Cost-plus pricing: Simplistic strategy that guarantees that price is higher than the estimated average cost Studies of pricing behavior suggest that many managers who use cost-plus pricing do not price optimally. Definition of Markup: Markup = (Price – Cost)/Cost where Cost here is cost per unit The short-run equilibrium in monopolistic competition is Identical to short-run equilibrium under monopoly As entry and exit of firms from the product group shifts individual firms’ demand curves, long-run equilibrium occurs where profit is equal to zero.

1. MANAGERIAL ECONOMICS:
THEORY, APPLICATIONS, AND CASES
W. Bruce Allen | Neil A. Doherty | Keith Weigelt | Edwin Mansfield
Chapter 8
MONOPOLY AND
MONOPOLISTIC
COMPETITION
Modified by Jung S. You

2. OBJECTIVES
• Explain how managers should set price and
output when they have market power
• With monopoly power, the firm’s demand curve
is the market demand curve. A monopolist is the
only seller of a product for which there are no
close substitutes and which is protected by
barriers to entry.
• Monopolistically competitive firms have market
power based on product differentiation, but
barriers to entry are modest or absent.

3. PRICING AND OUTPUT DECISIONS IN
MONOPOLY
• Example
• Demand: P = 10 – Q
• Total revenue: TR = PQ =(10 - Q) Q= 10Q –
Q2
• Marginal revenue: MR = 10 – 2Q
• Total cost: TC = 1 + Q + 0.5Q2
• Marginal cost: MC = 1 + Q
• MR = 10 – 2Q = 1 + Q = MC => Q = 3
• P = 10 – 3 = 7
• Profit = Q(P – ATC)

5. © 2013 W. W. Norton Co., Inc.

6. TOTAL REVENUE, TOTAL COST, AND
TOTAL PROFI T OF A MONOPOLIST
Managerial Economics, 8e
Copyright @ W.W. & Company 2013

7. PROFIT AND OUTPUT OF A MONOPOLIST
Managerial Economics, 8e
Copyright @ W.W. & Company 2013

8. Chapter Problem 3
The Coolidge Corporation is the only producer of a
particular type of laser. The demand curve for its product is
Q = 8,300 - 2.1P
and its total cost function is
TC = 2,200 + 480Q + 20Q2
where P is price (in dollars), TC is total cost (in dollars),
and Q is monthly output.
a. Derive an expression for the firm’s marginal revenue
curve.
b. To maximize profit, how many lasers should the firm
produce and sell per month?
c. If this number were produced and sold, what would be
the firm’s monthly profit?

10. Chapter Problem 4
The Madison Corporation, a monopolist, receives a report from a
consulting firm concluding that the demand function for its product is
Q = 78 - 1.1P + 2.3Y + 0.9A
where Q is the number of units sold, P is the price of its product (in
dollars), Y is per capita income (in thousands of dollars), and A is the
firm’s advertising expenditure (in thousands of dollars). The firm’s
average variable cost function is
AVC = 42 - 8Q + 1.5Q2
where AVC is average variable cost (in dollars).
a. Can we determine the firm’s marginal cost curve?
b. Can we determine the firm’s marginal revenue curve?
c. If per capita income is $4,000 and advertising expenditure is
$200,000, can we determine the price and output where marginal
revenue equals marginal cost? If so, what are they?

12. MONOPOLY VERSUS PERFECT COMPETITION
• Continuing the Same Example in Page 4
• Demand: P = 10 – Q
• Total revenue: TR = PQ = 10Q – Q2
• Marginal revenue: MR = 10 – 2Q
• Total cost: TC = 1 + Q + 0.5Q2
• Marginal cost: MC = 1 + Q
• Monopolist’s Price = 7 with Q = 3
• Perfectly Competitive Firms Would Produce
Aggregate Output Q = 4.5 at P=5.5

13. OUTPUT AND PRICE DECISIONS OF A
MONOPOLIST
Managerial Economics, 8e
Copyright @ W.W. & Company 2013

15. MONOPOLIST’S PROFIT-MAXIMIZING PRICE VS PRICE
ELASTICITY OF DEMAND
• MR = P[1 + (1/η)] = P[1 – (1/|η|)] where η is price
elasticity of demand (refer to Chapter 2-part 2, p.12).
Unlike perfect competition, marginal revenue (MR) is
less than price and depends on Q.
• A profit-maximizing monopolist will not produce
where demand is inelastic; that is, where |η| < 1,
because it makes MR < 0.
• Profit-maximization means MC = MR, then MC = P[1
– (1/|η|)]. So the profit-maximizing price is:
= (optimal) markup price
If you know the price elasticity of
demand and the marginal cost of the
monopolist, you can determine the
optimal price for the monopolist.

