NEW

Universidad Carlos III de Madrid – Departamento de Economía

Principles of Economics
Problem Set 6

Conceptual questions

1. When do we say that a seller has monopoly power? Please, indicate some
reasons for monopolies to arise.
When a seller is the only one that sells a good which does not have close substitutes, we
say that seller has monopoly power since the seller does not have any competitors, it
can alter the selling price in order to maximize its benefits.
Four reasons for monopolies to arise (See Angel’s slides):
 Only one firm is the owner of an essential resource.
 Only one firm has the exclusive license to produce a good or exploit a resource.
 The cost of production is lower when the good is produced by only one firm
(Natural Monopoly).
 One firm adopted methods to limit the entry of its competitors.

2. What condition must a firm satisfy in order to maximize its profits when it is
part of a perfectly competitive market? Why is marginal revenue equal to the price in a
perfectly competitive market?
In a perfectly competitive market, a firm chooses to produce a quantity such that the
price is equal to the marginal cost, MC=P, in order to maximize its profits. At this point,
the marginal revenue is exactly equal to the price, MR=P, because firms are price takers
in competitive market; they cannot alter the market price but sell any quantity they want
at the market price. Therefore, all the units are sold at the same price regardless of the
quantity produced by each firm.

3. What condition must the firm satisfy in order to maximize its profits when it is a
monopolist? Why is marginal revenue lower than the monopolistic price? Why does the
“price effect” exist in a monopoly?
As a monopolist, the produced quantity must satisfy the condition MC=MR in order to
achieve the maximal profit, and fix the price accordingly. The marginal revenue is lower
than the monopolistic price because for the monopolist changes in the quantity have two
effects: a quantity effect, coincident with that of perfect competition (more quantity
implies higher profits) and a price effect (more quantity implies lower prices due to the
law of demand). This last effect arises from the fact that the monopolist does not face a
fix price for any quantity produced, but a negatively sloped demand. Thus, in order to
sell one unit more, the monopolist has to reduce the price, obtaining less revenue from
the units that were already sold.

4. Given the profit-maximizing condition, how does the monopolist know what is
the price that consumers are willing to pay for the quantity that maximizes profits?
It is sufficient for the monopolist to know the market demand. Thus, once the
monopolist determines the quantity to produce according to the profit maximizing
condition, the price is the one under which all consumers will buy that quantity exactly.

1
5. How is welfare affected when a market goes from perfect competition to
monopoly? Who suffers most the inefficiency or welfare loss that arises from the
monopoly? Can an economic authority do something to fix this inefficiency?
The total welfare is negatively affected by monopolies, because compared with the
perfect competition situation, the price in monopoly is higher and the quantity sold is
lower. Some buyers that would have acquired the good under perfect competition are
excluded in this situation, reducing the total surplus. Thus, consumers suffer the most
from the existence of a monopoly. On the other hand, the monopolist supplier’s surplus
may even increase. To fix this inefficiency, the authority can regulate the market
competition to avoid the existence of market power, set the price at the level of the
competitive price or substitute the private producers in the supply of the goods (public
firms).

6. What do we mean by adverse selection and by moral hazard? Why does

asymmetric information prevent markets from working correctly?
Adverse selection is the result of the existence of significant asymmetries in the
information: this means that some of the participants in the market do have information
that is relevant for the exchange, while others do not, and this does not allow that
certain goods are traded. If, for example, goods are heterogeneous in quality and only
sellers know their quality, adverse selection arises and only the worst goods are
exchanged.
Moral hazard arises when the actions of one party are not observed by the other party
(e.g. the work effort) giving an incentive for undesired behavior (e.g. work less than
what is stated by the contract). Asymmetric information can cause markets to be
inefficient or to directly disappear, and its solution is generally costly (signaling quality,
creating schemes that incentivize against moral hazard, etc.)

2
 Problems

7. A firm provides electricity services to a population. It faces the demand schedule

included below. Notice that the unit used for measuring electricity is the kilowatt-hour
(kWh).
a) In a graph, depict the demand for electricity curve facing the monopolist and obtain
the algebraic form for such a demand. Fill in the table total revenue, average revenue
and marginal revenue. In the same graph you did the demand for electricity curve, draw
the marginal revenue curve and obtain the algebraic form.
b) What is the relationship between average revenue and marginal revenue? For
representing graphically and obtaining the algebraic forms keep in mind that the in the
table we are indicating some point of continuous curves. Moreover, notice that total
revenue is not a linear form.
c) Assuming that the cost of producing each kWh is 5 Euros, obtain the quantity that
maximizes profits for the monopolist and the corresponding selling price.
d) In case the economic authority wanted to eliminate the inefficiency caused by the
monopoly, what are the quantity and the price that the government should set? What is
the welfare loss associated with the monopoly and who loses the greatest part of
surplus?

