Monopoly Market

Chapter 10
 Chapter outline
• Monopoly
• Monopoly Power
• Sources of Monopoly Power
• The Social Costs of Monopoly Power
• Monopsony
• Monopsony Power
 The Theory of Monopoly
• A firm is a monopoly if . . .
• There is one seller
• The single seller sells a product for which there is no
close substitute
• There are extremely high barriers to entry

• ● Monopoly Market with only one seller

Monopsony Market with only one buyer.
Market power Ability of a seller or buyer to
affect the price of a good
 Monopoly

• For a monopoly firm, they need to reduce the price to increase the sale and revenue. [Price
is always above of MR, demand curve is always above of MR, there is no supply curve in
monopoly market]
• Monopoly firms can change the price because the firm it self is the industry and is price
maker.
• AR = TR/Q = P*Q/Q = P ;
• MR = Change of TR/Change of Q
 WHY MONOPOLIES ARISE……
Barriers To Entry

• Legal Barriers: A Public Franchise is a right granted to a firm by

government that permits the firm to provide a particular good
or service and excludes all others from doing the same. Public
franchise (like the Bangladesh Govt’s Postal Service, a public
franchise to deliver first-class mail)
• Economies of Scale: In some industries, low average total costs
are only obtained through large scale production. If only one
firm can survive in that industry, the firm is called a Natural
Monopoly.
• Exclusive Ownership of a Necessary Resource: Existing firms
may be protected from entry of new firms by the exclusive or
near-exclusive ownership of a resource needed to enter the
industry.
• Consumer lock-in
– Potential entrants can be deterred (protected) if they
believe high switching costs will keep them from inducing
many consumers to change brands

• Network externalities
– Occur when value of a product increases as more
consumers buy & use it
– Make it difficult for new firms to enter markets where firms
have established a large network of buyers

• Brand loyalties
– Strong customer allegiance to existing firms may keep new
firms from finding enough buyers to make entry
worthwhile
 Government Monopolies Vs. Market
Monopolies
Some economists use the term government monopoly to
refer to monopolies that are legally protected from
competition and the term market monopoly to refer to
monopolies that are not legally protected from competition.

• An industry is a natural monopoly when one firm can supply a

good or service to an entire market at a smaller cost than
could two or more firms.
– Example: delivery of electricity, phone service, tap water,
etc.
 Monopoly and How It Arises

One firm can produce

4 millions units of output
at 5 cents per unit.
Two firms can produce
4 million units—2 units
each—at 10 cents per
unit.
Perfect Competition v. Monopoly

9
 Figure 2 Demand Curves for Competitive and Monopoly Firms

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

Price Price

Demand

Demand

0 Quantity of Output 0 Quantity of Output

11
 Competition Vs. Monopoly
• For the perfectly competitive firm, P=MR; for
the monopolist, P>MR. The perfectly
competitive firm’s demand curve is its
marginal revenue curve; the monopolist’s
demand curve lies above its marginal
revenue curve
• The perfectly competitive firm charges a
price equal to marginal cost; the monopolist
charges a price greater than marginal cost.
 How price is set in Monopoly Market
• Profit Maximization MR = MC
TR = P*Q
dTR/dQ = MR = P.1+Q.dP/dQ = P(1+ Q/P(dp/dQ)
MR = P(1+ 1/e); e= elasticity
MR = MC
P(1+1/e) = MC;
P = MC/(1+1/e); (P-MC)/P = -1/e ; Learner’s Index
Learner’s Index for monopoly power
(P- MC)/P = Mark Up (%)
 EXAMPLE. EX.3. P. 396
MC = TAKA 20; Ed = -2
P =?
P = MC/(1+1/E) = 20/(1+1/-2)= TAKA 40
(P-MC)/P = MARK UP (%) = 40 -20/40 = 50%
MC GOES UP 25%; New MC = 20(1.25) = 25 = 20+ 20*25% = Taka 25

P = MC/(1+1/E) = 25/(1+1/-2) = 50
PRICE INCREASES BY 25% AS WELL
[= 50-40/40 =25%]
• Total Revenue
TR = P  Q
• Average Revenue
AR = TR/Q = P
• Marginal Revenue
MR = DTR/DQ

16
 MONOPOLY

• A Rule of Thumb for Pricing

(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:
 MONOPOLY POWER

• Measuring Monopoly Power

Remember the important distinction between a perfectly competitive firm

and a firm with monopoly power: For the competitive firm, price equals
marginal cost; for the firm with monopoly power, price exceeds marginal
cost.

