Chapter 10

Market
Power:
Monopoly and
Topics to be Discussed
• Monopoly
• Monopoly Power
• Sources of Monopoly Power
• The Social Costs of Monopoly Power

Chapter 1 2
Topics to be Discussed
• Monopsony
• Monopsony Power
• Limiting Market Power: The Antitrust
Laws

Chapter 1 3
Perfect Competition
• Review of Perfect Competition
– P = LMC = LRAC
– Normal profits or zero economic profits
in the long run
– Large number of buyers and sellers
– Homogenous product
– Perfect information
– Firm is a price taker

Chapter 1 4
Perfect Competition
P Market P Individual Firm
D S
LMC LRAC

P0 P0
D = MR = P

Q0 Q q0 Q
Monopoly
• Monopoly
1) One seller - many buyers

2) One product (no good substitutes)

3) Barriers to entry

Chapter 1 6
Monopoly
• The monopolist is the supply-side of
the market and has complete control
over the amount offered for sale.

• Profits will be maximized at the level

of output where marginal revenue
equals marginal cost.

Chapter 1 7
Monopoly
• Finding Marginal Revenue
– As the sole producer, the monopolist
works with the market demand to
determine output and price.
– Assume a firm with demand:
•P = 6 - Q

Chapter 1 8
Total, Marginal, and Average
Total Revenue
Marginal Average
Price Quantity Revenue Revenue Revenue
P Q R MR AR
$6 0 $0 --- ---
5 1 5 $5 $5
4 2 8 3 4
3 3 9 1 3
2 4 8 -1 2
1 5 5 -3 1

Chapter 1 9
Average and Marginal Revenue
$ per
7
unit of
output
6

4 Average Revenue (Demand)

2
Marginal
1 Revenue

0 1 2 3 4 5 6 7 Output
Chapter 1 10
Monopoly
• Observations
1) To increase sales the price must
fall

2) MR < P

3) Compared to perfect competition

• No change in price to change sales
• MR = P
Chapter 1 11
Monopoly
• Monopolist’s Output Decision
1) Profits maximized at the output
level where MR = MC

2) Cost functions are the same

π (Q) = R (Q) − C (Q)
∆π / ∆Q = ∆R / ∆Q − ∆C / ∆Q = 0 = MC − MR
or MC = MR
Chapter 1 12
 Maximizing Profit When Marginal
Revenue Equals Marginal Cost

The Monopolist’s Output Decision

• At output levels below MR = MC the

decrease in revenue is greater than
the decrease in cost (MR > MC).
• At output levels above MR = MC the
increase in cost is greater than the
decrease in revenue (MR < MC)

Chapter 1 13
Maximizing Profit When Marginal
Revenue Equals Marginal Cost

$ per
unit of
output MC

P1

P*
AC
P2
Lost
profit

D = AR

Lost
MR profit

Q1 Q* Q2 Quantity

Chapter 1 14
Monopoly
The Monopolist’s Output Decision

• An Example
Cost = C (Q) = 50 + Q 2

∆C
MC = = 2Q
∆Q

Chapter 1 15
Monopoly
The Monopolist’s Output Decision

• An Example
Demand = P (Q) = 40 − Q
R (Q) = P(Q)Q = 40Q − Q 2

∆R
MR = = 40 − 2Q
∆Q
Chapter 1 16
Monopoly
The Monopolist’s Output Decision

• An Example
MR = MC or 40 − 2Q = 2Q
Q = 10
When Q = 10, P = 30

Chapter 1 17
Monopoly
The Monopolist’s Output Decision

• An Example
– By setting marginal revenue equal to
marginal cost, it can be verified that
profit is maximized at P = $30 and Q =
10.
– This can be seen graphically:

Chapter 1 18
Monopoly
• Monopoly pricing compared to
perfect competition pricing:
– Monopoly
P > MC
– Perfect Competition
P = MC

Chapter 1 19
Monopoly
• Monopoly pricing compared to
perfect competition pricing:
– The more elastic the demand the closer
price is to marginal cost.
– If Ed is a large negative number, price is
close to marginal cost and vice versa.

