Monopoly

Intro Revenues Profit Maximization The Role of Demand Elasticity Monopoly Power
Economics - Lecture 18
Market Power
Monopoly
Anna D’Ambrosio
Polytechnic of Turin
Chapter 11, Besanko & Braeutigam, Microeconomics, 4th Edition
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Monopoly
1 Intro
2 Revenues
3 Profit Maximization
4 The Role of Demand Elasticity
5 Monopoly Power
2 / 28
Monopoly
A monopoly market consists of a single seller facing many buyers.

The monopolist knows that the number of customers willing to buy
its goods will depend on the price it charges, and it can therefore
set the price of the good. The monopolist will thus be a price
maker in the market.
One product (no good substitutes)
Barriers to entry
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Monopoly
The monopolist is the supply-side of the market and has complete

control over the amount offered for sale
Monopolist controls price but consumers will not buy at any cost.
The monopolist must consider consumer demand:
The higher the price it sets, the less it will sell;
The lower the price it sets, the more it will sell.
The properties of the demand curve will affect the price it can
set in the market
The profit-maximizing monopolist’s problem is finding the optimal
trade-off between volume (the number of units it sells) and
margin (the differential between price and marginal cost on the
units it sells)
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Monopoly
1 Intro
2 Revenues
5 Monopoly Power
5 / 28
Average and Marginal Revenue
The monopolist’s average revenue AR, price received per unit sold,
is the market demand curve
AR = TR/Q = (PQ )/Q = P
Since P(Q) is determined by market demand, the monopolist’s
AR curve coincides with the market demand curve:
AR (Q ) = P (Q )
Recall marginal revenue MR is the change in revenue resulting
from a unit change in output
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Revenues for a Monopolist
To increase sales, the price

must fall;
Increasing output increases TR
by (QB − QA ) ∗ PB
Decreasing price reduces TR
by (PA − PB ) ∗ QA
Overall,
∆TR = (QB − QA ) ∗ PB −
(PB − PA ) ∗ QA =
∆Q ∗ PB − QA ∗ ∆P:
In more general terms,
=⇒ ∆TR∆Q = P + Q ∆Q
∆P
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Marginal and Average Revenues
Marginal revenue is less than price (MR < P).

Because average revenue is equal to price, marginal revenue is less
than average revenue (MR < AR).
Since the average revenue curve coincides with the demand curve,
the marginal revenue curve must lie below the demand curve.
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Marginal Revenues for a Monopolist
∆TR
MR = ∆Q , and, for small changes in Q,
∂TR ∂P (Q )
MR = ∂Q = P + Q ∂Q
Hence, we can view MR as made up of two components:
The additional revenue P obtained by adding the price of one
unit of output;
The reduction in revenue associated with selling all units at a
∂P ∂P
lower price Q ∂Q ( ∂Q is always negative)
MR can be negative
9 / 28
Marginal and Average Revenues for a Linear Demand curve
Suppose market demand is P = a − bQ.

Average revenue coincides with the
demand curve. Thus, AR = a − bQ.
∂P
Marginal revenue is MR (Q ) = P + Q ∂Q ;
∂P
Noting that ∂Q = −b,
MR (Q ) = a − bQ + Q (−b ) = a − 2bQ
MR intersects the x axis halfway between
the origin and the horizontal intercept of
the demand curve at Q=a/(2b).
For Q > a/(2b ), MR is negative.
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Monopoly
1 Intro
2 Revenues
5 Monopoly Power
11 / 28
Profit maximisation for a Monopolist
Profits will be maximized at the level of output where MR = MC
max π = TR (Q ) − TC (Q ) = PQ − TC (Q )
q
∂TC (Q )
∂π
∂Q = 0 =⇒ ∂PQ
∂Q − ∂Q =0
(As for the competitive firm; however, for a monopolist, MR 6= P)!
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Profit Maximisation for a Monopolist
If the firm produces a quantity

at which MR > MC , the firm
cannot be maximizing π
because it could increase its
output and π would go up.
If the firm produces a quantity
at which MR < MC , the firm
cannot be maximizing π
because it could decrease its
output and π would go up.
The only situation at which the
monopolist cannot improve its
profit by increasing or
decreasing output is quantity
Q ∗ at which
MR (Q ∗ ) = MC (Q ∗ ) 13 / 28
Profit Maximisation for a Monopolist
At the profit-maximizing quantity Q ∗ , P > MC .

