You are on page 1of 4

Godirectlytoproblems

MonopolyandMarginalRevenue
Monopoliesare,literally,the"singleseller"inaparticularindustry.Whileperfectlymonopolized
marketsareasrareasperfectlycompetitivemarkets,thereareelementsofmonopolypowerinmany
markets,andunderstangingthoseelementsiseasiestifweconsidertheactionswhichwouldbetakenby
aperfectmonopoly.
Therearetwocategoriesofmonopoly:
Anaturalmonopoly,withitsmarketdominancerestingonhighfixedcosts(makingentrance
difficultforotherfirms)andonlowmarginalcostsofproductionandasaresultdeclining
averagecosts.Decliningaveragecostsimplythatlargescaleproducerscanproducemorecheaply
andhenceundersellnewentrants.
Legalmonopolies,wheremarketdominancedoesnotrestonacostadvantagebutonalegal
prohibitionofotherfirmsentering.Ifastateownedtelecommunicationsserviceorpostalservice
prohibitsotherfirmsfromentering,wehavealegalmonopoly.Ifpatentspreventotherfirmsfrom
enteringanindustry,wehavealegalmonopolygrantedtothefirmowningthepatent.
Bothcategorieswillmakedecisionsinthesamemanneritishoweversimplertobeginwiththenatural
monopolyandtoassumethatthelowermarginalcostsofthenaturalmonopolymaybemodelledas
constantratherthanrisingmarginalcosts.
Thebasiceconomiclogicusedbythemonopolististhesameasthatusedbythecompetitivefirm
INCREASEoutputifmarginalbenefitsareABOVEmarginalcosts.
DECREASEoutputifmarginalbenefitsareBELOWmarginalcosts.
STAYATTHECURRENTLEVELofoutputifmarginalbenefitsareEQUALtomarginalcosts.
Understandingtheapplicationofthislogicbyamonopolistrequires,however,carefulattentiontoboth
theCOSTsideandtheBENEFITside.

COSTSofaNATURALMONOPOLIST
thecostgraphofanaturalmonopolistisconstructedontheassumptionofconstantmarginalcosts.
Letusassumethat:
MC=k
wherekisaconstantmarginalcost.
WeknowthatVariablecost=sumofthemarginalcosts,
butifmarginalcostisconstantatk,wecancomputethismoreeasilyas
VC=kQ,whereQistheQuantityofoutput.
Sincetotalcost=fixedcost+variablecost,and

sinceaveragecost=TotalCost/Quantity,
wehaveforthenaturalmonopoly:
AC=(FC+kQ)/Q=FC/Q+k
AsQbecomeslarger,thefirsttermwilltendtozeroanotherwayofsayingthisisthataveragecostwill
fallasoutputincreases,andasoutputbecomesverylarge,ACwillapproachMC.
Graphically,theaveragecostcurveforanaturalmonopolylookslikethis:

MARGINALREVENUE
Whilemarginalrevenueisthesameaspriceforacompetitivefirm,itislessthanpriceforamonopolist.
Acompetitivewheatfarmerwilltakethepriceofwheatasgivenbythemarketat(say)$5abushel.
Sellinganotherbushelofwheatbringsthefarmeramarginalrevenueofanother$5.
Themonopolistdoesnottakethepriceofhisproductasgiven.Indeed,heknowsthatinordertosell
morehewillhavetoREDUCEthepriceofhisproduct.Inourintroductorymodelofmonopoly,we
assumethatthemonopolistcannotpricediscriminatethatis,thathemustsellalloutputatthesame
price.
Incalculatingmarginalrevenue,themonopolistwillhavetoconsiderconsumerdemand.Monopolists
maybetheonlyonesellingtheproduct,buttheycannotforceconsumerstobuymorethantheywish.
LetusassumethAtdemandisgivenbytheequation
P=30002Q

Notethatitisconvenienttowritethedemandequationwithpriceonthelefthandsideoftheequation.
TofindREVENUEweneedonlymultiplythedemandequationthroughbyQ.
REVENUE=PQ=3000Q2Q*Q
Thisequationmaybeusedtocalculatemarginalrevenue.Simplyconsidertherevenueatquantitiesof
(say)500and501andcalculatetheCHANGEINREVENUE.
AtQ=500,P=30002(500)=2000andhencerevenue=PQ=1,000,000.AtQ=501,P=3000
2(501)=1998andhencerevenue=PQ=1,000,998.
MarginalrevenueatQ=500is$998.
NotethatMarginalrevenueislessthanpricemarginalrevenueis$998andpricewas$2000.
NoteforthosewhohaVetakencalculus:
marginalrevenue,likeallmarginalconcepts,dealswithchanges.

Incalculus,youlearnthattofindthechangeinafunction,youdifferentiatethefunctionifwe
differentiatetherevenuefunctionabovewiththeaidofthepowerrulewefindthat
MR=30004Q
Noteforthosewhohavenottakencalculus:
TheMARGINALREVENUEfunctionmaybederivedfromastraightlinedemandequationby:
1. Arrangingthedemandequationwithpriceonthelefthandside.
Thatis,giventheequationQd=1500.5P,
rearrangeittoreadP=30002Q
2. Doublingthecoefficientonthequantityterm.
Withthepreviousdemandequation,marginalrevenueis:
MR=30004Q
Afulljustificationofthistrickrequirescalculus,butnotethatitworks:
atQ=500,MR=30004(500)=$1000,
closetothe$998calculatedabove.
(Ifwehadused500.5,halfwaybetweenourtwovalues,wewouldbeexactlyontarget)
GRAPHICALLY,themarginalrevenuecurvewillbeslopingdownwardandfallingexactlytwice
assteeplyasthedemandcurve.

MonopolyOutputandPricingDecisions
OUTPUT
ChoosetheoutputlevelatwhichMC=MR.
IfweassumethatMC=500andDEMANDisgivenbyQ=1500.5P
wefindasabovethatMR=30004Q.
Monopolyoutputwillbefoundbysetting
MR=MC
30004Q=500
4Q=3000500
Q=2500/4=625
PRICE
Monopolypricewillbefoundbylookingatthedemandcurveandchargingasmuchasthemarket
willbearforthelevelofoutputchosen.
SinceDEMANDis

P=30002Q
atQ=375,thepricechargedbythemonopolywillbe
P=30002(625)=30001250=$1750.
Priceismuchhigherthanthemarginalcostof$500.
Profits
Operatingprofit=REVENUEVARIABLECOST
Inthecaseabove,REVENUE=PQ=($1750)(625)=$1,093,750
VARIABLECOST=MCxQ=$500x625=$312,500
OPERATINGPROFIT=PQVC=1,093,750312,500=$781,250
Withoutafiguregivenforfixedcosts,wecannottellifthemonopolyismakinganoverallprofitor
not.
Youcanhowevervarytheoutputdecisionandseeifthemonopolyhasinfactfoundtheprofit
maximizingoutputlevel.
Assumethemonopolydecidedtoproduce600unitsofoutput.Whatwoulditsrevenues,
variablecostsandoperatingprofitbe?
Clickhereforanswer
Assumethemonopolydecidedtoproduce700unitsofoutput.Whatwoulditsrevenues,
variablecostsandoperatingprofitbe?
Clickhereforanswer
MOREMONOPOLYPROBLEMS
BacktoUPJEconomicsDepartment

You might also like