Economics for Managers (ECO1708)

Lecture 09
Markets - II
Prawesh Singh
Market Power: Monopoly and Monopsony

• Monopoly: Market with only one seller.

• Monopsony: Market with only one buyer.

• Market Power: Ability of a seller or buyer

to affect the price of a good.
Monopoly
Average Revenue and Marginal Revenue

• Average revenue: The price that a monopolist receives per unit sold, is precisely the
market demand curve.

• Marginal Revenue: Change in revenue resulting from a one-unit increase in output.

Average Revenue and Marginal Revenue

Figure: Average and Marginal Revenue

Average and marginal revenue are

shown for the demand curve
P = 6 − Q.
The Monopolist’s Output Decision
Figure: Profit Is Maximised When Marginal Revenue Equals Marginal Cost

Q* is the output level at which MR = MC.

If the firm produces a smaller output—say,

Q1—it sacrifices some profit because the
extra revenue that could be earned from
producing and selling the units between Q1
and Q* exceeds the cost of producing them.

Similarly, expanding output from Q* to Q2

would reduce profit because the additional
cost would exceed the additional revenue.
The Monopolist’s Output Decision
We can also see algebraically that Q* maximises profit. Profit π is the difference between
revenue and cost, both of which depend on Q:

As Q is increased from zero, profit will increase until it reaches a maximum and then begin to
decrease. Thus the profit-maximizing Q is such that the incremental profit resulting from a
small increase in Q is just zero (i.e., Δπ /ΔQ = 0). Then

But ΔR/ΔQ is marginal revenue and ΔC/ΔQ is marginal cost. Thus the profit-maximising
condition is that
An Example
Figure: Example of Profit Maximisation
Part (a) shows total revenue R, total cost C, and profit, the
difference between the two.

Part (b) shows average and marginal revenue and average and
marginal cost.

Marginal revenue is the slope of the total revenue curve, and

marginal cost is the slope of the total cost curve. The profit-
maximising output is Q* = 10, the point where marginal revenue
equals marginal cost.

At this output level, the slope of the profit curve is zero, and the
slopes of the total revenue and total cost curves are equal.
The profit per unit is $15, the difference between average revenue
and average cost. Because 10 units are produced, total profit is
$150.
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.

To do this, we first write the expression for marginal revenue:

A Rule of Thumb for Pricing

Note that the extra revenue from an incremental unit of quantity, Δ(PQ)/ΔQ, has two
components:

• Producing one extra unit and selling it at price P brings in revenue (1)(P) = P.

• But because the firm faces a downward-sloping demand curve, producing and selling this
extra unit also results in a small drop in price ΔP/ΔQ, which reduces the revenue from all
units sold (i.e., a change in revenue Q[ΔP/ΔQ]).

Thus,
A Rule of Thumb for Pricing
(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand, 1/Ed, measured at the profit-
maximising output, and

Now, because the firm’s objective is to maximise profit, we can set marginal revenue equal to
marginal cost:

which can be rearranged to give us

Equivalently, we can rearrange this equation to express price directly as a markup over marginal
cost:
Shifts in Demand
A monopolistic market has no supply curve.

The reason is that the monopolist’s output decision depends not only on marginal cost but also
on the shape of the demand curve.

As a result, shifts in demand do not trace out the series of prices and quantities that correspond
to a competitive supply curve.

Shifts in demand can lead to changes in price with no change in output, changes in output with
no change in price, or changes in both price and output.
Shifts in Demand
Figure: Shifts in Demand
Shifting the demand curve shows that a monopolistic market has no
supply curve—i.e., there is no one-to-one relationship between price and
quantity produced.

In (a), the demand curve D1 shifts to new demand curve D2.

But the new marginal revenue curve MR2 intersects marginal cost at the
same point as the old marginal revenue curve MR1.
The profit-maximising output therefore remains the same, although price
falls from P1 to P2.

In (b), the new marginal revenue curve MR2 intersects marginal cost at a
higher output level Q2.

