Monopolistic response to demand and supply shocks

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Demand shocks and supply shocks can both lead to new optimal (price, quantity) pairs for a given monopolistic firm. Unlike the case of a competitive market, where there is convergence towards market price by movement along the new demand and supply curves, the effect here arises from a top-down decision to optimize for the new scenario (the optimization may be immediate -- assuming perfect knowledge of the market by the monopolistic firm -- or based on gradual experimentation).

There are four types of shifts:

  • Shift to higher price, higher quantity
  • Shift to lower price, higher quantity
  • Shift to higher price, lower quantity
  • Shift to lower price, lower quantity

Of price and quantity, one may be easier to adjust more quickly. This opens up another optimization problem: find the optimal path to the new optimum. Setting up this problem formally would be too tricky here.

Consider the more dramatic case: the new optimum involves a switch to lower quantity. In case it is quicker to change the price and change the quantity sold than it is to change the quantity produced, there arises the question of what to do with the surplus quantity produced relative to the new optimum. If the good is non-perishable, the surplus can simply be stored for selling later. If the good is perishable, it may be destroyed or allowed to rot, in order to be able to avail of the new optimum quickly. This could be highly socially non-optimal.

Consider a situation where a demand curve suddenly expands outward, but the expansion is much greater for people at the highest reservation prices. As discussed in the comparative statics for supply and demand, it may make sense in these cases to reduce the quantity supplied and raise the price. This conclusion might hold even if the marginal costs of production are already incurred (though that transitional optimum would not be as severe as the eventual optimum). The conclusion holds partially for people with market power who are not monopolists: in the presence of food shortages, if certain segments of the population show a substantially greater willingness to pay more for food than others, the incentives to hoard and destroy food for a supplier with market power might increase.