Chapter 14 Solution Manual Microeconomic Theory

CHAPTER 14:
Monopoly
The problems in this chapter deal primarily with marginal revenue-marginal cost calculations in
different contexts. For such problems, students’ primary difficulty is to remember that the
marginal revenue concept requires differentiation with respect to quantity. Often students choose
to differentiate total revenue with respect to price and then get very confused on how to set this
equal to marginal cost. Of course, it is possible to phrase the monopolist’s problem as one of
choosing a profit-maximizing price, but then the inverse demand function must be used to derive
a marginal cost expression.
The analytical and behavioral problems in this chapter introduce students to some state-
of-the-art research on monopoly reflected in recent academic articles.
Comments on Problems
14.1 This problem is a simple marginal revenue-marginal cost and consumer surplus
computation.
14.2 This problem is an example of the MR = MC calculation with three different types of cost
curves.
14.3 This problem is an example of the MR = MC calculation with three different demand and
marginal revenue curves. The problem also illustrates the “inverse elasticity” rule.
14.4 This problem examines graphically the various possible ways in which shift in demand
may affect the market equilibrium in a monopoly.
14.5 This problem introduces advertising expenditures as a choice variable for a monopoly.
The problem also asks the student to view market price as the decision variable for the
monopoly.
14.6 Note: This problem has been subtly revised from the previous edition; the numbers for
production and transportation cost are now different, helping students see where each
distinctly shows up in the calculations. This is a price-discrimination example in which
markets are separated by transport costs, showing how the price differential is
constrained by the extent of those costs. Part (d) asks students to consider a simple two-
part tariff.
14.7 This problem shows how the welfare cost of monopoly may be larger than in the
traditional case if the monopoly has higher costs.
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160 Chapter 14: Monopoly
14.8 This problem examines some issues in the design of subsidies for a monopoly.
14.9 This problem involves quality choice. The result shows that, in this case, the monopoly
and competitive choices are the same (though output levels differ).
Analytical Problems
14.10 Taxation of a monopoly good. This problem focuses mainly on ad valorem taxes on a
monopoly good. The final part of the problem compares ad valorem and specific taxes.
14.11 Flexible functional forms. This problem has students run through the standard
monopoly analysis but for a class of flexible functional forms introduced in a recent
influential paper by Fabinger and Weyl (2015). While slightly complicated, the
functional forms allow for U-shaped average cost curves and realistic demand shapes.
14.12 Welfare possibilities with different market segmentations. This problem illustrates
extreme possibilities for price discrimination to create or destroy welfare identified in the
important recent paper by Bergemann, Brooks, and Morris (2015). To make their results
accessible, takes the simplest case of two consumer types, but the analysis of this case is
done in full generality.
Behavioral Problem
14.13 Shrouded prices. This problem introduces students to the problem of shrouded prices, a
topic that has received wide attention in behavioral economics. See for example, D.
Laibson and X. Gabaix, “Shrouded Attributes, Consumer Myopia, and Information
Suppression in Competitive Markets,” Quarterly Journal of Economics (May 2006):
505–540. More on whether competition uncovers shrouding to come in the next chapter.
Solutions
Given P 53  Q. Then TR PQ 53Q  Q , implying MR 53  2Q. Profit

2
14.1 a.
maximization yields MR 53  2q MC 5, implying Qm 24, Pm 29, and
 m  P  AC  Q 576.
b. MC P 5 implies Pc 5 and Qc 48.
Consumer surplus under competition is 2(48) 1,152. See the graph for
2
c.
monopoly.
14.2 Given market demand is Q 70  P, marginal revenue is MR 70  2Q.
a. Given AC MC 6. To maximize profit, set MC MR. We have 6 70  2Q,
implying Qm 32, Pm 38,  m ( P  AC )Q (38  6)32 1, 024.
b. C 0.25Q 2  5Q  300 implies MC 0.5Q  5. Setting MC MR gives

0.5Q  5 70  2Q, implying Qm 30, Pm 40, and
 m TR  TC
30 40   0.25 302  5 30  300 
825.
c. C 0.0133Q3  5Q  250 implies MC 0.04Q 2  5. Setting MR MC yields

