### A.9 Monopolistic Markets

Baye 6th edition or 7th edition, Chapter 8
BA 445 Lesson A.9 Monopolistic Markets
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Overview
Overview
BA 445 Lesson A.9 Monopolistic Markets
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Overview
Monopolistic Price and Quantity starts with quantity set where marginal cost
equals marginal revenue, then price set to the maximum willingness to pay for
the last unit.
Inefficient Output is implied when price and willingness to pay is greater than
marginal cost. — So, after your market purchases, there is a deal between you
and Microsoft that can benefit you both.
Monopolistically Competitive Entry and Exit drives profits to zero as in
competitive markets. — So, Pizza Hut profits from stuffed-crust pizza eventually
vanish, and profits require new variations.
Comparing Markets reveals different equilibrium for perfect competition,
monopoly, and monopolistic competition — So, Monsanto’s seed monopoly has
equilibrium unlike Pizza Hut’s pizza.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Monopolistic Price and Quantity
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Overview
Monopolistic Output maximizes profit with quantity equating
marginal revenue to marginal cost, then price equals the
maximum willingness to pay for that quantity.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Monopoly verses Perfect Competition
• Monopoly verses Perfect Competition differ in the price
or quantity interaction between firms:
 Perfect competition has other firms producing perfect
substitutes. That makes each firm’s demand perfectly
elastic, and each firm has to match other firms’ price.
 Monopoly has no other firm producing perfect
substitutes. That makes each firm’s demand less than
perfectly elastic.
• Demand inelasticity is called monopoly or market
power. If no one produces close substitutes to the
monopolist, there is more inelasticity and power.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Monopoly verses Perfect Competition
• The simplest monopoly model further assumes the price
and quantity chosen by the monopolist does not interact
with the prices and quantities chosen by other firms.
 That is never perfectly accurate since demand for
each good is affected by the prices of most other
goods, at least through the income effect.
• For example, the demand for computers is affected by the
price of gas.

We later (Part B) consider more complex and realistic
monopoly models where prices and quantity choices
interact with other firms, with those firms producing
either substitutes (like different kinds of computers) or
complements (like computer hardware and software).
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Monopoly verses Perfect Competition
• Monopoly verses Perfect Competition differ in the
potential entry of new firms:
 Perfect competition has free entry of firms producing
perfect substitutes.
• Any such entry takes the long-run since it takes the
long-run to adjust rented or owned capital.
• Monopoly has no entry of firms producing perfect
substitutes.
• The simplest monopoly model further assumes there is
no entry of firms whose prices or quantities affect the
demand for the monopolist’s product.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Natural Source of Monopoly Power
• The primary natural source of monopoly power is
economies of scale, meaning it is cheaper for one
firm to produce or supply a single product that it is to
divide production or supply between many firms.
• For example, it is cheaper to have a single grocery in
a neighborhood.
 When monopoly power comes from being the only
supplier in a neighborhood, call it a local
monopoly.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Artificial Sources of Monopoly Power
• Patents, copyrights, and other legal barriers to enter
an industry generate and sustain monopoly power.
 Copyrighted movies are monopolies because
there are no perfect substitutes.
 Monopoly power is limited by the closeness of
substitutes (like pirated copies of Armageddon, or
similar movies like Deep Impact)
• Collusion can generate monopoly power.
 OPEC (Organization of the Petroleum Exporting
Countries) would be a monopoly if all exporting
countries were included.
• Its monopoly power is limited by substitutes for
gas (like fuel efficient cars)
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Review: Monopolist’s Marginal Revenue
P
100
TR
Unit elastic
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
0
10
20
30
40
50 Q
0
10
20
30
40
50 Q
MR
Elastic
BA 445 Lesson A.9 Monopolistic Markets
Inelastic
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Monopolistic Price and Quantity
Set Monopolistic Quantity by increasing production
output until MR(QM) = MC(QM) . Then, charge the price
on the demand curve that corresponds to that quantity.
MC
\$
ATC
PM
D
QM
MR
BA 445 Lesson A.9 Monopolistic Markets
Q
12
Monopolistic Price and Quantity
Profit Computation
P = (P-ATC) x Q (from before)
MC
\$
ATC
Profit
PM
ATC
D
QM
MR
BA 445 Lesson A.9 Monopolistic Markets
Q
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Monopolistic Price and Quantity
Marginal Revenue Formulae
• What is MR if a firm faces a linear demand curve for its
product?
P  a  bQ
MR  a  2bQ, where b  0.
• What is MR if a firm faces a general demand curve (with
elasticity E)?
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
Marginal Revenue Formulae and Monopoly Power
• MR = P(1+1/E) means, if demand is more elastic (E more negative),
then MR is higher, so MC(Q) = MR(Q) is higher, so Q is higher, so P
is lower.
• Likewise, demand less elastic implies Q is lower and P is higher.
• Lower demand elasticity (fewer substitutes) thus means more
monopoly power.

