9 - CH10 - Monopoly

Chapter 10
Market Power: Monopoly

CHAPTER OUTLINE
10.1 Monopoly
10.2 Monopoly Power
10.3 Sources of Monopoly Power
10.4 The Social Costs of Monopoly

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Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Market Power: Monopoly and Monopsony (2 of 2)
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.

10.1 Monopoly (1 of 15)
Average Revenue and Marginal Revenue
marginal revenue Change in revenue resulting from a one-unit increase in output.
Consider a firm facing the following demand curve: P = 6  Q
TABLE 10.1 TOTAL, MARGINAL, AND AVERAGE REVENUE
TOTAL MARGINAL AVERAGE

PRICE (P) QUANTITY (Q) REVENUE (R) REVENUE (MR) REVENUE (AR)
$6 0 $0 — —
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 1 2
1 5 5 3 1

FIGURE 10.1
AVERAGE AND MARGINAL

REVENUE
Average and marginal revenue

are shown for the demand curve
P = 6 − Q.

The Monopolist’s Output Decision
FIGURE 10.2
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.
We can also see algebraically that Q* maximizes profit. Profit π is the difference between
revenue and cost, both of which depend on Q:
As Q is increased from zero, profit will increase until it reaches a maximum and then begin
to decrease. Thus the profit-maximizing Q is such that the incremental profit resulting from
a small increase in Q is just zero (i.e., Δπ /ΔQ = 0). Then
But ΔR/ΔQ is marginal revenue and ΔC/ΔQ is marginal cost. Thus the profit-maximizing
condition is that
MR − MC = 0, or MR = MC

An Example
FIGURE 10.3
EXAMPLE OF PROFIT MAXIMIZATION
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.
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

(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

(10.
1)
Equivalently, we can rearrange this equation to express price directly as a markup over
marginal cost:
(10.
2)

Shifts in Demand
A monopolistic market has no supply curve. In other words, there is no one-to-one

relationship between price and the quantity produced.
The reason 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 do not trace out the series of prices and quantities
that correspond to a competitive supply curve. Instead, 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.
Shifts in demand usually cause changes in both price and quantity. A competitive
industry supplies a specific quantity at every price. No such relationship exists for a
monopolist, which, depending on how demand shifts, might supply several different
quantities at the same price, or the same quantity at different prices.

FIGURE 10.4
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.

The Effect of a Tax
Suppose a specific tax of t dollars per unit is
levied, so that the monopolist must remit t
dollars to the government for every unit it
sells. If MC was the firm’s original marginal
cost, its optimal production decision is now
given by
FIGURE 10.5
EFFECT OF EXCISE TAX ON

MONOPOLIST
With a tax t per unit, the firm’s effective
marginal cost is increased by the amount t to
MC + t.
In this example, the increase in price ΔP is
larger than the tax t.

• The Multiplant Firm
Suppose a firm has two plants. What should its total output be, and how much of
that output should each plant produce? We can find the answer intuitively in two
steps.
• 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.

We can also derive this result algebraically. Let Q1 and C1 be the output and cost of
production for Plant 1, Q2 and C2 be the output and cost of production for Plant 2, and
QT = Q1 + Q2 be total output. Then profit is
The firm should increase output from each plant until the incremental profit from the last
unit produced is zero. Start by setting incremental profit from output at Plant 1 to zero:
Here Δ(PQT)/ΔQ1 is the revenue from producing and selling one more unit—i.e.,
marginal revenue, MR, for all of the firm’s output.

The next term, ΔC1/ΔQ1, is marginal cost at Plant 1, MC1. We thus have
MR − MC1 = 0, or
MR = MC1
Similarly, we can set incremental profit from output at Plant 2 to zero,

MR = MC2
Putting these relations together, we see that the firm should produce so that
MR = MC1 = MC2 (10.3)

FIGURE 10.6
PRODUCING WITH TWO PLANTS
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.

