Monopoly

Market Power: Monopoly
● monopoly Market with only one seller.
● market power Ability of a seller or buyer to affect the price of a good.
What a monopolist can choose?
I. Price (uniform or discriminating) or output
II. Quality/durability
III. R&D
IV. Advertisement
Uniform pricing rule of a monopolist
The monopolist cannot set both p & q independently.
Max π = pq-c(q) Subject to q = q(p)

P
Max π = pq(p)-c[q(p)]
P
Alternatively:
Max π = pq-c(q) Subject to p = p(q)
q
Max π = p(q)q-c(q)
q
Let p*= argmax π = pq(p)-c[q(p)]
Similarly, q*= argmax π = p(q)q-c(q)
Solution:
q* = q(p*)
p* = p(q*)
P
p0
q D q
q0
p
If he chooses this price , he will incur loss
q
q0 q
Let the monopolist chooses quantity.
Max π = p(q)q-c(q)
q
FOC: R’(q)=C’(q)
SOC: R”(q)<C”(q)
Difference between perfect competition and monopoly:
i. Equilibrium can occur even at the falling part of MC.
ii. Pm= AR(qm)> MR (qm)=C’(qm)=> Pm> C’(qm) => πm>0

MC
e
Pm
qm D
MC < MR MR
• Average Revenue and Marginal Revenue
● marginal revenue Change in revenue
resulting from a one-unit increase in output.
To see the relationship among total, average, and marginal revenue,

consider a firm facing the following demand curve:
P=6–Q
TABLE 1 Total, Marginal, and Average Revenue
Total Marginal Average
Price (P) Quantity (Q) Revenue (R) Revenue (MR) Revenue (AR)
$6 0 $0 --- ---
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1
Average and Marginal
Revenue
Average and marginal
revenue are shown for
the demand curve
P = 6 − Q.
• The Monopolist’s Output Decision
Profit Is Maximized When Marginal

Revenue Equals Marginal Cost
Q* is the output level at which

MR = MC.
If the firm produces a smaller
output—say, Q1—it sacrifices
some profit because the extra
revenue that could be earned
from producing and selling the
units between Q1 and Q*
exceeds the cost of producing
them.
Similarly, expanding output from
Q* to Q2 would reduce profit
because the additional cost
would exceed the additional
revenue.
Profit Maximization
• An Example
Part (a) shows total revenue R, total cost C,

and profit, the difference between the two.
Part (b) shows average and marginal
revenue and average and marginal cost.
Marginal revenue is the slope of the total
revenue curve, and marginal cost is the
slope of the total cost curve.
The profit-maximizing output is Q* = 10, the
point where marginal revenue equals
marginal cost.
At this output level, the slope of the profit
curve is zero, and the slopes of the total
revenue and total cost curves are equal.
The profit per unit is $15, the difference
between average revenue and average
cost. Because 10 units are produced, total
profit is $150.
Monopoly power: ● Lerner Index of Monopoly Power
Measure of monopoly power calculated as
excess of price over marginal cost as a
fraction of price.
Max π = p(q)q-c(q)
q
FOC:
∂p  q ∂p   1  p − c′ 1
+
p q − c′(q ) = 0 ⇒ p 1 +  = c′(q ) ⇒ 
p 1−  ′
= c (q) ⇒ =
∂q  p ∂q   e  p ep
 p 
For the competitive firm, price equals marginal cost;

Relative price
For a monopoly, price exceeds marginal cost. margin/relative mark up
Implication:
i. As long as ep < ∞ => p > c’(qm) => profit >0 (supernormal profit);
ii. Lerner Index of monopoly power varies inversely with ep;
iii. As long as MC > 0, at monopolist’s equilibrium demand is price elastic.

Elasticity of Demand and Price Markup
The markup (P − MC)/P is equal to minus the inverse of the elasticity of demand facing the firm.
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).
• If monopolist chooses price
Max π = pq(p)-c[q(p)]
P
∂π
=0
∂p
 1 q( p)    ′
q( p) + pq ′( p) − c ′(q)q ′( p) = 0 ⇒ p 1 +  = c ′(q) ⇒ p1 −
1  = c ′(q) ⇒ p − c = 1
 ′
p q ( p)   e  p ep
 p 
Supply curve of a MONOPOLY…Does it exist?
Shifts in Demand
Answer is No
Shifting the demand curve shows
that a monopolistic market has no
supply curve—i.e., there is no
one-to-one relationship
between price and quantity
produced.
In (a), the demand curve D1 shifts
to new demand curve D2.
But the new marginal revenue
curve MR2 intersects marginal
cost at the same point as the old
marginal revenue curve MR1.
The profit-maximizing output
therefore remains the same,
although price falls from P1 to P2.
In (b), the new marginal revenue
curve MR2 intersects marginal
cost at a higher output level Q2.
But because demand is now more
elastic, price remains the same.
• Effect of Tax
Suppose a specific tax of t dollars per unit is levied, so that the monopolist
must remit t dollars to the government for every unit it sells. If MC was the
firm’s original marginal cost, its optimal production decision is now given by
Effect of Excise Tax on Monopolist
With a tax t per unit, the firm’s

