L15 - Monopoly

Question 1

What is a Monopoly?

Answer 1

• Monopoly is when there is one large seller of a particular good or service
• At its extreme, there is no competition whatsoever in a monopolised market
• Monopoly lies at the other end of the competition spectrum
• Few firms are pure monopolists in the real world
• The term is often used for sellers that are much larger than others in the market –> hold 40% or more of market share
  Theory is similar whether a firm is a pure monopoly or has a ‘competitive fringe’

Question 2

What are some Assumptions for Monopolistic Markets?

Answer 2

• We retain A(1) and A(2) –>
  buyers are price takers & buyers and sellers have complete information
  A(5) -The Monopolist is a Price Maker –> A price maker can influence the price which it sells its output.
  This has two parts to it:
  (a) A seller sells more when its price is lower: its demand curve slopes downwards
  (b) the seller’s output choice does not trigger a reaction from competitors (if there
  are any)

A(4) - Entry is blocked –> A potential seller cannot enter the market. Not even in the long-run.

• Barriers can be three different types:
• Legal e.g. Government puts a regulation on the market e.g. electricians need to be qualified before they can provide their service,
• Structural –> e.g. related to a firms costs, a larger firms can exploit Economies of Scale in a market compared to a smaller newer firm who would be out priced
• Strategic –> Tesco was buying up Land around Town Centre and not building on it to make it more difficult for Competitors to build their Supermarkets

Question 3

What is the Appropriate Market Structure for a Monopolistic Market?

Answer 3

a) Size and Number of Sellers –> One and Large
- A firm must be large enough to affect price: it is a price maker
- Rivals (if any) must be small, otherwise they would respond strategically to the
seller’s output choice

b) Barriers to Entry –> High
- Firms must be unable to enter the market

c) Product Sustainability –> Differentiated
- When the seller is the only one, its product is unique.
- That is, it is differentiated so much so that it has no close rivals

Question 4

When Does a Equilibrium occur in a Monopoly?

Answer 4

• The equilibrium is again determined by the two rules for profit maximisation:
  (1) the marginal output rule and (2) the shut down rule. Consider (1) first.
• A pure monopolist’s demand curve is the market’s demand curve
  So, its demand curve slopes downwards
• This is also the average revenue (AR) curve:
• D = AR = P (price)

How does this affect the marginal revenue curve?

• To sell another unit, the price has to fall
• This has two effects on total revenue (TR):
  1. The good thing: another unit is sold at price P, so TR increases
  2. The bad thing: all other units are sold at a slightly lower price, so TR decreases
• These two effects imply the marginal revenue curves lies below the demand curve

Question 5

What do the Marginal Revenue and Average Revenue Lines look like on a graph in a Monopoly?

Answer 5

• With Price (p) is on the y-axis and Quantity (q) on the x-axis
• Demand (D)= AR = p is a negative gradient line
• the MR line (lying to the left of the AR curve) is also sloping down at a steeping gradient originating from the same point on the y-axis as AR
• The Area between the axis and the point of Price and Quantity is Total Revenue

Question 6

What does the Graph of Marginal Revenue and Average Revenue in a Monopoly tell us?

Answer 6

When Producing an extra unit of output:

1. increases the amount of units sold increasing Revenue but
2. it lowers the price for which all units are sold (which reduces Revenue)

• However at looking at the different areas when quantity is increased:
• If the Horizontal Area created by an increase in Quantity is greater than the Vertical Area caused by the drop in Price –> TR will increase
• If the Horizontal Area created by an increase in Quantity is less than the Vertical Area caused by the drop in Price –> TR will fall

Question 7

How is the Revenue Curves related to the Elasticity of Demand?

Answer 7

• When MR = 0 –> An extra unit of Output does not affect TR –> therefore ε = 1
• If MR is Positive ( to the left of unity) –> then
  TR rises with an extra
  unit of output and ε > 1
• If MR is negative ( to the left of Unity ) –> then
  TR fall with an extra
  unit of output and 0 < ε < 1

Question 8

Where is Equilibrium on a Monopoly Graph?