17. COST-PLUS PRICING
• Cost-plus pricing: Simplistic strategy that
guarantees that price is higher than the
estimated average cost
• Studies of pricing behavior suggest that many
managers who use cost-plus pricing do not price
optimally.
• Definition of Markup: Markup = (Price – Cost)/Cost
where Cost here is cost per unit
• Price = (Cost)(1 + Markup)
• Example: Price = 6, Cost = 4, Markup = 0.50
• https://azessays.com/exploring-monopolies-and-
oligopolies/

18. COST-PLUS PRICING AT THERMA-STENT
• Cost-plus pricing is widely used in medical group
purchasing organizations and government-
regulated industries.
• Factory cost = $2,300
• 40% markup = $920
• Price = $3,220
• Using the heuristic eases the complexity of setting price by
ignoring market considerations.
• The danger of such a pricing scheme in a government-
controlled industry is that when the profit is guaranteed, firm
managers may lose the incentive to be cost efficient.

20. Chapter Problem 11
The McDermott Company estimates its average total
cost to be $10 per unit of output when it produces
10,000 units, which it regards as 80% of capacity. Its
goal is to earn 20% on its total investment, which is
$250,000.
a. If the company uses cost-plus pricing, what price
should it set? P = 10 + 50,000/10,000 = 15
b. Can it be sure of selling 10,000 units if it sets this
price?
c. What are the arguments for and against a pricing
policy of this sort?

22. PROFIT-MAXIMIZING MARKUP PRICE
• Rewrite Markup = (P - MC)/MC using marginal
cost (MC) instead of average cost
• We can derive the profit-maximizing markup and
price (that is, the optimal markup and price)
• The profit-maximizing markup price is
P= MC/[1 – (1/|η|)]
that you have already learned in the page 15.

23. EXAMPLE: OPTIMAL MAKRUP PRICE
• Mickey is a monopolist. Currently, its average
cost is $15, and marginal cost is $30. The price
elasticity of demand is –3. What is Mickey’s
profit-maximizing price?
• Disregard average cost and apply the profit-
maximization price: P= MC/[1 – (1/|η|)]
• P = 30/(1-⅓) =30*3/2= 45
https://azessays.com/market-structure-and-game-
theory/

25. Example: Optimal Markup Pricing 2
If a monopolist faces a constant-elasticity demand
curve given by Q = 400 P –2 and has total costs given
by TC = 0.625Q 2, what is the profit-maximizing level of
output?
Solution: the answer is Q=4. Use the optimal markup
price formula P = MC/(1 - 1/|eta|). In this case, P =
1.25Q / (1-0.5) = 2.5Q. Plug this to the demand function
to replace P, then Q = 400(2.5Q)–2 and solve for Q.

27. THE MULTIPLE-PRODUCT FIRM
• Multiple-product monopolist produces multiple
products, for example, good X and good Y. Its
total revenue is the sum of revenue from each
product: TR = TRX + TRY
• We will focus on Joint products. Joint products
are multiple products generated by a single
production process at the same time.

29. PRICING OF JOINT PRODUCTS PRODUCED IN
FIXED PROPORTIONS (QA=QB)
• Product A and B are produced in a fixed proportion (by its
production technology), QA=QB
• Total marginal revenue curve: Vertical summation of the two
marginal revenue curves for individual products:
CASE 1: Marginal
revenue of both
products is positive at
the optimal level of
output.

30. OPTIMAL PRICING FOR JOINT PRODUCTS
PRODUCED IN FIXED PROPORTIONS (QA=QB)
CASE 2: Marginal
revenue of product B is
negative at the optimal
level of output for
product A.
If a product’s marginal
revenue is negative,
then the firm will dispose
of a quantity sufficient to
bring marginal revenue
to zero and thereby
maximize revenue on
that product.

32. Example of Case 1: Profit Maximizing at Humphrey
Humphrey managers manufacture two different
conference table legs that are cut from the same
piece of metal. They differ in their design but are
jointly produced in equal quantities. Managers face
the total cost function
TC = 100 + Q + 2Q2
The demand curve for the firm’s two products are
PA= 200 - QA
PB=150 - 2QB
Humphrey managers want to know how many units
of each leg they should produce to maximize profit.

34. Example of Case 2: Profit Maximizing at Humphrey
Managers face the same total cost function
TC = 100+ Q + 2Q2
The demand curve for the firm’s product A is the
same as
PA= 200 - QA
However, the demand for product B changes to
PB=100 - 2QB. What is the new equilibrium price
and output configuration?

36. MONOPOLISTIC COMPETITION
• Characteristics of monopolistic competition
• Product differentiation—products are not perceived as
identical by consumers
• Managers have some pricing discretion, but because
products are similar, price differences a relatively
small.
• Competition takes place within a product group.
• Product group: Group of firms that produce
similar products

37. MONOPOLISTIC COMPETITION
• Conditions that must be met, in addition to
product differentiation, to define a product
group as monopolistically competitive
• There must be many firms in the product group.
• The number of firms in the product group must be
large enough that each firm expects its actions to go
unheeded by its rivals and unimpeded by possible
retaliatory moves on their part.
• Entry into the product group must be relatively easy,
and there must be no collusion, such as price fixing or
market sharing, among managers in the product
group.

38. MONOPOLISTIC COMPETITION
• Price and Output Decisions
under Monopolistic
Competition
• The short-run equilibrium
in monopolistic
competition is Identical to
short-run equilibrium
under monopoly
• As entry and exit of firms
from the product group
shifts individual firms’
demand curves, long-run
equilibrium occurs where
profit is equal to zero.