Microeconomic Theory: Monopoly, Monopolistic Competition, Oligopoly, and Consumer Behavior

Monopoly

Price and Output in the Short Run

In the short run, a monopoly determines the profit-maximizing price and output by equating marginal revenue (MR) with marginal cost (MC). The monopolist faces the market demand curve directly.

• Profit Maximization Rule: Set output where MR = MC.

• Price Determination: After finding the profit-maximizing quantity, use the demand curve to find the corresponding price.

• Example: If the demand curve is $P = 100 - 2Q$ and MC = 20, set MR = MC to solve for Q, then substitute Q into the demand curve to find P.

Rule of Thumb for Pricing

Monopolists often use a markup rule based on the price elasticity of demand.

• Formula: $P = \frac{E}{E+1} MC$ where E is the price elasticity of demand (in absolute value).

• Interpretation: The less elastic the demand, the higher the markup over marginal cost.

Monopoly Power (Lerner Index)

The Lerner Index measures the degree of monopoly power by comparing price and marginal cost.

• Formula: $L = \frac{P - MC}{P}$

• Range: 0 (perfect competition) to 1 (maximum monopoly power).

No Supply Curve

Unlike competitive firms, a monopoly does not have a supply curve because its output decision depends on the demand curve and marginal cost, not just price.

Output and Price Decision in the Long Run

In the long run, a monopoly can adjust all inputs and may continue to earn economic profits if barriers to entry persist.

• Barriers to Entry: Legal restrictions, control of resources, economies of scale, etc.

Comparing Monopoly to Perfect Competition

• Monopoly: Lower output, higher price, positive economic profit.

• Perfect Competition: Higher output, lower price, zero economic profit in the long run.

Social Costs of Monopoly

The deadweight loss from monopoly represents the loss in total surplus due to reduced output. However, actual social costs may be higher or lower due to factors like rent-seeking or economies of scale.

• Deadweight Loss: Area between demand and marginal cost curves over the range of monopoly output to competitive output.

• Additional info: Rent-seeking behavior can increase social costs; natural monopolies may have lower costs due to economies of scale.

Monopolistic Competition

Definition and Market Characteristics

Monopolistic competition is a market structure with many firms selling differentiated products and free entry and exit.

• Key Features: Product differentiation, many sellers, some market power, free entry/exit.

Proportional Demand Curve

Each firm faces a downward-sloping demand curve that is more elastic than a monopoly's due to the presence of close substitutes.

Short Run Equilibrium

• Firms may earn economic profits or losses.

• Set MR = MC to determine output and price.

Long Run Equilibrium

• Entry and exit drive economic profit to zero.

• Firms produce where demand is tangent to average total cost (ATC).

Allocative and Productive Efficiency

• Allocative Efficiency: Not achieved; P > MC.

• Productive Efficiency: Not achieved; firms do not produce at minimum ATC.

Loss in Efficiency vs. Product Variety

• Some efficiency is lost compared to perfect competition, but consumers benefit from greater product variety.

Comparison to Monopoly and Perfect Competition in the Long Run

• Monopolistic Competition: Zero economic profit, excess capacity, differentiated products.

• Monopoly: Positive economic profit, no close substitutes.

• Perfect Competition: Zero economic profit, homogeneous products, efficient scale.

Oligopoly

Definition and Market Characteristics

An oligopoly is a market structure with a few large firms that are interdependent in their pricing and output decisions.

• Key Features: Few firms, barriers to entry, potential for collusion, strategic behavior.

Barriers to Entry

• Economies of scale, control of resources, legal restrictions, brand loyalty.

Key Characteristic

• Interdependence: Each firm's actions affect the others.

Collusion/Cartels

• Firms may attempt to collude to maximize joint profits (cartel).

• Why Difficult to Maintain: Incentive to cheat, legal restrictions, detection problems.

Strategic Behavior and Game Theory

• Firms use strategic actions, anticipating rivals' responses.

• Nash Equilibrium: No firm can improve its outcome by changing its strategy unilaterally.

• Dominant Strategy: A strategy that is best regardless of what others do.

• Credible Threat: A threat that is rational and believable.

Allocative and Productive Efficiency

• Oligopolies may not achieve allocative or productive efficiency due to market power and strategic behavior.

Comparison to Other Market Structures

• Oligopoly outcomes are between monopoly and perfect competition, depending on the degree of collusion and competition.

Consumer Behavior

Objective Function: Maximizing Utility

Consumers aim to maximize their utility (satisfaction) given their budget constraints.

Indifference Curves

• Definition: A curve showing all combinations of goods that provide the same level of utility.

• Shapes and Interpretations:

  • Downward sloping with diminishing marginal rate of substitution (MRS): Typical case, reflects trade-offs.

  • Flat/Steep: Indicates relative preferences for one good over another.

  • Perfect Complements: L-shaped curves (e.g., left and right shoes).

  • Perfect Substitutes: Straight lines (constant MRS).

  • Bads: Upward sloping (undesirable goods).

  • Neutrals: Vertical or horizontal lines (one good does not affect utility).

Utility Functions

• Different utility functions yield different shapes of indifference curves.

• Marginal Utility (MU): The additional utility from consuming one more unit of a good.

  • Calculated as the partial derivative of the utility function with respect to the good.

  • Example: For $U(x, y) = x^a y^b$, $MU_x = \frac{\partial U}{\partial x} = a x^{a-1} y^b$

• Finding Points on an Indifference Curve: Set utility equal to a constant and solve for combinations of goods.

• Marginal Rate of Substitution (MRS): $MRS_{xy} = -\frac{MU_x}{MU_y}$

Budget Constraints

• Definition: The set of all bundles a consumer can afford given prices and income.

• Equation: $P_x X + P_y Y = I$

• Graph: Straight line with slope $-\frac{P_x}{P_y}$

• Changes:

  • If price changes: Slope changes.

  • If income changes: Intercept shifts.

  • Income in kind: Budget line 'kinks' at the point where the free good runs out.

  • "Money on all other goods" on vertical axis: The slope is $-P_x$.

Consumer Equilibrium

• Occurs where the highest indifference curve is tangent to the budget constraint.

• Condition: $MRS_{xy} = \frac{P_x}{P_y}$

• Special Cases:

  • Multiplicative utility: Use Lagrangian method to solve for optimal bundle.

  • MOAOG (Money on all other goods) on vertical axis: Adjust budget equation accordingly.

  • Income in kind: Consider the kinked budget constraint.

  • Additive utility: $U(x, y) = ax + by$; consumer spends all income on the good with the highest marginal utility per dollar.

Dynamics: Changes in Income and Prices

• Income increase: Budget line shifts outward; consumer can reach higher indifference curves.

• Price decrease: Budget line pivots outward; substitution and income effects determine new optimum.

• Assessing Welfare: If the consumer reaches a higher indifference curve, they are better off.

Budget Constraint: Allocating Time

• Axes: Hours of leisure (horizontal) vs. income (vertical).

• Wage Change: Slope of budget constraint changes; higher wage makes leisure more expensive.

• Nonmarket Income: Shifts budget constraint upward; consumer can afford more leisure without working.

• Indifference Curves: Show trade-off between leisure and income.

• Preferences:

  • Individuals who prefer nonmarket time (NMT): Choose more leisure, less income.

  • Individuals who prefer money: Choose more work, less leisure.

  • Nonmarket income generally makes individuals better off, as they can reach higher indifference curves.