MICROECONOMICS

Chapter 10 – Market Power:

Monopoly and Monopsony

1
 Topics to be Discussed
• Monopoly and Monopoly Power
• Sources of Monopoly Power
• The Social Costs of Monopoly Power
• Limiting Market Power: The Antitrust Laws
• Monopsony and Monopsony Power

2
 Review of Perfect Competition
• Characteristics of perfectly competitive
market
– Large number of buyers and sellers
– Homogenous product
– Perfect information
– Firm is a price taker
• Characteristics of profit-maximizing
competitive firm
– P = LMC = LAC
– Normal profits or zero economic profits in the
long run
3
Review of Perfect Competition

P Market P Individual Firm

D S
LMC LAC

P0 P0
D = MR = P

Q0 Q q0 q
4
 Monopoly
• Monopoly
1. One seller - many buyers
2. One product (no good substitutes)
3. Barriers to entry
4. Price Maker

5
 Monopoly
• The monopolist is the supply-side of the market
– Monopolist has complete control over the quantity
offered for sale
• The monopolist’s (i.e., the firm’s) demand curve
is also the market demand curve
– Monopolist controls price but must consider consumer
demand in setting price
– In contrast, the competitive firm does not control price
(Recall: competitive firm is a price taker)
• Profits will be maximized at the level of output
where marginal revenue equals marginal cost
(Recall: this rule also applies for firm in a
competitive market)
6
Average and Marginal Revenue
• The monopolist’s average revenue curve,
price received per unit sold, is the market
demand curve
– By definition P=AR
• Monopolist also needs to find marginal
revenue, change in revenue resulting from
a unit change in output

7
Average and Marginal Revenue
• Finding Marginal Revenue
– As the sole producer, the monopolist works
with the market demand to determine output
and price
– An example can be used to show the
relationship between average and marginal
revenue
– Assume a monopolist with (market) demand:
P=6-Q
8
Total, Marginal, and Average
Revenue

9
 Total, Marginal, and Average
Revenue
• Revenue is zero when price is $6
– Nothing is sold
• Revenue increases then decreases as price
goes down below $6 and quantity increases
• When demand is downward sloping, the price
(average revenue) is greater than marginal
revenue
– For sales (quantity) to increase, price must fall
– Because new price applies not just for last unit but for
all units sold, addition to revenue (MR) is less than
price (AR)

10
Average and Marginal Revenue
To increase sales by one unit (Q0 Additional revenue of
to Q1) the monopolist must monopolist in selling last
$/Q
decrease price from P0 to P1. New unit would be (A-B). This
price P1 will apply to all units, not is MR1
just the last unit.
TR0=P0Q0 • MR1 = (A-B) < A

TR1=P1Q1 • A = (Q1-Q0)*P1 = 1*P1 = P1

=> MR1 < P1
P0 ●
B
P1 ●

D=AR
A

Q0 Q1= Q0 +1 Quantity

11
Average and Marginal Revenue
$/Q At any Q (e.g.,
Q1), MR< P

For a monopolist, MR< AR

The MR curve lies below the
AR (=D) curve

P1 ●

D=AR
MR1 ●
MR

Q1 Quantity

12
Average and Marginal Revenue
• For a linear demand function, MR curve is
the AR (demand) curve with double the
slope
P = a + bQ
TR = PQ = aQ + bQ2
TR
MR   a  2bQ
Q

13
 Monopoly
• Monopoly’s demand compared to
competitive firm’s demand:
– Monopoly
• Firm faces a downward-sloping demand
curve (the market demand curve)
○ To increase sales the price must fall
• MR < P
– Competitive firm
• Firm faces a horizontal demand curve
○ No change in price to change sales
• MR = P
14
Monopolist’s Output Decision
1. Cost functions are the same as with
competitive firm’s costs
– depends on production function and prices of
inputs
2. Profits maximized at the output level where
MR = MC
– But MR = MC ≠ P (because MR < P)
3. Monopolist's price determined by market
demand curve (not MR curve)
– MR = MC ≠ P = AR
15
Monopolist’s Output Decision
$ per
unit of
output MC

