WEEK 1: Monopoly and Monopsony Flashcards
What are Monopolies?
Only supplier of a good for which there’s no close substitute
If monopolies are price makers then what does this mean for the overall market and the monopolist?
- Monopoly output is the market output
- Monopoly demand curve is the market demand curve
- Monopolists given market demand can set own price
- Monopolists set price above MC to maximise profit since demand downward sloping
How do monopolies maximise profit?
Set price of the good or total amount of quantity to produce (output) so the MR = MC
What the profit function of a monopolist?
Chosing Q at:
π(Q) = TR (Q) - TC(Q) where:
- TR (Q) revenue function
- TC(Q) cost function
What are the necessary conditions for profit maximisation (1st and 2nd order)?
1ST ORDER CONDITION:
dπ (Q)/dQ = dR(Q)/dQ - dC(Q*)/dQ = 0
2ND ORDER CONDITION:
d2π(Q)/dQ2 = d2R(Q)/dQ2 - d2C(Q*)/dQ2 <0
SEE NOTES FOR CLEARER VIEW
What does a firm’s MR curve depend on?
Depends on its demand curve
MR also downward sloping and lies below D
What is the MR function if p(Q) is the inverse demand function?
Inverse demand function shows: Price received for selling Q
Function is:
MR(Q) = dR(Q)/dQ = dp(Q)Q/ dQ = p(Q) dQ?dQ + dp (Q)/dQ Q = P(Q) + dp(Q)/dQ Q
SEE NOTES FOR CLEARER VIEW
What does the marginal revenue depend on?
Inverse demand curve’s height (price) and elasticity of demand
What is the derivation of the elasticity of demand?
ε = dQ/dp x P/Q <0
How do you calculate the MR function in terms of elasticity?
MR = p + dp/dQ Q = p + p dp/dQ Q/p = p (1 + 1/ (dQ/dp)(p/Q)) = P (1 + 1/ε)
EXAMPLE IN NOTES
SEE IN NOTES
Where is the Monopolist’s profit of maximising choice of output?
Found where MR = MC
At the profit maximising output set P according to inverse demand
What is Market Power?
The ability of a firm to charge a price above MC and earn a positive profit
How do you calculate market power?
As market power is related to PED:
MR = p(1 + 1/ε) = MC
Rewrite as: P/MC = 1/1+ (1/ε)
Thus ratio of price to MC depends only on elasticity of demand at the profit maximising quantity
What is the Lerner Index
Index of firm’s market power. Also another way to examine how elasticity affects monopoly price relative to MC
Ranges from 0-1
As it gets closer to 1 firm has more market power (and less elastic demand)
What causes less market power for a firm?
As demand becomes more elastic:
- Better substitutes for product introduced
- Higher entry into market
- As firms that provide the same service locate closer to the firm
What are the effects of market power on welfare?
Higher market power (typically via monopoly) generates deadweight loss
SEE GRAPH IN NOTES
How do taxes (ad valorem and specific) affect monopolies?
- The tax incidence (burden) on consumers can exceed 100% in a monopoly market but not a competitive one
- If tax rates set so that after tax output same with either type, which tax used provides same revenue in comp market but raises more revenue using ad-valorem in monopoly
What is the before tax cost function?
C(Q)
What is the after tax cost function?
C(Q) + τQ
Where:
τ is the specific per unit of
product (specific tax)
What is the necessary condition for maximising after tax profits?
dR(Q)/ dQ - dC(Q)/dQ - τ = 0
What are the causes of monopolies?
- Cost advantages over other firms
- Govts create monopoly
What are the sources of cost advantages?
- Control of an essential facility, scarce resource that rival firm needs to use to survive
e. g. Owning infrastructure for telecommunication generate cost adv - Use of superior technology or better way of organising production
- Protection from imitation via patents or informational secrets
When does a market have a natural monopoly?
If one firm can produce total output of the market at lower cost than several firms could
Has high fixed costs but fairly constant marginal costs
e.g. Public utilities like water,gas, electricity
SEE GRAPH IN NOTES
How do govts create monopolies?
In 1/3 ways:
- By making it difficult for new firms to obtain a license
to operate
• Example: License to sell alcohol in Sweden - . By granting a firm the rights to be a monopoly
• Example: public utilities operated by private company - . By auctioning the rights to be a monopoly
• Example: selling government monopolies to private firms
(privatisation)
How do Govts limit monopolies market power?
- Optimal Price Regulation: Govt regulates the monopoly imposing a price ceiling that is equal to
the competitive price, which eliminates DWL - Nonoptimal Price Regulation:
Govt impose price ceiling not set at competitive lvl reducing but not eliminating DWL - Increasing Competition:
Allowing/encouraging market entry by new domestic firms and ending import bans that kept out international firms.
What does the graph for an optimal price regulation look like?
SEE IN NOTES
What is the cost advantage of a natural monopoly?
Has economies of scale at all levels of output so AC falls as output increases
How does a specific tax affect monopolies and DWL?
SEE GRAPH IN NOTES
