Chapter 10
Slide 1
Perfect Competition
nReview of Perfect Competition
lP = LMC = LRAC
lNormal profits or zero economic profits in the long run
lLarge number of buyers and sellers
lHomogenous product
lPerfect information
lFirm is a price taker

Perfect Competition
Q
Q
P
P
Market
Individual Firm
D
S
Q0
P0
P0
D = MR = P
q0
LRAC
LMC

Chapter 10
Slide 3
Monopoly
nMonopoly
n 1) One seller - many buyers
n 2) One product (no good substitutes)
n 3) Barriers to entry
nThe monopolist is the supply-side of the market and has complete control over what is offered for
sale.
nProfits will be maximized at the level of output where marginal revenue equals marginal cost.

Chapter 10
Slide 4
Monopoly
nIf the firm produces a quantity at which MR > MC, the firm cannot be maximizing its profit because
it could increase its output and its profit would go up.
nIf the firm produces a quantity at which MR < MC, the firm cannot be maximizing its profit because
it could decrease its output and its profit would go up.
nThus, the only situation at which the monopolist cannot improve its profit by increasing or
decreasing output is where marginal revenue equals marginal cost. That is, if Q* denotes the
profit-maximizing output, then
nMR(Q*) = MC(Q*)
nMR ≠ P

Chapter 10
Slide 5
Panel (a): Total cost TC increases as Q increases.
Total revenue TR first increases and then decreases,
and so does profit. The monopolist’s
profit is maximized at Q = 4 million ounces.
Panel (b): The monopolist’s profit-maximization
condition is MR = MC, where the marginal
revenue and marginal cost curves intersect.

Chapter 10
Slide 6
Average and Marginal Revenue
Output
0
1
2
3
$ per
unit of
output
1
2
3
4
5
6
7
4
5
6
7
Average Revenue (Demand)
Marginal
Revenue

Chapter 10
Slide 7
To increase output from 2 million to 5 million ounces per year, the monopolist must decrease price
from $10 to $7 per ounce. The gain in revenue due to the increased output of 3 million units (the
marginal units) is equal to area III, while the revenue sacrificed on the 2 million units (the
inframarginal units) it could have sold at the higher price is equal to area I. Thus, the change in
total revenue equals area III – area I.

Chapter 10
Slide 8
Marginal revenue (MR)
n
n
n
nMR consists of two parts:
nThe first part, P, corresponds to the increase in revenue due to higher volume—the marginal units
nThe second part, which is negative, since ΔP is negative), corresponds to the decrease in revenue
due to the reduced price of the inframarginal units and than MR < P   =>  the marginal revenue is
less than the price the monopolist can charge to sell that quantity, for any quantity greater than
0
n         when Q= 0 than MR = P

Average and marginal revenue
n
Chapter 10
Slide 9
Panel (a): Total revenue TR= PxQ= 7x5 = $35 million per year.
Panel (b): Average revenue AR=TR/Q = 35/5 = $7 per ounce.
Marginal revenue
MR = P+ Q(ΔP/ΔQ)= 7 + 5(-1) =  $2 per ounce.
The total revenue curve in panel (a) reaches its maximum when Q =6, the same quantity at which MR=
0 in panel (b).
AR=P

Chapter 10
Slide 10
The relationship between average revenue and marginal revenue is consistent
with other average–marginal relationship. When the average of something is falling, the marginal of
that thing must be below the average. Because market demand slopes downward (i.e., is falling) and
the average revenue curve corresponds to the demand curve, the marginal revenue curve must be below
the average revenue curve.

Chapter 10
Slide 11
Marginal and Average Revenue for a Linear Demand Curve
nSuppose that the equation of the market demand curve is:
nP= a – b*Q
nWhat are the expressions for the AR and MR curves?
n

Profit maximization condition
n
Chapter 10
Slide 12
The profit-maximizing output is 4 million ounces
per year, where MC=MR. To sell that output, the
monopolist will set a price of $8 per ounce (as indicated
by the demand curve D). Total revenue is
areas B+E+F. Total cost is area F. Profit (total
revenue minus total cost) is areas B+E.
Consumer surplus is area A.

