Chapter 10 - Monopoly

Question 1

Recall why perfect competition involves sellers and buyers who cant individually affect the price

Answer 1

They are so small compared to the whole that their transactions dont mean anything. The overall market forces (supply and demand) will drive the price.

Question 2

What is a monopoly?

Answer 2

A monopoly is a market that has only one seller but many buyers

Question 3

What is a monopsony?

Answer 3

A monopsony is a market with many sellers but only one buyer

Question 4

What can we say about the demand curve of a firm that operates as a monopolist?

Answer 4

Their individual (the firm’s) demand curve will be equal to the market demand curve.

Question 5

Name examples of monopsonys

Answer 5

A monopsony could be orgs like NFL, UEFA, the military in certain contries.

Question 6

What do we mean by saying that “monopolies and monopsonies are two forms of market power”?

Answer 6

Market power refers to the ability to affect price of a good.

Question 7

Define market power

Answer 7

market power is the ability of a seller or a buyer to affect price

Question 8

Explain exactly what a monopoly is

Answer 8

A monopoly refers to a position where a single seller control the entire market of the shit it sells. For instance, if a firm owns the rights for a book, this firm will serve as a monopoly for this book. It is the only firm that sell this particular item.

Question 9

In order to maximize profits, what does a monopolist do?

Answer 9

A monopolist must first figure out the costs, and the market demand. The monopolist will then use this information to figure out how much it should supply.

Therefore, the steps are:
1) FInd revenue function. Can be done by looking at the demand curve. EX: P(Q) = a - bQ
R(Q) = P(Q)*Q = aQ - bQ^2

2) Find the cost function of Q. C(Q) = f(Q)

3) Differentiate both functions. Solve for Q.

4) The Q level is the preferred output. In order to figure out the price we should charge per unit, we use the demand curve.

Question 10

What is the monopolists average revenue?

Answer 10

Average revenue is equal to the market demand curve.

Question 11

What is marginal revenue?

Answer 11

Marginal revenue is the change in revenue that results from a unit change in output. Keyword: The change in revenue.

Question 12

Consider the demand curve:

P = 6 - Q

Say we have Q = 3. What is the price? What is the total revenue?
What is the marginal revenue?

Answer 12

Price is 3.

Total revenue = 3*3 = 9

Marginal revenue is the change in total revenue resulting from increasing output by a single unit. We are looking at the marginal revenue avhieved in the current point. THerefore, we must consider the additional revenue we got by adding the unit we are looking at.
6-2 = 4. 42 = 8. Total revenue before was 8. Then we add the unit so that we get to our current point. 33 = 9. This is a 1-USD change. Therefore, the marginal revenue AT THIS POINT is 1.

Question 13

Say we run a firm that is a monopoly. How do we find the price we should set?

Answer 13

First of all, we need the cost function. The cost function will relate total costs of production as a function of the output.

TC = f(q)

We find marginal costs by differentiating.

MC = f’(q)

Then we use the general rule of finding the point where marginal revenue is equal to marginal costs. THerefore we need to find the marginal revenue function. This also needs to be a function of q.

So, how do we find the marginal revenue curve before the price is known?
We first find the total revenue curve.
TR = Price*QuantityDemanded

TR = (a-bQ)*Q

TR = aQ - bQ^2

Now, we can differentiate this to get the marginal revenue function/curve:

MR = a - 2bQ

Therefore, we can see that if we have a linear demand curve, the slope of the marginal revenue function will be twice as steep as the demand curve.

So, now that we have both the marginal cost function, and the marginal revenue function, we find their intersection point.

MR = MC
a - 2bQ = f’(Q)

This gives us a quantity that we should produce to maximize profits. Then we plug this quantity number into the demand curve, and we get the price.

So, in summary, we first find the production quantity that maximize profits, then we find the corresponding price level. This method will use prices into account because we use it to calculate the revenue function.

Question 14

Say we have cost function:
C(Q) = 50 + Q^2

And demand function:
P(Q) = 40 - Q

What is the price level the firm should set?

Answer 14

Marginal cost equals:
MC(Q) = 2Q

Total revenue curve:
TR(Q) = (40-Q)(Q) = 40Q - Q^2

MC(Q) = 40 - 2Q

MC = MR

2Q = 40 - 2Q
4Q = 40
Q = 10

Plug into demand curve:

P(10) = 40 - 10 = 30

Thus, the price level that maximize profits is 30.

Question 15

What can we say about the cost curve and the revenue curve at the point of profit maximization?

Answer 15

We know that marginal cost is equal to marginal revenue in the point of maximized profits. Therefore, MC(Q) will intersect MR(Q). Therefore, the slopes of the cost funciton and the revenue function will be the same. THE SLOPES. ‘

Question 16

What is the “alternative way” of marginal revenue?

