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Market Chapter Power: Monopoly and Monopsony
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Last Time
Competitive Markets: Flat Demand Curve for
firms
Firms set MC(q)=p Markets are efficient when p=MC: maximize
CS+PS
Thus, competitive markets are efficient
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Roadmap
Monopoly: Firms have control over prices. Firms choose MR=MC, but MR is no longer
equal to P! (because it is not perfectly competitive)
Supply decision now depends on both demand
curve for the firm and marginal costs
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Monopoly
Characteristics of Monopoly:
1. One seller - many buyers 2. One product (no good substitutes) 3. Barriers to entry 4. Price setter
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Monopoly
The monopolist is the supply-side of the market
and has complete control over the amount offered for sale
Monopolist controls price but must consider
consumer demand
Profits will be maximized at the level of output
where marginal revenue equals marginal cost
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Average and Marginal Revenue
Monopolist also needs to find marginal
revenue, the change in revenue resulting from a unit change in output
However, (unlike perfect competition) the
firm's marginal revenue is no longer equal to price!
The more the firm sells, the lower the price it
can command for its product
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Average and Marginal Revenue
Finding Marginal Revenue
Assume a monopolist with demand:
P=6Q
Total Revenue
R(Q) = P Q = (6 Q) Q
Marginal Revenue:
R Q [( 6 Q )Q ] Q 6 2Q
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Average and Marginal Revenue
R Q [ P (Q )Q ] Q P [ P (Q )] Q Q
Price falls on all units that are sold
Sell an extra unit
Average Revenue
AR=R/Q=(PQ)/Q=P
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Total, Marginal, and Average Revenue
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Average and Marginal Revenue
$ per unit of output
7 6
Technical Note: the MR is half the distance of the AR (Demand curve) on the horizontal for linear demand functions. See formula.
5 4 3 2
1 0
Marginal Revenue
Average Revenue (Demand)
1
2
3
4
5
6
7 Output
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Monopoly
Observations
1. To increase sales the price must fall 2. MR < P 3. Compared to perfect competition
No change in price to change sales MR = P
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Monopolist's Output Decision 1. Profits maximized at the output level where MR = MC
2. Cost functions are the same
(Q ) R(Q ) C (Q ) / Q R / Q C / Q 0 MC MR or MC MR
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Monopolist's Output Decision
At output levels below MR = MC, the
decrease in revenue is greater than the decrease in cost (MR > MC)
At output levels above MR = MC, the
increase in cost is greater than the decrease in revenue (MR < MC)
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Monopolist's Output Decision
$ per unit of output
MC
P1
P* AC
P2
Lost profit
D = AR
MR
Q1
Lost profit
Q*
Q2
Quantity
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Monopoly: An Example
Cost
C (Q ) C Q
50 2Q
40 40Q 40
Q2
MC
Demand : P (Q ) R (Q ) MR P (Q )Q R Q
Q Q2
2Q
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Monopoly: An Example
MC MR 2Q 40 2Q 4Q 40 Q 10
P (Q ) P (Q ) P (Q )
40 Q 40 10 30
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Monopoly: An Example
By setting marginal revenue equal to marginal
cost, we verified 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 produce little or no
output (average
Profit increases and q increases, maximized at Q*=10
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Example of Profit Maximization
$/Q
40
MC
Profit = (P - AC) x Q = ($30 - $15)(10) = $150
P=30
Profit
AC AR
20 AC=15
10
MR
0
5
10
15
20
Quantity
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Monopoly
A Rule of Thumb for Pricing
We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice Looking at Marginal Revenue we can see that it has two components
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A Rule of Thumb for Pricing
R Q [ P(Q )Q ] Q P [ P(Q )] Q Q
Price falls on all units that are sold
Sell an extra unit
Producing one more unit brings in revenue P With downward sloping demand, producing and
selling one more unit results in small drop in price P/ Q
Reduces revenue from all units sold, change in revenue:
Q( P/ Q)
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A Rule of Thumb for Pricing
MR P Q P Q P Q
1
Q P P P
P1
Q P / Q P
Elasticity 1
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P (1 Ed )
A Rule of Thumb for Pricing
is maximized where MR P P P MC P MC 1 1 ED
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MC
1
ED 1 ED
MC
P
A Rule of Thumb for Pricing
(P MC)/P is the markup over MC as a
percentage of price
Known as the Lerner Index
Value lies between 0 and 1 (the larger the value, the
greater the degree of monopoly power)
The markup (P MC) should equal the
inverse of the elasticity of demand
Price is expressed directly the as markup over
marginal cost
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A Rule of Thumb for Pricing: Example
9. P 1 Assume Ed P 1 4 MC 9 1 9 9 .75 $12 MC 1 Ed
4
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Market Power: The Beer Market's Price Elasticity