● Lerner Index of Monopoly Power Measure of monopoly power calculated as

excess of price over marginal cost as a fraction of price.

Mathematically:

This index of monopoly power can also be expressed in terms of the elasticity of
demand facing the firm.
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue

Note that P = AR > MR.

Recall that, in perfect

competition, P = AR =
MR.

19
 Figure 3 Demand and Marginal-Revenue Curves for a Monopoly

Price
$11 Note that P = AR > MR
10 at all quantities.
9
8
7
6
5
4
3 Demand
2 Marginal (average
1 revenue Revenue= TR/Q =P*Q/Q = P)
0
–1 1 2 3 4 5 6 7 8 Quantity of Water
–2
–3
–4
20
 Monopoly Pricing and Output Decisions

• A monopolist is a price searcher; that is, it is a

seller that has the ability to control to some
degree the price of the product it sells.

• In the theory of monopoly, the monopoly firm

is the industry and the industry is the monopoly
firm. They are the same.
A Single-Price Monopoly’s Output and Price
Decision
 A Single-Price Monopoly’s Output and Price
Decision

The Figure illustrates the

profit-maximizing choices
of a single-price monopoly.
[PR0FIT=ECONOMIC
PROFIT = TR –TC]
The monopoly produces
the quantity that
maximizes total revenue
minus total cost.
 Monopolist output decision. Page 361.
Fig.10.2
• Profit is maximized
when MR = MC. In
this diagram, Q* is
the output level at
which MR = MC.
• But a note of
caution: price
should be
determined from
the AR or price
line.
The Monopolist’s Profit

Costs and
Revenue

Marginal cost

Monopoly E B
price

Monopoly Average total cost

profit

Average
total D C
cost
Demand

Marginal revenue

0 QMAX Quantity
25
 Mathematical examples: Ex 4, P. 396
4). A firm faces the following average
revenue (demand) curve:
P = 120 – 0.02Q [ Inverse demand function]
where Q is weekly production and P is price,
measured in cents per unit. The firm’s cost
function is given by C = 60Q + 25,000.
Assume that the firm maximizes profits.
a. What is the level of production, price, and
total profit per week?
. A firm faces the following average revenue (demand) curve:
P = 120 – 0.02Q
where Q is weekly production and P is price, measured in cents per unit. The firm’s cost function is given by C = 60Q +
25,000. Assume that the firm maximizes profits.

ANSWER:

a) What is the level of production, price, and total profit per week?
Q =? MR = MC
P = 120 – 0.02Q [1]
P*Q = TR = 120Q - 0.02Q^2 [ Multiply equation by Q in both sides ]
dTR/dQ = MR = 120- 0.04Q
C = 60Q+ 25000; dC/dQ = MC = 60
MR = MC; Q = 1500
P = 120 -0.02*Q = 90
PROFIT = TR – TC = P*Q – 60Q – 25000 = 200
b) If the government decides to levy a tax of 14 cents per
unit on this product, what will
be the new level of production, price, and profit?
P* + T = 120 - 0.02Q,
P* = 120 - 0.02Q – T = 120 -0.02Q- 14= 106-0.O2Q
P*Q = TR = 106Q -0.02Q^2
dTR/dQ = MR = = 106 – 0.04Q
MR = MC
106 -0.04Q = 60; Q= 1150;
P* = 120 - (0.02)(1,150) - 14 = 83 cents. [ P* = SUPPLIER’S PRICE ]
P*+T = 83+14 = 97 [P*+T = BUYER’S PRICE]
Tax is equally shared between buyers and supplier.
Profit of the supplier = TR – TC [C = 60Q + 25,000.]
 Answer

3. A monopolist firm faces a demand with constant elasticity of

–2.0. It has a constant marginal cost of $20 per unit and sets a
price to maximize profit. If marginal cost should increase by 25
percent, would the price charged also rise by 25 percent?
[ APPLY LEQRNER’S INDEX]
(P –MC)/P = -1/Ed [LEQRNER’S INDEX]
P = MC/(1+1/Ed) = 20/(1+1/-2) = Taka 40
Markup (%) = (P –MC)/P = (40 -20)/40 = 50%
New MC = Taka 20(1.25) = Taka 25
New Price = P = MC/(1+1/Ed) = 25/(1+1/-2) = Taka 50
Price increases by = (50-40)/40 = 25%
 Explanation
• If we continue production, Profit
= (P –AC)*Q
= (75 -80)* 50
= -Taka 250

