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Semester II, AY2013-2014 NUS Business School

BSP1005 Managerial Economics

Lecture Notes 7

MARKET POWER AND ECONOMICS OF MONOPOLY

By Jo Seung-Gyu

OUTLINE

Preliminary Discussion

Review of Perfect Competition

Market Power

Economics of Monopoly with Simple (Uniform) Pricing Strategies

Monopolistic Equilibrium

Rule of Thumb Pricing

Economics of Multi-plant Monopoly

Social Costs of Monopoly

Mini Case Studies: Microsoft and US Electricity

 Monopsony is to be skipped.
 Monopsony is to be skipped.
OUTLINE Preliminary Discussion ─ Review of Perfect Competition ─ Market Power Economics of Monopoly with
OUTLINE
Preliminary Discussion
─ Review of Perfect Competition
─ Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
─ Monopolistic Equilibrium
─ Rule of Thumb Pricing
─ Economics of Multi-plant Monopoly
─ Social Costs of Monopoly
─ Mini Case Studies: Microsoft and US Electricity

Perfect competition is the most ideal market structure from the efficiency perspective.

Review of Perfect Competition

• P = LRMC = LRAC ( = SRMC = SRAC)

• Above-normal profits may prevail in the short run but only normal profits (or zero economic profits) in the long run.

P

P 0

P D S P 0 Q Q 0
P
D
S
P 0
Q
Q 0

Market

LRMC LRAC

LRMC LRAC SRMC SRAC D = MR = P 0

SRMC

SRAC

D = MR = P0

q 0

Individual Firm

OUTLINE Preliminary Discussion ─ Review of Perfect Competition ─ Market Power Economics of Monopoly with
OUTLINE
Preliminary Discussion
─ Review of Perfect Competition
─ Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
─ Monopolistic Equilibrium
─ Rule of Thumb Pricing
─ Economics of Multi-plant Monopoly
─ Social Costs of Monopoly
─ Mini Cases: Microsoft and US Electricity

We now examine markets where firms are not price takers any longer. That is, firms now have market power.

Market Power

• We now examine markets where firms are not price takers any longer. That is, firms now have market power.

Market power: Ability of a seller or buyer to affect the price of a good

Sources of Market Power

• Access to unique Resources (Eurostar’s exclusive right to use the Eurotunnel)

• Control over Intellectual Property and Copy Rights (Eli Lilly’s patent to Zovant – a drug for sepsis, Microsoft’s copyright over Windows 8)

• Economies of Scale and Scope (electricity distribution, cable TV/local telephone service/Internet Service)

• Regulation (natural gas, public transportation)

• Product differentiation, brand value (Evian vs generic mineral water brand)

Sources of Market Power – cont.

The less elastic its demand curve, the more monopoly power a firm has. The ultimate determinant of monopoly power of a firm is therefore the price elasticity of the firm’s demand.

Three factors determine the elasticity of a firm’s demand.

1. The elasticity of market demand. Because the firm’s own demand will be at least as elastic as market demand, the elasticity of market demand limits the potential for monopoly power.

2. The number of firms in the market. If there are many firms, it is unlikely that any one firm will be able to affect price significantly.

3. The interaction among firms. Even if only two or three firms are in the market, each firm will be unable to profitably raise price very much if the rivalry among them is aggressive, with each firm trying to capture as much of the market as it can.

How to Measure Market Structures

• We need a summary measure

• Our preference is for a simple measure, but no single one is perfect.

a. Concentration Measures:

Concentration ratio(CRi) or Herfindahl-Hirschman index (H or HHI)

b. Performance Measure:

Lerner Index (LI)

Note: Refer to the reading ‘Measuring Market Power’ for more details.

