Monopoly and monopolistic

competition
Introduction
Barriers to entry can affect the market structure.

But also, in presence of economies of scale, large firms can be more

efficient than small firms. This implies that ‘spontaneously’, based on
efficiency, there is a limited number of large firms (or only one) in the
market.

In those situations, we talk about imperfect competition.

2
Introduction
Economies of scale imply that the average cost of production decreases
with output.

Perfect competition, where p=MC, would imply losses for firms with
decreasing average costs (and force them to exit the market).

3
Imperfect competition
Within imperfectly competitive markets firms are aware that they can
influence the price of their products and decide how much to produce.

When: P
1. There are few firms within a specific
market, or
2. The good produced by each firm is
perceived as different compared to other
rival products.
D
the firm is price maker, since it can set Q
the price of its own products.
4
Monopoly
Costs and
Revenue MC

P
The profit-maximizing Q is where
MR = MC.
D
Find P from the demand curve at
this Q. MR

Q Quantity

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Monopoly
As with a competitive firm,
Costs and
the monopolist’s
Revenue MC
profit equals
(P – AC) x Q P
AC
AC

D
MR

Q Quantity
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Monopoly
• In a competitive market equilibrium, Price
P = MC and total surplus is MC
maximized.
• In the monopoly P > MC P
• The value to consumers of an additional P = MC
unit (P) exceeds the cost of the
resources needed to produce that unit
MC
(MC). D
• The monopoly Qm is too low – could
increase total surplus with a larger Qc. MR
• Thus, monopoly results in a deadweight
loss. Qm Qc Quantity

7
Monopoly
Let’s consider the following example

Suppose that the cost function is: C(Q) = 50 + Q2

Suppose the demand function is: P(Q) = 40 – Q

Profits: π=P(Q)*Q – C(Q)=(40-Q)Q - 50 - Q2

FOC: ∂π/ ∂Q=O  40 – 2Q -2Q = 0  Qm=10

8
 Monopoly
Euro
Euro
Euro per unit

MC

AC
Profits
D
Profits
MR

Q Q

9
Monopoly
Let’s consider MR (let’s rewrite them differently)

MR = ∆R/∆Q = ∆(P*Q)/∆Q

∆(P*Q) = (P0 - ∆P)(Q0 + ∆Q) – P0Q0 = P0Q0 – P0Q0 - ∆PQ0 + P0∆Q - ∆P∆Q

MR = (- ∆PQ0 + P0∆Q - ∆P∆Q)/∆Q = P0 – (∆P/ ∆Q)Q0 - ∆P

MR = P0 – (∆P/ ∆Q)Q0 - ∆P

MR = P0 – (∆P/ ∆Q)Q0 = P0( 1- (∆P/ ∆Q)Q0/ P0) = P0 (1-1/|ɛ|)

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Monopoly
We know that the monopolist to maximize profits:
P0 (1-1/|ɛ|) = MC
This can be rewritten
(P0 – MC)/ P0 = 1/|ɛ|
(P0 – MC)/ P0 represents the markup (how much P exceeds the MC)

It can be observed that if |ɛ| ∞ (perfect competition) then the markup  0

The more rigid is the demand, the higher the markup.

The more elastic is the demand, the lower is the markup.

The markup is a measure of market power.

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Monopoly (P0 – MC)/ P0

Costs and Costs and

Revenue MC Revenue MC

P P
D

MR
D
MR
Q Quantity Q Quantity
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Monopoly: The social costs
Let’s consider consumers’ and producer’s
surplus Costs and A
Revenue MC
Monopoly I
Pm B
Sc= ABI, Sp = BIEO
Pc
Perfect competition C D F
Sc= ACF, Sp = CFO E

D
∆Sc = - BIDC - IFD
∆Sp = BIDC - DFE MR
H G
O
Deadweight loss = IFD + DFE Qm Qc Quantity
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Multiplant Monopoly
Suppose there is monopolist that produces using two plants.

Its profits will be π=P(QT)*QT – C(Q1) – C(Q2)

To maximize profits the firm would choose QT= Q1 + Q2 such that

MR = MC1
MR = MC2
Let’s consider the following graph

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Multiplant Monopoly
The output should be Euro
per unit
MC1
distributed among plants such MC2
MCT
that MC1 = MC2
(if this is not the case, the
monopolist can redistibute the
production, lowering costs and
increasing profits)
D

QT is determined by MCT=MR
MR

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Multiplant Monopoly
Let’s consider the following exercise:

Demand function: P(Q) = 50 – 2Q, Q = q1 + q2

Cost functions (plant specific):
C(q1)= 4 + q12
C(q2)= 10 + q22/5

Monopolist profits:
π(q1, q2) = (50 – 2Q)Q – (4 + q12) – (10 + q22/5)
π(q1, q2) = (50 – 2q1 - 2q2)(q1 + q2) – (4 + q12) – (10 + q22/5)

