National University of Singapore

Department of Economics

EC2101 Microeconomic Analysis I

Semester 1 AY 2014/2015

Practice Problems 10 Solution

Monopoly
Question 1 The marginal cost of preparing a large latte in a specialty coffee house is
$1. The firms market research reveals that the elasticity of demand for its large lattes
is constant, with a value of about -1.3. If the firm wants to maximize profit from the
sale of large lattes, about what price should the firm charge?
Using the inverse elasticity pricing rule,
P MC
1
P 1 1
=
=
P = 4.33
P

P
1.3
Thus the profit-maximizing price is about $4.33.
Question 2 Suppose that Intel has a monopoly in the market for microprocessors in
Brazil. During the year 2005, it faces a market demand curve given by P = 9 Q,
where Q is millions of microprocessors sold per year. Suppose you know nothing
about Intels costs of production. Assuming that Intel acts as a profit-maximizing
monopolist, would it ever sell 7 million microprocessors in Brazil in 2005?
Marginal revenue is MR = 9 2Q. If Q=7, then MR=-5. To maximize profit, Intel
should produce at where MR=MC. Unless marginal cost is negative, which is
impossible, at Q=7, Intel is not maximizing profit because marginal revenue is not the
same as marginal cost. In fact, since marginal cost is positive, Intel is producing at the
region where MR<MC. To maximize profit, Intel should produce less.
Alternatively, the midpoint of the demand curve is Q=4.5 and P=4.5. Based on the
inverse elasticity pricing rule, we know that Intel should never produce at the inelastic
region of the demand curve, which is the region where Q>4.5 since the demand curve
is linear. So producing at Q=7 is not profit maximizing.
Question 3 Suppose a monopolist faces the market demand function P = a - bQ. Its
marginal cost is given by MC = c + eQ. Assume that a > c, b >0, and 2b + e > 0.
a) Derive an expression for the monopolists optimal quantity and price in terms of a,
b, c, and e.
The monopolist will operate where MR = MC . With demand P = a bQ , marginal
revenue is given by MR = a 2bQ . Setting this equal to marginal cost implies

a 2bQ = c + eQ

Q=

At this quantity price is

ac
2b + e

National University of Singapore

Department of Economics

EC2101 Microeconomic Analysis I

Semester 1 AY 2014/2015

a c
P = a b

2b + e
ab + ae + bc
P=
2b + e
b) Show that an increase in c (which corresponds to an upward parallel shift in
marginal cost) or a decrease in a (which corresponds to a leftward parallel shift in
demand) must decrease the equilibrium quantity of output.
Since

Q=

ac
2b + e

It is easy to see that increasing c or decreasing a will reduce the numerator of the
expression, reducing Q .
c) Show that when e 0 an increase in a must increase the equilibrium price.
Since e 0 and

P=

ab + ae + bc
2b + e

Increasing a will increase the numerator for this expression. This will therefore
increase the equilibrium price.
Question 4 Two monopolists in different markets have identical, constant marginal
cost functions. Suppose their linear demand curves have identical vertical intercepts
but different slopes. Which monopolist will have a higher markup: the one with the
flatter demand curve or the one with the steeper demand curve?
Let the marginal cost function be MC(Q)=c. Let the inverse demand curves be P=abQ. The equation of marginal revenue is thus MR=a-2bQ. Equating it with the
marginal cost, the profit-maximizing quantity is Q=(a-c)/2b and the profitmaximizing price is P=(a+c)/2. Interestingly, the profit-maximizing price does not
depend on the slope of the demand curve. It only depends on the marginal cost and
the vertical intercept of the inverse demand curve. Since the two monopolists have the
same marginal cost and the same vertical intercept, the profit-maximizing price will
be the same and the markup (P-MC) will also be the same.
This finding is called the monopoly midpoint rule. If we have a linear demand curve
and a constant marginal cost, the profit-maximizing price is halfway between the
vertical intercept of the inverse demand curve, a, and the marginal cost, c.
Question 5 The following diagram shows the average cost curve and the marginal
revenue curve for a monopolist in a particular industry. What range of quantities
could it be possible to observe this firm producing, assuming that the firm maximizes
2

National University of Singapore

Department of Economics

EC2101 Microeconomic Analysis I

Semester 1 AY 2014/2015

profit? You can read your answers off the graph, and therefore approximate values are
permissible.

The minimum point on the AC appears to be at about 15 (or 16) units of output, and
the point where the MR curve intersects the AC curve is at about 20 units. The
monopolists profit maximizing output must fall between the minimum point on AC
and the point where MR intersects AC. To see this, remember that the firm will
produce where MR = MC. This cannot happen at any point less than 15 units because
the AC curve is decreasing for Q < 15. Therefore the MC curve lies below the AC
curve for Q < 15. From the graph, it is clear that MR > AC for Q < 15. Thus we have
MR >AC > MC for Q < 15. Similarly, from the graph we can see that MR < AC for Q
> 20. Since the MC curve must lie above the AC curve to the right of 15 units, we
have MR < AC < MC for Q > 20.