Chapter 1 20
Monopoly
• Shifts in Demand
– In perfect competition, the market
supply curve is determined by marginal
cost.
– For a monopoly, output is determined by
marginal cost and the shape of the
demand curve.

Chapter 1 21
Monopoly
• Observations
– Shifts in demand usually cause a change
in both price and quantity.

– A monopolistic market has no supply

curve.

Chapter 1 22
Monopoly
• Observations
– Monopolist may supply many different
quantities at the same price.

– Monopolist may supply the same

quantity at different prices.

Chapter 1 23
Monopoly
• The Effect of a Tax
– Under monopoly price can sometimes
rise by more than the amount of the tax.
• To determine the impact of a tax:
– t = specific tax
– MC = MC + t
– MR = MC + t : optimal production
decision
• price change?
Chapter 1 24
Monopoly
• The Multiplant Firm
– For many firms, production takes place
in two or more different plants whose
operating cost can differ.

Chapter 1 25
Monopoly
• The Multiplant Firm
– Choosing total output and the output for
each plant:
• The marginal cost in each plant should be
equal.
• The marginal cost should equal the marginal
revenue for each plant.

Chapter 1 26
Production with Two Plants
$/Q
MC1 MC2

MCT

P*

MR* D = AR

MR

Q1 Q2 Q3 Quantity

Chapter 1 27
Production with Two Plants
• Observations:
1) MCT = MC1 + MC2
$/Q MC1 MC2
2) Profit maximizing
output: MCT

• MCT = MR at QT and P
*
P*
• MR = MR*
• MR* = MC1 at Q1,
MC* = MC2 at Q2
MR* D = AR
• MC1 + MC2 = MCT, Q1
+ Q2 = QT,
and MR = MC1 MR
+ MC2
Q1 Q2 Q3
Quantity

Chapter 1 28
Monopoly Power
• Monopoly is rare.
• However, a market with several
firms, each facing a downward
sloping demand curve will produce
so that price exceeds marginal cost.

Chapter 1 29
Monopoly Power
• Scenario:
– Four firms with equal share (5,000) of a
market for 20,000 toothbrushes at a
price of $1.50.

Chapter 1 30
Monopoly Power
• Measuring Monopoly Power
– In perfect competition: P = MR = MC
– Monopoly power: P > MC

Chapter 1 31
 Elasticity of Demand and Price Markup
$/Q The more elastic is $/Q
demand, the less the
markup.

MC P* MC

P*
AR
P*-MC

MR

AR
MR

Q* Quantity Q* Quantity
Sources of Monopoly Power
• Why do some firm’s have
considerable monopoly power, and
others have little or none?
• A firm’s monopoly power is
determined by the firm’s elasticity of
demand.

Chapter 1 33
Sources of Monopoly Power
• The firm’s elasticity of demand is
determined by:
1) Elasticity of market demand
2) Number of firms
3) The interaction among firms

Chapter 1 34
The Social Costs of Monopoly Power
• Monopoly power results in higher
prices and lower quantities.
• However, does monopoly power
make consumers and producers in
the aggregate better or worse off?

Chapter 1 35
Deadweight Loss from Monopoly Power
Because of the higher
$/Q price, consumers lose
A+B and producer
Lost Consumer Surplus
gains A-C.

MC
Deadweight
Loss
Pm
A
B
PC C
AR

MR

Qm QC Quantity

Chapter 1 36
The Social Costs of Monopoly Power
• Rent Seeking
– Firms may spend to gain monopoly
power
• Lobbying
• Advertising
• Building excess capacity

Chapter 1 37
The Social Costs of Monopoly Power
• The incentive to engage in monopoly
practices is determined by the profit
to be gained.
• The larger the transfer from
consumers to the firm, the larger the
social cost of monopoly.

Chapter 1 38
The Social Costs of Monopoly Power
• Example
– 1996 Archer Daniels Midland (ADM)
successfully lobbied for regulations
requiring ethanol be produced from corn
• Question
– Why only corn?

