Lecture 4 - Monopoly Flashcards
What is necessary for a firm to be able to charge p>MC ?
Market Power
is the ability to charge a price above marginal costs
What is Markup?
p - MC
What is Lerner Index?
a “normalized” measure of market power
Markup/p
Which values can the Lerner index take?
The Lerner index measures market power on the interval [0,1]
As the markup over MC increases, the Lerner index increases, max at 1
In a perfectly competitive market, L=0
Also; L=1/elasticity
How does the price elasticity of demand relate to market power?
The higher the elasticity of demand the lower the ability of the firm to exert market power
The more consumers are willing to switch away from a given firm, the lower the ability of the firm to charge prices above MC
When are profits maximised in a Monopoly?
MR(q)=MC(q)
How to find the MR?
Given: Inverse Demand Function => Multiply with quantity to find Revenue and take first derivative
How to find the ME for a generic demand function?
Apply the “product rule” to the revenue:
R(q)=p(q)*q
MR=p+q(dp/dq)
What is the sign of the marginal revenue?
How does the size of the marginal revenue relate to the price?
Positive or Negative but should be MR=<p> When the firm sells an extra unit, it gets p for it. But to sell an extra unit, it must lower the price by dp/dq for each unit sold!</p>
When is a firm a monopoly?
if it is the sole supplier of a product for which there are “no close substitutes”
How does the welfare loss caused by the monopoly relate to the price elasticity of demand?
The more “inelastic” the market demand, the larger this welfare loss
Caterpillar Tractor, one of the largest producers of farm machinery in the world, has
hired you to advise it on pricing policy. One of the things the company would like to
know is how much a 5% increase in price is likely to reduce sales. What would you
need to know to help the company with this problem? Explain why these facts are important.
Has market power and should consider the entire demand curve when choosing prices for its products.
Elasticity of demand should be determined. 4 Factors:
1)How similar is firm’s products to its competitors?
2)How will competitors react to a price increase?
3)What is the age of existing stock (of tractors)?
4)What is the expected profitability of the agricultural sector?
Why is there a social cost to monopoly power? If the gains to sellers from monopoly power could be redistributed to buyers, would the social cost of monopoly power be eliminated? Explain in your own words and graphs if applicable.
In monopoly, p is higher and q is less than under Competition. Because of the higher price and reduced sales, consumers obtain a lower surplus.
Only a part of this lost surplus is transferred to the seller as a revenue, and the net loss in total surplus is DWL. Even if the revenue could be redistributed to consumers, the DWL is still there.
This inefficiency will remain because quantity is reduced below the level where P = MC.
What determines the ability of the monopolist to set price above marginal costs?
Market power is the ability to set a price above marginal costs!
Market power in turn is determined by the price elasticity of demand.
A specific case is where the elasticity is infinite, i.e., the firm faces a perfectly elastic demand. The slightest increase in price would lose the firm ALL consumers.
The less elastic the demand faced by a firm, the more market power a firm has. Elasticity in turn is determined by consumers’ valuation for a product and the supply
of substitute goods.
If there are many alternatives available that can substitute for a firm’s product, elasticity will be high. The monopolist is the sole supplier of a product, so as long as there are some consumers with a valuation for the product that is higher than MC, the monopolist has some market power, which in turn determines the his ability to set P>MC.
Why does the monopolist set a price on the elastic part of the demand curve?
To maximize profits, the monopolist sets p or q such that MC = MR
MR is the additional R from selling an additional unit. If MR were less than MC, the monopolist would make a loss by selling that additional unit.
Because the monopolist faces a downward sloping market demand, she has to decrease the price for all units in order to sell an additional unit. The MC therefore is the p of the additional unit sold, minus the reduction in R due to the lower p for all other units.
The elasticity determines how much the monopolist has to lower the p to sell an extra unit. Recall that the elasticity measures the change in q demanded in response to a change in p. High elasticity means that a small change in p results in a high change in q demanded. From the monopolist’s perspective, this means that if elasticity is high, a small decrease in p suffices to sell an additional unit.
As elasticity decreases, however, the monopolist has to lower the p by a lot to sell an additional unit. This means that as elasticity decreases, the loss in Re to selling an additional unit becomes larger. As
demand becomes inelastic, the monopolist would have to reduce the price by so much that the loss in R from the lower p for all other units is larger than the p she could get for the additional unit. This is not profitable, so the monopolist stops lowering price before demand becomes inelastic.
TLDR: The MR is positive when the demand curve is elastic, it is zero when the demand curve is unit elastic and it becomes negative when the demand curve is inelastic. Hence the monopolist only makes more profit on the elastic part of the demand curve.
