ECON 1 ECON 101

PRINCIPLES OF
PRINCIPLES OF MICROECONOMICS
MICROECONOMICS
THEORY OF DEMAND

Monopoly

Dr. Shama Azad

Fall 2024
 RECAP: PERFECT COMPETITION

• Features of Perfect Competition Firms:

• Large number of buyers and sellers.
• Firms sell identical or homogenous products.
• Firms are price takers. Price set in the market
• No barriers to entry or exit in the industry
• Perfect Information.
• Firm’s demand curve is horizontal. We also know that D = AR = MR.
• Firms produce where MR = MC because they are profit maximizers.
• Firms can make positive economic profits (or supernormal profits) or losses
in the SR. If they make a loss in the SR, they have two choices: continue to
operate or shut down temporarily.
• In the long run, firms can only make zero economic profits (or normal
profits). We get: P = AR = MR = MC = ATC in the LR.
• Firms are allocative and productively efficient in the LR.
 REVENUE

• We know that revenue is the money a firm makes from selling goods and
services. Sometimes also known as ‘turnover’.
• We have seen that firms maximize profit when marginal revenue equals
marginal cost or when MR = MC.
• Total Revenue = P x Q.
• Average Revenue = TR / Q = (P x Q) / Q. So, AR = P.
• Marginal Revenue = change in TR / change in Q.
• Marginal revenue at any level of a firm’s output is the revenue it would
earn if it sold another (marginal) unit of its output
• What the revenue curves look like depends on the level of
competition. We can have perfect competition or imperfect
competiton.
 REVENUE

• A firm’s revenue depends on whether the firm is in perfect

competition or imperfect competition.
• In perfect competition, firms are price takers and the marginal
revenue and average revenue will be horizontal lines.
• In imperfect competition, the average revenue and marginal
revenue curves are both falling, but marginal revenue is falling at
a faster rate (it is twice as steep) as the average revenue curve.
• In imperfect competition, the firms are price makers. They
can set their own prices, but these prices are determined by the
law of demand.
• At high prices, quantity demanded is low and at low prices,
quantity demanded is higher.
• In order to generate a greater quantity of demand, the firms
lower prices.
 REVENUE

PRICE QUANTITY TOTAL AVERAGE MARGINAL • In imperfect competition, as the firm

DEMANDED REVENUE REVENUE REVENUE increases its quantity sold, the average
(P x Q) [(P x Q) / (TR /Q)
Q] = P revenue falls.
• This is indicative of a downward-sloping
25 2 50 25 demand curve. In markets with such
demand curves, consumers are typically
willing to pay a lower price for additional
20 4 80 20 30/2 = 15
units of a good, which results in
declining average revenue as the firm
15 6 90 15 10/2 = 5 produces and sells more units.
• Marginal revenue also decreases
because selling one more unit requires
10 8 80 10 -10/2 = -5 reducing the price for all units sold,
losing revenue from the ones that could
5 10 50 5 -30/2 = -15 have been sold at a higher price.
• This leads to smaller incremental gains
in total revenue. For this reason, the
marginal revenue curve is falling in
AVERAGE REVENUE &
MARGINAL REVENUE

• At a certain point, the price is set

so low to generate demand, that
total revenue starts to fall.
• This is also the point where the
marginal revenue curve crosses
the x-axis.
• From the graph we see that a firm
maximizes total revenue when
MR = 0.
 CONSTRUCING THE AR & MR
CURVES

AR CURVE:
• On a regular downward sloping demand curve, we have price on the y-axis and quantity
demanded on the x-axis. Writing it in function form, we can say that P = a – bQ d.
• The slope is negative since it is a downward-sloping curve.
• We know AR = P and also that P = a – bQ d. Therefore, we can say that AR = a – bQ d. This
indicates that the AR curve and the demand curve are the same.

