Recommended Texts
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 1
www.covenantuniversity.edu.ng
Raising a new Generation of Leaders
Topic – Monopoly
ECN421 – Advanced Microeconomic Theory (II)
Put away all distractions…!
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 3
Learning Objectives..…
Students should know and understand:
1. The basic features of a monopolistic market
2. Causes of monopoly
3. Profit maximisation conditions
4. Markup pricing and elasticity of demand
5. Monopoly inefficiency
6. Deadweight loss
7. Natural monopoly
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory
4
4
Monopoly
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 5
Monopoly..…Basic Features
𝑑𝑝
1. Defined as an industry 7. In PC, since = 0; 𝑀𝑅 = 𝑝𝑟𝑖𝑐𝑒
𝑑𝑦
structure with only one firm.
2. Not a price-maker 8. The demand curve has a unique
𝑑𝑝
3. Profit is maximised by inverse: 𝑝 = 𝑓(𝑦); where < 0.
𝑑𝑦
variations in price or output,
9. As price falls quantity sold
but not both.
increases
4. Total revenue is given by:
𝑅 𝑦 i.e. 𝑝 𝑦 𝑦 10.The marginal revenue function
𝑑𝑅 𝑑𝑝 (−2𝑏) is twice as steep as the
5. Then, 𝑀𝑅 = = 𝑝 + 𝑦( ) market demand function (−𝑏)
𝑑𝑦 𝑑𝑦
6. Since
𝑑𝑝
< 0; 𝑀𝑅 < 𝑝𝑟𝑖𝑐𝑒 (shown in the subsequent graph).
𝑑𝑦
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory
6
6
Causes of Monopoly
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 7
Some Causes of Monopoly….
1. Size of the minimum efficient scale 6. Restrictive foreign trade
(due to falling long-run average
7. Market size: it may not
costs) relative to market size
accommodate more than one firm
2. Exclusive knowledge of
production technique - patents, (natural monopoly)
trademarks, copyrights, brand 8. Pricing policy: made by
names etc. incumbent to prevent new entry
3. Government franchise/licence
9. Collusion (formation of Cartels)
4. Huge fixed costs outlay (e.g.
telecoms, oil and gas etc)
5. Ownership of strategic raw
material(s)
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 8
8
Profit-Maximisation and
Elasticity of Demand
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 9
Profit Maximisation……
The monopolist maximises profit
where: 𝑴𝑹 = 𝑴𝑪
1. That is: max 𝑅 𝑦 − 𝐶(𝑦)
2. Implies: 𝑟′ 𝑦 = 𝑐′(𝑦)
3. Output will increase if: 𝑟′ 𝑦 > 𝑐′(𝑦)
and vice-versa
Note: under Competition: 𝑴𝑹 = 𝑷 but
with monopoly, 𝑴𝑹 < 𝑷
Reason: the monopolist chooses
between 𝑝 and 𝑦. That is, to sell more
output (∆𝑦) it has to lower its price (∆𝑝).
The effect on revenue is:
∆𝒓 = 𝒑∆𝒚 + 𝒚∆𝒑
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 10
10
Profit Maximisation…and Elasticity
Note that: FOC: 𝒓′ 𝒚 = 𝒄′(𝒚) Using the inverse demand function:
Implies that marginal revenue should From [1]: max 𝑝𝑦 − 𝐶(𝑦)
equal marginal cost at the optimal Implies that: [𝑝 +𝑝′ 𝑦 𝑦] = 𝑐′(𝑦)
output level.
In elasticity form:
𝑑𝑝 𝑦 ′
The SOC: 𝒓′′ 𝒚 − 𝒄′′ 𝒚 ≤ 𝟎
𝑝 1 + 𝑑𝑦 𝑝
= 𝑐 𝑦
And implies that: Thus:
1
𝒄′′ 𝒚 ≥ 𝒓′′ 𝒚 𝑀𝑅 = 𝑝 1 + ∈ (𝑦) = 𝑀𝐶
Shows that the slope of the marginal cost Since elasticity is naturally negative:
exceeds that of the marginal revenue. 1
𝑀𝑅 = 𝑝 1 − |∈ 𝑦 |
= 𝑀𝐶
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 11
11
Profit Maximisation…and Elasticity
The revenue decisions of a 2. Inelastic demand, ∈ < 1, implies
monopolist is closely related to the that |∈1 | > 1 , thus, MR < 0 which
nature of elasticity of demand cannot equate MC. So, the monopolist
facing its products. will not choose to operate in this
case.
Remember that:
𝑀𝑅 = 𝑝 1 − |∈1 | = 𝑀𝐶 3. Elastic demand, ∈ > 1, implies
that |∈1 | < 1, thus, MR > 0. So, for the
monopolist profit maximisation
1. Infinitely elastic demand,
occurs where demand is elastic.
∈ = ∞ , implies that |∈1 | = 0 ,
equates to a competitive case.
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 12
12
Basis of Mark-up Pricing
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 13
Mark-up Pricing and
Constant Elasticity
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 14
Markup Pricing…
• Monopolist optimal pricing • If demand is elastic, then the
policy can be written as: markup > 1.
