CH 10

Chapter 10
Market Power:
Monopoly &
Monopsony
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.
CHAPTER 10 OUTLINE
10.1 Monopoly
10.2 Monopoly Power
10.3 Sources of Monopoly Power
10.4 The Social Costs of Monopoly Power
10.5 Monopsony
10.6 Monopsony Power
10.1 MONOPOLY
A Monopoly is the only supplier of a good for which there is no

close substitute.
A monopolys output is the market output, and the demand curve a

monopoly faces is the market demand curve.
Entry is not possible.
Unlike a competitive firm, a monopolist can set its price.
A monopolist has to decide the output (q) to produce and the price
per unit to charge (P) to maximize profit.
Average Revenue and Marginal Revenue

marginal revenue
Change in revenue resulting from a one-unit increase in output.
To see the relationship among total, average, and marginal revenue,

consider a firm facing the following demand curve:
P=6Q
TABLE 10.1
TOTAL, MARGINAL, AND AVERAGE REVENUE
PRICE (P)
QUANTITY (Q)
TOTAL
REVENUE (R)
MARGINAL
REVENUE (MR)
AVERAGE
REVENUE (AR)
$6
$0
$5
$5
1.
2.
3.
Average Revenue &

Marginal Revenue
Demand faced by the

monopolist is the market
demand (i.e. downward
sloping)
P = 6 Q.
The monopolists average
revenue curve is also the
market demand curve .
The marginal revenue curve:
MR = 6 2Q
Market demand:
Marginal Revenue:
2bQ
P=a-bQ
MR=a-
D=AR
For all linear demand functions with the form:

P(q)= a-bq
TR(q)=P*q
MR=TR/q
=(Pq+qP)/q
= P+q(P/q)
Since P(q)= a-bq
P/q = -b (the slope)
MR= P-bq = a-bq-bq = a-2bq
MR=a-2bq
Marginal Revenue Curve and Demand Curve

For all linear demand functions with the form:
P(q)= a-bq
MR(q)=a-2bq
1. MR curve is a straight line that starts at the same
point on the vertical (price) axis as the demand
curve.
2. The MR has twice the slope of the demand curve.
3. The MR curve hits the horizontal (quantity) axis at
half the quantity as the demand curve.
Practice Questions
The market demand is Q=100-5P. Find the MR function.
1. Find the inverse demand function.
Solve for P in Q=100-5P. Find P=20-(q/5) that is P=20-0.2q
Slope: -0.2 and intercept 20
2. Then MR is MR(q) = 20-2*0.2 q
So, MR(q)= 20-0.4q
The Monopolists Output Decision

Profit Is Maximized When MR=MC
At Q*, MR = MC.
If the firm produces Q1it
sacrifices some profit because the
extra revenue exceeds the cost of
producing them.
Increase Q* to Q2 would reduce
profit because the additional cost
would exceed the additional
revenue.
Example of Profit Maximization

(a) shows total revenue R, total cost C,
and profit.
(b) shows AR, MR, AC, and MC.
MR is the slope of the total revenue
curve, and MC is the slope of the total
cost curve.
The profit-maximizing output is Q* = 10,
the point where MR=MC (i.e., slopes of
the total revenue and total cost curves
are equal).
The profit per unit is $15, the difference
between average revenue and average
cost. Because 10 units are produced,
total profit is $150.
Question:
Consider a Monopolist with TC(q)= 50+ q 2 and MC(q)= 2q.
Let the market demand be P=40-q. Find the profit
max price & quantity. Determine the economic profit.
P=40-q
so we know MR=40-2q
Profit Max Rule: MR=MC

40-2q=2q , solve for q. q*=10.
Sub q*=10 into the demand function
P=40-q =40-10, so P*=30
Economic profit= TR-TC= P* q*-TC=30*10-50-10 2 =150
A Rule of Thumb for Pricing

We want to translate MR=MC into a rule of thumb that can be easily applied in
practice.
The extra revenue from supplying one more unit has two components:
1) Producing one extra unit and selling it at price P brings in revenue (1)*(P) = P.
2) Because the firm faces a downward-sloping demand curve, selling this extra
unit results in a small drop in price P/Q, which reduces the revenue from all
units sold (i.e., a change in revenue Q[P/Q]).
Thus,
(Q/P)(P/Q) is the inverse of the elasticity of demand,