Monopolist’s economic profits can be positive (P > AC ): the
monopolist does not face the threat of free entry
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A monopolist does NOT have a supply curve
For the monopolist, price is endogenous (i.e. the monopolist

determines both quantity and price).
Depending on the shape of the demand curve, the monopolist might
supply the same quantity at two different prices, or different
quantities at the same price.
The unique association between price and quantity that exists for a
perfectly competitive firm does not exist for a monopolist.
Thus, no unique supply curve exists for the monopolist
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Monopoly
1 Intro
2 Revenues
5 Monopoly Power
16 / 28
Marginal Revenues and Elasticity

∂P
The definition of MR = P + Q ∂Q implies a relationship between MR and
the elasticity of demand:
MR = P + P Q
P
∂P
∂Q
P ∂Q
Recall ed = (and that ed < 0)
Q ∂P

Hence, MR = P + P e1 = P 1 + e1
d d
The more elastic is $/Q

$/Q demand, the less the
markup.
MC P* MC
P*
P*-MC
D
P*-MC
MR
D
MR
Q* Quantity Q* Quantity
17 / 28
If demand is very elastic, there is little benefit to being a monopolist

The larger the elasticity, the closer to a perfectly competitive market
Notice a monopolist will never produce a quantity in the inelastic
portion of demand curve
In inelastic portion, can increase revenue by decreasing
quantity and increasing price
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19 / 28
The Inverse Price Elasticity Rule
Recalling that π is maximised where MR = MC ,

P + P e1 = MC
d
P −MC
“Markup” as a percentage of price: P = − e1d
Price for a monopolist can be expressed directly as the markup over
marginal cost P = 1+(MC1/e ) d
20 / 28
The Inverse Price Elasticity Rule in the case of a Linear

Demand Function
An Application
Suppose a monopolist has a constant marginal cost MC=$50 and faces

the demand curve P=100-Q/2 (which can be rewritten as Q=200-2P).
a. Find the profit-maximizing price and quantity for the monopolist using
the Inverse Price Elasticity Rule.
b. Find the profit-maximizing price and quantity for the monopolist by
equating MR to MC.
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Monopoly
Monopoly pricing compared to perfect competition pricing:

Monopoly
P > MC
Price is larger than MC by an amount that depends inversely
on the elasticity of demand
Perfect Competition
P = MC
Demand is perfectly elastic, so P = MC
22 / 28
Monopoly
1 Intro
2 Revenues
5 Monopoly Power
23 / 28
Monopoly Power
Pure monopoly is rare

But recall that the elasticity of demand largely depends on the
substitutability of a good:
Firms often produce similar goods that have some differences,
thereby differentiating themselves from other firms and enjoying
some monopoly power
A market with several firms, each facing a downward sloping
demand curve, will produce so that price exceeds marginal cost
Monopoly power, however, does not guarantee profits

Profit depends on average cost relative to price
One firm may have more monopoly power but lower profits due to
high average costs
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Monopoly Power
Considering that the markup is zero in perfect competition and

positive for the monopolist, the Lerner index offers a measure of the
(P −MC )
monopoly power: L = P
Monopoly power is determined by ability to set price higher than
marginal cost
A firm’s monopoly power, therefore, is determined by the firm’s
elasticity of demand
Pricing for any firm with monopoly power:
If ed is large, markup is small
If ed is small, markup is large: P = 1+MC
1/ed
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The Social Costs of Monopoly Power
Monopoly power results in higher prices and lower quantities

However, does monopoly power make consumers and producers in
the aggregate better or worse off?
We can compare producer and consumer surplus when in a
competitive market and in a monopolistic market
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The Social Costs of Monopoly
Perfectly competitive firm will produce where MC = D: PC and QC

Monopoly produces where MR = MC , getting their price from the
demand curve: PM and QM
There is a loss in consumer surplus when going from perfect
competition to monopoly
A deadweight loss is also created with monopoly
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Deadweight Loss from Monopoly Power
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Monopoly

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Intro Revenues Profit Maximization The Role of Demand Elasticity Monopoly Power

Chapter 11, Besanko & Braeutigam, Microeconomics, 4th Edition

A monopoly market consists of a single seller facing many buyers.

The monopolist is the supply-side of the market and has complete

Average and Marginal Revenue

Revenues for a Monopolist

To increase sales, the price

Marginal and Average Revenues

Marginal revenue is less than price (MR < P).

Marginal Revenues for a Monopolist

Marginal and Average Revenues for a Linear Demand curve

Suppose market demand is P = a − bQ.

Profit maximisation for a Monopolist

Profits will be maximized at the level of output where MR = MC

(As for the competitive firm; however, for a monopolist, MR 6= P)!

Profit Maximisation for a Monopolist

If the firm produces a quantity

Profit Maximisation for a Monopolist

At the profit-maximizing quantity Q ∗ , P > MC .

A monopolist does NOT have a supply curve

For the monopolist, price is endogenous (i.e. the monopolist

Marginal Revenues and Elasticity

The more elastic is $/Q

Marginal Revenues and Elasticity

If demand is very elastic, there is little benefit to being a monopolist

Marginal Revenues and Elasticity

The Inverse Price Elasticity Rule

Recalling that π is maximised where MR = MC ,

The Inverse Price Elasticity Rule in the case of a Linear

Suppose a monopolist has a constant marginal cost MC=$50 and faces

Monopoly pricing compared to perfect competition pricing:

Pure monopoly is rare

Monopoly power, however, does not guarantee profits

Considering that the markup is zero in perfect competition and

The Social Costs of Monopoly Power

Monopoly power results in higher prices and lower quantities

The Social Costs of Monopoly

Perfectly competitive firm will produce where MC = D: PC and QC

Deadweight Loss from Monopoly Power

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