𝑃𝑟𝑖𝑐𝑒 = 𝑀𝐶1 • With constant elasticity, the
1− monopolist will charge a price that
|∈|
is a constant mark-up on marginal
cost.
• market price is a markup over
marginal cost • Note: A constant elasticity
demand curve is of the form:
• thus, 𝑝𝑟𝑖𝑐𝑒 > 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 ∈.
q = Ap [E.g: q = 10p𝟑]
• the markup depends on the
where: q is quantity demanded, ∈ is
elasticity of demand
elasticity and A is a constant
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 15
15
Markup Pricing…and Constant Elasticity
• Empirical Explanation: • Therefore, optimal level of
output occurs where
𝑀𝐶
𝑃𝑟𝑖𝑐𝑒 = 1
1−
|∈|
where p(q) is price. Optimal Price is the constant
At maximum profit (optimal fraction higher than the initial
price) MR – MC. marginal cost.
So: = MC NB: with the markup on MC, price is
higher and output is lower.
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 16
16
Markup Pricing…and Constant Elasticity
• Graphical Illustration:
𝑀𝐶
1
1−
|∈|
is the constant fraction higher
than the initial marginal cost.
NB: with the markup on MC, price is
higher and output is lower.
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 17
17
Classroom Exercises
1) Suppose that a monopolist sells to two groups (A & B) that have
constant elasticity demand curves, with elasticity ∈1 and ∈2.
The marginal cost of production is constant at C. What price is
charged to each group?
2) Hint: 𝑃𝑟𝑖𝑐𝑒 = 𝑀𝐶
1
1−
|∈|
3) A monopoly firm faces a demand curve given by D(p) = 10p−3.
Its cost function is c(y) = 2y. What is its optimal level of output
and price?
4) Hint:
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 18
Classroom Exercises
3) A monopolist is operating at an output level where |∈ | = 3. The
government imposes a quantity tax of $6 per unit of output. If the
demand curve facing the monopolist is linear, how much does the
price rise?
4) What is the answer to the above question if the demand curve facing
the monopolist has constant elasticity?
1
5) Hint: Section 25.3 of Textbook: 1
1−
|∈|
6) Show mathematically that a monopolist always sets its price above
marginal cost.
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 19
Monopoly Inefficiency
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 20
Monopoly Inefficiency…
• Pareto efficient: impossible to p
make anyone better off without MC
Pm
hurting another.
Pnew Pareto improvement
Pc combination of price
and output
• Pareto inefficient: possible to
make anyone better off without
hurting another. MR MR’ DD
ym y yc
• Pareto efficiency is evident new
under perfect competition but Since 𝒚𝒎 < 𝒚𝒄 and 𝒑𝒎 > 𝒑𝒄 > 𝑴𝑪,
not with monopoly. there is room for Pareto improvement!
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 21
21
Monopoly Inefficiency…
How is Pareto improvement 4. So, it can reduce price and
possible? increase output i.e. fixing price
where: 𝒑𝒎 > 𝒑𝒏𝒆𝒘 > 𝑴𝑪
1. Consumers are already paying
more (𝒑𝒎) for less output (𝒚𝒎) 5. Consumers have more output at
lower price, the monopolist does
2. The MC is still unchanged
not incur extra MC and gets extra
whether output is at
surplus from the other units of
monopolistic or competition
output sold.
level
6. This arrangement makes both
3. The monopolist will not be
sides of the market better off!
incurring additional cost by
increasing output from 𝒚𝒎 to 𝒚𝒄
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 22
22
Deadweight Loss
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 23
Deadweight Loss…
• Deadweight loss measures the
total loss in efficiency due to
monopoly.
• The area 𝑩 + 𝑪 measures how
much worse off people are
paying the monopoly price than
paying the competitive price.
• Consumers’ surplus: goes up by
𝑨 and 𝑩
• Monopolist surplus: goes down
by 𝑨 and up by 𝑪
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 24
24
Natural Monopoly
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 25
Natural Monopoly……
Natural monopolies usually
operate under a government
franchise and are subject to
government regulation.
• public utilities (gas, electricity,
telephone) are often thought of
as natural monopolies
• often occurs when fixed costs
are big and marginal costs are
small
• occurs when 𝒑𝒎𝒄 = 𝑴𝑪 is
unprofitable
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 26
26
Brain Teasers
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 27
Brain Teasers….
1. If the monopolist’s demand 2. The monopolist faces a demand
function is 𝑄 = 60 − 0.4𝑃 and curve given by 𝐷 𝑝 = 100 − 2𝑝.
the cost function is Its cost function is 𝑐 𝑦 = 2𝑦. What
is the optimal level of output and
𝐶 = 30 + 50𝑄,
price?
1a) derive the profit-maximizing
output levels.
3. If the demand curve facing a
monopolist has a constant
1b) Show that the necessary and elasticity of 2, what will be the
sufficient conditions are satisfied. monopolist’s markup on marginal
cost?
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 28
28
…revise what you’ve
learnt…
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 29
Omega 2024/25 – Adv. Microeconomic Theory (ECN421) -
Game Theory 30