1. Can you compare markup over marginal costs from this table? 2. Under which assumption can we directly compare prices?
Elasticity of Demand for Beer in general is -0.25
If firms banded together they would charge much higher prices
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Market Power Across U.S. Industries
Lerner Indexes and Markup Factors for Selected U.S. Industries
Industry Lerner Index Markup Factor
Food Tobacco Textiles Apparel Paper Printing and publishing
0.26 0.76 0.21 0.24 0.58 0.31
1.35 4.17 1.27 1.32 2.38 1.45
Chemicals
Petroleum Rubber
0.67
0.59 0.43
3.03
2.44 1.75
Leather
0.43
1.75
Source: Shapiro (1987), Baye and Lee (1990)
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Difficulties with Measuring Market Power
Three problems with Lerner Index:
1. Marginal cost is difficult to measure (AVC often
used in Lerner Index calculations)
2. If a firm prices below its optimal price, potential
monopoly power is not noted by index
3. Index ignores dynamic aspects of pricing (e.g.
effects of learning curve and shifts in demand)
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Monopoly pricing versus 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
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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 Notice a monopolist will never produce a quantity in the inelastic portion of demand curve
In inelastic portion, can increase revenue by
decreasing quantity and increasing price
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Shifts in Demand
In perfect competition, the market supply
curve is determined by marginal cost
For a monopoly, output is determined by marginal cost and the shape of the demand curve
There is no supply curve for monopolistic market!
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Shifts in Demand
Shifts in demand do not trace out price and
quantity changes corresponding to a supply curve
Shifts in demand lead to:
Changes in price with no change in output Changes in output with no change in price Changes in both price and quantity
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Shifts in Demand
$/Q
MC
Shift in demand leads to change in price but same quantity
P1
P2
D2
D1 MR2
MR1
Q1= Q2 Quantity
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Shifts in Demand
$/Q
MC
Shift in demand leads to change in quantity but same price D2
P1 = P2
MR2
D1
MR1
Q1 Q2 Quantity
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Monopoly
Shifts in demand usually cause a change in both
price and quantity
Examples show how monopolistic market differs
from perfectly competitive market
Competitive market supplies specific quantity at
every price
This relationship does not exist for a monopolistic
market
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Putting It All Together: A Problem SetStyle Question On Today's Lecture
Consider that Automobili-Lamborghini has a monopoly on
producing Lamborghini cars at a cost of (in thousands of dollars): 1 2
C (Q)
2
Q
where Q is quantity being sold The demand for Lamborghini cars is given by:
D( P)
300
P
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where P is in thousands of dollars
Putting It All Together: A Problem SetStyle Question On Today's Lecture
(a) What will be the price of a car assuming that the monopoly firm maximizes its profits?
QP 1 2 Q 2
Note that Q D(P) so we have:
( P) (300 P) P 1 (300 P) 2 2 300P P 2 1 (300 P) 2 2
Profit-maximizing price P * solves:
( P) P
0,
that is, 300 2P (300 P) 0 ; 3P 600 So, we have P* 200 (200 thousand dollars)
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Putting It All Together: A Problem SetStyle Question On Today's Lecture
(b) What is the profit-maximizing quantity that Lamborghini will produce?
Q*
D( P*)
300 P* 300 200 100 cars
(c) What is the mark-up (P-MC)?
MC C (Q) Q Q
MC(Q*) 100
Mark-up = P * MC(Q*) 200 100 100 (in thousands of dollars)
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Putting It All Together: A Problem Set-Style Question On Today's Lecture
(d) What is the elasticity of demand (Ed) at the profit-maximizing price and quantity produced?
Ed
Q P Q P
1 Q P
1 100 200
2
(e) What is the Lerner Index at the profit-maximizing price and quantity produced by Lamborghini?
L
1 Ed
1 2
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Summary
Monopolists choose q such that MR=MC So, P=MC/(1+1/Ed) Products with higher elasticities of demand
lead to higher prices
There is no supply curve for monopolists:
choose p and q!
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