Lecture ?: Monopoly EEP 1 Peter Berck’s Class

Who is this guy who thinks he’s funny? Maximilian Auffhammer Assistant Professor IAS/ARE

Let’s Deviate From Perfect Competition –No Market Power –Perfect Information –No Externalities –No Public Goods –Look at Market Power first.

Monopoly Monopolist: Only supplier of a good with no close substitute. –Firm output = Market output –Firm faces market demand curve, not a horizontal residual demand Does not lose all sales if price increases Faces downward sloping demand

Monopoly Firm can “set price” within some reasonable range and will still sell goods Monopolist is a regular profit maximizing firm: –MR(Q) = MC(Q)

What is Marginal Revenue For a perfectly competitive firm: –Marginal Revenue = Average Revenue = Price For the monopolist: Price is no longer exogenous. Price depends on Q, which is the monopolists output choice Average Revenue = (P(Q) x Q)/Q = P(Q)

Average Revenue is not equal to Marginal Revenue for the Monopolist!!!!

Convenient Fact If inverse Demand is linear: –P(Q) = a – bQ –MR(Q) = a – 2bQ Same intercept as inverse demand Twice the slope of the inverse demand MR hits Q axis “half way” Can we show this? Yes!!!! If MR = p, demand is perfectly elastic

Where does the monopolist produce?

The Monopoly Decision

Market Power Market Power is the ability of a firm to charge a price above marginal cost profitably. Degree of market power depends on elasticity of demand curve at the profit maximizing quantity.

Measure of Market Power: The Lerner Index MR(Q*) = MC(Q*) Lerner Index: (p- MC)/p If firm is profit maximizing: –(p-MC)/p = -1/  d –Ranges from 0 to 1 –If p=MC Lerner Index = 0  Perfect Competition The more elastic the demand curve, the smaller the markup a monopolist is able to charge.

Sources of Market Power Demand is inelastic if: –Consumers are willing to pay virtually anything for a good –No close substitutes –No entry –Similar firms are far away –Other firms products are very different.