Page 201 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes Monopoly Power

Monopoly is relatively uncommon. While there are lots of situations where a few firms are the
principal suppliers of a particular good or service, cases where only a single supplier exists are
the exception far more often than the rule. But even if a firm is not the only supplier of a
particular good or service, it may have a certain amount of monopoly power, in the sense that,
unlike a perfectly competitive firm, it will find it profitable to raise its price above marginal
cost.
To measure the amount of monopoly power possessed by a firm, economists often use the
Lerner index, which equals

P MC
-
L =
P
Where P is the firm's price and MC is its marginal cost. This index varies between 0 and I. For a
0
perfectly competitive firm, price equals marginal cost, so L=0. Seller’s monopoly power = = 0.
P
The higher the L is, the higher the degree of monopoly power is.

Another way to calculate L is to obtain the reciprocal of the price elasticity of demand for the
firm's product. This is not the same as the reciprocal of the price elasticity of demand for the
industry's product. It is the (negatives) reciprocal of the percentage increase in the quantity
demanded by the firm's product if it cuts price by 1 per cent.
æ 1 ö æ 1 ö
 MR = AR 1 + ÷ = P 1 + ÷
ç
ç
è e P ø è e P ø
If the firm maximises profit
MR = MC

æ 1 ö
 MC = P × 1 +
ç ÷
è e P ø
This means that,
æ 1 ö
MC/P = ç 1 + ÷
è e P ø
1 (P MC)
-
And – = 1 – MC/P =
e P
P
What factors influence the price elasticity of demand for a firm's product and hence influence
this firm's degree of monopoly power, as measured by the Lerner index?
1. The higher the price elasticity of demand for any individual firm's product, lower is the
degree of monopoly power.
2. The larger the number of firms in the industry and the more strongly they compete, the
higher the price elasticity of demand is likely to be for any individual firm's product (and
the lower the degree of monopoly power).

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