Chapter 11

Monopoly and
Monopsony
Chapter Eleven Overview
• Profit Maximization by a Monopolist
• The Importance of Price Elasticity of Demand
• Comparative Statistics for Monopolists
• Monopoly with Multiple Plants and Markets
• The Welfare Economics of Monopoly

Copyright (c) 2020 John Wiley & Sons, Inc.

• Why do Monopoly Markets Exist?
• Monopsony

2
A Monopoly
• A monopoly market consists of a single seller facing many
buyers
• The monopolist's profit maximization problem:
– Max (Q) = TR(Q) - TC(Q)
– where: TR(Q) = QP(Q) and P(Q) is the (inverse) market demand
curve

Copyright (c) 2020 John Wiley & Sons, Inc.

• The monopolist's profit maximization condition:
– TR(Q)/Q = TC(Q)/Q
– MR(Q) = MC(Q)
3
The Monopolist’s Demand Curve Is the Market
Demand Curve
• Along the demand curve,
different revenues for different
quantities
• Profit maximization problem is
the optimal trade-off between
volume (number of units sold)
and margin (the differential

Copyright (c) 2020 John Wiley & Sons, Inc.

between price and marginal
cost on the units it sells).

4
A Monopoly – Profit Maximizing
• Demand curve: P(Q) = 12 – Q
• Total revenue: TR(Q) = Q x P(Q) = 12Q – Q2
• Total cost (given):
• Profit-maximization: MR = MC

Copyright (c) 2020 John Wiley & Sons, Inc.

5
A Monopoly – Profit Maximizing
• As Q increases TC increases,
TR increases first and then
decreases
• Profit maximization is at
MR = MC

Copyright (c) 2020 John Wiley & Sons, Inc.

6
A Monopoly – Profit Maximizing
• MR>MC, firm can increase Q and increase profit
• MR<MC, firm can decrease quantity and increase profit
• MR=MC , firm cannot increase profit
• Profit maximizing Q*:

Copyright (c) 2020 John Wiley & Sons, Inc.

7
 Marginal Revenue

Copyright (c) 2020 John Wiley & Sons, Inc.

 Marginal Revenue Curve and Demand

Copyright (c) 2020 John Wiley & Sons, Inc.

The Change in Total Revenue When the
Monopolist Increases Output
• To sell more units, a
monopolist has to lower the
price
• Increase in profit is Area III
while revenue sacrificed at a
higher price is Area I

Copyright (c) 2020 John Wiley & Sons, Inc.

• Change in TR equals Area III –
Area I

10
The Change in Total Revenue When the
Monopolist Increases Output Continued
• Area III = price x change in
quantity
– P(ΔQ)
• Area I = - quantity x change in
price
– -Q (ΔP)

Copyright (c) 2020 John Wiley & Sons, Inc.

• Change in monopolist profit:
P(ΔQ) + Q (ΔP)

11
Marginal Revenue
• Marginal revenue has two parts:
1. P: increase in revenue due to higher volume-the marginal units
2. Q(ΔP/ΔQ): decrease in revenue due to reduced price of the
inframarginal units
• The marginal revenue is less than the price the monopolist
can charge to sell that quantity for any Q>0

Copyright (c) 2020 John Wiley & Sons, Inc.

12
Average Revenue
• Since
• The price a monopolist can charge to sell quantity Q is
determined by the market demand curve, the monopolists’
average revenue curve is the market demand curve

Copyright (c) 2020 John Wiley & Sons, Inc.

13
Total, Average, and Marginal Revenue
• The demand curve D and
average revenue curve AR
coincide
• The marginal revenue curve
MR lies below the demand
curve

Copyright (c) 2020 John Wiley & Sons, Inc.

14
Marginal Revenue and Average Revenue
• Conclusions if Q > 0:
– MR < P
– MR < AR
• MR lies below the demand
• When P decreases by $3 per
curve
ounce, (from $10 to $7),
quantity increases by 3 million

Copyright (c) 2020 John Wiley & Sons, Inc.

ounces (from 2 million to 5
million per year)

15
Marginal Revenue and Average Revenue
Continued

• Given the demand curve, what are the average and

marginal revenue curves?

• and

Copyright (c) 2020 John Wiley & Sons, Inc.

• Vertical intercept is a
• Horizontal intercept is
16
Profit Maximization
• Given the inverse demand and MC, what is the profit
maximizing Q and P for the monopolist?
• and
• Here,

Copyright (c) 2020 John Wiley & Sons, Inc.

17
The Monopolist’s Profit-Maximization Condition

• Profit Maximizing output is at

MR=MC
• Monopolist will make 4 million
ounces and sells at $8 per
ounce
• TR = Areas B + E + F

Copyright (c) 2020 John Wiley & Sons, Inc.