FIGURE 10.7
THE DEMAND FOR
TOOTHBRUSHES
Part (a) shows the market
demand for toothbrushes.
Part (b) shows the demand for

toothbrushes as seen by Firm A.
At a market price of $1.50,

elasticity of market demand is
−1.5.
Firm A, however, sees a much

more elastic demand curve DA
because of competition from
other firms.
At a price of $1.50, Firm A’s

demand elasticity is −6.
Still, Firm A has some monopoly

power: Its profit-maximizing price
is $1.50, which exceeds marginal
cost. Copyright © 2018 Pearson Education, Ltd, All Rights Reserved
10.2 Monopoly Power (1 of 3)
Production, Price, and Monopoly Power
In figure 10.7, although Firm A is not a pure monopolist, it does have monopoly power—
it can profitably charge a price greater than marginal cost. Of course, its monopoly power is
less than it would be if it had driven away the competition and monopolized the market, but
it might still be substantial.
This raises two questions.
1. How can we measure monopoly power in order to compare one firm with another?
(So far we have been talking about monopoly power only in qualitative terms.)
2. What are the sources of monopoly power, and why do some firms have more monopoly
power than others?
We address both these questions below, although a more complete answer to the
second question will be provided in Chapters 12 and 13.

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.
(10.
4)

The Rule of Thumb for Pricing
FIGURE 10.8
ELASTICITY OF DEMAND AND

PRICE MARKUP
The markup (P − MC)/P is equal to

minus the inverse of the elasticity
of demand.
If the firm’s demand is elastic, as in

(a), the markup is small and the
firm has little monopoly power.
The opposite is true if demand is

relatively inelastic, as in (b).

10.3 Sources of Monopoly Power (1 of 4)
As equation (10.4) shows, the less elastic its demand curve, the more monopoly
power a firm has. The ultimate determinant of monopoly power is therefore the
firm’s elasticity of demand.
Three factors determine a firm’s elasticity of demand.
1. The elasticity of market demand. Because the firm’s own demand will be at least
as elastic as market demand, the elasticity of market demand limits the potential
for monopoly power.
2. The number of firms in the market. If there are many firms, it is unlikely that any
one firm will be able to affect price significantly.
3. The interaction among firms. Even if only two or three firms are in the market,
each firm will be unable to profitably raise price very much if the rivalry among
them is aggressive, with each firm trying to capture as much of the market as it
can.

The Elasticity of Market Demand
If there is only one firm—a pure monopolist—its demand curve is the market
demand curve. In this case, the firm’s degree of monopoly power depends
completely on the elasticity of market demand.
When several firms compete with one another, the elasticity of market demand
sets a lower limit on the magnitude of the elasticity of demand for each firm.
A particular firm’s elasticity depends on how the firms compete with one another,
and the elasticity of market demand limits the potential monopoly power of
individual producers.
Because the demand for oil is fairly inelastic (at least in the short run), OPEC could
raise oil prices far above marginal production cost during the 1970s and early
1980s. Because the demands for such commodities as coffee, cocoa, tin, and
copper are much more elastic, attempts by producers to cartelize these markets
and raise prices have largely failed. In each case, the elasticity of market demand
limits the potential monopoly power of individual producers.

The Number of Firms
Other things being equal, the monopoly power of each firm will fall as the number
of firms increases.
When only a few firms account for most of the sales in a market, we say that the
market is highly concentrated.
barrier to entry Condition that impedes entry by new competitors.
Sometimes there are natural barriers to entry:
Patents, copyrights, and licenses
Economies of scale may make it too costly for more than a few firms to supply the
entire market. In some cases, economies of scale may be so large that it is most
efficient for a single firm—a natural monopoly—to supply the entire market.

The Interaction Among Firms
Firms might compete aggressively, undercutting one another’s prices to capture

more market share, or they might not compete much. They might even collude (in
violation of the antitrust laws), agreeing to limit output and raise prices.
Other things being equal, monopoly power is smaller when firms compete
aggressively and is larger when they cooperate. Because raising prices in concert
rather than individually is more likely to be profitable, collusion can generate
substantial monopoly power.
Remember that a firm’s monopoly power often changes over time, as its operating
conditions (market demand and cost), its behavior, and the behavior of its
competitors change. Monopoly power must therefore be thought of in a dynamic
context.
Furthermore, real or potential monopoly power in the short run can make an
industry more competitive in the long run: Large short-run profits can induce new
firms to enter an industry, thereby reducing monopoly power over the longer term.

