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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.

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Chapter 11: Monopoly & Monopsony

In this chapter we will cover:

11.1 Monopoly Features11.2 Monopolistic Profit11.3 Monopoly Supply11.4 Inverse Elasticity Pricing Rule11.5 Welfare Effect of Monopolies11.6 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.

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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)ie: TC=Q2

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A monopolist’s profit is the difference between total revenue and total cost:

Profit=TR-TCIe: Profit=aQ-bQ2-Q2

The monopolist's profit maximization problem:

Max (Q) = TR(Q) - TC(Q) Q

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

If MR< MC, the monopolist is decreasing profit and should not produce

Therefore (like PC), the monopolist maximizes profits when MR=MC.

7Q

Q

TR

TC

Profit

D

MC

MR

P

MR=MC

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Demand: P=20-2QMR=20-4QMC=5+Q

MR=MC5+Q=20-4Q

5Q=15Q=3

P=20-2qP=14

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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:

Q

PQPMR

Q

PQQP

Q

TRMR

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Revenue Change: Q increases to Q2

Demand

Revenue Lost on units

Q

P

Q2

P2

Q1

Revenue gained on new units

P1

Therefore marginalrevenue is less thanprice.

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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)=8P(11)=6

Revenue gained = P(11) = 6Revenue lost =[P(10)-P(11)]10Revenue lost = (8-6)(10)=20

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Marginal Revenue and Linear Demand

Q

P

Demand: P=100-4Q

When demand is linear, MR has a slope twice as steep.

MR=100-8Q

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For the monopolist,

AR(Q)=TR(Q)/QAR(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)If Q>0

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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

OrPxQ-ACxQ

Or(P-AC)Q

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Price

Quantity

Demand curve

MR

20

80

MC

AC

20

100

50

e

Profit

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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

QuantityD2MR220

80

MC20

D1

MR1

Here the monopolist offers 20 units at 2 different prices, dependent on demand

Therefore, no supply curve exists

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We can rewrite the MR curve as follows:

MR = P + QP/Q = P(1 + (Q/P)(P/Q))

= P(1 + 1/)

where: is the price elasticity of demand, (P/Q)(Q/P)

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Using this formula:

When demand is elastic ( < -1), MR > 0When demand is inelastic ( > -1), MR < 0When 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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Example: Elastic Region of the Demand Curve

Quantity

Price

a/2b a/b

aElastic region ( < -1), MR > 0

Inelastic region (0>>-1), MR<0

Unit elastic (=-1), MR=0

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Since at equilibrium, MC=MR:

*

*1

**

)1

1(*

P

MCP

MCPP

PMC

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:

*

*1

**

)1

1(*

P

MCP

MCPP

PMC

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

Quantity

D0

MR0

Q0

P0

MC

D1MR1

P1

Q1

•Here an increase in demand increased monopoly price and quantity

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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=20-2QMR=20-4Q

MR=MC20-4Q=Q

4=Q

P=20-2QP=20-2(4)

P=12

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AFTER DEMAND SHIFT: P=35-2QMR=35-4Q

MR=MC35-4Q=Q

7=Q

P=35-2QP=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

Quantity

D0

MR0

Q0

P0

MC

MC1

P1

Q1

•An increase in cost increases monopoly price and decreases quantity supplied

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• 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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MC=S

Demand

MRQM

PM

PC

QC

CS with competition: A+B+CPS with competition: D+E

A

B C

D

E

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MC=S

Demand

MRQM

PM

PC

QC

A

B C

D

E

DWL = C+E

CS with monopoly: A PS with monopoly:B+D

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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/bribesAdvertisingHiring Thugs

This rent seeking behaviour is a social cost beyond simple deadweight losses

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MC=S

Demand

MRQM

PM

PC

QC

A

B C

D

E

DWL = C+E

Maximum rent seeking cost=B+D

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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:

41Quantity

Price

Demand

AC

If total market quantity is 45,000, one firm has a natural monopoly

Example: Natural Monopoly

45,00022,500

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Q

Price

Demand

AC

If total market quantity increased to 80,000, the natural monopoly might not stand

Example: Natural Monopoly

80,00040,000

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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 reasons

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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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MC=S

Demand

MRQM

PM

PC

QC

If PX was still

profitable to the monopolist, it could keep other firms out of the market.

Lowering profits to avoid competition

PX

PC Losses

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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:

L

wLwMEL

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Monopsonist Increases Labour:

Supply

Wage increase of current workers

L

W

L2

W2

L1

Wage of additional workersW1

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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+3QME: 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:

Supply

L

W

W*

L*

MRPL

MEL

ME=MRP

Wage

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

W=10+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+QME: W=20+2Q

ME=MRP20+2Q=100-2Q

4Q=80Q=20

W=20+QW=20+20

W=40

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Welfare Effects of Monopsonists:

Supply

L

W

W*

L*

MRPL=DPC

MEL

PCConsumer Surplus

Wage

PCProducer Surplus

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Monopsonist DWL:

Supply

L

W

W*

L*

MRPL=DPC

MEL

MonopsonistConsumer Surplus

Wage

MonopsonistProducer Surplus

DWL

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Chapter 11 SummaryA monopoly consists of one firm selling a goodA monopolist faces the market demand curve

To sell more, it must decrease priceMR is therefore less than demand

A monopolist chooses quantity where MC=MRThis quantity is sold at a price found on the demand curveThis typically produces a profit

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Chapter 11 SummaryA 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 lossThis 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 SummaryA monopsonist is a single BUYER of a good or inputMonopsonists deal with the market supply curveMonopsonists 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