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BEA-Unit 5-Monopoly
Monopoly
Basic steps in rational economic choice
Competitive market
Competitive markets work in society’s best interest by ensuring that market prices
are equal to opportunity cost and, as a result, all economic agents (consumers and
producers) can make their resource allocation decisions accordingly.
 In competitive market: firm’s marginal cost = market price = society’s opportunity
cost of production.
MC = P

Price elasticity of demand
(or elasticity of demand)
 Elasticity: the percentage change in a variable in response to a given percentage
change in another variable.
 Elasticity of demand: the percentage change in the quantity demanded in response
to a given percentage change in the price.
ε = (percentage change in the quantity demanded)/(percentage change in price)
= (ΔQ/Q)/(Δp/p)
 Elasticity of demand is a negative number, but we always use the absolute value.
Elasticity along the demand curve (pp.50)
Elasticity (ε < -1)

Higher the midpoint of the demand curve.
 A 1% increase in price causes a more than 1% fall in demanded quantity.
Unitary elasticity (ε = -1)

At the midpoint of the linear demand curve, a 1% increase in price causes 1% fall
in demanded quantity.
Inelastic (-1 < ε < 0)

Lower the midpoint of the demand curve.
 Where the demand curve is inelastic, a 1% increase in price leads to a fall in
demanded quantity of less than 1%.
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BEA-Unit 5-Monopoly
Monopoly Maximizing Profit

All firms, including competitive firms and monopolies, maximize their profits by
setting marginal revenue equal to marginal cost.
Marginal Revenue & Price

Marginal revenue (MR) is the change in revenue from selling one more unit.
 Marginal revenue curve: the monopoly’s marginal revenue curve lies below the
demand curve at every positive quantity. In general, the relationship between the
marginal revenue and demand curves depends on the shape of the demand curve.
Marginal revenue and Price elasticity of demand
MR = p(1 + 1/ε)
 When demand curve is perfectly elastic, ε  0,  MR = p
 When demand elasticity is unitary, ε = -1, MR = 0
 When demand curve is inelastic (-1 < ε < 0), MR is negative.

Choosing price or quantity
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A monopoly can adjust its price, so it has a choice of setting its quantity to
maximize profit (a competitive firm sets its quantity to maximize profit because it
cannot affect market price).
Monopoly demand curve is downward sloping  monopoly faces trade-off
between a higher price and a lower quantity or vice versa.
Profit-maximizing output
Linear demand curve is more elastic at smaller quantities, monopoly profit is
maximized in the elastic portion of the demand curve (higher midpoint of demand
curve).  monopoly never operates in the inelastic portion of its demand curve.
Shutdown decision
A monopoly shuts down to avoid making a loss in the long run if the monopolyoptimal price is below its average cost.
In the short run, shutdown if monopoly-optimal price is less than its average
variable cost.
MR = MC = p(1 + 1/ε) < P1
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BEA-Unit 5-Monopoly
P
MC
P1
MR
Q
Shift in demand curve – Monopoly
(pp. 354)
 Shift of demand curve causes the monopoly optimum change from E1 to E2.
 The monopoly quantity stays the same, but the price rises.
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