Chapter 10 Monopoly and Monopsony

Monopoly has only one seller of the good while a monopsony has only one buyer of
the good.
Since a monopoly has only one producer of the good the demand curve for the
industry is also the monopolist demand curve. When compared to a perfectly
competitive market we will see the monopolist producers less output and charges a
higher price. The cost to society is fewer consumers get the good. Even though pure
monopoly is rare we can discuss the model and than see if several firms in an industry
act as if they were a monopoly by affecting price and charging more than the marginal
cost of producing the good. (Remember in perfect competition P=MR=MC). When
a firm can charge more than MC it is said to have some monopoly power.
What is market power?
Even though a monopolist is the sole producer of the product it does not mean they
can charge any price they want. The negative slope of the demand curve for the
monopolist (industry and firms demand curve is the same) shows that at higher prices
fewer consumers want the product. Thus the monopolist must maximize profit just
like any other firm. It can not charge what ever it wants for their products they must
charge the price that will allow them to maximize profit.
Insert Table 10.1 here.

Marginal revenue (MR) is less than price in a monopoly. In perfect competition

MR=P.
Table 10.1 shows that the MR column is less than the price column after the first unit
is sold. Also notice that average revenue for a monopolist is the same as price. Thus
the AR curve is the same as the demand curve.

Explain why MR<P for a monopolist.

A monopolist will maximize profit and determine what price to charge and what
output level to produce by equating MR=MC. Note this is the exact same profit
maximizing condition as perfect competition. But in perfect competition P=MR in
monopoly P>MR.
Insert Figure 10.1 here.

Figure 10.1 shows that the slope of the MR curve is two times as steep as the demand
curve. In this figure the slope of the demand curve is 6/6=1 and the slope of the MR
curve is 6/3=2. It is two times as steep.
This can be proven.
If demand is written so that price is a function of Q then
P=a-bQ
since TR =PQ = (a-bQ)Q = aQ-bQ2
MR is TR/Q or using calculus
d(PQ)/dQ = a-2bQ
Note how the slope of the MR curve is 2b while the slope of the demand curve is b
thus the slope of MR is twice the slope of demand.
Insert figure 10.2 here.

In figure 10.2 the cost curves are added to the MR and AR (demand) curves.
Profit is maximized where MR=MC which occurs at Q* and the price the monopolist
will charge is P*
How do you know that the price is P*?

Explain why the output level Q1 and Q2 are not the profit maximizing level of
output.

In diagram 10.2 the yellow area is the lost profit from producing either Q 1 or Q2 levels
of output.
We can prove that profit is maximized when MR=MC
Profit () is TR-TC or = R(Q) C(Q)
We know that when the addition to profit is zero profit is a maximum so if Q changes
and profit does not change then it is a maximum.
Thus Q = R/Q C/Q = 0

R/Q=MR
C/Q = MC
thus
MR-MC =0 or MR=MC
Rule of Thumb for Pricing
While the concept of MR=MC is easy to show as the profit maximizing condition
sometimes it is not so easy for firms to actually figure out what price they should
charge. The following rule of thumb helps put the profit maximizing condition in a
more easily applied format.
Rewrite MR
MR = R/Q = (PQ)/ Q note revenue R = PQ
Since MR is the extra revenue a firm receives from selling one more unit of output we
can break down this extra revenue into two parts.
1. When the firm sells one more unit of output revenue goes up by the price that
output is sold by. (1)(P) = P the 1 is the one more unit of output that is sold and of
course P is the price it is sold for.
2.When the firm sells that one more unit of output it has to lower its price. (This is so
because the demand curve has a negative slope.) So price drops a little by the
amount P/Q. This is the amount that every unit of output sold at the lower price
reduces revenue by. (Remember it is only a small change in price) So each unit of
output Q is reduced by this amount so the reduction of revenue due to lower price is
Q[P/Q]
So if you look at the two components together of MR we get the following
MR = P + Q (P/Q)
If you multiply and divide this by P that is P/P (which is one) then
MR = P + P(Q/P)( P/Q)
Remember the elasticity formula was
E = (Q/Q)/ (P/P)= (Q/Q)*(P/P) =(Q/P)*(P/Q)
Notice this last term is the reciprocal of the last term in the MR formula thus

(Q/P)( P/Q) = 1/Ed

and MR = P + P(1/Ed )
Since maximizing profit is the objective we set MR=MC or
P + P(1/Ed ) = MC
P-MC +P(1/Ed = (P-MC)/P +1/Ed
or
(10.1)

