Chapter 11

Chapter 11
Monopoly
Topics
1. Monopoly Profit Maximization.

2. Market Power.
3. Market Failure Due to Monopoly Pricing.
4. Causes of Monopoly.
5. Government Actions That Reduce Market
Power.
6. Networks, Dynamics, and Behavioral
Economics.
Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-2

Monopoly Profit Maximization
• Monopoly – the only supplier of a good for

which there is no close substitute.
• A monopoly can set its price – not a price
taker.
• All firms, including competitive firms and
monopolies, maximize profits by setting
marginal revenue equal to marginal cost.

Marginal Revenue and Price
• A firm’s revenue is:

R = pq.
• A firm’s marginal revenue, MR, is: the
change in its revenue from selling one more
unit.
MR = ΔR/Δq.
– If the firm sells exactly one more unit,
• Δq = 1, its marginal revenue is MR = ΔR.

Marginal Revenue and Price
(cont.)
• The marginal revenue of a monopoly differs
from that of a competitive firm because the
monopoly faces a downward-sloping
demand curve unlike the competitive firm.
• Thus, the monopoly’s marginal revenue
curve lies below the demand curve at every
positive quantity.

Figure 11.1 Average and
Marginal Revenue

Deriving the Marginal Revenue
Curve
• For a monopoly to increase its output by ΔQ,
the monopoly lowers its price per unit by
Δp/ΔQ,
– the slope of the demand curve.
• By lowering its price, the monopoly loses:
(Δp/ΔQ) x Q
– on the Q units it originally sold at the higher
price,
– but it earns an additional p on the extra output it
now sells.

Deriving the Marginal Revenue
Curve (cont.)
• Thus, the monopoly’s marginal revenue is:
Dp
MR =p + Q
DQ

Figure 11.2 Elasticity of Demand and Total,
Average, and Marginal Revenue

Solved Problem 11.1
• Derive the marginal revenue curve when the

monopoly faces the linear inverse demand
function,
p=24 – Q,
in Figure 11.2. How does the slope of the
marginal revenue curve compare to the
slope of the inverse demand curve?

Solved Problem 11.1: Answer
p  24  Q
p
MR  p  Q  (24  Q)  (1)Q  24  2Q
Q
• The slope of this marginal revenue curve

is ΔMR/ΔQ = −2,
– so the marginal revenue curve is twice as
steeply sloped as is the demand curve.

Marginal Revenue and
Price Elasticity of Demand
• At a given quantity, the marginal
revenue equals the price times a term
involving the elasticity of demand:
 1
MR  p1  
 
• Marginal revenue is closer to price as
demand becomes more elastic.

Marginal Revenue and
Price Elasticity of Demand (cont.)
æ 1ö
MR =p ç1+ ÷
è eø
• Where the demand curve hits the price axis
(Q = 0), the demand curve is perfectly
elastic, so the marginal revenue equals
price: MR = p.
• Where the demand elasticity is unitary, ε =
−1, marginal revenue is zero: MR = p[1 +
1/(−1)] = 0.
• Marginal revenue is negative where the
demand curve is inelastic, −1 < ε ≤ 0.
Table 11.1 Quantity, Price, Marginal
Revenue, and Elasticity for the Linear
Inverse Demand Curve p = 24 - Q

Choosing Price or Quantity
• Any firm maximizes its profit by setting its

marginal revenue equal to its marginal cost.
• Unlike a competitive firm, a monopoly can
adjust its price – it has a choice of setting its
price or its quantity to maximize its profit.
• The monopoly is constrained by the market
demand curve. Because the demand curve
slopes downward, the monopoly faces a
trade-off between a higher price and a lower
quantity or a lower price and a higher
quantity.
Figure 11.3
Maximizing
Profit

Profit-Maximizing Output
• Because a linear demand curve is more

elastic at smaller quantities,
– monopoly profit is maximized in the elastic
portion of the demand curve.
• Equivalently, a monopoly never operates in
the inelastic portion of its demand curve.

Shutdown Decision
• In the short run, a monopoly shuts down to

avoid making a loss if its price is below its
average variable cost at its profit-
maximizing quantity.
• In the long run, the monopoly shuts down if
the price is less than its average cost.

Mathematical Approach
• The monopoly faces a short-run cost

function of:
C(Q) = Q2 + 12
– where Q2 is the monopoly’s variable cost as a

function of output and $12 is its fixed cost.
• Given this cost function the monopoly’s
marginal cost function is
MC = 2Q.

Mathematical Approach (cont.)
• The average variable cost is:

AVC = Q2/Q = Q,
– so it is a straight line through the origin with a
slope of 1.

• We determine the profit-maximizing output

by:
MR = 24 − 2Q = 2Q = MC.
• Solving for Q, we find that Q = 6.
• Substituting Q = 6 into the inverse demand
function:
p = 24 − Q = 24 − 6 = $18.

• At that quantity,
• AVC = $6,
– which is less than the price, so the
firm does not shut down.
– The average cost is AC = $(6 + 12/6)
= $8, which is less than the price, so
the firm makes a profit.