Chapter 10
Slide 13
Marginal and Average Revenue for a Linear Demand Curve
nSuppose that the equation of the market demand curve is:
nP= 12 – Q
nif MC=Q What are the profit-maximizing quantity and price for the monopolist?
n

A monopolist does not have a supply curve
n
n
n
n
n
nFor the monopolist, however, price is endogenous, not exogenous
Chapter 10
Slide 14
When the demand curve is
D1, the monopolist’s profit-maximizing quantity is 5 and the profit-maximizing price is $15.
When the demand curve is D2, the profit-maximizing quantity is also 5, but the profit-maximizing
price is $20. Thus, the monopolist might sell the same quantity at
different prices, depending on demand.

Price elasticity of demand and profit-maximazing price
n
Chapter 10
Slide 15
In market A, the profit-maximizing price is PA. In market B, where demand is less price elastic at
the price PA, the profit-maximizing monopoly price is PB. The difference between the
profit-maximizing price and the marginal cost MC is smaller when demand is more price elastic.

Price elasticity of demand and profit-maximazing price
n
Chapter 10
Slide 16

Marginal Revenue and Price Elasticity of Demand for a
Linear Demand Curve
n
Chapter 10
Slide 17
Where demand is elastic, marginal revenue is positive. Where demand is unitary elastic, marginal
revenue is zero (i.e., MR crosses the horizontal axis). Where demand is inelastic, marginal revenue
is negative.

Monopolist produces on the elastic region of the market demand curve
n
Chapter 10
Slide 18
At point A, on the inelastic region of the demand curve D, the monopolist is charging
price PA, and selling quantity QA. If the monopolist raises price to PB and decreases
quantity to QB, thereby moving to point B on the elastic region of the demand curve, total revenue
increases by area I - area II, and total costs go down because the monopolist is producing less.
Thus, the
monopolist’s profits must go up.

Chapter 10
Slide 19
Monopoly
nObservations
lShifts in demand usually cause a change in both price and quantity.
lA monopolistic market has no supply curve.
lMonopolist may supply many different quantities at the same price.
lMonopolist may supply the same quantity at different prices.

Chapter 10
Slide 20
Measuring Monopoly Power
nMonopoly is rare. However, a market with several firms, each facing a downward sloping demand
curve will produce so that price exceeds marginal cost.
nIn perfect competition: P = MR = MC
nMonopoly power: P > MC

Chapter 10
Slide 21
Measuring Monopoly Power
nLerner’s Index of Monopoly Power
lL = (P - MC)/P, where the larger the value of L (between 0 and 1) the greater the degree of
monopoly power.
lL = (P - MC)/P = -1/Ed, where Ed   is elasticity of demand for a firm
nMonopoly power does not guarantee profits. Profit depends on average cost relative to price.

Chapter 10
Slide 22
B
A
Lost Consumer Surplus
Deadweight
Loss
Because of the higher
price, consumers lose
A+B and producer
gains A-C.
C
Social Cost of Monopoly: DWL
Quantity
AR
MR
MC
QC
PC
Pm
Qm
$/Q

Chapter 10
Slide 23
MC
Pm
Qm
AC
AR
MR
If left alone, a monopolist
produces Qm and charges Pm.
Price Regulation
$/Q
Quantity
If price is lowered to PC output
increases to its maximum QC and
there is no deadweight loss.
P2 = PC
Qc
Any price below P4 results
in the firm incurring a loss.
P4
P1
Q1
Marginal revenue curve
when price is regulated
to be no higher that P1.
For output levels above Q1 ,
the original average and
marginal revenue curves apply.
P3
Q3
Q’3
If price is lowered to P3 output
decreases and a shortage exists.

OUTPUT CHOICE WITH TWO PLANTS
Chapter 10
Slide 24
The monopolist’s multiplant
marginal cost curve MCT is the horizontal sum of the individual plant’s marginal cost curves
MC1 and MC2. The monopolist’s optimal
total output of 3.75 million
units per year occurs at
MR =MCT, where the optimal price is $6.25 per unit. Plant 1 produces 1.25 million units of the
total output, and plant 2 produces 2.5 million units.