Concentration Measures: CRi i and HHI

• Concentration Ratio(CRi) vs Herfindahl-Hirschman index (H or HHI)

(Case of top 4 firms)

Firm Rank Market Share (%) Squared Market Share
Firm Rank
Market Share (%)
Squared Market Share

1

2

3

4

5

6

7

8

Concentration Index

25 25
25 25
25 25
25 25
25 25
25 25
5 5
5 5

5

5

5

5

CR 4 = 80

625

625

625

25

25

25

25

25

H4 = 1,900

Concentration Measures: CRi i and HHI – cont.

• Compare two different measures of concentration:

(Case of top 4 firms)

Firm Rank Market Share (%) Squared Market Share A B A B
Firm Rank
Market Share (%)
Squared Market Share
A
B
A
B
1 50
1
50

2

3

4

5

6

7

8

20

5

5
5

Concentration Index

CR 4 = 80

25 25 25 25
25 25
25 25
25 25
25 25
5 5
5 5

5

5

5

5

CR

4

= 80

2500

625

400

625

25

625

25

25

25

25

25

25

H4 = 2,950

H4 = 1,900

11

• Concentration index is affected by, e.g. merger

Firm Rank Market Share (%) Squared Market Share
Firm Rank
Market Share
(%)
Squared Market
Share
Assume that firms 1 2 4 and 5 decide to merge 3 4 } 5
Assume that firms
1
2
4 and 5 decide
to merge
3
4
}
5

6

7

8

25 25
25 25
25 25
25 25
25 25
25 25
5 5
5 5

5

5

5

5

The Concentration Index changes
The Concentration
Index changes

Concentration Index

CR

4 = 80

Market shares change
Market shares
change

625

625

625

25

}}10

25

25

25

25

85
85

H = 2,000

100
100

1,925Index changes Concentration Index CR 4 = 80 Market shares change 625 625 625 25 }}

b. Measure for Market Performance : Lerner Index

• Market performance is often measured using the Lerner Index

LI =

P-MC

P

– Perfect competition: LI = 0 since P = MC

– Monopoly: LI = 1/i.e. inverse of the price elasticity of demand

• Lerner Index can be a useful measure for the market structure, but has its own misspecification for a good performance measure:

• A dominant firm may charge a low price to prey upon competitors or to deter new entrants (predatory or preemptive practices)

• A severe price-competition even among “few” firms may lead to near-competitive prices

OUTLINE Preliminary Discussion ─ Review of Perfect Competition ─ Market Power Economics of Monopoly with
OUTLINE
Preliminary Discussion
─ Review of Perfect Competition
─ Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
─ Monopolistic Equilibrium
─ Rule of Thumb Pricing
─ Economics of Multi-plant Monopoly
─ Social Costs of Monopoly
─ Mini Cases: Microsoft and US Electricity

True monopoly markets are rather rare, yet their underlying economic principles help identify optimal behavior in markets where managers have varying degrees of market power. Such markets are quite prevalent in the business world.

Introduction

• Here we consider a simple case of monopoly: Supply-Side Monopoly with uniform pricing.

– One seller and many buyers.

– No close substitutes

– Barriers to entry

Our Plan

– Simple (Uniform) pricing Strategies under Monopoly (This lecture)

– Sophisticated Pricing Strategies under Monopoly (Next lecture)

• Price Discriminations

• Two Part Pricing and Bundling

Demand and MR

P
P
In the case of linear demand curves, the MR curve has the same price intercept
In the case of linear demand curves,
the MR curve has the same price
intercept as the demand curve (or AR
curve) and twice the slope.
has the same price intercept as the demand curve (or AR curve) and twice the slope.
a
a

Q

D = a –

MR = a – 2bQ

bQ

16

Monopolistic Equilibrium

• The demand curve also represents the average revenue (AR)

• In the case of linear demand curves, the MR curve has the same price intercept as the demand curve (or AR curve) and twice the slope.

• The monopolist produces where MR = MC.

