Chapter 11

Monopoly
&
Monopsony

1
Chapter Eleven Overview

1. The Monopolist’s Profit Maximization

Problem
• The Profit Maximization Condition
• Equilibrium
• The Inverse Pricing Elasticity Rule

2. Multi-plant Monopoly and Cartel

Production

3. The Welfare Economics and Monopoly

2
Chapter Eleven
A Monopoly
Definition:
Definition: AAMonopoly
MonopolyMarket
Marketconsists
consistsof
ofaasingle
singleseller
sellerfacing
facing
many
manybuyers.
buyers.

The
Themonopolist's
monopolist'sprofit
profitmaximization
maximizationproblem:
problem:

Max(Q)
Max (Q)==TR(Q)
TR(Q)--TC(Q)
TC(Q)QQ
where:
where:TR(Q)
TR(Q)==QP(Q)
QP(Q)and
andP(Q)
P(Q)isisthe
the(inverse)
(inverse)market
marketdemand
demand
curve.
curve.

The
Themonopolist's
monopolist'sprofit
profit maximization
maximizationcondition:
condition:

TR(Q)/Q
TR(Q)/Q== TC(Q)/Q
TC(Q)/Q
MR(Q)
MR(Q)== MC(Q)
MC(Q)
3
Chapter Eleven
 A Monopoly – Profit Maximizing
Monopolist’s demand Curve is downward-sloping
• Along the demand
curve, different
revenues for different
quantities
• Profit maximization
problem is the
optimal trade-off
between volume
(number of units sold)
and margin (the
differential between
price).

4
Chapter Eleven
A Monopoly – Profit Maximizing

• Demand Curve: P(Q)  12  Q

• Total Revenue: TR (Q)  Q  P(Q)  12Q  Q 2

1 2
• Total Cost (Given): TC (Q)  Q
2
• Profit-Maximization: MR = MC

5
Chapter Eleven
A Monopoly – Profit Maximizing

• As Q increases TC
increases, TR
increases first and
then decreases.
• Profit
Maximization is at
MR = MC

6
Chapter Eleven
A Monopoly – Profit Maximizing

• MR>MC, firm can increase Q and increase

profit
• MR<MC, firm can decrease quantity and
increase profit
• MR=MC , firm cannot increase profit.

• Profit Maximizing Q: MR(Q*)  MC (Q*)

7
Chapter Eleven
 Marginal Revenue
Price Price
Competitive Firm Monopolist

Demand facing firm Demand facing firm

P0 P0
P1 C

A B A B

q q+1 Firm output Q0 Q0+1 Firm output

8
Chapter Eleven
 Marginal Revenue Curve and Demand
Price
The MR curve lies below the demand curve.

P(Q0)

MR(Q0) P(Q), the (inverse) demand curve

MR(Q), the marginal revenue curve

Q0 Quantity
9
Chapter Eleven
Marginal Revenue Curve and Demand

• To sell more units, a

monopolist has to
lower the price.
• Increase in profit is
Area III while revenue
sacrificed at a higher
price is Area I
• Change in TR equals
area III – area I

10
Chapter Eleven
 Marginal Revenue Curve and Demand

• Area III = price x change in quantity = P(ΔQ)

• Area I = - quantity x change in price = -Q (ΔP)
• Change in monopolist profit: P(ΔQ) + Q (ΔP)

TR PQ  QP P

MR    PQ
Q Q Q

11
Chapter Eleven
Marginal Revenue

Marginal revenue has two parts:

• P: increase in revenue due to higher volume-
the marginal units
• Q(ΔP/ΔQ): decrease in revenue due to
reduced price of the inframarginal units.
• The marginal revenue is less than the price
the monopolist can charge to sell that
quantity for any Q>0

12
Chapter Eleven
Average Revenue

Since TR PxQ
AR   P
Q Q

The price a monopolist can charge to sell

quantity Q is determined by the market
demand curve the monopolists’ average
revenue curve is the market demand curve.
AR (Q)  P (Q)

