Problem Set 7.

Monopoly

EconS 526

1. A monopolist has a linear cost function, 10y. It consulted with an economist to estimate the
demand for its good. The economist derived the following demand equation, 𝑦𝑦 = 100 − 𝑝𝑝.
a. How much should the monopolist produce and what price should it set to maximize profit?
Show the monopolist’s problem and solution.

max(100 − 𝑦𝑦)𝑦𝑦 − 10𝑦𝑦

𝑦𝑦

FOC: 100 − 2𝑦𝑦 − 10 = 0. Therefore y=45 and p=100-45=55.

b. If the government forced the monopolist to act like a competitive market, what price level
would be set and how much would be produced? Derive the deadweight loss in the market
given the monopolist operating in the market.

In this case, price should equal marginal cost. 100 − 𝑦𝑦 = 10. Therefore y=90 and p=10. The deadweight
loss is a triangle bounded by the difference in output, difference in price and the demand curve. In this
case it is (90-45)x(55-10)/2=1012.5

c. Another economist found that the correct demand equation should be 𝑦𝑦 = 100/𝑝𝑝 if 𝑝𝑝 ≤ 20
and 𝑦𝑦 = 0 if 𝑝𝑝 > 20. Given this new information, what is the monopolist’s profit maximizing
price and quantity?

A price higher than 20 leads to negative profit so price is less than or equal to 20. Note that revenue is
fixed at 100. Therefore, the monopolist only needs to choose the lowest quantity to maximize profit. In
this case, it is y=5 when p=20.

d. If the government forced the monopolist to act like a competitive market, what price level
would be set and how much would be produced?

The government would equate price to marginal cost. So p=10. The resulting y=10.

2. A monopolist has a convex cost function 𝑐𝑐(𝑦𝑦) and is faced with an inverse demand 𝑝𝑝(𝑦𝑦, 𝐼𝐼)
where y is output level and I is income. The good produced by the monopolist is a normal good.
a. Set up and solve the monopolist’s problem. Given your solution, derive an expression
showing the effect of income on optimal output of the monopolist. What assumption(s) do
you need to make to sign the comparative static?
max 𝑝𝑝(𝑦𝑦, 𝐼𝐼)𝑦𝑦 − 𝑐𝑐(𝑦𝑦)
𝑦𝑦
FOC: 𝑝𝑝𝑦𝑦 (𝑦𝑦, 𝐼𝐼)𝑦𝑦 + 𝑝𝑝(𝑦𝑦, 𝐼𝐼) − 𝑐𝑐𝑦𝑦 (𝑦𝑦) = 0. Thus, y*(I). SOC: 𝑝𝑝𝑦𝑦𝑦𝑦 𝑦𝑦 + 2𝑝𝑝𝑦𝑦 − 𝑐𝑐𝑦𝑦𝑦𝑦 < 0
 𝑑𝑑𝑦𝑦 ∗
Get by substituting y*(I) into the FOC and totally differentiating with respect to I to
𝑑𝑑𝑑𝑑
derive,
𝑑𝑑𝑦𝑦 ∗ 𝑝𝑝𝑦𝑦𝑦𝑦 𝑦𝑦 + 𝑝𝑝𝐼𝐼
=−
𝑑𝑑𝑑𝑑 𝑝𝑝𝑦𝑦𝑦𝑦 𝑦𝑦 + 2𝑝𝑝𝑦𝑦 − 𝑐𝑐𝑦𝑦𝑦𝑦

The denominator is negative because that is the second order condition. The numerator is ambiguous. It
𝑑𝑑𝑦𝑦 ∗
will be positive if 𝑝𝑝𝑦𝑦𝑦𝑦 > 0. Note 𝑝𝑝𝐼𝐼 > 0 because the good is normal. So if that assumption holds, > 0.
𝑑𝑑𝑑𝑑

b. How does an increase in income affect the price set by the monopolist? Show an expression
that proves this relationship.

𝑑𝑑𝑝𝑝∗ 𝜕𝜕𝑝𝑝∗ 𝜕𝜕𝑝𝑝∗ 𝑑𝑑𝑦𝑦 ∗

= + ∗
𝑑𝑑𝑑𝑑 𝜕𝜕𝐼𝐼 𝜕𝜕𝑦𝑦 𝑑𝑑𝑑𝑑
𝑑𝑑𝑦𝑦 ∗
This is ambiguous. The direct effect is positive but the indirect effect is negative when 𝑑𝑑𝑑𝑑
> 0 because
𝜕𝜕𝑝𝑝∗
𝜕𝜕𝑦𝑦 ∗
< 0.

