Monopoly and monopolistic competition

Sample Solution

Monopoly Profit Maximization with Marginal Analysis

1) Maximizing Profit as a Monopoly Manager:

A) Markup for Price Elasticity of 2:

To maximize profit, a monopolist will set the price where marginal revenue (MR) equals marginal cost (MC). Elasticity plays a crucial role in determining MR. With a price elasticity of 2, a 1% increase in price leads to a 2% decrease in quantity demanded, causing MR to fall faster than price rises. Therefore, to reach equilibrium where MR = MC, the markup above MC needs to be smaller than with a less elastic demand.

Using the formula P = MC / (1 - 1/E), where P is price, MC is marginal cost, and E is price elasticity, we get:

P = $100 / (1 - 1/2) = $200

Therefore, the markup over MC would be:

Markup = P - MC = $200 - $100 = $100

B) Markup for Price Elasticity of 3:

With a higher elasticity of 3, a 1% price increase leads to a 3% decrease in quantity demanded, causing MR to fall even faster. To reach equilibrium, the markup needs to be further reduced compared to scenario A.

Using the same formula:

P = $100 / (1 - 1/3) = $300

Markup = P - MC = $300 - $100 = $200

As expected, the markup increases from $100 to $200 as demand becomes more elastic.

C) Factors Affecting Elasticity:

Full Answer Section

The magnitude of price elasticity affects the optimal markup. Factors influencing elasticity include:

• Availability of substitutes: Close substitutes make demand more elastic, reducing the markup.
• Necessity of the good: Essential goods are less elastic, allowing higher markups.
• Time horizon: Elasticity typically increases over time as consumers have more options.
• Income level: Luxury goods with fewer buyers have less elastic demand and higher markups.

2) Marginal Analysis for Different Market Structures:

• Monopoly: As stated in part 1, marginal analysis helps a monopolist find the price and quantity where MR = MC, maximizing profit. This point occurs where the demand curve intersects the MR curve, which lies below the demand curve due to the negative slope of MR.
• Dominant Firm: Similar to a monopoly, a dominant firm in an oligopoly (few large firms) uses marginal analysis to find the profit-maximizing price and quantity, considering the reactions of smaller competitors.
• Monopolistic Competition: Firms in this market face downward-sloping demand curves due to product differentiation and competition. They use marginal analysis to find the output where MR = MC, similar to a monopoly, but the resulting price and quantity are lower due to competition.

In all three cases, marginal analysis provides a framework for determining the output level that brings the highest economic profit, making it a valuable tool for managers to optimize their businesses.

Remember: This is a simplified model, and other factors can influence price and quantity decisions in real-world scenarios.