Solved Problem 11.2
• When the iPad was introduced, Apple’s

constant marginal cost of producing this
iPad was about $220. We estimate that its
average cost was about AC = 220+
2,000/Q , and that Apple’s inverse demand
function for the iPad was p = 770 - 11Q ,
where Q is measured in millions of iPads
purchased. What was Apple’s marginal
revenue function? What were its profit-
maximizing price and quantity? What was its
profit?

Effects of a Shift of the Demand
Curve
• Unlike a competitive firm, a monopoly does
not have a supply curve.
• A given quantity can correspond to more
than one monopoly-optimal price.
– A shift in the demand curve may cause the
monopoly optimal price to stay constant and the
quantity to change or both price and quantity to
change.

Figure 11.4 Effects of a Shift of
the Demand Curve

Market Power
• Market power - the ability of a firm to

charge a price above marginal cost and earn
a positive profit.
æ 1ö
MR =p ç1+ ÷=MC
è eø
– and rearranging the terms:
p 1
=
MC 1+(1 / e)
– so the ratio of the price to marginal cost depends
only on the elasticity of demand at the profit-
maximizing quantity.

Table 11.2 Elasticity of Demand,
Price, and Marginal Cost

Lerner Index
• Lerner Index - the ratio of the difference

between price and marginal cost to the
price: (p − MC)/p.
– In terms of the elasticity of demand:
p  MC 1

p 
– Because MC ≥ 0 and p ≥ MC, 0 ≤ p − MC ≤ p, so the

Lerner Index ranges from 0 to 1 for a profit-
maximizing firm.

Solved Problem 11.3
• Initially, Apple sold its iPad for $500 and its

marginal cost was approximately $220.
What was its Lerner Index? If it was
operating at the short-run profit-maximizing
level, what was the elasticity of demand for
the iPad?

• Calculate the Lerner Index by substituting

the iPad’s price and marginal cost into the
definition. Apple’s Lerner Index for the iPad
was ( p - MC)/ p=(500 - 220)/500 = 0.56.
• Determine the elasticity by substituting the

iPad’s Lerner Index into equation 11.9.

Sources of Market Power
• All else the same, the demand curve a firm

faces becomes more elastic as:
1. better substitutes for the firm’s product are
introduced,
2. more firms enter the market selling the same
product, or
3. firms that provide the same service locate
closer to this firm.

Market Failure Due to
Monopoly Pricing
• Welfare, W, is lower under monopoly than
under competition.
• Competition maximizes welfare because
price equals marginal cost.
• By setting its price above its marginal cost,
a monopoly causes consumers to buy less
than the competitive level of the good, so a
deadweight loss to society occurs.

Figure 11.5 Deadweight Loss
of Monopoly

Solved Problem 11.4
• In the linear example in Figure 11.3, how

does charging the monopoly a specific tax of
t = $8 per unit affect the monopoly optimum
and the welfare of consumers, the
monopoly, and society (where society’s
welfare includes the tax revenue)? What is
the incidence of the tax on consumers?


Causes of Monopoly
• Why are some markets monopolized?

– A firm has a cost advantage over other firms or
– A government created the monopoly.

Cost Advantages
• Reasons for cost advantages:

– the firm uses a superior technology or has a
better way of organizing production.
– the firm controls an essential facility: a scarce
resource that a rival needs to use to survive.

Natural Monopoly
• Natural monopoly - situation in which one

firm can produce the total output of the
market at lower cost than several firms
could.
• Believing that they are natural monopolies,
governments frequently grant monopoly
rights to public utilities to provide essential
goods or services such as water, gas,
electric power, or mail delivery.

Natural Monopoly (cont.)
• If the cost for any firm to produce q is C(q),

the condition for a natural monopoly is
where Q=q1+q2+…+qn is the sum of the output

of any n≥2 firms.

Figure 11.6 Natural Monopoly
AC, MC, $ per unit

40
20 AC = 10 + 60/Q
15
10
MC = 10
0 6 12 15
Q, Units per day

Solved Problem 11.5
• A firm that delivers Q units of water to

households has a total cost of C(Q) = mQ + F.
If any entrant would have the same cost,
does this market have a natural monopoly?
• Answer
– Determine whether costs rise if two firms
produce a given quantity.

Barriers to Entry
• Governments create many monopolies.

– Sometimes governments own and manage
monopolies, forbidding other firms from entering.
– In the United States, as in most countries, the
postal service is a government monopoly.
• Frequently, however, governments create
monopolies by preventing competing firms
from entering a market.

Patents
• Patent - an exclusive right granted to the

inventor to sell a new and useful product,
process, substance, or design for a fixed
period of time.
– The length of a patent varies across countries.
• Question: If a firm with a patent monopoly
sets a high price that results in deadweight
loss then why do governments grant patent
monopolies?

Application: Botox Patent
Monopoly

Optimal Price Regulation
• In some markets, the government can

eliminate the deadweight loss of monopoly
by requiring that a monopoly charge no
more than the competitive price.