P*
AC

D = AR

MR

Q* Quantity
16
Monopolist’s Output Decision
• At output levels below MR = MC, the
increase in revenue is greater than the
increase in cost (MR > MC)
• At output levels above MR = MC, the
increase in cost is greater than the
increase in revenue (MR < MC)

17
Monopolist’s Output Decision
$ per
unit of
output MC

P1

P*
AC
P2
Lost
profit

D = AR

Lost
MR profit

Q1 Q* Q2 Quantity
18
Monopoly: An Example

Cost  C (Q )  50  Q 2

C
MC   2Q
Q

Demand : P (Q )  40  Q
R  PQ  (40  Q )Q  40Q  Q 2
R
MR   40  2Q
Q
19
 Monopoly: An Example
To determine monopolist’s profit-
maximizing price and quantity:

Step 1: Find Q* for which Step 2: Use D curve to find

MC = MR P corresponding to Q*

MC  MR P (Q )  40  Q
2Q  40  2Q
P (Q )  40  10
4Q  40
P (Q )  30
Q  10
20
Example of Profit Maximization
$/Q MR = MC at Q =10
40 P = 30 at Q = 10 MC

P=30 ●
AC
20
AR

10
MR

0 5 10 15 20 Quantity
21
 Monopoly: An Example
• By setting marginal revenue equal to
marginal cost, we showed that profit is
maximized at P = $30 and Q = 10
• This can be seen graphically by plotting
cost, revenue and profit
– Profit is initially negative when firm produces
little or no output
– Profit increases and q increases, maximized
at Q*=10
22
Example of Profit Maximization
$ C = 50+Q2
r' R = 40Q-Q2
400

When profits are

300 maximized (at Q=10),
slope of rr’ and cc’ are
equal: MR=MC
c’
200 r
Profits
150

100

50
c
0 5 10 15 20 Quantity
23
Example of Profit Maximization
$/Q MR = MC at Q =10
40 P = 30 at Q = 10 MC Profit = (P - AC) x Q
= ($30 - $15)(10) =
$150
P=30 ●
Profit
20 AC
AR
AC=15

10
MR

0 5 10 15 20 Quantity
24
Monopolist’s Price and Elasticity of
Demand
• Can show a relationship between
monopolist’s profit-maximizing price
and the elasticity of demand
If MR = MC, then
P  MC 1

P ED
(see P&R, 8th ed., pp. 363 for proof) 25
Monopolist’s Price and Elasticity of
Demand
• (P – MC)/P is the markup over MC as
a percentage of price
• The markup should equal the inverse
of the elasticity of demand
– The more elastic the demand, the smaller the
monopolist’s mark-up

26
Monopolist’s Price and Elasticity of
Demand
• If monopolist knows elasticity of
demand and firm’s MC, there is a
simple rule of thumb for setting profit-
maximizing price
• To maximize profit, P should be set
at:
MC
P
1  (1 / Ed )
27
Monopolist’s Price and Elasticity of
Demand – Example 1
$/Q
For previous
40
MC example:
Mark-up = (P-MC)/P
= (30-20)/30 = 1/3 or
P=30 33.3%
AC
20
AR
AC=15
10
(P-MC)/P = - 1/Ed
=> Ed = -3
MR

0 5 10 15 20 Quantity
28
Monopolist’s Price and Elasticity of
Demand – Example 1
• To double check:
Given:
P  40  Q or Q  40  P
P  30; Q  10
Therefore:
Q P 30
Ed   [1]  3
P Q 10
29
Monopolist’s Price and Elasticity of
Demand – Example 2
Given ED =-4; MC = 9
What price should monopolist charge
to maximize profit?
MC
P
1  (1 / Ed )
= 9/(1 + (1/-4))
= 9/.75 = $12
30
 Monopoly
• Monopoly pricing compared to perfect
competition pricing:
– Monopoly
• P > MC
• Price is larger than MC by an amount that
depends inversely on the elasticity of
demand
– Perfect Competition
• P = MC
• Demand is perfectly elastic, so P=MC
31
 Monopoly
• If demand is very elastic, there is
little benefit to being a monopolist
• The larger the elasticity, the closer
to a perfectly competitive market