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Multiplant Monopoly
First order conditions:
∂π/ ∂q1 = (50 – 4q1 - 4q2) – 2q1 = 0  q1 = 25/3 – 2q2/3
∂π/ ∂q2 = (50 – 4q1 - 4q2) – 2q2/5 = 0

(50 – 4*(25/3 – 2q2/3) - 4q2) – 2q2/5 = 0

1/15*(750 – 500 – 20q2 – 6q2) = 0
q2* = 250/26 (≈ 9,6)
q1* = 25/3 – (250*2)/(26*3) (≈ 2)

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Multiplant Monopoly
The total quantity produced by the monopolist is

Q * = q1* + q2* ≈ 11,6

The market price will be:

[recall: P(Q) = 50 – 2Q, Q = q1 + q2 ]

P(Q) = 50 – 2*11,6 = 26,8

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Let’s do some exercise:
1) There is a monopolist that maximizes profits producing Qm = 4. The
inverse demand function is P=10-Q. Compute:
• The marginal cost and the elasticity of demand with respect to price in that
point.
• Assuming that marginal costs are constant and equal to what obtained
previously, compute profits and represent them graphically.
• Quantify the deadweight loss due to the monopoly.

19
Let’s do some exercise:
2) There is monopolist operating in a market having the following
demand function: Q = 10-2P, the cost function is C(Q) = Q2.
• Compute quantity and price that maximize the monopolist’s profits
• Compute quantity and price in perfect competition
• Compute the deadweight loss due to the monopoly

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Monopolistic competition
There is Monopolistic competition when
• The number of firms in the market is ‘high’,
• None of them has a ‘significant’ market share.
• ( price decisions are not inter-related)

In the market
o there could be firms that sell differentiated products
o there could be a small number of firms producing the same good
(oligopoly)
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Monopolistic competition
When there is monopolistic competition, a firm will produce (and sell):

• A higher quantity the larger the aggregate demand in the market and
the higher the competitors’ price;
• A lower quantity the higher the number of firms in the market and
the higher its own price.

Those concepts can be represented by the following model:

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Monopolistic competition
Suppose that

Q = S × [1/n – b × (P – P*)]
where:
• Q is the quantity demanded to firm i
• S are total sales
• n is the number of firms
• b represents how the quantity reacts to changes in price
• P is the firm i’s price
• P* is the average price of competitors
• In this case firms are ‘symmetric’ (same demand and costs)

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Monopolistic competition
To describe the market equilibrium, we need to know two aspects:
- The number of firms (n)
- The price (P)

To determine n and P:

1. First derive the relation between n and AC (average costs for each firm):
this will be increasing – the higher the number of firms in the market, the lower will be firm i’s output, the
higher will be average costs).
2. Second, we derive the relation between n and P (average price):
this will be decreasing – the higher the number of firms the higher the competition the lower will be P.

3. Third, we derive entry and exit choices of firms in the market by comparing P and
AC.
(If P>AC => Profits => Is profitable to enter the market for new firms, if P<AC, viceversa)
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Monopolistic competition
Step 1: n and AC

Given that firms are symmetric, the following equation

Q = S × [1/n – b × (P – P*)]
simplifies into:
Q = S/n.

The quantity produced by each firm will be a fraction (1/n) of the total
output in the market. We can use this to understand how n and AC are
related.

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Monopolistic competition
The function describing AC is the following:

AC = F/Q +c
Considering that Q = S/n, then
AC = (n * F/S) + c

Average costs depend on the market dimension, S, and the number of firms,
n. We will call this relation CC, it highlights that:

The higher n, the higher will be AC (the quantity produced by each firm is
lower).
The higher S, the lower will be AC (the quantity produced by each firm is
higher).
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Monopolistic competition
Step 2: n and P

The price set by each firm depends on the number of firms in the market.

In general, the higher the number of firms, n, the lower will be the price, due
to a higher competition.

It can be shown that between n and P there is the following relation (PP):

P = c + 1/(b*n)

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Monopolistic competition
C, P
Step 3:
Now we have the following: CC
P = c + 1/(b*n) (PP) AC3
AC = (n * F/S) + c (CC)
P1
and we can derive entry E
and exit choices of firms. P2=AC2
AC1
P3
n1: P1>AC1 PP

n3: P3<AC3

n1 n2 n3 n
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Monopolistic competition
The equilibrium in the market is represented by the point E (where CC and
PP intersect).

Given n, the price (that is lower the higher n) set by firm i is equal to AC (that
is higher the higher n)

n2 represents the number of firm in the long term equilibrium. Firms do not
have incentives to enter or exit the market. If n is different from n2, then
there are incentives to enter/exit the market:
• If P > AC, the there are incentives to enter (Profits);
• If P < AC, the there are incentives to exit (Losses).

