ECO303 Varian Chapter24_Monopoly

Chapter 24: Monopoly

Pure Monopoly

• Definition: A monopolized market has a single seller.

• Demand Curve: The monopolist’s demand curve is the downward sloping market demand curve.

  • The monopolist can influence the market price by adjusting output.

Price and Output Relationship

• Higher output (y) causes a lower market price (p(y)).

Causes of Monopolies

• Legal Fiat: E.g., the US Postal Service.

• Patents: E.g., protection for new drugs.

• Sole Ownership of Resources: E.g., toll highways.

• Formation of a Cartel: E.g., OPEC.

• Large Economies of Scale: E.g., local utility companies.

Profit Maximization in Monopolies

• Monopolists seek to maximize economic profit by selecting an output level (y*) that maximizes profit.

• Profit Function: II(y) = p(y)y - c(y)

  • Conditions for Maximization: At y*,

    • dII(y)/dy = 0

    • Marginal Revenue (MR): MR(y*) = MC(y*)

Marginal Revenue

• Definition: Marginal revenue is the rate of change of revenue as the output level increases.

• Calculation: d (p(y)y)/dy = p(y) + y(dp(y)/dy)

• General Result: MR(y) < p(y) for output y > 0 due to the downward slope of the demand curve.

Marginal Cost

• Definition: Marginal cost is the rate of change of total cost as output increases.

• Example: If c(y) = F + ay + by², then MC(y) = a + 2by.

Profit Maximization Example

• Given functions: p(y) = a - by and c(y) = F + ay + by².

• Optimal output level y*: Solve

  • MR(y*) = MC(y*): a - 2by* = a + 2By*

Monopolistic Pricing & Elasticity of Demand

• If market demand becomes less sensitive to price changes, the monopolist may cause the market price to rise (exploit elasticity).

• Simplified equation relationships involving MR and average elasticity of demand defined.

Markup Pricing

• Definition: The output price is marginal cost plus a markup.

• Impact of Elasticity: As elasticity rises towards -1, monopolist's markup increases, and the price-cost relationship evolves based on demand elasticity.

• Example Calculations show how markup varies with demand elasticity.

Effects of Taxes on Monopoly Profits

Profits Tax

• A profits tax leads to reductions in profits but does not alter monopolistic output or price choices; it is a neutral tax.

Quantity Tax

• A quantity tax increases marginal costs, decreasing profits and causing market prices to rise and input demands to drop. This is a distortionary tax.

Inefficiency of Monopoly

• Pareto efficiency is achieved when total gains-to-trade are maximized. Monopoly leads to inefficiency as it does not produce at this level.

• Deadweight Loss: A measure of lost efficiency in trade due to monopoly production below the efficient output level.

Natural Monopoly

• Definition: Arises from economies of scale allowing a single firm to supply the market at lower average costs compared to multiple firms.

Regulation of Natural Monopolies

• Challenges and Solutions: Natural monopolies cannot simply be forced to use marginal cost pricing as it may lead to losses and exit from the market.

• Effective regulatory schemes must enable natural monopolists to produce efficiently without exit.