• So output will equal Q*, market price is P*, and Profit = π = P*ABC

$ per

unit of

output

P 1

P*

P 2

MC AC A B C D: P(Q) Lost Profit if Q = Q 1 E
MC
AC
A
B
C
D: P(Q)
Lost Profit
if Q = Q 1
E
Lost Profit
if Q = Q 2
MR
Quantity
O
Q*
Q 1
Q 2

Monopolistic Equilibrium – contd.

An Algebraic Illustration:

π(Q) = TR(Q) – TC(Q) is maximized when MR = MC

since

dπ (Q)/dQ

= [dTR(Q)/dQ] –[dTC(Q)/dQ]]

= MR – MC = 0

= [P + Q [dP(Q)/dQ]] - MC

• Note that P > MR = MC at Monopolistic Equilibrium.

A Numerical Example Suppose P = 10 – Q and TC = 5 + Q
A Numerical Example
Suppose
P = 10 – Q
and TC = 5 + Q + 0.5Q 2 .
Then
MR = 10 – 2Q = 1 + Q = MC
Q = 3 and P = 7.
π = TR – TC = 7x3 – 12.5 = 8.5
yields
Or, more systematically,
  = TR – TC = (10 – Q)Q – (5 + Q + 0.5Q 2 )
and
d/dQ = 0 yields Q = 3.
Then P = 7 and π = 8.5

7

1

P MC = 1 + Q Q O 3 Demand: MR
P
MC = 1 + Q
Q
O
3
Demand:
MR

P = 10 - Q

A numerical example – cont.

 

P

Q

TR

MR

e D

TC

VC

ATC

MC

10

0

0

10

-

5

-5

0

-

-

9

1

9

8

-9

6.5

2.5

1.5

6.5

2

8

2

16

6

-4

9

7

4

4.5

3

7

3

21

4

-2.33

12.5

8.5 **

7.5

4.167

4

monopoly eqlm

 

6

4

24

2

-1.5

17

7

12

4.25

5

5.5

4.5

24.75

1

-1.22

19.625 5.125

14.625 4.361

5.5

competitive eqlm

 

5

5

25

0

-1

22.5

2.5

17.5

4.5

6

5 5 25 0 -1 22.5 2.5 17.5 4.5 6

4

6

24

-2

-0.67

29

-5

24

4.833

7

3

7

21

-4

-0.43

36.5

-15.5

31.5

5.214

8

2

8

16

-6

-0.25

45

-29

40

5.625

9

1

9

9

-8

-0.11

54.5

-45.5

49.5

6.056

10

0

10

0

-10

0

65

-65

60

6.5

11

Comparison between Monopoly (M) and Competitive (C) Market:

 

P M > P C , and Q M < Q C

 

  M > c

 

P M > P C = MC C > MC M , thus resource allocation is not efficient.

 

-

As we will see later, this inefficiency is represented through the monopoly deadweight loss: (CS + PS) M < (CS + PS) C

Outline Preliminary Discussion ─ Review of Perfect Competition ─ Market Power Economics of Monopoly with
Outline
Preliminary Discussion
─ Review of Perfect Competition
─ Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
─ Monopolistic Equilibrium
─ Rule of Thumb Pricing
─ Economics of Multi-plant Monopoly
─ Social Costs of Monopoly
─ Mini Cases: Microsoft and US Electricity

In the real world, managers may only have a limited knowledge of D and C. Still, we can derive a heuristic yet more practical rule of thumb from MR = MC condition.

Monopoly - A Rule of Thumb (Markup) Pricing

• Rewriting MR formula,

MR = dTR/dQ = d(PxQ)/dQ = P + Q (dP/dQ)

= P + P (Q/P)(dP/dQ)

= P [1 + (Q/P)(dP/dQ)] = P [1 + (1/e)]

where e = (P/Q)(dQ/dP) < 0 is the price elasticity of demand

• Since MR = MC, we have

MR = P [1 + (1/e )] or P[1 – (1/|e | )] = MC

Then,

P – MC

=

– (P/e ) or (P/|e | ). Thus,

22
22

Monopoly - A Rule of Thumb (Markup) Pricing – cont.

