Monopoly

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Chapter 10

Monopoly

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Lecture plan• Objectives• Introduction• Features• Types of Monopoly• Demand and MR Curve• Price and Output Decisions in Short Run• Price and Output Decisions in Long Run• Supply Curve of Monopolist• Multiplant Monopolist• Price Discrimination• Price and Output Decisions of Discriminating

Monopolist• Economic Inefficiency of Monopolist

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Objectives

To examine the nature and different forms of a monopoly market.

To explore the vistas of emergence of monopoly power, with focus on barriers to enter the market.

To analyze the pricing and output decisions of a monopolist in the short run and long run.

To develop an understanding of output and pricing decisions of a multi plant monopolist.

To explore the nuances of price discrimination by a monopolist and the different degrees of such discrimination.

To lay down a representation of the economic inefficiency of monopoly.

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Introduction

A monopoly (from the Greek word “mono” meaning single and “polo” meaning to sell) is that form of market in which a single seller sells a product (good or service) which has no substitute.

Monopoly exists when there is no close substitute to the product and also when there is a single producer and seller of the product E.g. Indian Railway is a monopoly, since there is no other

agency in the country that provides railway service.

Pure monopoly is that market situation in which there is absolutely no substitute of the product, and the entire market is under control of a single firm.

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Features

Single seller The entire market is under control of a single firm.

Single product A monopoly exists when a single seller sells a

product which has no substitute or, at least, no close substitute in the market.

No difference between firm and industry There is a single firm in the industry

Independent decision making Firm is regarded as a price maker

Restricted entry Existence of barriers leads to the emergence and/or

survival of a monopoly

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Types of Monopoly Legal Monopoly

Created by the laws of a country in the greater public interest. To prevent disparity in distribution of wealth, or imbalanced

growth of the economy Economic Monopoly

Created due to superior efficiency of a particular player. Attainment of economies of scale leads to monopoly, often referred

to as an “innocent” or a structural barrier. Technical know-how restrained in the hold of single firm

Natural Monopoly Formed when the size of the market is so small that it can

accommodate only one player. Regional Monopoly

Geographical or territorial aspects also help in creation of monopolies.

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The demand curve of the monopolist is highly price inelastic because there is no close substitute and consumers have no or very little choice.

It is not perfectly inelastic because pure monopoly does not exist in real life.

Hence it faces a normal downward sloping demand (AR) curve.

The monopolist cannot set both price and quantity at its own will.

Demand and MR Curves

Revenue, Cost

ARMR

Quantity

O

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Price and Output Decisions in Short Run

In order to maximize profit a monopoly firm follows the rule of MR=MC when MC is rising.

A monopoly firm may earn supernormal profit or normal profit or even subnormal profit in the short run.

The negative slope of the demand curve is instrumental for chances of monopoly profits in the short run.

In the short run, the firm would reap the benefits of supplying a product which not only is unique, but also has negligible cross elasticity.

B

Quantity

AR

MCPrice, Revenue, Cost

MR

E

PE

A

QE

O

Firm maximizes profit where (i) MR=MC (ii) MC cuts MR from

below, at point E.

Equilibrium price=OPE, Output= OQE

Total revenue =OPEBQE

Total cost = OAEQE

Supernormal profit= AEBPE, since price PE > Average cost

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Price and Output Decisions in Short Run

Total revenue= OPEBQE

Total cost = OPEBQE

Profit = Nil

Firm makes normal profit.

MR

Quantity

MC

O

AC

AR

B

E

Price, Revenue, Cost

PE

QE

Quantity

C

AR

MCPrice, Revenue, Cost

MR

AC

E

PE

A

QEO

B

Total revenue= OPECQE

Total cost = OABQE

Loss = ABCPE

Firm makes loss.

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A monopolist is in full control of the market price It would not continue to incur loss in the long run. It would try to reduce cost of production Otherwise it would close down in the long run.

Monopolist would try to earn at least normal profit in the long run and may earn supernormal profit due to entry restrictions in the market.

If in the long run a monopoly firm earns supernormal profit This would attract competition and high price would make it possible for a

new entrant to survive.