0.04Q 2  5 70  2Q, or 0.04Q 2  2Q  75 0. Applying the quadratic formula,
Qm 25. Solving for the other equilibrium variables, Pm 45, Rm 1,125,
Cm 332.8, MCm 20,  m 792.2.
14.3 a. Given AC MC 10 and Q 60  P, implying MR 60  2Q. For profit
maximum, MC MR  10 60  2Q  Qm 25. Solving for the other
equilibrium variables, Pm 35 and  m TR  TC 25 35  25 10 625.
b. Given AC MC 10 and Q 100  2 P, implying MR 90  4Q. For profit
maximum, MC MR  10 90  4Q  Qm 20. Solving for the other
P 50 and  m 40 30  40 10 800.
equilibrium variables, m
c. Given AC MC 10 and Q 100  2 P, implying MR 50  Q. For profit

maximum, MC MR  10 50  Q  Qm 40. Solving for the other
P 30 and  m 40 30  40 10 800. π = (40)(30) – (40)
equilibrium variables, m
(10) = 800.
Note: Here the inverse elasticity rule is clearly illustrated:
Q P 1 P  MC
Problem part eQ , P =  =
P Q eQ,P P
(a)  1 35 25   1.4 0.71  35  10  35
(b)  0.5  50 20   1.25 0.80  50  10  50
(c)  2  30 40   1.5 0.67  30  10  30
d.
The supply curve for a monopoly is a single point, namely, that quantity–price
combination that corresponds to the quantity for which MC MR. Any attempt to
connect equilibrium points (price–quantity points) on the market demand curves
has little meaning and brings about a strange shape. One reason for this is that as
the demand curve shifts, its elasticity (and its MR curve) usually changes bringing
about widely varying price and quantity changes.
14.4 a.
b. There is no supply curve for monopoly; have to examine MR MC intersection

because any shift in demand is accompanied by a shift in MR curve. Cases (1) and
(2) above show that P may rise or fall in response to an increase in demand.
c. Can examine this using inverse elasticity rule:
P P
 e= = .
P  MC P  MR
As  e falls toward 1 (becomes less elastic), P  MR increases.
 Case 1 MC constant, so profit-maximizing MR is constant

o If  e  , then P  MR   P  .
o If  e constant, then P  MR constant  P constant.
o If  e  , then P  MR   P .
 Case 2 MC falling, so profit-maximizing MR falls

o If  e  , then P  MR   P may rise or fall.
o If  e constant, then P  MR constant  P .
o If  e  , then P  MR   P  .
 Case 3 MC rising, so profit maximizing MR must increase

o If  e  , then P  MR   P  .
o If  e constant, then P  MR constant  MR   P .
o If  e  , then P  MR   P may rise or fall.
Q  20  P   1  0.1A  0.01A2  .
Let K 1  0.1A  0.01A . Then
2
14.5 Given
dK dA 0.1  0.02 A and
 PQ  C
 20 P  P 2  K   200  10 P  K  15  A.
The first-order condition with respect to price is

 20  2 P  K 10 K 0.
P
Solving, 20  2 P  10 0  Pm 15, regardless of K or A.
a. If A 0, Qm 5, Cm 65,  m 10.
b. Substituting P 15 into the profit function,

 75 K  50 K  15  A
25 K  15  A
10  1.5 A  0.25 A2 .
The first-order condition with respect to A is
d
= 1.5  0.5 A = 0,
dA
implying A 3, Qm 5(1  0.3  0.09) 6.05, Rm 90.75,
Cm 60.5  15  3 78.5, and  m 12.25; this represents an increase over the
case A 0.
In the first market, Q1 55  P1  R1 (55  Q1 )Q1 55Q1  Q1

2
14.6 a.
 MR1 55  2Q1. Setting MR1 MC 5 yields Q1* 25 and P1* 30. In the
second market, Q2 70  2 P2  R2 [(70  Q2 ) / 2]Q2 (70Q2  Q22 ) / 2