Monopoly - A Rule of Thumb (Markup) Pricing – cont. Meaning:  Price can be viewed

Meaning:

Price can be viewed as a simple markup over marginal cost.

Monopoly mark-up is always positive since e < 0 or |e | > 0, and thus / or /| | are always smaller than one.

If e is large, markup is small and if e is small, markup is large, as depicted below:

Example:

When the MC of a unit is $10 and the own price elasticity is –2. Then the monopolist can determine the price as follows:

P = 10/(1 + [1/-2]) = 10/[1/2]

= $20.

Examples of Mark-up Pricing

Astra-Merck prices Prilosec, a new generation antiulcer medication.

Prilosec was approved as a long-term ulcer treatment in 1995, while others were only for short- term treatment, which created a very large market with no major competitor.

Price of Prilosec = $3.5/daily dose

MC of Prilosec = 30 - 40 cents/daily dose

Price elasticity estimated to be between ( – 1.0) and ( – 1.2).

Then,

P =

0.35

1.1 = 0.35 0.09 = 3.89

1

1 1 1

=

Price of $3.5 is quite consistent with “the rule of thumb pricing”.

Example of Mark-up Pricing – cont.

Supermarkets vs Convenience Stores

Supermarkets

1. Several firms

2. Similar product

3.

E d

10 for individual stores



4. P

MC

1

1

10

MC

0.9

1.11(

MC

)

5. Prices set

about 10 - 11% above MC.

Convenient Stores

1.Higherpricesthansupermarkets

2.Convenience diffrentiates them

3.

E

d



5

4. P

MC

1

1

5

MC

0.8

1.25(

)

MC

5. Pricesset about25% aboveMC.

Comparison: Convenience stores have more monopoly power.

Question: Do convenience stores have higher profits than supermarkets?

Outline Preliminary Discussion ─ Review of Perfect Competition ─ Market Power Economics of Monopoly with
Outline
Preliminary Discussion
─ Review of Perfect Competition
─ Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
─ Monopolistic Equilibrium
─ Rule of Thumb Pricing
─ Economics of Multi-plant Monopoly
─ Social Costs of Monopoly
─ Mini Cases: Microsoft and US Electricity
Many firms produce goods and services at multiple locations (for the same market). One issue
Many firms produce goods and services at multiple
locations (for the same market). One issue facing
managers is how to allocate production across the
various plants.

Story of a Multi-plant Monopoly

You have two water-bottling plants in Indonesia and Malaysia. You import from the two plants and sell in Singapore. Your decisions include:

How many to sell at Singapore at what price

How many to import from each plant

at what price ─ How many to import from each plant Indonesia MC1 (Q1) Singapore MRT
Indonesia MC1 (Q1)
Indonesia
MC1 (Q1)
Singapore MRT (Q1 + Q2)
Singapore
MRT (Q1 + Q2)
from each plant Indonesia MC1 (Q1) Singapore MRT (Q1 + Q2) Malaysia MC 2 (Q 2

Malaysia

MC2 (Q2)

Experiment: What would you do if MRT = MC1 > MC2 ?
Experiment:
What would you do if MRT = MC1 > MC2 ?

Questions were:

What should its total output be, and how much of that output should each plant produce? We can find the answer intuitively in two steps.

Step 1. Whatever the total output, it should be divided between the two plants so that marginal cost is the same in each plant. Otherwise, the firm could reduce its costs and increase its profit by reallocating production. (MC1 = MC2 = MC3 = )

Step 2. We know that total output must be such that marginal revenue equals marginal cost. Otherwise, the firm could increase its profit by raising or lowering total output. (MCi = MR for i = 1, 2, 3, …)

Therefore, the profit maximization condition for a two-plant monopoly becomes:

MR = MC 1 = MC 2

Profit Maximization Condition for Multi-plant monopoly

= PxQ T – C 1 (Q 1 ) – C 2 (Q 2 ), where Q T = Q 1 + Q 2

/Q 1 = (PxQ T )/ Q 1 – dC 1 (Q 1 )/dQ 1 – dC 2 (Q 2 )/dQ 1 =

= MR – MC1

0

So MR = MC 1 for plant 1.

