Price and output determination under Monopoly

Concept of Monopoly market Price elasticity and MR Price and output determination Price determination

Monopoly market
single seller for a product with no close substitutes barriers to entry

Sources and kinds of Monopolies

Legal restriction created by law in public interest; distribution of electricity, petroleum products are created by the government economies of scale or efficiency whereby the most efficient scale of production coincides with the size of the market; large sized firms may eliminate competition by lowering the price in short run Control over key raw materials some firms may acquire monopoly power from their legally granted control over certain scarce and key raw materials that are essential for the production of certain other goods Patent rights Patent rights are granted by the government to a firm to produce a commodity of specified quality and character or to use a specified technique of production. It gives firm exclusive rights to produce the specified commodity or to use specified technique of production

Price elasticity and MR

The demand curve facing a monopoly firms is downward sloping, MR < P MR > 0 when demand is elastic MR = 0 when demand is unit elastic MR < 0 when demand is inelastic

Short run equilibrium of the Monopoly

TR - TC approach MC MR approach A monopolist maximizes total profits by producing the level of output at which marginal revenue equals marginal cost or where the distance between the total revenue and total cost curves is the largest).

TR TC PQ Q ( ATC) Q.(P ATC)

P(Rs) Q 8 0

TR (Rs) 0

MR ..

TC 6

MC

AC

/un Total it 6

7
6 5.50 5 4 3

1
2 2.5 3 4 5

7
12

7
5

8
9 10 12 20 35

2
1 3 3 8 15

8
4 4 4 5 7

-1
1.5 1.5 1 -1 -4

-1
3 3.75 3 -4 -20

13.75 3 15 16 15 3 1 -1

Equilibrium of Monopoly firm

Zero-profit monopolist

Monopolist receiving economic loss

Monopoly price setting

There is a unique profit-maximizing price and output level for a monopoly firm. It is optimal to produce at the level of output at which MR = MC and to charge the price given by the demand curve at this output level. Charging a higher (or lower) price results in lower profits.

Deadweight loss due to monopoly

Price discrimination
Price discrimination - practice in which a firm charges consumers different prices for the same good By virtue of monopoly power a monopolist can charge different prices to different consumers or different groups Consumers are discriminated on the basis of their income or purchasing power, geographic location, age, sex, quantity they purchase etc.

Cont. Some common

Consulting physicians charge different fees from different clients on the basis of their paying capacity price discrimination on the basis of age is found in railways, roadways and airways: children are charged half of adult rates. price discrimination based on bulk purchases In case of public utility services, lower rates are charged when commodity or service consumed is smaller quantity. For example Nepal Electricity Authority and Water Supply Authority of Pokhara. Most common practice of price discrimination is found in entertainment business, e.g. cinema shows, musical concerts, game shows, etc. Different rates are charged from different class of audience.

Necessary condition for Discrimination

Market are so separated that resale is not profitable. The factors that separate markets: (i) geographical distance involving high cost of transportation, domestic and foreign market , (ii) lack of distribution channels e.g. transfer of electricity and water supply price elasticity of demand is different in different markets If markets are subdivided into sub-markets, the elasticity of demand at a given price must be different in each sub-market. Eg airlines facing demand: traveler for business trip (steeper demand) and traveler on holiday The firm must have some monopoly power to control production and price.

Why Price Discrimination Pays

A price-discriminating firm earns a higher profit from price discrimination because:
it charges a higher price to customers who are willing to pay more than the uniform price, capturing some or all of their consumer surplus it sells to some people who were not willing to pay as much as the uniform price.

