Deriving the MR curve

• We start with a relationship between P & MR

• As the monopolist faces a downward sloping demand
curve, to increase Q by ΔQ it must lower its price per
unit by Δp/ΔQ, which is the slope of the demand
curve
• By lowering its price, the monopolist loses
(Δp/ΔQ)*Q on the units it originally sold at the
higher price (area C) but earns an additional p on the
extra output it now sells (area B)
• The monopoly’s MR is:
MR = p + (Δp/ΔQ)*Q (Eq. 11.1)

• Since the demand curve is negative Δp/ΔQ is

negative

• Eq 11.1 confirms that the price is always greater

than MR
Figure 11.2 Elasticity of Demand and Total,
Average, and Marginal Revenue
p, $ per unit

24

DMR= –2
Dp= –1
DQ= 1
DQ= 1
12

Demand (p= 24 –Q)

0 12 24
MR = 24 – 2Q Q, Units per day
Price Elasticity of DD (ep)

• MR at any point depends on the demand curves height (price) & shape
• The shape of the demand curve is at a particular quantity is described by
the price-elasticity of demand

• ep = % change in quantity demanded (Qd) over % change in price

• When calculated, ep has a negative sign (D price & D Qd are in opposite directions)

• At a given quantity, MR equals price times a term involving the elasticity of demand:

MR = p (1 + 1/ε) (Eq. 11.4)

• Eq 11.4 shows that the more elastic is demand, the closer MR is to the price level

• When Q=0, the demand curve is perfectly elastic & MR=P  y-axis intercept

• When the demand elasticity is unitary, ε = -1, MR=0  x-axis intercept

• MR is negative where the demand curve is inelastic

MR & (ep) See Fig. 11.2 (p372, 7th ed.) (p379, 6th ed.)
Figure 11.2 Elasticity of Demand and Total,
Average, and Marginal Revenue
p, $ per unit

24 Perfectly elastic ε = -

Elastic, e < –1 e.g. ε = -1.5; -3; -5

DMR= –2
Dp= –1
DQ= 1
DQ= 1
e = –1
12

e.g. ε = -0.2; -0.5; -0.8

Inelastic, –1 < e < 0

Demand (p= 24 –Q)

Perfectly ε=0
inelastic
0 12 24
MR = 24 – 2Q Q, Units per day
 At which Q will monopolist max. π?

•All firms maximise profit where MR = MC

•A monopolist is constrained the market demand curve  trade-off between high

price/low Q or low P/high Q

•If the monopolist chooses P, then it has to accept the Q dictated by the demand curve

•If the monopolist chooses its Q, it must accept the price determined by the demand
curve

•Since the monopolist wants to maximise profit, it chooses the same profit-max solution
whether it chooses price or output

•From here on we assume that a monopolist chooses quantity.

See Fig. 11.3 (p375, 7th ed.) (p382, 6th ed.)

Figure 11.3 Maximizing Profit

Profit = Revenue – Cost

Revenue = Price x Quantity

AR = TR  TR = AR x Q
Q
AC = TC  TC = AC x Q
Q

Steps for profit maximisation:

1. Choose Q* where MR=MC (profit is
a max)
2. Whether to produce Q* or shut down
Monopolist’s eqm position:

• MR = MC at Q = 6

• Monopolist will charge $18 (what consumers WTP – read off

DD curve)

• P>MC

• At Q<6, MR>MC – profits increase from producing more

• At Q>6, MC>MR – profits decline from producing more

• For a monopolist to maximise profit, MR=MC, but MC>0

(always) so MR>0 for MR=MC – this only occurs in the elastic
portion of the demand curve

• Monopolist will never operate in inelastic portion of DD curve.

Monopolist’s shutdown decision

•Monopolist will only shutdown if the optimal monopoly price is below average cost  if
the price is less than AVC in the SR

•At Q = 6, AVC = $6:  p > AVC  firm stays open

•Does firm make economic profit (AR>ATC), normal profit (AR=ATC) or economic loss
(AR<ATC)?

•AT Q = 6, ATC = $8

• profit on each unit = $18-$8 = $10 x 6 units:

Total profit = $60
• Mathematical approach

• Can solve for profit-max Q mathematically

• With the demand curve:
P = 24-Q
• Cost function:
C(Q) = Q2 + 12
• Cost has a fixed and variable component
• Fixed component  $12
• Variable component  Q2
• For profit maximisation we need MR = MC
• So we need to calculate MR & MC and equate them
• We calculate MR by differentiating the revenue
function
R = PQ
• We know the relationship between P & Q from the
demand curve :
P = 24-Q
Thus R = (24-Q)*Q = 24Q-Q2
MR(Q) = 24-2Q
• We calculate MC by differentiating the cost function
with respect to Q
C(Q) = Q2 + 12
MC (Q) = 2Q
• Equating MR & MC
MR = 24-2Q = MC = 2Q
24-2Q=2Q
4Q = 24
Q* = 6 units
• Substitute back into the demand equation:
• P* = 24-Q* = 24 – 6 = $18
• Profit = TR-TC = (P*.Q*) – ((Q*)2 + 12)
= (18*6) – (62 + 12) = $60
• AC = C/Q = Q* + 12/Q* = 6+2 = $8
• Since P>AC - firm is profitable
11.2 Market Power
•  Ability of a firm to charge p>MC & earn positive profit  extent to which
P>MC depends on ep (shape of the demand curve at profit-max Q)

• If a monopolist faced a highly elastic (nearly flat) demand curve it would

lose a lot by raising P - opposite for not very elastic

• We derive the relationship between market power & the elasticity of demand
at the profit-max Q using eq. 11.4 & the firms profit-max condition

MR = p (1 + 1/ε) (Eq. 11.4)

& MR = MC (profit-max condition)
MC = p (1 + 1/ε)
 (p/MC) = 1/ (1 + 1/ε) (Eq. 11.8)

• Eq. 11.8 says that the ratio of price to MC depends only on the elasticity of
demand at the profit-max Q

• Table 11.2 shows how the ratio of P/MC changes with the elasticity of
demand
Table 11.2 Elasticity of Demand, Price, and Marginal Cost

• Table 11.2 shows that not all monopolies can set high prices
• A monopolist which faces a perfectly elastic (horizontal) demand curve sets its
P = MC, like a firm in perfect-competition
• The more elastic is the demand curve, the less a monopolist can raise its price
without losing sales
• Ceteris paribus, the more substitutes which are available for a good, the more
elastic is the demand curve
The Lerner Index
•Another way of showing how the elasticity of demand affects a monopoly’s P relative to
MC  Lerner index (price markup)

•Lerner Index (L.I.) = (P-MC)

P

•larger the L.I. the greater the firm’s mkt power

• zero for PC firm as P=MC

•We can express the Lerner index in terms of elasticity if the firm is maximising profit by
rearranging eqn 11.8:

(P-MC) = -1 (Eq 11.9)

P ep

 L.I. ranges from 0 to 1 for profit max. firm -as DD becomes less elastic, L.I. increases

See Table 11.2 (p380, 7th ed.) (p387, 6th ed.)

Sources of market power

• What determines the elasticity of demand & monopolist’s market power ? 

consumers’ tastes & options

• The more consumers want a good  the more they are willing to pay for it –
the less elastic is the demand curve
• The demand curve a firm faces becomes more elastic:
- the greater are the substitutes for a good;
- the more firms there are selling a good; and
- the closer firms which sell the good are to the firm.