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What is the impact of an inelastic demand function on a monopoly production and pricing strategy ?

Theory states, that a monopoly will strive to maximize its profits, by arriving to a point where the difference between the revenues and costs is at a maximum

The potential revenues derive from quantity of sales at a certain price, whixh by turn, are affected by demand

If the demand is inelastic, that means that quantity will remain fixed, no matter the price

Does that narrow or broaden the monopoly's options ? What's the impact of that type of demand on the equilibrium price ?

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  • $\begingroup$ You write "quantity will remain fixed, no matter the price" and then ask "Does that narrow or broaden the monopoly's options?" The answer seems very straightforward. What is causing you difficulties? $\endgroup$ – Giskard Sep 18 '18 at 6:57
  • $\begingroup$ Well, quantity wise you're right, price wise, the optimum is infinite... still we don't see infinite oil prices, for example $\endgroup$ – Guy Louzon Sep 18 '18 at 7:19
  • $\begingroup$ beyond that, how does this affect the monopoly model? $\endgroup$ – Guy Louzon Sep 18 '18 at 7:19
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    $\begingroup$ Take a look at Lerner's Index. $\endgroup$ – superhulk Sep 18 '18 at 7:55
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    $\begingroup$ Industrial Organisation: Markets and Strategies by Paul Belleflamme can be a good place to start. For some more advanced treatment in this area, you can also refer to 'The Theory of Industrial Organistaion' by Jean Tirole. $\endgroup$ – superhulk Sep 18 '18 at 8:21
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Perfectly inelastic demand means quantity demanded is $q$ irrespective of the price. If producing quantity $q$ costs $c$ then the monopolist's problem is

$$\max_p \{pq-c\}.$$

This problem is not well-defined because the function $pq-c$ is increasing in $p$ and has no maximum. So there is no solution to the monopolist's problem. Intuitively, since the monopolist can sell $q$ units at any price, it would want to choose a price of $+\infty$.

You remark incredulously that we do not observe infinite oil prices. If the price of fuel increased to \$1000 per gallon then people would obviously drive their cars less and demand less fuel. So the demand for oil is not perfectly inelastic!

One way to make the problem more well behaved, which is quite common in the literature, is to assume a so-called "choke-price" (a price above which demand drops to zero). Demand is therefore $$D(p)=\begin{cases}q\text{ if }p\leq\overline{p}\\[0.3em]0\text{ if }p>\overline{p}\end{cases}.$$

The monopolist's problem is then

$$\max_p \{pq-c\}\text{ s. th. }p\leq\overline{p}.$$

This is a well-defined maxmisation problem with a unique solition: $p=\overline{p}$ (assuming $\overline{p}q<c$, otherwise the firm would just shit down).

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  • $\begingroup$ so... the monopoly would reach the maximum possible price BUT nots its theoretical marginal profit or mr = mc... $\endgroup$ – Guy Louzon Sep 18 '18 at 11:07
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    $\begingroup$ @GuyL Yes, the $MR=MC$ condition is a convenient shorthand that works well when the problem is well-defined and we can compute $MR$. But to compute $MR$ we need to be able to differentiate the revenue function. We can't differentiate revenue when demand is inelastic because revenue is not well-defined below $q$ and is discontinuous at $q$. $\endgroup$ – Ubiquitous Sep 18 '18 at 13:13

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