Question

Use the following set-up for all parts of question 5 (i.e., parts a through e). A monopolist produces its product at a constant average cost and marginal cost of $20 (i.e., AC=MC=20). The market demand for its product is P = 70 – 0.2Q and so its marginal revenue is MR= 70 – 0.4Q where P is the price per unit of the product and Q is the number of units.

a) (9 points) Suppose that the monopolist must charge the same price on each unit sold. What is the profit-maximizing quantity and price? What is the profit? You must show your step-by-step calculations to receive credit.

b. (5 points) If this market were perfectly competitive, what would be the quantity and price? What would be the profit? You must show your step-by-step calculations to receive credit.

c.(3 points) Explain in words: Why is there deadweight loss with the monopoly market structure?

d.(3 points) Describe a specific government intervention than can reduce the deadweight loss in this market.

Answer 1

Part a)

Monopolist sells 125 units at a price of 45 and earns a profit of 3125

Part b)

Competitive firm would sell 250 units at price of 20 and earns zero profits

Part c)

The fact that price in monopoly exceeds marginal cost suggests that the monopoly solution violates the basic condition for economic efficiency, that the price system must confront decision makers with all of the costs and all of the benefits of their choices. Efficiency requires that consumers confront prices that equal marginal costs. Because a monopoly firm charges a price greater than marginal cost, consumers will consume less of the monopoly’s good or service than is economically efficient.

The monopoly pricing creates a deadweight loss because the firm forgoes transactions with the consumers. The deadweight loss is the potential gains that did not go to the producer or the consumer. As a result of the deadweight loss, the combined surplus of the monopoly and the consumers is less than that obtained by consumers in a competitive market. A monopoly is less efficient in total gains from trade than a competitive market.

Part d)

Government can consider giving subsidy to monopolist which leads to a lower equilibrium price and higher equilibrium quantity.Subsidy shifts the marginal cost curve rightwards and down.Consumer surplus and profits increase after subsidy.

The deadweight loss from the monopoly decreases. This is because the deadweight loss comes from the price being too high (higher than the marginal cost), which leads to not enough goods being consumed in equilibrium. Since the subsidy redices the price, the deadweight loss decreases. The subsidy itself does not increase the deadweight loss, because the only thing it does is reduce the price and there are no other effects.