Ch 11: Monopoly and Monopsony
•In the Perfectly Competitive market, the
individual firm or consumer had no effect on
the market price
•A monopolist or monopsonist has market
power; the market price is affected by their
choice of quantity
•A monopolist or monopsonist must then
choose q to maximize their profits, given
that p depends on q.
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Chapter 11: Monopoly & Monopsony
In this chapter we will cover:
11.1 Monopoly Features
11.2 Monopolistic Profit
11.3 Monopoly Supply
11.4 Inverse Elasticity Pricing Rule
11.5 Welfare Effect of Monopolies
11.6 Why Monopolies?
11.7 Monopsonists
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A MONOPLY is an industry where there is only
ONE producer/seller.
The monopolist is the market; they face the
market demand curve P(Q).
By lowering price, the monopolist is able to sell
more goods.
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A monopolist faces the market demand curve:
P=f(Q)
ie: P=a-bQ
A monopolist’s revenue is equal to:
TR=PQ
ie: TR=aQ-bQ2
A monopolist’s costs increase with production:
TC=f(Q)
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ie: TC=Q2
A monopolist’s profit is the difference between
total revenue and total cost:
Profit=TR-TC
Ie: Profit=aQ-bQ2-Q2
The monopolist's profit maximization problem:
Max (Q) = TR(Q) - TC(Q)
Q
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If MR > MC, the monopolist is increasing profit
and should produce
If MR< MC, the monopolist is decreasing profit
and should not produce
Therefore (like PC), the monopolist maximizes
profits when MR=MC.
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TC
TR
Profit
Q
P
MR=MC
MC
MR
D
Q
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Demand: P=20-2Q
MR=20-4Q
MC=5+Q
MR=MC
5+Q=20-4Q
5Q=15
Q=3
P=20-2q
P=14
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When a monopolist increases production, 2
things occur:
1) The monopolist earns MORE revenue from the
extra goods sold
2) The monopolist earns LESS revenue from the
previous goods sold due to a reduced price:
TR PQ  QP
MR 

Q
Q
P
MR  P  Q
Q
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Revenue Change: Q increases to Q2
P
Revenue
Lost on
units
P1
P2
Therefore marginal
revenue is less than
price.
Revenue gained on new
units
Demand
Q1
Q2
Q
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A monopolist facing demand curve P=28-2Q
originally produces 10 units. Calculate the
revenue gained and lost by moving to 11 units.
P(10)=28-2(10)
P(10)=8
P(11)=6
Revenue gained = P(11) = 6
Revenue lost =[P(10)-P(11)]10
Revenue lost = (8-6)(10)=20
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Marginal Revenue and Linear Demand
When demand
is linear, MR
has a slope
twice as
steep.
P
Demand: P=100-4Q
Q
MR=100-8Q
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For the monopolist,
AR(Q)=TR(Q)/Q
AR(Q)=P(Q)
Or, since price is found on the demand curve,
AR(Q)=D
Since MR is always below the demand curve,
AR(Q)>MR(Q)
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If Q>0
1) The Monopolist will produce Q where MR=MC
2) Given this Q, the monopolist will charge a price
determined by their demand curve
3) Monopolist profit is equal to:
TR-TC
Or
PxQ-ACxQ
Or
(P-AC)Q
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Price
MC
AC
100
80
e
Profit
MR
20
Demand curve
20
50
Quantity
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The Monopolist does not have a suply curve!
Why?
For the Perfect Competitor, price is exogenous;
taken as given.
For the Monopolist, price is endogenous; it is part
of the Monopolist’s decision.
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Price
80
MC
20
Here the monopolist
offers 20 units at 2
different prices,
dependent on
demand
Therefore, no supply
curve exists
MR1
20
D1
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MR2
D2
Quantity
We can rewrite the MR curve as follows:
MR = P + QP/Q
= P(1 + (Q/P)(P/Q))
= P(1 + 1/)
where:  is the price elasticity of
demand, (P/Q)(Q/P)
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Using this formula:
When demand is elastic ( < -1), MR > 0
When demand is inelastic ( > -1), MR < 0
When demand is unit elastic ( = -1), MR= 0
Therefore,
The monopolist will always operate on the elastic
region of the market demand curve
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Price
a
Example: Elastic Region of the Demand Curve
Elastic region ( < -1), MR > 0
Unit elastic (=-1), MR=0
Inelastic region (0>>-1), MR<0
a/2b
a/b
Quantity 20
Since at equilibrium, MC=MR:
IEPR:
1
MC  P * (1  ) The monopolist’s
 markup above MC (as
P*
a percentage of price)