10.4 The Social Costs of Monopoly Power
(1 of 5)
FIGURE 10.10
DEADWEIGHT LOSS FROM MONOPOLY

POWER
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.
Rent Seeking
rent seeking Spending money in socially unproductive efforts to acquire, maintain, or exercise
monopoly.
We would expect the economic incentive to incur rent-seeking costs to bear a direct relation
to the gains from monopoly power (i.e., rectangle A minus triangle C.)

10.4 The Social Costs of Monopoly Power (2 of 5)
Price Regulation
FIGURE 10.11 (1 of 2)
PRICE REGULATION
If left alone, a monopolist produces

Qm and charges Pm.
When the government imposes a

price ceiling of P1 the firm’s average
and marginal revenue are constant
and equal to P1 for output levels up
to Q1.
For larger output levels, the original

average and marginal revenue curves
apply.
The new marginal revenue curve is,

therefore, the dark purple line, which
intersects the marginal cost curve at
Q1.

FIGURE 10.11 (2 of 2)
PRICE REGULATION
When price is lowered to Pc, at the

point where marginal cost
intersects average revenue,
output increases to its maximum
Qc. This is the output that would
be produced by a competitive
industry.
Lowering price further, to P3,

reduces output to Q3 and causes a
shortage,
Q’3 − Q3.

Natural Monopoly
natural monopoly Firm that can produce the
entire output of the market at a cost lower
than what it would be if there were several
firms.
FIGURE 10.12
REGULATING THE PRICE OF A NATURAL

MONOPOLY
A firm is a natural monopoly because it has

economies of scale (declining average and
marginal costs) over its entire output range.
If price were regulated to be Pc the firm

would lose money and go out of business.
Setting the price at Pr yields the largest

possible output consistent with the firm’s
remaining in business; excess profit is zero.

Regulation in Practice
The regulation of a monopoly is sometimes based on the rate of return
that it earns on its capital. The regulatory agency determines an allowed price, so
that this rate of return is in some sense “competitive” or “fair.”
rate-of-return regulation Maximum price allowed by a regulatory agency is based

on the (expected) rate of return that a firm will earn.
Although it is a key element in determining the firm’s rate of return, a firm’s capital
stock is difficult to value.
Regulatory lag is a term associated with delays in changing regulated prices.
Another approach to regulation is setting price caps based on the firm’s variable
costs. A price cap can allow for more flexibility. For example, a firm could raise its
prices each year (without having to get approval from the regulatory agency) by
an amount equal to the actual rate of inflation, minus expected productivity
growth.

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Chapter 10

Market Power: Monopoly

10.2 Monopoly Power

10.3 Sources of Monopoly Power

10.4 The Social Costs of Monopoly

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

monopsony Market with only one buyer.

market power Ability of a seller or buyer to affect the price of a good.

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

marginal revenue Change in revenue resulting from a one-unit increase in output.

Consider a firm facing the following demand curve: P = 6  Q

TABLE 10.1 TOTAL, MARGINAL, AND AVERAGE REVENUE

TOTAL MARGINAL AVERAGE

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

AVERAGE AND MARGINAL

Average and marginal revenue

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

If the firm produces a smaller

Similarly, expanding output from Q*

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

EXAMPLE OF PROFIT MAXIMIZATION

Marginal revenue is the slope of the total revenue curve, and

The profit-maximizing output is Q* = 10, the point where marginal

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

which can be rearranged to give us

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

A monopolistic market has no supply curve. In other words, there is no one-to-one

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

EFFECT OF EXCISE TAX ON

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Similarly, we can set incremental profit from output at Plant 2 to zero,

MR = MC1 = MC2 (10.3)

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

PRODUCING WITH TWO PLANTS

A firm with two plants

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Part (b) shows the demand for

At a market price of $1.50,

Firm A, however, sees a much

At a price of $1.50, Firm A’s

Still, Firm A has some monopoly

This raises two questions.

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

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

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

ELASTICITY OF DEMAND AND

The markup (P − MC)/P is equal to

If the firm’s demand is elastic, as in

The opposite is true if demand is

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Three factors determine a firm’s elasticity of demand.

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

barrier to entry Condition that impedes entry by new competitors.

Sometimes there are natural barriers to entry:

Patents, copyrights, and licenses