(P-MC)/P = -1/Ed

Equation 10.1 provides a rule of thumb for setting the price. Equation 10.2 will show
the pricing rule of thumb directly from the price. But first look at equation 10.1.
The left hand side is a markup (markup is the price they are charging) over the MC of
producing the good as a percentage of price. Thus the P MC is how much above
MC the firm is marking up the price. Then when that is divided by price it is making
it a percentage of the price. So it would be interpreted as a 33% markup or a 11%
markup over MC. For instance if P=12 and MC =8 then the markup would be 33%.
That is the price is 33% more than the MC. Or if the P=9 and MC=8 then the markup
of price above MC is 11%.
What equation 10.1 tells us is that this markup is equal minus the inverse of the
elasticity of demand. Since elasticity of demand is always negative (because demand
curve is negative) this number must be positive. Thus if Ed = -3 then the markup
would be (1/-3) = 33%. Knowing the markup of course is very useful but it would
be more useful to be able to determine what price the firm should charge in order to
get that markup. This can be done by rearranging equation 10.1 so that we can solve
for P we can find out what price the firm should charge.
Try to rearrange equation 10.1 so that you get 10.2. This might take 10 or 15
minutes of algebra but you should be able to figure it out.

P = MC/(1+1/Ed )

equation 10.2

Note how the price is now shown. Thus if Ed = -4 and MC is 9 then the price should
be
9/(1-1/4) = 9/.75 =$12
It is clear that the Price the monopolist charges is greater than the marginal cost
($12>$9). In a perfectly competitive market P=MC. Suppose Ed was 10, that is it
is very elastic then in our example 9/(1-1/10)= 9/.9= $10 that is the price $10 is closer
to MC ($9) the more elastic demand is.
Shifts in Demand
In a perfectly competitive market whenever the demand curve changes there is a new
unique quantity supplied at every price. This is the supply curve, which shows how
much will be produced at each price and is shown by the marginal cost of production
for the industry. This does not happen in a monopoly. That is, in a monopoly there
may not be a unique quantity associated with each and every price.
Insert Figure 10.4 here.

Notice that with two different demand curves one being more elastic than the other it
is possible that the same quantity would have two different prices. Thus there is no
one for one relationship between quantity and price thus there is no supply curve in a
monopoly.
Multiplant Monopoly
If a firm is a monopoly most likely they will produce output using several different
plants that might be located in different areas or countries for that matter. The

MR=MC rule allows the monopolist to determine how much output it should produce
at each of their plants.
Suppose there are only two plants then the firm should divide its total output among
the two plants such that the Marginal cost of each plant is the same.
Why must this occur in order to maximize profit?

The monopolist will maximize profit where MR=MC. But MC is the same for each
plant so profit is maximized where MR = MC 1 = MC2 .
Insert Figure 10.6 here.

MCT is the horizontal sum of the two individual plants marginal cost curves.
Profit is maximized where MR = MCT Notice the Demand and MR curve for the
monopolist is something we already discussed. The profit maximizing output QT,
which is the total output of monopolist that has to be produced between its two
plants. The profit maximizing MR =MR* and each firms MC must equal this so
MR*=MC1 = MC2 and the output that each plant producers is Q1 and Q2 when added
together equal QT.
will continue on page 339.
We do not see pure monopoly too often. Usually we see some form of monopoly
power.
Insert figure 10.7 here.

Figure a is the market demand curve while figure b show one firm in the market.
Notice that the market demand curve is more inelastic than one of the firms in the
market. But the firm in the market does not have a perfectly elastic demand curve like
that in a perfectly competitive market place.
The firm might have a little bit of product differentiation so if it raises its price it will
not lose all of its loyal customers and if it lowers its price it will not gain all the
market.
Measuring monopoly power
In perfect competition MR=MC
In monopoly P>MC.
One way to measure market power is to see how much the profit maximizing price
exceeds MC. The greater the difference the more monopoly power.
The markup ratio helps explain this.
The Lerner Index of monopoly power is
L=(P MC)/P
The greater this markup the greater monopoly power. In perfect competition P=MC
thus
L=0 The greater L the greater monopoly power.
L= (P-MC)/P = - 1/Ed
Thus the more elastic the demand curve the smaller the monopoly power. If demand
is inelastic then the markup is greater and there is more monopoly power.
Insert Figure 10.8 here.

Notice the difference between P and MC is smaller when the demand curve is more
elastic.
There are three sources of monopoly power
1. The elasticity of market demand. The more inelastic the market demand whether
one firm or several the more market power.
2. The fewer firms in the market the more monopoly power
3. The more rivalry between firms in the market the less monopoly power. If rivals
compete aggressively with each other even though theyre a very few firms they can
drive the price down to competitive levels. If they collude and dont compete then
there will be more monopoly power.
Insert figure 10.10 here.