13
Chapter Eleven
Marginal Revenue and Average Revenue

• The demand curve D

and average revenue
curve AR coincide
• The marginal
revenue curve MR
lies below the
demand curve

14
Chapter Eleven
 Marginal Revenue and Average Revenue

P
 1
Q When P decreases by
$3 per ounce, (from
TR  P  Q  7  5  $35 million per year $10 to $7), quantity
increases by 3 million
TR 35
AR    $7 per ounce ounces (from 2
Q 5 million to 5 million
per year)
P
MR  P  Q  7  5(1)  $2 per ounce
Q

15
Chapter Eleven
Marginal Revenue and Average Revenue

• Conclusions if Q > 0:
• MR < P
• MR < AR
• MR lies below the demand curve.

16
Chapter Eleven
 Marginal Revenue and Average Revenue
• Given the demand curve, what are the average and
marginal revenue curves?
P  a  bQ AR  a  bQ
P P
MR(Q )  P  Q  b
Q Q

MR  a  bQ  Q(b)
 a  2bQ
Vertical intercept is a
a
Horizontal intercept is Q 
2b
17
Chapter Eleven
 Profit Maximization
• Given the inverse demand and MC, what is the profit
maximizing Q and P for the monopolist?

P  12  Q MC  Q
Here a  12, b  1 MR  12  2Q
MR  MC  12  2Q  Q
Q4 P  12  4  8

18
Chapter Eleven
Profit Maximization

• Profit Maximizing output is

at MR=MC
• Monopolist will make 4
million ounces and sells at
$8 per ounce
• TR = Areas B + E + F
• Profit (TR-TC) is B + E
• Consumer surplus is area A

19
Chapter Eleven
Shutdown Condition

In the short run, the monopolist shuts

down if the most profitable price does
not cover AVC. In the long run, the
monopolist shuts down if the most
profitable price does not cover AC.
Here, P* exceeds both AVC and AC.

20
Chapter Eleven
Positive Profits for Monopolist

This
This profit
profit isis positive.
positive. Why?Why? Because
Because the the
monopolist
monopolist takestakes into
into account
account thethe price-
price-
reducing
reducing effect
effect ofof increased
increased output
output so so that
that
the
the monopolist
monopolist has has less
less incentive
incentive to
to increase
increase
output
outputthan
thanthe theperfect
perfectcompetitor.
competitor.

Profit
Profit can
can remain
remain positive
positive inin the
the long
long run.
run.
Why?
Why? Because
Becausewe weare areassuming
assumingthatthatthere
thereisis
no
no possible
possible entry
entry inin this
this industry,
industry, soso profits
profits
are
arenot
notcompeted
competedaway.
away.

21
Chapter Eleven
Equilibrium

AA monopolist
monopolist does
does not
not have
have aa supply
supply curve
curve
(i.e.,
(i.e.,an
anoptimal
optimaloutput
outputfor
forany
anyexogenously-
exogenously-
given
given price)
price) because
because price
price isis endogenously-
endogenously-
determined
determined by by demand:
demand: the the monopolist
monopolist
picks
picks aa preferred
preferred point
point on
on the the demand
demand
curve.
curve.

One
One could
could also
also think
think of
of the
the monopolist
monopolist
choosing
choosing output
output to
to maximize
maximize profits
profits subject
subject
to
to the
the constraint
constraint that
that price
price be
be determined
determined
by
bythe
thedemand
demandcurve.
curve.
22
Chapter Eleven
Price Elasticity of Demand
• Market A profit maximizing price is PA.
• Market B profit maximizing price is PB. Demand is less elastic
in Market B

23
Chapter Eleven
Inverse Elasticity Pricing Rule

We
Wecan
canrewrite
rewritethe
theMR
MRcurve
curveas
asfollows:
follows:

MR
MR==PP++Q(P/Q)
Q(P/Q)

==P(1
P(1++(Q/P)(P/Q))
(Q/P)(P/Q))

