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Lecture Notes for

Pindyck and Rubinfeld Chapter 10


Market Power: Monopoly and Monopsony
Monopoly
A monopoly is a market with only one firm.
Entry into the market is blocked by technological or legal barriers.

e.g. Patents, trademarks, copyrights, or need a license from the


government to produce

A natural monopoly is a monopoly that occurs because a firm benefits


from economies of scale. This situation is likely to occur
either when the market is small or when fixed costs are necessarily very
large.
e.g. Utilities (electricity, water and sanitation, etc.)
- Until a few years ago it had been argued that the telecoms market was a
natural monopoly. The massive fixed costs of laying cables into millions of
homes meant that it was sensible to allow one company to have a monopoly.
However, in recent years governments have deliberately broken up these
monopolies or allowed new firms to enter the market. Technological
advances, such as the invention of mobile phones, have removed the
necessary conditions of natural monopoly.

The Monopolist
The monopolist has market power. In other words, the monopolist is a
price maker. (Recall: perfectly competitive firms are price takers.)
The monopolist chooses price and quantity conditional on the consumers
willingness to pay that price for that quantity of the good.
Essentially, the monopolist chooses a point on the demand curve.

Not willing to pay

Willing to pay
more
D

The monopolist cannot choose any point above the demand curve because
the consumers would not be willing to pay that price for that quantity of the
good.
Likewise, the monopolist would not want to choose a point below the
demand curve because the consumers would be willing to pay a higher price
for that quantity of the good.

Therefore, the monopolist chooses a point (a price and quantity)


on the demand curve, since the demand tells us the willingness to
pay for each quantity.

Revenue Effects
When a monopolist increases output, price decreases, and there are two
effects on revenue:
1. Revenue increases by the extra output times the price (area B).
2. Revenue decreases by output times the change in price (area C).
Monopoly
Price, p
$ per unit

p
p

C
2

Demand curve
A

Q Q+ 1

Quantity, Q

Units per year

With Monopoly,
Initial Revenue (at p1): A+C
Revenue with one more unit: A+B
Marginal Revenue: B C = p2 C

For a monopolist, since p is given by the demand curve, p = AR.


However, as we see here, p is NOT equal to MR for the monopolist.

Recall that for a Competitive Firm:


Price, p ,
$ per unit

Demand curve

p1

q q+ 1
Recall that for a competitive firm, p=MR=AR

Quantity (units per year)

The Monopolists Profit Maximization Problem:


Like all firms, the monopolist chooses output by setting marginal revenue
equal to marginal cost.
MR = MC
Marginal revenue is the derivative of total revenue, where TR=PQ. For a
monopolist, price is a function of quantity, specifically the demand curve.
Therefore,
TR = PQ = P(Q)*Q
MR = (d/dQ)P(Q)*Q = P(Q) + P'(Q)*Q

MR is always below the demand curve. Reason: Since demand curve is also
AR curve, then for AR to be falling (in other words, for demand to be
downward sloping), the MR must be below the AR.

If the demand curve is a straight line, the MR curve is also a straight line,
with: i) same vertical intercept as demand curve, and ii) slope of MR is twice
the slope of the demand curve.

Demand: P = a bQ
TR: PQ = aQ bQ2
MR: a 2bQ

Example:
Let the demand curve be given by: P = 24 Q
Also let MC = ATC = $6
Solve for profit maximizing Q and P, and calculate the profit:
Solution:
TR = PQ = 24Q Q2
MR = dTR/dQ = 24 2Q
Set MR = MC
24 2Q = 6
Q* = 9
Plug Q* = 9 into the demand curve to get:
P* = $15
Profit = (P-ATC)*Q = (15 6)*9 = $81

(a) Monopolized Market


MC

p, $ per unit

24

AC
AVC

18
= 60
12
8
6

Demand
MR

12
Q

24
, Units per day

(b) Profit, Revenue


R, , $
144

Revenue, R

108

60

Profit,

12

24
Q, Units per day

Elasticity of Demand and Marginal Revenue

Elasticity of Demand and Total, Average, and Marginal


Revenue

p, $ per unit
24

Perfectly elastic

Elastic, < 1
MR = 2
Q= 1
12

p = 1
Q= 1
= 1

Inelastic, 1 < < 0

Demand ( p = 24 Q)

12
MR = 24 2Q

Perfectly
inelastic
24
Q, Units per day

When demand is elastic, increasing quantity will increase total revenue.


