1   .
 
Suppose the monopolist’s marginal cost of
production is constant, at $k/output unit.
For a profit-maximum
 1
MR( y*)  p( y*) 1    k which is
  k
p( y*)  .
1
1

 Monopolistic Pricing & Own-Price
Elasticity of Demand
k
p( y*)  .
1
1

E.g. if  = -3 then p(y*) = 3k/2,
and if  = -2 then p(y*) = 2k.
So as  rises towards -1 the monopolist
alters its output level to make the market
price of its product to rise.
 Monopolistic Pricing & Own-Price
Elasticity of Demand
 1
Notice that, since MR ( y*)  p( y*)1    k ,
 
 1
p( y*) 1    0
 
 Monopolistic Pricing & Own-Price
Elasticity of Demand
Notice that, since MR ( y*)  p( y*)1    k ,
 1
 
 1 1
p( y*) 1    0  1   0
  
 Monopolistic Pricing & Own-Price
Elasticity of Demand
 1
Notice that, since MR ( y*)  p( y*)1    k ,
 
 1 1
p( y*) 1    0  1   0
  
1
That is,  1

 Monopolistic Pricing & Own-Price
Elasticity of Demand
Notice that, since MR ( y*)  p( y*)1  1   k ,
 
 1
p( y*) 1    0  1   0
1
  
1
That is,  1    1.

 Monopolistic Pricing & Own-Price
Elasticity of Demand
 1
Notice that, since MR ( y*)  p( y*)1    k ,
 
 1 1
p( y*) 1    0  1   0
  
1
That is,  1    1.

So a profit-maximizing monopolist always
selects an output level for which market
demand is own-price elastic.
 Markup Pricing
• Markup pricing: Output price is the marginal
cost of production plus a “markup.”
• How big is a monopolist’s markup and how
does it change with the own-price elasticity of
demand?
 Markup Pricing
 1 k k
p( y*) 1    k  p( y*)  
  1
1 1 

is the monopolist’s price.
 Markup Pricing
 1 k k
p( y*) 1    k  p( y*)  
  1
1 1 

is the monopolist’s price. The markup is
k k
p( y*)  k  k   .
1  1 
 Markup Pricing
 1 k k
p( y*) 1    k  p( y*)  
  1
1 1 

is the monopolist’s price. The markup is
k k
p( y*)  k  k   .
1  1 
E.g. if  = -3 then the markup is k/2,
and if  = -2 then the markup is k.
The markup rises as the own-price
elasticity of demand rises towards -1.
A Profits Tax Levied on a Monopoly
• A profits tax levied at rate t reduces profit from
(y*) to (1-t)(y*).
• Q: How is after-tax profit, (1-t)(y*),
maximized?
A Profits Tax Levied on a Monopoly
• A profits tax levied at rate t reduces profit from
(y*) to (1-t)(y*).
• Q: How is after-tax profit, (1-t)(y*),
maximized?
• A: By maximizing before-tax profit, (y*).
 A Profits Tax Levied on a Monopoly
• A profits tax levied at rate t reduces profit from
(y*) to (1-t)(y*).
• Q: How is after-tax profit, (1-t)(y*),
maximized?
• A: By maximizing before-tax profit, (y*).
• So a profits tax has no effect on the
monopolist’s choices of output level, output
price, or demands for inputs.
• I.e. the profits tax is a neutral tax.
Quantity Tax Levied on a Monopolist
• A quantity tax of $t/output unit raises the
marginal cost of production by $t.
• So the tax reduces the profit-maximizing
output level, causes the market price to rise,
and input demands to fall.
• The quantity tax is distortionary.
Quantity Tax Levied on a Monopolist
$/output unit

p(y)

p(y*)
MC(y)

y* y

MR(y)
Quantity Tax Levied on a Monopolist
$/output unit

p(y)
MC(y) + t
p(y*) t
MC(y)

y* y

MR(y)
Quantity Tax Levied on a Monopolist
$/output unit

p(y)
p(yt) MC(y) + t
p(y*) t
MC(y)

yt y* y

MR(y)
Quantity Tax Levied on a Monopolist
$/output unit The quantity tax causes a drop
in the output level, a rise in the
output’s price and a decline in
p(y) demand for inputs.
p(yt) MC(y) + t
p(y*) t
MC(y)

yt y* y

MR(y)
 Quantity Tax Levied on a Monopolist
• Can a monopolist “pass” all of a $t quantity
tax to the consumers?
• Suppose the marginal cost of production is
constant at $k/output unit.
• With no tax, the monopolist’s price is

k
p( y*)  .
1 
 Quantity Tax Levied on a Monopolist
• The tax increases marginal cost to
$(k+t)/output unit, changing the profit-
maximizing price to
t (k  t ) 
p( y )  .
1 
• The amount of the tax paid by buyers is
p( yt )  p( y*).
Quantity Tax Levied on a Monopolist
t (k  t )  k t
p( y )  p( y*)   
1  1  1 

is the amount of the tax passed on to

buyers. E.g. if  = -2, the amount of
the tax passed on is 2t.
Because  < -1,  /1) > 1 and so the
monopolist passes on to consumers more
than the tax!
 The Inefficiency of Monopoly
• A market is Pareto efficient if it achieves the
maximum possible total gains-to-trade.
• Otherwise a market is Pareto inefficient.
 The Inefficiency of Monopoly
$/output unit The efficient output level
ye satisfies p(y) = MC(y).
p(y)

