Paper: Managerial Economics

Module 20: Monopoly

Subject: Managerial Economics

Principal Investigator

Co-Principal Investigator

Paper Coordinator

Content Writer

Prof. S P Bansal Vice Chancellor

Maharaja Agrasen University, Baddi

Prof Yoginder Verma

Pro–Vice Chancellor

Central University of Himachal Pradesh. Kangra. H.P.

Prof. S.K. Garg

Former Dean and Director,

HPU, Shimla

Mrs. Ritu K.Walia Assistant Professor, Department of Economics

Guru Nanak Girls College, Yamuna Nagar,

Haryana-135001

QUADRANT-I

Items Description of Module

Subject Name Managerial Economics

Paper Name Managerial Economics

Module Title Monopoly

Module Id

Pre- Requisites Basic knowledge of Monopoly & its related concepts

Objectives To understand Monopoly, Monopoly Power & Price Discrimination

Keywords Monopoly, Price Discrimination, Monopolist

Module: Monopoly

1. Learning Outcome

2. Introduction and Meaning of Monopoly

3. Assumptions / features of Monopoly

4. Reasons of Emergence of Monopoly Power

5. Revenue & Cost Curves

6. Price and Output Determination under Monopoly

7. Equilibrium under Multi Plant Monopoly

8. Monopoly Power

9. Price Discrimination

10. Dumping

11. Summary

1. Learning Outcome:

After completing this module the students will be able to:

Understand the meaning and features of monopoly.

Understand the reasons of its emergence

Learn equilibrium/Price & Output determination under monopoly.

Knowledge about monopoly power

Know about price Discrimination and equilibrium under it.

Understand Dumping.

MONOPOLY

2. INTRODUCTION

Earlier it was observe that there was no monopoly market. It was just exceptional case but

now a day we can see many examples in real world of this market. There are two extreme

cases of market one is perfect competition where there are large number of sellers selling

homogenous product and other extreme end is pure monopoly when there is only single seller

for example Indian railway.

MEANING

Monopoly is a market having single seller of a product which has no close substitutes.

Literally Monopoly implies ‘Mono’ means One and ‘Poly’ means seller. Thus monopoly

means ‘One Seller’ or ‘One Producer’ exist in a market.

There are three main important points regarding monopoly

i. There must be single seller of a product. The single producer can be in the form of

individual owner, a single partnership or a joint stock company.

ii. No substitutes of the product in the market.

iii. There must be strong barriers to entry of new firms into the market.

DEFINITION

According to Koutsoyiannis “Monopoly is a market situation in which there is a single

seller, there are no close substitutes for commodity it produces there are barriers to entry”

According to Lerner “Monopoly as any seller who is confronted with a falling demand curve

for his product”

3. ASSUMPTIONS/ FEATURES OF MONOPOLY

The following are the main features or assumptions of monopoly market:

i. Single Seller & Large number of Buyers: This is the main feature of monopoly that

there must be single seller of the product and there are strong barriers to entry for new

firms. And there is an existence of large number of buyers.

ii. No Close Substitutes: There must be no close substitutes of the product in the market

otherwise monopoly will break.

iii. Barriers to Entry: There must be barrier to entry for the new firms into the market. It

can be through licence, limit pricing policy, economies of production etc.

iv. Price Maker: A monopolist is the whole seller of the product with no close

substitutes. So it is industry itself. It is price maker as well as price taker also.

v. Price Discrimination: When a monopolist charges different prices for the same

product from different buyers it is case of price discrimination. In monopoly seller can

practised price discrimination as he is single producer of the product.

4. REASONS OF EMERGEMCE OF MONOPOLY POWER

There are many causes due to which monopoly generates

i. Patent rights for a product or for a process of production of the product.

ii. Exclusive ownership of raw material and exclusive knowledge of production technique.

iii. Some time government provide gnat for franchise to a firm.

iv. Monopoly may be generate due to scale of production which give economies of scale.

v. Monopoly can be generated through limit pricing policy.