 MR2 35  Q2 . Setting MR2 MC 5 yields Q2* 30 and P2* 20. Profits
across both markets are  (30  5) 25  (20  5) 30 1, 075.
b. If the producer ignores the problem of arbitrage among consumers, the price
differential between the two markets found to be optimal in the previous part
($10) induces arbitrage. The producer does better by preventing arbitrage by
keeping the price differential to $4, that is, P1 P2  4. We can solve this as a
constrained maximization problem. Setting up the associated Lagrangian,
L  P1  5   55  P1    P2  5   70  2 P2     4  P1  P2  .
Taking the first-order conditions,
L P1 60  2 P1   0,
L P2 80  4 P1   0,
L  4  P1  P2 0.
This yields two equations in two unknowns 60  2 P1 4 P2  80 and P1 P2  4.
60  2  P2  4  4 P2  80, P* 22. Further, P1* 26 and  * 1, 051.
Solving, or 2
(The same answer can be obtained by substituting P1 P2  4 into profits from the
two markets and solving as a single-variable, unconstrained maximization
problem.)
Now P1 P2 P. So  140 P  3P  625. Taking the first-order condition,

2
c.
d  dP 140  6 P 0, implying P* 140 / 6 23.33, Q1 31.67, Q2 23.33,
* *
and  1, 008.33.

*
d. If the firm adopts a linear tariff of the form T (Qi ) =  i + mQ i, it can maximize
profit by setting m 5,
1 0.5(55  5)(50) 1, 250,

 2 0.5(35  5)(60) 900,
earning  2,150. Notice that in this problem neither market can be uniquely
*
identified as the “least willing” buyer, so a solution similar to Example 14.5 is not
possible. If the entry fee were constrained to be equal in the two markets, the firm
could set m 0 and charge a fee of 1,225 (the most buyers in market 2 would
pay). This would yield profits of 2, 450  125 5 1,825, which is inferior to
profits obtained with T (Qi ).
14.7 a. Under perfect competition, MC 10. Under monopoly, MC 12.

Demand is QD 1, 000  50 P. The competitive equilibrium is Pc MC 10,
Q 500. To solve for the monopoly outcome, P 20  Q 50
implying c
 R 20Q  Q 2 50  MR 20  Q 25. Profits are maximized where
MR MC  20  Q 25 12  Qm 200. Further, Pm 16.
b. Calculations are aided by the graph below. Loss of consumer

surplus equals CSc  CS m 2,500  400 2,100. Of this 2,100 loss, 800 is a
transfer into monopoly profit, 400 is a loss from increased costs under monopoly,
and 900 is a “pure” deadweight loss.
c.
The new feature of the analysis is that costs are not given, but vary
with the market structure, rising under monopoly. The possibility of higher costs
under monopoly was dubbed “X-inefficiency.”
14.8 a. The government wishes the monopoly to expand output toward P MC. A lump-
sum subsidy will have no effect on the monopolist's profit maximizing choice, so
this will not achieve the goal.
b. A subsidy per unit of output will effectively shift the MC curve downward. The
figure illustrates this for the constant MC case.
c. A subsidy ( t ) must be chosen so that the monopoly chooses the socially

optimal quantity, given t . Since social optimality requires P MC and profit
maximization requires
 1
MC  t MR P  1   ,
 e
substitution yields
t 1
=
P e,
as was to be shown. Intuitively, the monopoly creates a gap between price and
marginal cost and the optimal subsidy is chosen to equal that gap expressed as a
ratio to price.
14.9 Since consumers only value XQ, firms can be treated as selling that commodity
(i.e., batteries of a specific useful life). Firms seek to minimize the cost of
producing XQ for any level of that output. Setting up the Lagrangian,
L C ( X )Q   ( K  XQ)
yields the following first-order conditions for a minimum:
L X C ( X )Q  Q 0,
LQ C ( X )   X 0,
L  K  XQ 0.
Combining the first two shows that C ( X )  C ( X ) X 0, or
C(X )
X= .
C ( X )
Hence, the level of X chosen is independent of Q (and of market structure). The
nature of the demand and cost functions here allows for the durability decision to
be separated from the output-pricing decision. (This may be the most general case
for which such a result holds.)
Analytical Problems
14.10 Taxation of a monopoly good
The inverse elasticity rule is

