Chapter 9 Market Power: Monopoly and Monopsony Market Power: Monopoly and Monopsony Slide 1Chapter 9

Slide 2 Perfect Competition Review of Perfect Competition P = LMC = LRAC Normal profits or zero economic profits in the long run Large number of buyers and sellers Homogenous product Perfect information

Perfect Competition Q Q PP MarketIndividual Firm DS Q0Q0 P0P0 P0P0 MR = P q0q0 LRACLMC Slide 3Chapter 9

Slide 4 Monopoly 1) One seller - many buyers 2)One product (no good substitutes)

Chapter 9Slide 5 Monopoly The monopolist is the supply-side of the market and has complete control over the amount offered for sale. Profits will be maximized at the level of output where marginal revenue equals marginal cost.

Chapter 9Slide 6 Monopoly Finding Marginal Revenue As the sole producer, the monopolist works with the market demand to determine output and price. Assume a firm with demand:  P = 6 - Q

Chapter 9Slide 7 Total, Marginal, and Average Revenue $60$ $5$ TotalMarginalAverage PriceQuantityRevenueRevenueRevenue PQRMRAR

Chapter 9Slide 8 Average and Marginal Revenue Output $ per unit of output Average Revenue (Demand) Marginal Revenue

Chapter 9Slide 9 Monopoly Observations 1)To increase sales the price must fall 2)MR < P 3)Compared to perfect competition  No change in price to change sales  MR = P

Chapter 9Slide 10 Monopoly Monopolist’s Output Decision 1)Profits maximized at the output level where MR = MC 2)Cost functions are the same

Chapter 9Slide 11 Maximizing Profit When Marginal Revenue Equals Marginal Cost At output levels below MR = MC the decrease in revenue is greater than the decrease in cost (MR > MC). At output levels above MR = MC the increase in cost is greater than the decrease in revenue (MR < MC) The Monopolist’s Output Decision

Chapter 9Slide 12 Lost profit P1P1 Q1Q1 Lost profit MC AC Quantity $ per unit of output D = AR MR P* Q* Maximizing Profit When Marginal Revenue Equals Marginal Cost P2P2 Q2Q2

Chapter 9Slide 13 Monopoly An Example The Monopolist’s Output Decision

Chapter 9Slide 14 Monopoly An Example The Monopolist’s Output Decision

Chapter 9Slide 15 Monopoly An Example The Monopolist’s Output Decision

Chapter 9Slide 16 Monopoly An Example By setting marginal revenue equal to marginal cost, it can be verified that profit is maximized at P = $30 and Q = 10. This can be seen graphically: The Monopolist’s Output Decision

Chapter 9Slide 17 Example of Profit Maximization Observations Profits are maximized at 10 units P = $30, Q = 10, TR = P x Q = $300 AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR - TC  $150 = $300 - $150 Quantity $ R C Profits t t' c c

Chapter 9Slide 18 Example of Profit Maximization Observations AC = $15, Q = 10, TC = AC x Q = 150 Profit = TR - TC = $300 - $150 = $150 or Profit = (P - AC) x Q = ($30 - $15)(10) = $150 Quantity $/Q MC AR MR AC Profit

Chapter 9Slide 19 Monopoly A Rule of Thumb for Pricing We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice. This can be demonstrated using the following steps:

Chapter 9Slide 20 A Rule of Thumb for Pricing

Chapter 9Slide 21 A Rule of Thumb for Pricing

Chapter 9Slide 22 A Rule of Thumb for Pricing

Chapter 9Slide 23 = the markup over MC as a percentage of price (P-MC)/P A Rule of Thumb for Pricing 8. The markup should equal the inverse of the elasticity of demand.

Chapter 9Slide 24 A Rule of Thumb for Pricing

Chapter 9Slide 25 Monopoly Monopoly pricing compared to perfect competition pricing: Monopoly P > MC Perfect Competition P = MC

Chapter 9Slide 26 Monopoly Monopoly pricing compared to perfect competition pricing: The more elastic the demand the closer price is to marginal cost. If E d is a large negative number, price is close to marginal cost and vice versa.

Chapter 9Slide 27 Monopoly The Effect of a Tax Under monopoly price can sometimes rise by more than the amount of the tax. To determine the impact of a tax: t = specific tax MC = MC + t MR = MC + t : optimal production decision

Chapter 9Slide 28 Effect of Excise Tax on Monopolist Quantity $/Q MC AR MR Q0Q0 P0P0 MC + tax t Q1Q1 P1P1 Increase in P: P 0 P 1 > increase in tax