Marginal revenue is positive.
When demand is inelastic, increasing quantity will decrease total revenue.
Marginal revenue is negative.
We already know that marginal cost is always positive.
Therefore, a profit maximizing monopolist will always choose an output in
the elastic portion of the demand curve. (MR = MC)
If a monopolist were producing in the inelastic portion of the demand
curve it could always increase profits by decreasing output, because TC
would decrease and TR would increase.

Pricing in Practice: Rules of Thumb


We can develop pricing rules for a monopolist with only limited knowledge
of MC and demand curves, as long as we have information on MC and
demand for the range of Q under consideration.
TR = P(Q)*Q
MR = (d/dQ)P(Q)*Q = P(Q) + P'(Q)*Q
= P + P(P'(Q)*(Q/P)]
= P* [1 + 1/ed] (where ed = elasticity of demand)
Remember: ed is a negative number.
If demand is inelastic, so that -1 < ed < 0, then MR < 0.
If demand is unit elastic, so that ed = -1, then MR = 0.
If demand is elastic, so that ed < -1, then MR > 0.
Now, for profit maximization, MR = MC:
MR = P*[1 + 1/ed]
MR = MC P*[1 + 1/ed] = MC
We can arrange this into two formulations for the mark-up of price over
MC:
i)

P = MC/[1 + 1/ed]

ii)

(P MC)/P = -1/ed

Measuring Monopoly Power


The second formulation of the mark-up, which is also called the Lerner
Index is:
(P MC)/P = -1/ed
Notice that the mark-up depends inversely on ed. The larger is as ed, the
closer is the monopolists price to the competitive price. The smaller is ed,
the larger is the mark-up over price.
For this reason, as ed - infinity, MR price, so the monopolists price
becomes closer and closer to the MC, P MC. In other words, when
demand is perfectly elastic, the monopolist has no market power its like
were in the perfectly competitive case.
Therefore, the Lerner Index is used as a way to measure monopoly power.

Effects of a Shift of the Demand Curve in a Competitive Market

(a) Competition
p, $ per unit

p2
p1

e2

MC, Supply curve

e1
D2
Q1 Q2

D1
Q, Units per year

In a competitive market, theres a one-for-one relationship between P and Q


for suppliers. In this graph, as demand increases, both P and Q rise.

Effects of a Shift of the Demand Curve with a Monopoly

(b) Monopoly
p, $ per unit

p2
p1

E2

MC

E1
MR1
MR 2
Q1= Q2

D2

D1
Q, Units per year

However, with a monopolist, NO supply curve exists, because theres no


one-for-one relationship between P and Q. For example, when theres an
increase in demand, any of the three can happen:
i)
P rises but Q stays the same
ii)
Q rises but P stays the same
iii) both P and Q rise
The reason theres no one-for-one relationship between P and Q: The
monopolists P and Q decision depend on the shapes of both MC and the
demand curve.

Monopoly vs. Competitive Market:


Deadweight Loss of Monopoly
p, $ per unit
24
MC

pm = 18
p c = 16
MR= MC= 12

A = $18
B = $12

D =$60

em
C =$2
ec
E= $4

Demand
MR
0

Q m = 6 Q c= 8

12

24
Q , Units per day

The competitive market solution (where the MC curve crosses the demand,
so that MC = P) is always the combination of price and quantity that gives
the consumers and producers the most total surplus.
Deadweight Loss is the difference in total surplus between an inefficient
market (e.g. monopoly) and an efficient market (competitive).

The Effect of Taxing a Monopolist


Here, we consider a specific tax i.e. the tax is a specific amount of
money levied per unit produced.
From our rule-of-thumb pricing formula from earlier, we have:
P = MC/[1 + 1/ed]
The price depends on both the MC and the elasticity of demand.
If the government levies a specific tax, t, then we have:
P = (MC+t)/[1 + 1/ed]
Note that if MC is constant, then the price will increase by more than the
amount of the tax. This is because for any demand that is less than
perfectly elastic, 1/[1 + 1/ed] > 1.
If MC is an increasing curve, then the price will not necessarily increase
by more than the tax, because by lowering Q, MC will fall.

