8.

PRODUCER SURPLUS
It is the difference between the price at which the producer
is willing to sell each of the units and the price at which they
sell (difference between the market price and the marginal
cost).
Graphically,

Thus, it is the area between the market price and the

marginal cost.
If we use the graph for its calculation, you can observe that
the producer surplus is the difference between the area
below the price (p.q) and the area below the marginal cost.
The area below the price is the revenue: R(q) = 𝑝. 𝑞
The area below the marginal cost can be calculated by
integrating the marginal cost:

∫ 𝑀𝐶 (𝑞)𝑑𝑞 = 𝑉𝐶 + (𝐾)

In the short run, there are variable and fixed costs,

therefore:
𝑃𝑆 = 𝑅(𝑞) − 𝑉𝐶
Then, 𝜋 = 𝑅(𝑞) − 𝑉𝐶 − 𝐹𝐶 = 𝑃𝑆 − 𝐹𝐶 → 𝑃𝑆 = 𝜋 + 𝐹𝐶

In the long run, all costs are variable, therefore,

𝑃𝑆 = 𝑅(𝑞) − 𝑉𝐶 = 𝜋

How to calculate the market producer surplus?

The market supply function is the aggregate of individual’s
supply functions, and basically, these functions are their
marginal costs. So, the market producer surplus is the area
between the market price and the market supply function.

MONOPOLY
1. MONOPOLY vs PERFECT COMPETITION
Monopoly Perfect Competition
*One firm. *Many firms.
*Market power. *Price taker.
*Barriers to entry. *Free entry and exit.
*Supplies the whole *Firm’s demand = market
market. price.
CAUSES OF MONOPOLY
1. Natural.
*Scarcity of a resource: one firm owns a key resource (De
Beer’s Diamonds).
*Technological reasons: existence of large economies of
scale relative to the market size – one firm may serve the
demand more efficiently than several firms (water,
telephone, …).
2. Legal.
*Licenses (taxis, pharmacies, notaries …)
*Patents (medical drugs, intellectual property)

2. PROFIT MAXIMIZATION CONDITIONS.

The monopoly serves the whole market demand, that is, it
has market power over price. The price is not given to the
firm like in the case of a competitive market; in the
monopoly, the price depends on the quantity that the firm
supplies. The price is determined by the inverse demand
function, 𝑝(𝑄 ).

To obtain the inverse demand function, just solve the

equation for the price. For example,
10 − 𝑄
Q(𝑝) = 10 − 2𝑝 → 𝑝(𝑄 ) =
2

Max 𝜋(𝑄) = 𝑅(𝑄) − 𝐶(𝑄) = 𝑝(𝑄). 𝑄 − 𝐶(𝑄)

FOC 𝜋´(𝑄) = 𝑀𝑅(𝑄) − 𝑀𝐶(𝑄) = 0

→ 𝑀𝑅(𝑄) = 𝑀𝐶(𝑄)

SOC 𝜋´´(𝑄 ) = 𝑀𝑅´(𝑄 ) − 𝑀𝐶´(𝑄 ) < 0

→ 𝑀𝑅´(𝑄 ) < 𝑀𝐶´(𝑄 )

→ A monopoly can maximize profit with increasing,

decreasing or constant marginal cost (a competitive firm,
only maximizes profit when marginal cost is non –
decreasing.
Shutdown condition
As any other type of firm, the monopoly will produce a
positive quantity when the profit is greater than the profit
shutting down.
πmáx (Q) ≥ π(0)

Example: A monopoly produces a good with costs given by

the function 𝐶 (𝑄 ) = 𝑄 2 , and where the market demand
function is: 𝐷(𝑝) = 60 − 2𝑝. Calculate the monopoly
equilibrium.
Representation. Is price equal to marginal cost?

A monopoly always produces a quantity that satisfies, 𝑝 >

𝑀𝐶.