==P(1
P(1++1/)
1/)

where:isisthe
where: theprice
priceelasticity
elasticityof
of demand,
demand, (P/Q)(Q/P)
(P/Q)(Q/P)

24
Chapter Eleven
Inverse Elasticity Pricing Rule

Using
Usingthis
thisformula:
formula:
••When
Whendemand
demandisiselastic
elastic((<<-1),
-1),MR
MR>>00
••When
Whendemand
demandisisinelastic
inelastic((>>-1),
-1),MR
MR<<00
••When
Whendemand
demandisisunit
unitelastic
elastic((==-1),
-1),MR=
MR=00

25
Chapter Eleven
 Inverse Elasticity Pricing Rule
• Given the constant elasticity demand curve and MC:
• What is the optimal P when Q = 100P-2?
• What is the optimal P when Q = 100P-5?
b
Q  aP Price elasticity of demand  b
MC  $50
for Q  100 P 2 Price elasticity of demand  Q , P  2 P  50   1
P 2

5
P  $100
for Q  100 P
P  100 1 P  $62.50
Price elasticity of demand  Q , P  5 
P 5

26
Chapter Eleven
 Elasticity Region of the Linear Demand Curve

Price

a
Elastic region ( < -1), MR > 0

Unit elastic (=-1), MR=0

Inelastic region (0>>-1), MR<0

Quantity
a/2b a/b
27
Chapter Eleven
Marginal Cost and Price Elasticity Demand

• Profit maximizing condition is MR = MC with

P* and Q* MR(Q*)  MC (Q*)
 1 
MC (Q*)  P * 1  
  
 Q,P 

• Rearranging and setting MR(Q*) = MC(Q*)

P *  MC * 1

P*  Q,P

28
Chapter Eleven
Inverse Elasticity Pricing Rule

• Inverse Elasticity Pricing Rule: Monopolist’s

optimal markup of price above marginal cost
expressed as a percentage of price is equal
to minus the inverse of the price elasticity of
demand.
P *  MC * 1

P*  Q,P

29
Chapter Eleven
Price Elasticity

• Monopolist operates
at the elastic region
of the market
demand curve.
Increasing price from
PA to PB, TR increases
by area I – area II and
total cost goes down
because monopolist is
producing less

30
Chapter Eleven
Elasticity Region of the Demand Curve

Therefore:

The monopolist will always operate on the elastic

region of the market demand curve As demand
becomes more elastic at each point, marginal
revenue approaches price

31
Chapter Eleven
Elasticity Region of the Demand Curve
Example:

Now, suppose that QD = 100P-b and MC = c (constant).

What is the monopolist's optimal price now?

P(1+1/-b) = c
P* = cb/(b-1)

We need the assumption that b > 1 ("demand is

everywhere elastic") to get an interior solution.

As b -> 1 (demand becomes everywhere less elastic),

P* -> infinity and P - MC, the "price-cost margin" also
increases to infinity.

As b -> , the monopoly price approaches marginal

cost.
32
Chapter Eleven
Market Power

Definition:
Definition: An
An agent
agent has
has Market
Market PowerPower ifif
s/he
s/he can
can affect,
affect, through
through his/herhis/her own
own
actions,
actions, the
the price
price that
that prevails
prevails inin the
the
market.
market. Sometimes
Sometimes thisthis isis thought
thought ofof as
as
the
the degree
degree toto which
which aa firm
firm can
can raise
raise price
price
above
abovemarginal
marginalcost.
cost.

33
Chapter Eleven
The Lerner Index of Market Power

Definition:
Definition:thetheLerner
LernerIndex
Indexof
ofmarket
market
power
power isis the
the price-cost
price-cost margin,
margin, (P*-
(P*-
MC)/P*.
MC)/P*. ThisThis index
index ranges
ranges between
between 00
(for
(for the
the competitive
competitive firm)
firm) and
and 1,
1, for
for aa
monopolist
monopolist facingfacing aa unitunit elastic
elastic
demand.
demand.

