Applied Topic Managerial Economics

1. The demand curve in an industry in which there is a single retailer is P = 12 –Q. There
is a single producer of the good sold by the retailer. The cost to the producer of this good
is $4. The producer incurs no other production costs.

(a) Draw the demand curve in this industry with price on the vertical axis and quantity on
the horizontal axis.

(b) On this figure, draw the marginal revenue curve for the monopoly retailer. Write
down the expression for the marginal revenue curve facing the monopoly retailer.

R R =P
T Q
R R =(12 −Q)Q
T
R R =12Q−Q2
T
∂TR R
RR=
M =12 −2Q
∂Q

(c) Treat the marginal revenue curve facing the monopoly retailer as the demand curve
for the monopoly producer. Using this demand curve, draw the marginal revenue curve
that faces the monopoly producer on your graph. Write down the expression for the
marginal revenue curve for the monopoly producer.

R P =P
T Q
R P =(12 −2Q)Q
T
R P =12Q−2Q2
T
∂TR
P
RP=
M =12 −4Q
∂Q

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Applied Topic Managerial Economics

(d) Calculate the quantity of the good the monopoly producer will produce by using the
marginal cost (=4) and the marginal revenue expression for the monopoly producer. This
is the expression you derived in (c). Substitute this quantity into the demand curve facing
the monopoly producer (this is the marginal revenue curve facing the monopoly retailer
and you found it in (b) ) to find what price the monopoly producer will set. Calculate the
monopoly producer’s profit.

 To find producer quantity:

R P =M
M C =4
MR P =12 −4Q=4
8=4Q
Q=2

 To find price set by monopoly producer, equate quantity (above) with producer’s
demand curve – i.e. the retailer’s MR curve:

PP = M
RR
PP =12 −2Q
PP =12 −2(2)
PP =$8

 Producer profit

Pt P=
ro
f
i (×
2$8
)−(
2×$
4)=$
8

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Applied Topic Managerial Economics

(e) The price the monopoly producer sets is the monopoly retailer’s marginal cost. This
may be used to determine what quantity the monopoly retailer will sell by equating the
marginal cost to the monopoly retailer’s marginal revenue. With this quantity
information, the retail price charged by the monopoly retailer may be found by using the
demand curve P = 12 – Q. What is the profit earned by the retailer?

 Retailer quantity:

C R =M
M BR
2 −2Q
8=1
Q=2

 Retailer price:

PR =12 −Q
PR =12 −2
PR =10

 Retailer price:

Pt R=
ro
f
i (×
2$1
0−
) (
2×$
8=
) $
4

(f) Suppose that the monopoly retailer and the monopoly producer decided to merge. Find
the quantity that will be supplied to the market and the price that the good will sell for.
Do you think that the merger is a good outcome?

Set MR = MC like a regular monopoly.

MR VI =12 −2Q
MC =4
12 −2Q=4
2Q=8
QVI =4
PVI =12 −Q=12 −4 =$8

Profit for vertically integrated monopoly is:

Pt R=
ro
f
i (4×
$8
)−(
4×$
4)=$
1
6

So price for consumers is now $8 (not $10). They buy 4 units (instead of two). And the
monopolist earns $16 profit (instead of $12 combined profit). Everyone is happy!

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Applied Topic Managerial Economics

12

11

10

9
MCPM = 8
8

4 MCP = 4

3
P = 12 - Q
2
R
MR = 12 – 2Q
1

0 MRP = 12 – 4Q

1 0 1 2 3 4 5 6 7 8 9 10 11 12

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Applied Topic Managerial Economics

2. The cheese industry consists of three interrelated stages. The milk is produced on
dairy farms and is then taken to processing plants where it is turned into cheese. The
cheese is then sold to consumers through retail stores.

(a) Draw a diagram representing the three stages of production. Include a demand
curve for cheese and show the equilibrium quantity of cheese produced and the price
that retailers will receive for this cheese.

 To find the supply of the final good (cheese), the supply curves from the processing
sector & from the raw material sector (dairy farms) are “added together”.

(b) High fuel prices have increased the cost structure of the dairy farm producing milk
and have also increased the cost of milk processing. Adjust your diagram to illustrate the
effects of these changes on the equilibrium price and quantity of cheese. What impact
will these changes have on dairy farms and on the processing sector?

