ECON1268

Managerial and Business Economics

Lecture 7: Monopoly
 Topics for today's lecture . . .
1. Revenue & market power

2. Profit maximisation

3. Measuring market power

4. Comparative statics

5. Multiple markets
Revenue & market power
 Definition: Inverse demand
The highest price at which a firm can sell a given quantity of
output.

The inverse demand function is the equation for the demand

curve, rearranged such that price is stated as a function of
quantity.
Inverse demand

Suppose a monopolist faces

the inverse demand function,

P(Q) = 12 – 0.4Q.

As the only supplier in a

market, the monopolist can
choose the point on the
demand curve at which it will
operate.
• If the monopolist produces
10 units, the price is $8.
• If the monopolist produces
15 units, the price is $6.
 Marginal revenue
The total revenue of a firm that sells its product at a uniform price, is given by
the function,

Marginal revenue is the rate at which a firm's total revenue changes as its output
increases; the derivative of total revenue with respect to Q,

The first term in this equation is the revenue the monopolist receives from the
marginal sale.
The second term is the rate at which the monopolist loses revenue from its pre-
existing sales.
Note: You will not be assessed on the derivation of this result.
The marginal revenue curve

The position of the marginal

revenue curve, relative to the
demand curve, is described by
the function,

At Q = 0, marginal revenue is
equal to (inverse) demand.

Marginal revenue is less than

inverse demand where Q > 0,
as demand is downward
sloping (dP(Q)/dQ < 0).
 Marginal revenue and elasticity

• At any given point on the demand curve, the price elasticity of

demand is given by the function,

We can use the elasticity to restate marginal revenue as,

• Where demand is elastic (< < -1), marginal revenue is positive.

• Where demand is unit elastic (= -1), marginal revenue is zero.
• Where demand is inelastic (-1 < < 0), marginal revenue is negative.
Marginal revenue along a linear
demand curve
If the monopoly sells nothing (Q = 0), it
has no revenue (TR = 0).

As the quantity increases, total

revenue increases at a decreasing
rate.

The maximum total revenue occurs

where marginal revenue is equal to
zero.

Thereafter total revenue declines with

quantity, as marginal revenue is
negative.

If the monopoly gives its product away

(P = 0), it has no revenue (TR = 0).
 Quiz 1
Greg owns and operates a florist. Greg estimates that at his
current price, the price elasticity of demand for his flowers is .
If Greg increases his price by a small amount then,
a) his total revenue will increase.
b) his total revenue will not change.
c) his total revenue will fall.
d) the direction of the change in total revenue will depend on
whether or not Greg faces alinear demand function.
Profit maximisation
Firm profit

A firm's profit is its total

revenue minus its total cost,

For any given quantity, the

firm's profit is the vertical
distance between the TR
and TC curves.
The firm's problem is to
identify the quantity that
maximises the profit
function.
 The profit maximising condition
At the profit maximising quantity, the slope of the profit
function is zero,

From the final equality it follows that the profit maximising

condition can be written as,

This condition does not depend on the nature of competition

in the market.

Note: You will not be assessed on the derivation of this result.

The profit maximising
condition
A profit maximising firm selects
its quantity of output such that
marginal revenue equals
marginal costs.

The profit maximising

(monopoly) quantity is denoted
Q*.

At the monopoly quantity, the

total cost curve and total revenue
curve have the same slope.

The monopoly price P* is found

by substituting Q* into the
inverse demand function.
 Exercise: Monopoly price & quantity
Greg's florist has a monopoly over the sale of cup flowers.
The monopolist faces the inverse demand function P(Q) = 50
– 0.02Q, where Q is the number of bunches of flowers sold.
Greg's florist's total cost is TC(Q) =0.005Q2
1. Write an expression for Greg’s profit function.
2. Find the derivative of Greg’s profit function with respect to
Q.
3. Set the derivative equal to zero and solve for Q (this is the
monopoly quantity).
4. Substitute the monopoly quantity into inverse demand to
find the monopoly price.
Measuring market power
The monopoly markup

The monopoly's market power

allows it to enjoy a markup over its
marginal cost.