Answer 8

• With Price of the y-axis and Quantity on the x-axis
• With both the downwards sloping lines of AR and MR
• And the positive gradient curves of AC and the steeping gradient curve of MC to the left of it
• Equilibrium occurs at the point MR=MC but at the price at the point directly above on the AR line –> this meets the shut down rule as P is greater than or equal to AC
• the about of Super normal profit generated is the area above the AC curve which is –> (P^m - AC) x Q^m
• Price > Marginal Cost
• the monopolist produces on the elastic part of the demand curve as MR > 0
• In the long run P^m > AC

Question 9

What is the Comparison of Monopolies and Perfect Competition Markets?

Answer 9

• A monopolist produces less and prices higher than a perfectly competitive market
• Thus, monopoly is worse than perfect competition, other things equal.
  … But we want to be able to quantify how much worse
• First, assume that the cost functions remain the same
• Next define ‘total welfare’ as the sum of consumer surplus and producer surplus:
  (i) CONSUMER SURPLUS: the sum of the difference between the amount
  consumers are willing to pay for the good and what they actually pay
  (ii) PRODUCER SURPLUS: the sum of the difference between the price of a good and what price producers are willing to supply it
• Perfect competition will be ‘better’ than monopoly in this sense if:
• total welfare is greater under perfect competition than under monopoly
  11

Question 10

What is Consumer Surplus?

Answer 10

• We use the Vertical Interpretation of the demand curve –> shows what the maximum price
  that a buyer is willing to pay for this unit of the product
• The difference between the demand curve at different quantities at a base price and the base price shows each consumer’s surplus
  -The sum of these differences
  for every unit bought gives the CONSUMER SURPLUS

Question 11

What is Producer Surplus?

Answer 11

• Using Vertical Interpretation of the Supply Curve –> shows what the minimum price that a
  seller is willing to accept for this unit of the product
• The difference between the base price and the supply curve at different quantities shows each producer surplus per unit
• The sum of these differences
  for every unit bought gives the PRODUCER SURPLUS

Question 12

What is Total Welfare like under Monopoly?

Answer 12

• P on the y-axis and Q on the x-axis
• Downward line of AR=D and positive curve of MC (supply under perfect competition)
• MR line sloping downwards to the left of the AR=D line
• at point b which is above the point MR=MC is what the monopoly will produce at
• consumer surplus is the triangle above the price level, as consumers were willing to pay more than the given price
• Producer surplus is the area difference between the MC up to the level of price P^m at b and Quantity Q^m

Question 13

What is Total Welfare like under Perfect Competition?

Answer 13

• P on the y-axis and Q on the x-axis
• Downward line of AR=D and positive curve of MC (supply under perfect competition)
• MR is not on this diagram as MR=AR=D
• Equilibrium is at P=AR=MR=MC
• consumer surplus is the triangle above the price level, as consumers were willing to pay more than the given price
• Producer surplus is the area difference between the MC up to the level of price P^pc at ‘a’ and Quantity Q^pc

Question 14

What happens when we compare total welfare under an monopoly to total welfare under perfect competition?

Answer 14

• is combining the graphs into one we see that the monopoly produces at a high price P^m than under perfect competition P^pc
• however the monopolist produces less at Q^m than under perfect competition at Q^pc
• Consumer surplus is the same as the monopoly –> the triangle above the price
• Consumers do better under perfect competition than a monopoly
• Producer Surplus is also the same for the monopoly –> the area up to the Price P^m and the Quantity Q^m
• Producers do better under a monopoly than under perfect competition
• the triangle in between the two prices is called the Dead weight welfare loss
• this is welfare lost under a monopoly than under perfect competition
• therefore in the a monopoly total welfare is less than under perfect competition