MR CURVE:
• Now let’s look at the MR curve. We know taking the first derivative of the TR function will give
us the MR curve (which is also the slope of the TR curve).
• TR = P x Q and from above we know that P = a – bQ d. Thus, we can write the total revenue as:
TR = (a – bQd) * Q or expanding the bracket: TR = aQ – bQ 2.
• Differentiating the TR function will give us the slope, which is the MR:
• dTR / dQ = MR = a – 2bQ.
• So we see here that the MR curve is also negative as it is downward sloping and is
twice as steep as the AR curve.
 MONOPOLY MARKET STRUCTURE

• Monopoly is a model that contrasts perfect competition.

• The characteristics of a monopoly are:
1. There is a single seller in the market: In perfect competition, many firms
make up the industry. In contrast, a monopoly means that a single firm is in
the industry. One firm provides the total supply of a product in a given
market.
2. The seller has a differentiated / unique product: A unique product
means there are no close substitutes for the monopolist’s product. Thus, the
monopolist faces little or no competition.
3. Very high barriers to entry into the industry: Extremely high barriers
make it very difficult or impossible for new firms to enter an industry. Some
of the reasons why there are high barriers to entry could be because: (a) The
monopoly owns and controls an important resource for production; (b) Legal
barriers could exist in the form of government permits and licenses; and (c)
Economies of scale because the monopoly’s cost per unit of output produced
is lower compared to other smaller competitors.
4. A monopoly is a profit maximizer.
 MONOPOLY MARKET STRUCTURE

• The fundamental cause for a monopoly to arise is barriers to entry.

• In a perfectly competitive market, there are no barriers to entry. Firms
are free to enter and exit.
• A monopoly remains the only seller in its market because other firms
cannot enter the market and compete with it.
• Therefore, in a monopoly, the demand and supply for the firm and
the industry are the same.
• Examples of Monopoly include: Microsoft OS for Windows users, new
patented drugs to cure illnesses, utility companies, etc. Monopoly
leads to market power. A monopoly firm is the market.
• Market power alters the relationship between the firm’s costs
and the price at which it sells its product.
 MONOPOLY PRICING

• A monopoly firm is a price maker. A price maker is a firm that faces a

downward-sloping demand curve. This means a monopolist has the ability to
select the product’s price.
• In short, a monopolist can set the price with a corresponding level of output.
• A perfectly competitive firm takes the price as given by the market and then
produces output where P = MR = MC.
• On the other hand, monopoly firms charge a price that exceeds MC.
• It is important to note that even though a monopoly has the power to set a
price higher than MC, it cannot set an exorbitantly high price because it is still
ruled by the Law of Demand. The higher the price, the lower the quantity
demanded will be.
• Therefore, a monopoly’s profits are not unlimited.
 DEMAND, AR & MR CURVES
FOR A MONOPOLY

• One of the key differences between a competitive firm

and a monopoly is the monopoly’s ability to influence
the price of its output.
• The monopoly firm is the market.
• Market demand curve is downward sloping – we know
from the Law of Demand. Therefore, the monopolist’s
demand curve is downward sloping.
• A monopolist can control price or output but not both.
 MONOPOLY REVENUE

Consider a town with a monopoly supplier of water.

Quantity of Price ($) TR = P*Q AR = TR/Q MR = ∆TR/∆Q
Water ($)
(Gallons)
0 11 0 -- ---
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
 MONOPOLY REVENUE
FOR A MONOPOLIST