MC(y)
p(ye)

ye y
 The Inefficiency of Monopoly
$/output unit The efficient output level
ye satisfies p(y) = MC(y).
p(y)

CS
MC(y)
p(ye)

ye y
 The Inefficiency of Monopoly
$/output unit The efficient output level
ye satisfies p(y) = MC(y).
p(y)

CS
MC(y)
p(ye)
PS

ye y
 The Inefficiency of Monopoly
$/output unit The efficient output level
ye satisfies p(y) = MC(y).
p(y) Total gains-to-trade is
maximized.
CS
MC(y)
p(ye)
PS

ye y
 The Inefficiency of Monopoly
$/output unit

p(y)

p(y*)
MC(y)

y* y

MR(y)
 The Inefficiency of Monopoly
$/output unit

p(y)
CS
p(y*)
MC(y)

y* y

MR(y)
 The Inefficiency of Monopoly
$/output unit

p(y)
CS
p(y*)
PS MC(y)

y* y

MR(y)
 The Inefficiency of Monopoly
$/output unit

p(y)
CS
p(y*)
PS MC(y)

y* y

MR(y)
 The Inefficiency of Monopoly
$/output unit

p(y)
CS
p(y*)
PS MC(y)

y* y

MR(y)
 The Inefficiency of Monopoly
$/output unit
MC(y*+1) < p(y*+1) so both
seller and buyer could gain
p(y) if the (y*+1)th unit of output
CS was produced. Hence the
p(y*)
PS MC(y) market
is Pareto inefficient.

y* y

MR(y)
 The Inefficiency of Monopoly
$/output unit Deadweight loss measures
the gains-to-trade not
p(y) achieved by the market.
p(y*)
MC(y)
DWL

y* y

MR(y)
 The Inefficiency of Monopoly
The monopolist produces
$/output unit
less than the efficient
quantity, making the
p(y)
market price exceed the
p(y*) efficient market
e DWL
MC(y) price.
p(y )

y* ye y

MR(y)
 Natural Monopoly
• A natural monopoly arises when the firm’s
technology has economies-of-scale large
enough for it to supply the whole market at a
lower average total production cost than is
possible with more than one firm in the
market.
 Natural Monopoly
$/output unit

ATC(y)

p(y)

MC(y)

y
 Natural Monopoly
$/output unit
ATC(y)

p(y)

p(y*)

MC(y)
y* y
MR(y)
 Entry Deterrence by a Natural
Monopoly
• A natural monopoly deters entry by
threatening predatory pricing against an
entrant.
• A predatory price is a low price set by the
incumbent firm when an entrant appears,
causing the entrant’s economic profits to be
negative and inducing its exit.
 Entry Deterrence by a Natural
Monopoly
• E.g. suppose an entrant initially captures one-
quarter of the market, leaving the incumbent
firm the other three-quarters.
 Entry Deterrence by a Natural
$/output unit Monopoly
ATC(y)
p(y), total demand = DI + DE

DE

DI

MC(y)

y
 Entry Deterrence by a Natural
$/output unit Monopoly
An entrant can undercut the
ATC(y) incumbent’s price p(y*) but ...
p(y), total demand = DI + DE

DE
p(y*)
pE DI

MC(y)

y
 Entry Deterrence by a Natural
$/output unit Monopoly
An entrant can undercut the
ATC(y) incumbent’s price p(y*) but
p(y), total demand = DI + DE

DE
the incumbent can then
lower its price as far
p(y*)
DI
as pI, forcing
pE
the entrant
pI to exit.
MC(y)

y
 Inefficiency of a Natural Monopolist
• Like any profit-maximizing monopolist, the
natural monopolist causes a deadweight loss.
 Inefficiency of a Natural Monopoly
$/output unit
ATC(y)

p(y)

p(y*)

MC(y)

y* y
MR(y)
 Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
Profit-max: MR(y) = MC(y)
p(y) Efficiency: p = MC(y)

p(y*)

MC(y)
p(ye)
y* ye y
MR(y)
 Inefficiency of a Natural Monopoly
$/output unit
ATC(y)
Profit-max: MR(y) = MC(y)
p(y) Efficiency: p = MC(y)

p(y*)

DWL
MC(y)
p(ye)
y* ye y
MR(y)
 Regulating a Natural Monopoly
• Why not command that a natural monopoly
produce the efficient amount of output?
• Then the deadweight loss will be zero, won’t
it?
 Regulating a Natural Monopoly
$/output unit
At the efficient output
ATC(y) level ye, ATC(ye) > p(ye)
p(y)

MC(y)
ATC(ye)
p(ye)

ye y
MR(y)
 Regulating a Natural Monopoly
$/output unit
At the efficient output
ATC(y) level ye, ATC(ye) > p(ye)
so the firm makes an
p(y)
economic loss.

MC(y)
ATC(ye)
p(ye) Economic loss
ye y
MR(y)
 Regulating a Natural Monopoly
• So a natural monopoly cannot be forced to
use marginal cost pricing. Doing so makes the
firm exit, destroying both the market and any
gains-to-trade.
• Regulatory schemes can induce the natural
monopolist to produce the efficient output
level without exiting.