Figure 11.7 Optimal Price
Regulation

Problems in Regulating
• Problems that governments face in

regulating monopolies:
– because they do not know the actual demand
and marginal cost curves, governments may set
the price at the wrong level.
– Second, many governments use regulations that
are less efficient than price regulation.
– Third, regulated firms may bribe or otherwise
influence government regulators to help the
firms rather than society as a whole.

Nonoptimal Price Regulation
• If the regulated price is not optimal, a

deadweight loss results.
• If the price is set below the firm’s minimum
average cost, the firm will shut down.
• The deadweight loss equals the sum of the
consumer plus producer surplus under
optimal regulation.

Solved Problem 11.6
• Suppose that the government sets a price,

p2, that is below the socially optimal level,
p1, but above the monopoly’s minimum
average cost. How do the price, the quantity
sold, the quantity demanded, and welfare
under this regulation compare to those
under optimal regulation?


Application: Natural Gas
Regulation

Increasing Competition
• Encouraging competition is an alternative to

regulation as a means of reducing the harms
of monopoly.

Solved Problem 11.7
• How did the presence of me-too rival

products produced by firms with higher
marginal costs affect Apple’s iPod pricing in
more recent years? Assume that Apple has a
constant marginal cost MC . The large
number of identical, higher-cost rivals—the
competitive fringe—act like (competitive)
price takers so that their collective supply
curve is horizontal at
p2 = MC + x .


Networks, Dynamics and
Behavioral Economics
• In some markets, decisions today affect
demand or cost in a future period, creating
a need for a dynamic analysis, in which
firms explicitly consider relationships
between periods.
• In such markets the monopoly may
maximize its long-run profit by making a
decision today that does not maximize its
short-run profit.

Network Externalities
• Network externality - the situation where

one person’s demand for a good depends on
the consumption of the good by others.

Direct Size Effect
• Many industries exhibit positive network

externalities where the customer gets a
direct benefit from a larger network.
– Example: the larger an ATM network such as the
Plus network, the greater the odds that you will
find an ATM when you want one, so the more
likely it is that you will want to use that network.

Indirect Effect
• In some markets, positive network

externalities are indirect.
• They stem from complementary goods that
are offered when a product has a critical
mass of users.
– The more applications (apps) available for a
smart phone, the more people want to buy that
smart phone; however, many of these extra apps
will be written only if a critical mass of customers
buys the smart phone.

Network Externalities and
Behavioral Economics
• Bandwagon effect - the situation in which
a person places greater value on a good as
more and more other people possess it.
• Snob effect - the situation in which a
person places greater value on a good as
fewer and fewer other people possess it.

A Two-Period Monopoly Model
• A monopoly may be able to solve the

chicken-and-egg problem of getting a critical
mass for its product by initially selling the
product at a low introductory price.
• By doing so, the firm maximizes its long-run
profit but not its short-run profit.

A Two Period Monopoly Model
(cont.)
• Suppose that a monopoly sells its good
only two periods.
• If the monopoly sells less than a critical
quantity of output, Q, in the first period, its
second-period demand curve lies close to
the price axis.
• However, if the good is a success in the
first period—at least Q units are sold—the
second-period demand curve shifts
substantially to the right.

A Two Period Monopoly Model
(cont.)
• Should the monopoly charge a low
introductory price in the first period?
• The firm chooses to charge a low
introductory period in the first period if its
first period loss (from charging a less than
optimal price) is less than its extra profit in
the second period.

Brand-Name and Generic Drugs

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Chapter 11

1. Monopoly Profit Maximization.

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-2

• Monopoly – the only supplier of a good for

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-3

• A firm’s revenue is:

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-4

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-5

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-6

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-7

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-8

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-9

• Derive the marginal revenue curve when the

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-10

• The slope of this marginal revenue curve

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-11

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-12

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-14

• Any firm maximizes its profit by setting its

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-16

• Because a linear demand curve is more

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-17

• In the short run, a monopoly shuts down to

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-18

• The monopoly faces a short-run cost

– where Q2 is the monopoly’s variable cost as a

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-19

• The average variable cost is:

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-20

• We determine the profit-maximizing output

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-21

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-22

• When the iPad was introduced, Apple’s

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-24

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-25

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-26

• Market power - the ability of a firm to

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-27

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-28

• Lerner Index - the ratio of the difference

– Because MC ≥ 0 and p ≥ MC, 0 ≤ p − MC ≤ p, so the

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-29

• Initially, Apple sold its iPad for $500 and its

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-30

• Calculate the Lerner Index by substituting

• Determine the elasticity by substituting the

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-31

• All else the same, the demand curve a firm

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-32

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-33

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-34

• In the linear example in Figure 11.3, how

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-35

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-36

• Why are some markets monopolized?

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-37

• Reasons for cost advantages:

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-38

• Natural monopoly - situation in which one

Copyright ©2015 Pearson Education, Inc. All rights reserved. 11-39