Chapter 13 - Monopoly

Question 1

When is MR < P for a monopolist?

Answer 1

Always.

This is because the demand curve for a monopolist is downward sloping.

• to sell an additional unit the monopolist must lower the price and that reduces the revenue from the quantity of units that were sold!

Question 2

Why does a Profit Maximising Monopolist never produce on an inelastic portion of the demand curve?

Answer 2

Raising price on IE portion will always increase revenue and lowers cost. Firm should move up the demand curve where it is not inelastic if prof-max is the goal!

Question 3

Would a Revenue Maximising monopolist ever produce on the inelastic portion of the demand curve?

Answer 3

No, since an increase in price will always increase revenue. Will produce at the point where PED = 1 (unit elasticity)

and where MR = 0

Question 4

If a monopolist faces a perfectly horizontal demand curve, then the deadweight loss to the economy is zero? true or false.

Answer 4

True!

• there will be no deadweight loss.
• the monopolist has no influence on price, so MR = MC gives P = MC just like in perfect competition

Question 5

Demand curve and Marginal Revenue curve relationship!

Answer 5

Marginal revenue is twice as steep as the Demand Curve therefore…

P = a - bQ

MR = a - 2Q

Downward sloping demand and MR curve

Question 6

What are the 5 sources of MONOPOLY?

Answer 6

1) Exclusive control over important inputs
- (e.g. rare earth elements, China)
- new ways are constantly being devised and the exclusive input that generates today’s monopoly is likely to become obsolete tomorrow

2) Economies of Scale
- cost per unit of output decreasing with increasing scale of production
- however with a downward sloping LRAC the least costly way would be a single firm to concentrate entire market

3) Patents
- confers the right to exclusive benefit from all exchanges involving the invention to which it applies
- creates higher prices for consumers but at the cost of the “great” invention that may not have occurred.
- The protection from competition is what makes it possible for the firm to recover its costs of innovation
- e.g. Intel Chip production cost several billion euros

4) Network Economies
- product becomes more valuable as greater numbers of consumers use it
- example: Airbnb

5) Government licenses/Franchises
- Law preventing anyone but a government-licensed firm from doing business
- sometimes with strict restrictions on what the firm can do

Question 7

At what point is TR maximised?

Answer 7

TR = P*Q

• TR is maximised at the point where PED = 1
• this is also the midpoint of the demand curve (P = a-Q)

Question 8

Marginal Revenue (definition)

Answer 8

The change in total revenue when the sale of output changes by 1 unit

MR = ∆TR/∆Q

• it is the slope of the total revenue curve

Question 9

Optimality condition for a monopolist

Answer 9

MC = MR

A monopolist maximises profit by choosing the level of output where MR = MC

Question 10

Marginal Revenue and Elasticity

equations and main points

Answer 10

Total demand is highest when the price elasticity of demand is equal to 1

PED = ∆Q/∆P * P/Q

Demand curve is downward sloping…

|e| = ∆Q/∆P * P/Q

MR = P (1 - 1/ |e| )

• tells us that the less elastic demand is with respect to price, the more price will exceed MR
• also limiting case of infinite price elasticity, MR and P are exactly the same

Question 11

Profit-maximising Mark UP

Answer 11

Prof-Max level of output must therefore lie on the elastic portion of the demand curve, where further price increases = both revenue and costs to go down

MR = MC combined with P [1 - (1/|e|)]

(P - MC)/P = 1/ |e|
- profit maximising markup grows smaller as demand grows more elastic

Question 12

Monopolist Shut-Down condition

Answer 12

AR < AVC

- AR another name for Price (value of P along monopolist’s demand curve)

Question 13

When the MR curve intersects MC curve from below

Answer 13

this means that this point corresponds to a lower profit level than any other output levels nearby, a local minimum point.

• can earn higher profits by expanding or contracting

A local maximum point would be where MR curve intersects MC curve from above!

Question 14

LR profit-maximising condition for Monopolist

Answer 14

Where LMC = MR

• optimal capital stock in the long run gives rise to the short-run marginal cost curve SMC, which passes through the intersection of LMC and MR

Question 15

Efficiency Loss from Monopoly

Answer 15

Loss in efficiency can be measured by comparing consumer and producer surplus at the monopoly and efficient outcome.

