Elasticity and tax incidence

Elasticity and tax burden

¨ The tax incidence is also determined by the elasticity of supply and
demand of a good.
¤ The more elastic demand and less elastic supply, the larger burden of taxes
on suppliers.
¤ The more elastic supply and less elastic demand, the larger tax burdens on
the buyers of the good.
¨ Because elasticity measures how sellers and buyers are able or willing
to leave the market when tax increases market price. So the party
who is less able to leave the market tends to take more tax burdens.
 Case study: Tax on Cars
14-3

¨ Assume the car market is constant-cost

and perfectly competitive Deadweight loss
n No external costs or benefits
S+T
¨ Initial equilibrium is $20,000 and 6 22

Cost ($000s/car)
million cars 20 S
¤ $2,000 tax on cars shifts supply curve Buyer’s
up tax
burden
n New equilibrium at $22,000 and 4
million
n Total surplus decreases D

¨ When supply is perfectly elastic, 4 6

all the tax burden is on the buyers. Quantity (millions of cars/year)

©McGraw-Hill Education. All rights reserved.

Elasticity and tax incidence (tax burden)
BUSI1117
LECTURE 8 MARKET STRUCTURE AND
MONOPOLY
NUBS China
2024/25 Semester 1
Learning objectives
¨ Distinguish among three types of imperfectly competitive industries and
describe how imperfect competition differs from perfect competition
¨ Identify the five sources of monopoly power and describe why economies
of scale are the most enduring of the various sources of market power
¨ Apply the concepts of marginal cost and marginal revenue to find the
output and price that maximizes a monopolist's profits
¨ Explain why the profit-maximizing output level for a monopolist is too small
from society's perspective
¨ Discuss the three types of price discrimination for a monopolist

FRA Chapter 8;
PIN Chapter 10.1-10.4; 11.1-11.2
SLO: Chapter 7.4
Overview
¨ Imperfect competition
¨ Monopoly
¤ Profit maximization for the monopolist
¤ Welfare cost of monopoly

¨ Price discrimination
Imperfect competition
¨ Imperfectly competitive firms have some ability to set their own price:
they are price setters
¤ Long-run economic profits possible
¤ Reduce economic surplus

¨ Three types:
1. Monopoly has only one seller, no close substitutes
2. Monopolistic competition has many firms producing slightly differentiated
products that are reasonably close substitutes
3. Oligopoly has a small number of large firms producing products that are
close substitutes
Examples
¨ Monopoly:
¤ Most utilities, such as electricity, natural gas, water, etc.
¤ e.g. State Grid Corporation of China
¤ Monopolist can usually operate with lower marginal cost than its potential competitors.
This cost advantage associated with large size are one of the primary reasons for
monopoly.
¤ Usually granted with legal rights from the government.
¨ Oligopoly:
¤ Some sell undifferentiated products, e.g. China Mobile, China Telecom, China Unicom
¤ Some sell differentiated products, e.g. Airbus and Boeing
¨ Monopolistic competition
¤ Most prevalent in the market, such as various brands of toothpaste, cosmetics, etc.
The Essential Difference
¨ Market power is the firm's ability to raise its price without losing all its sales
¨ Any firm facing a downward sloping demand curve
¤ Firm picks P and Q on the demand curve

¨ Market power comes from factors that limit competition

Imperfectly Perfectly
Competitive Firm Competitive Firm
Price

Price
D

D
Quantity Quantity
©McGraw-Hill Education. All rights reserved. 7-10
Sources of market power
¨ Market power: the ability to set prices of firms’ products.
¨ Sources of market power:
¤ Exclusive control over important inputs
¤ Patents and copyrights

¤ Government licenses or franchises

¤ Economies of scale

¤ Network economies
Exclusive control over important inputs
¨ A single firm controls an input essential to the production of a given
product: barriers to entry
DeBeers, one of the largest diamond
corporations in the world, possesses
40% of diamond processing and
trading.
Patents and copyrights
¨ Patents, the exclusive right to sell a product
for a specific period of time, given to the
developer or inventor. Copyrights, protect the
authors of movies, software, music, books and
other published works.
¨ Legal barriers to limit competition
¨ Example: pharmaceutical companies(recently
the protection intervals increased from 20
years to 25 years in China. )
Government licenses and franchises
¨ Presents as legal barriers to entry
¨ Example: Macau International Airport Company

¨ The company won the franchise contract from the Macau government to
develop the air transport sector in Macau for a term of 25 years. The firm
has successfully obtained the extension of its concession contract in 2001,
giving the company monopoly power in the industry up to the year 2039.
Market Power: Economies of Scale
¨ Economies of scale: if average costs decrease as output increases
¨ Natural monopoly: a monopoly that results from economies of scale
¨ Example: natural gas distribution, electricity generation

