ECON3010: Lecture Notes

Topic 4: Markets and Prices

Market Power and Monopoly
Safoura Moeeni
University of Manitoba

Safoura Moeeni Monopoly 1

Textbook Reading

• Chapter 25: Monopoly

• Chapter 28: Oligopoly

Safoura Moeeni Monopoly 2

Map

Market Structure
& Firm Behaviour

Competitive Market Oligopoly Monopoly

Monopolistic
Perfect Competition
Competition

Safoura Moeeni Monopoly 3

Firm Behaviour & Market Structure
Perfect Monopolistic Oligopoly Monopoly
Competition Competition

#Firms Many Many Few One

Type of Product identical Differentiated Identical/ diff Unique

Barriers to Entry None None Some Many
Market power None ?
Pricing decision None ?
Output decision No restriction ?
(demand curve) (flat)
Price Price=Mc ?
LR Profit Zero (MC=MR) ?
Government Little to None ?
intervention (efficiency)

Safoura Moeeni Monopoly 4

Map
Market Structure
& Firm Behaviour

Competitive Market Oligopoly Monopoly

Monopolistic Profit Maximization

Perfect Competition
Competition (with market power)

Profit Maximization
(sort-run vs long-run)
Reacts to market welfare effects & role
changes of government

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This Lecture
• In the previous lectures (chapter 20-24), we explained
where supply curves come from by studding the
behavior of firms in a perfect competitive market.
• In the real world, there are very few examples of
perfectly competitive industries. Firms often have
market power, or an ability to influence the market price
of a product. The most extreme example is a monopoly.
• In this lecture, we will see how firms with market power
don’t treat output price as fixed but instead recognize
that price depends on the quantity produced.
Safoura Moeeni Monopoly 6
Map
Market Structure
& Firm Behaviour

Competitive Market Oligopoly Monopoly

Monopolistic Profit Maximization

Perfect Competition
Competition (with market power)

Profit Maximization
(sort-run vs long-run)
Reacts to market welfare effects & role
changes of government

Safoura Moeeni Monopoly 7

Sources of Market Power

The key difference between perfect competition and a market structure

in which firms have pricing power is the presence of barriers to entry,
or factors that prevent entry into the market with large producer surplus.

• Normally, positive producer surplus in the long run will induce additional firms
to enter the market until it is driven to zero.

• The presence of barriers to entry means that firms in the market may be able
to maintain positive producer surplus indefinitely.

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Monopoly
Sources of Market Power

1- Large Economies of Scale: Natural Monopoly

One common barrier to entry results from a production process that
exhibits economies of scale at every quantity level.
• Long-run average total cost curve is downward sloping; diseconomies never
emerge.
Results in a natural monopoly:
• It’s more efficient for a single firm to produce the entire industry output.
• Splitting output across multiple firms raises the average cost of production.
‒ An example is a production process with the following total cost
structure:
100
TC 100  10Q  ATC   10
Q

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Monopoly
Sources of Market Power

1- Extreme Scale Economies: Natural Monopoly

2- Switching Costs
Another barrier to entry results from the presence of consumers’
switching costs, which can result from:
• brand-related opportunity costs (e.g., preferred status on an airline).
• technology constraints (e.g., once you buy a DIRECTV satellite dish and
install it, the only way to switch to DISH Network is to get a new satellite dish
and converter box installed).
• search costs (e.g., health insurance plans).

Some goods have characteristics that make them network goods.

• A good whose value to each consumer increases with the number of other
consumers of the product (Instagram)

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Monopoly
Sources of Market Power

1- Extreme Scale Economies: Natural Monopoly

2- Switching Costs
3- Product Differentiation
For most non-commodity markets, consumers may not treat products
from different firms as perfect substitutes.
• Example: Bicycle makers operate in what could be thought of as the same
market, but not every potential bike buyer will see a Trek bicycle as exactly
the same thing as a Cannondale.

Product differentiation refers to imperfect substitutability across

varieties of a product.

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Monopoly
Sources of Market Power

1- Extreme Scale Economies: Natural Monopoly

2- Switching Costs
3- Product Differentiation
4- Absolute Cost Advantages or sole ownership of a resource
Many production processes rely on scarce inputs (e.g., natural resource
products).