Answer 16

MR = P + Q*dP/dQ

What does this mean?
It means, if we change price in order to manipulate output, we have the following effect:
Say we obtain one more unit sold.
Then we get revenue equal to the price of the unit we sell extra.
However, we must also accept a decline in the overall price, thereby reducing the overall revenue by some amount. This effect could by larger than the additional price effect.

The dP/dQ term basically calculates the price effect PER quantity. This could be -2 per quantity. In such case, we could multiple this number with the quantity we have sold. Say -2*10 = -20. Then, if the price is lower than 20, we will loose money by reducing the price.

This is essentially due to the downward sloping demand curve. Increasing output means decreasing price. Therefore, there is a trade off. At some point, this trade off is no longer beneficial.

Question 17

What can we say about the marginal revenue as a result of the fact that the demand curve is downward slopiung?

Answer 17

We know that increasing output will decrease price. Therefore, the marginal revenue has 2 effects:

1) The additional revenue we get by selling another unit at the new price
2) The reduction in overall revenue on all the previous units.

This can mathematically by written as:

MR = P + Q*dP/dQ

Question 18

Use the result from the “downward sloping demand curve” to derive an expression for the marginal revenue that contains price elasticity of demand.

What can we do with this result?

Answer 18

The result is:

MR = P + Q*dP/dQ

MR = P + P(Q/P)(dP/dQ)

MR = P + P(1/E_d)

Now, since we know that firms want to maximize profits, we typically want MC = MR. We can do this here:

MC = P + P(1/E_d)

(MC - P)/P = 1/E_d

E_d = P / (MC - P)

We can rearrenge for price:

E_d * (MC - P) = P

P ( 1 + E_d) = E_d*MC

P = MC*E_d / (1+E_d)

P = MC / (1 + (1/E_d))

Question 19

How does the price set by a monopolist compare to a firm that is competitive?

Answer 19

The rule is still MC = MR

The competitive firm also has the effect of MR = P + Q*dP/dQ, but the last term is 0. Therefore, it choose to produce at the level where the price (given) is equal to its marginal costs.

The monopolist set a price that is higher than the marginal revenue.

From the formula:

P = MC / (1 + (1/E_d))

…we see that if E_d is a large negative number, the price will be close (approach) marginal costs. This means, if the market is very ELASTIC, the monopolist will set a price very close to marginal costs.

However, if the market is less elastic, we get more of a deviation.

It is also worth noting that a monopoly will never produce in the “inelastic” part of the demand curve. This means less than 1 in absolute value. This is because if this was the case, the monopolist would increase prices and earn more, and at the same time move into a more elastic portion of the demand curve.

Question 20

In a competititve market, what is the relationship between price and quantity supplied?

Answer 20

The supply curve.

We also know that the supply curve, for the competitive market, is the part of the marginal cost curve that is above variable costs.

Question 21

How does the supply curve of the monopolist firm look like?

Answer 21

Monopolies have no supply curve. This is because the decision on how much to produce is not only dependent on the marginal costs, but also on the demand.

IN OTHER WORDS, there is not a one to one relation between price and quantity supplied. If we look at perfect competition, there is a willingness to produce X at each price. This is determined by the cost function of the firm. Cost func is all that matters. For the monopoly though, the price level is not determined like that. We need to figure out the price that gives the highest profit for us. Since price is not given, marginal revenue becomes a topic.

Shifts in demand curve can lead to a higher price while the quantity supplied remains the same. It can also leads to other changes.

This marks a fundamental difference between competitive firms/industries and monopolies. Competitive firms will supply a specific quantity for each level of price.
Monopolies will supply a quantity that is dependent on the marginal costs AND the demand. This is the result of not being a price taker.

Question 22

Consider a monopolist. What must “change” in order for it to change the “optimal” quantity to produce?

Answer 22

The profit maximized quantity to produce is given at the intersection between MR and MC. Therefore, if the marginal costs were to change, the production volume would change as well.

This also means, that a change in demand doesnt necessarily change the production quanta. It will change the price though.

Question 23

Suppose a monopolist is given a tax of t USD per unit sold. How would this affect price?

Answer 23

First of all, the tax would be entered as a part of the marginal costs. We would therefore get the following :

MR = MC + t

Solving this would solve for a quantity.

Graphically, this shifts the marginal cost curve up. The new intersect point will cause a new price level as well (from the demand curve). The demand curve will determine what happens to the price. The price might move less than the tax, and it might move more. This is because the relationship between price and marginal cost depends on the elasticity of demand.

