MGMT-5245

Managerial economics

LECTURE 10
Market power: monopoly
 Admin.
• The answer key to the first exam is posted.

• No office hours today.

 Review
1. In the long-run, profit-maximizing competitive firms choose the output at which P =
MC.

2. A long-run competitive equilibrium occurs under three conditions:

a. When firms maximize profit;
b. When all firms earn zero economic profit so that there is no incentive to enter or exit the
industry;
c. When the quantity of the product demanded is equal to the quantity supplied.

3. The long-run supply curve for a firm is horizontal when the industry is a constant-cost
industry in which the increased demand for inputs to production (associated with an
increased demand for the product) has no effect on the market price of the inputs.

4. The long-run supply curve for a firm is upward sloping in an increasing-cost industry,
where the increased demand for inputs causes the market price for some inputs to
rise.

5. The long-run supply curve for a firm is downward sloping for a decreasing-cost
 Road map
• From perfect competition to monopoly
• Average and marginal revenues of a
monopolist
• Monopolist’s profit-maximizing-output
decision
• Supply curve of a monopolist
 From perfect competition to monopoly
• In the perfectly competitive market that we have been
studying in the past three lectures, the large number of
sellers and buyers of a good ensures that no single seller or
buyer can affect its price.
– The market forces of supply and demand determine price instead.
– Individual firms take the market price as given in deciding how
much to produce and sell, and consumers take it as a given in
deciding how much to buy

• The polar opposite case of perfect competition is monopoly,

that we will discuss in the following few lectures.

• A monopoly is a market that has only one seller but many

buyers.
 Monopoly

• There are certain things we need to keep in mind about monopoly.

• First of all, since the monopolist is the sole producer of a product, this gives
the monopolist some freedom when deciding to raise the price of product for
example, since it need not worry about competitors who, by charging lower
prices would capture a larger share of the market at the monopolist’s expense.

• The monopolist is the market and completely controls the amount of output
offered for sale.

• This also means that, since a monopolist is the sole producer of a product, the
demand curve that it faces is the market demand curve.
 Monopoly

• This does not mean that the monopolist can charge any price it wants—at
least not if its objective is to maximize profit.
– For example, if electricity was too expensive very few people would have access to
that, and the firm providing electricity would earn a lower profit.

• As it was the case so far with any firm, even the monopolist, in order to
maximize profit, the monopolist must first determine its costs and the
characteristics of the market demand.
– Given this knowledge, then the monopolist must decide how much to produce and
sell.

• Let’s start our analysis as we did before by examining the monopolist’s

average and marginal revenue.
 
 Average and marginal revenue - monopoly

• The monopolist’s average revenue – the price it receives per unit sold – is precisely the
market demand curve.

• To choose its profit-maximizing output level, the monopolist also needs to know its
marginal revenue:
– the change in revenue that results from a unit change in output.

• Recall that, for every firm the profit-maximizing condition is given by the: MR(q) = MC(q).

• To understand those relationships, consider a firm facing the following demand curve:

P = 6 –Q

• The following table shows the behavior of total, average and marginal revenue for this
demand curve:
Average and marginal revenue - monopoly
 Average and marginal revenue - monopoly

• When the price is $6, total Q is 0, as a result total revenue are $0.

• At a price of $5, one unit is sold, so total and marginal revenue are equal to
$5.

• A further increase by one unit to a total of 2 units sold, increases revenue

from $5 to $8, and the marginal revenue is $3.

• As quantity sold increases from 2 to 3, marginal revenue falls to $1, and

when quantity increases from 3 to 4, marginal revenue becomes negative.

• When marginal revenue is positive, total revenue is of course increasing,

and when marginal revenue is negative, total revenue is decreasing.
 Average and marginal revenue - monopoly

AVERAGE AND MARGINAL

REVENUE
Average and marginal revenue are
shown for the demand curve
P = 6 − Q.

The demand curve here is a straight

line and, in this case, the marginal
revenue curve has twice the slope of
the demand curve (and the same
intercept).
 Monopolist’s output decision

• Recall that to maximize profit a firms should set output so that marginal revenue
is equal to marginal cost.

