Chapter 9

The Age of Entrepreneurship:

Monopoly

Copyright © 2001 Addison Wesley Longman Slide 9- 1

 Roadmap
– Overview

– Monopolistic Pricing and Output

– Monopolistic Pricing & Price Elasticity of

Demand

– Markup pricing and Price Discrimination

– The Socially Optimal Price and Social

Costs of Monopoly Power
 Overview
Chapter 3: market demand q=D(p)

Chapter 5: the rise of an entrepreneur

(jam making firm)

Chapter 6: the cost function C(q) of the

firm

This chapter:
What quantity should the firm produce, and
what price should the firm charge?

Copyright © 2001 Addison Wesley Longman Slide 9- 3

 Figure 9.2 Linear Market Demand Function

Copyright © 2001 Addison Wesley Longman Slide 9- 4

 Figure 9.1 The Average and Marginal Cost
Functions for Our Entrepreneur’s Firm

Copyright © 2001 Addison Wesley Longman Slide 9- 5

 Monopoly

Primary characteristics of a monopoly:

Single Seller;
No close substitutes;
Price maker.

For example, DeBeers control of the world diamond markets;

the situation of Viagra before competing drugs emerged.

Copyright © 2001 Addison Wesley Longman Slide 9- 6

 Roadmap
– Overview

– Monopolistic Pricing and Output

– Monopolistic Pricing & Price Elasticity of

Demand

– Markup pricing and Price Discrimination

– The Socially Optimal Price and Social

Costs of Monopoly Power
 Pure Monopoly

• Suppose that the monopolist seeks to

maximize its economic profit,
( y )  p( y ) y  c ( y ).
• What output level y* maximizes profit?

Copyright © 2001 Addison Wesley Longman Slide 9- 8

 Marginal Revenue

Marginal revenue is the rate-of-change of revenue as

the output level y increases;
d dp( y )
MR( y )   p ( y ) y  p ( y )  y .
dy dy
dp(y)/dy is the slope of the market inverse
demand function so dp(y)/dy < 0. Therefore
dp( y )
MR( y )  p( y )  y  p( y )
dy
E.g. if p(y) = a – by, then
R(y) = p(y)y = ay - by2
and so MR(y) = ? < a - by = p(y) for y > 0.

Copyright © 2001 Addison Wesley Longman Slide 9- 9

 Figure 9.3 Marginal Revenue and Demand

Copyright © 2001 Addison Wesley Longman Slide 9- 10

 Profit-Maximization

( y )  p( y ) y  c ( y ).
At the profit-maximizing output level y*
d( y ) d dc ( y )
  p ( y ) y  0
dy dy dy
At the profit-maximizing output level y*,
MR(y*) = MC(y*).

The optimal price is then p(y*). It is the price that is on the

demand curve at the optimal quantity point y* (pricing rule
2).

Copyright © 2001 Addison Wesley Longman Slide 9- 11

 Figure 9.4 Optimal Price and Quantity

The optimal price for a monopolist

is the price that is on the demand
curve at the optimal quantity point
y*.

Copyright © 2001 Addison Wesley Longman Slide 9- 12

 Profit-Maximization; An Example

At the profit-maximizing output level y*,

MR(y*) = MC(y*).
So if p(y) = a - by and if c(y) = F + ay + by2 then

and the profit-maximizing output level is

causing the market price to be

Copyright © 2001 Addison Wesley Longman Slide 9- 13

 Profit-Maximization; An Example

$/output unit

a p(y) = a - by
p( y*) 
aa
ab
2( b  b ) MC(y) = a + 2by

a
y*  y
aa
2(b  b ) MR(y) = a - 2by

Copyright © 2001 Addison Wesley Longman Slide 9- 14

 Roadmap
– Overview

– Monopolistic Pricing and Output

– Monopolistic Pricing & Price Elasticity of

Demand

– Markup pricing and Price Discrimination

– The Socially Optimal Price and Social

Costs of Monopoly Power
 Monopolistic Pricing & Own-Price Elasticity of
Demand

d dp( y)
MR( y)  p( y)y  p( y)  y
dy dy
 y dp( y) 
 p( y )  1   .
 p( y) dy 
p( y) dy
Own-price elasticity of demand is  
y dp( y)

so MR( y )  p( y ) 1  .
1
  

Copyright © 2001 Addison Wesley Longman Slide 9- 16

 Monopolistic Pricing & Own-Price Elasticity of
Demand

Suppose the monopolist’s marginal cost of production is

constant, MC= $k/output unit. For a profit-maximizing firm

 1
MR ( y*)  p ( y*) 1    MC must be true.
 

p ( y*) 1 p ( y*)

This implies that  
MC 1 k
1

E.g. if e = -3 then p(y*) = 3k/2,
and if e = -2 then p(y*) = 2k.
So as | e | goes down towards 1 the monopolist alters its output
level to make the market price of its product to rise.
Copyright © 2001 Addison Wesley Longman Slide 9- 17
 Monopolistic Pricing & Own-Price Elasticity of
Demand

 1
Since MR ( y*)  p ( y*) 1    k  0,
 

we have  1
p( y*) 1    0 
1
1  0
  
That is, 1 1   1  | |1.

So a profit-maximizing monopolist always selects an output level
for which market demand is own-price elastic (pricing rule 1).