Types of Price Discrimination

First-degree price discrimination - situation in which a firm sells each unit at the maximum amount any customer is willing to pay for it So prices differ across customers and a given customer may pay more for same units than for others In this whole of consumer surplus available at MR=MC is extracted by the sellers Example a doctor who can guess the paying capacity of patients can charge highest possible fee from richest patient and lowest from poorest ones

First degree price discrimination

In this case the producer charges the highest possible price a consumer is willing to pay; So selling every unit at highest possible price to every potential payer, monopolist extracts all the consumer surplus = area PmN
P

N D

Second degree discrimination

It is adopted when markets are large and divided according to different kinds of buyers monopolist charge different prices for different quantities of purchases. It is also called block pricing system. It is feasible where, (a) no. of consumer is large and rationing can be effective, e.g. telephones, natural gas and also consumer durables, (b) demand curves of all the consumers is identical, (c) a single rate is applicable only for a group of large no. of buyers Telephone, natural gas, drinking water supply

Second degree: Quantity Discrimination

90

P1

70

r
C= $200

P2

50

30

The monopolist sets price $70 to sell 20 units to a particular group of consumers. At $50 it sells 40 units to another group of consumers; Sellers total revenue is higher than a single price mc case Demand A part of consumers surplus is extracted: area P1rtP2 and rts
90 Q, Units per day

p1, $ per unit

20

40

Third degree discrimination

Sets different prices in different markets having demand curve with different price elasticities Fixing same price: monopolist would loss possible profits Eg pepsi and coke prices are different in Nepal and India Different prices of Harry porter DVDs in UK and US market Mankiws Principle of Microeconomics, printed as India Edition

Third degree price discrimination

$
Market A Market B Total Market

D1 MR1 D2

MC MR2

MR = MR1 +MR2
60

D= D1+D2

o
40
20

What is Monopolistic Competition?

Monopolistic competition is a market structure in which there are a large number of firms selling differentiated products and there is easy entry and exit.
Examples: Apartments, books, bottled water, clothing, fast food, night clubs

Characteristics
1. Product differentiation: Firms differentiate their products from one another in respect of their shape, size, color, design, efficiency in use, packaging, after sale service, guarantee and warrantee. The main aim is to make consumer believe that a product is different from others, to create brand loyalty 2. Large number of sellers: Number of sellers is large; it may be 10, 20 or more depends on the size of the market. The number of firms is only so large that firms retains its power to be a price maker 3. Free entry and free exit: Firms are free to enter and exit from the market. Entry of new firms reduces a firms market share and exits of some firms does the opposite. It leads an intensive competition among them to retain their market share 4. Selling costs: Firms make heavy expenditures on advertisement and sales promotion costs; It is a distinguishing feature 5. Downward sloping demand curve: Firms face downward sloping demand curve; firms by exercising monopoly power can set higher prices and still retain some consumers
16-23

Cont
Product differentiation: Product differentiation implies that the products are different enough that the producing firms exercise a mini-monopoly over their product. The firms compete more on product differentiation than on price. Entering firms produce close substitutes, not an identical or standardized product. Many sellers: When there are many sellers, they do not take into account rivals reactions. The existence of many sellers makes collusion difficult. Monopolistically competitive firms act independently. Easy entry and exit: There are no significant barriers to entry. Barriers to entry prevent competitive pressures. Ease of entry limits long-run profit.

Output, Price & Profit: Monopolistic firm

Like a monopoly, the monopolistic competitive firm has some monopoly power so the firm faces a downward sloping demand curve It prices in the same manner as a monopolist where MC = MR. Marginal revenue is below price At profit maximizing output, marginal cost will be less than price Like a perfect competition, zero economic profits exist in the long run
16-25

Short run equilibrium: < Normal Profit

Short run: Economic Loss

Long run equilibrium: Normal Profit

Entry and Normal Profit

Comparing Perfect & Monop. Competition

Perfect competition number of sellers free entry/exit long-run econ. profits many yes zero Monopolistic competition many yes zero

the products firms sell

identical

differentiated
yes

firm has market power? none, price-taker D curve facing firm

MONOPOLISTIC COMPETITION

horizontal

downwardsloping

30

Comparing Monopoly & Monop. Competition

Monopoly number of sellers free entry/exit long-run econ. profits firm has market power? D curve facing firm close substitutes
MONOPOLISTIC COMPETITION

Monopolistic competition
many yes zero yes

one no positive yes

downwarddownwardsloping sloping (market demand) none

31

many