Ch 11: Monopoly and Monopsony

•In the Perfectly Competitive market, the

individual firm or consumer had no effect on
the market price

•A monopolist or monopsonist has market

power; the market price is affected by their
choice of quantity

•A monopolist or monopsonist must then

choose q to maximize their profits, given
that p depends on q. 1
 Chapter 11: Monopoly & Monopsony
In this chapter we will cover:
11.1 Monopoly Features
11.2 Monopolistic Profit
11.3 Monopoly Supply
11.4 Inverse Elasticity Pricing Rule
11.5 Welfare Effect of Monopolies
11.6 Why Monopolies?
11.7 Monopsonists

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A MONOPLY is an industry where there is only
ONE producer/seller.

The monopolist is the market; they face the

market demand curve P(Q).

By lowering price, the monopolist is able to sell

more goods.

3
A monopolist faces the market demand curve:
P=f(Q)
ie: P=a-bQ

A monopolist’s revenue is equal to:

TR=PQ
ie: TR=aQ-bQ2

A monopolist’s costs increase with production:

TC=f(Q)
4
ie: TC=Q 2
A monopolist’s profit is the difference between
total revenue and total cost:

Profit=TR-TC
Ie: Profit=aQ-bQ2-Q2

The monopolist's profit maximization problem:

Max (Q) = TR(Q) - TC(Q)

Q
5
If MR > MC, the monopolist is increasing profit
and should produce more

If MR< MC, the monopolist is decreasing profit

and should produce less

Therefore (like PC), the monopolist maximizes

profits when MR=MC.

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 TC

TR
Profit

Q
P

MR=MC
MC

MR D

Q 7
Demand: P=20-2Q
MR=20-4Q
MC=5+Q

MR=MC
5+Q=20-4Q
5Q=15
Q=3

P=20-2q
P=14 8
When a monopolist increases production, 2
things occur:

1) The monopolist earns MORE revenue from the

extra goods sold
2) The monopolist earns LESS revenue from the
previous goods sold due to a reduced price:

9
Revenue Change: Q increases to Q2
P
Revenue Therefore marginal
Lost on revenue is less than
units price.
P1

P2 Revenue gained on new

units

Demand

Q
Q1 Q2
10
A monopolist facing demand curve P=28-2Q
originally produces 10 units. Calculate the
revenue gained and lost by moving to 11 units.

P(10)=28-2(10)
P(10)=8
P(11)=6

Revenue gained = P(11) = 6

Revenue lost =[P(10)-P(11)]10
11
Revenue lost = (8-6)(10)=20
Marginal Revenue and Linear Demand
When demand
P
is linear, MR
has a slope
twice as
steep.

Demand: P=100-4Q

Q
MR=100-8Q
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For the monopolist,

AR(Q)=TR(Q)/Q
AR(Q)=P(Q)

Or, since price is found on the demand curve,

AR(Q)=D

Since MR is always below the demand curve,

AR(Q)>MR(Q)
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If Q>0
1) The Monopolist will produce Q where MR=MC
2) Given this Q, the monopolist will charge a price
determined by their demand curve
3) Monopolist profit is equal to:
TR-TC
Or
PxQ-ACxQ
Or
(P-AC)Q
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 Price

MC

100 AC

80 e

Profit

MR
20
Demand curve
20 50 Quantity 15
 The Monopolist does not have a suply curve!

Why?

For the Perfect Competitor, price is exogenous;

taken as given.

For the Monopolist, price is endogenous; it is part

of the Monopolist’s decision.
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Price Here the monopolist
offers 20 units at 2
different prices,
80 dependent on
MC
demand
20
Therefore, no supply
curve exists

MR1
D1
17
20 MR2 D2 Quantity
We can rewrite the MR curve as follows:

MR = P + QP/Q

= P(1 + (Q/P)(P/Q))

= P(1 + 1/)

where:  is the price elasticity of

demand, (P/Q)(Q/P)
18
Using this formula:

When demand is elastic ( < -1), MR > 0

When demand is inelastic ( > -1), MR < 0
When demand is unit elastic ( = -1), MR= 0

Therefore,
The monopolist will always operate on the
elastic region of the market demand curve

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Price
Example: Elastic Region of the Demand Curve

a
Elastic region ( < -1), MR > 0

Unit elastic (=-1), MR=0

Inelastic region (0>>-1), MR<0

a/2b a/b Quantity 20

Since at equilibrium, MC=MR:
IEPR:
The monopolist’s
markup above MC (as
a percentage of price)
is the negative
inverse of elasticity of
demand

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Example:

 = -2
MC = $50

a. What is the monopolist's optimal price?

