ECONOMICS Paul Krugman | Robin Wells with Margaret Ray and David Anderson SECOND EDITION in MODULES

MODULE 25 (61) Introduction to Monopoly Krugman/Wells

How a monopolist determines the profit- maximizing output and price How to determine whether a monopoly is earning a profit or a loss 3 of 17

The Monopolist’s Demand Curve and Marginal Revenue The price-taking firm’s optimal output rule is to produce the output level at which the marginal cost of the last unit produced is equal to the market price. A monopolist, in contrast, is the sole supplier of its good. So its demand curve is simply the market demand curve, which is downward sloping. This downward slope creates a “wedge” between the price of the good and the marginal revenue of the good—the change in revenue generated by producing one more unit. 4 of 17

Comparing the Demand Curves of a Perfectly Competitive Producer and a Monopolist (a) Demand Curve of an Individual Perfectly Competitive Producer D C Price (b) Demand Curve of a Monopolist D M Market price Quantity Price 5 of 17 An individual perfectly competitive firm cannot affect the market price of the good  it faces a horizontal demand curve DC, as shown in panel (a). A monopolist can affect the price (sole supplier in the industry)  its demand curve is the market demand curve, DM, as shown in panel (b).

The Monopolist’s Demand Curve and Marginal Revenue An increase in production by a monopolist has two opposing effects on revenue: –A quantity effect— One more unit is sold, increasing total revenue by the price at which the unit is sold. –A price effect— In order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue. The quantity effect and the price effect are illustrated by the two shaded areas in panel (a) of the following figure based on the numbers on the table accompanying it. 6 of 17

The Monopolist’s Demand Curve and Marginal Revenue 7 of 17

A Monopolist’s Demand, Total Revenue, and Marginal Revenue Curves A MR TR D 9 20 $1,000 –200 – Quantity of diamonds $5,000 4,000 3,000 2,000 1,000 Total Revenue B C (a) Demand and Marginal Revenue (b) Total Revenue Price, cost, marginal revenue of demand Price effect = -$450 Quantity effect = +$500 Marginal revenue = $50 Quantity effect dominates price effect. Price effect dominates quantity effect. 10 Quantity of diamonds 8 of 17

The Monopolist’s Demand Curve and Marginal Revenue Due to the price effect of an increase in output, the marginal revenue curve of a firm with market power always lies below its demand curve. A profit-maximizing monopolist chooses the output level at which marginal cost is equal to marginal revenue—not to price. As a result, the monopolist produces less and sells its output at a higher price than a perfectly competitive industry would. It earns a profit in the short run and the long run. 9 of 17

The Monopolist’s Demand Curve and Marginal Revenue At low levels of output, the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small. At high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it now has to lower the price on many units of output, making the price effect very large. 10 of 17

The Monopolist’s Profit-Maximizing Output and Price To maximize profit, the monopolist compares marginal cost with marginal revenue. If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less. At the monopolist’s profit-maximizing quantity of output: MR = MC 11 of 17

The Monopolist’s Profit-Maximizing Output and Price B C MR Monopoly profit MC = ATC D $1, –200 –400 0 Quantity of diamonds A P C P M Q M Q C Price, cost, marginal revenue of demand Monopolist’s optimal point Perfectly competitive industry’s optimal point The optimal output rule: the profit maximizing level of output for the monopolist is at MR = MC, shown by point A, where the MC and MR curves cross at an output of 8 diamonds. 12 of 17

Monopoly Behavior and the Price Elasticity of Demand When a monopolist increases output by one unit, it must reduce the market price in order to sell that unit. If the price elasticity of demand is less than 1, this will actually reduce revenue—that is, marginal revenue will be negative. The monopolist can increase revenue by producing more only if the price elasticity of demand is greater than 1. The higher the elasticity, the closer the additional revenue is to the initial market price. A monopolist that faces highly elastic demand will behave almost like a firm in a perfectly competitive industry. 13 of 17

Monopoly Versus Perfect Competition P = MC at the perfectly competitive firm’s profit- maximizing quantity of output P > MR = MC at the monopolist’s profit-maximizing quantity of output Compared with a competitive industry, a monopolist does the following: –Produces a smaller quantity: QM < QC –Charges a higher price: PM > PC –Earns a profit 14 of 17

The Monopolist’s Profit Q M Quantity P M ATC M C D MR A B MC ATC Price, cost, marginal revenue Monopoly profit Profit = TR − TC = (P M × Q M ) − (ATC M × Q M ) = (P M − ATC M ) × Q M Profit = TR − TC = (P M × Q M ) − (ATC M × Q M ) = (P M − ATC M ) × Q M The average total cost of QM is shown by point C. Profit is given by the area of the shaded rectangle. The monopolist maximizes profit by producing the level of output at which MR = MC, given by point A, generating quantity QM. It finds its monopoly price, PM, from the point on the demand curve directly above point A, point B here. 15 of 17

1.The key difference between a monopoly and a perfectly competitive industry is that a single perfectly competitive firm faces a horizontal demand curve but a monopolist faces a downward-sloping demand curve. This gives the monopolist market power, the ability to raise the market price by reducing output compared to a perfectly competitive firm. 2.The marginal revenue of a monopolist is composed of a quantity effect (the price received from the additional unit) and a price effect (the reduction in the price at which all units are sold). Because of the price effect, a monopolist’s marginal revenue is always less than the market price, and the marginal revenue curve lies below the demand curve. 16 of 17

3.At the monopolist’s profit-maximizing output level, marginal cost equals marginal revenue, which is less than market price. 4.At the perfectly competitive firm’s profitmaximizing output level, marginal cost equals the market price. 5.So in comparison to perfectly competitive industries, monopolies produce less, charge higher prices, and earn profits in both the short run and the long run. 17 of 17