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Chapter 10
Monopoly
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© 2009 Pearson Education Canada
Monopoly
A
firm is a monopoly if no other
firm produces the same good or a
close substitute for it.
 The degree to which goods are
substitutes is measured by the cross
price elasticity of demand.
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The Monopolist’s Revenue Function
A
monopolist faces a downward sloping
market demand curve.
 To sell additional units the monopolist
must lower its price. p=D(y).
 Since all units must sell for the same
price, p=average revenue (AR).
 Total revenue is output times price:
TR(y)=y(D)(y)
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The Monopolist’s Revenue Function
 Marginal
revenue MR(y) is the rate at
which total revenue changes with
changes in output.
 Since the monopolist must reduce price
to sell additional units of output, for any
positive output, MR is less than price.
 As Δp approaches zero, MR is equal to
(p) plus quantity (y) multiplied by the
slope of the demand curve.
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Figure 10.1 The monopolist’s marginal revenue
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Marginal Revenue and Price
Elasticity of Demand
 Price
elasticity of demand (E) at a
point (y, p) on the demand curve is:
E=p/(y x slope of demand curve)
 Rearranging: MR(y)=p(1-1/lEl)
 Marginal revenue is positive if
demand is price elastic and is
negative if demand is price inelastic.
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Figure 10.2 A linear demand function and the
associated total and marginal revenue functions
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From Figure 10.2
 Linear
demand curve: P=a-by
 TR=P*y, Therefore: TR(y)=ay-by2
 MR(y)=a-2by
 The demand curve intersects the
quantity axis at a/b.
 The MR curve intersects the quantity
axis at a/2b.
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From Figure 10.2
1.
2.
3.
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When TR function has a positive
slope, MR is positive.
When the TR function is at its
maximum, MR is zero.
When TR function has a negative
slope slope, MR is negative.
© 2009 Pearson Education Canada
Maximizing Profit
 Maximize
profit by choosing output (y*)
where MC intersects MR (from below).
 From the demand curve, find the price
(p*) that corresponds with the profit
maximizing y.
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Figure 10.3 Maximizing monopoly profit
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Figure 10.4 The inefficiency of monopoly
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The Inefficiency of Monopoly
Because p* exceeds MC in equilibrium, some
potential gains from trade are not realized,
representing market failure.
 Efficiency criterion requires producing output
to the point where p=MC. The monopoly
equilibrium is therefore not Pareto-optimal.
 A deadweight loss occurs because at
equilibrium, there exists unrealized gains from
trade, signalling unrealized monopoly profit.

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Sources of Monopoly
 Government
Franchise
 Patent Monopoly
 Resource Based Monopoly
 Technological (Natural) Monopoly
 Monopoly by Good Management
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Figure 10.5 Natural monopoly
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Regulatory Responses to a
Natural Monopoly
 Average
Cost Pricing: Forcing the
monopoly to produce a level of
output where p=AC.
 This regulation will fail to minimize
production costs.
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Figure 10.6 Average cost pricing
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Regulatory Responses to a
Natural Monopoly
 Rate
of Return Regulation: Aimed
at limiting the rate of return on
invested capital.
 Under this regulation, the firm will
choose an input bundle that is not
cost minimizing, choosing too much
capital and too little labour.
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Figure 10.7 Rate-of-return regulation
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Patent Policy
 Appropriability
Problem: Many
inventions with social value are not
pursued because inventors do not
have the private incentives to pursue
them (they are not able to capture
the social benefits).
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Figure 10.8 The inducement to develop
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Optimal Patent Policy
 At
the optimal patent period, the
marginal social benefit of increasing
the patent period is equal to the
marginal social cost.
 The optimal patent policy maximizes
aggregate social value less
aggregate social costs.
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