©McGraw-Hill Education. All rights reserved. 7-15

Economies of scale
¨ A growing share of the value of goods and services we buy now
comes from fixed investment in Research and Development.
¨ e.g. fixed cost now accounts for about 85% of total costs in computer
software industry.
¨ A leading example is Intel
Intel's Advantage
¨ Development cost of a new chip …………$2 billion
¨ Marginal cost of making a chip ………….Pennies
¨ Dominating the market ………...Priceless

¨ Intel supplies more than 80% of the processors for PCs

¨ The larger market a firm serves, the lower average cost the firm
can sell products at.

©McGraw-Hill Education. All rights reserved. 7-17

Economies of Scale

Average cost ($/unit)

Total cost ($/year)

TC = F + M Q ATC = F/Q + M
F

Quantity Quantity

©McGraw-Hill Education. All rights reserved. 7-18

Market Power: Network Economies
¨ Network economies occur when the value of the product increases as
the number of users increases. Similar to economies of scale. Adding
an additional user costs the firm almost zero, but financial benefit
increases may be huge as more users interact and trade.
¤ Windows operating system: currently installed in more than 80% of all
personal computers.
¤ TMall and Taobao
¤ Facebook

©McGraw-Hill Education. All rights reserved. 7-19

MONOPOLY
Profit maximization for a monopolist
¨ Being the only supplier in a market, can a monopolist charge any price
it wants?
¤ No.
¤ Because demand curve is downward sloping.

¨ So how to decide output and price for a monopoly?

¤ A monopolist must decide how much to sell and the price is then determined
directly from the market demand curve
¤ Or it can determine price, and the quantity it should sell at that price is
determined by the market demand curve
Profit Maximization for a Monopolist
¨ Major difference between a monopolistic market and a perfectly
competitive market is the marginal revenue curve.
¨ Marginal benefit/marginal revenue:
¤ Change in total revenue from a one-unit change in output
¤ Equal to price for the perfectly competitive firm

¤ Less than price for the monopolist

©McGraw-Hill Education. All rights reserved. 7-22

Profit Maximization for the Monopolist
¨ Different from a perfectly competitive market, where a firm can sell at the market price
for any quantities, selling another unit the monopolist must lower price
¤ Total revenue from 2 units = $12
¤ Total revenue from 3 units = $15
n Marginal revenue = $3 < price

Price ($/unit)

6
5
D

2 3
Quantity (units/week)

©McGraw-Hill Education. All rights reserved. 7-23

Monopolist's Marginal Revenue

Price & marginal revenue ($/unit)

8

3
D
1

-1 8
2 3 4 5 MR
Quantity (units/week)

Price Quantity Total Revenue

$6 2 $12 Marginal Revenue
$5 3 $15 3
$4 4 $16 1
$3 5 $15 -1

©McGraw-Hill Education. All rights reserved. 7-24

Monopoly Demand and Marginal Revenue

a
¨ The monopolist's marginal
revenue curve:
¤ Has the same intercept as the
Price

straight-line demand curve

a/2 ¤ Has twice the slope of the
demand curve
D
MR ¤ Lies below the demand curve

Q0
Q0/2
Quantity

©McGraw-Hill Education. All rights reserved. 7-25

Monopoly Demand and Marginal Revenue
¤ Mathematical proof of the
a
slope of the marginal revenue
curve
Price

n Suppose P= a – bQ
a/2 n Total revenue (TR) = PQ =
aQ – bQ2
D
MR n MR=∆TR/∆Q=a – 2bQ
¨ Proved
Q0
Q0/2
Quantity

©McGraw-Hill Education. All rights reserved. 7-26

Profit maximization for a monopolist- choosing
output
¨ Like all other firms, a monopolist:
¤ Maximizes profits
¤ Applies the Cost-Benefit Principle:
n Increase output if marginal benefit > marginal cost
n Decrease output is marginal benefit < marginal cost
Profit maximization for a monopolist- choosing output

Q* is the output level at which MR =

MC.
If the firm produces a smaller output—
say, Q1—it sacrifices some profit
because the extra revenue that could
be earned from producing and selling
the units between Q1 and Q* exceeds
the cost of producing them.
Similarly, expanding output from Q* to
Q2 would reduce profit because the
additional cost would exceed the
additional revenue.
A numeric example of profit max of a monopolist

Cost of production : C(Q ) = 50 + Q 2

Demand : P (Q ) = 40 - Q
TR = PQ = 40Q - Q 2
MR = 40 - 2Q
MC = 2Q
MR = MC
40 - 2Q = 2Q
Q = 10
A numeric example of profit max of a monopolist
Cost of production : C(Q ) = 50 + Q 2
Demand : P (Q ) = 40 - Q

Part (a) shows total revenue R, total cost C, and profit, the difference
between the two.