3. There are two consumers with the following utility functions: 𝑢𝑢1 = 𝑎𝑎1 𝑥𝑥1 and 𝑢𝑢2 = 𝑎𝑎2 𝑥𝑥2 where
𝑎𝑎1 > 𝑎𝑎2 . A monopolist supplies the good. It can produce the good at zero marginal cost but it
can only produce 10 units of the good at most. The monopolist offers two price-quantity
packages: (𝑟𝑟1 , 𝑥𝑥1 ) and (𝑟𝑟2 , 𝑥𝑥2 ) where 𝑟𝑟𝑖𝑖 is the cost of purchasing 𝑥𝑥𝑖𝑖 units of the ith good.
a. Write the monopolist’s profit maximization problem. Hint: It should have four constraints
along with a capacity constraint. Identify which constraints are binding.
max 𝑟𝑟1 + 𝑟𝑟2 𝑠𝑠. 𝑡𝑡. 𝑎𝑎1 𝑥𝑥1 ≥ 𝑟𝑟1 , 𝑎𝑎2 𝑥𝑥2 ≥ 𝑟𝑟2 ,
𝑟𝑟1 ,𝑟𝑟2
𝑎𝑎2 𝑥𝑥2 − 𝑟𝑟2 ≥ 𝑎𝑎2 𝑥𝑥1 − 𝑟𝑟1 , 𝑎𝑎1 𝑥𝑥1 − 𝑟𝑟1 ≥ 𝑎𝑎1 𝑥𝑥2 − 𝑟𝑟2 , 𝑥𝑥1 + 𝑥𝑥2 ≤ 10

The binding constraints are 𝑎𝑎2 𝑥𝑥2 = 𝑟𝑟2 and 𝑎𝑎1 𝑥𝑥1 − 𝑟𝑟1 = 𝑎𝑎1 𝑥𝑥2 − 𝑟𝑟2 and 𝑥𝑥1 + 𝑥𝑥2 = 10.

b. Substitute these constraints into the monopolist’s profit maximization problem and derive
the values of (𝑟𝑟1 , 𝑥𝑥1 ) and (𝑟𝑟2 , 𝑥𝑥2 ).

So now, max 𝑎𝑎1 𝑥𝑥1 − 𝑎𝑎1 𝑥𝑥2 + 2𝑎𝑎2 𝑥𝑥2 𝑠𝑠. 𝑡𝑡. 𝑥𝑥1 + 𝑥𝑥2 = 10 or max 𝑎𝑎1 10 + 2(𝑎𝑎2 − 𝑎𝑎1 )𝑥𝑥2 So 𝑥𝑥1 = 10 and
𝑥𝑥1 ,𝑥𝑥2 𝑥𝑥2
𝑥𝑥2 = 0. This means that 𝑟𝑟2 = 0 and 𝑟𝑟1 = 10𝑎𝑎1 .

4. A monopolist sells the same product in two markets. The production cost is linear such that 𝑐𝑐𝑦𝑦𝑖𝑖
is the cost of production in the ith market. The demand equations for each market are: 𝑦𝑦𝑖𝑖 = 𝑎𝑎𝑖𝑖 −
𝑏𝑏𝑖𝑖 𝑝𝑝𝑖𝑖 ∀ 𝑖𝑖 = 1,2 where 𝑝𝑝𝑖𝑖 is the price in the ith market.
a. If the monopolist is allowed to set different prices in each market, write down the
monopolist’s problem and solve for optimal prices and quantity in each market.
𝑎𝑎1 − 𝑦𝑦1 𝑎𝑎2 − 𝑦𝑦2
max � � 𝑦𝑦1 + � � 𝑦𝑦2 − 𝑐𝑐(𝑦𝑦1 + 𝑦𝑦2 )
𝑦𝑦1 𝑦𝑦2 , 𝑏𝑏1 𝑏𝑏2
 𝑎𝑎1 −2𝑦𝑦1 𝑎𝑎2 −2𝑦𝑦2 𝑎𝑎1 −𝑐𝑐𝑐𝑐1 𝑎𝑎2 −𝑐𝑐𝑐𝑐2
FOCs: � 𝑏𝑏1
�− 𝑐𝑐 = 0 and � 𝑏𝑏2
�− 𝑐𝑐 = 0 so 𝑦𝑦1 = 2
and 𝑦𝑦2 = 2
. So that prices are

𝑎𝑎1 +𝑐𝑐𝑐𝑐1 𝑎𝑎2 +𝑐𝑐𝑐𝑐2

𝑝𝑝1 = and 𝑝𝑝1 =
2𝑏𝑏1 2𝑏𝑏2

b. Under what conditions, i.e. the values for the demand parameters in each market, will the
monopolist opt not to price discriminate?

If a1=a2 and b1=b2.

Deadline: November 12, 2015, 12noon. See syllabus for penalty due to late submissions.