1/Ed, measured at the profit-maximizing output
Because the firms objective is to maximize profit, we can

set MR=MC
Rearranging this equation:
Or, we can express price directly as a markup over marginal cost:
With downward-sloping demand, when output increases (say

of 1 unit), then the price falls. The change in total revenue depends
on the elasticity of the demand.
Recall
If demand is elastic, TR increases when price falls.
If demand is inelastic, TR decreases when price falls.
When q increases, p falls, then
1. If demand is elastic, MR is positive
2. If demand is inelastic, MR is negative
3. If demand is unitary elastic, MR is zero
Profit-maximizing P* will NEVER be in the inelastic part of
the demand. The monopolist will set a price in the elastic
part of the demand
Consider: Shifts in Demand

A monopolist has no supply
curve i.e., there is no one-toone relationship between price
and quantity produced.
In (a), the demand curve D1
moves to D2.
The new marginal revenue curve
MR2 intersects MC at the same
point as the old marginal
revenue curve MR1.
The profit-maximizing output
remains the same, although
price falls from P1 to P2.
In (b), MR2 intersects MC at a
higher output level Q2.
Because demand is now more
elastic, price remains the same.
The Effect of a Tax

Suppose a specific tax of t dollars per unit is levied, so that the
monopolist must pay t dollars to the government for every unit it sells.
With a tax t per unit, the

firms effective marginal
cost is increased by the
amount t to
MC + t.
In this example, the
increase in price P is
larger than the tax t.
The Multiplant Firm

Suppose a firm has two plants. What should its total output be, and how much of
that output should each plant produce?
Let Q1 and C1, Q2 and C2 be the output and cost of production for Plant 1 and 2.
QT = Q1 + Q2 be total output. Then profit
The total output should be divided between the two plants so that (1) marginal
cost is the same in each plant, and (2) the MR should be equal to marginal costs.
Thus, the profit maximization rule for the multiplant firm is:
Production with Two Plants
A firm with two plants

maximizes profits by
choosing output levels Q1
and Q2 so that marginal
revenue MR (which
depends on total output)
equals marginal costs for
each plant, MC1 and MC2.
Example
P = 120 - 3Q
demand
MC1 = 10 + 20Q1 plant 1
MC2 = 60 + 5Q2 plant 2
a. What are the monopolist's optimal total quantity and price?
Step 1: Derive MCT as the horizontal sum of MC1 and MC2
Inverting marginal cost (to get Q as a function of MC), we have:
Q1 = -1/2 + (1/20)MC1
Q2 = -12 + (1/5)MC2
Now, sum Q1 and Q2 to get

QT = Q1 + Q2 =(-1/2 + (1/20)MC1)+(-12 + (1/5)MC2 ).
Hence
QT =-12.5+ (1/20)MC1 + (1/5)MC2
Let MCT equal the common marginal cost level in the two plants.
Then: MCT= MC1= MC2 and
QT =-12.5 + (1/20)MC1 + (1/5)MC2 becomes
QT =-12.5 + (1/20)MCT + (1/5)MCT
That is
QT = Q1 + Q2 = -12.5 + .25MCT
And, writing this as MCT as a function of QT:
MCT = 50 + 4QT
Using the monopolist's profit maximization condition:
MR = MCT
120 - 6QT = 50 + 4QT
QT* = 7
P* = 120 - 3(7) = 99
b. What is the optimal division of output across the

monopolist's plants?
MCT (QT* )= 50 + 4(7) = 78
Therefore,
Q1* = -1/2 + (1/20)(78) = 3.4
Q2* = -12 + (1/5)(78) = 3.6
10.2
MONOPOLY POWER
Measuring Monopoly Power

Remember: For the competitive firm, P=MC; for the firm with
monopoly power, P>MC.
Lerner Index of Monopoly Power
Measure of monopoly power calculated
as excess of price over marginal cost as
a fraction of price.
This index of monopoly power can also be expressed in terms of the

elasticity of demand.
The Rule of Thumb for Pricing
Elasticity of Demand and Price Markup

The markup (P MC)/P is equal to -1/Ed.
If the firms demand is elastic, as in (a), the markup is small and the firm has little monopoly power.
The opposite is true if demand is relatively inelastic, as in (b).
10.3
SOURCES OF MONOPOLY POWER
Three factors determine a firms market power.
1. The elasticity of market demand.

