ECON 2210 Chapter Notes - Chapter 10: Learned Hand, Inverse Demand Function, Round-Off Error
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Chapter 10
Market Power: Monopoly and Monopsony
ļ® Review Questions
1. A monopolist is producing at a point at which marginal cost exceeds marginal revenue. How
should it adjust its output to increase profit?
When marginal cost is greater than marginal revenue, the cost of producing the last unit is greater
than the additional revenue from the sale of the last unit, so the firm loses money on that unit. The
firm would increase profit by not producing as many units. It should reduce production, thereby
decreasing marginal cost and increasing marginal revenue, until marginal cost is equal to marginal
revenue. The diagram shows this situation. The firm is producing an output like Qļ¢, where MC > MR.
The firm should decrease output until it reaches the profit-maximizing output Q*.
2. We write the percentage markup of prices over marginal cost as (P ļ MC)/P. For a profit-
maximizing monopolist, how does this markup depend on the elasticity of demand? Why can
this markup be viewed as a measure of monopoly power?
Equation 10.1 on page 363 shows that the markup percentage is equal to the negative inverse of the
price elasticity of demand.
1
d
P MC
PE
ļļ½ļ
.
Therefore, as demand becomes more elastic (Ed becomes more negative), the markup percentage
becomes smaller. For example, if Ed changes from ļ2 to ļ5, the markup decreases from 0.5 to 0.2.
This tells us that the firm has less power to mark up its price above marginal cost when it faces a
more elastic demand. Therefore, the markup percentage can be viewed as a measure of monopoly
power.
3. Why is there no market supply curve under conditions of monopoly?
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164 Pindyck/Rubinfeld, Microeconomics, Eighth Edition
Copyright Ā© 2013 Pearson Education, Inc. Publishing as Prentice Hall.
The monopolistās output decision depends not only on marginal cost, but also on the demand curve.
Shifts in demand do not trace out a series of prices and quantities that we can identify as the supply
curve for the firm. Instead, shifts in demand lead to changes in price, output, or both. Thus there is
no one-to-one correspondence between the price and the sellerās quantity; therefore, a monopolized
market lacks a supply curve.
4. Why might a firm have monopoly power even if it is not the only producer in the market?
A firm can have some monopoly power if its product is differentiated from other firmsā products,
and if some consumers prefer its product to other firmsā products. A firm might also be located more
conveniently for some consumers. These differences allow the firm to charge a price above its
marginal cost and different from its rivals.
5. What are some of the different types of barriers to entry that give rise to monopoly power?
Give an example of each.
There are several types of barriers to entry, including exclusive rights (e.g., patents, copyrights,
and licenses), control of an essential resource, and economies of scale. Exclusive rights are legally
granted property rights to produce or distribute a good or service. Complete control over an essential
raw material such as bauxite to produce aluminum or oil to produce gasoline prevents other firms
from producing the same product. Large economies of scale lead to ānatural monopoliesā because the
largest producer can charge a lower price, driving competition from the market. For example, in the
production of aluminum, there is evidence to suggest that there are scale economies in the conversion
of bauxite to alumina. (See U.S. v. Aluminum Company of America, 148 F.2d 416 [1945], discussed
in Exercise 10, below.)
6. What factors determine the amount of monopoly power an individual firm is likely to have?
Explain each one briefly.
Three factors determine the firmās elasticity of demand and hence its market power: (1) the elasticity
of market demand, (2) the number of firms in the market, and (3) the interaction among firms in the
market. The elasticity of market demand depends on the uniqueness of the product, i.e., how easy it is
for consumers to substitute for the product. As the number of firms in the market increases, the demand
elasticity facing each firm increases because customers have more choices. The number of firms in
the market is determined by how easy it is to enter the industry (the height of barriers to entry).
Finally, the ability to raise price above marginal cost depends on how other firms react to the firmās
price changes. If other firms match price changes, customers have little incentive to switch to another
supplier, and this increases market power.