But because demand is now more elastic, price remains the same.
*The Multiplant Firm

Suppose a firm has two plants. What should its total output be, and how much of that output
should each plant produce? We can find the answer intuitively in two steps.

• Step 1. Whatever the total output, it should be divided between the two plants so that
marginal cost is the same in each plant. Otherwise, the firm could reduce its costs and
increase its profit by reallocating production.

• Step 2. We know that total output must be such that marginal revenue equals marginal
cost. Otherwise, the firm could increase its profit by raising or lowering total output.
*The Multiplant Firm

Figure: Production with Two Plants

A firm with two plants maximizes profits

by choosing output levels Q1 and Q2 so
that marginal revenue MR (which
depends on total output) equals
marginal costs for each plant, MC1 and
MC2.
Monopoly Power
Figure: The Demand for Toothbrushes

Part (a) shows the market demand for toothbrushes.

Part (b) shows the demand for toothbrushes as seen
by Firm A.

At a market price of $1.50, elasticity of market

demand is −1.5. Firm A, however, sees a much more
elastic demand curve DA because of competition from
other firms.
At a price of $1.50, Firm A’s demand elasticity is −6.

Still, Firm A has some monopoly power: Its profit-

maximising price is $1.50, which exceeds marginal
cost.
Measuring Monopoly Power

Remember the important distinction between a perfectly competitive firm and a firm with
monopoly power: For the competitive firm, price equals marginal cost; for the firm with
monopoly power, price exceeds marginal cost.

• Lerner Index of Monopoly Power: Measure of monopoly power

calculated as excess of price over marginal cost as a fraction of price.

Mathematically:

This index of monopoly power can also be expressed in terms of the elasticity of demand facing
the firm.
The Rule of Thumb for Pricing
Figure: Elasticity of Demand and Price Markup

The markup (P − MC)/P is equal to minus the inverse of the elasticity of demand facing the firm.
If the firm’s demand is elastic, as in (a), the markup is small and the firm has little monopoly power.
The opposite is true if demand is relatively inelastic, as in (b).
Sources of Monopoly Power

The Elasticity of Market Demand

The Number of Firms

The Interaction Among Firms

The Social Costs of
Monopoly Power
Figure: Deadweight Loss from
Monopoly Power
The shaded rectangle and triangles show
changes in consumer and producer surplus
when moving from competitive price and
quantity, Pc and Qc,

to a monopolist’s price and quantity, Pm

and Qm.

Because of the higher price, consumers lose

A+B

and producer gains A − C. The deadweight

loss is B + C.
Natural Monopoly
• Natural Monopoly: Firm that can produce the entire output of the market at a cost lower
than what it would be if there were several firms.

Figure: Regulating the Price of a

Natural Monopoly
When price is lowered to Pc, at the point
where marginal cost intersects average
revenue, output increases to its maximum
Qc. This is the output that would be
produced by a competitive industry.
Price Discrimination
CAPTURING CONSUMER SURPLUS
• Price discrimination:
Practice of charging different prices to different consumers for similar goods.

• If a firm can charge only one price for all its customers, that price will be P*
and the quantity produced will be Q*.
• Ideally, the firm would like to charge a higher price to consumers willing to
pay more than P*, thereby capturing some of the consumer surplus under
region A of the demand curve.
• The firm would also like to sell to consumers willing to pay prices lower than
P*, but only if doing so does not entail lowering the price to other consumers.
• In that way, the firm could also capture some of the surplus under region B of
the demand curve. If a firm can charge only one price for all its customers,
that price will be P* and the quantity produced will be Q*.
• Ideally, the firm would like to charge a higher price to consumers willing to
pay more than P*, thereby capturing some of the consumer surplus under
region A of the demand curve.
• The firm would also like to sell to consumers willing to pay prices lower than
P*, but only if doing so does not entail lowering the price to other consumers.
• In that way, the firm could also capture some of the surplus under region B of Figure: Capturing Consumer Surplus
the demand curve.
First-Degree Price Discrimination

• Reservation price: Maximum price that a customer is willing to pay for a good.
• First-Degree Price Discrimination: Practice of charging each customer her reservation price.