The Effect of Taxing a Monopolist


p, $ per unit
24

MC2 (after tax)

p 2 = 20 A
B
p1 = 18
D

e2
e

= $8

MC 1 (before tax)

G
MR

Q 2 = 4 Q 1= 6

12

Demand
24
Q, Units per day

Result: Taxing a monopolist increases the deadweight loss of monopoly.


We can also note that the monopolists profit falls when there is a tax.

Sources of Monopoly Power


When there are multiple firms providing similar but not homogeneous
products, how can we tell if a firm is exercising market power?
A firms demand curve will be at least as elastic as the market demand curve.
Recall that the mark-up over MC depends inversely on demand elasticity.
The less elastic the demand curve, the greater the mark-up over MC.
Mark-up: (P MC)/P = -1/ed
We can look at three factors:
1. Elasticity of Market Demand: If the market demand is relatively
elastic, the potential for monopoly power is limited, because the firms
demand curve will also be elastic.
2. Number of Firms: As the number of firms increase, the monopoly
power decreases, because firms will compete more and more.
3. Interaction Among Firms: Even when there is only a few firms, they
may compete aggressively, driving down prices, and act almost like
competitive firms. On the other hand, if firms tend to cooperate and
collude to limit output and raise prices, then there will be greater
monopoly power.

Typical Monopoly:
MC

, $ per unit

24

AC
AVC

18
= 60
12
8
6

Demand
MR

12
Q

24
, Units per day

Application: A Drug Patent


p, per
daily dose
143.0

A $0.44
million
em

75.0

Demand
B $0.88 million
C $0.44 million
ec

7.5
0

1.30
MR

MC = AVC

2.61 2.75
Q, Million daily doses of Tagamet

--Patents may be necessary to stimulate innovation

Natural Monopoly
AC, MC,
$ per unit
40

20

AC =10 + 60/Q

15
10

MC = 10

12
15
Q, Units per day

In the case of a natural monopoly, for example local utility companies, ATC
is falling over a long range of output. This means that the service can be
provided to the population for a lower cost if there is only one provider. In
this way, a single provider can take advantage of the economies of scale.

Public Policy: Dealing with Monopoly Power


1. Monopoly power may be limited by breaking up monopolies into multiple
companies, or by preventing firms from merging (so that monopoly power is
not achieved). In the U.S., this is referred to as anti-trust policy.
2. Monopoly power may also be limited by policies regulating the price that
can be charged.
There may be instances when monopoly power is permitted, such as:
i)
Patents firms would have no incentive to innovate without a
patent protecting the invention. Monopoly profits earned on an
innovation pay for the investment to create it.
ii)
Natural monopolies: can take advantage of the economies of scale
when a single producer supplies the good or service.
However, even in cases where monopoly is allowed, government may
take steps to regulate it.

Optimal Price Regulation


p, $ per unit
24

MC
Market demand
A

18

16

e
m
C
E

Regulated demand
e
o

D
MR r

MR

12

24
Q , Units per day

Since the government regulation sets the maximum price that the monopolist
can charge at P = 16, the regulated MR curve (MRr) is now the horizontal
line at P = 16 (for 0<Q<8) and then the old MR curve for Q>8.
At the regulated price, the monopolist sets MRr = MC, and chooses Q= 8,
the competitive outcome.
Consumers gain and producers lose surplus. However, the net result is that
total welfare improves by the amount C + E.

However, if the regulated price is set too low, then there will be a shortage.

p, $ per unit
MC

Market demand

A
p1
p2

e1 Regulated demand

e2
E
MR

Q 2 Q1

MR r

Qd

Excess demand

Q, Units per day

Regulating an Electric Utility


p, Yen ( ) per
hundred KWH
53

MC
30.3
26.9
22.3
21.9
19.5

e
A

AC

Demand

MR
0

23

31 34

54
Q, Billion kWh per year

If government regulation sets P = MC, then the firm will exit the market,
because AC > MC where MC crosses the demand curve, and the firm would
make losses = area B.
Therefore, in regulating a natural monopoly, government must ensure that
the firm is not losing money.
It can regulate price and ensure the firm doesnt make losses by setting
P = AC.

