24

Monopoly
 Pure Monopoly
• A monopoly is a single supplier to a market.
– Single Seller—the firm is the industry.
– No Substitutes—the product is unique.
– “Price Maker”—the firm can set whatever price
(or quantity) only subject to the market
demand.
– Barriers to Entry—there are barriers preventing
potential competitors from entering the market.
 Barriers to Entry
• Barriers to entry are the sources of all
monopoly power.
– Technical Barriers to Entry
– Legal Barriers to Entry
– Strategic Barriers to Entry
 Technical Barriers to Entry
• Economies of Scale or Scope: Production may exhibit
decreasing marginal and average costs over a wide
range of output levels or varieties.
– Natural Monopoly argument: To achieve low costs and low
prices, it is better to have a few large firms (and in the
extreme case, only one firm).

• Ownership or Control of Essential Resources

 Legal Barriers to Entry

• Patent: temporarily created to encourage

innovation.

• License: created by government to limit entry

into an industry.
 Strategic Barriers to Entry
• Predatory Pricing: cutting prices below cost,
intending to drive competitors out of the market,
or create barriers to entry for potential new
competitors.
• Maintaining Excess Capacity: maintaining a
plant size beyond what it needs to sustain its
ordinary level of production to signal potential
competitors that if they enter, it will expand
production and thus reduce product price.
• Acquisition: purchasing competitors outright.
Pure Monopoly’s Profit Maximization
• A monopolist chooses price p (or quantity q) to
max p ( p − c ) D ( p )
or
max q [ p ( q ) − c ]q

• What price (or output) level maximizes profit?

 Golden Rule: MR=MC
∆p  D ( p ) + p  ∆ D ( p )
• Price Setting: MR =
∆p
∆D ( p )
= D( p) + p
∆p
∆D ( p )
MC = c
∆p
∆D ( p )
∴ ( p − c ) = − D( p)
∆p

∆p (q )q + p (q )∆q
• Quantity Setting: MR =
∆q
∆p (q )
= q + p(q)
∆q
MC = c
∆p (q )
∴ q + p (q ) = c
∆q
 Inverse-Elasticity Rule
• Inverse-Elasticity Rule
p−c 1
=
p ε
∆Q P
where ε = −  .
∆P Q

• The firm’s “markup” over marginal cost depends

inversely on the elasticity of market demand.

• MR=MC and the Inverse-Elasticity Rule are

equivalent.
• Result: A monopolist would NEVER produce
in the inelastic part of the demand (0 ≤ ε < 1 ).
∆p (q )
=
 MR q + p (q )
∆q
∆p (q )
= q [1 − ε ]
∆q

∴ If 0 ≤ ε < 1, then MR<0 for ∆q>0.

Price MC The monopolist will maximize
profits where MR = MC
AC
P* The firm will charge a
price of P*
C
Profits can be found
in the shaded
rectangle
D
MR
Quantity
Q*
 Monopoly Profits

• Monopoly profits will be positive as long as

P > AC
• Monopoly profits can continue into the long
run because entry is not possible
– some economists refer to the profits that a
monopoly earns in the long run as monopoly
rents
• the return to the factor that forms the basis of the
monopoly
Price Price
MC MC
AC

AC
P* P*=AC

D D
MR MR

Q* Quantity Q* Quantity

Positive profits Zero profit

 No Monopoly Supply Curve
• With a fixed market demand curve, the
supply “curve” for a monopolist will only be
one point
– the price-output combination where MR = MC
• If demand shifts, the marginal revenue curve
shifts and a new profit-maximizing output
will be chosen
 Monopoly and Resource Allocation

Price
If this market was competitive, output
would be Q* and price would be P*
Under a monopoly, output would be
P**
Q** and price would rise to P**

P* MC=AC

∆
MR
Q** Q* Quantity
 DWL from Monopoly Pricing

Price Consumer surplus would fall

Producer surplus will rise
Consumer surplus falls by
P**
more than producer surplus
rises.
P* MC=AC

There is a deadweight
D
ΜΡ loss from monopoly
Q** Q* Quantity
 Calculating Monopoly Profit
• Suppose that the market for Frisbees has a
linear demand curve of the form
Q = 2,000 – 20P
or
P = 100 – Q/20
• The total costs of the Frisbee producer are
given by
C(Q) = 0.05Q2 + 10,000
• To maximize profits, the monopolist chooses
the output for which MR = MC