If we should down, we must bear the Fixed cost

ATC = AVC +AFC
80 = 65+AFC
AFC = 80 -65 = Taka 15
TFC = Taka 15*50 = Taka 750

Decision: Continue production with a loss rather than shut-down. If we shut-

down, if we have to bear the FC in the short-run.
 For Monopolists:
• Note that the price of the good being sold is greater
than the marginal revenue. P>MR
• To sell an additional unit of a good (per time
period), the monopolist must lower price.
• The monopolist gains and loses by lowering price.
• The gain equals the price of the product times one.
• The loss equals the difference between the new
lower price and the old higher price times the units
of output sold before the price was lowered.
 The Dual Effects of a Price Reduction on
Total Revenue

To sell an additional unit of the

good, a monopolist needs to
lower price. This price
reduction both gains revenue
and loses revenue for the
monopolist. In the exhibit, the
revenue gained and revenue
lost are shaded and labeled.
Marginal revenue is equal to
the larger shaded area minus
the smaller.
 The Case Against Monopoly
• The Deadweight Loss of Monopoly: Greater output is
produced under perfect competition than under
monopoly. The net value of the difference in these two
output levels is said to be the deadweight loss of
monopoly. This is the amount buyers value the
additional output over and above the opportunity costs
of producing the additional output.
• Rent Seeking: If firm A tries to get the government to
transfer “income” or consumers’ surplus from buyers
to itself it is undertaking a transfer seeking activity. In
economics, these activities are usually called Rent
Seeking.
Social costs of monopoly. Page 378
• The shaded rectangle and
triangles show changes in
consumer and producer
surplus when moving
from competitive price
and quantity, Pc and Qc,
to a monopolist’s price
and quantity, Pm and Qm.
• Because of the higher
price, consumers lose A +
B and producer gains A −
C. The deadweight loss is
B + C.
• CHANGE OF CS = -A –B
• CHANGE OF PS = A;
• LOST PRODUCTION = C
• DWL = -B –C= INEFFICIENCY BROUGHT BY
MONOPOLY
 X-Inefficiency
Refers to the increase in costs when monopolists
are operating at higher than lowest possible costs,
and to the organizational slack that is directly tied
to this.
 Price Discrimination
– Price discrimination occurs when the seller charges different
prices for the product it sells, and the price differences do
not reflect costs. Example: Movie tickets, Airline
tickets ,Discount coupons, Financial aid Quantity discounts
• Perfect Price Discrimination (First degree discrimination): sells
each unit separately and charges the highest price each
consumer would be willing to pay for the product.
• Second Degree Discrimination: it charges a uniform price per
unit for one specific quantity, a lower price for an additional
quantity, and so on.
• Third Degree Discrimination: it charges a different price in
different markets or charges a different price to different
segments of the buying population.
 Why Price Discrimination?
• For the monopolist who practices perfect price
discrimination, price equals marginal revenue.
• Conditions of Price Discrimination:
– The seller must exercise some control over price; it
must be a price searcher.
– The seller must be able to distinguish among buyers
who would be willing to pay different prices.
– It must be impossible or too costly for one buyer to
resell the good at other buyers. The possibility of
arbitrage, or “buying low and selling high” must not
exist.
2000 Ticket : profit = (P-AC)*Q= (1800 -600)*2000 = $2400000
2000 =(1600 -600)*2000 = $2000000
 THE MULTI-PLANT FIRM
 Step 1. Whatever the total output, it should be divided
between the two plants so that marginal cost is the same
in each plant. Otherwise, the firm could reduce its costs
and increase its profit by reallocating production.
 ● Step 2. We know that total output must be such that
marginal revenue equals marginal cost. Otherwise, the
firm could increase its profit by raising or lowering total
output.
 The condition that should be satisfied is:

MR = MC1 = MC2 = MCt ( Marginal cost total plant= over all)

THE MULTI-PLANT FIRM
 A firm with two
plants maximizes
profits by choosing
output levels Q1 and
Q2 so that marginal
revenue MR (which
depends on total
output) equals
marginal costs for
each plant, MC1 and
MC2.
MATHEMATICAL EXAMPLE: EX. 8. CH10, P.396

 A firm has two factories for which costs are given by: C1 = 10Q12 and C2 = 20Q22
The firm faces the following demand curve:
P = 700 – 5Q [ inverse demand function]
where Q is total output – i.e., Q = Q1 + Q2.
a) Calculate the values of Q1, Q2, Q, and P that maximize profit.