Answer:
a) Fill the form
Quantity Price per Total Average Marginal
demanded kWh in revenue revenue revenue
in kWh Euros (TR) (AR) (MR)
0 16
1 15 15 15 15
2 14 28 14 13
3 13 39 13 11
4 12 48 12 9
5 11 55 11 7
6 10 60 10 5
7 9 63 9 3
8 8 64 8 1
9 7 63 7 -1
10 6 60 6 -3
11 5 55 5 -5
12 4 48 4 -7
13 3 39 3 -9
14 2 28 2 -11
15 1 15 1 -13
16 0 0 0 -15

3
The graph of the demand curve and the marginal revenue are:

The algebraic expression of the demand is a linear equation. The quantity demanded,
Qd, can be represented as Qd=a+bp. a is the quantity demanded when p=0, thus a=16. b
is the slope, thus, b=-1. The algebraic expression of the demand is Qd=16-p.
The algebraic expression of the marginal revenue is the linear equation, MR=a+bQ,
where a is the marginal revenue when Q=0 and b is the slope, thus, b=-2. As we do not
know the marginal revenue when Q=0, we can use the point in Q=1 in order to calculate
a. We will have that 15=a+b·1, given that b=-2, we will obtain 15=a-2, so a=17. The
algebraic expression of the marginal revenue is MR=17-2Q.

b) The graphic representation of the average revenue and marginal revenue:

4
The average revenue can be expressed as AR=a+bQ. b is the slope, thus, b=-1. We can
use the point in Q=1 to calculate a. We will have 15=a+b·1. Given that b=-1, we will
obtain 7=a-1, so a=16. The algebraic expression of the average revenue is AR=16-Q.
The graphic shows that the marginal revenue is below the average revenue.

c) The quantity that maximizes the monopolist’s profit satisfies MC=MR. The MC is 5
and the quantity for which MR=5 is QM=6. The monopolist price will be the Price for
which the demand is 6. This price is PM=10.

d) In order to remove the inefficiency, the economic authority should choose P*=5 and
Q*=11. In this point P=MC.
The shaded area in the graphic is the deadweight loss. This loss is due to the fact that
with monopoly the quantity produced is lower than the quantity that maximizes the total
surplus.

The consumers are the only ones who suffer a decrease in their surplus in the case of
monopoly. The reason is that they consume a lower quantity and the quantity they
consume is charged at a higher Price. The producer surplus does not suffer any loss of
its surplus.

8. A monopolist faces the following conditions: The Price that maximizes profits is
16 Euros; the marginal revenue equals the marginal cost when it produces 10 units and
the marginal cost is 8 Euros; total surplus is maximized when it produces 14 units. The
demand curve and the marginal cost curve are linear. Therefore, the welfare lost is (in
Euros):
a) 8 b) 16 c) 48 d) It is not possible to determine.

5
b) 16

(16−8)(14−10)
The deadweight loss is: = 16.
2

Problem (Solved)

The total cost function for a monopolist is TC = Q2 + 100Q + 500 and the market
demand for the product is Q = 4(200 – P).
a) Calculate price and quantity that maximize profits and the value of the latter.
b) If this market magically becomes a perfectly competitive market, what would be
the equilibrium quantity and price?
c) Under each of the previous conditions, obtain and compare surpluses, of
consumer, of producer, and total.
d) Assume that the government knows total cost of production in this market and
decides to intervene setting a price equal to that of perfect competition. In addition the
government decides to auction a license for just one firm to operate in this market. How
much will be monopolist be willing to offer for this sole license?

Solution
To solve this problem, we are going to use two different methods. One uses only the
concepts we have seen in class, here we will use an excel file to do all the computations
and graphs required by the problem. The second method requires a more advanced
knowledge in math, particularly using derivatives.

6
We can open the excel file included here by clicking twice on the
icon. When you open it you will find 4 sheets. In the first one we
have the data generated using the demand, total cost, and total Hoja_6-Ejercicio_Mo
revenue functions. To get the marginal costs and marginal revenue, nopolio_vs_Competencia.xlsm
we use the incremental difference in the total costs and total
revenue respectively. The independent variable is que quantity Q, which has values
starting from zero with the desired increment (depending on the precision we want on
the outcomes). In this case, we have used an increment of 0.01 given that the solution in
perfect competition requires two decimals. The other sheets in the excel file contain the
graphs needed for the solution.

a) The monopolist maximizes profits producing the quantity (Q) that is obtained
when the marginal cost is equal to the marginal revenue, that is:
𝑀𝐶 = 𝑀𝑅
In the graphic, we can see that this is achieved when the MC=MR=180 and the quantity
produced and supplied to the market is QM = 40.
For this quantity, the consumers are willing to pay, using the demand function, a price
equal to PM = 190.
For these price and quantity, the total revenue of the monopolist (TR = PM * QM) is
7,600, while the total cost (TC) is 6,100, which means that the profit of the monopolist
will be (B = TR - TC) BM =1,500.