The monopolist charges a higher price and lower quantity than a competitive firm as
the diagram shows. The question is whether society is better off with the gains to the
firm versus the losses to the consumer.
In monopoly consumers buy less and pay a higher price. The higher price causes
consumers who buy the product to lose consumer surplus of A. Triangle B shows the
loss of consumer surplus due to fewer consumers buying the good than they did under
perfect competition.
The producer who charges a higher price for the goods gains producer surplus equal to
A. So we can ignore A because consumers lose that amount while producers gain that
amount. Producer surplus declines by C because it loses the sales it would have made
if in a competitive market.
The deadweight loss B and C is how much society loses as a result of the monopoly
power causing a higher price and lower quantity than perfect competition.
If the monopolist engages in rent seeking, which is spending money in socially
unproductive efforts to acquire, maintain or exercise monopoly power then the
deadweight loss to society can be even bigger. For example firms spend billions
lobbying the legislature to maintain market power by making entry into the market
more difficult. They can spend lots of money to avoid antitrust legislation.

The greater the transfer from consumers to the firm A the more loss due to rent
seeking.
The government can limit monopoly power by using price regulations.
Insert Figure 10.11 here.

The government can also limit monopoly power by price regulation. Even though we
talked about how price regulation in perfect competition reduces social welfare we
will see how in the case of a firm having monopoly power the deadweight loss can be
eliminated. The monopoly price and quantity without regulation is Pm and Qm. If
the government regulates the price to be P 1 the output level will be Q1. The average
revenue associated with this price and up to Q 1 is the horizontal purple line. For
outputs greater than Q1 AR is the same as before.
The marginal revenue curve associated with the regulated price is the dark purple line,
which intersects MC at output Q1. Note that at the regulated price of P1and Q1output
the deadweight loss from monopoly power is reduced. As the price is lowered and
gets closer to the competitive price Pc the deadweight loss from monopoly gets
smaller until it is eliminated.
If the price is regulated to below the competitive price then there is a shortage.
Monopsony is when there is only one buyer and oligopsony is when there are only a
few buyers.
In either situation there can be monopsony power where the buyer can affect the price
of a good thus allowing the buyer to get the good for a lower price than would exist in
a competitive market place.
The marginal value of a good is the same as the demand for the good thus MV = D. It
is the extra benefit received from buying one more unit of the good. The extra cost of
buying one more unit of the good is called the marginal expenditure. Profit is
maximized when the marginal benefit (MV) = marginal cost (ME).

Insert figure 10.13 here.

If you are a competitive buyer of the good that means you have no influence over the
price you are going to pay for the good. Thus the cost of buying any number of goods
is the same and that cost is the market price.
Figure 10.13a shows this and the average expenditure AE is the same as ME = P*.
The market price of the competitive buyer is taken as given by the Note the output
bought is Q* where ME=MV.
Diagram b shows a competitive seller (not a buyer). Notice in a competitive market
the Price of the seller is given by the market also P* =AR =MR=D. The profit
maximizing quantity Q* occurs where MC=MR.
Insert figure 10.14 here.

This shows a firm that is the only buyer of the good in the industry. As a result the
industry supply curve is the firms supply curve and is positively sloped which
indicates for the market to supply more the price has to be higher thus to increase
quantity supplied price must rise. However, if the market price rises in order to
supply more for you to buy it must raise the price not only for the extra good you buy
but it raises the price for all the goods including the goods you previously bought at
the lower price. Thus the ME line is above the supply curve to reflect this. Profit is
maximized where ME=MV at Qm* and the price charged is P*m. Notice the
monopsony takes advantage of its situation and ends up buying the good for less than

the MV of the good.

Insert figure 10.15 here.

Compare the monopoly model and the monopsony model in seeing what price is
paid.
Insert Figure 10.16 here.

The degree of monopsony power depends on how much lower the Price is than the
MV of the good. The greater the gap the more power the lower the gap the less
monopsony power.
Notice when the supply curve is very elastic the monopsony power is less than if the
supply curve is inelastic.
What will determine the monopsony power?
just discussed the elasticity of supply. Also the more buyers the more elastic the
supply curve because no one buyer can influence the price.

Also if all the buyers compete with each other then supply will be more elastic. If
they are in collusion with each other then the supply is more inelastic.
Insert figure 10.17.

This figure shows the social cost of monopsony power. Note monopsony results in
lower prices and quantities thus the buyers are better off and sellers are worse off.
The competitive prices are shown by PC and QC and the same goes for monopsony.
When the price is lower consumer surplus increases by A but producer surplus goes
down by A also because fewer units are sold at a lower price. So we need not be
concerned with A. However, sellers in addition to loosing A because of few units sold
at a lower price they also lose C associated with less sales. While consumers also gain
A because they can buy the good a lower prices, they also buy fewer goods thus lose
B. Thus we see the deadweight loss to society is B+C.