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MSCI 332 (14)


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University of Waterloo
Management Sciences
MSCI 332
Uzma Rehman

Principles of Economics: Monopoly MONOPOLY A monopoly (‘single sellers’) is the sole producer in an industry. This means that Demand for the industry is Demand for the Monopoly and that the marginal cost and average cost functions of the monopoly are the marginal cost and average cost functions for the industry. A monopoly is not a price taker since a change in industry output changes the price of the commodity for the monopoly. . Since price is not constant, marginal revenue is not equal to price for a monopolist. The Marginal Revenue at a given output is always less than price at that quantity since Marginal revenue (MR) = P + QΔP/ΔQ (I derived this formula for marginal revenue in an earlier lecture.) and ΔP/ΔQ < 0. (Marginal Revenue only equals Price for a monopolist if market demand is perfectly elastic (horizontal), which is analogous to the perfect elastic demand function facing the individual competitive firm) Since P is not constant and price is dependent upon the output of the monopoly, a monopoly can determine commodity price by restricting output. The marginal cost function of the monopoly is not the supply function for the industry because quantity supplied is not simply determined by marginal cost in response to a price but depends upon the the monopolist’s determination of price to maximize profit. Profit Maximization for a Monopolist: MR = MC Profit maximization for the monopolist occurs at the output where Marginal Cost = Marginal Revenue (MC = MR) as we derived earlier for all firms. We cannot simplify this to P = MC because MR ≠ P. Deriving Marginal Revenue from Demand: Slope MR = 2*Slope Dor Linear Demand We know that Marginal Revenue = P + QΔP/ΔQ but we can also express Marginal Revenue in relation to the Demand function. In particular, Linear Demand functions generate linear Marginal Revenues functions that have twice the slope of the Demand function. - 1 - Principles of Economics: Monopoly Proof: A Linear Demand function is of the form P = a – bQ. 2 => MR = ΔTR/ΔQ = Δ(P*Q)/ΔQ = Δ(a – bQ)Q/ΔQ = Δ(a – bQ )/ΔQ = a – 2bQ 2 (MR = dTR/dQ = d(PQ)/dQ = d(a – bQ)Q/dQ = d(a – bQ )/dQ = a – 2bQ) i.e. Marginal Revenue for Linear Demand has the same intercept term as the Demand function and twice the slope. We can also say that quantity that gives a specific Marginal Revenue is half the quantity from the Demand function that gives a Price equal to that Marginal Revenue. Proof: If Demand is P = a – bQ so that Marginal Revenue is MR = a – 2bQ , then D MR P = MR => a – bQ = D – 2bQ , =>MRQ = 2bQ D MR We already know this by the way from our understanding of the elasticity of a linear Demand function. Elasticity is unit elastic at the midpoint of a Demand function, which means that Marginal Revenue is 0 at the midpoint (bQ =D2Q ) bMRause Total Revenue doesn’t change. E.g. Suppose that Demand is P = 80 – 2Q. What is Marginal Revenue? Marginal Revenue: MR = 80 – 4Q because slope of Marginal Revenue = 2(-2) Demand: P = 80 - 2Q => MR = 80 - 4Q P, MR 80 60 MR=0 => unit elasticity 40 20 Demand MR 0 Q 0 10 20 30 40 50 - 2 - Principles of Economics: Monopoly A monopolist will not produce in the inelastic portion of a Demand function since a decrease in quantity will a) increase Total Revenue and b) reduce Variable Costs. The monopolist reduces quantity in the elastic portion of the Demand function so long as the decreased Variable Cost of one less unit is greater than the decreased revenue from one less unit, i.e., until MR = MC. Monopoly Equilibrium and Economic Profit Monopoly Equilibrium => monopoly output (Q ) Mhere MR = MC => Monopoly Price (P M from Demand at Q M => Average Cost (AC )Mrom Average Cost at Q M => Economic Profit = (PM– AC )MQ M or PM*Q M Total Cost M E.g. Suppose that P = 80 – 2Q and Total Cost = Q /2 + 5Q + 200 are the Demand and Total Cost functions of an Industry. a) What is the competitive equilibrium price and quantity? Competitive equilibrium => P = MC => 80 – 2Q = Q + 5 →Q = 25 and P = $30 from either 80 – 2*30 or 25 + 5 b) What is the competitive equilibrium economic profit? Profit = PQ – TC = 30*25 – (25 /2 + 5*25 + 200) = $112.50 c) What is monopoly price and quantity MR = MC => 80 – 4Q = Q + 5 (Note the slope of MR in relation to Demand) →Q = 15 and P = $50 from 80 – 2*15 d) What is monopoly profit? 2 Profit = 50*15 – (15 /2 + 5*15 + 200) = $362.50 - 3 - Principles of Economics: Monopoly This following graph depicts monopoly equilibrium. 2 P = 80 - 2Q; TC = Q /2+5Q+200 => AC = Q/2 + 5 + 200/Q and MC = Q + 5 P, MR 80 60 Pm MC 40 Economic Profit AC ACm 20 Demand MR 0 0 10 Qm 20 30 40 50Q Types of Monopoly: Barriers to entry The monopolist makes a profit greater than the competitive profit by restricting quantity supplied in the industry but the economic profit attracts other firms to enter the industry. The key to the economic profit of a successful monopoly is therefore the monopoly’s ability to utilize barriers that prevent the entry of other firms. There are four main barriers to entry corresponding to four different types of monopoly. 1. Government Monopolies. Government legislation can establish monopolies in industries. Governments perform functions that otherwise might be monopolized (highways, bridges, etc.), establish public corporations with monopoly power in an industry (such as Ontario Hydro, the TTC, or the LCBO), or grant monopoly power to private firms (such as the Hudson’s Bay Company or, more - 4 - Principles of Economics: Monopoly recently, Highway 407). The rationale for government monopolies is to prevent private exploitation of a natural monopoly (see below) or for revenue purposes. 2. Control of an Essential Input (‘Normal’ monopoly) Control over an essential resource (e.g., water, mineral), technology (through patents, for example) (drugs), or a product establishes the barrier to entry for most monopolies. (Most successful firms try to distinguish their product from other similar products (e.g., Coca Cola and Pepsi) to reap higher than normal profits as a monopoly but this marketing of similar products is best analyzed as monopolistic competition rather than monopoly per se) Since control over an input or output eliminates the entry of other firms, the ‘Normal’ need only be large enough to produce the output that maximizes profit. This means that the minimum average cost of the Normal monopoly is to the left of the Demand function for the industry. There is usually room in the industry for more than one competitive firm of the size of the monopoly but the monopoly’s co
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