MR = MC  P(1+1/) = MC 
P(1+1/(-2)) = 50
P* = 100

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Since at equilibrium, MC=MR:
IEPR:
The monopolist’s
markup above MC (as
a percentage of price)
is the negative
inverse of elasticity of
demand

Note: The IEPR is related to the

Lerner Index of Market Power…….
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While a firm may be a monopoly, its MARKET
POWER, or control over price may be limited.
-Perhaps people don’t really need the good
-Perhaps imperfect substitutes exist

The Lerner index of market power measures

market power; the control a firm has over price

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Lerner Index = (P-MC)/P = -1/

The Lerner Index lies between 0 and 1

The Lerner Index is 0 for a perfectly competitive

firm (P=MC, the firm has no control over price).

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 Shifts in market demand
•A shift in market demand will cause the
monopolist’s MR curve to shift also

•This will cause a new equilibrium

(MR=MC)

•This new equilibrium will cause a new

price
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Price

MC
• Here an increase in
P1
demand increased
monopoly price and
P0 quantity

MR1 D1
D0
Q 0 Q1 Quantity 27
MR0
An ice cream monopolist with a MC curve of
MC=Q originally faced a demand curve of
P=20-2Q. Due to an increase in temperature,
demand shifted to P=35-2Q.

Calculate the change in price and quantity due to

this shift in demand.

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ORIGINALLY: P=20-2Q
MR=20-4Q
MR=MC
20-4Q=Q
4=Q

P=20-2Q
P=20-2(4)
P=12
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AFTER DEMAND SHIFT: P=35-2Q
MR=35-4Q
MR=MC
35-4Q=Q
7=Q

P=35-2Q
P=35-2(7)
P=21
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The shift in demand caused:

-An increase in monopoly price of $9

($21-$12)

-An increase in quantity produced of 3

cones (7-4)
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 Shifts in marginal cost
•A shift in marginal cost will create a
new equilibrium (MR=MC)

•This new equilibrium will cause a new

price

•Increases in cost will always raise

price and decrease quantity supplied
for a monopolist
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 Price
MC1
MC
• An increase in cost
increases monopoly
P1 price and decreases
P0 quantity supplied

D0
Q1 Q0 Quantity 33
MR0
• We saw before how a perfectly competitive
market maximized consumer and producer
surplus

• Since a monopoly decreases output to increase

prices, a monopoly will normally create a
DEADWEIGHT LOSS:

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 CS with competition: A+B+C
PS with competition: D+E
MC=S
A
PM
B
C
P C

E
D

Demand

QM QC 35
MR
 CS with monopoly: A
PS with monopoly:B+D
MC=S

A
PM
B
P C C DWL = C+E
E
D

Demand

QM QC 36
MR
Since PM>AC for most Monopolists, they earn
ECONOMIC PROFIT. There is an incentive for a
monopoly to maintain market power.

RENT SEEKING is any activity aimed an creating

or preserving monopoly power:
Government lobbying/bribes
Advertising
Hiring Thugs

This rent seeking behaviour is a social cost 37

beyond simple deadweight losses
 Maximum rent seeking cost=B+D
MC=S

P
M
A DWL = C+E
B
C
P C

E
D

Demand

QM QC 38
MR
Monopolies exist for a number of reasons, some
“good”, some “bad”:

 Natural Monopolies
 Barriers to Entry
 Structural
 Legal
 Strategic

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A natural monopoly exists in an industry with
INCREASING RETURNS TO SCALE:

One large firm is a natural monopoly if it can

supply the total market at a lower total cost
than any other 2 firms:

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Price Example: Natural Monopoly

If total market quantity is

45,000, one firm has a natural
monopoly

AC

Demand
22,500 45,000 41
Quantity
Price Example: Natural Monopoly

If total market quantity

increased to 80,000, the natural
monopoly might not last

AC

Demand
Q
40,000 80,000 42
Normally, if economic profit is available in an
industry, firms will enter until that profit is
pushed to zero.