Question 16

Public policy towards natural monopoly

(1) State ownership and management

Answer 16

1) State ownership and Management
- Efficiency requires that P = MC
- difficult for natural monopoly as MC is below ATC, and private firms are not able to charge prices less than AC and remain in business in LR
- has no choice but to set P > MC

option to set P = MC if the rest of economic loss is absorbed through general tax revenues
- state ownership can be motivated by the large fixed costs that would make private provision inefficient

X-inefficiency = a condition in which a firm fails to obtain maximum output from a given combination of inputs!

Question 17

Public policy towards natural monopoly

(2) State regulation of Private Monopolies

Answer 17

Common form of regulation is a cap on prices.

2 options to regulator

1) P=MC - would result in economic loss need to be subsidised by government
2) P = AC would constrain economic profit = 0, unit next best thing

• firm has incentive to reduce x-inefficiency if price is set at right level
• difficult for regulator to know what the MC and AC curves of monopolist would look like
• if price is set too low the firm will have an incentive to reduce its quality of service and go out of business
• if price is set too high, firms earn economic profit
• firm also has an incentive to overstate its cost in order to set a higher price

Question 18

Public policy towards natural monopoly

(3) Exclusive contracting for Natural Monopoly

Answer 18

Basic problem of knowledge, firm knows a LOT more than regulator (e.g. cost function) - this constraints regulator to control the firm to best ability.

• Lowest bidder would win the contract to be sole supplier
• advantage = firms have incentive to bid the true value of operating in the market
• this keeps costs down and reduces x-inefficiency
• cheaper provider may not provide the best service, so judging which firm provides the best value for money is complicated
• another complication, provider to go bankrupt mid-contract because it underestimated the cost of providing the service

Question 19

Public policy towards natural monopoly

(4) vigorous enforcement of antitrust laws
(5) A Laissez-Faire Policy toward natural monopoly

Answer 19

Antitrust Laws:

• Prohibiting firms holding a dominant position on a determined market
• limiting agreements between companies that would restrict competition
• one response would be to apply laws to prevent only those mergers where significant cost savings would not be realised

Laissez-Faire:

• Letting monopolist produce whatever quantity they choose and sell at whatever price the market will bear
• certain situs objections are not serious enough to warrant intervention
• this is relevant for luxury goods, the fairness of objection to monopoly becomes less pronounced

Question 20

3rd Degree Price Discrimination (definition)

Answer 20

Different prices are charged in different markets or to different categories of consumer
(e.g. cinema tickets)

conditions to be feasible:

• able to distinguish the categories of consumers (E.g. Student ID)
• must be impossible (or impractical) for buyers to trade among themselves

Question 21

Arbitrage (definition)

Answer 21

the purchase of something for costless risk-free resale at a higher price

• this is why large price differentials for a single product cannot persist

Question 22

1st Degree Price Discrimination (definition)

Answer 22

Consumers are charged individual prices that capture all consumer surplus!
- e.g. 2 part tariffs for tennis membership

Question 23

2nd Degree Price Discrimination (definition)

Answer 23

Different quantities of the good sell for different prices

(e. g. declining tail block rate structures & 3-for2 offers)
- enables monopolist to capture a substantial share of consumer surplus

Question 24

Hurdle model of Price Discrimination!

Answer 24

Price discrimination technique where the firm induces the most elastic buyers to identify themselves

• basic idea: seller sets up a hurdle and makes a discount price available to those buyers who elect to jump over it
• people who are more price inelastic will not care to jump over the hurdle

A perfect hurdle: imposes only a negligible cost on the buyer who jump it yet perfectly separates buyers according to their elasticity of demand

• smaller efficiency loss: being able to offer a discount price to the most elastic portion of the demand curve

Question 25

Lerner Index

Answer 25

(P - MC)/ P = 1/ |E|

• profit-maximising mark-up grows smaller as demand grows more elastic

Question 26

Calculating price discrimination packages (& not being able to distinguish consumers)

Answer 26

• For membership fees calculate consumer surplus (Draw out graph it is easier)
• then charge MC as the rate per hour

for consumers you cannot distinguish you cannot charge the same packages!
- almost all consumers will go for the cheaper one to maximise consumer surplus

Adjust packages through:
- Deducting the gain of consumer surplus from the membership price of the more expensive package