MC
P .
1 1 e
When the monopoly is subject to an ad valorem tax, t , this becomes
MC 1
P  .
1  t 1 1 e
a. With linear demand, e falls (becomes more elastic) as price rises. Hence,
MC 1
Pafter tax  
1  t 1  1 eafter tax
MC 1
 
1  t 1  1 epre tax
Ppre tax
 .
1 t
b. With constant elasticity demand, the inequality in part (a) becomes an equality so
P
Pafter tax  pre tax .
1 t
c. If the monopoly operates on a negatively sloped portion of its marginal cost curve
we have (in the constant elasticity case)
MCafter tax 1
Pafter tax  
1 t 1 1 e
MCpre tax 1
 
1  t 1 1 e
P
 pre tax .
1 t
d. The key part of this question is the requirement of equal tax revenues. That is
tPa Qa  Qs , where the subscripts refer to the monopoly’s choices under the two
tax regimes. Suppose that the tax rates were chosen so as to raise the same
revenue for a given output level, say Q. Then  tPa , hence   tMRa . But in
general under an ad valorem tax MRa (1  t ) MR MR  tMR, whereas under a
specific tax, MRs MR   . Hence, for a given Q, the specific tax that raises the
same revenue reduces MR by more than does the ad valorem tax. With an
upward sloping MC , less would be produced under the specific tax, thereby
dictating an even higher tax rate. In all, a lower output would be produced, at a
higher price than under the ad valorem tax. Under perfect competition, the two
equal-revenue taxes would have equivalent effects.
14.11 Flexible functional forms
a. Writing the monopoly profit function as  (Q) [ P (Q)  AC (Q)]Q, substituting

the given functional forms yields, after rearranging,
 (Q)  (a0  c0 )  ( a1  c1 )Q  s  Q.
 
The first-order condition with respect to Q is
( a0  c0 )  (1  s)( a1  c1 )Q  s 0.
It is straightforward to solve this equation directly for the optimal quantity:
1/ s
 ( s  1)(a1  c1 ) 
Qm   .
 a0  c0 
Looking ahead to part (c), where it will be important to simplify, we could have
s
alternatively made the substitution x Q in the first-order condition and solved
for x. Let’s try that, as well as substituting di ai  ci to further simplify. The
first-order condition becomes
1
d 0  (1  s) d1  0,
x
yielding xm ( s  1)d1 / d 0 , or m 
Q  ( s  1)d1 / d 0 
1/ s
, the same solution as above.
b. Constant average and marginal cost corresponds to c1 0. Substituting into the
solution from part (a) gives
1/ s
 ( s  1)a1 
Qm   .
 a0  c0 
c. Monopoly profit with this yet more flexible specification is

 (Q)  (a0  c0 )  (a1  c1 )Q  s  (a2  c2 )Q s  Q
 

 d 0  d1Q  d 2Q  Q.
s s
 
The first-order condition with respect to Q is
d 0  (1  s)d1Q  s  (1  s)d 2Q s 0,

s
or, substituting x Q ,
1
d 0  (1  s)d1   (1  s )d 2 x 0.
x
Multiplying both sides by x turns the first-order condition into the quadratic
equation
(1  s) d 2 x 2  d 0 x  (1  s )d1 0.
The quadratic formula yields two solutions, one of which will be negative in what
is probably the leading case of positive d0 , d 2 . The other solution is
d 02  4d1d 2 ( s 2  1)  d 0
xm  .
2(1  s )d 2
1/ s
Using the relationship x Q , we can solve for quantity as Qm xm .
s
d. Here is a graph showing possible shapes for the average cost curve.
14.12 Welfare possibilities with different market segmentations
a. The perfectly competitive outcome with marginal-cost pricing ( pc 0 ) yields the

socially efficient outcome. Both types of consumers purchase, implying
qc q  q . W qv  q v .
Welfare is the sum of values added up over consumers c
b. With just two consumer types, the monopolist can achieve perfect price
discrimination by segmenting each type into one of two markets, charging v on
the low-value market and v on the high-value market. Social welfare is the same
Wc qv  q v
as under perfect competition, but now the monopolist appropriates
it all as profit; consumers obtain zero surplus.
c. The single-price monopolist can choose from one of two pricing strategies, either
selling at the high types’ willingness-to-pay and just serving them, earning profit
qv , or selling at the low types’ willingness-to-pay and serving all consumers,
(q  q ) v.
earning profit The assumed inequality means that the high-price
strategy is more profitable.
i. The monopoly price is v , quantity is q , and profit is q v . There is no

consumer surplus because the whole valuation is extracted from the high-
value consumers who end up buying. Welfare equals the profit, q v .
ii. The profit from serving just high-value consumers in segment B is bq v ,