5. REVENUE AND COST CURVES IN CASE OF MONOPOLY

To study the price and output determination under monopoly it is important to know the

nature of demand curve under it.

i. Demand Curve: under perfect competition demand curve for a firm is horizontal while for

industry it is downward sloping. In monopoly a firm itself is industry so its demand curve is

downward sloping implying if a monopolist want to increase the sale of its product it must

lower the price or vice versa. So demand and average revenue curve are downward. When

average revenue curve is downward marginal revenue curve is also downward and under it. It

is shown in the table & Figure1.

Table 1: Total Revenue, Average Revenue and Marginal Revenue

Number of Unit Sold Price Per Unit

(in Rupees)

Total Revenue

(in Rupees)

Average Revenue

(in Rupees)

Marginal Revenue

(in Rupees)

1 10 10 10 10

2 9 18 9 8

3 8 24 8 6

4 7 28 7 4

5 6 30 6 2

Figure 1: Revenue Curve

AR is average revenue curve and MR is marginal revenue curve. Implying if a monopolist

want to sell more quantity it has to lower down its price of the product and he can sale less at

higher prices. AR and MR are less elastic in monopoly because there are no close substitutes

of the product.

ii. Cost Curves: Cost curves under monopoly also follow the shape of traditional theory of

cost. Average Cost, Average variable cost, marginal costs are U shaped and average fixed

cost is rectangular hyperbola.

6. PRICE AND OUTPUT DETERMINATION/ EQUILIBRIUM UNDER MONOPOLY

Price and output determination under monopoly can be studies through two approaches:

i. Total Revenue and Total Cost Approach: A firm will produce that level of output which

provides it maximum profit or if it working under losses, it will produce upto that level of

output where losses are minimum.

Maximum Profit = Total Revenue – Total Cost -------- Maximum

Minimum Losses = Total Cost – Total Revenue -------- Minimum and firm covers average

variable costs.

In the diagram 2, TR is total revenue curve and TC is total Cost Curves, OP is profit curve.

Initially TC is greater than TR so firm has losses and at the B point TR is equal to TC this is

breakeven point when firm has no profit and no loss. Firm will increase its production upto

the Q1 quantity as here difference between TR and TC is maximum and profit are maximum

Approaches of Equilibrium

Total Revenue and Total Cost Marginal Revenue and Marginal Cost

Figure 2: Equilibrium under Monopoly

i.e. P1Q1. If firm increase its output more than Q1 profit will start falling and again at point C

TR and TC are equal. So firm’s equilibrium will be at OQ1 level of output.

ii. Marginal Revenue and Marginal Cost

Under monopoly AR is downward sloping indicating a firm can sell more by reducing output

and MR is below it. Monopolist will produce upto the point:

Marginal revenue is equal to marginal cost (MR=MC)

Marginal cost curve cut marginal revenue curve from below (MC cut MR from

below)

These are the two conditions of Equilibrium of monopolist.

In figure 3 condition of equilibrium is shown. Both conditions are fulfilled at point E, so a

monopolist will produce upto OQ level of output and charge OP prices. Before it MC > MR

so monopolist will increase its production. After OQ level of output MR < MC so firm will

reduce its output.

Equilibrium can be explained in short run and long run.

a. Short Run Equilibrium of Firm

Short run is the time period in which there are fixed and variable factors of production.

Monopoly can increase its output by increasing variable factors only upto existing production

capacity. In short run a monopoly can face three situations depending upon cost conditions

Short Run Equilibrium Under Monopoly

Super Normal Profit

AR > AC

Normal Profit

AR=AC

Minimum Losses

AC > AR; AVC > AR

Figure 3: Equilibrium under Monopoly

i. Super Normal Profit: Monopolist will get super normal profit when at the equilibrium

output, average revenue is greater than average cost. In other words, prices are higher than

per unit cost.

Figure 4 shows the Super Normal profit. Condition of equilibrium that MC equal MR and

MC cut MR from below is fulfilled×××× at point E. Monopolist will produce OQ level of

output. OP price will be charged. At this price average cost is BQ = OP1. Here monopolist is

getting super normal profit as average cost is less than average revenue i.e. AB.

Total Revenue = OP × OQ = OPAQ

Total Cost = OP1 × OQ = OP1BQ

Super Normal Profit = PP1BA

ii. Normal Profit: Monopolist can get normal profit also. It is the situation when average

revenue is equal to average cost at the equilibrium level of output.

