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Chapter 10 Monopoly

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Monopoly
A

firm is a monopoly if no other firm produces the same good or a close substitute for it. The degree to which goods are substitutes is measured by the cross price elasticity of demand

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The Monopolists Revenue Function


A

monopolist faces a downward sloping market demand curve. To sell additional units the monopolist must lower its price. p=D(y). Since all units must sell for the same price, p=average revenue (AR). Total revenue is output times price: TR(y)=y(D)
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The Monopolists Revenue Function


Marginal

revenue MR(y) is the rate at which total revenue changes with changes in output. Since the monopolist must reduce price to sell additional units of output, for any positive output, MR is less than price. As p approaches zero, MR is equal to (p) plus quantity (y) multiplied by the slope of the demand curve.
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Figure 10.1 The monopolists marginal revenue

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Marginal Revenue and Price Elasticity of Demand


Price

elasticity of demand (E) at a point (y, p) on the demand curve is: E=p/(y x slope of demand curve) Rearranging: MR(y)=p(1-1/lEl) Marginal revenue is positive if demand is price elastic and is negative of demand is price inelastic.

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Figure 10.2 A linear demand function and the associated total and marginal revenue functions

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From Figure 10.2


Linear

demand curve: P=a-by TR=P*y, Therefore: TR(y)=ay-by2 MR(y)=a-2by The demand curve intersects the quantity axis at a/b. The MR curve intersects the quantity axis at a/2b.
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From Figure 10.2


1.

2.

3.

When TR function has a positive slope, MR is positive. When the TR function is at its maximum, MR is zero. When TR function has a negative slope slope, MR is negative.

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Maximizing Profit
Maximize

profit by choosing output (y*) where MC intersects MR (from below). From the demand curve, find the price (p*) that corresponds with the profit maximizing y.

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Figure 10.3 Maximizing monopoly profit

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Figure 10.4 The inefficiency of monopoly

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The Inefficiency of Monopoly


Because p* exceeds MC in equilibrium, some potential gains from trade are not realized. Efficiency requires producing output to the point where p=MC. The monopoly equilibrium is not Pareto-optimal. A deadweight loss occurs because at equilibrium there exists unrealized gains from trade, signalling unrealized monopoly profit.

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Sources of Monopoly
Government

Franchise Patent Monopoly Resource Based Monopoly Technological (Natural) Monopoly Monopoly by Good Management

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Figure 10.5 Natural monopoly

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Regulatory Responses to a Natural Monopoly


Average

Cost Pricing: Forcing the monopoly to produce a level of output where p=AC. This regulation will fail to minimize production costs.

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Figure 10.6 Average cost pricing

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Regulatory Responses to a Natural Monopoly


Rate

of Return Regulation: Aimed at limiting the rate of return on invested capital. Under this regulation, the firm will choose an input bundle that is not cost minimizing, choosing too much capital and too little labour.

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Figure 10.7 Rate-of-return regulation

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Patent Policy
Appropriability

Problem: Many inventions with social value are not pursued because inventors do not have the private incentives to pursue them (they are not able to capture the social benefits).

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Figure 10.8 The inducement to develop

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Optimal Patent Policy


At

the optimal patent period, the marginal social benefit of increasing the patent period is equal to the marginal social cost.

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