Question

Irion County Pipeline (ICP) enjoys monopoly power because it is the only pipeline available to transport crude oil out of Irion County. The demand (average revenue) curve for oil transport services is given by AR = 600 − (Q/2)—this implies a marginal revenue curve of 600 − Q. Here Q represents thousands of barrels of oil shipped each day. The average and marginal cost curves curves for moving oil are given as: AC = 20Q + (200/Q) MC = 40Q (a) Determine the profit-maximizing price for oil pipeline transport, keeping in mind that ICP will maximize its profits when it fully exercises its monopoly power. (b) Calculate the difference in the amount of oil that would be transported if ICP did not exercise any market power versus the amount transported in (a). (c) Calculate the monopoly rent that ICP earns by fully exercising its market power. What share of total profits is the rent? (d) Calculate the deadweight loss associated with ICP exercising its monopoly power. Give a one sentence description of how this deadweight loss might manifest itself on the ground in Irion County.

Answer 1

a) Profit maximizing condition for monopoly is when marginal revenue (MR)= marginal cost (MC)

Therefore 600-Q = 40Q

Q= 600/41

Q=14.63

Demand curve for monopolist is Average revenue(AR).Hence at Q=600/41 monopolist charges the price determined by AR curve.

price = 600-300/41 (substituting Q=600/41 in AR curve)

Price charged by monopolist

=592.68

d)Refer to figure in part b

Dead weight loss is the shaded area of triangle ABC

BD=0.18 (Calculated in part b)

At point C, Price = 585.2 (substitute Qm=14.63 in MC=40Q)

AC=7.48

Therefore dead weight loss is area of triangle ABC=1/2 * 7.48 * o.18

=0.67

The dead weight loss represents the social cost of monopoly i.e. an indication of market inefficiency ( output is produced less than the desired level)