As long as the price elasticity of demand (in absolute value)

for most customers is less than one, it is advantageous for a firm to
increase its prices: it then receives more money for fewer goods.
With a price increase, price elasticity tends to rise, and in the
optimum it will be greater than one for most customers.
Copyright © 2001 Addison Wesley Longman Slide 9- 18
 Roadmap
– Overview

– Monopolistic Pricing and Output

– Monopolistic Pricing & Price Elasticity of

Demand

– Markup pricing and Price Discrimination

– The Socially Optimal Price and Social

Costs of Monopoly Power
 Markup Pricing

• Markup pricing: Output price is the marginal

cost of production plus a “markup.”
• How big is a monopolist’s markup and how
does it change with the own-price elasticity of
demand?

Copyright © 2001 Addison Wesley Longman Slide 9- 20

 Markup Pricing

 1 k k
p( y*) 1   k  p( y*)  
   1
1 1 

is the monopolist’s price. The markup is
k k
p( y*)  k  k   .
1  1 
E.g. if  = -3 then the markup is k/2,
and if  = -2 then the markup is k.
The markup rises as the own-price
|elasticity| of demand goes down towards 1.
Copyright © 2001 Addison Wesley Longman Slide 9- 21
 Price Discrimination

Price discrimina tion with two market segments [see Figure 9.12]
Objective monopolist : max P1 ( q1 ) q1  P2 ( q2 ) q2  C ( q1  q2 )
q1 ,q2

 Two first - order conditions :

P1 ' ( q1 ) q1  P1 ( q1 )  C ' ( q1  q2 )  0
P2 ' ( q2 ) q2  P2 ( q2 )  C ' ( q1  q2 )  0
In other word s : MR1 ( q1 )  MC ( q1  q2 ) and MR2 ( q2 )  MC ( q1  q2 )

Pricing Rule 4: At the profit-maximizing quantity, the

marginal revenue from selling the last unit in each
market should be equal to each other and also equal to
the common marginal cost.
[Charge ‘high’ price to market segment with ‘low’ price-
elasticity of demand, charge ‘low’ price to segment with
‘high’ price-elasticity of demand.]
Copyright © 2001 Addison Wesley Longman Slide 9- 22
 Roadmap
– Overview

– Monopolistic Pricing and Output

– Monopolistic Pricing & Price Elasticity of

Demand

– Markup pricing and Price Discrimination

– The Socially Optimal Price and Social

Costs of Monopoly Power
 Welfare

Consumer surplus (CS) = the measure of consumer welfare

– CS expresses how much consumers value presence of market
– Measure CS by area under demand curve and above price level
[see picture next slide and Figure 9.5]
Producer surplus (PS) = the measure of producer welfare
– PS expresses how much producers value presence of market given
that fixed costs have already been incurred
– Measure PS by area between MC curve and under price level
Total surplus = the measure of social welfare (welfare for
society) = CS+PS
– Total surplus expresses how much all agents in society (e.g. all
consumers and producers) value the presence of a market
– Measure total surplus by area between MC curve and demand
curve

Copyright © 2001 Addison Wesley Longman Slide 9- 24

 Welfare

D(q) Deadweight loss at quantity q1 (Welfare loss as

compared to social optimum)
p1
MC(q)
=CS at quantity q1 (and price p1)
p2 =PS at quantity q1 (and price p1)
(p2,q2) =socially optimal price-quantity combination

q1 q2
q
Price rule 3: The socially optimal price (which
maximizes the sum of consumer surplus and the
producer surplus) is the price at which the market
demand curve intersects the marginal cost curve
p = MC(q)

Copyright © 2001 Addison Wesley Longman Slide 9- 25

 Profit-Maximization versus
Social Welfare Maximization

p Profit-Max: MR(q) = MC(q)

Social Welfare Max: p = MC(q)
a p(y) = a - by
p ( y*)
 a  by *
s
MC(y) = a + 2by
p( y )
 a  by s
a
a a a a
y*  ys  y
2b  2 b b  2b

MR(y) = a - 2by

Copyright © 2001 Addison Wesley Longman Slide 9- 26

 deadweight loss of monopoly power

D(q)
(p1,q1) = monopolist’s price and quantity
p2 = socially optimal price (CS + PS is
maximal)
p1
MC(q)

p2

= Deadweight loss of monopoly

MR(q)
power
q1 q2
Explanation: The monopolist chooses its quantity such that
MR(q) = MC(q). The monopoly price is higher than the socially
optimal price. The cost of the high price of the monopolist to
society is called the deadweight loss (welfare loss) of
monopoly power.

Copyright © 2001 Addison Wesley Longman Slide 9- 27

 Figure Demand and Associated Marginal Revenue

1.Find a and b in the market demand function p=a-bq.

2. what’s the MC?
3. what’s the social optimal price?
4. what’s the monopolist’s price?
5. what’s the loss of consumer surplus? Profit of the
monopolist? Deadweight loss?

Copyright © 2001 Addison Wesley Longman Slide 9- 28

 Figure 9.7 The Profitability of Production

Does the firm make

a profit or loss?
Is the current loss the
smallest possible one?

Copyright © 2001 Addison Wesley Longman Slide 9- 29

 The Social Costs of Monopoly Power

Rent Seeking: spending money in socially

unproductive efforts to acquire, maintain, or
exercise monopoly power.
• Lobbying
• Advertising
• Building excess capacity
The incentive to engage in monopoly practices is determined
by the profit to be gained.

Copyright © 2001 Addison Wesley Longman Slide 9- 30

Summary
 Four pricing rules
(elasticity, profit maximizing,
socially optimal price,
segmented markets)
 Deadweight loss
 Hw#3: Chp7 (11)-1,6,7
Chp9 (17) -2,4,6
Answer questions at the end of the article “The
Fundamentals of Rent”.
For Chapter 17- 2, “P=100P-2Q” should be “P=100-2Q”
For Chapter 17-4 (c), “MC=Q^2+22Q+150” should be
“MC=Q^2-22Q+150”