Principles of Economics: 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.
=> MR = ΔTR/ΔQ = Δ(P*Q)/ΔQ = Δ(a – bQ)Q/ΔQ = Δ(a – bQ )/ΔQ = a – 2bQ
(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
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 = DQ ) 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
MR=0 => unit elasticity
0 10 20 30 40 50
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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 )Mwhere 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?
Profit = 50*15 – (15 /2 + 5*15 + 200) = $362.50
This following graph depicts monopoly equilibrium.
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P = 80 - 2Q; TC = Q /2+5Q+200
=> AC = Q/2 + 5 + 200/Q and MC = Q + 5
80 P, MR
40 Economic Profit
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 recently,
Highway 407). The rationale for government monopolies is to prevent private exploitation of a
natural monopoly (see below) or for revenue purposes.
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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 control over i