• Greg's florist earns a profit of

$20 on the marginal sale.

• By contrast, firms in a
competitive market sell their
marginal units at marginal cost.

Note: Positive marginal revenue

implies that a monopoly operates
on the elastic portion of its
demand curve.
 The inverse elasticity pricing rule
The profit maximising condition (MR = MC) can be rewritten in
terms of the price elasticity of demand,

Rearranging yields the inverse elasticity pricing rule,

The rule states that a monopolist facing a more inelastic

demand, enjoys a higher marginal profit.
Note: You will not be assessed on the derivation of this result.
Measuring market power

The proportional markup of a

firm's price over its marginal cost
is known as the Lerner index,

The Lerner index measures a

firm's market power:
• Lerner indices range between
0 and 1.
• An index of 0 corresponds to a
firm in a competitive market.
 Exercise: The market power of
cellphone manufacturers
• Apple's iPhone is estimated to have a marginal cost of
US$224, and retails for US$649.
• Samsung's Galaxy S is estimated to have a marginal cost
of US$255, and retails for US$599.
1. Calculate the Lerner index of market power for each firm.
2. Calculate the price elasticity of each firm's demand. Which
firm is face the more inelastic demand?
3. Which of the two products do you think has the closer
substitutes? Explain your answer.
Comparative statics
An increase in the marginal cost
of production
• The new intersection of
marginal revenue and
marginal cost occurs above
and to the left of the original
intersection.
• There is an increase in the
monopoly price, and a fall in
the monopoly quantity.
• Note: If MC is at or upward-
sloping, the increase in the
monopoly price is less than
the increase in marginal
cost.
The impact of a cost increase on
total revenue
An increase in marginal cost
must result in a decrease in the
monopolist's total revenue.
• The monopoly operates on
the elastic portion of its
demand curve.
• Any reduction in the quantity
produced must result in a
movement down along the
total revenue curve.

It follows that an increase in

marginal cost must result in a fall
in profits.
An increase in demand

A rightward shift of the demand

curve causes a rightward shift
of the marginal revenue curve.

The intersection of marginal

revenue and marginal cost
occurs to the right of the
original monopoly quantity.
• The monopoly quantity
increases.
• In this example, the
monopoly price also
increases.
An increase in demand causing a
fall in price
It is important to note that an
increase in demand can results
in a fall in the monopoly price.

This can only occur if marginal

cost is downward sloping over
some range.

Lowering the price is protable

in this example, as the
monopolist achieves
considerable cost advantages
by expanding production.
Exercise: Comparative statics (1)

A monopolist faces the

inverse demand function
P(Q) = a - bQ, and marginal
cost function MC(Q) = c +
eQ. Assume that a > c > 0, b
> 0 and 2b + e > 0.
1. Derive an expression for
the monopolist's optimal
quantity and price.
2. Show that an increase in
c, or a decrease in a,
must decrease the
equilibrium quantity of
Multiple markets
A monopolist with multiple
markets
Tiger's Door entertainment has
a monopoly over the sale of
movies in two countries:
• Demand for movies in the
`Alpha Islands' is given by
the function QA(P) = 180 - P.

• Demand for movies in `Beta

Peninsula' is given by the
function QB(P) = 120 - P.

The monopolist's marginal cost

is MC(Q) = 30.
Combining the demands of
the two markets
Suppose that Tiger's Door
entertainment must charge a
uniform price across both
markets.

The total demand for the

monopolist‘s movies is the sum
of the demand in the two
markets:

• If 120 < P < 180 then Q = QA

= 180 - P.

• If P 120 then Q = QA + QB =
300 - 2P.
Inverse demand & marginal
revenue
The corresponding inverse
demand is:
• If 120 < P < 180 then P =
180 - Q.
• If P < 120 then P = 150 –
Q/2.
If follows that marginal revenue
is:
• If 120 < P < 180 then MR =
180 - 2Q.
• If P 120 then MR = 150 – Q.
 Profit maximisation with a
uniform price
Let's begin by assuming that 120 < P < 180:
• Equating marginal revenue with marginal cost 180 - 2Q =
30, or Q* = 75.
• Substituting for Q into inverse demand P* = 180 - 75 =
$105. This is not consistent with the initial assumption.
Alternatively, lets assume that P 120:
• Equating marginal revenue with marginal cost 150 - Q =
30, or Q* = 120.
• Substituting for Q* into inverse demand P* = 150 – 0.5 x
120 = $90. This is consistent with the initial assumption.
Producer surplus with
uniform pricing
The monopolist's producer
surplus is the area between its
price and its marginal cost
curve.