To retain its monopoly power, the firm may have to resort to a low price and earn only normal profit even in the long run to create an economic barrier to new entrants.

Price and Output Decisions in Long Run

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Supply Curve of Monopoly Firm

A monopolist is a price maker The firm itself sets the price of the product it sells,

instead of taking the price as given.

It equates MC with MR for profit maximization, but unlike perfect competition, it does not equate its price to MR.

Supply of the good by the monopolist at a given price would be determined by both the market demand and the MC curve.

As such, there is no defined supply curve for a monopolist.

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Multi Plant Monopoly

A monopolist may produce a homogeneous product in different plants. different cost functions but the same demand function for the entire

market. hence the same AR and MR curves for the entire market.

A multi plant monopolist has to take two decisions: how much to produce and what price to sell at, so as to maximize its profit how to allocate the profit maximizing output between the plants.

Assuming that a monopoly firm produces in two plants, A and B.

Profit maximising output will be at MR= MCA= MCB

If MCA< MCB, it would increase production in A, (lower MC) and reduce production in B (higher MC), till the equality is satisfied.

The firm produces till MCA and MCB are individually equal to MR, which is same for both plants.

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Multi Plant Monopoly

OQ is the profit maximizing output satisfying MR=MC, when MC is rising. QA+QB= OQ, i.e. total output

Price is shown by PP, which determines AR in both the plants. OP is the equilibrium price and RPBE is the total profit (TR-TC) of the

firm (Panel a). Panel b shows the cost function of plant A, in which MC is lesser. Panel c shows the cost function of plant B in which MC is greater.

Price, Revenue, Cost

MC=MR

P

R

MC A

C

Quantity

QBQA

MRAR

BE

Q

MCA

MCB

ACA ACBB1 B2

E1

E2R1

R2

P= AR

O

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Price Discrimination Discrimination among buyers on the basis of the price charged for

the same good (or service). Objective is to maximise sales

Preconditions of Price Discrimination Market control

Market imperfection and control are necessary Monopoly is the most suitable market condition, because it is a

price maker. Division of market

when the whole market can be divided into various segments, and transfer of goods between the markets is not possible

Different price elasticities of demand in different markets Separation of market is a necessary condition for price

discrimination, but the sufficient condition is that price elasticities of demand should be different in these market segments

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Bases of Price Discrimination

Personal On basis of the paying capacity and/or the intensity of needs. Since this discrimination is being done on a personal basis, the

good (or service) is non transferable. Geographical

People living in different areas are required to pay different prices for the same product.

E.g. edible oils and many packaged food items are sold at different prices in different States of India.

Time The same person may be required to pay different prices for the

same product. E.g. off season discounts.

Purpose of use Customers are segregated on basis of their purpose of use.

E.g. electricity rates are lower for domestic purpose and higher for industrial purpose.

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Degrees of Price Discrimination

Pigou has identified three degrees of price discrimination. First Degree

charges a price exactly equal to the marginal utility of the consumer and leaves no consumer surplus.

Joan Robinson referred to it as perfect discrimination. Second Degree

Divides consumers in groups on the basis of their paying capacities; a person with lower paying capacity is charged a lower price and vice versa

Takes away the major (but not entire) portion of consumer surplus. Third Degree

Segregates consumers such that each group of consumers is a separate market, and charges the price on basis of price elasticity of different groups.

Takes away only a small portion of consumer surplus.

Degrees of Price Discrimination

First Degree: Monopolist’s income is equal to the area OPEQ leaving no consumer surplus. MR curve coincides with AR.

Second Degree: divided consumers in three segments and charges price P1, P2, P3 and leaves some surplus except the third group which marginal consumer.

Third Degree: charges higher price to buyers with less elastic demand and lower price to those with highly elastic demand, and maximizes its revenue.

First degree Second degree Third degree

Q

D

E3P3

Q1

OD=MR

E

P

OQuantity

Price

Q2 Q3

P2

P1

E2

E1

A1

A2 A1

D

EP

P1

QQ1

O

E1

Price and Output Decisions of Discriminating Monopolist

Assume that the firm can segregate the market on basis of price elasticity of demand: M1 with high price elasticity and M2 with low price elasticity.