Figure 5 shows normal profits. Equilibrium is at point E. Monopolist will produce OQ level

of output and charge OP price.. At this level of output Average revenue is equal to average

cost i.e. AQ = OP.

Total Revenue = Total Cost = OP × OQ = OPAQ. Monopolist is getting normal profit.

Figure 4: Super Normal Profit

AR > AC

AR = AC

Figure 5: Normal Profit

iii. Minimum Losses: Monopolists can incure minimum losses. It is the situation when

average cost is greater than average revenue but a firm covers its average variable cost.

Figure 6 shows minimum losses. Equilibrium is at point E. OQ level of output will be

produced and OP price will be charged. At this level of price and output average revenue is

OP = QB and average cost is QA = OP1. Per unit Loss is AB.

Total Revenue = OP × OQ = OPBQ

Total Cost = OP1 × OQ = OP1AQ

Total Loss = PP1AB

These losses are minimum because monopolist is covering average variable cost i.e. QC.

b. Long Run Equilibrium

Long run is the time period when all the factors of production are variable. Monopolist can

change the size of the plant and machinery. Monopolist will produce that level of output at

which long run marginal cost is equal to marginal revenue curve. Monopolist will earn super

normal profit in long run because he is the single seller of the product. There is barrier to

entry. It will not produce upto optimum capacity. It will also not bear losses in the long run as

it will shut down its business.

Figure 8 shows the long run equilibrium of monopolist. He is at equilibrium at point E. OQ is

equilibrium output here MR = LMC. And OP price will be charged. Here monopolist is

getting super normal profit equal to PP1AB as average revenue is greater than long run

average cost.

Long Run Equilibrium and Laws of Cost

In the long run monopolist decides whether he will charge high or low price it will depend

upon elasticity of demand and laws of cost of production. There are three laws of cost in the

long run

i. Diminishing Cost: It is the case when by increasing output additional cost of production

goes down. In this situation monopolist should increase the sale by charging lower prices.

AC > AR; AVC > AR Figure 6: Minimum Loss

Figure 8: Long Run Equilibrium

AR > LAC

Figure 8: Diminishing Cost

In figure 8 LAC and LMC are downward sloping indication diminishing cost condition of

production. Condition of equilibrium that LMC equal MR is fulfilled at point E. Monopolist

will produce OQ level of output. OP price will be charged. At this price average cost is BQ =

OP1. Here monopoly is earning super normal profit as long average cost is less than average

revenue i.e. AB.

Total Revenue = OP × OQ = OPAQ

Long Run Total Cost = OP1 × OQ = OP1BQ

Super Normal Profit = PP1BA

ii. Constant cost: it is the case when by expanding production additional cost remains

constant. In figure 9 LAC and LMC are horizontal to X axis indicating constant cost

condition of production. LMC equal MR at point E. Monopolist will produce OQ level of

output. OP price will be charged. At this price average cost is BQ = OP1. Here monopolist is

earning super normal profit as long average cost is less than average revenue i.e. AB.

Total Revenue = OP × OQ = OPAQ

Long Run Total Cost = OP1 × OQ = OP1BQ

Super Normal Profit = PP1BA

iii. Increasing Cost: It is the case when for expanding output additional cost of production

increases. In this condition monopolist should produce less and charge high prices.

Figure 9: Constant Cost

Figure 10: Increasing Cost

In figure 10, LAC and LMC are increasing indicating increasing cost of production. LMC

equal MR at point E. Monopolist will produce OQ level of output. OP price will be charged.

At this price average cost is BQ = OP1. Here monopoly is earning super normal profit as long

average cost is less than average revenue i.e. AB.

Total Revenue = OP × OQ = OPAQ

Long Run Total Cost = OP1 ×OQ = OP1BQ

Super Normal Profit = PP1BA

7. PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY FOR MULTI

PLANT FIRM

If a monopolist produces its same product in two different plants he will decide what should

be the price of the product and what should be the optimum level of output at each plant.