32
 Shifts in Demand
• In perfect competition, the market
supply curve is determined by
marginal cost (of all firms in the
market)
• Any shifts in the demand curve trace
out price and quantity changes
corresponding to a supply curve, as
defined by MC
• There is a one-to-one relationship
between price and quantity
33
Example 1 – Shift in Demand
$/Q
MC = S

Shifts in demand
trace P and Q
● combinations on
● D3
the market S curve
●
D2

D1

Quantity
34
 Shifts in Demand
• In a monopoly, shifts in demand do
not trace out price and quantity
changes corresponding to a supply
curve
• Shifts in demand may result in :
– Changes in both price and quantity
– Changes in price with no change in
output
– Changes in output with no change in
price 35
Example 2 – Shifts in Demand
$/Q

MC Shift in demand
leads to change
P2 D2 in both quantity
and price
P1
MR2

D1

MR1

Q1 Q2 Quantity
36
Example 2 – Shift in Demand
$/Q

MC Shift in demand
leads to change
in price but
same quantity
P1

P2 D2

D1

MR2
MR1

Quantity
QQ1=Q
1
2
37
Example 2 – Shifts in Demand
$/Q

MC Shift in demand
leads to change
in quantity but
same price
P1 = P 2
D2

MR2

D1

MR1

Q1 Q2 Quantity
38
 Shifts in Demand
• For a monopoly, output is determined
by marginal cost and the shape of the
demand curve
• There is no one-to-one relationship
between price and quantity
• There is no supply curve for a
monopolistic market
39
 Monopoly Power
• Pure monopoly is rare
• However, possible to have a market with
several firms, each facing a downward
sloping demand curve
– E.g., Firms produce similar goods that have
some differences, thereby differentiating
themselves from other firms
– Although firm is not a pure monopolist, they
have monopoly power
– Each firm will produce so that price exceeds
marginal cost
40
 Measuring Monopoly Power
• How can we measure monopoly power
to compare firms?
• What are the sources of monopoly
power?
– Why do some firms have more than
others?

41
 Measuring Monopoly Power
• Could measure monopoly power by the
extent to which price is greater than MC
for each firm (i.e., by size of mark-up)
• Lerner’s Index of Monopoly Power
– L = (P - MC)/P
• The larger the value of L (between 0 and 1) the
greater the monopoly power
– L can be expressed in terms of Ed
• L = (P - MC)/P = -1/Ed
• L is the firm’s mark-up ratio
• Ed is elasticity of demand for a firm, not the
42
market
Elasticity of Demand and Price
Markup
• Pricing rule for any firm with monopoly
power (same as for pure monopoly):
P  MC 1

P ED
• where Ed is elasticity of demand of the
firm, not the market demand
– If |Ed | is large, markup is small
– If |Ed | is small, markup is large
43
 Elasticity of Demand and Price
Markup
The more elastic is $/Q
$/Q demand, the less the
markup.

MC P* MC

P*
P*-MC
D
P*-MC

MR

D
MR

Q* Quantity Q* Quantity
 Sources of Monopoly Power
• Why do some firms have considerable
monopoly power, and others have little or
none?
• Monopoly power is determined by ability to
set price higher than marginal cost
• A firm’s monopoly power, therefore, is
determined by the firm’s elasticity of
demand

45
 Sources of Monopoly Power
• The less elastic the firm’s demand curve,
the more monopoly power a firm has
• The firm’s elasticity of demand is
determined by:
1) Elasticity of market demand
2) Number of firms in market
3) The interaction among firms