Product differentiation increases monopoly power. Apple
computers are artistic, so Apple has more monopoly power, and
higher prices.

Jimmy Choo is fashionable, and so more power and higher
prices.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
A Numerical Example
• Given estimates of
• Demand: P = 10 - Q
• Cost: C(Q) = 6 + 2Q
• Monopolistic output?
•
•
•
•
MR = 10 - 2Q, since R(Q) = (10-Q) x Q
MC = 2
10 - 2Q = 2
Q = 4 units
• Monopolistic price?
• P = 10 - (4) = \$6
• Monopolistic profits?
• PQ - C(Q) = (6)(4) - (6 + 8) = \$10
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistic Price and Quantity
• None, as long as the source of monopoly power
remains.
BA 445 Lesson A.9 Monopolistic Markets
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Inefficient Output
Inefficient Output
BA 445 Lesson A.9 Monopolistic Markets
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Inefficient Output
Overview
Inefficient Output is implied when price and willingness to
pay is greater than marginal cost. — So, after your market
purchases, there is a deal between you and Microsoft that
can benefit you both.
BA 445 Lesson A.9 Monopolistic Markets
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Inefficient Output
Inefficient Output is implied when P > MC
• Inefficiency means it is possible for some people to help
themselves without hurting anyone else.
• For example, consider DVDs selling at monopoly price P
= \$20 while MC = \$1.


There now exist “victimless crimes” if consumers adopt a policy
of paying for a DVD if they value the DVD at the monopoly price
P = \$20 or more, but they illegally download the DVD if they
value it less than the monopoly price P (and at more than the
Those victimless crimes help the consumers when they
monopolist has the same sales as when there is no
BA 445 Lesson A.9 Monopolistic Markets
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Inefficient Output
Measuring Social Inefficiency
 There is a loss in the total of consumer surplus plus
producer surplus.
 That is a loss in total happiness (a loss in the
American Pie).
BA 445 Lesson A.9 Monopolistic Markets
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Inefficient Output
\$
of Monopoly
MC
ATC
PM
D
MC
QM
MR
BA 445 Lesson A.9 Monopolistic Markets
Q
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Inefficient Output
Arguments for Monopoly are that the negative
effects (deadweight loss) of monopoly market power may
be outweighed by beneficial effects, including
• the beneficial effects of economies of scale that reduce
cost
• the beneficial effects of patents and copyrights that
encourage the development of new products
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
Monopolistically Competitive Entry
and Exit
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
Overview
Monopolistically Competitive Entry and Exit drives profits to
zero as in competitive markets. — So, Pizza Hut profits
from stuffed-crust pizza eventually vanish, and profits
require new variations.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
Monopolistic competition is one market environment
that lies between Monopoly and Perfect Competition.
Price or quantity competition with other firms:
• Like perfect competition, monopolistic competition has other firms
producing substitutes (but not perfect substitutes), and so each
firm’s demand is affected by other firms’ prices and quantities.
• But like the simplest monopoly model, we do not consider the
monopolist’s prices and quantities affecting other firms own prices
and quantities, which in turn affect the monopolist’s profit.
Entry into the industry:
• Like perfect competition, monopolistic competition has free entry of
firms producing substitutes (but not perfect substitutes).
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
When are markets monopolistically competitive?

Implication: There is little or no strategic interaction between
sellers (unlike the forthcoming analysis of oligopoly).
• Differentiated products

Implication: Since products are differentiated (not perfect
substitutes), each firm faces a downward sloping demand curve.
• Consumers view differentiated products as close substitutes:
there exists some willingness to substitute.
• Free entry and exit of production of close substitutes --What is a close substitute for the movie “Spiderman”?

