Monopoly1

In this note, we will derive the inverse elasticity rule for a monopoly and
work on some numerical examples to see how the optimal quantity and price
are determined. The rule is given as formula 14.1 in Nicholson & Snyder,
10th edition. You may find some discussion on firm’s profit maximization
problem and the elasticity of demand in Chapter 11 helpful. The anwers to
numerical exercise are be found online as the solution to the practice prob-
lems.

Profit maximization problem for a monopoly

A monopoly is a single supplier to a market. There are at least two things
we need to know in order to analyze its production decision. The first is a
demand curve q = q(p), or equivalently, an inverse demand curve p = p(q),
both of which summarize the behavior of consumers as a group. The firm
needs this information to calculate how much revenue R = p(q)q = q(p)p it
can get by choosing a particular quantity q or price2 p. The second necessary
information is its cost function C(q).
Given these two pieces of information, a monopoly faces the following
profit maximization problem:

max p(q)q − C(q) (1)

q

The first order condition with respect to q is

dp
F.O.C : q + p − C 0 (q) = 0
dq
1
Please send me an email at ziyanhuang@ucla.edu if you find any typos or mistakes.
2
It does not matter whether the monopoly is choosing quantity or price. However, it
matters for other market structures, as you will see in the incomplete competition models
later this quarter.

1
or
dp
q + p = C 0 (q) (2)
dq
The righthand side of (2) is the marginal cost (usually denoted by M C) of
producing q. The lefthand side is the marginal revenue (M R). Notice that
for a monopoly, the extra revenue it gets from selling one more unit of good
is not simply the current price p. Consumers’ downward-sloping demand
curve means that the monopoly has to lower price a little bit to make con-
sumers willing to consume this extra unit, and this decrease in price reduces
its revenue for all units that have already been demanded. The term p0 (q)q
captures this effect.

Elasticity of demand eq,p

The elasticity of demand is defined as the percentage change in quantity
responding to 1 percent change in price:

dq/q dq p
eq,p = = (3)
dp/p dp q

With the downward-sloping demand that prevails in economics, eq,p is usu-

ally negative. Demand is called elastic if eq,p < −1. In this case, 1 percent
increase (decrease) in price results in more than 1 percent decrease (increase)
in quantity. The opposite case, where eq,p > −1, is the case of inelastic de-
mand, and consumers do not respond much to price changes.

Monopoly pricing and the inverse elasticity rule

Under the help of eq,p , we can rewrite the expression of marginal revenue
we got in (2):

dp dp q 1
MR = q+p=p ( + 1) = p ( + 1)
dq dq p eq,p

2
Rearranging above equation, we have

p − MC 1 1
=− = (4)
p eq,p | eq,p |

Two observations from (4):

(a). A monopoly will not operate at a production level q where the de-
mand is inelastic, eq,p > −1. You can use (4) to figure out that such a q
implies M C < 0 which makes no sense, or you can think in more details
about what actually happens after the monopoly’s raising price. With in-
elastic demand, quantities respond less than one-to-one to price changes, so
the revenue will increase. On the other hand, higher price results in less
goods produced, so the total cost of production decreases. Combining above
two aspects, the monopoly in fact enjoys a higher profit, so it is not optimal
for it to stay in the inelastic part of the demand curve.
(b). Larger elasticity of demand (consider its level or its absolute value)
implies smaller markup. It is straight-forward to see this result from (4). It
is also intuitive since raising price results in a greater loss of demand if | eq,p |
is large.

You should be able to do Problem 14.1-14.3 in the textbook and solutions

can be found online later.