Chapter 25

Monopoly
 Pure Monopoly
a single seller in the market:
monopolist.
 The monopolist’s demand curve is
the (downward sloping) market
demand curve.
 Not a price taker.
 Pure Monopoly
$/output unit
Higher output y causes a
p(y)
lower market price, p(y).

Output Level, y
 Pure Monopoly

 Supposethat the monopolist seeks

to maximize its economic profit,

 What output level y* maximizes

profit?
 Pure Monopoly

 Fordownward sloping demand

curve, we can find out the revenue.

= a – by
 p(y)
 R=p*y is maximized at y=a/2b
 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)

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

y*
y

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

y*
y

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

y*
y
At the profit-maximizing
output level the slopes of
the revenue and total cost P(y)
curves are equal; MR(y*) = MC(y*).
 Profit Maximization

 What happens if
– MR > MC
– MR < MC
 MR : If there is a little change in y,

 One unit change in y,

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 Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;
 Marginal Revenue
Marginal revenue is the rate-of-change of
revenue as the output level y increases;

dp(y)/dy is the slope of the market inverse

demand function so dp(y)/dy < 0. Therefore

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;

E.g. if c(y) = F + ay + by2 then

 $ 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
 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

and the profit-maximizing output level is

 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

and the profit-maximizing output level is

causing the market price to be

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

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

a p(y) = a - by

MC(y) = a + 2by

a
y

MR(y) = a - 2by
25
Monopolistic Pricing & Own-Price
Elasticity of Demand
 Market demand becomes less
sensitive to changes in price
– Market price?
– Profit?
 less sensitive => shape of the
demand curves?
 We use elasticity to measure the
sensitivity.
 Review of Elasticity

 Formula
A downward-sloping demand curve
– Elastic
– Inelastic
– Unit elastic

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Monopolistic Pricing & Own-Price
Elasticity of Demand
Monopolistic Pricing & Own-Price
Elasticity of Demand

Own-price elasticity of demand is

Monopolistic Pricing & Own-Price
Elasticity of Demand

Own-price elasticity of demand is

so
Monopolistic Pricing & Own-Price
Elasticity of Demand
 1 
MR(y )  p(y )1   .
 | |

For constant MC=k.

For a profit-maximum
 1  which is
MR(y *)  p(y *)1   k
 | | 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 || moves 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  1
p(y *)1    01   0
 |  | | |

That is, |  | 1.

So a profit-maximizing monopolist always

selects an output level for which market
demand is own-price elastic.
 Monopolistic v.s. Competitive

 Under what condition, monopoly

output level = competitive output
level?
 1 
MR(y *)  p(y *)1   k,
 |  |

p=MC
 A horizontal demand curve

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 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
 𝑴𝑹 =𝒑 𝒚 𝟏− = 𝑴𝑪
𝜺
∗ 𝑴𝑪
 So 𝒑 𝒚 = 𝟏
𝟏−
𝜺

𝟏
 Markup : 𝟏
𝟏−
𝜺

 Price is a markup over marginal cost.

 Markup Pricing

 Since 𝜺 >𝟏
𝟏
 So 𝟏 > 𝟏, P > MC
𝟏−
𝜺

 E.g.
if e = -3 then the markup is k/2,
and if e = -2 then the markup is k.
Less elastic => markup rises
 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 A perfectly competitive market

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) 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
If the firm could produce
p(y) extra ∆𝒚 units of output
CS
p(y*)
PS MC(y)
𝒑′
Pareto inefficient!

y* y

MR(y)
𝒚∗ + ∆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

 What
if the government forces the
monopolist producer to set p=MC?

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Natural Monopoly

50
 Natural Monopoly

 Situations such as this is called

natural monopoly.
 It is optimal to have only one firm in
this market.
 If we split one firm into two, the
demand will be smaller for each firm,
AC higher.
 It exhibits IRS.

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 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 cost than is possible with more
than one firm in the market.
 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.
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 An Example

 D(p) = 100−2p
 c(y) = 2y
 Monopoly output & price?

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