34
Chapter Eleven
The Lerner Index of Market Power

Restating
Restating the
the monopolist's
monopolist's profit
profit maximization
maximization
condition,
condition,we
wehave:
have:

P*(1
P*(1++1/)
1/)==MC(Q*)
MC(Q*) …or…
…or…

[P*
[P*--MC(Q*)]/P*
MC(Q*)]/P*==-1/
-1/

In
In words,
words, the
the monopolist's
monopolist's ability
ability to
to price
price above
above
marginal
marginal cost
cost depends
depends on on the
the elasticity
elasticity of
of
demand.
demand.

35
Chapter Eleven
Comparative Statics – Shifts in Market Demand

• Rightward shift in the demand curve causes an increase

in profit maximizing quantity.
• (a) MC is increases as Q increases
• (b) MC decreases as Q increases

36
Chapter Eleven
Comparative Statics – Monopoly Midpoint Rule

For a constant MC, profit maximizing price is found using the

monopoly midpoint rule – The optimal price P* is halfway
between the vertical intercept of the demand curve a (choke
price) and vertical intercept of the MC curve c.

37
Chapter Eleven
 Comparative Statics – Monopoly Midpoint Rule
• Given P and MC what is the profit maximizing P and Q?

P  a  bQ MC  c
MR  a  2bQ MR  MC
ac
a  2bQ*  c Q* 
2b

 ac 1 1 ac
P*  a  b a a c
 2b  2 2 2

38
Chapter Eleven
Comparative Statics – Shifts in Marginal Cost

• When MC shifts up, Q falls and P increases.

39
Chapter Eleven
Comparative Statics – Revenue and MC shifts

• Upward shift of MC
decreases the profit
maximizing monopolist’s
total revenue.
• Downward shift of MC
increases the profit
maximizing monopolist’s
total revenue.

40
Chapter Eleven
Multi-Plant Monopoly

Recall:
• In the perfectly competitive model, we could
derive firm outputs that varied depending on
the cost characteristics of the firms. The
analogous problem here is to derive how a
monopolist would allocate production across
the plants under its management.

Assume:
• The monopolist has two plants: one plant has
marginal cost MC1(Q) and the other has
marginal cost MC2(Q).

41
Chapter Eleven
Multi-Plant Monopoly – Production Allocation

Whenever
Whenever thethe marginal
marginal costs
costs of
of the
the two
two plants
plants are
are
not
notequal,
equal,the
thefirm
firmcan
canincrease
increaseprofits
profitsbybyreallocating
reallocating
production
productiontowards
towardsthe
thelower
lowermarginal
marginalcostcostplant
plantand
and
away
awayfrom
fromthethehigher
highermarginal
marginalcost
costplant.
plant.

Example:
Example:

Suppose
Supposethe
themonopolist
monopolistwishes
wishesto
toproduce
produce66units
units

33units
unitsper
perplant
plantwith
with
••MC
MC11==$6
$6
••MC
MC22==$3
$3

Reducing
Reducingplant
plant1's
1'sunits
unitsand
andincreasing
increasingplant
plant2's
2'sunits
units
raises
raisesprofits
profits
42
Chapter Eleven
 Multi-Plant Monopoly – Production Allocation
Price MC1
MCT

6 • Example:
Example: Multi-Plant
Multi-PlantMonopolist
Monopolist
This
This is analogous to exitby
is analogous to exit byhigher
higher
cost
cost firms and an increase inentry
firms and an increase in entry
3 by low-cost firms in the perfectly
by low-cost firms in the perfectly
competitive
competitivemodel.
model.

3 6 9 Quantity
43
Chapter Eleven
 Multi-Plant Monopoly – Production Allocation
Price MC1 MC2
MCT

6 • Example:
Example: Multi-Plant
Multi-PlantMonopolist
Monopolist
This
This is analogous to exitby
is analogous to exit byhigher
higher

3 • cost
cost firms and an increase inentry
by
firms
low-cost
competitive
and an
firms
competitivemodel.
model.
increase
in the
in entry
perfectly
by low-cost firms in the perfectly

3 6 9 Quantity
44
Chapter Eleven
Multi-Plant Marginal Costs Curve

Question: How much should the monopolist produce in total?