Chapter 1 39
The Social Costs of Monopoly Power
• Price Regulation
– Recall that in competitive markets, price
regulation created a deadweight loss.
• Question:
– What about a monopoly?
• 1990s?

Chapter 1 40
Monopsony
• A monopsony is a market in which
there is a single buyer.
• An oligopsony is a market with only a
few buyers.
• Monopsony power is the ability of the
buyer to affect the price of the good
and pay less than the price that
would exist in a competitive market.
Chapter 1 41
Monopsony
• Competitive Buyer
– Price taker
– P = Marginal expenditure = Average
expenditure
– D = Marginal value

Chapter 1 42
 Competitive Buyer
Compared to Competitive Seller

$/Q Buyer $/Q Seller MC

ME = AE AR = MR
P* P*

MR = MC
ME = MV at Q* P* = MR
ME = P* P* = MC
P* = MV D = MV

Quantity Quantity
Q* Q*
 Monopsonist
$/Q
Buyer
The market supply curve is the monopsonist’s
average expenditure curve

ME
Monopsony
•ME > P & above S
S = AE

PC
Competitive P*m
•P = PC
•Q = Q+C MV

Q*m QC Quantity

Chapter 1 44
Monopoly and Monopsony
$/Q Monopoly
Note: MR = MC;
AR > MC; P > MC

MC
P*

PC

AR

MR

Q* QC Quantity

Chapter 1 45
Monopoly and Monopsony
$/Q
ME Monopsony
Note: ME = MV;
ME > AE; MV > P

S = AE

PC
P*

MV

Q* QC Quantity
Chapter 1 46
Monopoly and Monopsony
• Monopoly • Monopsony
– MR < P – ME > P
– P > MC – P < MV
– Qm < QC – Qm < QC
– Pm > PC – Pm < P C

Chapter 1 47
Monopsony Power
• A few buyers can influence price (e.g.
automobile industry).
• Monopsony power gives them the
ability to pay a price that is less than
marginal value.

Chapter 1 48
Monopsony Power
• The degree of monopsony power
depends on three similar factors.
1) Elasticity of market supply
• The less elastic the market supply, the
greater the monopsony power.

Chapter 1 49
Monopsony Power
• The degree of monopsony power
depends on three similar factors.
2) Number of buyers
• The fewer the number of buyers, the less
elastic the supply and the greater the
monopsony power.

Chapter 1 50
Monopsony Power
• The degree of monopsony power
depends on three similar factors.
3) Interaction Among Buyers
• The less the buyers compete, the greater
the monopsony power.

Chapter 1 51
 Monopsony Power:
Elastic versus Inelastic Supply

ME
$/Q $/Q MV - P*
MV - P* S = AE

ME

S = AE
P*

P*

MV MV

Q* Quantity Q* Quantity
Deadweight Loss from
Monopsony Power

• Determining the
deadweight loss in
monopsony $/Q
ME
– Change in seller’s
surplus = -A-C Deadweight Loss
– Change in buyer’s S = AE
surplus = A - B B
– Change in welfare = PC A C
-A - C + A - B = -C P*
-B
MV
– Inefficiency occurs
because less is
purchased Q* QC Quantity

Chapter 1 53
Monopsony Power
The Social Costs of Monopsony Power

• Bilateral Monopoly
– Bilateral monopoly is rare, however,
markets with a small number of sellers
with monopoly power selling to a market
with few buyers with monopsony power
is more common.

Chapter 1 54
Monopsony Power
The Social Costs of Monopsony Power

• Question
– In this case, what is likely to happen to
price?

Chapter 1 55
Summary
• Market power is the ability of sellers
or buyers to affect the price of a
good.
• Market power can be in two forms:
monopoly power and monopsony
power.

Chapter 1 56
Summary
• Monopoly power is determined in
part by the number of firms
competing in the market.
• Monopsony power is determined in
part by the number of buyers in the
market.

Chapter 1 57
Summary
• Market power can impose costs on
society.
• Sometimes, scale economies make
pure monopoly desirable.
• We rely on the antitrust laws to
prevent firms from obtaining
excessive market power.

Chapter 1 58
End of Chapter
10
Market
Power:
Monopoly and