Intermediate Microeconomic
Theory II
Instructor: Prof Berta Esteve-Volart
Department of Economics, York University
Chapter 25 – Monopoly
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Monopoly
• This is an industry in which there is only
one firm
• This means that the demand faced by the
monopolist is the whole market demand
• We choose y that maximizes profits, and
then we find the corresponding p as given
by the demand function
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Maximizing profits
• If we choose y, then in this framework the price
is not given: it depends on people’s willingness
to pay for that y: p(y)
• Revenue: R(y)=p(y) y
max R( y) - c( y)
• Profit-max problem:
y
• Optimal choice is still such that MR=MC
• But how does MR look like now? if the
monopolist wants to increase y, needs to reduce
the price on previous units, too à MR below
demand curve
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If change y:
DR = pDy + yDp
From this we get (as in chapter 15):
é
é
1 ù
1 ù
p( y) ê1 ú = MR, p( y) ê1 ú = MC ( y)
êë e ( y) úû
êë e ( y) úû
(25.1)
- Competitive case: |ε|=∞, hence p=MC
- Monopoly: for |ε|<1, MR<0 so then it cannot be
equal to MC à it cannot be optimal
(Intuition: could increase profits by reducing y)
Hence, the monopolist optimally operates on the
elastic part of the demand, where MR>0
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Linear demand curve and
monopoly [p(y)=a – by]
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Inefficiency of monopoly
• The competitive firm operates where p=MC
• The monopolist operates where p>MC à this
means larger p and lower q than the competitive
firm:
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24.04
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à Inefficiency: the monopoly restricts production
where producing more costs less than people
are willing to pay (i.e., where MC(y)<p(y))
• But we know that the efficient level of output is
reached where MC(y)=p(y)
• Therefore, producing one more unit would be a
Pareto improvement
• Deadweight loss due to the monopoly measures
how much worse off the society is due to lost
output:
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24.05
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Natural Monopoly
• Then, if p=MC is best, why not regulate a
monopoly so p=MC and then the firm has to
produce the efficient q according to that?
• In some cases, that would imply a loss: in some
cases, p=MC means p<AC
àNatural monopoly: AC decreasing for a wide
range of q, so the minimum point of AC curve is to
the right of the demand
àA monopolist would prefer to go out of business
rather than producing q such that p=MC, and then
have a loss
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• This is the case for industries for which AC is
decreasing for a wide range of q: public utilities,
like gas
à These industries are called natural monopolies
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24.06
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• There are two ways of dealing with this:
- Nationalization (company operated by the
government): firm could be selling yMC at pMC at
a loss (and the government pays a subsidy)
- Regulation (private company regulated by the
government): the company is asked to charge a
price that is just enough to break even, so that
profits=0 (p=AC) and hence produce yAC
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What causes monopolies?
• Whether an industry is competitive or a
monopoly in general depends on the relationship
between the AC curve and the demand curve
• The minimum efficient scale (MES) is the level of
output that minimizes AC, so we look at the MES
and the demand curve
• In Figure 25.7, on the left, there is room for
many firms; on the right, only one firm can make
profits
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• Therefore, the underlying technology is important,
because it determines the shape of the AC curve
• Economic policy can determine the size of the
market
• Sometimes a monopoly occurs because several
different firms in an industry might be able to
collude and restrict output in order to raise prices
and, in this way, increase profits – that is a cartel,
which is illegal
• Finally, one industry may have one dominant firm
by historical accident, and may be able to remain
the only firm by threatening to lower prices if
other firms enter the industry
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