DEPARTMENT OF ECONOMICS

ECON1012: Principles of Economics II

Problem Set 5: Monopoly Power

1. The demand curve faced by a firm is shown in the table along Price Demand Total
with the associated costs of production. Cost
330 1 290
a) Does the firm have monopoly power? How do you know?
270 2 390
Monopoly power is indicated by the inverse relationship 220 3 510
between price and the quantity demanded from the firm; that 180 4 660
is, unlike the case under perfect competition, a higher price 150 5 850
here does not diminish to zero the quantity demanded from 130 6 1,110
the firm. The firm is not a price taker. So the relationship
between price and quantity demanded shown in the first two columns shows that this firm has
monopoly power.
b) At what level will this firm produce?
Firms produce where marginal cost is Total Total Marg. Marg.
Price Demand Cost Rev. Rev. Cost
equal to marginal revenue, so first
we have to derive the marginal cost 330 1 290 330 330
and marginal revenue columns. 270 2 390 540 210 100
220 3 510 660 120 120
Doing so reveals that MC equates to
180 4 660 720 60 150
MR at a quantity of 3, so that is the
150 5 850 750 30 190
amount the firms will produce.
125 6 1,110 750 0 260
c) How much profit will it make at
that level?
At a quantity of 3, total revenue is 660 while total cost is 510, so the profit is the difference of
150.

2. Consider the market and cost structure represented in the P

diagram. 90
a) What would be the amount of output supplied if the market 80
were being served by a monopolist? 70
60
For the monopolist, MC equates to MR at a quantity to 6, so that 50 MC
is the level of output supplied. 40
30 D
b) What would be the price? 20
10 MR
Quantity of 6, according to the demand (average revenue) curve,
will fetch a price of $60. 12345678 9 Q
c) Calculate the amount of consumer surplus. P
The amount of consumer surplus (the area between the demand 90
curve and price) is $90, which can be derived from the area of the 80
70
triangle which is 6 x 30 x ½. 60
50 MC
40
30 D
20
d) If the market were being supplied by perfectly competitive 10 MR
firms who therefore treat P as marginal revenue, the price in 12345678 9 Q
the market would be $40. Calculate the amount of consumer
surplus? P
Consumer surplus above a price of $40 is 10 x 50 x ½ = 250 90
80
70
60
50 MC
40
30 D
20
10 MR
1 2 3 4 5 6 7 8 9 10
 e) Shade the area that represents the amount of welfare being lost if a monopolist were
supplying the market instead of competitive firms? Explain why this area represents a
welfare loss.
By producing only 6 units of output instead of 10, the welfare loss is P
shown by the shaded area. Under competition, the total welfare is 90
80
the area between the demand curve and the supply (= MC) curve. If 70
the monopolist produces only 6 unites, the welfare derived from 60
units 7 thru 10 is lost. 50 MC
40
30 D
20
10 MR
1 2 3 4 5 6 7 8 9 10

3. Use the diagram to show that a price discriminating monopolist P

earns more profit than one charging a single price. Show further that 90
he enjoys a greater profit the more he can discriminate (that is, the 80
more prices he can charge). 70
60
The profit-maximizing output is 8, which can be sold at a price of 50 MC
$50 if the monopolist can charge only one price. His profit will be 8 40
30 D
x $10 = $80. [The total profit may be derived also by simply 20 MR
counting squares, since each square is $10. 10
If he can price discriminate, he can sell (say) 4 units at a price of $70 12345678 9 Q
and the remaining 4 at $50. In this case, profit is (4 x $30) + (4 x P
$10) = $160, higher than it was under a single price. 90
As the number of prices increases, the monopolist gets a larger 80
70
share of the area under the demand curve. the last diagram shows 60
the profit with four prices, which yields a profit of $200. 50 MC
40
30 D
P 20 MR
90 10
80
70 12345678 9 Q
60
50 MC
40
30 D
20 MR
10
12345678 9 Q

4. Draw the average and marginal revenue and average and marginal cost curves for a
monopolistically competitive firm in long run equilibrium.
$ MC
a) Explain the interpretation of each curve.
The marginal cost curve shows the additional cost of producing each AC
unit. The average cost is the cost attributed equally to each unit.
Marginal revenue is the addition to revenue due to selling an
a P
additional unit. And average revenue is the selling price – what each
person pays when everyone pays the same price. MR

x Q
b) How much profit is the firm making?
Since this is the long run and monopolistic competition allows the entry and exit of firms in the
presence of profits or losses, then the level of profit must be zero. This is shown by the equality
of average cost and price (average revenue).

c) Suppose there is a sudden increase in demand for this category of goods. Show on the
diagram how this would be reflected in the short run.
 An increase in the market demand would result in the demand curve $ MC
facing the individual firm shifting in a north-easterly direction, along
AC
with the associated marginal revenue curve. b
d) Show that the firm is now making a profit? P
At the new profit-maximizing output of “y”, average revenue is “b” c
MR
exceeds average cost, “c”, so the firm is earning a profit.
e) On the diagram, show the new equilibrium that would obtain in the
long run. How does the firm’s price and quantity compare to that y Q
which existed before the demand increase?
In the long run, new firms enter the industry to take advantage of the $ MC
excess profits. The typical firm’s market share will shrink, reflected on
the diagram by the firm’s demand curve (and marginal revenue curve) AC
shifting in a south-easterly direction, reversing the original shift. This
will continue until excess profits have disappeared, which occurs a P
when the two revenue curves have returned precisely to their original c
locations. MR

x Q

5. Once again, start by drawing the revenue and cost curves for a monopolistically competitive firm
in long run equilibrium. Now suppose the industry’s firms lose a labour arbitration dispute with
its labour union and has to implement a wage increase across the board. Describe and illustrate
the short run and long run effects on the firm’s output and price.
Starting with average revenue curve P1 and marginal revenue curve $
MR1, the long run equilibrium is at “x” quantity where profit is zero
since both AC and AR are equal to “a” at that level of output. MC1
AC1
The wage settlement causes the cost $ MC2 AC2
curves to shift upwards to AC2 and c a
MC2. The profit maximizing level of MC1
a AC1 P1
output falls to “y”, with average MR1
revenue of “b” and average cost higher b
x Q
at “c”. The firm is making a loss.
P1 $ MC2 AC2
The losses induce firms to leave the MR1
industry, increasing the market share of d
y x Q
the remaining firms, shown as the
P2
revenue curves shifting upwards and to the right (P2 and MR2). In the MR2
long run, profits are back to zero, but there are fewer firms in the
industry. P1
MR1

y z Q