Loss of efficiency due to monopolies

Ka-fu Wong
November 16, 2013

A lot of students have difficulty in the following question on Monopoly (from Sapling), even after reading the
soultion. Let me try to explain in steps.
Suppose a firm is the monopolist seller of ripe bananas. Call this seller RB. He faces the daily national demand
curve for pounds of bananas of Q = 16000 10000P .
Plotting the demand curve facing RB should be straightforward. Given the demand curve, we can compute the
marginal revenue curve. Remember the formula: for the linear demand curve of P = a bQ, the MR curve is
M R = a 2bQ. Thus, to find the MR curve, we need to rewrite the demand curve in the form of P = a bQ.
Q =
P

=
=

16000 10000P
1
(16000 Q)
10000
16000
1

Q
10000 10000

Hence,
MR

16000
2

Q
10000 10000

The alternative is to look at the plotted demand curve, find the mid-point of the x-intercept of demand and
made it the x-intercept of the MR curve. The demand and MR curves are shown below.

Lets assume that the only input in the production of ripe bananas is green bananas, which are turned into ripe
bananas at a 1-to-1 rate. For simplicity, lets also assume that green bananas have a marginal cost of $0, and
there are no other costs faced by the ripe banana monopolist than his cost of green bananas.
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1. If the monopolist buys green bananas from a competitive market, how much is deadweight loss in the market?
ANSWER and DISCUSSIONS:
We will need to do it in several steps. First, we need to identify the price of green bananas in the competitive market. Since the marginal cost of production is zero, the market supply curve of green banana is also
horizontal at zero. Thus, the market price should be zero too. Second, we need to take this price as the
marginal cost of the ripe banana monopolist and determine the optimal output and price. Given the zero
marginal cost, the monopolist will choose to produce 80 hundred pounds (M R(Q = 80) = M C(Q = 80)).
The monopolist will charge the highest price possible (constrained by the demand), i.e., 80 cents per pound.

Next, we need to think about the social optimal output. From the society perspective, we should continue
to expand output as long as the willingness to pay for the additional unit (a point on the demand curve)
is higher than the marginal cost. Thus, the social optimal output is 160 hundred pounds. Finally we are
ready to compute the deadweight loss. For each unit short of the optimal output, there is a deadweight
loss. So, the total deadweight loss is
0.5 (160 80) (80 0) 100 = 320000 cents
or 3200 dollars (recall the price per pound is in cents and quantity in hundred pounds in the diagram).

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2. Suppose that the ripe banana (RB) monopolist instead buys bananas from a green banana (GB) monopolist.
The RB monopolist has on influence on the price set by his supplier. The green banana monopolist sets his
price by raising or lowering the marginal cost curve of the RB monopolist and his profit is the difference
between the marginal cost of the RB monopolist and $0. So, if the green banana monopolist charges the
RB monopolist $0.2/lb, the marginal cost curve will move up to 0.2, the RB monopolist will sell 7,000
pounds of bananas, and the green banana monopolist will make $0.20/lb over 7000 pounds, or $1400. How
much should the green banana monopolist charge the RB monopolist per pound of bananas?
ANSWER and DISCUSSIONS:
We need to know that the green banana monopolist will charge. Since there is zero marginal cost, and
maximization of the profit is the same as maximization of total revenue (profit = total revenue - total
cost). How much will RB demand for green bananas? Essentially, it is the MR curve. We can easily
verify this point by setting different price of the green banana and find out the quantity RB will buy. If
GB charges the RB monopolist $0.2/lb, the marginal cost curve will move up to 0.2, the RB monopolist
will sell 7,000 pounds of bananas, and the green banana monopolist will make $0.20/lb over 7000 pounds,
or $1400. After we are convinced that the MR curve is the demand curve for green bananas, which price
should GB set to maximized total revenue? From the study of elasticity, we know that it has to be the
midpoint. So, the price should be set at 80 cents. At 80 cents per pound, RB will choose to supply 40
hundred pounds of banana (MR=MC) and change a price of 120. Thus, GB gets a total revenue/profit of
80 40 100 = 320000 cents = 3200 dollars
.

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3. What is the deadweight loss to the society?

ANSWER and DISCUSSIONS:
From the society perspective, the optimal output is 160 hundred pounds, as discussed earlier. The reason
is really that the marginal cost of ripe banana is zero to the society. Marginal cost of green banana is
zero. One green banana can make one ripe banana. Thus, the marginal cost of ripe banana is really zero
from the society perspective. Now given the double monopoly situation, there will be only 40 hundred
pounds of ripe bananas. The deadweight loss is then
0.5 (160 40) (120 0) 100 = 720000 cents
or 7200 dollars. That is, there is an increase in deadweight loss by the amount of 4000 dollars (72003200=4000) when GB acts as a monopoly selling green banana to RB.

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