The rule is:

Lower price and more supply in the market with high price elasticity

Higher price and less supply in the market with low price elasticity. The firm will charge lower price in the market M1 and higher price in the

market M2 and it would supply more to the market M1 and less to the market M2.

Firm would determine the profit maximizing output at MC=MR while MC is increasing.

The upper portion of the AR curve refers to the less elastic demand and the lower portion to highly elastic demand.

The MR curve corresponds to the AR curve.

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Price and Output Decisions of Discriminating Monopolist

In the market M1 the optimum output is OQ1 and in the market M2 the optimum output is OQ2. (OQ1> OQ2 and OP1< OP2)

Price discrimination leads to greater profits. Without price discrimination, for output OQ, the firm would earn the

area OPEQ, which is less than the area given by OP1E1Q1+OP2E2Q2.

MC

MR1

AR

AR1

AR2

MR2

Price, Cost, Revenue

O O O

P1

PE1

E2P2

MRQuantity

MC=MR1

=MR2

Market 1 Market 2

Firm

Q Q1

E

Q2

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Economic Inefficiency of Monopoly

A monopoly firm operates at less than optimum output and charges a higher price.

Monopoly does not allow optimum use of all the factors of production, thereby allowing loss of output and creating excess capacity in the economy

Considered as a loss of social welfare, hence authorities make regulations to check and prevent monopoly practices.

Also termed as deadweight loss to the economy, since this increase in output is actually possible under perfect competition.

Compare two firms, one under perfect competition, and the other under monopoly to explain the condition; assuming that both the firms earn normal profits.

The firm under perfect competition faces a horizontal demand curve (DC), whereas the monopoly firm faces a downward sloping curve DM, which is less elastic.

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Economic Inefficiency of Monopoly

The monopolist produces an output QM(<QC), and sells at price PM(>PC) OQC-OQM (i.e. QMQC), is regarded as excess capacity (Fig 1).

Perfectly competitive firm allows maximum consumer surplus (PCDB); Monopoly takes away PCPMAE from consumers to the firm. (Fig 2). AEB is neither part of firm’s income nor of consumer surplus; hence is the

deadweight loss or economic inefficiency due to monopoly.

Quantity

QM

EC

EM

O

Price, Revenue, Cost

PC DC

LAC

QC

PM

DM

Fig 1: Excess Capacity Fig 2: Deadweight Loss

D

E

A

BMC=AC=MRP=ARP

ARMMR

M QC

QM

O

PC

PM

Quantity

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Summary

A monopoly is that form of market in which a single seller sells a product (or service) which has no substitute.

Pure monopoly is where there is absolutely no substitute of the product, and the entire market is under control of a single firm.

A monopoly has a single seller, sells a single product (pure monopoly) and decides on its own price and output, based on individual demand and cost conditions and is hence regarded as a price maker.

In monopoly the firm and the industry are one and the same. Barriers to entry are the major sources (or reasons) of monopoly power

and may include restriction by law, control over key raw materials, specialized know how restricted through patents or licences, small market and economies of scale.

A monopoly firm has a normal demand curve with a negative slope. The demand curve is highly price inelastic because there is no close substitute.

A monopolist firm may earn supernormal profit, or normal profit, or may even incur loss in the short run, but would not incur loss in the long run.

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Summary

The monopolist being a price maker does not have any supply curve. A multi plant monopolist decides on how much to produce and what price to

sell at so as to maximize its profit on the basis of the principle of marginalism.

When a seller discriminates among buyers on basis of the price charged for the same good (or service), such a practice is called price discrimination.

Price discrimination can be done on personal basis (demographical, paying capacity or need), on the basis of geography, on the basis of time or purpose of use.

The discriminating firm will charge a higher price and supply less to the market having higher price elasticity and a lower price and supply more in the market having lower price elasticity.

Monopoly runs at less than optimum level of output and generates excess capacity in the economic system, which in turn results in deadweight loss that adds neither to consumer surplus, nor to seller’s profit.