Definition: The Multi-Plant Marginal Cost Curve traces out the

set of points generated when the marginal cost curves of the
individual plants are horizontally summed (i.e. this curve shows
the total output that can be produced at every level of marginal
cost.)

Example:

For MC1 = $6, Q1 = 3

MC2 = $6, Q2 = 6

Therefore, for MCT = $6, QT = Q1 + Q2 = 9

45
Chapter Eleven
Multi-Plant Marginal Costs Curve

The
The profit
profit maximization
maximization condition
condition that
that
determines
determinesoptimal
optimaltotal
totaloutput
outputisisnow:
now:

••MR
MR==MC
MCTT

The
The marginal
marginal cost
cost of
of aa change
change in
in output
output
for
forthe
themonopolist
monopolistisisthe
thechange
changeafter
afterall
all
optimal
optimal adjustment
adjustment hashas occurred
occurred inin the
the
distribution
distributionof
ofproduction
productionacross
acrossplants.
plants.

46
Chapter Eleven
 Multi-Plant Monopolistic Maximization
Price MC1 MC2
MCT

P*

MR Quantity
47
Chapter Eleven
 Multi-Plant Monopolistic Maximization
Price MC1 MC2 MCT

P*

Demand

MR Quantity
Q*1 Q*2 Q*T
48
Chapter Eleven
Multi-Plant Monopolistic Maximization

Example:

P = 120 - 3Q …demand…
MC1 = 10 + 20Q1 …plant 1…
MC2 = 60 + 5Q2 …plant 2…

What are the monopolist's optimal total

quantity and price?

Step 1: Derive MCT as the horizontal sum

of MC1 and MC2. Inverting marginal cost
(to get Q as a function of MC), we have:

Q1 = -1/2 + (1/20)MCT
Q2 = -12 + (1/5)MCT

49
Chapter Eleven
Multi-Plant Monopolistic Maximization

Let MCT equal the common marginal cost level in the

two plants. Then:

• QT = Q1 + Q2 = -12.5 + .25MCT

And, writing this as MCT as a function of QT:

• MCT = 50 + 4QT

Using the monopolist's profit maximization condition:

• MR = MCT => 120 - 6QT = 50 + 4QT

• QT* = 7
• P* = 120 - 3(7) = 99

50
Chapter Eleven
Multi-Plant Monopolistic Maximization

Example:

P = 120 - 3Q …demand…
MC1 = 10 + 20Q1 …plant 1…
MC2 = 60 + 5Q2 …plant 2…

What is the optimal division of output

across the monopolist's plants?

MCT* = 50 + 4(7) = 78

Therefore,

Q1* = -1/2 + (1/20)(78) = 3.4

Q2* = -12 + (1/5)(78) = 3.6
51
Chapter Eleven
Cartel

Definition:
Definition: AA cartel
cartel isis aa group
group
of
of firms
firms thatthat collusively
collusively
determine
determine the the price
price and and
output
output inin aa market.
market. In In other
other
words,
words, aa cartel
cartel acts
acts as
as aa single
single
monopoly
monopoly firmfirm that
that maximizes
maximizes
total
totalindustry
industryprofit.
profit.

52
Chapter Eleven
Cartel

The problem of optimally allocating output across cartel

members is identical to the monopolist's problem of
allocating output across individual plants.

Therefore, a cartel does not necessarily divide up market

shares equally among members: higher marginal cost firms
produce less.

This gives us a benchmark against which we can compare

actual industry and firm output to see how far the industry
is from the collusive equilibrium

53
Chapter Eleven
The Welfare Economies of Monopoly

Since
Since the
the monopoly
monopoly equilibrium
equilibrium output
output
does
does not,
not, in
in general,
general, correspond
correspond to
to the
the
perfectly
perfectly competitive
competitive equilibrium
equilibrium itit
entails
entailsaadead-weight
dead-weightloss.loss.