• Profit (TR-TC) is B + E
• Consumer surplus is area A

18
Shutdown Condition
• In the short run, the monopolist shuts down if the most
profitable price does not cover AVC
• In the long run, the monopolist shuts down if the most
profitable price does not cover AC

Copyright (c) 2020 John Wiley & Sons, Inc.

19
Positive Profits for Monopolist
• Monopoly profits are positive
– Why?
• Because the monopolist takes into account the price-reducing
effect of increased output so that the monopolist has less
incentive to increase output than the perfect competitor
• Profit can remain positive in the long run

Copyright (c) 2020 John Wiley & Sons, Inc.

– Why?
• Because we are assuming that there is no possible entry in this
industry, so profits are not competed away
20
Equilibrium
• A monopolist does not have a supply curve because price
is endogenously-determined by demand: the monopolist
picks a preferred point on the demand curve
– An optimal output for any exogenously-given price
• One could also think of the monopolist choosing output to
maximize profits subject to the constraint that price be

Copyright (c) 2020 John Wiley & Sons, Inc.

determined by the demand curve

21
How Price Elasticity of Demand Affects Monopoly
Pricing
• Market A profit maximizing
price is PA
• Market B profit maximizing
price is PB
• Demand is less elastic in
Market B

Copyright (c) 2020 John Wiley & Sons, Inc.

22
Inverse Elasticity Pricing Rule
• We can rewrite the MR curve • When demand is elastic
• MR = P + Q(P/Q) ( < -1), MR > 0
• = P(1 + (Q/P)(P/Q)) • When demand is inelastic
( > -1), MR < 0
• = P(1 + 1/)
• When demand is unit elastic
– where:  is the price elasticity of
demand, (P/Q)(Q/P) ( = -1), MR= 0

Copyright (c) 2020 John Wiley & Sons, Inc.

23
Marginal Revenue and Price Elasticity of Demand
for a Linear Demand Curve
• Where demand is elastic,
marginal revenue is positive
• Where demand is unitary
elastic, marginal revenue is
zero
– MR crosses the horizontal axis

Copyright (c) 2020 John Wiley & Sons, Inc.

• Where demand is inelastic,
marginal revenue is negative

24
Marginal Cost and Price Elasticity Demand

• Profit maximizing condition is MR = MC with P* and Q*

• Rearranging and setting MR(Q*) = MC(Q*)

• Monopolist’s optimal markup of price above marginal cost

Copyright (c) 2020 John Wiley & Sons, Inc.

expressed as a percentage of price is equal to minus the
inverse of the price elasticity of demand
– Inverse elasticity pricing rule
25
Why a Profit-Maximizing Monopolist Will Not
Operate on the Inelastic Region
• Monopolist operates at the
elastic region of the market
demand curve
• Increasing price from PA to PB,
TR increases by Area I – Area
II and total cost goes down
because monopolist is

Copyright (c) 2020 John Wiley & Sons, Inc.

producing less

26
Elasticity Region of the Demand Curve
• The monopolist will always operate on the elastic region of
the market demand curve
• As demand becomes more elastic at each point, marginal
revenue approaches price

Copyright (c) 2020 John Wiley & Sons, Inc.

27
Elasticity Region of the Demand Curve
• Now, suppose that QD = 100P-b and MC = c (constant)
• What is the monopolist's optimal price now?
– P(1+1/-b) = c
– P* = cb/(b-1)
• We need the assumption that b > 1 ("demand is everywhere
elastic") to get an interior solution

Copyright (c) 2020 John Wiley & Sons, Inc.

• As b -> 1 (demand becomes everywhere less elastic), P* -> infinity
and P - MC, the "price-cost margin" also increases to infinity
• As b -> , the monopoly price approaches marginal cost
28
Market Power
• An agent has Market Power if s/he can affect, through
his/her own actions, the price that prevails in the market
• Sometimes this is thought of as the degree to which a firm
can raise price above marginal cost

Copyright (c) 2020 John Wiley & Sons, Inc.

29
The Lerner Index of Market Power
• the Lerner Index of market
power is the price-cost margin,
(P*-MC)/P*
• This index ranges between 0
(for the competitive firm) and 1,
for a monopolist facing a unit
elastic demand
• Restating the monopolist's
profit maximization condition,
we have:
– P*(1 + 1/) = MC(Q*)…or…
– [P* - MC(Q*)]/P* = -1/
• In words, the monopolist's
ability to price above marginal
Copyright (c) 2020 John Wiley & Sons, Inc.
cost depends on the elasticity
of demand
30
How a Shift in Demand Affects the Monopolist’s
Profit-Maximizing Quantity and Price
• Rightward shift in the demand
curve causes an increase in
profit maximizing quantity
• (a) MC is increases as Q
increases
• (b) MC decreases as Q

Copyright (c) 2020 John Wiley & Sons, Inc.

increases

31
Comparative Statics – Monopoly Midpoint Rule

• For a constant MC, profit

maximizing price is found
using the monopoly midpoint
rule
• The optimal price P* is halfway
between the vertical intercept
of the demand curve a (choke

Copyright (c) 2020 John Wiley & Sons, Inc.

price) and vertical intercept of
the MC curve c

32
How an Increase in Marginal Cost Changes the
Monopoly Equilibrium
• When MC shifts up, Q falls and
P increases
• In this case, the profit
maximizing quantity falls from
6 million to 4 million units per
year and price goes up from $8
to $9 per unit

Copyright (c) 2020 John Wiley & Sons, Inc.