Part (b) shows average and marginal revenue and average and
marginal cost.

Marginal revenue is the slope of the total revenue curve, and marginal
cost is the slope of the total cost curve.

The profit-maximizing output is Q* = 10, the point where marginal

revenue equals marginal cost.

At this output level, the slope of the profit curve is zero, and the slopes
of the total revenue and total cost curves are equal.

The profit per unit is $15, the difference between average revenue and
average cost. Because 10 units are produced, total profit is $150.
Profit maximization for a monopolist- choosing
output
¨ A profit maximizing monopolist chooses output so that MR=MC, P>MC.
¨ Does it mean a monopolist will always earn a positive economic profit?
¤ No.
Monopoly Profits and losses
¨ Profit = Total revenue – total cost
¤ Total cost = ATC x Q
¤ Profit = P x Q – ATC x Q

¤ Profit = (P-ATC) x Q

¨ If P > ATC then the firm earns a profit

¨ If P < ATC then the firm suffers a loss
¨ This can be graphically illustrated

©McGraw-Hill Education. All rights reserved. 7-32

Monopoly Losses and Profits
Example: Long-distance telephone service provider

Economic loss Economic profit

= $400,000/day = $400,000/day
0.12
ATC
Price ($/minute)

0.10

Price ($/minute)
0.10
0.08
ATC
0.05 MC 0.05 MC
D D
MR
MR
20 24
20 24
Minutes (millions/day)
Minutes (millions/day)

©McGraw-Hill Education. All rights reserved. 7-33

Profit maximizing monopolist – choosing price
¨ MR =dTR/ dQ = d(PQ)/dQ
¨ MR =P*dQ/dQ + Q*dP/dQ
¨ MR= P+Q*dP/dQ
¨ Extra revenue from an incremental unit of quantity has two
components:
¤ producing one extra unit and sells at price P brings in revenue 1*P=P
¤ but b/c of downward sloping demand curve, producing and selling this
extra unit also results in a small price drop dP/dQ, which reduces the
revenue from all units sold (i.e. a change in revenue Q*(dP/dQ))
Profit maximizing monopolist – choosing price
dP
dP Q dP 1
MR = P + Q ´ = P+P = P + P´ P = P + P´
dQ P dQ dQ Ed
Q
¨ Because MR=MC at profit maximizing point,
¨ P+P*(1/Ed)= MC
q The markup over MC as a
P - MC 1 percentage of price should
=-
P Ed equal minus the inverse of the
MC elasticity of demand
P= q Price is directly a markup over
1
1+ marginal cost
Ed
Profit maximizing monopolist – choosing price
¨ A monopolist chooses a price that exceeds marginal cost, by an
amount that depends on the inverse of elasticity of demand.
¤ When demand is very elastic, price will be very close to marginal cost.
¤ In the extreme case where demand is perfectly elastic (perfectly competitive
market), price will be equal to MC.
¤ When demand is very elastic, there is little benefit to being a monopolist.
A monopolistic market has no supply curve
¨ The reason is that the monopolist’s output decision depends not only on
marginal cost but also on the shape of the demand curve.
¨ Shifts in demand can lead to:
¤ changes in price with no change in output
¤ changes in output with no change in price

¤ changes in both price and output

A monopolistic market has no supply curve
The Social Costs of Monopoly
The shaded rectangle and triangles show
changes in consumer and producer surplus
when moving from competitive price and D
quantity, Pc and Qc, to a monopolist’s price
and quantity, Pm and Qm.
Because of the higher price, consumers lose A
+ B and producer gains A − C. The
deadweight loss is B + C. E
Socially optimal case Monopoly case
CS: A+B+D CS: D
PS: E+C PS: A+E

TS: A+B+C+D+E TS: A+D+E

Total DWL: B+C
 The Social Costs of Monopoly

Actual loss in social welfare may be

higher because of rent seeking D
(spending money in socially
unproductive efforts to acquire,
maintain, or exercise monopoly.)
We would expect the economic incentive
to incur rent-seeking costs to bear a E
direct relation to the gains from
monopoly power (i.e., rectangle A minus
triangle C.) The larger A is, the greater
DWL
Monopoly and Perfect Competition
Monopoly: Perfect Competition