• Therefore, marginal revenue is

MR =Q*(P(Q)/Q)+P(Q)
= – Q/20 +100 – Q/20
=100 – Q/10
while marginal cost is
MC = 0.1Q
• Thus, MR = MC where
100 – Q/10 = 0.01Q
Q* = 500 P* = 75
• At the profit-maximizing output,
C(Q) = 0.05(500)2 + 10,000 = 22,500

π = P* ⋅ Q – C(Q) = 75 *500 – 22,500 = 15,000

Monopoly with General Linear Demand
• Suppose that the inverse demand function
facing the monopoly is of the form
P = a – bQ

• In this case
MR = – bQ+ a – bQ
= a – 2bQ
• Profit maximization requires that
MR = MC
a – 2bQ = c

Q* = (a – c)/2b

• Inserting this back into the inverse demand

function yields
P *= a – bQ*= a – (a – c)/2 = (a + c)/2
Profits Tax Levied on a Monopoly
• A profits tax levied at rate t reduces profit from
Π(y*) to (1-t)Π(y*).
• Q: How is after-tax profit, (1-t)Π(y*), maximized?
• A: By maximizing before-tax profit, Π(y*).

• So a profits tax has no effect on the monopolist’s

choices of output level, output price, or demands
for inputs.
– the profits tax is a neutral tax.
Quantity Tax Levied on a Monopolist
• A quantity tax of $t/output unit raises the
marginal cost of production by $t.

• So the tax reduces the profit-maximizing

output level, causes the market price to rise,
and input demands to fall.
– The quantity tax is distortional.
$/output unit

p(y)

p(y*)
MC(y)

y* y

MR(y)
$/output unit

p(y)
MC(y) + t
p(y*) t
MC(y)

y* y

MR(y)
$/output unit

p(y)
p(yt) MC(y) + t
p(y*) t
MC(y)

yt y* y

MR(y)
 The quantity tax causes a drop
$/output unit
in the output level, a rise in the
output’s price and a decline in
p(y) demand for inputs.
p(yt) MC(y) + t
p(y*) t
MC(y)

yt y* y

MR(y)
 Tax Pass-Through
• Can a monopolist “pass” all of a $t quantity
tax to the consumers?
• Suppose the marginal cost of production is
constant at $c per unit.
• With no tax, the monopolist’s price is
p* − c 1
= *
p *
ε
ε*
∴ p = c
*
.
ε −1
*
• The tax increases marginal cost to $(c+t) per
unit, changing the profit-maximizing price to
εt
p=
t
(c + t ) .
ε −1
t

• The amount of the tax paid by buyers is

p − p
t *
 εt ε*
p − p =(c + t )
t *
− c
ε −1
t
ε * −1
1 1
=(c + t )(1 + t ) − c(1 + * )
ε −1 ε −1
1 1 1
= c ( t − * ) + t (1 + t )
ε −1 ε −1 ε −1

is the amount of the tax passed on to

buyers.
•e.g. if ɛ = 2 constantly, the amount of the tax passed on is 2t.

Because at optimal monopoly price ɛ >1,

so the monopolist MAY pass on to
consumers more than the tax!
 Summary
• The most profitable level of output for the monopolist
is the one for which MR=MC
– Inverse-Elasticity Rule
– at this output level, p>MC
– the profitability of the monopolist will depend on the
relationship between price and average cost
• Relative to perfect competition, monopoly involves a
loss of consumer surplus for demanders
– some of this is transferred into monopoly profits
– some of the loss in consumer surplus represents a
deadweight loss of overall economic welfare
• a sign of Pareto inefficiency
 Bonus Q: Monopoly Pricing and Tax
• A monopolist faces the demand function as
q=2000–100p, with $1000 fixed cost and marginal cost
of $4.

1. Write down the monopolist’s total revenue function

and total cost function.
2. Find out its profit-maximizing quantity and profit.
3. What would be the smallest fixed cost for the
monopolist to stop producing?
4. Suppose government impose a quantity tax $2 on the
monopolist. What is the new monopoly price?
 Reading Assignment
• Please read Ch 25: Monopoly Behavior before
next lecture.
– We will focus on Price Discrimination.