• A monopolist’s MR is always less than or equal to the AR or the price of

the good.
• This is because a monopolist faces a downward sloping demand curve
and MR falls twice as fast as AR.
• If the monopolist wants to sell more output, the price has to be reduced.
Or price can be held at a high level, and less output will be sold.
• MR for monopolies is very different to MR for a perfectly competitive
firm.
• When a monopoly increases amount sold, we get a combination of two
effects:
• Output effect: More output sold, Q higher, TR increases
• Price effect: Price falls, P lower, TR decreases
• For a perfectly competitive firm, there is no price effect because price is
given and constant. That is why AR = MR.
MONOPOLY REVENUE
FOR A MONOPOLIST
• In a monopoly, when production rises by even 1
unit, price has to be reduced in order to sell that
unit, and this reduces TR on the units it was
already selling. That is why we get MR < AR.
• When the output effect > price effect, TR is
increasing. MR is falling but positive.
• When price effect > output effect, TR is
falling. MR can become negative.
• When the MR curve is above the x-axis, the total
revenue is rising.
• At the intersection of the MR curve and the x-
axis, the total revenue is at its maximum level.
• When the MR curve falls below the x-axis, the
total revenue is decreasing.
• The monopolist will prefer not to operate where
MR is negative.
PROFIT MAXIMIZATION
FOR A MONOPOLY
• The monopolist can maximize profits if they
produce at the quantity corresponding to MC =
MR. Therefore they will produce where the MC
curve and the MR curve intersect.
• If MC < MR, the firm can increase profits by
increasing output
• If MC > MR, the firm can increase profits by
reducing output
• In the end, equilibrium is reached where MC =
MR.
• For a competitive firm, we know that P = MR =
MC
• For a monopoly, we see that P > MR = MC or P
> MC.
• To determine the price that a profit-maximizing
monopoly firms set, we see where MR = MC and
then read it off the AR curve or demand curve to
see how much people will pay for the quantity
 PROFIT FOR A MONOPOLY

• We know that Profit = TR – TC.

• Or we can say, Profit = [ TR/Q – TC/Q] *Q
We have multiplied and divided the equation by Q, the value will
remain the same.
• We also know that TR/Q = AR = P and TC/Q = ATC.
Therefore, Profit = [P – ATC]*Q.
SHORT RUN LOSSES FOR A
MONOPOLY

• It is possible for a monopolist to make losses in the short

run.
• This could happen if the demand or cost conditions change.
• If the demand curve is lower than any point on the ATC
curve, the total cost will exceed total revenue for any price
charged.
• In the diagram, we see that at the quantity corresponding
with MR = MC, the price is higher than the AVC curve, but
below the ATC curve.
• In this case, the firm is making losses and the best they can
do is to minimize losses.
• Similar to perfect competition, as long as the monopolist
can recover the average variable cost, the firm should
continue to produce.
• If MR = MC corresponded to a quantity at which the price
was lower than the AVC, the monopolist firm would shut
down.
 LONG RUN FOR A MONOPOLY

• In the long run, the monopolist firm has greater flexibility.

• It can alter its plant size to adjust costs.
• Or alternatively, it is possible for demand to change such that the
monopolist does not make any more losses.
• However, if losses were to persist, the monopolist will not
continue in the long run and will instead transfer its resources to
a more profitable industry.
• If the monopolist firm was making economic profits in the short
run, it is possible for the firm to sustain that in the long run as
well due to high barriers to entry in the industry and their product
having no close substitutes.
 CHANGE IN MARKET STRUCTURES
OVER TIME
• If a big pharma firm discovers a new drug. A patent gives it
monopoly rights on the sale of the drug for a period of time.
• When the patent expires, anyone can make the drug and
market becomes competitive.
• What happens to the price of the drug when the patent
expires?
• During life of patent, the monopolist firm can maximize profit
by producing output where MR=MC and charging a price well
above MC.
• But after patent expires, the market becomes much more
competitive.
 WELFARE COST OF MONOPOLIES

• Is a monopoly firm good or bad for the market?

• From a consumer’s viewpoint, prices are higher than in a
competitive markets.
• From the firm’s point of view, there are higher profits and
benefits.
• We now look at how this trade-off will work.
• Remember:
• Consumer Surplus (CS) is the difference between consumer’s
willingness to pay and the actual price paid.
• Producer Surplus (PS) is the difference between the amount
received for a good and the cost of producing it i.e. difference
between price and marginal cost.
 WELFARE COST OF MONOPOLIES