Implication: Firms will earn zero profits in the long run.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
Managing a Monopolistically Competitive Firm
• Like a monopoly, monopolistically-competitive firms


have market power that permits pricing above marginal cost.
level of sales depends on the price it sets.
• But …


The presence of other brands in the market makes the
demand for your brand more elastic than if you were a
monopolist.
• Monopolistically-competitive firm’s demand is more
elastic, and so prices are lower than monopoly prices.
Free entry and exit cause zero economic profit in the long
run.
• Therefore, monopolistically-competitive firms have
limited market power.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
Marginal Revenue Like a Monopolist
P
100
TR
Unit elastic
Elastic
Unit elastic
1200
60
Inelastic
40
800
20
0
10
20
30
40
50 Q
0
10
20
30
40
50 Q
MR
Elastic
BA 445 Lesson A.9 Monopolistic Markets
Inelastic
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Monopolistically Competitive Entry and Exit
Short-Run (fixed number of firms) Monopolistic Competition
• Maximize profits like a monopolist

Produce output where MR = MC.

Charge the price on the demand curve that corresponds to that
quantity.
\$
MC
ATC
Profit
PM
ATC
D
QM
MR
Quantity of Brand X
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
• If the industry is monopolistically competitive, there is
free entry.


In this case other firms start producing close substitutes, and
their new brands steal market share.
This reduces the demand for your product until economic profits
are zero.
BA 445 Lesson A.9 Monopolistic Markets
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Monopolistically Competitive Entry and Exit
Long-Run monopolistic competition, as entry decreases
demand.
\$
MC
Long Run Equilibrium
(P = AC, so zero profits)
AC
P*
P1
Entry
MR
Q1 Q*
MR1
D
D1
Quantity of Brand
X
BA 445 Lesson A.9 Monopolistic Markets
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Comparing Markets
Comparing Markets
BA 445 Lesson A.9 Monopolistic Markets
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Comparing Markets
Overview
Comparing Markets reveals different equilibrium for perfect
competition, monopoly, and monopolistic competition —
So, Monsanto’s seed monopoly has equilibrium unlike
Pizza Hut’s pizza.
BA 445 Lesson A.9 Monopolistic Markets
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Comparing Markets
A Numerical Example
• C(Q) = 125 + 4Q2
• Determine the profit-maximizing output and price, and
discuss its implications, if



You are a price taker and other firms charge \$40 per unit;
You are a monopolist and the inverse demand for your product is
P = 100 - Q;
You are a monopolistically competitive firm and the inverse
demand for your brand is P = 100 – Q.
BA 445 Lesson A.9 Monopolistic Markets
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Comparing Markets
Price Taker or Perfect Competition
• MC = 8Q
• MR = P = \$40.
• Set MR = MC.
• 40 = 8Q.
• Q = 5 units.
• Cost of producing 5 units.
• C(Q) = 125 + 4Q2 = 125 + 100 = \$225.
• Revenues:
• PQ = (40)(5) = \$200.
• Maximum profits of -\$25.
• Implications: Expect exit in the long-run.
BA 445 Lesson A.9 Monopolistic Markets
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Comparing Markets
Monopoly and Monopolistic Competition
• MR = 100 - 2Q (since P = 100 - Q).
• Set MR = MC, or 100 - 2Q = 8Q.



Optimal output: Q = 10.
Optimal price: P = 100 - (10) = \$90.
Maximal profits:
• PQ - C(Q) = (90)(10) -(125 + 4(100)) = \$375.
• Implications


Monopolist will not face entry (unless patent or other entry
barriers are eliminated).
Monopolistically competitive firm should expect other firms to
clone (produce close substitutes), so profits will decline over time.
BA 445 Lesson A.9 Monopolistic Markets
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Summary
Summary
BA 445 Lesson A.9 Monopolistic Markets
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Summary
Summary
• Firms operating in a perfectly-competitive market take
the market price as given.
 Produce output where MC = P.
 Firms may earn profits or losses in the short run.
 But, in the long run, entry or exit forces profits to zero.
• A monopoly firm, in contrast, can earn persistent profits
provided that source of monopoly power continues.
• A monopolistically-competitive firm can earn profits in the
short run, but entry by competing brands (producing
close substitutes) will erode these profits over time.
BA 445 Lesson A.9 Monopolistic Markets
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Review Questions
Review Questions
 You should try to answer some of the review
questions (see the online syllabus) before the next
class.
request to discuss their answers to begin the next class.
 Your upcoming Exam 1 and cumulative Final Exam
will contain some similar questions, so you should
eventually consider every review question before taking