With a constant marginal cost,

producer surplus can be
calculated as,
• PS = Q*(P* - MC)

= 120 x (90 - 30) = $7200.

• Note: Profit is equal to
producer surplus minus fixed
cost.
 Definition: Price discrimination

• The practice of charging consumers different prices for the

same good or service.

• For a firm to engage in price discrimination it must (a) have

market power, and (b) be able to prevent the resale
(arbitrage) of its good or service.
Producer surplus with price
discrimination
If the Tiger's Door
entertainment can charge a
different price each country,

• QA* = 75 movies, P*A = $105

and PSA = $5625.

• QB* = 45 movies, P*B = $75

and PSB = $2025.

You should check this.

The total producer surplus

across the two markets is thus
$7650, $450 more than under
uniform pricing.
Price discrimination and
elasticity
In each market, the prot
maximising price satisfies the
inverse elasticity pricing rule.
• The monopoly price is higher
in market A because
demand is less elastic in that
market.
Compared to uniform pricing,
consumers with,
• inelastic demands are worse
off.
• elastic demands are better
off.
Discussion: Arbitrage

Suppose that enterprising

citizens of Beta Peninsula
(market B) can resell the
movies they purchase, to
consumers in the Alpha
Islands (market A), via online
auction sites.
What would you expect to
happen?
How would you expect the
monopolist to alter its
behaviour in response?
 Methods for separating markets
(and market segments)
Geo-blocking: A technology used by digital media
companies to prevent consumers in one country from
accessing content in another country.
Screening: Offering consumers who are members of a group
with elastic demand a discount, if they can prove their
membership of the group (eg. student discounts with a
student ID).
Inter-temporal price discrimination: Altering the price of a
product over time. (eg. Flights tend to be cheaper if
purchased in advance because last-minute travellers tend to
have less elastic demand.)
 Methods for separating markets
(and market segments)
• Coupons & rebates: Coupons offer consumers a
discount on an item if the coupon is presented at the point
of sale. Rebates return a portion of the purchase price to a
consumer if they complete a form and send it to the
manufacturer. Consumers are more likely to cut out
coupons, or mail in rebates, if they are price sensitive.
• Versioning: Producing multiple versions of product, with
different levels of performance, so that consumers who
derive the highest benefits pay higher prices. (eg. In the
early 1990s IBM produced the LaserPrinter in two versions.
The two printers were identical except that the low priced
version had an extra chip that caused the printer to pause,
thereby slowing it down.)
Quiz 3

Using the figure provided,

find the producer surplus for
Greg's florist.
a) 20,000 bunches of
flowers.
b) $20,000.
c) 25,000 bunches of
flowers.
d) $25,000.
 Quiz 4
Suppose that a monopolist serves two markets, and that the monopolist
can price discriminate between markets.
• In the first market, at the optimal price, and Q1* = 500 units.

• In the second market, at the optimal price , and Q2* = 1000 units.
Which of the following statements is true?
a) The optimal price in market 1 is higher than the optimal price in
market 2.
b) The optimal price in market 2 is higher than the optimal price in
market 1.
c) The optimal prices in both markets are equal.
d) We cannot compare the optimal prices without the inverse demand
and marginal cost functions.
Questions?
 Key concepts from today's
lecture
You can use these concepts (as search terms) to conduct
further research into the topics covered in today's lecture:

• Monopoly • Inverse elasticity pricing

rule
• Inverse demand
• Lerner index
• Marginal revenue
• Comparative statics
• Elasticity
• Uniform price
• Prot maximisation
• Price discrimination
• Market power
• Producer surplus