Difficulties of Regulating Monopoly:


It may be difficult for government regulators to determine monopolists
costs therefore, its difficult for the government to calculate the correct
regulated price. There are no incentives for the monopolist to give the
government the most accurate information! The monopolist will try to keep
the real costs as private information.
Even if the government can calculate a regulated price, this price may need
to change, depending on demand conditions and the costs of production. If
MC curve shifts, the regulated price will be incorrect.
Problem of regulatory lag in updating the government set price.
Regulation may reduce incentives for innovation. If innovation reduces MC,
then government setting P = MC (and lowering the regulated price whenever
the firms MC falls) means that the firm does not benefit from lower costs
they are passed directly to consumers and the firm has no incentive to
invest in cost reducing measures.
This may be dealt with by: allowing firms to keep some of the benefits of
innovation; or enforcing regular reductions in the regulated price, p, to force
firms to engage in cost cutting measures.

The Multi-Plant Monopolist


Suppose that a monopolist has two factories.
Then the profit maximizing condition becomes:
MRT = MR(Q1+Q2) = MC1(Q1) = MC2(Q2)
Where Q1 and Q2 are the production levels at plant 1 and plant 2 respectively,
and MC1 and MC2 are the marginal cost curves of each plant. (were
allowing for the possibility that the two plants have different cost structures).
In other words, the MC of the first plant must each the MC of the other
plant. (We need MC1 = MC2.) If not, the firm could reduce the production
at the plant with the higher MC and increase production at the plant with
lower MC, thus lowering total costs.
For example, if MC1(Q1) > MC2(Q2), then lower Q1 and raise Q2 to lower
total cost while keeping the same total Q, QT = Q1+Q2.

MC1

MC2

MCT

MRT

Q1

Q2

QT

So we add horizontally the two MC curves of each plant to get a total MC


curve. (Hint: Write Qi as a function of MCi for each plant, then add them to
get QT as a function of MCT.) Where the MCT curve intersects MRT
determines the total output of the firm.

Monopsony:
Definition: A monopsony is a market where there is only one buyer.
We refer to the demand curve of the monopsonist as the marginal value
(MV) curve. The height of the demand curve at each Q tells us the
willingness to pay for the last unit of Q, which is therefore also the value of
that unit of the good to the consumer. Each additional unit of the good adds
less and less to utility (in other words, the marginal value of additional units
falls) giving us a negatively sloped demand/MV curve.
The price that a buyer pays gives us the average expenditure (AE) per unit
of the good.
The additional cost of buying one more unit is the marginal expenditure
(ME).
A consumers decision about the quantity of units to buy should set MV =
ME.
(NOTE: In a competitive market, the market price p = AE = ME. Therefore,
the competitive consumer chooses the quantity to buy where p = MV.)
For the monopsonist, however, ME does NOT equal AE. The buyer faces an
upward sloping AE curve (which is the market supply curve). Given that the
AE curve is upward sloping, the ME curve lies above the AE curve.

S=AE

P2
P1

Q+1

At Q, total expenditures are P1Q.


In order to purchase Q+1 units, total expenditures are P2(Q+1).
Marginal expenditure is greater than average expenditure because if the
monopsonist wants to increase its purchases (from Q to Q+1), it has to pay a
higher price (P2) for all units of the good, not just the last/additional unit
purchased.

The Monopsonists Decision:


ME

S = AE
E

Pc
B

D
Pm
C

D = MV

Qm

Qc

The monopsonist chooses Q by setting MV = ME. The price that the


monopsonist pays is Pm. (Pm is the minimum price that suppliers will accept
for Qm). The price and quantity that the monopsonist chooses is less than the
price and quantity that would prevail in a competitive market (Pc and Qc).
The change in CS to a buyer from being a monopsonist is D A.
The change in PS due to monopsony is D B.
The deadweight loss from monopsony can be measured on the graph above
as the areas A + B. (Change in Total Surplus is A B.)

Monopsony Power:
ME = d(PQ)/dQ = P + QP(Q).
We can rearrange this equation for ME and set MV = ME to get a measure of
monopsony power. Monopsony power or the markdown can be measured
as:
(MV-P)/P = 1/es
where es is the elasticity of supply.
The more elastic is the supply curve, the closer is the monopsony price to
the competitive price, in other words, the markdown is small. The more
inelastic the supply curve, the greater the difference between the monopsony
and competitive prices (i.e. the markdown is large).