WEEK 1: Monopoly and Monopsony

Question 1

What are Monopolies?

Answer 1

Only supplier of a good for which there’s no close substitute

Question 2

If monopolies are price makers then what does this mean for the overall market and the monopolist?

Answer 2

• 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

Question 3

How do monopolies maximise profit?

Answer 3

Set price of the good or total amount of quantity to produce (output) so the MR = MC

Question 4

What the profit function of a monopolist?

Answer 4

Chosing Q at:
π(Q) = TR (Q) - TC(Q) where:
- TR (Q) revenue function
- TC(Q) cost function

Question 5

What are the necessary conditions for profit maximisation (1st and 2nd order)?

Answer 5

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

Question 6

What does a firm’s MR curve depend on?

Answer 6

Depends on its demand curve

MR also downward sloping and lies below D

Question 7

What is the MR function if p(Q) is the inverse demand function?

Answer 7

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

Question 8

What does the marginal revenue depend on?

Answer 8

Inverse demand curve’s height (price) and elasticity of demand

Question 9

What is the derivation of the elasticity of demand?

Answer 9

ε = dQ/dp x P/Q <0

Question 10

How do you calculate the MR function in terms of elasticity?

Answer 10

MR = p + dp/dQ Q = p + p dp/dQ Q/p = p (1 + 1/ (dQ/dp)(p/Q)) = P (1 + 1/ε)

Question 11

EXAMPLE IN NOTES

Answer 11

SEE IN NOTES

Question 12

Where is the Monopolist’s profit of maximising choice of output?

Answer 12

Found where MR = MC

At the profit maximising output set P according to inverse demand

Question 13

What is Market Power?

Answer 13

The ability of a firm to charge a price above MC and earn a positive profit

Question 14

How do you calculate market power?

Answer 14

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

Question 15

What is the Lerner Index

Answer 15

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)

Question 16

What causes less market power for a firm?

Answer 16

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

Question 17

What are the effects of market power on welfare?

Answer 17

Higher market power (typically via monopoly) generates deadweight loss

SEE GRAPH IN NOTES

Question 18

How do taxes (ad valorem and specific) affect monopolies?

Answer 18

1. The tax incidence (burden) on consumers can exceed 100% in a monopoly market but not a competitive one
2. 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

Question 19

What is the before tax cost function?

Answer 19

C(Q)

Question 20

What is the after tax cost function?

Answer 20

C(Q) + τQ

Where:
τ is the specific per unit of
product (specific tax)

Question 21

What is the necessary condition for maximising after tax profits?

Answer 21

dR(Q)/ dQ - dC(Q)/dQ - τ = 0

Question 22

What are the causes of monopolies?

Answer 22

• Cost advantages over other firms

- Govts create monopoly

Question 23

What are the sources of cost advantages?

Answer 23

1. Control of an essential facility, scarce resource that rival firm needs to use to survive
   e. g. Owning infrastructure for telecommunication generate cost adv
2. Use of superior technology or better way of organising production
3. Protection from imitation via patents or informational secrets

Question 24

When does a market have a natural monopoly?

Answer 24

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

Question 25

How do govts create monopolies?

Answer 25

In 1/3 ways:

1. By making it difficult for new firms to obtain a license
   to operate
   • Example: License to sell alcohol in Sweden
2. . By granting a firm the rights to be a monopoly
   • Example: public utilities operated by private company
3. . By auctioning the rights to be a monopoly
   • Example: selling government monopolies to private firms
   (privatisation)

Question 26

How do Govts limit monopolies market power?

Answer 26

1. Optimal Price Regulation: Govt regulates the monopoly imposing a price ceiling that is equal to
   the competitive price, which eliminates DWL
2. Nonoptimal Price Regulation:
   Govt impose price ceiling not set at competitive lvl reducing but not eliminating DWL
3. Increasing Competition:
   Allowing/encouraging market entry by new domestic firms and ending import bans that kept out international firms.

Question 27

What does the graph for an optimal price regulation look like?

Answer 27

SEE IN NOTES

Question 28

What is the cost advantage of a natural monopoly?

Answer 28

Has economies of scale at all levels of output so AC falls as output increases

Question 29

How does a specific tax affect monopolies and DWL?

Answer 29

SEE GRAPH IN NOTES