• Recall that at the intersection of supply and demand, we get

the point of equilibrium, and this a natural as well as a
desirable outcome.
• This is because allocative efficiency is being reached, and
thus the allocation of resources is at its most optimal level.
This maximizes the total surplus.
• However, we know that in a monopoly the price is not set at
the intersection of the demand and supply curves, it is set
higher.
• Therefore, the allocation of resources in a monopoly will also
be different, and we will not be maximizing society’s welfare.
WELFARE COST OF MONOPOLIES

• Monopolist produces output where

MC=MR.
• At this point, the monopolist produces
less than the socially efficient quantity
of output.
• Consider the impact of a monopoly
price to be similar to a price floor.
• Whenever a consumer pays an extra
dollar because of monopoly price, the
consumer is worse off by a dollar and
the monopolist is better off by a dollar.
• Monopoly profit is not a reduction in the
total pie, but a bigger share for the
producer and a smaller share for the
 PRICE DISCRIMINATION

• In the graph above we saw that the monopolist charged the same price to all
of its consumers.
• However, it may be that a firm charges different prices to different consumers
for an identical good or service with no differences in cost of production. This
is price discrimination.
• In order for a monopolist to engage in price discrimination, a monopoly must
satisfy three conditions:
1. The seller must be a price-maker, and therefore must face a downward
sloping demand curve.
2. The seller must be able to segment the market by distinguishing
between consumers willing to pay different prices. This separation of
buyers can be shown to be based on different price elasticities of
demand.
3. The monopoly must be able to prevent re-sale (or market seepage). This
means the monopoly must stop customers from buying where the price is
low and sell where the price is high. This would not allow the price
FIRST DEGREE PRICE
DISCRIMINATION

• This is also known as perfect price

discrimination.
• In first degree price discrimination, the seller
charges each buyer exactly the price that
they are willing to pay, e.g.: the price that
stall holders are charged at a trade show.
• The pricing in this type of discrimination is
set down the demand curve.
• As a result, they erode all of the consumer
surplus, turning it into producer surplus.
• Therefore, the firms increase profit at the
expense of consumers.
• However, for first degree price
discrimination to be implemented, the
monopolist must have exact information
about the buyer’s willingness to pay, which
 FIRST DEGREE PRICE
DISCRIMINATION

• First degree price discrimination is highly efficient, in fact, as efficient

as perfect competition in terms of resource allocation.
• Every consumer willing to pay above cost is served. Therefore, the
monopoly:
• Cannot make anyone pay more than it is worth to them
• Charges them exactly what is worth to them, i.e.: the willingness to pay
• Anytime the willingness to pay is greater than cost, there is profit
available
• Why does 1st degree PD do so well?
• Selling more does not require lowering of price
• Seller captures full value created and tries to maximise value created
• However, in this process, the consumers gain no surplus at all.
• First degree price discrimination is rarely seen in practice as difficult to
implement.
 WELFARE WITH AND WITHOUT
PRICE DISCRIMINATION

