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Microeconomics in Modules and Economics in Modules Third Edition Krugman/Wells Module 28 Monopoly in Practice

What You Will Learn 1 How a monopolist determines the profitmaximizing output and price 2 How to determine whether a monopoly is earning a profit or a loss 2 of 17

The Monopolist’s Demand Curve and Marginal Revenue • The price-taking firm’s optimal output rule is to produce at the level whose marginal cost of the last unit produced is equal to the market price. • A monopolist, in contrast, is the sole supplier of its good. So its demand curve is simply the market demand curve, which is downwardsloping. 3 of 17

The Monopolist’s Demand Curve and Marginal Revenue • This downward slope creates a wedge between the price of the good and the marginal revenue of the good—the change in revenue generated by producing one more unit. 4 of 17

Comparing the Demand Curves of a Perfectly Competitive Producer and a Monopolist (a) Demand Curve of an Individual Perfectly Competitive Producer (b) Demand Curve of a Monopolist Price Market price Price DC DM Quantity An individual perfectly competitive firm cannot affect the market price of the good; therefore, it faces the horizontal demand curve DC as shown in panel (a). Quantity A monopolist can affect the price (sole supplier in the industry); therefore, its demand curve is the market demand curve DM as shown in panel (b). 5 of 17

The Monopolist’s Demand Curve and Marginal Revenue • An increase in production by a monopolist has two opposing effects on revenue: – A quantity effect. One more unit is sold, increasing total revenue by the price at which the unit is sold. – A price effect. To sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue. 6 of 17

The Monopolist’s Demand Curve and Marginal Revenue • The quantity effect and the price effect are illustrated by the two shaded areas in panel (a) of Figure 28 -2 based on the numbers in the table on the next slide. 7 of 17

The Monopolist’s Demand Curve and Marginal Revenue 8 of 17

A Monopolist’s Demand, Total Revenue, and Marginal Revenue Curves Price, cost, marginal revenue of demand \$1, 000 550 500 (a) Demand Marginal Revenue A Price effect = –\$450 Quantity effect = +\$500 B C 50 0 9 10 Quantity of diamonds Marginal revenue = \$50 – 200 – 400 20 D MR (b) Total Revenue Quantity effect dominates price effect. Total Revenue Price effect dominates quantity effect. \$5, 000 4, 000 3, 000 2, 000 1, 000 0 10 TR Quantity of diamonds 20 9 of 17

The Monopolist’s Demand Curve and Marginal Revenue • Because of the price effect of an increase in output, the marginal revenue curve of a firm with market power always lies below its demand curve. • A profit-maximizing monopolist chooses the output level at which marginal cost is equal to marginal revenue—not to price. 10 of 17

The Monopolist’s Demand Curve and Marginal Revenue • As a result, the monopolist produces less and sells its output at a higher price than a perfectly competitive industry would. It earns a profit in the short run and the long run. 11 of 17

The Monopolist’s Demand Curve and Marginal Revenue • At low levels of output, the quantity effect is stronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small. • At high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more, it has to lower the price on many units of output, making the price effect very large. 12 of 17

The Monopolist’s Profit-Maximizing Output and Price • To maximize profit, the monopolist compares marginal cost with marginal revenue. • If marginal revenue exceeds marginal cost, De Beers increases profit by producing more; if marginal revenue is less than marginal cost, De Beers increases profit by producing less. 13 of 17

The Monopolist’s Profit-Maximizing Output and Price • At the monopolist’s profit-maximizing quantity of output: MR = MC 14 of 17

The Monopolist’s Profit-Maximizing Output and Price, cost, marginal revenue \$1, 000 of demand The optimal output rule: the profit maximizing level of output for the monopolist is at MR = MC, shown by point A, where the MC and MR curves cross at an output of 8 diamonds. Monopolist’s optimal point B PM 600 Perfectly competitive industry’s optimal point Monopoly profit PC 200 0 – 200 A MC = ATC C 8 QM 10 16 MR QC D 20 Quantity of diamonds – 400 15 of 17

Monopoly Versus Perfect Competition • P = MC at the perfectly competitive firm’s profitmaximizing quantity of output. • P > MR = MC at the monopolist’s profit-maximizing quantity of output. 16 of 17

Monopoly Versus Perfect Competition • Compared with a competitive industry, a monopolist does the following: – Produces a smaller quantity: QM < QC. – Charges a higher price: PM > PC. – Earns a profit. 17 of 17

The Monopolist’s Profit Price, cost, marginal revenue Profit = TR − TC = (PM × QM) − (ATCM × QM) = (PM − ATCM) × QM MC ATM B PM Monopoly profit ATCM The average total cost of QM is shown by point C. Profit is given by the area of the shaded rectangle. A D C MR QM Quantity The monopolist maximizes profit by producing the level of output at which MR = MC, given by point A, generating quantity QM. It finds its monopoly price, PM, from the point on the demand curve directly above point A, point B here. 18 of 17

Economics in Action • Electric utilities were recognized as natural monopolies with a defined area. They owned the plants and the transmission lines. • In the late 1990 s, there was a move toward deregulation. • Power generation entails large up-front costs. • Lack of competition after deregulation enabled power generators to engage in market manipulation. • From 2002 to 2006 average electricity prices rose 21% in regulated states versus 36% in fully deregulated states. 19

Summary 1. The key difference between a monopoly and a perfectly competitive industry is that a perfectly competitive firm faces a horizontal demand curve but a monopolist faces a downward-sloping demand curve. This gives the monopolist market power, the ability to raise the price by reducing output. 2. The marginal revenue of a monopolist is composed of a quantity effect (the price received from the additional unit) and a price effect (the reduction in the price at which all units are sold). Because of the price effect, a monopolist’s marginal revenue is always less than the market price, and the marginal revenue curve lies below the demand curve. 20 of 17

Summary 3. At the monopolist’s profit-maximizing output level, marginal cost equals marginal revenue, which is less than market price. 4. At the perfectly competitive firm’s profit-maximizing output level, marginal cost equals the market price. 5. So in comparison to perfectly competitive industries, monopolies produce less, charge higher prices, and earn profits in both the short run and the long run. 21 of 17