MC = MR MC = MR

P >MR P = MR
P > MC P = MC

Deadweight No Deadweight
Loss Loss

©McGraw-Hill Education. All rights reserved. 7-41

PRICE DISCRIMINATION
Price discrimination
¨ Price discrimination means charging different buyers different prices
for essentially the same good or service
¨ Many forms of price discrimination
¤ First degree price discrimination (Perfect discrimination): charge each
buyer the reservation price for each unit of product
¤ Second degree price discrimination: charge consumers with different prices
according to the quantity they buy (e.g. quantity discounts)
¤ Third degree price discrimination (hurdle method) : charge different price
for separate groups
Price discrimination
First degree price discrimination
Because the firm charges each consumer Variable profit
= TR – VC =
her reservation price, it is profitable to
expand output to Q**. å MR - å MC

When only a single price, P*, is charged,

the firm’s variable profit is the area
between the marginal revenue and
marginal cost curves.
With perfect price discrimination, this
profit expands to the area between the
demand curve and the marginal cost
curve.
Consumer surplus reduces to zero. All
surpluses are captured by the producer.
Carla the Editor: Social Optimum
What is the social optimum? 6 papers with an economic profit of $6
Opportunity cost of Carla's time is $29 (=180-29*6)
Reservation
Student Total Revenue
Price
A $40 $40
B 38 $76
C 36 $108
D 34 $136
E 32 $160
F 30 $180
G 28 $196
©McGraw-Hill Education. All rights reserved. 7-46
 Carla the Editor: Social Optimum

Student Reservation Price Consumer Producer

surplus surplus
A $40 $40 – 30 =10 $30 – 29 =1
B 38 $38 – 30 =8 $30 – 29 =1
C 36 $36 – 30 =6 $30 – 29 =1
D 34 $34 – 30 =4 $30 – 29 =1
E 32 $32 – 30 =2 $30 – 29 =1
F 30 $30 – 30 = 0 $30 – 29 =1
Total 30 6 Total surplus:
30+6 =36
7-47
Carla the Editor: Profit maximizer
What is Carla's marginal revenue?
¨ Opportunity cost of Carla's time is $29

Reservation
Student Total Revenue MR
Price
A $40 $40 $40
B 38 $76 $36
C 36 $108 $32
D 34 $136 $28
E 32 $160 $24
F 30 $180 $20
G 28 $196 $16
3 papers with an economic profit of $21 (=108-29*3)
7-48
Carla the Editor: Profit maximizer
What is Carla's marginal revenue?
¨ Opportunity cost of Carla's time is $29

Reservation Consumer Producer

Student
Price surplus surplus
A $40 $40 – 36 = 4 $36 – 29 = 7
B 38 $38 – 36 = 2 $36 – 29 = 7
C 36 $36 – 36 = 0 $36 – 29 = 7
Total 6 21

Total surplus = 27

7-49
Carla the Editor: First degree price discrimination

¨ Suppose Carla can discern student’s reservation price and can price discriminate
¨ Opportunity cost of Carla's time is $29
Reservation What is Carla's total
Student Total Revenue
Price revenue?
A $40 $40
B 38 $78 6 papers with an
economic profit of
C 36 $114
$36(=40+38+36+34+
D 34 $148 32+30 – 29*6)
E 32 $180
F 30 $210
G 28 $238
©McGraw-Hill Education. All rights reserved. 7-50
Carla the Editor: First degree price discrimination

Reservation Consumer Producer

Student
Price surplus surplus
A $40 $40 – 40 = 0 $40 – 29 = 11
B 38 $38 – 38 = 0 $38 – 29 = 9
C 36 $36 – 36 = 0 $36 – 29 = 7
D 34 $34 – 34 = 0 $34 – 29 = 5
E 32 $32 – 32 = 0 $32 – 29 = 3
F 30 $30 – 30 = 0 $30 – 29 = 1
Total 0 36
Total surplus = 36
©McGraw-Hill Education. All rights reserved.
7-51
Carla the Editor: First degree price discrimination

¨ Carla’s profit maximizing level of output under perfect price

discrimination was exactly the same as the socially efficient level of
output (6 papers per week)
¨ Consumer surplus exactly zero and producer surplus equals to total
economic surplus.
First degree price discrimination
¨ In practice, perfect price discrimination can never occur, because
¤ Difficulty to know the reservation price of buyers
¤ Difficulty to charge each buyer a different price

¨ But in many cases, firms can discriminate imperfectly by charging a

few different prices based on estimates of buyers’ reservation prices.
(called imperfect price discrimination)
¨ Examples: lawyers, accountants, doctors who know their clients well