Answer:……………………….
MR = MC1 = MC2 = MCt
P = 700 – 5Q
P*Q = TR = 700Q -5Q2; dTR/dQ = MR = 700 -10Q
ANSWER:

C1 = 10Q12 and C2 = 20Q22

MC1 = dC1/Q1 = 10*Q1^2 -1 = 20Q1; MC2 = dC2/Q2 = 40Q2

Q1 = MC1/20; Q2 = MC2/40
Q = Q1+ Q2 = MC1/20 + MC2/40 = (2MC1+ MC2)/40; [USING LEAST COMMON MULTIPLES]
Q = 3MC1/40= 3MC2/40 = 3MCt/40 [ SINCE MC1 = MC2 = MCt = MC]
MCt = MC = 40Q/3

MR = MC [ COMBINED PLANT]
700 -10Q = 40Q/3; 2100 -30Q = 40Q ; -700Q = -2100; Qt = 30 [ = Q1+Q2]
MR = 700 -10Q = 700 – 10*30 = 400
……………………………………………………………………………..
MR = MC1 [ FOR INDIVIDUAL PLANT]
MR = MC1
400 = 20Q1; Q1 = 20
MR = MC2
400 = 40Q2; Q2 =10
……………………………………………………………………………………
P = 700 -5Q; P = 700 -5*30 = 550; PROFIT = TR –TC= P*Q- C1- C2;
P ROFIT = 550*30 – 10Q1^2- 20Q^2
= 550*30 – 10*20^2 -20*10^2 = 10500
 Ex. 5: Page. 396. Mathematical example
The following table shows the demand curve
facing a monopolist who produces at a constant Price Quantity
marginal cost of $10: 18 0
a) Calculate the firm’s marginal revenue curve. 16 4
b) What are the firm’s profit-maximizing output 14 8
and price? What is its profit? 12 12
……………………………………………………………….. 10 16
C) What would the equilibrium price and 8 20
quantity be in a competitive industry? 6 24
D) What would the social gain be if this 4 28
monopolist were forced to produce and price at 2 32
the competitive equilibrium? Who would gain 0 36
and lose as a result?
………………………………………………
In perfect competition: Q =?
P =MC =10
 Answer

a) We know Qd = f(P) = a+bp

P1 =18; Q1 = 0; P2 =16; Q2 = 4
b = slope = (q2 –q1)/(p2- p1) = 4 -0/16-18; b = -2
Qd = a -2P
If price = 18
Qd = a -2*18; 0 = a -36; a = 36
Qd = a+bp = 36 -2P
2P = 36 –Q
P = 36/2 – Q/2 = 18 -0.5Q; P*Q = TR = 18Q -
0.5Q^2
dTR/dQ = MR = = 18 -0.5*2Q = 18 - Q
 Contd..
b) P =? Q =? Profit = TR –TC =?
For finding Q,
MR = MC [ Profit maximization rule]
18 –Q = 10
-Q = 10-18 = -8; Q = 8;
P = 18 - 0.5Q =18 – 0.5*8 = 14
Profit = TR –TC = P*Q – TC= 14*8 - $10*8 = 112-
80 = $32
C) In perfect competition Q =?
P = MC =10
Q = 16
b) Q= ? MR = MC
18 –Q = 10; Q = 8;
P = 18 -0.5Q
P = 18 – 0.5*8 = 14;
Profit = TR –TC= P*Q – TC = 14*8 - $10*8
= $32
C) Under Perfect competition, P = $10 = MC
Q = 16
Profit = P*Q – TC = 10*16 - $10*8 = 80
 d) Pm = 14; Qm = 8; Qc =16: Pc =10; B = 4*8 =32;
C = ½*4*8 = 16; Social Gain = B+C = 32+16 = 48; There
should be no deadweight loss, Producer loss = B = 32
For perfect competition:
Pc = MC = 10