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Intermediate Microeconomic Theory

by: Armand Homenick

Intermediate Microeconomic Theory IAS 106

Armand Homenick

GPA 3.88


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This 7 page Class Notes was uploaded by Armand Homenick on Thursday October 22, 2015. The Class Notes belongs to IAS 106 at University of California - Berkeley taught by Staff in Fall. Since its upload, it has received 53 views. For similar materials see /class/226620/ias-106-university-of-california-berkeley in International and Area Studies at University of California - Berkeley.

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Date Created: 10/22/15
Monopoly and Monopolistic Competition IAS 106 jenny C Aker Market Power Monopoly and Monopolistic Competition Key Concepts monopoly natural monopoly output rule monopsony marginal revenue monopolistic competition average revenue oligopoly price elasticity of demand market power Lerner index Key Equations MRpApAQQ Output rule MRMC but p MR Lerner index p MC p 1 a Monopoly Profit Maximization A monopoly is the only supplier of a good for which there is no close substitute What does this imply This implies that o The firm s output q is equal to the market output We will use these interchangeably o The firms faces the downward sloping market demand curve not a horizontal residual demand curve Therefore the monopolist can set price it isn t a price taker like the competitive firm Marginal Revenue for Competitive Firms 390 Monopolies Like the competitive firm the monopoly s output rule is MRMC In the competitive firm example the firm s marginal revenue curve was its demand curve For the monopoly its MR curve likes below the demand curve at any positive quantity Recall that for the competitive firm TRpq MRATR Aq Monopoly and Monopolistic Competition IAS 106 jenny C Aker For the competitive firm the marginal revenue average revenueprice since it faced a perfectly horizontal demand curve price taker In other words the competitive firm can sell another unit of output without dropping its price See Figure 11 This isn t the case with a monopoly The monopoly faces a downward sloping demand curve So when selling Q1 at price p1 it can only sell an extra unit Q2 Q11 by dropping its price to p2 see Figure 12 lts initial revenue is p1Q1 which is AC When it sells the extra unit at Q2 its revenue is AB Therefore its marginal revenue is ATRR1R2ABACB C Therefore the monopoly gets MORE revenue from the extra output but loses revenue because it has to lower the price For the monopolist then MR ARp Figure 1 Deriving Muthemuticu lly the MR Curve for u Monopoly Let s look at this another way The monopoly s MR curve lies below the demand curve at every positive quantity as in Figure 2 how much below depends on the shape of the original demand curve An example of the D curve and the MR curve for a linear demand curve is shown in Figure 2 Monopoly and Monopolistic Competition IAS 106 jenny C Aker Figure 2 The actual equation for the monopoly s MR curve is the following derived using calculus 1 MRPAP AQ Q Why does it take this form Well since MRATR AQ for the monopoly to increase its Q by AQ it must lower its price by Ap AQ the slope of the demand curve So it loses Ap AQQ on the units it originally sold at the higher prices but earns an additional p on the extra output sold Since the second term in equation 1 is negative then pgtMR This can be done using a specific functional form of the demand function Example Suppose that demand is Q24 p Then inverse demand is p24 Q What is the slope of the inverse demand curve 1 which is just the coefficient on Q The MR of this function is just MRpAp AQQ 24Q 1Q 24 2Q Notice that the slope of this MR curve is 2 the coefficient on Q which is twice as big as the coefficient on the demand curve 1 Therefore the MR curve is twice as steep This relates to Max s point in the notes that if the inverse demand curve is linear PQabQ then the MRQa2bQ The MR Curve and Elusiicities Remember Those Monopoly and Monopolistic Competition IAS 106 jenny C Aker Remember something called the price elasticity of demand The price elasticity of demand tells us the percentage by which Q demanded changes for a one percent change in price In other words AQ Q AP P39 AQ AP P Q How does this relate to the MR of a monopolist Well let s substitute in MRPAPAQQ39P P1 39 P11 a What does this say This says that the MR of the monopoly is closer to price as 5900 in other words as the demand curve becomes more elastic ie as it approaches the competitive firm scenario and that it is negative as the demand curve is inelastic ie as 590 This says that the monoplist will never produce in the inelastic portion of the demand curve where MR is negative as is seen in Figure 3 Figure 3 Choosing Price or Quantity The TwoStep Approach Recall that the competitive firm maximized profits by choosing the optimal quantity ie where MRMC taking price as a given The monoplist uses the same rule but it can set either price or quantity It is only contrained by the market demand curve If the monpolist sets p the demand curve tells which q it can sell and vice versa What is the two step approach to maximize profits for the monopoly First it determines output to maximize profits Q then it determines whether or not it will produce Qquot or shut down using the shutdown rule Monopoly and Monopolistic Competition IAS 106 jenny C Aker The output rule is the same as before MRMC But now MR has changed as we see in Figure 4 Figure 4 For this figure we see that the monopolist s profit is maximized in the elastic portion of the demand curve as we saw from the MR equation above The shutdown rule is also the same as before the monopolist will shut down if the priceltmini1num of the AVC Market Power The monopoly has market power ie it can charge a price above its MC and therefore earn a positive profit unlike the competitive firm The degree to which the monopoly raises its price above marginal costs depends on the shape of the demand curve at Qquot or the elasticity of demand In other words since Qquot is determined where MRMC and MR p11 MC then we can rearrange terms to get PMC111 a This says that the amount that price exceeds MC depends upon the elasticity of demand As 5 00 or as demand becomes elastic then PMC and we have the competitive case As 50 demand is inelastic then PgtMC and there is a markup This can also be written as the Lerner Index or price markup PMCP1 Monopoly and Monopolian Competition IAS 106 jenny C Aker which ranges from 0 to 1 not greater than one What is the Lerner index of a competitive firm Zero but why What is the Lerner index for a monopoly 1but why Can all monopolies then set price above MC No Why Getting Market Power How can a monopoly s market power be reduced By in uencing the elasticity of demand There are three main ways to increase the elasticity of demand 0 More substitutes for the firm s product 0 More firms entering the market selling the same market 0 Firms that provide the same service move closer to the original firm Monopolies and Welfare Recall that total welfare is PS CS Will W under a monopoly be greater or less than under perfect competition Less because of the DWL See the comparison of welfare in Figure 5 Figure 5 Monopoly and Monopolistic Competition IAS 106 jenny C Aker Welfare questions for a monopoly o How would a specific tax affect the monopoly optimal output and the welfare of consumers the monopoly and the society What is the DWL o What about for an ad valorum tax See Figure 6 What Creates Monopo lies Cost Advantages In general cost advantages create monopolies What create such cost advantages Well there are several potential reasons 0 The monopolist controls a key input such as a palm oil refinery that owns the palm tree plantations 0 Superior knowledge in production or distribution 0 Economies of scale natural monopoly However governments can create monopolies by changing the policy environment and favoring one supplier Monopolistic Competition Monopolistic competition is a market structure where there are many firms like a competitive market but these firms have some market power ie they are able to set price above MC profitably In this case there are 0 Many firms 0 Free entry and exit 0 Differentiated products the firms face downward sloping demand But the degree of market power depends on the degree of differentiation and the elasticity of demand The firm will set its optimal output q where MRMC and can make positive profits in the short run but will make 0 profits in the long run as is shown below This is different from oligopolies where there are a few firms there is restricted entry exit the firms have market power but they make positive profits usually


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