(c) What strategy at the retail level should the dairy industry instigate to try to increase
cheese consumption, given the hit that the industry has experienced as a result of the
changes listed in b.

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Applied Topic Managerial Economics

P Cheese: retail level

Qcheese

Processing activity

Qprocessing

Milk: raw material

R
for cheese

Qmilk

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Applied Topic Managerial Economics

Cheese: retail level

P
The supply curve for cheese has
shifted left because of increased
input prices in cheese processing
and on dairy farms. This results in a
higher price to consumers and less
cheese being consumed

Qcheese

Processing activity

Higher fuel prices shift the supply

curve of processing activity left.
Cheese processing becomes more
expensive

Qprocessing

Milk: raw material for cheese

R

Increased fuel prices shift the supply

curve for milk left.

Qmilk

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Applied Topic Managerial Economics

Q2(c)

The strategy available to the cheese industry at the retail level is to introduce a promotion
program for cheese. If successful, this should restore cheese consumption to its previous
level (ie before the increase in the price of fuel).

That is, to try to shift the demand curve to the right.

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Applied Topic Managerial Economics

3. Explain making use of diagrams why the monopoly producer of a product should not
restrict the number of retailers selling its product. In answering this question, you should
assume that the product is well known and understood by consumers and that the
producer is not in the position to adjust its level of production.

Outcome first:

The conclusion is that the monopoly producer of a standardised product should allow all
retailers that want to sell the product sell it. This will ensure that the product is
distributed at least cost, maximising the manufacturer’s profit.

That is, it is in the producer’s interests to have strong competition in the retail market for
its product.

It wants retailers to sell at as low a price as possible.

Note that this doesn’t decrease the profits of the producer. The producer still sells to the
retailer at the same (wholesale) price, set by equating MC = MR.

If the retailer has monopoly power, it may choose to sell a smaller quantity to increase its
own profits  but the producer will make less profits as less units are being sold.

The model:

A few points before we look at diagrams…

When retailers are restricted:

1. The retailers gain some monopoly power. That is, the power to be a price maker.

2. In the model, the total industry output declines (Q* < Q) there are less sellers.

3. But each individual firm sells more (q* > q)  the total industry output is split
between less

4. Each retail firm is better off with some market power. They now sell more units
(q*>q) at a higher price (R* > R) than under perfect competition.

5. But the producer is worse off because it gets none of the higher price (R*) gained by
retailers, but sells a lower quantity (Q* < Q) because the retail price has increased
(RR*).

6. One option available to the monopolist is to reduce the wholesale price W to W*.

The original quantity Q will be sold. However, the producer will be worse-off since the
wholesale price is lower.

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Applied Topic Managerial Economics

How to draw the diagrams

We are interested in the overall quantity (Q  for the whole market) and the quantity
sold by each firm (q).

So, at each stage in the process, we need to draw two diagrams:

 One with supply and demand curves for the whole market, and

 One with the cost curves (MC and AC) for each individual firm. We also put the
wholesale price on this diagram.

Step One – Competitive Market Before Restriction of Retailers

QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.

The producer sells to retailers at wholesale price W.

The retailers set MC equal to MR. Since we are in perfect competition, MR = price = R.

Each firms sells quantity q. Total quantity is Q.

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Applied Topic Managerial Economics

Step Two – The Silly Monopoly Producer Restricts Sellers

QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.

The market supply curve is no longer horizontal at R. It slopes upwards because retailers
now have market power. They will only sell more units in return for a higher price.

Each retailer increases quantity sold from q  q*, and achieves a higher price (R R*).

The retailers gain market share as there are now less retailers.

The retailers also make economic profits because they sell more units at a higher price
which is above average costs.

But the market (overall) quantity decreases from Q  Q* because there are less retailers.

This means the producer is worse off because less units are being sold, but the producer
is still receiving the same wholesale price W.

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Applied Topic Managerial Economics

Step Three – Producer Cuts Wholesale Price to Restore Original Sales Volume

QuickTime™ and a
TIFF (Uncompressed) decompressor
are needed to see this picture.

But the producer is still not very happy because they are had to lower wholesale price
from W  W** to make sales volume increase back Q*  Q.

The retailer probably doesn’t care. They sell more units (q**) but at a lower price since
AC has fallen due to the lower wholesale price.

So it is in the producer’s interests to have lots of retailers selling its product in a

competitive market.

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