 P *  MC
is the negative

1
P *  MC inverse of elasticity of


demand

P*
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Example:
 = -2
MC = $50
a. What is the monopolist's optimal price?
MR = MC  P(1+1/) = MC 
P(1+1/(-2)) = 50
P* = 100
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Since at equilibrium, MC=MR:
IEPR:
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MC  P * (1  ) The monopolist’s
 markup above MC (as
P*
a percentage of price)

 P *  MC
is the negative

1
P *  MC inverse of elasticity of


demand

P*
Note: The IEPR is related to the
Lerner Index of Market Power…….
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While a firm may be a monopoly, its MARKET
POWER, or control over price may be limited.
-Perhaps people don’t really need the good
-Perhaps imperfect substitutes exist
The Lerner index of market power measures
market power; the control a firm has over price
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Lerner Index =(P-MC)/P=-1/ 
The Lerner Index lies between 0 and 1
The Lerner Index is 0 for a perfectly competitive
firm (P=MC, the firm has no control over price).
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Shifts in market demand
•A shift in market demand will cause
the monopolist’s MR curve to shift also
•This will cause a new equilibrium
(MR=MC)
•This new equilibrium will cause a new
price
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Price
MC
P1
P0
MR1
Q0 Q1
MR0
•Here an increase in
demand increased
monopoly price and
quantity
D0
D1
Quantity
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An ice cream monopolist with a MC curve of
MC=Q originally faced a demand curve of
P=20-2Q. Due to an increase in temperature,
demand shifted to P=35-2Q.
Calculate the change in price and quantity due to
this shift in demand.
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ORIGINALLY:
P=20-2Q
MR=20-4Q
MR=MC
20-4Q=Q
4=Q
P=20-2Q
P=20-2(4)
P=12
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AFTER DEMAND SHIFT: P=35-2Q
MR=35-4Q
MR=MC
35-4Q=Q
7=Q
P=35-2Q
P=35-2(7)
P=21
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The shift in demand caused:
-An increase in monopoly price of $9
($21-$12)
-An increase in quantity produced of 3
cones (7-4)
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Shifts in marginal cost
•A shift in marginal cost will create a
new equilibrium (MR=MC)
•This new equilibrium will cause a new
price
•Increases in cost will always raise
price and decrease quantity supplied
for a monopolist
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Price
MC1
MC
P1
P0
•An increase in cost
increases monopoly
price and decreases
quantity supplied
D0
Q1 Q0
MR0
Quantity
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• We saw before how a perfectly competitive
market maximized consumer and producer
surplus
• Since a monopoly decreases output to increase
prices, a monopoly will normally create a
DEADWEIGHT LOSS:
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CS with competition: A+B+C
PS with competition: D+E
MC=S
A
PM
B
PC
C
E
D
Demand
QM
QC
MR
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CS with monopoly: A
PS with monopoly:B+D
MC=S
A
PM
B
PC
DWL = C+E
C
E
D
Demand
QM
QC
MR
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Since PM>AC for most Monopolists, they earn
ECONOMIC PROFIT. There is an incentive for a
monopoly to maintain market power.
RENT SEEKING is any activity aimed an creating
or preserving monopoly power:
Government lobbying/bribes
Advertising
Hiring Thugs
This rent seeking behaviour is a social cost
beyond simple deadweight losses
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Maximum rent seeking cost=B+D
MC=S
DWL = C+E
A
PM
B
PC
C
E
D
Demand
QM
QC
MR
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Monopolies exist for a number of reasons, some
“good”, some “bad”:
 Natural Monopolies
 Barriers to Entry
 Structural
 Legal
 Strategic
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A natural monopoly exists in an industry with
INCREASING RETURNS TO SCALE:
One large firm is a natural monopoly if it can
supply the total market at a lower total cost
than any other 2 firms:
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Price
Example: Natural Monopoly
If total market quantity is
45,000, one firm has a natural
monopoly
AC
Demand
22,500
45,000
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Quantity
Price
Example: Natural Monopoly
If total market quantity
increased to 80,000, the natural
monopoly might not stand
AC
Demand
Q
40,000
80,000 42
Normally, if economic profit is available in an
industry, firms will enter until that profit is
pushed to zero.
A BARRIER TO ENTRY is any factor that allows a
firm to earn positive economic profit while
making it unprofitable for another firm to enter
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A structural barrier to entry is a cost or demand
advantage that prevents another firm from
entering