A BARRIER TO ENTRY is any factor that allows a

firm to earn positive economic profit while
making it unprofitable for another firm to enter

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A structural barrier to entry is a cost or demand
advantage that prevents another firm from
entering
-Cost Advantages (includes natural monop.)
-Positive Externalities (iTunes/Ebay)
-Advertising/Brand Dominance
(Kleenex, Heinz)
-May be seen as strategic barrier

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A legal barrier to entry exists when a firm is
legally protected from competition.
-Patents (encourages research)
-Exclusive Rights
-ie: Marijuana growers
-ie: Out-of-country vehicle inspections
(ie: Canadian Tire)
-ie: Printing Money (Canadian Mint)
-ie: Degrees (Universities)
Often these barriers are set up for good
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reasons
A strategic barrier to entry exists when a firm
takes EXPLICT steps to prevent entry
-Operating at a loss/reduced profit
-Developing a Predatory Reputation
-”Unofficial” agreements to maintain monopoly
-Consumer Contracts
-Incompatible inputs (ie: Phone numbers,
memory cards, software, chargers, etc.)

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 Lowering profits to avoid competition
If PX was still
MC=S
profitable to the
monopolist, it
PM
could keep other
PC
PC
firms out of the
Losses market.
PX

Demand

QM QC 47
MR
A MONOPSONIST is a single buyer of a good or
input.
-ie: Only the government purchases military
equipment (we hope).
-If the film Teenage Mutant Ninja Star
Spidermen 4: The Ballet of the Forgotten
Princess were to film in Edmonton, there’d be 1
film but many people wanting to be extras

-The monopsonist faces the market supply curve

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Marginal Product (MP) is the additional
productivity of another unit of input.
-ie: 1 more worker increases output by 7

Marginal Revenue Product (MRP) is the

additional revenue of another unit of input.
-ie: 1 more worker increases revenue by
$21 (if each output sells for $3)

MRP=P x MP
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Since the monopsonist faces the market supply
curve, it can only increase inputs (ie: Labour) by
increasing the price

To hire another worker, the monopsonist both

has to give that worker a higher wage, plus
increase the wage of every other worker:

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Monopsonist Increases Labour:
W
Wage increase of current workers
Supply

W2
W1
Wage of additional workers

L
L1 L2
51
If supply of any input is linear, the Marginal
Expenditure (ME) if that input has TWICE the
slope of the supply curve.

Ie:

Supply: W=50+3Q
ME: W=50+6Q

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If, for the next input (worker) MRP>ME, the firm
should use that input, as the input will earn the
firm more than it increases costs.

If, for the next input (worker) MRP<ME, the firm

should not use that input, as the input will earn
the firm less than it increases costs.

Therefore a monopsonist maximizes when

MRP=ME
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Monopsonist Maximization:
W MEL
Supply
ME=MRP

W*

Wage MRPL

L
L*
54
A film crew comes to the city to hire extras. It
faces a supply curve of:

W=20+Q

Extras have a marginal revenue product curve of

W=100-2Q

Maximize the film’s hiring of extras.

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Supply: W=20+Q
ME: W=20+2Q

ME=MRP
20+2Q=100-2Q
4Q=80
Q=20

W=20+Q
W=20+20
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W=40
Welfare Effects of Monopsonists:
W MEL
Supply

PC
Consumer Surplus
PC
W* Producer Surplus

Wage MRPL=DPC

L
L*
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Monopsonist DWL:
W MEL
Supply

Monopsonist
Consumer Surplus
Monopsonist
W* Producer Surplus

Wage MRPL=DPC
DWL
L
L*
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 Chapter 11 Summary
A monopoly consists of one firm selling a
good
A monopolist faces the market demand
curve
To sell more, it must decrease price
MR is therefore less than demand
A monopolist chooses quantity where
MC=MR
This quantity is sold at a price found on
the demand curve
This typically produces a profit 59
 Chapter 11 Summary
A monopolist always operates on the
ELASTIC portion of the demand curve
The elasticity of demand determines a
monopolist’s market power through the
Learner Index of Market Power
Monopolies cause deadweight loss
This loss increases if Monopolies spend
resources to maintain their monopoly
Monopolies exist due to barriers to entry
(structural – includes natural monopoly -
strategic, legal)
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 Chapter 11 Summary
A monopsonist is a single BUYER of a
good or input
Monopsonists deal with the market supply
curve
Monopsonists operate where marginal
revenue product equals marginal
expenditure (MRP=ME)
Monopsonists cause Deadweight loss
**Remember that Deadweight Loss could
be a reason for government intervention,
but that intervention itself carries a cost
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