(bq  q ) v . *
and from serving all consumers in that segment is At b , these
b*q v (b*q  q ) v ,
profits are equal: or solving,
qv
b*  .
q (v  v )
This is obviously positive because v  v . The assumed inequality in part
*
(c) ensures b  1.
The discriminatory price is v in segment A and (by assumption
when it is indifferent) v in segment B. Monopoly profit is
(1  b* ) q v  (b*q  q ) v (1  b* ) q v  b*q v q v ,
where the first equality follows from substituting from the indifference
condition on profits and the second equality from simplifying. The only
*
consumer surplus comes from the b q high-value consumers in segment
B, who obtain surplus v  v each for total consumer surplus of
b*q (v  v ) qv .
Profit is the same as under a single price. Welfare equals
q v  qv ,
the same as under perfect competition. The gain in welfare from
a single-price monopolist to perfect competition all accrues to consumers.
iii.
To get to a point somewhere in the middle of the base of the triangle—in

other words, to move only part way from part (c.i) to part (c.ii)—one
could imagine subdividing market B in two segments, keeping the same
proportion of the two types in each. In one segment, the monopolist, still
indifferent between a high and low price, could charge the low price but in
the other it could charge the high price. The monopolist’s profit stays the
same, but the increase in consumer surplus would only be a fraction of
what was seen in part (c.ii).
To get to a point somewhere above the base of the triangle, one
could imagine carving new segments from existing ones containing single
types across which the monopolist can perfectly price discriminate, raising
the monopolist’s profit.
d. The inequality assumed in this part means that the profit-maximizing single price
for the monopolist now equals v .
q  q, (q  q ) v ,
i. The monopoly price is v , quantity is profit is consumer
W qv  q v .
surplus is q (v  v ), and welfare is c
ii. The profit from serving just high-value consumers in segment A is qv ,

( q  aq ) v . *
and from serving all consumers in that segment is At a , these
q v (q  a*q ) v ,
profits are equal: or upon solving,
q (v  v )
a*  ,
qv
*
the reciprocal of b . This can be shown to be in the interval (0,1) in the
*
same way we showed this for b in part (c).
The discriminatory price is v in segment A (by assumption when
it is indifferent) and v in segment B. Monopoly profit is
q v  (1  a* ) qv (q  a*q ) v  (1  a* ) qv (q  q ) v .
There is no consumer surplus, and welfare equals profit. Relative to the
single-price case, profit stays the same but all consumer surplus is
destroyed, and welfare falls.
iii.
The graph is identical to that in part (c) except that the labels on the
corners have been swapped because price discrimination across this
segmentation destroys rather than creates consumer surplus.
14.13 Shrouded prices
a. Monopoly profit is  Q( P  AC ) (10  P)( P  6). Solving the first-order

condition 16  2 P 0 yields Pm 8. Thus, Qm 2,  m 4,
CS m (1/ 2)(10  8) 2 2, and Wm  m  CSm 4  2 6.
b. Monopoly profit is  Q ( P  s  AC ) (10  P )( P  s  6). Solving the first-order