-Cost Advantages (includes natural monop.)
-Positive Externalities (iTunes/Ebay)
-Advertising/Brand Dominance
(Kleenex, Heinz)
-May be seen as strategic barrier
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A legal barrier to entry exists when a firm is
legally protected from competition.
-Patents (encourages research)
-Exclusive Rights
-ie: Marijuana growers
-ie: Out-of-country vehicle inspections
(ie: Canadian Tire)
-ie: Printing Money (Canadian Mint)
-ie: Degrees (Universities)
Often these barriers are set up for good
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reasons
A strategic barrier to entry exists when a firm
takes EXPLICT steps to prevent entry
-Operating at a loss/reduced profit
-Developing a Predatory Reputation
-”Unofficial” agreements to maintain
monopoly
-Consumer Contracts
-Incompatible inputs (ie: Phone numbers,
memory cards, software, chargers, etc.)
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Lowering profits to avoid competition
MC=S
PM
PC
PC
Losses
If PX was still
profitable to the
monopolist, it
could keep other
firms out of the
market.
PX
Demand
QM
QC
MR
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A MONOPSONIST is a single buyer of a good or
input.
-ie: Only the government purchases military
equipment (we hope).
-If the film Teenage Mutant Ninja Star
Spidermen 4: The Ballet of the Forgotten
Princess were to film in Edmonton, there’d be 1
film but many people wanting to be extras
-The monopsonist faces the market supply curve
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Marginal Product (MP) is the additional
productivity of another unit of input.
-ie: 1 more worker increases output by 7
Marginal Revenue Product (MRP) is the
additional revenue of another unit of input.
-ie: 1 more worker increases revenue by
$21 (if each output sells for $3)
MRP=P x MP
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Since the monopsonist faces the market supply
curve, it can only increase inputs (ie: Labour) by
increasing the price
To hire another worker, the monopsonist both
has to give that worker a higher wage, plus
increase the wage of every other worker:
w
ME L  w  L
L
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Monopsonist Increases Labour:
W
Wage increase of current workers
Supply
W2
W1
Wage of additional workers
L1
L2
L
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If supply of any input is linear, the Marginal
Expenditure (ME) if that input has TWICE the
slope of the supply curve.
Ie:
Supply: W=50+3Q
ME: W=50+6Q
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If, for the next input (worker) MRP>ME, the firm
should use that input, as the input will earn the
firm more than it increases costs.
If, for the next input (worker) MRP<ME, the firm
should not use that input, as the input will earn
the firm less than it increases costs.
Therefore a monopsonist maximizes when
MRP=ME
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Monopsonist Maximization:
W
MEL
Supply
ME=MRP
W*
Wage
MRPL
L
L*
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A film crew comes to the city to hire extras. It
faces a supply curve of:
W=10+Q
Extras have a marginal revenue product curve of
W=100-2Q
Maximize the film’s hiring of extras.
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Supply:
ME:
W=20+Q
W=20+2Q
ME=MRP
20+2Q=100-2Q
4Q=80
Q=20
W=20+Q
W=20+20
W=40
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Welfare Effects of Monopsonists:
W
MEL
Supply
PC
Consumer Surplus
PC
Producer Surplus
W*
Wage
MRPL=DPC
L
L*
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Monopsonist DWL:
W
MEL
Supply
Monopsonist
Consumer Surplus
Monopsonist
Producer Surplus
W*
Wage
MRPL=DPC
DWL
L
L*
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Chapter 11 Summary
A monopoly consists of one firm selling a
good
A monopolist faces the market demand
curve
To sell more, it must decrease price
MR is therefore less than demand
A monopolist chooses quantity where
MC=MR
This quantity is sold at a price found on
the demand curve
This typically produces a profit
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Chapter 11 Summary
A monopolist always operates on the
ELASTIC portion of the demand curve
The elasticity of demand determines a
monopolist’s market power through the
Learner Index of Market Power
Monopolies cause deadweight loss
This loss increases if Monopolies spend
resources to maintain their monopoly
Monopolies exist due to barriers to entry
(structural – includes natural monopoly strategic, legal,
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Chapter 11 Summary
A monopsonist is a single BUYER of a
good or input
Monopsonists deal with the market supply
curve
Monopsonists operate where marginal
revenue product equals marginal
expenditure (MRP=ME)
Monopsonists cause Deadweight loss
**Remember that Deadweight Loss could
be a reason for government intervention,
but that intervention itself carries a cost
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