33
An Increase in Marginal Cost Must Decrease the
Monopolist’s Total Revenue
• Upward shift of MC decreases
the profit maximizing
monopolist’s total revenue
• Downward shift of MC
increases the profit maximizing
monopolist’s total revenue

Copyright (c) 2020 John Wiley & Sons, Inc.

34
Multi-Plant Monopoly
• Recall:
– In the perfectly competitive model, we could derive firm outputs
that varied depending on the cost characteristics of the firms
– The analogous problem here is to derive how a monopolist
would allocate production across the plants under its
management

Copyright (c) 2020 John Wiley & Sons, Inc.

• Assume:
– The monopolist has two plants: one plant has marginal cost
MC1(Q) and the other has marginal cost MC 2(Q)
35
Multi-Plant Monopoly – Production Allocation
• Whenever the marginal costs of the two plants are not equal, the
firm can increase profits by reallocating production towards the
lower marginal cost plant and away from the higher marginal cost
plant
• Suppose the monopolist wishes to produce 6 units
• 3 units per plant with

Copyright (c) 2020 John Wiley & Sons, Inc.

• MC1 = $6
• MC2 = $3
• Reducing plant 1's units and increasing plant 2's units raises profits

36
Profit Maximization by a Multiplant Monopolist
• The monopolist’s multiplant
marginal cost curve MCT is the
horizontal sum of the individual
plant’s marginal cost curves MC1
and MC2.
• The monopolist’s optimal total
output of 3.75 million units per year

Copyright (c) 2020 John Wiley & Sons, Inc.

occurs at MR=MCT
• Plant 1 produces 1.25 million units
of the total output
• Plant 2 produces 2.5 million units
37
Cartel
• A cartel is a group of firms that collusively determine the price and output in a
market
• In other words, a cartel acts as a single monopoly firm that maximizes total
industry profit
• The problem of optimally allocating output across cartel members is identical
to the monopolist's problem of allocating output across individual plants
• Therefore, a cartel does not necessarily divide up market shares equally

Copyright (c) 2020 John Wiley & Sons, Inc.

among members
– Higher marginal cost firms produce less
• This gives us a benchmark against which we can compare actual industry
and firm output to see how far the industry is from the collusive equilibrium
38
The Welfare Economies of Monopoly
• Since the monopoly equilibrium
output does not, in general,
correspond to the perfectly
competitive equilibrium it entails a
dead-weight loss
• Suppose that we compare a
monopolist to a competitive

Copyright (c) 2020 John Wiley & Sons, Inc.

market, where the supply curve of
the competitors is equal to the
marginal cost curve of the
monopolist
39
Natural Monopolies
• A market is a natural monopoly
if the total cost incurred by a
single firm producing output is
less than the combined total
cost of two or more firms
producing this same level of
output among them

Copyright (c) 2020 John Wiley & Sons, Inc.

• Benchmark: Produce where
P = AC

40
Barriers to Entry
• Factors that allow an incumbent firm to earn positive economic
profits while making it unprofitable for newcomers to enter the
industry
1. Structural barriers to entry – occur when incumbent firms have
cost or demand advantages that would make it unattractive for a
new firm to enter the industry

Copyright (c) 2020 John Wiley & Sons, Inc.

2. Legal barriers to entry – exist when an incumbent firm is legally
protected against competition
3. Strategic barriers to entry – result when an incumbent firm takes
explicit steps to deter entry
41
A Monopsony
• A monopsony market consists of a single buyer facing
many sellers
• The monopsonist's profit maximization problem:
– Max  = TR – TC = P*f(L) – w*L
– where: Pf(L) is the total revenue for the monopsonist and w*L is
the total cost

Copyright (c) 2020 John Wiley & Sons, Inc.

• The monopsonist's profit maximization condition:
– MRPL = P*MPL = P (Q/L) = TC/L = w + L (w/L) = MEL

42
Inverse Elasticity Pricing Rule
• Monopsony equilibrium condition results in:

• where:  is the price elasticity of labor supply, (w/L)(L/w)

Copyright (c) 2020 John Wiley & Sons, Inc.

43
Monopsony Equilibrium versus Perfectly
Competitive Equilibrium
• At the monopsony equilibrium,
net economic benefit is
A+B+C+D
• At the perfectly competitive
equilibrium, net economic
benefit is A+B+C+D+F+G

Copyright (c) 2020 John Wiley & Sons, Inc.

• The deadweight loss due to
monopsony is thus F+G

44