Figure: Additional Profit from Perfect

First-Degree Price Discrimination
Because the firm charges each consumer her reservation price, it
is profitable to expand output to Q**.
When only a single price, P*, is charged, the firm’s variable profit
is the area between the marginal revenue and marginal cost
curves.
With perfect price discrimination, this profit expands to the area
between the demand curve and the marginal cost curve.
First-Degree Price Discrimination

• Perfect Price Discrimination:

The additional profit from producing and selling an incremental unit is now the difference
between demand and marginal cost.
Figure: First-Degree Price Discrimination
in Practice
Imperfect Price Discrimination

Firms usually don’t know the reservation price of every

consumer, but sometimes reservation prices can be
roughly identified.
Here, six different prices are charged. The firm earns
higher profits, but some consumers may also benefit.
With a single price P*4, there are fewer consumers.
The consumers who now pay P5 or P6 enjoy a surplus.
Second-Degree Price Discrimination
Second-degree price discrimination:
Practice of charging different prices per unit for different quantities of the same good or service.

Block pricing:
Practice of charging different prices for different quantities or “blocks” of a good.

Figure: Second-Degree Price Discrimination

Different prices are charged for different quantities, or
“blocks,” of the same good. Here, there are three blocks,
with corresponding prices P1, P2, and P3.
There are also economies of scale, and average and marginal
costs are declining. Second-degree price discrimination can
then make consumers better off by expanding output and
lowering cost.
Third-Degree Price Discrimination
Third-degree price discrimination:
Practice of dividing consumers into two or more groups with separate demand curves and
charging different prices to each group.

Creating Consumer Groups

If third-degree price discrimination is feasible, how should the firm decide what price to charge each group of
consumers?

1. We know that however much is produced, total output should be divided between the groups of customers
so that marginal revenues for each group are equal.
2. We know that total output must be such that the marginal revenue for each group of consumers is equal to
the marginal cost of production.
Third-Degree Price Discrimination
Determining Relative Prices:

(11.2)

Figure: Third-Degree Price Discrimination

Consumers are divided into two groups, with separate
demand curves for each group. The optimal prices and
quantities are such that the marginal revenue from each
group is the same and equal to marginal cost.
Here group 1, with demand curve D1, is charged P1,
and group 2, with the more elastic demand curve D2, is
charged the lower price P2.
Marginal cost depends on the total quantity produced QT.
Note that Q1 and Q2 are chosen so that
MR1 = MR2 = MC.
Effects of Advertising

Figure: Effects of Advertising

AR and MR are average and marginal revenue
when the firm doesn’t advertise,
and AC and MC are average and marginal cost.
The firm produces Q0 and receives a price P0.
Its total profit π0 is given by the gray-shaded
rectangle.
If the firm advertises, its average and marginal
revenue curves shift to the right.
Average cost rises (to ACʹ) but marginal cost
remains the same.
The firm now produces Q1 (where MRʹ = MC), and
receives a price P1.
Its total profit, π1, is now larger.
Exercise 1
A firm faces the following average revenue (demand) curve:
P = 120 – 0.02Q
where Q is weekly production and P is price, measured in cents per unit.

The firm’s cost function is given by:

C = 60Q + 25,000

Assume that the firm maximizes profits.

a. What is the level of production, price, and total profit per week?

b. If the government decides to levy a tax of 14 cents per unit on this product, what
will be the new level of production, price, and profit?
Exercise 2
Suppose that an industry is characterized as follows:
C = 100 + 2q2 each firm’s total cost function
MC = 4q firm’s marginal cost function
P = 90 - 2Q industry demand curve
MR = 90 - 4Q industry marginal revenue curve

a. If there is only one firm in the industry, find the monopoly price, quantity, and level
of profit.

b. Find the price, quantity, and level of profit if the industry is competitive.

c. Graphically illustrate the demand curve, marginal revenue curve, and marginal cost
curve. Identify the difference between the profit level of the monopoly and the profit
level of the competitive industry.
Thank You!