• We can do the same for plant 2 (i.e. /Q 2 = 0) and derive

MR = MC 2 .

• Combining the both conditions, it follows:

MR = MC 1 = MC 2

MC 1 MC 2 MC T Remarks: P * MR * D = AR MR
MC 1
MC 2
MC T
Remarks:
P *
MR *
D = AR
MR
When MC’s are non-constant but
increasing, the monopolist will produce
more from the lower-cost plant than
from the higher-cost firm. If MCs of
the two firms are not increasing in the
same speed, the distribution of the
Q 1
Q 2
Q T
Q production across the two plants would
depend on how big the total sales is,
which again would depend on how
strong the market demand is.
Algorithm: You choose total quantity
Q T first by equalizing MR and MC T and
distribute Q T over the two plants so that
MC 1 = MC 2 = MR. (Note that MC T is
obtained by horizontally adding up MC 1
and C 2 .)
If the demand is not too strong, then
the monopolist may decide to produce
the total sales from one plant only and
idle the other plant.
(Can you depict the cases graphically?)
Outline Preliminary Discussion ─ Review of Perfect Competition ─ Market Power Economics of Monopoly with
Outline
Preliminary Discussion
─ Review of Perfect Competition
─ Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
─ Monopolistic Equilibrium
─ Rule of Thumb Pricing
─ Economics of Multi-plant Monopoly
─ Social Costs of Monopoly
─ Mini Cases: Microsoft and US Electricity

Monopoly power results in higher prices and lower quantities, leading to a social welfare loss (called ‘deadweight loss’). Therefore, monopolies are inefficient from a social cost perspective.

Welfare Effect of Monopoly: Deadweight loss

• Consumers lose A+B and producer gains A-C

• Deadweight loss = (B+C)

$/Q

P m

P C

Lost Consumer Surplus MC Deadweight Loss A B C AR=D MR Quantity Q m Q
Lost Consumer Surplus
MC
Deadweight
Loss
A
B
C
AR=D
MR
Quantity
Q m
Q C

Debates on Economic Effects of monopoly:

– Can there be additional costs other than (B+C)?

– Can there be benefits of monopoly not captured in the above diagram?

Additional costs of monopoly

Deadweight loss in practice can be bigger than (B+C).

– If the monopolist spends resources to create and/or maintain the monopoly position (so called “Rent-Seeking Behavior” such as lobbying, advertising and legal efforts), there could be an additional loss. (A monopoly would have an incentive to spend up to (A-C) for the monopoly right.)

Potential Benefits of monopoly

Sometimes, offsetting efficiency may result from the creation or maintaining of a monopoly

– Prospect of monopoly profit is the main motivation for R&D, which is why innovation is patent-protected.

• However: Patent monopoly is only temporary, but network effect can extend monopoly beyond patent expiration.

Price Regulation of Usual Monopoly

The regulatory authority would be concerned about potential inefficiency of a monopoly. Often, monopoly is regulated through a price ceiling.