P 8  s / 2. Thus, Qm 2  s / 2 and
condition 16  2 P  s 0 yields m
 m (2  s / 2)2 . The monopolist would like the shrouded price to be as high as
possible (infinite) because this allows it to extract a higher price per unit without
the decline in quantity demanded that accompanies the usual price increase.
c. Gross consumer surplus can be computed as the area of the trapezoid under the
demand curve up to the quantity sold:
1 1 s  s
GCSm  (10  Pm )Qm   18    2   .
2 2 2  2
Consumers’ expenditure equals
 s  s
( Pm  s)Qm  8    2   .
 2 2
Subtracting,
1 s  s  s  s 1
CSm   18    2     8    2    (4  3s )(4  s ).
2 2  2  2 2 8
d. Welfare is
2
 s 1 1
Wm  m  CSm  2     4  3s   4  s   (12  s)(4  s),
 2 8 8
*
a quadratic function, maximized for s 4. While shrouded prices distort
consumer behavior, this distortion counteracts the monopoly distortion to some
extent, so a positive amount of shrouding can be good for welfare in a monopoly
market. Notice that this level of shrouding induces the monopolist to reduce
perceived price Pm down to marginal cost.
e. The solution for the monopoly price is exactly as in part (b). The difference here
is that the subsidy expenditure sQm comes from the government, whereas the
shrouded expenditure comes from consumers, so these parties’ surpluses must be
adjusted accordingly. To the extent that the subsidy is funded by a tax that
ultimately comes from citizens = consumers, the distributional consequences of
subsidies and shrouding could be quite similar.
A moderate, positive subsidy improves welfare in a monopoly market
because it induces the monopolist to lower price (similar to a reduction in
marginal cost). This is not true under perfect competition; a subsidy induces
overconsumption and introduces a deadweight loss. By analogy to shrouding,
while some shrouding can improve welfare in a monopoly market, any positive
shrouding will lower welfare under perfect competition, again because of the
overconsumption that is induced.

Chapter 14 Solution Manual Microeconomic Theory

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Chapter 14 Solution Manual Microeconomic Theory

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CHAPTER 14:

Given P 53  Q. Then TR PQ 53Q  Q , implying MR 53  2Q. Profit

b. MC P 5 implies Pc 5 and Qc 48.

14.2 Given market demand is Q 70  P, marginal revenue is MR 70  2Q.

b. C 0.25Q 2  5Q  300 implies MC 0.5Q  5. Setting MC MR gives

c. C 0.0133Q3  5Q  250 implies MC 0.04Q 2  5. Setting MR MC yields

c. Given AC MC 10 and Q 100  2 P, implying MR 50  Q. For profit

Note: Here the inverse elasticity rule is clearly illustrated:

b. There is no supply curve for monopoly; have to examine MR MC intersection

c. Can examine this using inverse elasticity rule:

 Case 1 MC constant, so profit-maximizing MR is constant

 Case 2 MC falling, so profit-maximizing MR falls

 Case 3 MC rising, so profit maximizing MR must increase

o If  e  , then P  MR   P may rise or fall.

a. If A 0, Qm 5, Cm 65,  m 10.

b. Substituting P 15 into the profit function,

In the first market, Q1 55  P1  R1 (55  Q1 )Q1 55Q1  Q1

second market, Q2 70  2 P2  R2 [(70  Q2 ) / 2]Q2 (70Q2  Q22 ) / 2

Now P1 P2 P. So  140 P  3P  625. Taking the first-order condition,

and  1, 008.33.

1 0.5(55  5)(50) 1, 250,

14.7 a. Under perfect competition, MC 10. Under monopoly, MC 12.

b. Calculations are aided by the graph below. Loss of consumer

c. A subsidy ( t ) must be chosen so that the monopoly chooses the socially

14.10 Taxation of a monopoly good

The inverse elasticity rule is

14.11 Flexible functional forms

a. Writing the monopoly profit function as  (Q) [ P (Q)  AC (Q)]Q, substituting

c. Monopoly profit with this yet more flexible specification is

d 0  (1  s)d1Q  s  (1  s)d 2Q s 0,

14.12 Welfare possibilities with different market segmentations

a. The perfectly competitive outcome with marginal-cost pricing ( pc 0 ) yields the

i. The monopoly price is v , quantity is q , and profit is q v . There is no

ii. The profit from serving just high-value consumers in segment B is bq v ,

To get to a point somewhere in the middle of the base of the triangle—in

ii. The profit from serving just high-value consumers in segment A is qv ,

14.13 Shrouded prices

a. Monopoly profit is  Q( P  AC ) (10  P)( P  6). Solving the first-order

b. Monopoly profit is  Q ( P  s  AC ) (10  P )( P  s  6). Solving the first-order

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