2. The number of firms in the market.
3. The interaction among firms.
The Interaction Among Firms

Firms might compete aggressively, undercutting one anothers
prices to capture more market share. This could drive prices down
to nearly competitive levels.
Firms might even collude (in violation of the antitrust laws),
agreeing to limit output and raise prices. Collusion can generate
substantial monopoly power.
10.4
THE SOCIAL COSTS OF MONOPOLY POWER
Deadweight Loss from

Monopoly Power
Competitive price and quantity:
Pc and Qc,
A monopolists price and quantity:
Pm and Qm.
Consumers lose A + B
Producer gains A C.
The deadweight loss is B + C.
Price Regulation
If left alone, a monopolist
produces Qm and charges
Pm.
When the government
imposes a price ceiling of P1
the firms AR and MR are
constant and equal to P1 for
output levels up to Q1.
For Q>Q1, the original AR
and MR curves apply.
The new marginal revenue
curve is, therefore, the dark
purple line, which intersects
the MC at Q1.
When P=Pc, at the point

where MC intersects AR
curve, output increases
to its maximum Qc.
This is the output that
would be produced by a
competitive industry.
Lowering price further, to
P3 reduces output to Q3
and causes a shortage,
Q3 Q3.
Natural Monopoly
Firm that can produce the entire output of the market at a cost lower
than what it would be if there were several firms.
A firm is a natural monopoly

because it has economies of
scale (declining average and
marginal costs) over its entire
output range.
If price were regulated to be Pc
the firm would lose money and
go out of business.
Setting the price at Pr yields the
largest possible output
consistent with the firms
remaining in business; excess
profit is zero.
Regulating the Price of

a Natural Monopoly
Regulation in Practice
rate-of-return regulation Maximum price
allowed by a regulatory agency is based on the
(expected) rate of return that a firm will earn.
The difficulty of agreeing on a set of numbers to be used in rate-ofreturn calculations often leads to delays in the regulatory response to
changes in cost and other market conditions.
The net result is regulatory lagthe delays of a year or more usually
entailed in changing regulated prices.
10.5
MONOPSONY
oligopsony
Market with only a few buyers.
monopsony power
price of a good.
Buyers ability to affect the
marginal value Additional benefit derived from

purchasing one more unit of a good.
Total expenditure
Total cost of buying Qs units of a good. TE=P*Qs
marginal expenditure Additional cost of
buying one more unit of a good. ME=TE/Qs
average expenditure
good. AE=TE/Qs
Price paid per unit of a
Competitive Buyer Compared to Competitive Seller
In (a), the competitive buyer takes market price P* as given. Therefore, marginal
expenditure and average expenditure are constant and equal;
quantity purchased is found by equating price to marginal value (demand).
In (b), the competitive seller also takes price as given. Marginal revenue and
average revenue are constant and equal;
quantity sold is found by equating price to marginal cost.
Monopsonist Buyer
The market supply curve is
monopsonists average expenditure
curve AE.
Marginal expenditure (ME) lies above
AE.
The monopsonist purchases Q*m,
where marginal expenditure and
marginal value (demand) intersect.
The price paid per unit P*m is then
found from the average expenditure
(supply) curve.
Profit Max Rule: ME=MV

(MV is also the demand curve)
In a competitive market, price and

quantity, Pc and Qc, are both higher.
Pc and Qc are found at the point where
average expenditure (supply) and
marginal value (demand) intersect.
Monopsony and Monopoly Compared
D=AR
a) The monopolist produces where MR=MC. AR exceeds MR, so that P>MC.

b) The monopsonist purchases up to the point where ME=MV. ME exceeds
AE, so that MV exceeds P.
10.6
MONOPSONY POWER
Monopsony Power: Elastic versus Inelastic Supply

Monopsony power depends on the elasticity of supply.
When supply is elastic, as in (a), marginal expenditure and average expenditure do not
differ by much, so price is close to what it would be in a competitive market.
The opposite is true when supply is inelastic, as in (b).
Relationship between Supply and ME

If Supply curve P = c+dQ, then ME =c+2dQ
Example
Say that the (inverse) supply is P=4Q+3
Calculate the ME
Answer: Double the slope in the expression of the (inverse)
supply and get ME
That is double 4 in P=4Q+3 and get ME =8Q+3
For all linear supply functions with the form:

P(q)= c+dq
Total Expenditure :TE(q)=P*q
ME=TE/q
=(Pq+qP)/q
= P+q(P/q)
Since P(q)= c+dq
P/q = d (the slope)
ME= P+dq =(c+dq)+dq = c+2dq
ME= c+2dq
We have shown that:

ME=TE/qs =(Pq+qP)/q = P+q(P/q)
ME= P+ P*(1/P) *q(P/q) =P+P*(q/P)*(P/q)
(q is the quantity supplied)
(q/P)*(P/q) is the inverse of the elasticity of supply Es
ME= P+P*(1/Es)
Recall that the profit max rule: MV=ME
At the optimal Q, MV= P+P*(1/Es)
(MV-P)/P=1/Es
Since Es>0 (law of supply), so MV>P
Practice:
The employment of nurses by the only local hospital can be
characterized as a monopsony.
Demand for nurses: w=30,000-125q
Supply for nurses: w=1000+75q
a. Find the optimal w* and employment of nurses for the
hospital.
b. If instead, the hospital faced an infinite supply of nurses at
the wage level of $10,000, how many nurses would it hire?
a.
Supply for nurses: w=1000+75q
So we can derive that ME=1000+150q
Profit max rule is ME=MV
We know that MV (marginal value curve) is the demand curve
So 1000+150q=30,000-125q
q*=106
Sub it into the supply curve, w* =1000+75*106=8950
b. In this new condition, the supply curve changes. It is now a

horizontal line at $10,000. This means that the hospital is
no longer a monopsonist. It is a competitive buyer now.
New supply curve is W=10,000
It means that when it hires one more nurse, the marginal
expenditure is always 10,000
ME=supply curve=10,000
Profit Max Rule: MV=ME
30,000-125q=10,000
q*=160
Sources of Monopsony Power

Elasticity of Market Supply
Number of Buyers
Interaction Among Buyers
The Social Costs of Monopsony Power
Competitive price and

quantity: Pc and Qc,
Monopsonists price and
quantity: Pm and Qm.
Change in buyer
(consumer) surplus: A B.
Producer surplus falls by
A+C
Deadweight loss : B and
C.
Bilateral Monopoly
bilateral monopoly Market with only
one seller and one buyer.
Monopsony power and monopoly power will tend

to counteract each other.
The optimal P and Q depend on the relative
bargaining position of the two parties.

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Chapter 10

A Monopoly is the only supplier of a good for which there is no

A monopolys output is the market output, and the demand curve a

Entry is not possible.

Unlike a competitive firm, a monopolist can set its price.

Average Revenue and Marginal Revenue

Change in revenue resulting from a one-unit increase in output.

To see the relationship among total, average, and marginal revenue,

TOTAL, MARGINAL, AND AVERAGE REVENUE

Average Revenue &

Demand faced by the

For all linear demand functions with the form:

Marginal Revenue Curve and Demand Curve

The Monopolists Output Decision

Example of Profit Maximization

Profit Max Rule: MR=MC

A Rule of Thumb for Pricing

(Q/P)(P/Q) is the inverse of the elasticity of demand,

Because the firms objective is to maximize profit, we can

Rearranging this equation:

Or, we can express price directly as a markup over marginal cost:

With downward-sloping demand, when output increases (say

Consider: Shifts in Demand

The Effect of a Tax

With a tax t per unit, the

The Multiplant Firm

Production with Two Plants

A firm with two plants

Now, sum Q1 and Q2 to get

120 - 6QT = 50 + 4QT

b. What is the optimal division of output across the

Measuring Monopoly Power

This index of monopoly power can also be expressed in terms of the

The Rule of Thumb for Pricing

Elasticity of Demand and Price Markup

SOURCES OF MONOPOLY POWER

Three factors determine a firms market power.

1. The elasticity of market demand.

The Interaction Among Firms

THE SOCIAL COSTS OF MONOPOLY POWER

Deadweight Loss from

When P=Pc, at the point

A firm is a natural monopoly

Regulating the Price of

Market with only a few buyers.

Buyers ability to affect the

marginal value Additional benefit derived from

Price paid per unit of a

Competitive Buyer Compared to Competitive Seller

Profit Max Rule: ME=MV

In a competitive market, price and

Monopsony and Monopoly Compared

a) The monopolist produces where MR=MC. AR exceeds MR, so that P>MC.

Monopsony Power: Elastic versus Inelastic Supply

Relationship between Supply and ME

For all linear supply functions with the form:

We have shown that:

b. In this new condition, the supply curve changes. It is now a

Sources of Monopsony Power

The Social Costs of Monopsony Power

Competitive price and

Monopsony power and monopoly power will tend