200,00
190,00

180,00
180,00

160,00

140,00

120,00

100,00

40,00

80,00
0,00 5,00 10,00 15,00 20,00 25,00 30,00 35,00 40,00 45,00 50,00

Demanda Ingreso Marginal Coste Marginal

b) Under perfect competition the market equilibrium will be reached when the
supply is equal to the demand function, that is, the point at which the demand
crosses the marginal cost. At this point the quantity will be Qc =44.44 and the
price will be Pc = 188.89.

7
 200,00

188,88

180,00

160,00

140,00

120,00

100,00

44,44

80,00
0,00 5,00 10,00 15,00 20,00 25,00 30,00 35,00 40,00 45,00 50,00

Demanda Ingreso Marginal Coste Marginal

c) Using the graph, the surplus of the monopolist will be:

The light blue area that contains the rectangle and the triangle
PS = (180 - 100)*40*1/2 + (190 - 180)*40 = 2,000.

The consumer surplus is the area of the green triangle:

CS= (200 - 190)*40*1/2 = 200

The deadweight loss is the area of the small orange triangle:

DWL=(190 - 180)*(44.44 - 40)*1/2 = 22.2

200,00
190,00

180,00
180,00

160,00

140,00

120,00

100,00

40,00

80,00
0,00 5,00 10,00 15,00 20,00 25,00 30,00 35,00 40,00 45,00 50,00

Demanda Ingreso Marginal Coste Marginal

8
The total surplus is the sum of the consumer surplus and the producer surplus:
TS = PS + CS = 2,000 + 200 = 2,200

In the same way, looking at the graph, the total surplus in perfect competition will be:

200,00

188,88

180,00

160,00

140,00

120,00

100,00

44,44

80,00
0,00 5,00 10,00 15,00 20,00 25,00 30,00 35,00 40,00 45,00 50,00

Demanda Ingreso Marginal Coste Marginal

The producer surplus is the light blue area:

PS = (188.88 - 100)*44.44*1/2 = 1974.91
The consumer surplus is the area of the green triangle:
CS = (200-188.88)*44.44*1/2 = 247.09
The total surplus in the economy will be:
TS = PS + CS = 2,222
It is clear from these calculations that the monopolist takes part of the consumer surplus
and also generates a deadweight loss in the economy.
d) The maximum amount of money that the monopolist will be willing to pay is the
profit he gets. If the government decides to regulate the market setting a price P
= 188.89, then we know that at this price the quantity will be Q = 44.44.
Therefore, the total cost for the monopoly will be TC = 44.44*44.44 +
100*44.44 + 500 = 6,918.91. On the other hand, total revenue will be TR = P*Q
= 188.89*44.44 = 8,394.27, which means that the profits are (TR - TC) =
1,475.36

9
Alternative solution

In order to obtain the price, the quantity and the maximum profits of the monopolist, we
are going to change the demand function to its inverse form, that is, price as a function
of quantity instead of quantity as a function of price:
Q = 4(200 – P); Q/4= 200 – P; P = 200 – Q/4
The total revenue of the monopolist is TR = P*Q = (200 – Q/4)Q, that is, TR = 200Q –
1/4Q2. Then, we can obtain the marginal revenue: MR = ΔTR/ΔQ = 200 – 1/2Q. We
can also calculate the marginal cost MC = ΔTC/ΔQ = 2Q + 100.
Since MC = MR, we obtain: 2Q + 100 = 200 – 1/2Q. That is, 5/2Q = 100. Thus, Q = 40.
Substituting Q = 40 in the inverse demand function, we get P = 200 – 40/4 = 190.
Therefore, the monopolist’s price is P = 190 and the monopolist’s quantity is Q = 40, so
total revenue of the monopolist is TR = P*Q=190*40 = 7600. Now we can calculate
total cost of producing 40 units: TC = 402 + (100*40) + 500 = 6100. Thus, the
monopolist’s profits are 7600 - 6100 = 1500.
b) In perfect competition, the equilibrium is reached when the demand (P = 200 – Q/4)
equals the offer (CM = 2Q + 100). Since P = CM, that is, 200 – Q/4 = 2Q + 100 we
obtain Q = 44.44. This quantity can be sold at the price P = 200 – 44.4444/4 = 188.89
c) We calculate now the surpluses and compare them. In the monopoly: CS = 200 and
PS= 2000. Under perfect competition: CS = 246.42 and PS = 1973.58.
d) At most, the monopolist would be willing to pay the profits it gets. If the government
decides to intervene setting P = 188.89, we know that at this price Q = 44.44. Thus, the
total cost would be TC = 44.44*44.44 + 100*44.44 + 500 = 6918.91. Total revenue
would be TR = 188.89*44.44 = 8394.27. Finally, the amount of profit would be TR –
TC=1475.36.

10