7. Why is there a social cost to monopoly power? If the gains to producers from monopoly power
could be redistributed to consumers, would the social cost of monopoly power be eliminated?
Explain briefly.
When the firm exploits its monopoly power by charging a price above marginal cost, consumers buy
less at the higher price, and consumer surplus decreases. Some of the lost consumer surplus is not
captured by the seller, however, because the quantity produced and consumed decreases at the higher
price, and this is a deadweight loss to society. Therefore, if the gains to producers were redistributed
to consumers, society would still suffer the deadweight loss.
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Copyright Ā© 2013 Pearson Education, Inc. Publishing as Prentice Hall.
8. Why will a monopolistās output increase if the government forces it to lower its price? If the
government wants to set a price ceiling that maximizes the monopolistās output, what price
should it set?
By restricting price to be below the monopolistās profit-maximizing price, the government can
change the shape of the firmās marginal revenue curve. When a price ceiling is imposed, MR is equal
to the price ceiling for all quantities less than or equal to the quantity demanded at the price ceiling.
For example, in the diagram the price ceiling is set at Pļ¢, which is below the profit-maximizing price
P*. The MR curve becomes the line Pļ¢A and then jumps down to B and follows the original MR curve
beyond that point. The optimal output for the monopolist is then Qļ¢, which is greater than the profit-
maximizing output.
If the government wants to maximize output, it should set a price ceiling at the point where the
demand curve and the marginal cost curve intersect, point C in the diagram. Then, when the firm
produces where MR ļ½ MC, it will be producing the output level at which P ļ½ MC, where P is the
price ceiling. In this way, the government can induce the monopolist to produce the competitive
level of output. If the price ceiling is set below this point, the monopolist will decrease output below
the competitive level.
9. How should a monopsonist decide how much of a product to buy? Will it buy more or less than
a competitive buyer? Explain briefly.
The marginal expenditure is the change in the total expenditure as the purchased quantity changes.
For a firm competing with many firms for inputs, the marginal expenditure is equal to the average
expenditure (price). For a monopsonist, the marginal expenditure curve lies above the average
expenditure curve because the decision to buy an extra unit raises the price that must be paid for all
units, including the last unit. All firms should buy inputs so that the marginal value of the last unit is
equal to the marginal expenditure on that unit. This is true for both the competitive buyer and the
monopsonist. However, because the monopsonistās marginal expenditure curve lies above the average
expenditure curve and because the marginal value curve is downward sloping, the monopsonist buys
less than a firm would buy in a competitive market.
10. What is meant by the term āmonopsony powerā? Why might a firm have monopsony power
even if it is not the only buyer in the market?
Monopsony power refers to a buyerās ability to affect the price of a good and to purchase the good for
a lower price than in a competitive market. Any buyer facing an upward-sloping supply curve has
some monopsony power. In a competitive market, the seller faces a perfectly elastic market demand
curve and the buyer faces a perfectly elastic market supply curve. Thus, any characteristic of the
market (e.g., a small number of buyers or buyers who engage in collusive behavior) that leads to a
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Document Summary
A monopolist is producing at a point at which marginal cost exceeds marginal revenue. When marginal cost is greater than marginal revenue, the cost of producing the last unit is greater than the additional revenue from the sale of the last unit, so the firm loses money on that unit. The firm would increase profit by not producing as many units. It should reduce production, thereby decreasing marginal cost and increasing marginal revenue, until marginal cost is equal to marginal revenue. The firm is producing an output like q , where mc > mr. The firm should decrease output until it reaches the profit-maximizing output q*. We write the percentage markup of prices over marginal cost as (p mc)/p. Equation 10. 1 on page 363 shows that the markup percentage is equal to the negative inverse of the price elasticity of demand. Therefore, as demand becomes more elastic (ed becomes more negative), the markup percentage becomes smaller.