46
 Elasticity of Market Demand
• With one firm, their demand curve is
market demand curve
– Degree of monopoly power is determined
completely by elasticity of market demand
• With more firms, individual demand may
differ from market demand
– Demand for a firm’s product is more elastic
than the market elasticity

47
 Number of Firms
• The monopoly power of a firm falls as the
number of firms increases, all else equal
– More important are the number of firms with
significant market share (“major players”)
– Market is highly concentrated if only a few
firms account for most of the sales
• Many markets in Philippines highly concentrated –
beer, school supplies, drug retailing, shopping
malls, large department store, shipping, etc.
• Firms would like to create barriers to
entry to keep new firms out of market
– Patent, copyrights, licenses, economies of
48
scale
 Interaction Among Firms
• If firms are aggressive in gaining market
share by, for example, undercutting the
other firms, prices may reach close to
competitive levels
• If firms collude (in violation of antitrust
laws, where they exist), could generate
substantial monopoly power
• Markets are dynamic and therefore, so is
monopoly power (with changing demand
and costs, behavior of firm and
competitors) 49
 The Social Costs of Monopoly
Power
• Monopoly power results in higher prices
and lower quantities
• Does monopoly power make consumers
and producers in the aggregate better or
worse off?
• We can compare producer and consumer
surplus when in a competitive market and
in a monopolistic market
50
 The Social Costs of Monopoly
• In competitive market, PC = MC
• With monopoly power PM > MC (monopolist
gets their price from the demand curve)
• PM > PC and QM < QC
• There is a loss in consumer surplus when
going from perfect competition to monopoly
(see figure)
• A deadweight loss is also created with
monopoly
51
 Deadweight Loss from
Monopoly Power
$/Q Because of the
higher price,
Lost Consumer Surplus consumers lose
A+B and producer
MC gains A-C.
Deadweight
Loss
competitive
In a monopoly,
Pm market,price
market marketand
A price andwould
quantity quantity
be
B would
P m andbe
QmP and
, Cwhere
PC QC, where
MR = MC D = S
C
AR=D
Producer Surplus
Gained
Lost Producer Surplus
MR

Qm QC Quantity
52
 The Social Costs of Monopoly
• Social cost of monopoly is likely to exceed
the deadweight loss
• Firms may spend to gain monopoly power
– Lobbying
– Advertising
– Building excess capacity to enhance market
share
• Rent Seeking – spending money in
socially-unproductive efforts to acquire,
maintain or exercise monopoly
53
 The Social Costs of Monopoly
• The incentive to engage in rent-seeking
practices is determined by the advantage
to be gained by the firm from monopoly
power
• The larger the transfer from consumers to
the firm (rectangle A), the greater the
incentive for rent-seeking
• Hence, the larger the additional social cost
of monopoly (beyond DWL of B+C) due to
rent-seeking
54
 The Social Costs of Monopoly
• Government can regulate monopoly power
through price regulation
– Recall that in competitive markets, price
regulation creates a deadweight loss
– With a monopoly, price regulation can
eliminate deadweight loss by pushing price
down to the competitive level PC (see figure)
– The effect of the regulation depends on the
relationship between the regulated price and
the firm’s costs
55
 Price Regulation
When price is regulated to be no
higher than P1 , MR curve is
$/Q
MR horizontal at P1 for output levels
less than Q1. MR = P1 = AR
Pm
P1 MC

AC

AR
If left alone, a monopolist
For output levels
produces greater
Qm and than
charges PmQ. 1 ,
the original average and
marginal revenue curves apply. Qm Q1 Quantity
56
 Price Regulation
Marginal revenue curve
when price is regulated
$/Q to be no higher than P1 is ABCD.
MR
Quantity = Q1; Price = P1
Pm
A B
P1 MC