Chapter 10
Slide 25
Multiplant Monopolist
nSuppose a monopolist faces a demand curve given by     P =120 - 3Q. The monopolist has two plants.
The first has a marginal cost curve given by MC1 = 10 + 20Q1, and the second plant’s marginal cost
curve is given by MC2 = 60 &#7;+ 5Q2
n
n(a) Find the monopolist’s optimal total quantity and price.
n(b) Find the optimal division of the monopolist’s quantity between its two plants.

Chapter 10
Slide 26
OUTPUT CHOICE WITH TWO MARKETS
nSky Tour is the only firm allowed to provide parasailing service on an island in the Caribbean.
The firm knows that there are two types of customers: those visiting the island on business and
those on vacation. The firm can charge whatever price it wishes for a parasailing trip, but it is
required to charge the same price P to all customers. The demand for a parasailing trip by business
customers is Q1(P) = 180 - P. The demand by customers on vacation is Q2(P) = 120 - P. The firm’s
marginal cost of providing a parasailing trip is MC(Q) = 30.
n(a) How many trips will the firm provide, and what price will the firm charge if it wishes to
maximize profits?

Chapter 10
Slide 27


Chapter 10
Slide 28
MC
AC
AR
MR
$/Q
Quantity
Setting the price at Pr
yields the largest possible
output; profit is zero.
Qr
Pr
PC
QC
If the price were regulate to be PC,
the firm would lose money
and go out of business.
Pm
Qm
Unregulated, the monopolist
would produce Qm and
charge Pm.
Natural Monopoly: Price Regulation

Chapter 10
Slide 29
nRegulation in Practice
lIt is very difficult to estimate the firm's cost and demand functions because they change with
evolving market conditions
lAn alternative pricing technique = rate-of-return regulation allows the firms to set a maximum
price based on the expected rate or return that the firm will earn.
lUsing this technique requires hearings to arrive at the respective figures.
Natural Monopoly: Regulation in Practice

Chapter 10
Slide 30
nSherman Act (1890)
lSection 1 prohibits contracts, combinations or conspiracies in restraint of trade
lExplicit agreement to restrict output or fix prices
lImplicit collusion through parallel conduct
lSection 2 makes it illegal to monopolize or attempt to monopolize a market and prohibits
conspiracies that result in monopolization.
Limiting Market Power: Antitrust Laws

Chapter 10
Slide 31
n1983: Six companies and six executives indicted for price of copper tubing
n1996: Archer Daniels Midland (ADM) pleaded guilty to price fixing for lysine - three sentenced to
prison in 1999
n1999: Roche A.G., BASF A.G., Rhone-Poulenc and Takeda pleaded guilty to price fixing of vitamins -
fined more than $1 billion.
Limiting Market Power: Antitrust Laws
Examples of Illegal Combinations

Chapter 10
Slide 32
nClayton Act (1914)
n 1) Makes it unlawful to require a buyer or lessor not to buy from a competitor
n 2) Prohibits predatory pricing
n 3) Prohibits mergers and acquisitions if they “substantially lessen competition” or “tend to
create a monopoly”
nRobinson-Patman Act (1936): Prohibits price discrimination if it is likely to injure the
competition
n
Limiting Market Power: Antitrust Laws

Chapter 10
Slide 33
nFederal Trade Commission Act (1914, amended 1938, 1973, 1975) n 1) Created the Federal Trade
Commission (FTC) n 2) Prohibitions against deceptive advertising, labeling, agreements with
retailer to exclude competing brands
Limiting Market Power: Antitrust Laws

Chapter 10
Slide 34
nAntitrust laws are enforced three ways:
1)Antitrust Division of the DOJ: a part of the executive branch (the administration can influence
enforcement). Fines levied on businesses; fines and imprisonment levied on individuals.
2)FTC: enforces through voluntary understanding or formal commission order.
3)Private Proceedings: Lawsuits for damages. Plaintiff can receive treble damages.
Limiting Market Power: Antitrust Laws