• On Graph 2, we see the graph representing a monopoly that

charges the same price to all of its consumers. Any consumer
whose willingness to pay is above the price will buy the good and
get consumer surplus as shown in the triangular area above the
price.
• Graph 1 shows the monopoly operating with perfect price
dicrimination. We see that all of the previous consumer surplus is
now part of the monopolist’s profits.
• If a firm can charge each person his/her maximum willingness to
pay, then MR = price as found on the demand curve (i.e.: the AR
and demand curve also becomes the MR curve). So it would be
willing to sell its products up to the point where the MC curve
crosses the demand curve, i.e. where MC = price = MR.
• This means that not only will the firm would be willing to sell
more units than it did as a single priced monopolist, but it will
also be allocatively efficient because price equals marginal cost at
the last unit.
• However, each consumer is now paying her maximum willingness
GRAPH 1 GRAPH 2 to pay, and therefore receives no consumer surplus. So although
the output level is allocatively efficient and the same as perfect
competition would obtain, the distribution of economic surplus is
quite different – the firm extracts all of the surplus.
SECOND DEGREE PRICE
DISCRIMINATION
• Second degree price discrimination is also known as
non-linear pricing.
• Firms charge consumers different prices based on the
quantity or volume they purchase. It may charge a high
price for the 1st ‘x’ number of units, and a lower price for
‘y’ number of units.
• If a consumer gets a discount when they buy a large
quantity of goods (or when they bulk buy), that is
second degree price discrimination.
• Consumers who bulk buy tend to be more price
sensitive, so they are charged a lower price.
• Second degree price discrimination can also work with
quality, e.g: different prices for airline seats in different
classes of travel.
SECOND DEGREE PRICE
DISCRIMINATION
 THIRD DEGREE PRICE
DISCRIMINATION
• Third degree price discrimination occurs when a firm is able to segment the market into different price
elasticities of demand.
• There will be groups of consumers who will have similar demands and they can be segmented based on
easily identifiable characteristics such as age, time of purchase, geography, etc.
• Some consumers will have price inelastic demand, while some consumers have more price elastic demand.
• The monopolist then charges different prices to the different groups based on their relative elasticities of
demand. The more inelastic the demand, the higher the price.
• Instead of charging just one price overall in the market, if they charge two different prices, the firm is able
to maximize their joint profits.
• Demand curves (AR) and MR will look different in both cases.
• Movie theaters often charge different prices based on the time of consumption and age. The elasticity of
demand for those attending a daytime show is more elastic than those during primetime, so a lower price
is charged for in the daytime.
• People also have different elasticities of demand based on age, allows which allows companies to price
accordingly.
• Airlines also price discriminate. Those purchasing tickets at least two weeks in advance will pay a different
price than individuals making a last-minute purchase.
THIRD DEGREE PRICE
DISCRIMINATION
 PROS & CONS OF
PRICE DISCRIMINATION

• The cons of price discrimination are:

• Allocative inefficiency: Charging prices way beyond marginal cost,
exploiting consumers. Level of production will not be at the point of
allocative efficiency most times.
• Inequalities: Like first degree price discrimination and the inelastic segment
in third degree. Each of these can widen the income inequalities in society.
• Anti competitive pricing: comes down to third degree price discrimination.
If the lower prices (especially in the elastic segment of third degree) is
driving out competitiors, then the firm will really become a monopoly.
• The pros:
• Dynamic efficiency: greater economic profits made by firms, so greater
investment potential, greater dynamic efficiency benefits.
• Economies of scale and perhaps lower prices in the future.
• Some consumers benefit, like in second degree as well as those in the
elastic segment of third degree price discrimination.
REGULATION OF A MONOPOLY

• Sometimes the government may choose to regulate a monopoly’s

actions and play a part in setting prices.
• A monopolist would set the price at which MR = MC and trace that
corresponding quantity up to it’s demand curve. Therefore, in our
graph price P1 and quantity Q1 would maximize profits. The
monopolist would operate at point A.
• If the government wants to achieve allocative efficiency, it would
make the monopolist set the price P2 and the monopoly would
operate at point C. At this point, the government is making the
monopolist firm charge a price no higher than P2. The firm will
produce at Q2. This is the socially optimal point.
• However, that may be so low that the firm won’t be able to cover its
average total costs (ATC). The result may be a loss for the firm in the
short run and a bankruptcy (and exit) in the long run.
• In this case, the government will modify the allocative efficiency
policy P=MC, so that firms may establish a fair-return price. In this
case firms will have only a normal profit and this price is determined
by intersection of ATC and demand curves. Firms then operate at
point B.
 PERFECT COMPETITION VS
MONOPOLY
• The monopolist's price is set above the marginal cost of
the good.
• In the long-run, a monopolist is not forced to produce at
the minimum point of the average total cost curve.
• A monopolist earns more economic profit in the long-run
than does the competitive firm.
• The monopolist has no competition to force him to
produce where MC = P.
• Monopolist’s demand curve is downward-sloping, unlike
for a single firm in perfect competition.
 DISADVANTAGES OF A MONOPOLY