A firm can have an absolute cost advantage over other firms in obtaining
the key input.

Controlling this input allows a firm to keep its costs lower than those of
any other competitor.

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Monopoly
Sources of Market Power

1- Extreme Scale Economies: Natural Monopoly

2- Switching Costs
3- Product Differentiation
4- Absolute Cost Advantages or Control of Key Inputs
5- Government Regulation
A final important barrier is government regulation that limits entry to a
market.
• Examples:
‒ Patents and copyrights
‒ Licensing requirements (e.g., medical board certification)
‒ Prohibition of competition (e.g., U.S. Postal Service)

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Monopoly
Market Power and Marginal Revenue

A true monopolist faces the market demand curve:

• There are no competing firms in this market.
• Price is not fixed; the only way to sell more of a product is to lower the price.

How does this differ from perfect competition?

Perfectly competitive firms can sell as much as they want at the market price.

Other market structures associated with downward-sloping demand:

• Oligopoly is a market structure in which a few competitors operate.

• Monopolistic competition is a type of imperfect competition where a large

number of firms have some market power, but each makes zero economic
profit in the long run.

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Monopoly
Market Power and Marginal Revenue

Marginal Revenue
In perfect competition, the demand curve facing an individual firm is
horizontal, and marginal revenue is equal to price.
If a firm has market power, the demand curve for its product(s) will have a
downward slope.
What does this imply for the shape of the marginal revenue curve?
‒ It must also be downward sloping.

Consider the production decisions of Durkee-Mower, Inc., a

Massachusetts firm that makes Marshmallow Fluff.
• Has had a dominant market position since the 1920s
• Table 9.1 shows how price and marginal revenue are related to the quantity of
Fluff produced.
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Monopoly
Market Power and Marginal Revenue

Marginal Revenue for Marshmallow Fluff

Quantity Price Total Revenue
 ΔTR 
millions of pounds  $ / pound  $ millions  Marginal Revenue ($ millions)  MR = 
 ΔQ 
Q  P  TR = P × Q 
0 6 0 -
1 5 5 5
2 4 8 3
3 3 9 1
4 2 8 -1
5 1 5 -3

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Monopoly
Market Power and Marginal Revenue

Marginal revenue is not equivalent to price for a firm facing a downward-

sloping demand curve.
Why is this the case?
‒ When a firm produces more of a product, the price for all of its
products in the marketplace falls.

• This occurs because we are considering a specific market (time and place) --
decisions are not sequential.

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Monopoly
Market Power and Marginal Revenue

Marginal revenue is not equivalent to price for a firm facing a downward-

sloping demand curve.

Marginal revenue is the change in total revenue associated with an

increase in output, which is composed of two parts.

Two components for a firm with market power:

1. Increase in total revenue associated with an increase in sales
2. Decrease in total revenue associated with the fall in market price for all
previously produced units of output

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Monopoly
Market Power and Marginal Revenue

Understanding Marginal Revenue

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Monopoly
Market Power and Marginal Revenue

The two opposing effects on marginal revenue of an increase in

production by a monopolist can be examined mathematically:

1. The additional revenue from selling one more unit at market price:

2. The fall in revenue associated with a decline in market price for all
units produced:

Combining these effects gives the equation for marginal revenue:

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Monopoly
Market Power and Marginal Revenue

Consider what the equation for marginal revenue means

Consider a linear demand curve ( is constant).

The inverse demand curve is given by P = a − bQ
therefore:
P P
MR P  Q a  bQ  Q a  bQ   b Q a  2bQ
Q Q

MR = a −2 bQ
(MR ≠ P)
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Monopoly
Market Power and Marginal Revenue

Question 1:
A firm’s demand curve is Q = 200 – P. Which is the marginal revenue
that corresponds to this demand curve?

A. MR = 200 – 2P
B. MR = 400 – 2Q
C. MR = 200 – 2Q
D. MR = 400 – 2P

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Monopoly
Market Power and Marginal Revenue

Question 2:
A firm’s demand curve is Q = 100 – 2P. What is the marginal revenue
when Q = 10?