3. FIRST ORDEN CONDITION: LERNER INDEX

FOC 𝑀𝑅 = 𝑀𝐶
𝑅(𝑄) = 𝑝(𝑄 ). 𝑄 → 𝑀𝑅 = 𝑝´(𝑄 ). 𝑄 + 𝑝(𝑄 ) =
𝑄
𝑝´(𝑄 ). 𝑝(𝑄) + 𝑝(𝑄 ) = (∗)
𝑝(𝑄 )

𝜕𝑄 𝑝 1 𝑝
(The demand – price elasticity is 𝜀𝑄,𝑝 = . = . )
𝜕𝑝 𝑄 𝑝´(𝑄) 𝑄

1 1 1
(∗) = . 𝑝 + 𝑝 = 𝑝 ( + 1) = 𝑝(1 + )
𝜀 𝜀 𝜀
1 1
𝑀𝑅 = 𝑝 (1 + ) = 𝑝 (1 − )
𝜀 |𝜀 |
1
In the equilibrium, 𝑀𝑅 = 𝑀𝐶 → 𝑝 (1 − |𝜀|) = 𝑀𝑅
Lerner Index:
1 1 𝑀𝐶 𝑀𝐶 1
𝑝 (1 − ) = 𝑀𝐶 → 1 − = →1− =
|𝜀 | |𝜀 | 𝑝 𝑝 |𝜀 |
𝑝 − 𝑀𝐶 1
𝐿= =
𝑝 |𝜀 |

Example: 𝑄 ∗ = 10; 𝑝∗ = 25; 𝑀𝐶 = 2𝑄; 𝑄 = 60 − 2𝑝

¿Lerner Index?
Two possibilities:
𝑝 − 𝑀𝐶
𝐿= =
𝑝
1
𝐿= =
|𝜀 |
′ 𝑃
|𝜀 | = 𝑄 𝐷 =
𝑄

The Lerner Index measures monopoly power: it explains the

percentage of price that is not due to costs.
This index is always between O and 1: when 𝐿 = 0, price is
equal to the marginal cost, therefore, there is no mark – up,
and the firm behaves as a competitive company.

What happens with the monopoly power when demand’s

elasticity increases?
There is an inverse relation between monopoly’s mark – up
and demand elasticity.

4. MONOPOLY AND COMPETITIVE FIRM

EQUILIBRIUM
The monopoly and the competitive firm maximize profit,
however,
1
*Monopoly’s Marginal Revenue 𝑀𝑅 = 𝑝 (1 − |𝜀|)

*Competitive firm Marginal Revenue 𝑀𝑅 = 𝑝

This is the representation of both cases: Situation 1, where

the firm behaves as a monopoly, and, Situation 2, where it
behaves as a competitive firm.

Comparing both situations:

𝑃𝑀 > 𝑃𝑃𝐶
𝑄𝑀 < 𝑄𝑃𝐶
𝜋𝑀 > 𝜋𝑃𝐶
𝐶𝑆𝑀 < 𝐶𝑆𝑃𝐶
𝑃𝑆𝑀 > 𝑃𝑆𝑃𝐶
𝑇𝑆𝑀 < 𝑇𝑆𝑃𝐶 There is a deadweight loss.

5. MONOPOLY REGULATIONS
A monopoly generates a deadweight loss. This market is
less efficient than the competitive market: the monopoly
Total Surplus is lesser than the competitive Total Surplus.
Therefore, this type of market tends to be regulated (to
avoid the deadweight loos). Regulating a market means to
change its behaving rule, that in a monopoly means not
letting it produces where its marginal revenue equals the
marginal cost.

1. Efficient Regulation. An obvious solution (if possible –

that is, if we know the monopoly’s cost function) is to
impose a regulated price equal to marginal cost, thus
generating the competitive outcome, 𝑝 = 𝑀𝐶 (𝑄 ).
This solution may lead to monopoly’s losses that would
have to be subsidized.
𝑝 = 𝑀𝐶
𝑃(𝑄)
(Solution: intersection between demand and marginal cost)
2. Subsidizing the monopoly’s losses. The firm is regulated
with the efficient price, and in case of negative profit, the
authorities subsidize the company, so its profit is zero.

3. Impose a regulated price equal to average cost, 𝑝 = 𝐴𝐶.

This solution leads to zero profit.
𝑝 = 𝐴𝐶
𝑃(𝑄)

Representation of the regulation of the monopoly when it

produces with economies of scale.

Natural Monopoly: this type of monopoly arises when there

are large economies of scale: cost minimization would lead
to a single firm producing the total output.
Exercise: obtain the deadweight loss of a market with
demand function 𝐷(𝑝) = 60 − 2𝑝, and where the only
producer’s cost function is 𝐶 (𝑄 ) = 𝑄 2 .
Monopoly: 𝑝𝑀 = 25; 𝑄𝑀 = 10
Competitive firm: 𝑝 = 𝑀𝐶
𝑃(𝑄)