 Monopoly price: Pm  Price regulation (price ceiling) could be set at • P1:
 Monopoly price: Pm
 Price regulation (price ceiling)
could be set at
• P1: still economic profit > 0
• (MC-Pricing) P2 = PC:
competitive equilibrium
• P3: shortage
be set at • P1: still economic profit > 0 • (MC-Pricing) P2 = PC: competitive

34

Price Regulation of ‘Natural Monopoly’

A natural monopoly exists when there is great scope for economies of scale to be exploited over a very large range of output: AC decreases. (natural gas, cable TV, electricity etc)

 Monopoly price: Pm  Price regulation • (MC-pricing) If P2 = PC (=MC) as
 Monopoly price: Pm
 Price regulation
• (MC-pricing) If P2 = PC
(=MC) as in usual monopoly
regulation case, firm makes
a loss and would go out of
business.
• (AC-pricing) Pr is the price
ceiling that would induce the
firm to yield the highest
possible output while not
losing money (zero econ.
profit)
ceiling that would induce the firm to yield the highest possible output while not losing money

35

Regulation in Practice

The regulation of a monopoly is sometimes based on the rate of return that it earns on its capital. The regulatory agency determines an allowed price, so that this rate of return (ROR) is in some sense “competitive” or “fair.”

rate-of-return regulation

is based on the (expected) rate of return that a firm will earn.

Maximum price allowed by a regulatory agency

It has its own drawbacks:

A firm’s capital stock is difficult to value.

A firm’s actual cost of capital depends in turn on the behavior of the regulatory agency.

Regulatory lag is a natural nuisance.

Outline Preliminary Discussion ─ Review of Perfect Competition ─ Market Power Economics of Monopoly with
Outline
Preliminary Discussion
─ Review of Perfect Competition
─ Market Power
Economics of Monopoly with Simple (Uniform) Pricing Strategies
─ Monopolistic Equilibrium
─ Rule of Thumb Pricing
─ Economics of Multi-plant Monopoly
─ Social Costs of Monopoly
─ Mini Cases: Microsoft and US Electricity

Now, let us bring some real aspects….

CASES OF US AND EU ANTITRUST AGAINST MICROSOFT

• Over the past two decades Microsoft has grown to become the largest computer software company in the world, and has dominated the office productivity market.

Under the antitrust laws of the United States and the European Union, efforts by firms to restrain trade or to engage in activities that inappropriately maintain monopolies are illegal.

Did Microsoft engage in anticompetitive, illegal practices?

US AND EU ANTITRUST AGAINST MICROSOFT – cont.

• In 1998, the U.S. government said yes; Microsoft disagreed. The Antitrust Division of the U.S. DOJ filed suit, claiming that Microsoft had illegally bundled its Internet browser, Internet Explorer, with its operating system for the purpose of maintaining its dominant operating system monopoly. Following an eight-month trial that was hard- fought on a range of economic issues, the District Court found that Microsoft did have monopoly power in the market for PC operating systems, which it had maintained illegally in violation of Section 2 of the Sherman Act.

• The U.S. case was ultimately settled in 2004, with (among other things) Microsoft agreeing to give computer manufacturers (1) the ability to offer an operating system without Internet Explorer and (2) the option of loading competing browser Programs on the PCs that they sell.

US AND EU ANTITRUST AGAINST MICROSOFT – cont.

• Microsoft’s problems did not end with the U.S. settlement, however. In 2004, the European Commission ordered Microsoft to pay $794 million in fines for its anticompetitive practices, to produce a version of Windows without the Windows Media Player to be sold alongside its standard editions. In 2008, the European Commission levied an additional fine of $1.44 billion, claiming that Microsoft had not complied with the earlier decision. Even more recently, in response to a concern relating to the bundling of browsers, Microsoft agreed to offer customers a choice of browsers when first booting up their new operating system.

• As of 2011, the European case against Microsoft remains on appeal. There is strong evidence that the European-imposed remedies have had little impact on the market for media players or browsers.

However, Microsoft is facing an even stronger threat than U.S. or E.U. enforcement, such as competition from the powerful Google search engine and social media sites such as Facebook

CASE OF ELECTRICITY: REGULATE OR NOT?

Electricity in US

• Regulation (Price ceiling) seems to be necessary

• But some states in USA rather removed price ceilings.

– Hoping deregulation will increase competition and lower the prices.