A. 10
B. 20
C. 40
D. 80

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Monopoly
Profit Maximization for a Firm with
Market Power

How to Maximize Profit

Firms with market power are still assumed to maximize profits.
• However, unlike in perfect competition, production decisions influence price.

MR ≠ P

How much will firms choose to produce?

• They will engage in production until MR = MC

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Monopoly
Profit Maximization for a Firm with
Market Power

Profit Maximization: A Graphical Approach

Consider the market for iPads; assume that the marginal cost of
production for Apple is constant at $200 per unit.

There are three steps to determining the profit-maximizing quantity

of production:
1. Derive the marginal revenue curve from the demand curve.
2. Find the output quantity at which marginal revenue equals marginal cost.
3. Determine the profit-maximizing price by locating the point on the demand
curve at the optimal quantity level.

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Monopoly
Profit Maximization for a Firm with
Market Power
1) Suppose MC is constant (MC=$200)

Profit is maximized when

marginal revenue is equal to
marginal cost.

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Monopoly
Profit Maximization for a Firm with
Market Power

Profit Maximization: A Mathematical Approach

Consider, again, the market for iPads. The marginal cost of production
for Apple is constant at $200 per unit. Now suppose demand is given by
Q = 200 − 0.2P
where quantity is measured in millions and price in dollars.

How do we determine the profit-maximizing price–quantity

combination that Apple should choose?
1. Derive the marginal revenue curve from the demand curve.
2. Find the output quantity for which marginal revenue is equal to marginal
cost.
3. Determine the profit-maximizing price by locating the point on the demand
curve at the optimal quantity level.

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Monopoly
Profit Maximization for a Firm with
Market Power

Profit Maximization: A Mathematical Approach

1. Derive the marginal revenue curve from the demand curve.
Q = 200 − 0.2P

0.2P = 200 − Q → P = 1,000 − 5Q

This is a linear demand curve, so marginal revenue takes

the form
MR = a − 2bQ = 1,000 − 10Q

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Monopoly
Profit Maximization for a Firm with
Market Power

2. Find the output quantity for which marginal revenue is equal to

marginal cost.
For this step, simply set the equation for marginal revenue equal to
$200 and solve for quantity.

MR = MC → 1,000 − 10Q = 200 → Q* = 80 million

3. The profit-maximizing price can be found by substituting the profit-

maximizing quantity into the inverse demand curve.

P* = 1,000 − 5(80) → P* = $600

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Monopoly
Profit Maximization for a Firm with
Market Power
2) Suppose MC is not constant (MC=5Q)

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Monopoly
Firm Behaviour & Market Structure

(a) Perfect Competition (b) Monopoly

Safoura Moeeni Monopoly 31

Profit Maximization for a Firm with
Market Power
Example

At the profit-maximizing output level

So, if and

then
And the profit maximizing level is

Causing the market price to be

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Monopoly
Profit Maximization for a Firm with
Market Power
Example

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Monopoly
Profit Maximization for a Firm with
Market Power

Market Power:
Suppose that market demand becomes less sensitive to changes in
price (i.e., the own-price elasticity of demand becomes less negative).
Does the monopolist exploit this by causing the market price to rise?

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Monopoly
Profit Maximization for a Firm with
Market Power

Market Power:

Own-price elasticity of demand is

So,
Suppose the monopolist’s marginal cost of production
is constant, at $k per output. For a profit maximum,

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Monopoly
Profit Maximization for a Firm with
Market Power

A Markup Formula for Companies with Market Power: The

Lerner Index

It is useful to have a general approach to determining the rate of markup

for firms with market power.
• Markup is the percentage of a firm’s price that is greater than its
marginal cost.
• The Lerner Index is a measure of a firm’s markup, which indicates
the degree of market power the firm enjoys.

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Monopoly
Profit Maximization for a Firm with
Market Power

Markup for Companies with Market Power

It is useful to have a general approach to determining the rate of markup
for firms with market power.
• Markup pricing is the output price that is greater than its marginal
cost (Marginal cost + “Markup”).