• The same thing holds true for the monopolist. The following figure shows the
solution to the monopolist’s problem.

• The market demand curve is D which is also the average revenue curve for the
monopolist.

• The figure also plots the MR, the AC, and MC.

• Marginal revenue and marginal cost are equal at a level of output equal to Q*.
Then from the demand curve, we find that the price P* corresponds to this
quantity Q*.
 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.
 Monopolist’s output decision – notes on the
previous graph
• Why is this the profit-maximizing quantity?

• Suppose the monopolist produces a smaller quantity Q1 and receives the corresponding
higher price P1.
• As the previous figure shows, marginal revenue would then exceed marginal cost.
– In that case if the monopolist produced a little more than Q1, it would receive extra profit (MR-
MC) and thereby increase its total profit.
– In fact, the monopolist could keep increasing output, adding more to its total profit until output
Q*, at which point the incremental profit earned from producing one more unit is zero.
– So the smaller quantity Q1 is not profit maximizing , even though it allows the monopolist to
charge a higher price.
– If the monopolist produced Q1 instead of Q*, its total profit would be smaller by an amount equal
to the shaded area below the MR curve and above the MC curve, between Q1 and Q*.

• Likewise, the larger quantity Q2 is not a profit maximizing quantity, since marginal cost
then exceeds marginal revenue.
 Monopolist’s output decision: 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
A Rule of Thumb for Pricing

With limited knowledge of average and marginal revenue, we can derive a rule of thump
that can be more easily applied in practice. First, write the expression for marginal
revenue:

Note that the extra revenue from an incremental unit of quantity, Δ(PQ)/ΔQ, has two
components:

1. Producing one extra unit and selling it at price P brings in revenue (1)(P) = P.

2. But because the firm faces a downward-sloping demand curve, producing and
selling this extra unit also results in a small drop in price ΔP/ΔQ, which reduces the
revenue from all units sold (i.e., a change in revenue Q[ΔP/ΔQ]). Thus:
 Monopoly
(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand, 1/Ed, measured at the
profit-maximizing output, and

Now, because the firm’s objective is to maximize profit, we can set marginal revenue
equal to marginal cost:

which can be rearranged to give us

Equivalently, we can rearrange this equation to express price directly as a markup over
marginal cost:
 Supply curve in monopoly

• Remember that in a competitive market, there is a supply curve which

shows the relationship between the price and the quantity supplied.
– In fact, the supply curve in that case represents the cost of production for the
industry as a whole.

• On the other hand, a monopolistic market has no supply curve.

Why?
– Because there is no one-to-one relationship between price and the quantity
produced.
– The reason for that is that the monopolist’s output decision depends not only
on marginal cost but also on the shape of the demand curve.
– As a result, shifts in demand can lead to changes in price with no change in
output, changes in output with no change in price, or changes in both price
and output. Let’s see that graphically.
 Supply curve in monopoly
• Take a look at the following figure.

• In both panels, the demand curve is initially, D1, the corresponding marginal
revenue curve is MR1, and the monopolists’ initial price and quantity are P1 and
Q1.

• In panel (a) the demand curve is shifted down and rotated.

• The new demand and marginal revenue curves are shown as D2 and MR2.

• Note that the MR2 intersects the marginal cost curve at the same point that MR1
does. As a result, the quantity produced stays the same. Price, however, falls to P2.

• On the other hand in panel (b), the demand curve is shifted up and rotated. The
new marginal revenue curve MR2 intersects the marginal cost curve at a larger
quantity, Q2 instead of Q1. But the shift in the demand curve is such that the price
is exactly the same.
 Supply curve in monopoly
SHIFTS IN DEMAND
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.
 Takeaways
1. A monopoly is a market that has only one seller but many buyers.

2. The monopolist is the market and completely controls the amount

of output offered for sale.

3. The monopolist in order to maximize profits sets the price according

to the rule MR=MC.

4. The rule-of-thumb pricing rule helps in expressing the price directly

as a markup over marginal cost.

5. A monopolistic market has no supply curve.

Thank you!