Question 24

Consider the case where a monopolist has constant MC = 10, and the elasticity of demand is equal to -2. What is the price it should set?

Now consider if the good is given a tax of 5 bucks per unit. What would then be the price?

Answer 24

P = MC / (1 + (1/E_d))

P = 20.

P = (MC + t) / (1 + (1/E_d))

P = (10+5) / (1 + (1/-2))

P = 30

In this, case, we can see that a tax increase of 5 bucks per unit sold leads to a price increase of 10 bucks per unit.

Question 25

Consider a multiplant firm. Say a firm has 2 plants. How should output levels be determined?

Answer 25

The logic is still the same.

We want to produce at a level where the Marginal costs of plant 1 is equal to the marginal costs of plant 2. Otherwise, we could up production at one plant and earn more.

Then we apply the logic where MR = MC.

MR = MC1 = MC2

Question 26

Without being too detailed here, what can we say about the demand curve that an individual firm will face, in comparison with the market demand curve, if we consider an industry of 4 toothbrush sellers. There is some level of competition.

Answer 26

The individual demand curves will be more elastic than the market demand curve. This is due to the fact that if firm A were to increase prizes, you’d have other good options to choose. As a result, consumers will be more responsive to changes in prices. However, it is worth noting that you’d not see the same effect as with perfect competition. In perfect competition, if one firm were to increase prize, their sales would drop to zero (product homogeneity). This will not happen when we only have some level of competition though, as brands carry value and products are very seldom exactly equal.

Question 27

Give a definition/characteristic of monopoly power

Answer 27

Monopoly power could mean that a firm has the power to charge a price that is higher than the marginal costs.

Question 28

Do monopolies charge higher prices than they should?

Answer 28

No, there is meaning behind the prices.

all firms want to maximize their profits. This will depend on the MR = MC equation.

Question 29

What are 2 great questions, almost philosophical questions, that arise when discussing monoploies?

Answer 29

1) How can we measure monopoly power?

2) What are the sources of monopoly power?

Question 30

What is one way to measure monopoly power?

Answer 30

The Lerner Index.

L = (P - MC) / P

For a perfect competitive, L = 0 becasue P = MC.

The closer the Lerner index gets to 1, the more power it will have.

You could also mix up the Lerner index to make it dependent on demand.

L = -1/E_d

Question 31

What is the Lerner index?

Answer 31

Lerner index is a ratio that measure monopoly power.
Lerner index is always a ratio that is between 0 and 1. 0 indicates perfect competition. 1 indicates extreme monopoly.

L = (P - MC) / P

L = - 1/E_d

Question 32

What value will the lerner index have if the firm is under perfect competition?

Answer 32

L = 0

Question 33

Why is it so difficult to determine individual firm’s demand curves?

Answer 33

Because this requires understanding of how competitors will react to your/the firm’s price changes.

Question 34

What is a general rule for determinining monopoly power? (not lerner)

Answer 34

We can look at elasticity of demand. The more elastic the demand is, the less monopoly power the firm is likely to have. Remember that monopoly power is the ability to charge a price higher than marginal costs.

Question 35

If we consider firms and consumers as “equals”, on aggregate, what is better? Competition or monopoly?

Answer 35

We can tackle this problem by considering consumer and producer surplus at each type of market form.

Question 36

What is producer surplus?

Answer 36

Producer surplus is defined as the difference between what a producer is payed and what the producer is willing to accept. Meaning, dekningsbidrag.

It can be visualized graphically as the area under the price curve, but above the marginal cost curve.

THerefore, we calculate it with:

pq - Integral(MC(q)dq)[0, q*]

Why marginal cost? Because marginal cost shows what each unit would cost to produce. We are interested in the difference between price we get payed, and the price we would accept. Thus, the marginal cost curve.

Question 37

What is a monopolist’s average revenue? Average revenue is defined as revenue per unit sold on average.

Answer 37

The average revenue is given by the market demand curve. The demand curve associates price with quantitiy. If the monnopoly choose a certain output, it will get a specific price per unit.

Question 38

How do we find revenue function?

Answer 38

The revenue function can be created from the demand function, if one exists. Revenue equals number of units multiplied by price per unit. Since the demand function gives average price per unit, this gives a simple result.

P(Q)Q

For instance, if P(Q) = 6 - Q

R(Q) = 6Q - Q^2

Then we can differentiate and get the marginal revenue function: R’(Q) = 6 - 2Q

we set this equal to the marginal cost function to get the profit maximizing point.

Question 39

Due to the downward facing demand curve, what can we say about a rule of thumb for pricing?

