Econ 101 - Microeconomic Theory

Monopoly

John Asker
University of California, Los Angeles

Winter 2023
Beyond Perfect Competition
I In previous coursework, you studied the case of
perfect competition
I Key features:
I Large number of buyers and sellers
I Homogeneity of the product
I Free entry and exit of firms
I Sellers and buyers are price takers
I Good theoretical starting point
I But rarely a complete model of real world markets
I A lot of this course is about analyzing settings other
than perfect competition

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Monopoly and Oligopoly

I We will start by the other extreme: Monopoly

I A single producer in the market!
I In the coming weeks, we will cover oligopolies
I For example, what happens when there are two firms
in the market
I To study oligopolies, we will need to acquire a new
tool-set: Game Theory
I This will be another major topic of our course

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Monopoly

I A monopolist is the single supplier to a market

I Why only one supplier?

I Barriers to entry

I Barriers may be either technical or legal

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Technical barriers to entry (1/2)
I Large economies of scale

I Production exhibits decreasing average costs

I Producing at very large scale reduces average costs

I Once a monopoly gets established, entry of new firms

is difficult (existing firm’s average costs are lower)

I This situation is known as natural monopoly

I Common in industries with very large fixed costs and

relatively low variable costs

I Example: utilities such as electricity and gas; rapid

transit systems (metro)

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Technical barriers to entry (2/2)
I Another technical basis of monopoly is special
knowledge of a production technique

I Example: Only one pharmaceutical company knows

the formula for a drug

I Monopolist might try to keep its knowledge secret, but

this is hard

I Ownership of unique resources may also maintain a

monopoly

I Example: DeBeers controlled 90% of the world’s

diamond supply throughout most of the 20th century

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Legal barriers to entry

I Many monopolies are created as a matter of law

I Patents might assign the basic technology for a

product to a single firm
I Governments can also establish monopolies for
political or national security reasons

I Example: oil production in many countries is done

exclusively by the national state-owned company

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Key idea of pricing

I Monopolist is not a price-taker

I Instead, it faces a downward sloped market demand

I Trade-off between price and quantity

I To sell more, the firm must charge less

I Selling more may also increase production costs

I What is the optimum price for the monopolist?

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The Monopolist’s Problem
I Inverse demand curve faced by the firm:

p(q)
I Profit:

Profit(q) = p(q)q C(q) = R(q) C(q)

revenue costs

I Firm solves
max R(q) C(q)
q

I First-order condition:
dR dC
= =) MR = MC
dq dq
marginal marginal
revenue cost

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The Marginal Revenue Curve

I Revenue = p(q)q
I To get the marginal revenue, we take the derivative:

dR dp
= q+p (product rule, from calculus)
dq dq
I The marginal revenue is the extra revenue provided
by the last unit sold
I Since demand is downward sloped, marginal revenue
lies below demand curve
I Reason: extra sale reduces price for all units sold

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The Marginal Revenue Curve
I Graphically

Price

p(q)

MR

Quantity

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Back to the Monopolist’s Problem
I Solution: set MR = MC

Price

p(q)

pM
MR

MC
Quantity
qM

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Example
I First assume

q(p) = 10 p
C(q) = 2q

I Then,

R(q) = (10 q)q =) MR = 10 2q

MC = 2
=) q = 4 , p = 6 , Profits = 16

I What happens if, instead, q(p) = 10 2p?

7
=) q=3, p= , Profits = 4.5
2

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Note: Choosing Quantity or Price?
I For a monopolist, the following two are equivalent:
I Choose q to maximize p(q)q C(q)
I Choose p to maximize q(p)p C [q(p)]
I To see that, let us go back to our example
q(p) = 10 p and C(q) = 2q
I Choose p to maximize
Profit(p) = (10 p)p (10 p)2
I It is easy to check that the solution is p = 6, which
implies q = 4 and Profits = 16
I This equivalency will not hold later in the course,
when we discuss oligopolies

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Note: Profit vs. Revenue Maximization (1/3)
I Back in the day when record sales were a thing,
artists often complained that music companies
charged too much for their records

I Were these people crazy?