• The problem in a monopoly market is that the firm

produces less than the socially optimum level of output
that would maximize both CS and PS.
• The DWL measures how much the economic pie shrinks
because of monopoly power.
• Has to do with P > MC.
 PRACTICE PROBLEM 1

In a monopoly, price exceeds marginal cost because:

a) The firm produces a standardized product
b) Of the extensive economies of scale that exist
c) Asymmetric information exists
d) The firm has the ability to set the price
e) Of collusive behaviour
 PRACTICE PROBLEM 2

The characteristic of monopoly that allows the firm to set

the price of the product is that
a) There are no close substitutes for the product
b) Firms are mutually interdependent
c) There is no product differentiation
d) There are no barriers to entry
e) The firm experiences diseconomies of scale
 PRACTICE PROBLEM 3

The socially optimal (or the allocatively efficient) level of

output occurs where:
a. Marginal revenue is maximized.
b. Economic profits are maximized.
c. Price equals marginal cost.
d. Marginal revenue equals marginal cost.
 PRACTICE PROBLEM 4

Which of the following is true about deadweight loss in a

monopolistic market?
a) It is eliminated by perfect or first degree price
discrimination.
b) It is greater than in a perfectly competitive market.
c) It occurs because the monopolist produces more than
the socially optimal quantity.
d) It only exists if the monopolist earns zero economic
profit.
 PRACTICE PROBLEM 5

Which of the following statements is true about a monopoly firm?

a. Monopoly firms can charge any price they wish to set without losing
customers.
b. Monopoly firms produce less output and charge higher prices than
firms in perfect competition.
c. Monopoly firms can only make positive economic profits in the
short run.
d. In third degree price discrimination, a monopoly firm charges each
consumer their maximum willingness to pay.
 PRACTICE PROBLEMS: SOLUTIONS

1. The answer is D. A monopoly firm is a price maker and they have control over the price
they set. Therefore, the firm will produce where MR = MC and set a price at P > MC.
2. The answer is A. Since the product sold by a monopoly firm is unique and has no close
substitutes, this allows the firm to have control over the price and makes them price
makers.
3. The answer is C. The condition for allocative efficiency is met when P = MC. This is also
the socially optimal level of output as it maximizes social welfare.
4. The answer is A. When a monopoly firm undertakes perfect or first degree price
discrimination, it produces all the way up to the point at which the MC curve intersects
the D = AR curve. This is a socially optimal level without any DWL. For first degree PD,
the D = AR curve is also the MR curve.
5. The answer is B. Monopoly firms restrict output to less than the socially optimal level
and charge higher prices (at P > MC) than the firms in perfect competition.
 PRACTICE PROBLEM 6

A firm faces the following demand (AR) curve: P = 120 –

0.02Q
Where Q is weekly production and P is price in $/unit.
The firm’s cost function is C = 60Q + 25,000. Assume
the firm maximises profits.
What is the level of production, price and total profit per
week for this firm?
 PRACTICE PROBLEM 6: SOLUTION

Since the firm maximises profit, to find output produced we need

to equate MR and MC. But we first need to find MR and MC.

We know that if AR = P = 120 – 0.02Q, then TR = PxQ

So, TR = 120Q – 0.02Q2
Then MR is dTR/dQ = 120 – 0.04Q

And TC = 60Q + 25,000

So MC = dTC/dQ = 60

Equating MR and MC we get

120 – 0.04Q = 60 or 120 – 60 = 0.04Q
We get: Q = 1500 units
 PRACTICE PROBLEM 6: SOLUTION

To get the price, we substitute the value Q = 1500 into the

demand (AR) equation. We get: P = 120 – 0.02(1500) = 120 – 30
= $90/unit.

We know that Profit = TR – TC

TR = P x Q
TR = 90 * 1500 = $135,000
For Total Cost, we substitute the value of Q that we have
calculated into the cost function and get:
TC = 60Q + 25,000 = (60 x 1500) + 25,000. Or TC = $115,000

Therefore Profit = 135,000 – 115,000 = $20,000.