The Production Decision of a Monopoly Firm

Alternative market structures:

• perfect competition

• monopolistic competition

• oligopoly

• monopoly

The following market attributes characterize the case of monopoly:

– There is a single seller of a product having no close substitutes; there is only one source of supply.

– There is complete information regarding price and product availability.

– There are barriers to new firms entering the market.

Reasons for barriers to entry include the following:

• Government franchises and licenses

• Patents and copyrights

• Ownership of the entire supply of a resource

• Economies of scale (natural monopoly)

Generally, a firm has monopoly power if by producing more or less of the good,

the market price is affected.

A firm with monopoly power is a price-maker.

Such a firm is not able to choose price and quantity.

The firm’s marginal revenue from selling an additional unit will be less than the price

received for that unit; MR < P.

Marginal revenue for a firm with monopoly power

Suppose a firm’s demand curve is downward sloping and all units of the good are sold at

the same price.

Marginal revenue is the additional revenue that results from the sale of an additional unit.

MR = P - (reduction in price)(previous quantity)

$8.30 = $9.10 - (.10 $/unit)(8 units)

= $9.10 - $0.80

Explanation for why MR < P:

To sell additional units, the firm must lower price. There is an associated revenue loss resulting from the infra-marginal units being sold at a lower price than would otherwise have been the case.

FACT: Marginal revenue can be negative even when price is positive.

MR = P - (reduction in price)(previous quantity)

-$0.10 = $4.90 - (.10 $/unit)(50 units)

= $4.90 - $5.00

Q

QQ3

Q

Q1

Q1

Q1

Q2

Q2

Q2

Q3

Q3

Q4

Q4

Q4Q5

Q5

Q5

$

$/Q

$/Q

P1P2

P3P4P5

P

TR

TR

D

MR

elastic demand

inelastic demand

TR1

TR2

TR4

TR3

TR5

Marginal Revenue and the price elasticity of

demand.

QQ3

$/Q

MR

D

Marginal Revenue and the price elasticity of demand.

D

P

Q

Unit elastic demand

Inelastic demand

Elastic demand

MR

FACT: A firm having monopoly power will never choose to produce a level of output corresponding to an inelastic point on its demand curve.

Π = TR - TC

If demand is price inelastic, reducing the level of output will result in an increase in TR and a reduction in TC, implying an increase in profits, Π.

Q

$ perunit MC

AVCP1

Q1

D

MR

What level of output will the firm produce?

Q2

Profit maximizing output rule:

A profit-maximizing firm will produce the level of output where MC = MR, provided that the corresponding total revenue is at least as large as than associated total variable cost (i.e., P >AVC).

If the price corresponding to the output where MR = MC is less than the corresponding AVC, the firm will shut down.

Q

P$ perunit

MC

AVC

10,000

$2.00

$2.50

$5.00

FC

FC

FCAVCPQ

FCAVCQPQ

FCVCTR

000,25$

)50.2$00.5($000,10

)(

In the long-run, a monopolist may exit or adjust its scale of production (i.e., adjust its mix of inputs).

Profits will be nonnegative in the long-run.

If a firm continues to produce, it will do so at the lowest average cost possible.

Q

P$/Q

MC

Q1

P1

Q2

DMR

Marginal value to buyer (and society)

Marginal private (and social) cost

Marginal value to monopolist

The Welfare Cost of Monopoly

Q

P$/Q

MC

Q1

P1

Q2

D

MR

deadweight loss

Q

P$/Q

MC

Q1

P1

Q2

D

MR

monopolyoutput

efficient quantity

The Welfare Cost of Monopoly

monopolyoutput

efficient quantity

Perfect Price Discrimination

A monopolist who knows each buyer’s demand (willingness to pay) and is able to charge each buyer a different price for each unit purchased is said to be able to perfectly price discriminate.

Q

P$/Q

Q1

P1

DMR

MR with noprice discrimination

MR with perfect price discrimination

Marginal Revenue with and without Perfect Price Discrimination

Q

P$/Q

MC = AC

Q1

P1

Q2

D = MR

Profit Maximization in the Case of Perfect Price Discrimination

Q

P$/Q

MC = AC

Q1

P1

Q2

DMR

Profit Maximization in the Case of No Price Discrimination

Consumers surplus

Producer surplus (monopoly profits)

Q

P$/Q

MC = AVC

Q1

P1

Q2

D = MR

Distributional Consequences of Perfect Price Discrimination