Answer 39

Due to the downward sloping demand curve, we know that by increasing the output, or upping to price, we will see some reaction. For instance, by selling another unit, we’d have to sacrifice a price decrease. Therefore, we say that such a change has 2 effects:
1) The additional revenue from another unit sold
2) The price effect that happens on ALL units as a result of wanting a higher level of production.

Therefore, we say that because of the downward sloping demand curve, we will not be able to operate freely. Price is likely to be highly flexible.

In other words: MR = P + QdP/dQ
The change in price is negative if we increase Q.

If we factor out a “P” variable that doesnt exist, we can get teh expression to be including the price elsaticity:

MR = P + P(Q/P)(dP/dQ)

MR = P + P(1/E_d)

Now, we can use the fact that at profit maximizing level, we know that MR = MC. Therefore, we can set this expression equal to MC:

MC = P + P(1/E_d)

This can finally be transformed to give us the price level we need to set in order to maximize profits:

P = MC / (1+(1/E_d))

Question 40

Why would a monopolist never produce at inelastic demands?

Answer 40

Because inelastic demand is exploitable. Higher prices without seeing significant drops in demand.

Question 41

What is important when calculating proft maximizing levels of output and price at a multiplant firm?

Answer 41

The principle of MR = MC1 = MC2 still applies, but we need to use several variables here. The two plants will produce at different levels, Q1 and Q2.

Question 42

Why dont monopoly have a supply curve?

Answer 42

A supply curve is a relationship that gives a certain level of output for a given price. This assumes that the price is given. For a monopoly, the output we determine, and the price, is not related in a traditional way.

A monopoly only looks at the demand in the market, and its cost structure. Then it find the point of produciton where the cost of adding another unit is equal to the profit of adding another unit. MR = MC. Then we use the demand curve to determine price.

One can also avoid using the demand curve, and instead use price elasticity of demand to find the monopoly price.

Question 43

Why do some firms have considerably more monopoly power than others?

Answer 43

Firstly, we know that monopoly power firms can use the following rules to determine price:

P = MC /(1+1/E_d), where E_d is elasticity of demand for facing the firm (not the market).
MC is fixed, so this suggests that monopoly power is mainly about the elasticity of demand.

So, the question then becomes, why do some firms face more or less elastic demand curves?

We consider 3 factors.

1) THe elasticity of market demand. The elasticity of the market demand work as an upper limit for monopoly power. If the market is elastic, the firm is generally not going to be less elastic. Firms tend to be more elastic than their overall market.

2) The number of firms in the market.

3) The interaction among firms. If there is a hard rivalry, monopoly power is going to be worse.

Question 44

Consider the case where a firm is a pure monopoly. What can it do to keep its position?

Answer 44

it would want to perform actions that make significant barriers to entry. Could be redicilous marginal costs, making the initial investment too high to join.

Could also do predatory pricing.

Economies of scale is also very important. It would make it extremely difficult for many smaller firms to supply the entire market.

Question 45

how can the government reduce monopoly power?

Answer 45

The government can use price regulation.

With perfect competition, price regulation always results in a deadweight loss. This is not the case with monopolies. We can actually receive more surplus by governmental price regulation.

Question 46

Elaborate on price regulation

Answer 46

The point is that the government place a limit on upper price. This will change our marginal revenue curve. The price limit will be horizontal line until it meets the market demand curve. It this point, the price ceiling is no longer needed as we produce more units, pricing each unit lower than the ceiling.

We would still follow MR = MC. But now, MR = Price ALL THE WAY UNTIL price equals price from demand (indirect demand). At this point, the marginal revenue curve will go straight down, and meet up with the ORIGINAL marginal revenue curve, and continue along it like normal.

So, a price regulation leads to a desire to produce more.

Question 47

What is a natural monopoly?

Answer 47

A natural monopoly is a firm that can produce the entire output of the market at a cost lower than what it would be if there were several firms. Thus, a natural monopoly is better for society. It is more efficient to let them do it.

A natural monopoly usually arises when there are very large economies of scale.

Since natural monopolies have strong economies of scale, their average cost will always be higher than marginal cost. Therefore, if the government were to set price regulation at the competitive level, the monopoly would get fucked and forced to quit due to higher costs than profits. This is not wanted. What we want, is to regulate price so that it is equal to the average cost of the natural monopoly.

Question 48

What happens if we have a natural monopoly, and the government regulate price so that price is equal to the competitive price level?

Answer 48

A natural monopoly usually have strong economies of scale. Therefore, average costs will always be higher than marginal cost. Therefore, if the government sets price equal to MC, we actually get more costs than revenue, which means we loose money. Therefore, if a natural monopoly gets price equal to competitive level, it gets completely fucked.

It is better to set price ceiling at the firm’s average costs.