• The monopolist’s price

• Markup = price – MC

For example, if ε = –3, then the markup is k/2. if ε = –2, then the markup
is k.
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Monopoly
Map
Market Structure
& Firm Behaviour

Competitive Market Oligopoly Monopoly

Monopolistic Profit Maximization

Perfect Competition
Competition (with market power)

Profit Maximization
(sort-run vs long-run)
Reacts to market welfare effects & role
changes of government

Safoura Moeeni Monopoly 38

How a Firm with Market Power Reacts
to Market Changes

1- Response to a Change in Marginal Cost

Just as in the case of a firm in a perfectly competitive industry, firms with
market power will alter output decisions in response to changing
marginal costs of production.
Suppose an accident at the factory of an Apple parts supplier leads to
an increase in the marginal cost of iPad production from $200 to $250
per unit.
How will this affect Apple’s production decisions?

‒ Marginal cost will increase, and because of the downward-sloping

marginal revenue curve, the new optimal production should decrease.
‒ Price will also decrease as a result.

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Monopoly
How a Firm with Market Power Reacts
to Market Changes

How a Firm with Market Power Reacts to an Increase in

Marginal Cost

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Monopoly
How a Firm with Market Power Reacts
to Market Changes

Response to a Change in Demand

Now suppose there is a parallel shift in the demand for iPads due to a
doubling of the iPad’s battery life. The new demand curve is given by

Q = 280 − 0.2P

The new inverse demand curve is given by

P = 1,400 − 5Q

To find the new profit-maximizing price–quantity combination, follow the

same three-step procedure.

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Monopoly
How a Firm with Market Power Reacts
to Market Changes

2- Response to a Change in Demand

1. Derive the marginal revenue curve from the inverse demand curve.
P = 1,400 − 5Q
Marginal revenue takes the form
MR = a − 2bQ → MR = 1,400 − 10Q

2. Find the output quantity for which marginal revenue is equal to

marginal cost.
MR = MC → 1,400 − 10Q = 200 → Q* = 120 million

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Monopoly
How a Firm with Market Power Reacts
to Market Changes

Response to a Change in Demand

3. The profit-maximizing price can be found by substituting the profit-
maximizing quantity into the inverse demand curve.

P = 1,400 − 5(120) = $800

So, an outward shift in demand increases both the quantity of iPads

produced and the price at which each is sold.

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Monopoly
How a Firm with Market Power Reacts
to Market Changes

3- Changing the Price Sensitivity of Consumers

A major way in which firms with market power react differently from
those subject to perfect competition is in response to changes in the
price sensitivity of demand.

For instance, consider what would happen to the demand for iPads if a
new competing tablet is introduced to the market that makes consumers’
demand for iPads more price-sensitive without changing the quantity
demanded at the current price.
• Demand for iPads should have become more price-elastic.
• The demand curve for iPads should have had a shallower slope.

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Monopoly
How a Firm with Market Power Reacts
to Market Changes

Responses to a Rotation in the Demand Curve

In perfect competition, the shape of the demand

curve does not matter—only the intersection
with the supply curve.
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Monopoly
Map
Market Structure
& Firm Behaviour

Competitive Market Oligopoly Monopoly

Monopolistic Profit Maximization

Perfect Competition
Competition (with market power)

Profit Maximization
(sort-run vs long-run)
Reacts to market welfare effects & role
changes of government

Safoura Moeeni Monopoly 46

The Winners and Losers of Market
Power

The Inefficiency of Monopoly

A market is Pareto efficient if it achieves the maximum possible total

gains to trade. Otherwise a market is Pareto inefficient.

If firms with market power find it profitable to choose a level of output

that is different from what would occur in perfect competition, there must
be some additional benefit.

How much better off are firms when they have market power, and
what does this imply for consumers’ well-being?

‒ Examine Producer and Consumer Surplus to see!

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Monopoly
The Winners and Losers of Market
Power

Consumer and Producer Surplus under Market Power

Returning to the example of Apple and the iPad, recall that Apple has a
marginal cost of production of $200 per unit and faces inverse demand:
P = 1,000 − 5Q
where quantity is measured in millions.