effective marginal cost is
increased by the amount t to
MC + t.
In this example, the increase in
price ΔP is larger than the tax t.
• The Multiplant Firm
Suppose a firm has two plants. What should its total output be, and how
much of that output should each plant produce? We can find the answer
intuitively in two steps.
● Step 1. Whatever the total output, it should be divided between the two
plants so that marginal cost is the same in each plant. Otherwise, the firm
could reduce its costs and increase its profit by reallocating production.
● Step 2. We know that total output must be such that marginal revenue
equals marginal cost. Otherwise, the firm could increase its profit by
raising or lowering total output.
We can also derive this result algebraically. Let Q1 and C1 be the

output and cost of production for Plant 1, Q2 and C2 be the output and
cost of production for Plant 2, and QT = Q1 + Q2 be total output. Then
profit is
The firm should increase output from each plant until the incremental
profit from the last unit produced is zero. Start by setting incremental
profit from output at Plant 1 to zero:
Here Δ(PQT)/ΔQ1 is the revenue from producing and selling one more
unit—i.e., marginal revenue, MR, for all of the firm’s output.
The next term, ΔC1/ΔQ1, is marginal cost at Plant 1, MC1. We thus

have MR − MC1 = 0, or
Similarly, we can set incremental profit from output at Plant 2 to zero,
Putting these relations together, we see that the firm should produce so
that
(3)
Production with Two Plants
A firm with two plants

maximizes profits by
choosing output levels Q1
and Q2 so that marginal
revenue MR (which
depends on total output)
equals marginal costs for
each plant, MC1 and MC2.
THE SOCIAL COSTS OF MONOPOLY POWER
Deadweight Loss from Monopoly Power
The shaded rectangle and triangles

show changes in consumer and
producer surplus when moving from
competitive price and quantity, Pc
and Qc,
to a monopolist’s price and quantity,
Pm and Qm.
Because of the higher price,
consumers lose A + B
and producer gains A − C. The
deadweight loss is B + C.
• Price Regulation in Monopoly
Price Regulation
When price is lowered to

Pc, at the point where
marginal cost intersects
average revenue, output
increases to its maximum
Qc. This is the output that
would be produced by a
competitive industry.
Lowering price further, to
P3 reduces output to Q3
and causes a shortage,
Q’3 − Q3.
• Natural Monopoly
Firm that can produce the entire output of the

market at a cost lower than what it would be if
there were several firms.
Regulating the Price of a Natural

Monopoly
A firm is a natural monopoly
because it has economies of
scale (declining average and
marginal costs) over its entire
output range.
If price were regulated to be Pc
the firm would lose money and
go out of business.
Setting the price at Pr yields the
largest possible output consistent
with the firm’s remaining in
business; excess profit is zero.

Monopoly

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Market Power: Monopoly

● monopoly Market with only one seller.

● market power Ability of a seller or buyer to affect the price of a good.

What a monopolist can choose?

I. Price (uniform or discriminating) or output

Max π = pq-c(q) Subject to q = q(p)

Similarly, q*= argmax π = p(q)q-c(q)

If he chooses this price , he will incur loss

Difference between perfect competition and monopoly:

i. Equilibrium can occur even at the falling part of MC.

ii. Pm= AR(qm)> MR (qm)=C’(qm)=> Pm> C’(qm) => πm>0

To see the relationship among total, average, and marginal revenue,

Profit Is Maximized When Marginal

Q* is the output level at which

Part (a) shows total revenue R, total cost C,

For the competitive firm, price equals marginal cost;

ii. Lerner Index of monopoly power varies inversely with ep;

iii. As long as MC > 0, at monopolist’s equilibrium demand is price elastic.

Effect of Excise Tax on Monopolist

With a tax t per unit, the firm’s

We can also derive this result algebraically. Let Q1 and C1 be the

The next term, ΔC1/ΔQ1, is marginal cost at Plant 1, MC1. We thus

Similarly, we can set incremental profit from output at Plant 2 to zero,

A firm with two plants

Deadweight Loss from Monopoly Power

The shaded rectangle and triangles

When price is lowered to

Firm that can produce the entire output of the

Regulating the Price of a Natural

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