Chapter 9

Profit maximization under

imperfect market
 9. 1. MONOPOLY
The word monopoly originally meant the right of exclusive
sale.
It has come to be used to describe any situation in which
some firm or small group of firms has the exclusive control
of a product in a given market.
A monopoly is a single supplier to a market
This firm may choose to produce at any point on the
market demand curve.
A monopolist is price makers as contrast to price taker
behavior of competitive market.
The demand behavior of the consumers will constrain
the monopolist's choice of price and quantity.
 SOURCES OF MONOPOLY POWER
Entry barriers
The reason a monopoly exists is that other
firms find it unprofitable or impossible to enter
the market.
Barriers to entry are the source of all monopoly
power
there are two general types of barriers to entry:
technical barriers
legal barriers
 PROFIT MAXIMIZATION
The monopolist faces 3 sort of constraints when it
choices its price and output levels:
Standard technology constraint- certain
patterns of inputs and output that are technically
feasible ….represented by Production Function,
Economic Constraint, represented by C(y).
Consumer’s behavior …represented by D(p)
The monopolists profit maximizing problem:
Usually the monopolist produces output that the
consumer demands and D(p)=y

Substituting the problem will become:

Using the inverse demand fun (p(y), the problem can

be:
The first-order conditions for profit maximization are that
marginal revenue equals marginal cost, or

Let us examine this more:

Selling dy unit more output leads to two effects:
First, its revenues increase by pdy because it sells more
output at the current price.
But to sell this, it must decrease price by
dp=(dp/dy)dy
o and this lower price applies to all the units y it is
selling
o he will lose this much revenue on unit of output sold
(dpy).
The sum of these two effects gives the
marginal revenue:

The first-order condition can be rearranged to

take the form:
If the marginal revenue exceeds the marginal
cost of production the monopolist will expand
output.
The expansion stops when the marginal
revenue and the marginal cost balance out.
 Markup Pricing
We can use the elasticity formula for the monopolist to express
its optimal pricing policy in another way.
A markup rule refers to the pricing practice of a producer with
market power, where a firm charges a fixed mark up over its
marginal cost.
By rearranging the above equation, we can get:

This formulation indicates that the market price is a markup

over marginal cost, where the amount of the markup depends
on the elasticity of demand.
for a competitive firm ε(y) = ∞, so the appropriate version of
the above equation is simply price equals marginal cost.
 Graphically
The monopolist will maximize profits where MR = MC
The firm will charge a price of P*
Profits can be found in the shaded rectangle
Monopoly profits will be positive as long as P > AC
Monopoly profits can continue into the long run
because entry is not possible.
some economists refer to the profits that a monopoly
earns in the long run as monopoly rents.
o the return to the factor that forms the basis of the
monopoly.
The size of monopoly profits in the long run will
depend on the relationship between average costs and
market demand for the product.
 NO MONOPOLY SUPPLY CURVE
With a fixed market demand curve, the supply “curve” for
a monopolist will only be one point.
the price-output combination where MR = MC
If the demand curve shifts, the marginal revenue curve shifts
and a new profit-maximizing output will be chosen.
 SPECIAL CASES
There are two special cases for monopoly behavior that
are worth mentioning.
1. Linear demand curve
If the inverse demand curve is of the form p(y)=a-by
TR(y)=ay-by2
MR(y) =a-2by …. Marginal revenue is twice as steep
as price (demand curve)
If the firm has constant marginal cost of the form
c(y)=cy c’(y) =c
2. Constant elasticity demand function
The other case of interest is the constant elasticity demand
function,
the elasticity of demand is constant and given by –b.
we can apply

and write

Hence, for constant elasticity demand function, price is a

constant markup over marginal cost, with the amount of
markup depending on the elasticity of demand.
MONOPOLY AND PRODUCT QUALITY
Monopolies choose not only output levels and market
price , but also other dimensions of the products they
produce.
• type, quality, or diversity of goods
Whether a monopoly will produce a higher-quality or
lower-quality good than would be produced under
competition depends on demand and the firm’s costs.
Suppose that consumers’ willingness to pay for quality
(X) is given by the inverse demand function P(Y,X) where
 MONOPOLY AND PRODUCT QUALITY
If costs are given by C(Y,X), the monopoly will choose Y
and X to maximize

First-order conditions for a maximum are

 MONOPOLY AND PRODUCT QUALITY

Marginal revenue from increasing quality by one unit is

equal to the marginal cost of making such an increase.