Producer surplus is the difference between the monopoly price of iPads

and the constant marginal cost, multiplied by the quantity sold.

PS = (Pm − MC) ×Qm = ($600 − $200) ×80 million = $32,000

million = $32 billion

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Monopoly
The Winners and Losers of Market
Power

Consumer and Producer Surplus under Market Power

Consumer surplus is calculated as the area under the inverse demand
curve and above the sales price.

First, calculate the demand choke price, which is the price at which
quantity demanded is equal to zero.
P = 1,000 − 5(0) = $1,000
With linear demand, consumer surplus is a right triangle with height equal
to the demand choke price net of the sales price and length equal to
quantity sold.
CS = ½(Pchoke − Pm) ×Qm = ½($1,000 − $600) ×80 million = $16,000
million = $16 billion
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Monopoly
The Winners and Losers of Market
Power
Consumer and Producer Surplus under Perfect Competition
How would the outcome of the market for iPads change under perfect
competition?
In perfect competition, marginal cost is equal to industry supply, and
equilibrium occurs when industry supply is equal to demand.
P = MC → 1,000 − 5Q = 200 → Q = 160 million
and price is equal to $200.

What happens to Apple’s producer surplus?

‒ It equals zero in perfect competition because P = MC.
Consumer surplus becomes
CS = ½(Pchoke − PC) ×QC = ½($1,000 − $200) ×160 million = $64,000
million= $64 billion
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Monopoly
The Winners and Losers of Market
Power

Surplus from the Apple iPad

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Monopoly
The Winners and Losers of Market
Power

The Deadweight Loss of Market Power

Producer surplus is eliminated under perfect competition, but consumer
surplus increases.
Also, net surplus improves under perfect competition, from $48 billion to
$64 billion.
This illustrates the loss in efficiency in markets that are not perfectly
competitive.
• When producers have market power, they can improve overall outcomes.
• However, if producers reduce output to a level below the perfectly
competitive level, total surplus falls.
This loss of efficiency is a deadweight loss and, in this case, it is equal
to $16 billion.

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Monopoly
The Winners and Losers of Market
Power

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Monopoly
The Winners and Losers of Market
Power

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Monopoly
Governments and Market Power:
Regulation, Antitrust, and Innovation

The deadweight loss associated with market power can justify

government intervention if regulations help achieve a more competitive
or efficient outcome.
Direct Price Regulation
In some cases, the government will regulate price rather than attempting
to dismantle a monopoly or encourage new participants.
• This is often the case for natural monopolies, or industries in which a firm’s
long-run average total cost falls continuously as output increases.
Consider a utility that provides electricity to a town.
• Significant fixed costs (generation and transmission)
• Low marginal costs

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Monopoly
Governments and Market Power:
Regulation, Antitrust, and Innovation

Government Regulation of a Natural Monopoly

What happens if a regulator

forces the utility to provide the
“efficient” level of electricity
(where LMC = demand)?

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Monopoly
Governments and Market Power:
Regulation, Antitrust, and Innovation

Antitrust laws are designed to promote competitive markets by

restricting behaviors that limit competition.
• Mergers and acquisitions
• Price fixing and other forms of collusion
• Predatory pricing
Can be difficult to determine if concentration is bad for consumers

In other cases, the government may actually promote monopolies.

• Patents, licenses, copyrights
‒ Designed to spur innovation
‒ In setting length of patents, must balance the incentive for innovation with the
reduction in consumer welfare that comes with granting a monopoly.

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Monopoly
Governments and Market Power:
Regulation, Antitrust, and Innovation

Monopoly Power and Innovation

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Monopoly
Conclusion
• In this chapter, we have shown how firms with market power don’t
treat output price as fixed but instead recognize that price depends
on the quantity produced.
• Firms produce where marginal cost is equal to marginal revenue.
• Equilibrium output is lower than under perfect competition.
• Market power leads to a deadweight loss.

• In the next lecture (Chapter 28), we examine firms with degrees of

market power that fall between perfect competition and monopoly:

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Monopoly