– But deregulation did not lead to lower prices (recall ‘2001 California Blackout’)

– Reasons are:

o

Capacity constraint (environmental regulations banned new power plants)

o

Collusive behavior by whole sale suppliers, while retail market became competitive

From the Reading:

• NYT article ‘Competitively Priced Electricity Cost More, Studies Show (Nov 6, 2007)’

“… Since 1999, prices for industrial customers in deregulated states have risen from 18 percent above the national average to 37 percent above,” said Mrs. Showalter, an energy lawyer and former Washington State utility regulator. In regulated states, prices fell from 7 percent below the national average to 12 percent below, she calculated… In market states, electricity customers of all kinds, from homeowners to electricity-hungry aluminum plants, pay $48 billion more each year for power than they would have paid in states with the traditional system of government boards setting electric rates…”

Environment Issue:

For deregulated market, high electricity price leads to high costs to households and producers but high profits to power-generating firms.

High price may be good news to environmentalists (mostly power is generated using fossil fuels)

- Some advocates carbon taxes: government utilize tax revenue for social benefits, which power-generators’ hight profits cannot do.

carbon taxes: government utilize tax revenue for social benefits, which power-generators’ hight profits cannot do. 43
carbon taxes: government utilize tax revenue for social benefits, which power-generators’ hight profits cannot do. 43
44
Here are some exercises for you to get cooled down…. 45

Here are some exercises for you to get cooled down….

Exercise 1

You work for Nuxo Lighting Company. Nuxo produces specialized lighting fixture generally acknowledged as the best in their class and there are no close substitutes. A market research firm has estimated the market demand to be:

Q = 2,000 – 5P

You estimate Nuxo’s total cost for producing, storing, and marketing its lighting fixtures to be:

TC = 100 + 4Q + 0.4Q 2

You are asked to estimate how many lighting fixtures should be manufactured and how should they be priced to maximize profits?

Step 1: Rewrite the demand function

or Step 2: Find TR

5P = 2,000 – Q P = 400 – 0.2Q

TR = P*Q = (400 – 0.2Q)Q = 400Q – 0.2Q 2

Step 3: Derive MR

Step 4: Derive MC

MR

MC

= dTR/dQ = 400 – 0.4Q

= dTC/dQ = 4 + 0.8Q

Step 5: Set MR = MC to maximize profits

MR = 400 – 0.4Q = 4 + 0.8Q = MC

or

1.2Q = 396

or

Q = 330

Step 6: Substitute Q = 330 into the demand curve to get P

P = 400 – 0.2(330) = 400 – 66 = 334

Exercise 2

Consider a monopolist with the following market demand and total cost:

P = 10 – Q and TC = 5 + Q + 0.5Q 2

Solve for the competitive outcome and monopoly outcome, respectively. Also, do the welfare analysis.

Competitive outcome:

Monopoly outcome:

P = 10 – Q = 1 + Q = MC gives Q = 4.5 and P = 10 – 4.5 = 5.5

MR = 10 – 2Q = 1+ Q = MC gives =

Q

3 and P = 10 – 3 = 7

Note that society is better off with perfect competition, i.e., consumer gains less producer losses = 5.625 – 3.375 = 2.25. This is shown in the figure in the next slide:

10 MC A If monopoly, CS = A and PS = B + C +
10
MC
A
If monopoly, CS = A and PS = B + C + E
Thus, social welfare (SW) is:
7
CS + PS = A + B + C + E
B
F
If perfect competition, CS = A + B + F
5.5
and PS = E + C + G
C
G
Thus, SW = A + B +C + E + F + G
So SW under perfect competition is greater
4
than SW under monopoly by F + G
E
(F + G = 0.5x3x1.5 = 2.25)
1
D = AR
MR
3
4.5
5
10

CS: consumers’ surplus PS: producer’s surplus SW: social welfare

THANK YOU!

THANK YOU! 49