MONOPOLY Z.M.

CONTENTS:
I. Introduction
2. Demand Curve of a Monopolist
3. Profit Maximization when the finn is a monopoly
4. Market Power of a Monopoly
5. The Nature of Demand faced by a Monopolist and the Supply Relationship of a Monopoly
6. The Multiplant Monopolist
7. Social Cost of a Monopoly.
8. Price Discrimination

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1. Introduction:
A monopoly is a market that has only one seller and many buyers. A monopsony is a market that has many
sellers and one buyer.
A key difference between a monopoly and all other types of market structures is the degree of market power
enjoyed by the firms. Market power refers to the ability of a buyer or a seller to influence the market price of
the good. In a perfectly competitive industry, individual firms do not have the ability to influence the market
price. In contrast, a monopolist enjoys significant market power. Since it does not have any competitors, the
firm can set its own price, given the market demand curve. In fact, for any output level, the monopolist is able
to charge the maximum price consumers would be willing to pay at that output level.

There are two main differences between a perfectly competitive market and a market with a monopolist:
(i) In a monopoly, other finns cannot enter the market. Therefore, the economic profit does not drop to zero in
the long run equilibrium.
(ii) The monopolist faces a downward sloping market demand curve. Since it is the only supplier in the market,
it decides its output level based on the entire market demand curve. Note, this is different from the case of an
individual finn in a perfectly competitive industry, which faces a horizontal (perfectly elastic) demand curve.

2. Demand Curve of a Monopolist:

The downward sloping market demand curve faced by the monopolist represents the firm's average revenue
(AR) curve. Why?
R=PQ
AR = R/Q = (PQ)/Q
or, P= AR

What is the relationship between demand and marginal revenue?

We know that marginal revenue (MR) is the change in revenue in response to a small change in output. The
MR function can be mathematically represented as follows.

Thus, MR= p + Q llQ

llP

The tenn �� shows the change in price in response to a change in output level. Note, in case of a perfectly
competitive industry, this term is zero because an individual firm's output decision does not have any impact
on the existing market price. Remember, an individual firm faces a horizontal demand curve and, which
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implies at the existing market price, the firm can supply any amount without having any impact on the price
level. Thus, MR= P in perfectly competitive markets.
However, in a monopoly, a change in the firm's output results in a change in the price level because the firm
faces a downward sloping market demand curve. Thus, the marginal revenue is less than the price in a
monopoly.
Graphically, the slope of the marginal revenue curve is twice the slope of the AR curve.
(We can illustrate this with the application of calculus.]

Relationship between the marginal revenue and the elasticity of demand:

f!.P
MR= P + Q
f!.Q

or, MR = P
[1 + QflP]
PflQ '

PtlQ
since ed = QaP·

Example:

If the demand function is given as P=50 - Q, then the slope of this line is flQ
flP = -1.

MR= (50 -Q) + (-l)Q

or, MR= 50 - 2Q

3. Profit Maximization under a Monopoly:

The general mle for profit maximization is: MR = MC . The monopolist will follow this mle to find the
output level that will maximize its profit earnings and then obtain the price based on the demand curve.
Steps to find the profit maximizing output and price for the monopolist:
Step 1: Derive the marginal revenue function from the inverse demand function given. Plot the demand and
marginal revenue curves. For a linear demand curve, the MR curve will have the same vertical slope and
twice the slope.
Step 2: Find the output level where the MR line intersects the MC line. This output is the firm's profit
maximizing output level.

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Step 3: Determine the profit-maximizing price by locating the point on the demand curve at that optimal level
of output.
Example:

Let P = I000- SQ and MC= $200. Find the monopolist's profit maximizing output and price.
Solution: MR= 1000- IOQ
Therefore, MR=MC or I 000 - I0Q= 200

or, Q* = 80

Now, r· = 1000- so·

Therefore, p* = $600.

4. Market Power of a Monopoly:

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We can rewrite the MR= MC condition as P[I +--] = MC
e"

(P-MC)
Rearranging the above terms yields

The left-hand side of the above equation shows the profit-maximizing firm's markup, i.e., the percentage of
the firm's price that is greater than (or "marked up") its marginal cost.
The equation indicates that the markup should depend on the price elasticity of demand that the firm faces. As
demand becomes more elastic (ed is larger), the optimal markup as a fraction of price falls.
The measure of the markup given by the above equation is known as the Lerner index (after economist Abba
Lerner). The index is a measure of the monopoly power of a firm.

L = (P-MC)
p

5. The Nature of Demand faced by a Monopolist and the Supply Relationship of a Monopoly:
We can use the MR = MC profit maximizing rule to figure out the different levels of profit maximizing
quantities and prices for any possible combination of demand and marginal cost curves. Note, if we plot these
profits maximizing quantity and price levels for the monopolist, we will not obtain a supply curve for the
monopolist. Unlike perfectly competitive firms, monopolies do not have supply curves because for monopolies,
the optimal price-output choices depend on both the marginal cost of production and the market demand. In
contrast, output decision by a perfectly competitive firm depends only on the firm's cost of production (its
marginal cost) because an individual firm faces a horizontal (perfectly elastic) demand curve. That is why a
perfectly competitive firm's supply curve is represented by the upward sloping section of its marginal cost

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curve. The short run supply curve is the upward sloping section of the MC curve above the minimum point of
the short run average variable cost curve. The long run supply curve of the firm is the upward sloping section
of the MC curve above the minimum point of the long run average cost curve.
The monopolist's optimal output level depends on both its marginal cost and its downward sloping marginal
revenue curve, which is derived from the downward sloping market demand curve. A monopoly firm can charge
a higher price at a given quantity if it faces a steeper demand curve or a lower price at the same quantity if it
faces a natter demand curve. Thus, a monopolist's optimal output and price decisions depend not only on its
marginal cost but also on the nature of the market demand it faces.

DIAGRAM:
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1
rR,e,� A Mov\opvl:j 5

prvice. w�r£; -hvo cLif�evJ:,

½ft½ 6r

IVANTITj

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6. Multiplant Monopolist:
In many cases, a monopolist may have multiple production plants where production takes place and the
operating costs of production can differ. In this case, two questions arise.
Question 1: How will a firm decide the total output that should be produced to maximize its profit?
Question 2: How much of that output should each plant produce?
Suppose a firm has two plants.
Step 1: Total output should be divided between two plants so that the marginal cost in plant I (the numerical
value of the vertical axis) is the same as the marginal cost in plant 2.

Step 2: Set MR= MC in each plant.

DIAGRAM:

'-'---1---�----1---___::-----------0 �NTTTY
&2.

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 7. Social Cost of a Monopoly:
Since a monopolist charges a price higher than the marginal cost, we can expect a monopoly market
environment makes consumers worse off than they would be in a perfectly competitive market where price is
equal to the marginal cost.

The monopoly firm is better off than it would be in perfectly competitive industry. With barriers to entry, the
monopoly firm enjoys maximum market power and can charge the highest price, given demand.
Question: Wit I society be better off if it moves from a monopoly market environment to a perfectly
competitive market environment?

To answer the above question, we will have to the level of total economic surplus generated in both markets.
Total surplus is an economic measure of social welfare. Total surplus is comprised of consumer surplus and
producer surplus. Consumer surplus is an economic measure of consumers' welfare in a market. Producer
surplus is an economic measure of producers' welfare in a market.
Graphically, consumer surplus is represented by the area below the demand curve and above the market price.
Producer surplus is represented by the area below the market price and above the supply curve a firm. In case
of a monopoly, the producer surplus is the area below the market price and above the marginal cost curve of
the firm.

DIAGRAMS:
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DIAGRAM:

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