INDUSTRIAL ECONOMICS I

1. INDUSTRIAL ECONOMICS I MONOPOLY

2. Introduction • A firm is a monopoly; • If it is the only supplier of product for which there is no substitute • It sets price without fear that it will be undercut by any rival firm. • It faces downward-sloping demand curve and sets price above MC. • As a result less is sold than if the market were competitive (at the point where P = MC) and society suffers deadweight loss.

3. Monopoly Compare to Competitive • Monopoly Price: • Like competitive firm, a monopoly sets its level of output to maximize profits. • Because the demand curve is downward sloping the more it sells the lesser the price. • The market demand curve constrains monopoly – in its quest to maximize profit it can only sets quantity or price – not both. i.e. If it sets price quantity is determined by the market demand curve, and if sets quantity market demand curve will set its price

4. MonopolyCompareto Competitive To sell more monopoly reduce price to p1. But its revenue may rise or fall. Area B shows monopoly gains revenue on extra unit sold. To sell extra unit it will have to cut price down to p1on original Q0 units. It resulted in loss of revenue of (p0 – p1)Q0 – Area A. $ Decrease in revenues on sales of Qo from lowering price = (p0 – p1)Q0 p0 A Increase in revenue from increasing output by 1 unit = p1 p1 B Demand Q0 Q0 + 1 Output, Q

5. MonopolyCompareto Competitive • If area B > area A, selling extra unit causes revenue to increase. • The extra revenue is p1(Q0 + 1) – p0Q0 (the firm receives when it produces 1 more unit of product) called the marginal revenue. • MR= (Area B – Area A)

6. MonopolyCompareto Competitive • If monopoly did not have to lower its price to sell additional unit, to increase revenue from selling extra unit is at its initial price p0. • Because of the downward demand curve, monopoly must lower price to sell more units. • Hence, MR < P for a monopoly.

7. MonopolyCompareto Competitive • For a competitive firm there is no loss of revenue due to lower price. • This is because competitive firm faces horizontal demand curve – price-taking. • Hence, price does not fall as it expands its quantity. • MR = P for a perfectly competitive firm.

8. MonopolyCompareto Competitive • To proof mathematically: • If straight line demand curve hits the horizontal line at Q, corresponding MR curve also hit horizontal line at Q/2. • Ifstraight line demand curve isequal to p = a – bQ[1] • Total revenue is TR = pQ = Q(a – bQ) = aQ – bQ2[2]

9. MonopolyCompareto Competitive • MR is obtained by taking first difference on equation [1] (differentiating R with respect to Q) • ∂R/∂Q = ∂(aQ – bQ2) / ∂Q = a – 2bQ = MR[3] • Therefore the demand curve hits the horizontal axis (p = 0) at Q = a/b. • The MR curve hits the horizontal axis at (MR = 0) at Q a/(2b)

10. MonopolyCompareto Competitive • MR and TR are closely related. • When MR is positive TR when output expands. • When MR is negative , TR as output expands. • TR is maximized when MR = 0

11. MonopolyCompareto Competitive • Monopoly maximized its profit rather than its revenue. • This is when the extra revenue from selling 1 more unit just equal to the extra cost of producing that last unit of output. • Hence, profit is maximized when • MR = MC

12. MonopolyCompareto Competitive Profit maximizing monopoly output is Qm < Qc. Qc is determined by the intersection of the D curve and MC curve – which is the market s curve for competitive firm. Monopoly does not have the supply curve that can be specified solely as a function of price . Monopoly’s output depends on MR (which depends on the slope of the demand curve) and MC. Properties of the d curve determine that the monopoly overcharged and the price elasticity of demand. $ pm D Monopoly overcharge Monopoly Profit DWL pc MC Q Qc MR

13. MonopolyCompareto Competitive • Elasticity of demand is the % change in quantity that results from 1% change in price. • If elasticity if demand is high (large negative number0 then the curve is elastic • If the elasticity is low(a number between -1 and 0)the demand curve isinelastic.

14. MonopolyCompareto Competitive • MR can be rewritten as • MR = p( 1 + 1/ε),[4] • where ε is the elasticity of demand. • MR is positive if d curve is elastic (ε < -1). • MR is negative if the D curve is inelastic; (-1<ε<0).

15. MonopolyCompareto Competitive • Substituting [4], into MR [3], profit maximizing condition for the monopoly is; • p-MC / p = -1/ε[5] • The left side of the equation is the price- cost margin ; the difference between price and MC as a fraction of price. • Hence, price cost-margin depends on only on the elasticity of demand the monopoly faces. • It is also the Lerner Index of market power.

16. MonopolyCompareto Competitive • Equation [5] shows monopoly’s price is close to MC when demand is very elastic. • Price increasingly exceed MC when demand when demand is less elastic. • E.g. when elasticity of demand is -2, price id twice MC • If elasticity is -100 (very elastic), price is 1.01 MC.

17. MonopolyCompareto Competitive • The higher the elasticity of demand the closer the monopoly price to competitive price. • Therefore the key element in market power is the price elasticity of demand . • Where demand is relatively elastic, monopoly markup will be substantial.

18. Market and Monopoly Power • Monopoly knows it can sets its own price. • Price chosen can affects the quantity sold. • A monopoly can sets its price above MC, but not necessary that it can make supra-competitive profit. • E.g. if monopoly incurs fixed cost, profits may be zero (competitive level), even if P> MC.

19. Market and Monopoly Power • When a firm profitably sets its price above MC without making a loss • It is said that the firm has monopoly power.