AC

AR

C
D
Qm Q1 Quantity
57
 Price Regulation
$/Q
MR

Pm MC
P1

P2 = P C
AC
P3

AR
P4
If price is lowered to P3 output
Any price below
decreases P4 results
to Q3 and
If price is lowered to aPCshortage
output
in the firm incurring a loss.
increasesresults (D=Q’3). Q and
to its maximum C
Qm Q1 Q3 Qc Q’3 Quantity
there is no deadweight loss. 58
 Regulating the Price of a
Natural Monopoly
• Natural Monopoly
– A firm that can produce the entire output of an
industry at a cost lower than what it would be if there
were several firms
– Usually arises when there are large economies of
scale (or small market demand)
• The market demand (AR) curve crosses the AC curve of the
firm at the declining portion of AC
• Therefore MC < AC
– Splitting the market between two firms results in each
firm’s demand curve shifting to the left of market
demand
• higher AC for each firm than when only one firm was
producing

59
Regulating the Price of a
Natural Monopoly
$/Q Market demand (AR) curve
crosses AC curve of the firm at If market demand is split
the declining portion of the AC between 2 firms, each
curve because of large firm’s D curve (D’) would
economies of scale or small be to the left of market D.
market demand AC would be higher.

MC

AC

AR = D
MR’ D’ MR

Quantity
60
 Regulating the Price of a
Natural Monopoly
• Unregulated, the monopolist would produce Qm
and charge Pm
• Government could regulate a lower price
– If price is set at competitive price (Pc) where D or
AR=MC, DWL is zero but the firm would lose money
and go out of business because AC > MC. Firm can’t
cover AC.
– If price is set at Pr where AR=AC, the firm will make
zero economic profit (no monopoly profit) but will
survive.
• This policy allows firm to produce the largest output possible
without going out of business.
• DWL is positive but less than at monopolist’s unregulated
price and quantity.
61
Regulating the Price of a
Natural Monopoly
At Pc (competitive price where
$/Q Unregulated monopolist
D=S or AR=MC ), the firm would
would produce Qm and
lose money and go out of
chargeCan’t
business. Pm. cover ACs
because AC > MC

At Pr where D=AC or AR=AC,

Pm firm makes zero economic
profit. Firm produces the
largest output possible without
going out of business.
AC
Pr

MC = S
PC
AR = D
MR

Qm Qr QC Quantity
62
 Limiting Market Power
• Market power harms some players in the
market
• Market power reduces output, leading to
deadweight loss
• Excessive market power could raise
problems of equity and fairness

63
 Limiting Market Power
• What can be done to limit market power
and keep it from being used anti-
competitively?
– Tax away monopoly profits and redistribute to
consumers
• Difficult to measure and find all those who lost
– Direct price regulation of natural monopolies
– Keep firms from acquiring excessive market
power
• Antitrust laws - prohibit actions to restrain or likely
to restrain competition
– read the fascinating account of the antitrust case against
Microsoft (“The United States and the European Union
versus Microsoft” – P&R, 8th ed., pp. 394-395) 64
 Limiting Market Power:
Antitrust Laws
• Philippines:
– Industry structures notoriously non-
competitive (highly concentrated)
– 1987 Constitution has section that contains
antitrust policy
• Sec. 19 Article XII (National Economy and
Patrimony): “The State shall regulate or prohibit
monopolies when the public interest so requires.
No combinations in restraint of trade or unfair
competition shall be allowed."
– Philippine Competition Act finally signed into
law July 2015, after being stalled for two
65
decades
 Monopsony
• A monopsony is a market in which there is a
single buyer
• Monopsony power is the ability of the buyer to
affect the price of the good and pay less than the
price that would exist in a competitive market
• In a monopsony, the single buyer faces the
market supply curve