Suppose
Supposethat
thatwe
wecompare
compareaamonopolist
monopolist
to
to aa competitive
competitive market,
market, where
where thethe
supply
supplycurve
curveof
ofthe
thecompetitors
competitorsisisequal
equal
to
to the
the marginal
marginal cost
cost curve
curve ofof the
the
monopolist
monopolist

54
Chapter Eleven
The Welfare Economies of Monopoly
CS with competition: A+B+C ; CS with monopoly: A
PS with competition: D+E ; PS with monopoly: B+D

A MC
PM
B
C DWL
DWL==C+E
C+E
P C

E
D

Demand

QM QC
55
MR Chapter Eleven
Natural Monopolies

Definition: A market is a natural monopoly if the total

cost incurred by a single firm producing output is less
than the combined total cost of two or more firms
producing this same level of output among them.

Benchmark: Produce where P = AC

56
Chapter Eleven
Natural Monopolies

Price
Natural
NaturalMonopoly
Monopolyfalling
falling
average
averagecosts
costs

AC

Demand
Quantity
57
Chapter Eleven
 Barriers to Entry
Definition:
Definition: Factors
Factorsthat
thatallow
allowan
anincumbent
incumbentfirm
firmto
toearn
earn
positive
positiveeconomic
economicprofits
profitswhile
whilemaking
makingititunprofitable
unprofitablefor
for
newcomers
newcomersto toenter
enterthe
theindustry.
industry.

1.1. Structural
StructuralBarriers
Barriersto
toEntry
Entry––occur
occurwhen
whenincumbent
incumbentfirms
firmshave
havecost
cost
or
ordemand
demandadvantages
advantagesthat
thatwould
wouldmake
makeititunattractive
unattractivefor
foraanew
newfirm
firm
to
toenter
enterthe
theindustry
industry
2.2. Legal
LegalBarriers
Barriersto
toEntry
Entry––exist
existwhen
whenan
anincumbent
incumbentfirm
firmisislegally
legally
protected
protectedagainst
againstcompetition
competition
3.3. Strategic
StrategicBarriers
Barriersto
toEntry
Entry––result
resultwhen
whenan
anincumbent
incumbentfirm
firmtakes
takes
explicit
explicitsteps
stepsto
todeter
deterentry
entry

58
Chapter Eleven
 A Monopsony
Definition:
Definition: AAMonopsony
MonopsonyMarket
Marketconsists
consistsof
ofaasingle
singlebuyer
buyerfacing
facing
many
manysellers.
sellers.

The
Themonopsonist's
monopsonist'sprofitprofitmaximization
maximizationproblem:
problem:
Max==TR
Max TR––TCTC==P*f(L)
P*f(L)––w*L
w*L
where:
where:Pf(L)
Pf(L)isisthe
thetotal
totalrevenue
revenuefor
forthe
themonopsonist
monopsonistand
andw*L
w*Lisis
the
thetotal
totalcost.
cost.

The
Themonopsonist's
monopsonist'sprofit
profitmaximization
maximizationcondition:
condition:

MRP
MRPLL ==P*MP
P*MPLL ==PP(Q/L)
(Q/L)
==TC/L
TC/L== ww++LL(w/L)
(w/L) ==ME
MELL

59
Chapter Eleven
Monopsony - Example

Q = 5L
P = $10 per unit
w = 2 + 2L

MEL = w + L (w/L) = 2 + 4L

MRPL = P*(Q/L) = 10*5 = 50

MEL = MRPL
2 + 4L = 50 (or) L = 12
W = 2 + 2L = $26
60
Chapter Eleven
Inverse Elasticity Pricing Rule

Monopsony
Monopsonyequilibrium
equilibriumcondition
conditionresults
resultsin:
in:

MRPL  w 1

w  L,w

where:isisthe
where: theprice
priceelasticity
elasticityof
of labor
laborsupply,
supply,
(w/L)(L/w)
(w/L)(L/w)

61
Chapter Eleven
The Welfare Economies of Monopsony

62
Chapter Eleven