I Were they just pretending to be on the consumers’

side

I Could there be an economic explanation?

I Artists are often paid as a fraction of the revenue

generated by sales
I And firms maximize profits rather than revenue!

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Note: Profit vs. Revenue Maximization (2/3)
I Going back to our numerical example
q(p) = 10 p and C(q) = 2q
I Assume the firm sets q to maximize revenue:
R(q) = (10 q)q
I Taking the derivative with respect to q and making it
equal to zero:
10 2q R = 0 =) q R = 5
I This quantity is greater than 4, the profit-maximizing
output
I This is intuitive: the revenue-maximizing quantity is
what the monopolist would choose if MC were zero

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Note: Profit vs. Revenue Maximization (3/3)
Price

p(q)

MR

MC

Quantity
qM qR

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A Different Demand Function
I We already saw that, when

q(p) = 10 p
C(q) = 2q,

we have q = 4, p = 6 and Profits = 16

I What happens if, instead, q(p) = 10 2p?

7
=) q=3, p= , Profits = 4.5
2
I Thus, as demand became more sensitive to prices,
output went down

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Price Elasticity
I Price elasticity is a property of the demand curve

dq p
✏p =
dp q
⇡% in Quantity / % in Price

Generally ✏p < 0
I Jargon:
I If ✏p = 0, demand is perfectly inelastic
I If ✏p =2 ( 1, 0), demand is inelastic
I If ✏p = 1, demand is unitarily inelastic
I If ✏p < 1, demand is elastic
I If ✏p = 1, demand is perfectly elastic

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Price elasticity and marginal revenue

I R(q) = p(q)q

MR = R 0 (q)
dp
= q + p (product rule)
dq
✓ ◆ ✓ ◆
dp q 1
=p +1 = p +1
dq p ✏p

I If demand is inelastic (✏p > 1), MR < 0

I If demand is elastic (✏p < 1), MR > 0
I If demand is unitarily elastic (✏p = 1), MR = 0

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The mark-up rule
I Therefore, MR = MC implies
✓ ◆
1
p + 1 = MC
✏p

I Defining the relative margin m as

p MC
m=
p

we can write
⇣ ⌘
p p 1
+1 ✓ ◆
✏p 1 1
m = = 1 +1 =
p ✏p ✏p

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Market Power
I Market power is the ability of a firm to profitably and
unilaterally raise prices above marginal cost

I It is standard, particularly when engaging in policy

work, to require that this increase also be substantial

I The example above makes it clear that

I A monopolist has market power

I Very different from perfect competition, where firms

always set price equal to marginal cost

I Monopolist’s market power decreases as demand

becomes more elastic

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Monopoly and Resource Allocation
I Is market power good for the society?
I Let us compare total surplus under monopoly and
perfect competition
I Remember that

Total surplus = Consumer surplus + Producer surplus

I Consumer surplus: area below demand curve and

above price
I Value (in dollars) of how much consumers are better
off by participating in the market
I Producer surplus: area below price and above
marginal cost
I Profits (without considering fixed costs)

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Total Surplus: Perfect Competition
Price

p(q)

CS

pPC MC
Quantity
q PC

I Consumer surplus: pink area

I Producer surplus: zero
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Total Surplus: Monopoly
Price

p(q)

pM

MC
MR
Quantity
qM q PC

I Consumer surplus: pink area

I Producer surplus: light gray area
I Dark gray area: dead-weight loss
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Monopoly and Resource Allocation
I Therefore, we have that q M < q PC

I Dead-weight loss: surplus that would be generated

by selling (q PC q M ) extra units to consumers
I Consumers value those units more than what it costs
to produce them
I But selling q PC would bring prices down to pPC = MC

I That would make profits equal to zero

I Monopolist prefers to produce only q M to keep prices

at pM and make positive profits

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Monopoly and Resource Allocation

I A monopolist firm uses its market power to keep

prices above marginal cost and make positive profits
I This reduces total surplus

I Relative to perfect competition, consumers loose

more than monopolist gains

I This is why governments tend to be concerned about

monopolies

I Monopolists tend to be regulated to prevent them

from abusing their market power

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