Microeconomics in Modules

and
Economics in Modules
Third Edition

Krugman/Wells

Module 28
Monopoly in Practice
 What You Will Learn
1 How a monopolist determines the profit-
maximizing output and price
2
How to determine whether a monopoly is
earning a profit or a loss

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 The Monopolist’s Demand Curve and
Marginal Revenue
• The price-taking firm’s optimal output rule is
to produce at the level whose marginal cost of
the last unit produced is equal to the market
price.
• A monopolist, in contrast, is the sole supplier
of its good. So its demand curve is simply the
market demand curve, which is downward-
sloping.

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 The Monopolist’s Demand Curve and
Marginal Revenue
• This downward slope creates a wedge between
the price of the good and the marginal revenue
of the good—the change in revenue generated
by producing one more unit.

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 Comparing the Demand Curves of a Perfectly Competitive
Producer and a Monopolist
(a) Demand Curve of an Individual (b) Demand Curve of a Monopolist
Perfectly Competitive Producer

Price Price

Market
DC
price

DM
Quantity Quantity

An individual perfectly competitive firm A monopolist can affect the price (sole
cannot affect the market price of the supplier in the industry); therefore, its
good; therefore, it faces the horizontal demand curve is the market demand
demand curve DC as shown in panel (a). curve DM as shown in panel (b).

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 The Monopolist’s Demand Curve and
Marginal Revenue
• An increase in production by a monopolist has two
opposing effects on revenue:
– A quantity effect. One more unit is sold,
increasing total revenue by the price at which the
unit is sold.
– A price effect. To sell the last unit, the monopolist
must cut the market price on all units sold. This
decreases total revenue.

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 The Monopolist’s Demand Curve and
Marginal Revenue
• The quantity effect and the price effect are
illustrated by the two shaded areas in panel (a)
of Figure 28-2 based on the numbers in the
table on the next slide.

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The Monopolist’s Demand Curve and
Marginal Revenue

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 A Monopolist’s Demand, Total Revenue, and
Marginal Revenue Curves
Price, cost, marginal
(a) Demand and Marginal Revenue
revenue of demand
$1,000

Quantity effect = +
A $500
550 B
500
Price effect =
–$450
C
50 D
0 9 10 20
Marginal revenue = $50 Quantity of diamonds
–200
MR
–400
(b) Total Revenue
Total Quantity effect dominates price
effect. Price effect dominates quantity effect.
Revenue

$5,000

4,000

3,000

2,000

1,000
TR
0 10 Quantity of diamonds 20 9 of 17
 The Monopolist’s Demand Curve and
Marginal Revenue
• Because of the price effect of an increase in
output, the marginal revenue curve of a firm
with market power always lies below its
demand curve.
• A profit-maximizing monopolist chooses the
output level at which marginal cost is equal to
marginal revenue—not to price.

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 The Monopolist’s Demand Curve and
Marginal Revenue
• As a result, the monopolist produces less and
sells its output at a higher price than a
perfectly competitive industry would. It earns
a profit in the short run and the long run.

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 The Monopolist’s Demand Curve and
Marginal Revenue
• At low levels of output, the quantity effect is
stronger than the price effect: as the
monopolist sells more, it has to lower the price
on only very few units, so the price effect is
small.
• At high levels of output, the price effect is
stronger than the quantity effect: as the
monopolist sells more, it has to lower the price
on many units of output, making the price
effect very large.
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 The Monopolist’s Profit-Maximizing
Output and Price
• To maximize profit, the monopolist compares
marginal cost with marginal revenue.
• If marginal revenue exceeds marginal cost, De
Beers increases profit by producing more; if
marginal revenue is less than marginal cost, De
Beers increases profit by producing less.

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 The Monopolist’s Profit-Maximizing
Output and Price
• At the monopolist’s profit-maximizing
quantity of output:
MR = MC

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 The Monopolist’s Profit-Maximizing
Output and Price
Price, cost,
The optimal output rule: the
marginal
profit maximizing level of output
revenue of
for the monopolist is at MR =
demand
$1,000 Monopolist’s MC, shown by point A, where
optimal point the MC and MR curves cross at
an output of 8 diamonds.
B
PM 600
Perfectly competitive
Monopoly industry’s optimal point
profit
PC 200 MC = ATC
A C

0 D
8 10 16 20

–200 QM QC Quantity of diamonds

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 Monopoly Versus Perfect Competition

• P = MC at the perfectly competitive firm’s profit-

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 Monopoly Versus Perfect Competition

• Compared with a competitive industry, a monopolist

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 The Monopolist’s Profit
Price, cost,
marginal
Profit = TR − TC
revenue
= (PM × QM) − (ATCM × QM)
MC
ATM = (PM − ATCM) × QM
B
PM The average total cost of QM
is shown by point C. Profit is
Monopoly given by the area of the
profit shaded rectangle.
A
D
ATCM
C

MR

QM Quantity

The monopolist maximizes profit by producing the level of output at which MR = MC, given
by point A, generating quantity QM. It finds its monopoly price, PM, from the point on the
demand curve directly above point A, point B here.

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Economics in Action
• Electric utilities were recognized as natural
monopolies with a defined area. They owned the
plants and the transmission lines.
• In the late 1990s, there was a move toward
deregulation.
• Power generation entails large up-front costs.
• Lack of competition after deregulation enabled
power generators to engage in market manipulation.
• From 2002 to 2006 average electricity prices rose
21% in regulated states versus 36% in fully
deregulated states.
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Summary
1. The key difference between a monopoly and a perfectly
competitive industry is that a perfectly competitive firm
faces a horizontal demand curve but a monopolist faces a
downward-sloping demand curve. This gives the
monopolist market power, the ability to raise the price by
reducing output.
2. The marginal revenue of a monopolist is composed of a
quantity effect (the price received from the additional
unit) and a price effect (the reduction in the price at which
all units are sold). Because of the price effect, a
monopolist’s marginal revenue is always less than the
market price, and the marginal revenue curve lies below
the demand curve.
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Summary
3. At the monopolist’s profit-maximizing output level,
marginal cost equals marginal revenue, which is less than
market price.
4. At the perfectly competitive firm’s profit-maximizing
output level, marginal cost equals the market price.
5. So in comparison to perfectly competitive industries,
monopolies produce less, charge higher prices, and earn
profits in both the short run and the long run.

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