66
 Monopsonist Buyer’s Decision
• Marginal value (MV) is the additional benefit
derived from purchasing one more unit of a good
– Equivalent to Demand curve
– downward sloping
• Marginal expenditure (ME) is the additional
cost of buying one more unit of a good
• Monopsonist buyer will buy until value from last
unit equals expenditure on that unit
MV = ME
67
 Monopsony
• The market supply curve is not the
marginal expenditure curve
– Market supply shows how much buyer must
pay per unit as a function of total units
purchased
– Supply curve is average expenditure curve
– Decision to buy extra unit raises price paid
for all units => marginal expenditure curve
lies above supply curve

68
 Monopsony
$/Q Suppliers will increase
ME
production by 1 unit if price
increases from P0 to P1. New
price P1 will apply to all units, not
just the unit Q1.
ME1 ● S=AE
Additional expenditure of
monopsonist in buying last unit
(ME1) would be greater than P1.
P1 ● The ME curve lies above the AE
(=S) curve
P0 ●

Q0 Q1= Q0 +1 Quantity

69
Monopsony vs Competitive Market
• Competitive Buyer
– Price taker
– Marginal expenditure = P = Average
expenditure
– Marginal value = D
– Decision rule: MV = ME = P
• Monopsonist Buyer
– ME > P
– Decision rule: MV = ME > P

70
Monopsony vs Competitive Market
$/Q Monopsony
• ME above AE = S
ME • Quantity where ME = MV:
Qm
• Price from Supply curve: Pm
S = AE

Competitive
PC • P = PC
Pm • Q = QC

MV

Qm QC Quantity
71
 Monopoly and Monopsony
• Monopsony is easier to understand if we
compare to monopoly
• We can see this graphically

72
Monopoly and Monopsony
$/Q Monopoly
For monopolist: MR = MC;
AR > MR; P > MC

MC
P*

PC

AR = D

MR

Q* QC Quantity
73
Monopoly and Monopsony
$/Q
ME Monopsony
For monopsonist: ME = MV;
ME > AE; MV > P

S = AE

PC
P*

MV

Q* QC Quantity
74
 Monopoly and Monopsony
• Monopoly • Monopsony
– MR < P = AR – ME > P = AE
– To maximize profit: – To maximize value
MR = MC or utility:
– Therefore: ME = MV
• P > MC – Therefore:
• Qm < Q C • P < MV
• Pm > P C • Qm < Q C
• Pm < P C
75
 Monopsony Power
• More common than pure monopsony are a
few firms competing among themselves as
buyers so that each firm has some
monopsony power
– E.g., Automobile industry as buyer of inputs
• Monopsony power gives them the ability to
pay a price that is less than marginal value

76
 Monopsony Power
• The degree of monopsony power
depends on three factors:
1. Number of buyers
• The fewer the number of buyers, the greater the
influence of individual buyers on price
2. Interaction Among Buyers
• The less the buyers compete, the greater the
monopsony power

77
 Monopsony Power
• The degree of monopsony power
depends on three factors (cont’d):
3. Elasticity of market supply
• Extent to which price is marked down below
MV depends on elasticity of supply facing
buyer
• If supply is very elastic, markdown will be
small
• The more inelastic the supply, the more
monopsony power

78
 Monopsony Power:
Elastic Versus Inelastic Supply
$/Q
Elastic $/Q Inelastic
ME
MV - P*
MV - P*
ME S = AE

S = AE
P*

MV P*

MV

Q* Quantity Q* Quantity
 Social Costs of Monopsony
Power
• Since monopsony power gives lower prices and
lower quantities purchased, we would expect
sellers to be worse off and buyers better off
• We can show the effects of monopsony power
using producer and consumer surplus compared
to competitive market
– For sole monopsonist, quantity is where ME = MV
and price is from supply curve
– For competitive market, quantity and price where
S=D

80
 Deadweight Loss from
Monopsony Power
$/Q ME

Deadweight Loss
Consumers
gain A-B S = AE
B
PC
A C
P*

MV
Lost Producer Surplus

Q* QC Quantity
81
 Class Assignment
Prepare to discuss the following questions
and exercises from P&R, chapter 10:
• Questions: 1- 8
• Exercises: 3-5, 7

82