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Let’s do some exercise:
3) Suppose that there is a firm operating in the car markets with fixed
costs equal to 5 billions of $ and marginal costs equal to 17000 $
per car. We have that the higher is n (the number of firms operating
in the market) the higher is the competition, and the higher is n the
lower is the price according to the following P=17000 + 150/n (PP).
• Let’s first assume 2 separate markets, EU and US, with market size equal to
300 and 533 millions of inhabitants respectively. Compute the long-term
equilibrium in terms of number of firms and prices.
• Let’s now suppose that there’s free trade, so that EU and US can be
considered as a unique market, how does the long-term equilibrium change?
Compute the number of firms and price.

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Monopoly and monopolistic
competition
Exercises
Let’s do some exercise:
1) There is a monopolist that maximizes profits producing Qm = 4. The
inverse demand function is P=10-Q. Compute:
• The marginal cost and the elasticity of demand with respect to price in that
point.
• Assuming that marginal costs are constant and equal to what obtained
previously, compute profits and represent them graphically.
• Quantify the deadweight loss due to the monopoly.

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Solution
Revenues: R=P*Q=(10-Q)*Q
Marginal revenues: first derivative  MR=10-2Q
The monopolist maximizes profits according to MR=MC, the quantity
that maximizes profits is Qm = 4  MR = MC = 10 -2*4 = 2
The price will be Pm = 10-4 = 6
Profits will be π = (Pm-MC)*Qm = (6-2)*4 = 16
∆ ∆
Elasticity: ɛ = =  -1*6/4 = -1.5
∆ ∆

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Solution
Perfect competition p=MC=2 Qc=8

Monopoly Perfect competition

Sc = (10-6)*4/2 = 8 Sc = (10-2)*8/2 = 32
Sp = (6-2)*4 = 16 Sp = 0
Total = 24 Total = 32

Deadweight loss = (4*4)/2 = 8

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Let’s do some exercise:
2) There is monopolist operating in a market having the following
demand function: Q = 10-2P, the cost function is C(Q) = Q2.
• Compute quantity and price that maximize the monopolist’s profits
• Compute quantity and price in perfect competition
• Compute the deadweight loss due to the monopoly

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Solution
Q = 10-2P  2P = 10-Q, P = 5-1/2*Q
R = (5-1/2*Q)*Q
MR = 5-Q
MC =2Q
MR=MC: Qm = 5/3, Pm = 25/6 (quantity and price that maximize the
monopolist’s profits)

Perfect competition: p=MC  5-1/2*Q=2Q  Qc = 2, Pc=4

Deadweight loss = 5/36

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Solution
Monopoly:
Price
Sc = ½*(5-25/6)*5/3 = 25/36 5
MC
Sp = (25/6)*(5/3) – 25/9 = 150/36
Ts = 175/36
Pm = 25/6
Perfect competition: Pc = 4
Sc=1/2*((5-4)*2)=1 10/3
Sp=4*2-4=4
Ts=5 D
MR
Deadweight loss=5-175/36=5/36
Deadweight loss (triangle area)=((25/6-10/3)*(2-
5/3))/2=5/36 Qm Qc Quantity
5/3 2
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Let’s do some exercise:
3) Suppose that there is a firm operating in the car markets with fixed
costs equal to 5 billions of $ and marginal costs equal to 17000 $
per car. We have that the higher is n (the number of firms operating
in the market) the higher is the competition, and the higher is n the
lower is the price according to the following P=17000 + 150/n (PP).
• Let’s first assume 2 separate markets, EU and US, with market size equal to
300 and 533 millions of inhabitants respectively. Compute the long-term
equilibrium in terms of number of firms and prices.
• Let’s now suppose that there’s free trade, so that EU and US can be
considered as a unique market, how does the long-term equilibrium change?
Compute the number of firms and price.

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Solution
(CC) AC = (n * F/S) + c = (n* 5000000000/S) + 17000
(PP) P=17000 + 150/n

EU:
AC = (n* 5000000000/300000000) + 17000
AC = (n* 50/3) + 17000 $
P=AC  n* 50/3 = 150/n  n2 = (150/50)*3 = 9, n=3  P=17050

US:
AC = (n* 5 000000000/533000000) + 17000
P=AC  n2 = 16, n=4  P=17037.5

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Solution
Free trade
(CC) AC = (n * F/S) + c = (n* 5000000000/(Seu+Sus)) + 17000
(PP) P=17000 + 150/n

AC=(n* 5000000000/(300000000+533000000)) + 17000

P=17000 + 150/n
P=AC  n=5
P = 17030

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