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The Production Decision of a
Monopoly Firm
Alternative market structures:
• perfect competition
• monopolistic competition
• oligopoly
• monopoly
The following market attributes
characterize the case of monopoly:
– There is a single seller of a product having no
close substitutes; there is only one source of
supply.
– There is complete information regarding price
and product availability.
– There are barriers to new firms entering the
market.
Reasons for barriers to entry
include the following:
• Government franchises and licenses
• Patents and copyrights
• Ownership of the entire supply of a
resource
• Economies of scale (natural monopoly)
Generally, a firm has monopoly power if
by producing more or less of the good,
the market price is affected.
A firm with monopoly power is a
price-maker.
Such a firm is not able to choose price
and quantity.
Marginal revenue for a firm with
monopoly power
Suppose a firm’s demand curve is downward
sloping and all units of the good are sold at
the same price.
The firm’s marginal revenue from selling an
additional unit will be less than the price
received for that unit; MR < P.
Example:
P=AR Q
$9.20
8
$9.10
9
$9.00 10
$8.90 11
TR=PQ
$73.60
$81.90
$90.00
$97.90
MR
$8.30
$8.10
$7.90
Marginal revenue is the additional revenue
that results from the sale of an additional unit.
MR = P - (reduction in price)(previous quantity)
$8.30 = $9.10 - (.10 $/unit)(8 units)
= $9.10 - $0.80
Explanation for why MR < P:
To sell additional units, the firm must lower price.
There is an associated revenue loss resulting from
the infra-marginal units being sold at a lower price
than would otherwise have been the case.
P
P1
P2
D
Q1 Q2
Q
FACT: Marginal revenue can be negative
even when price is positive.
Demand
P=AR
Q
$5.10
49
$5.00
50
$4.90
51
$4.80
52
TR=PQ
$249.90
$250.00
$249.90
$249.60
MR
$0.10
-$0.10
-$0.30
MR = P - (reduction in price)(previous quantity)
-$0.10 = $4.90 - (.10 $/unit)(50 units)
= $4.90 - $5.00
P
$/Q P1
P2
P3
P4
P5
elastic demand
inelastic demand
Q1 Q2
D
Q3 Q4 Q5 Q
TR $ TR3
TR4
TR5
TR2
Marginal
Revenue and the
price elasticity of
demand.
TR
TR1
Q1 Q2
Q3 Q4 Q5 Q
$/Q
$/Q
D
Q1 Q2
Q3 Q4 Q5 Q
MR
Q3
Q
MR
Marginal Revenue and the price
elasticity of demand.
P
Elastic demand
Unit elastic demand
Inelastic demand
D
Q
MR
FACT: A firm having monopoly power
will never choose to produce a level of
output corresponding to an inelastic
point on its demand curve.
Π = TR - TC
If demand is price inelastic, reducing the level of
output will result in an increase in TR and a
reduction in TC, implying an increase in profits,
Π.
What level of output will the firm produce?
$ per
unit
MC
P1
AVC
D
MR
Q1
Q2
Q
Profit maximizing output rule:
A profit-maximizing firm will produce the
level of output where MC = MR, provided
that the corresponding total revenue is at least
as large as than associated total variable cost
(i.e., P >AVC).
If the price corresponding to the output where
MR = MC is less than the corresponding
AVC, the firm will shut down.
P
$ per
unit
MC
AVC
$5.00
$2.50
$2.00
10,000
Q
  TR  VC
 FC
 Q  P Q  AVC  FC
 Q( P  AVC)  FC
 10,000($5.00$2.50)  FC
 $25,000  FC
In the long-run, a monopolist may exit or
adjust its scale of production (i.e., adjust
its mix of inputs).
Profits will be nonnegative in the long-run.
If a firm continues to produce, it will do so
at the lowest average cost possible.
The Welfare Cost of Monopoly
P
$/Q
Marginal value to
buyer (and society)
P1
Marginal value to monopolist
MC
D
MR
Q1
Q2
Q
Marginal private
(and social) cost
The Welfare Cost of Monopoly
P
$/Q
P
$/Q
deadweight loss
P1
P1
MC
MR
MC
MR
D
Q1
monopoly
output
Q2
Q
efficient
quantity
D
Q1
monopoly
output
Q2
Q
efficient
quantity
Perfect Price Discrimination
A monopolist who knows each buyer’s
demand (willingness to pay) and is able to
charge each buyer a different price for each
unit purchased is said to be able to
perfectly price discriminate.
Demand Relation
P=AR
Q
$9.90
1
$9.80
2
$9.70
3
$9.60
4
$9.50
5
$9.40
6
$9.30
7
$9.20
8
$9.10
9
$9.00
10
$8.90
11
TR
MR
(perfect price discrimination)
$9.90
$9.90
$19.70
$9.80
$29.40
$9.70
$39.00
$9.60
$48.50
$9.50
$57.90
$9.40
$67.20
$9.30
$76.40
$9.20
$85.50
$9.10
$94.50
$9.00
$103.40
$8.90
Marginal Revenue with and without
Perfect Price Discrimination
P
$/Q
MR with perfect
price discrimination
P1
MR with no
price discrimination
MR
Q1
D
Q
Profit Maximization in the
Case of Perfect Price Discrimination
P
$/Q
P1
MC = AC
D = MR
Q1
Q2
Q
Profit Maximization in the
Case of No Price Discrimination
P
$/Q
P1
Consumers surplus
Producer surplus
(monopoly profits)
MC = AC
D
MR
Q1
Q2
Q
Distributional Consequences of
Perfect Price Discrimination
P
$/Q
P1
MC = AVC
D = MR
Q1
Q2
Q