Here we assume that monopolist know its market demand and cost. It is also assumed that

monopolist has two plants A and B. So its cost will be MC= MCA + MCB

Monopolist will produce upto where MC1 = MC2 = MR

Figure 11 shows the equilibrium of monopolist when he is producing two different plans. MC

is his combined marginal cost. His equilibrium is at point E. He will produce OQ level of

output and will charge P* price. In plant A he will produce OQa level of output and earn

PAP1B super normal profit. In plant B he will produce OQb level of output and earn

P2P3DC super normal profit.

8. MONOPOLY POWER

Due to single seller, a monopolist can enjoy its monopoly power. A monopolist Power to

influence the price and output by monopolist is known as monopoly power. The two main

methods to measure monopoly power are

1. Lerner’s Measure: Lerner considers that larger the difference between price and marginal

cost higher will be the monopoly power. It can be measure from following formula:

Monopoly Power = P – MC

P

Figure 11: Multi Plant Monopoly

2. Bains Measure: He considers that higher the difference between price and average cost

higher will be the monopoly power. In other words higher the super normal profit higher will

be the monopoly power.

Monopoly Power = AR-AC

9. PRICE DISCRIMINATION

Price discrimination is a feature of monopoly market. It refers to a situation when a

monopolist sells its same product at different prices to different buyers. For this seller can do

slight product differentiation. It is practisised by seller when it is possible and profitable.

a. Type of Price Discrimination

b. Degrees of Price Discrimination

There are three degrees of price discrimination

c. When Price Discrimination is Possible:

i. Legal sanction: Price discrimination can be legally sanctioned. We can see the example of

railway. There are different prices for sleeper, AC and general coaches in same train.

ii. Monopoly: There should be monopoly of a product or production technique to

differentiate price.

Local: Charges different prices from different people of different localitis

Personal: Charges different prices from different persons

According to use: Charges different prices according to different uses of the product for persons

• Monopolist charges that price which a consumer is willing to pay so there is a loss of consumer surplusFirst

• Monopolist divides consumers into different groups and from each group charges which is lowest williness to pay so some cosumers get consumer surplus

Second

• Monopolist divides its market into two sub markets and charges different prices.Third

iii. Sub- markets: Monopolist should divide its market into two or more sub market for price

differentiation. It is not possible to charge different price at a same market. It will break the

trust of the consumers.

iv. Non transferable: The difference between two markets should be so large that no

consumer can shift to the other market.

v. Different group of customers: monopolist charges different price from different

customers after studying there demand pattern. So if consumers are different then price

differentiation is possible.

vi. Minimum cost: The cost of sub dividing the market should be minimum; otherwise it is

wasteful for monopolist to divide the market into two sub markets.

vii. Commodity on order: if commodity is produce on order then it is possible to charge

different prices.

d. When Price Differentiation is Profitable:

Price differentiation is profitable only when the elasticity of demand in different markets is

different. Monopolist charge low price in that market where demand is more elastic and

charges high prices where elasticity of demand is less elastic.

e. Price and Output Determination under Discriminating Monopoly

Monopolist indulges in price discrimination with the objective of maximising profit. There

are two conditions for equilibrium

i. He must earn same marginal revenue in both the markets.

ii. Marginal revenue in both the market should be equal to marginal cost i.e.

MR1 = MR2 = MC

In the figure 12, equilibrium under discriminating monopoly has been shown. MR and MC

cut at point E monopolistic will produce OQ level of output. In market A equilibrium is at

Figure 12: Equilibrium under Discriminating Monopoly

point E1.He will sale OQa level of output and charges OP1 price. In market B equilibrium is

at point E2. He will sale OQb output on OP2 price. In market A demand is less elastic than b

market so monopolist charges high prize in A market and low price in B market.

9. DUMPING

Dumping is also known as international price discrimination. Monopolist faces two type of

market. One in which he is single seller i.e. domestic market and second competitions in

international market. He will charge high price at home market and low price in international

market.

Figure 13 shows the price determination under dumping. It is assumed there are two markets

domestic market and foreign market. ARd and MRd are average and marginal revenue of

monopolist in home/domestic market and ARf and MRf are average and marginal revenue of

monopolist in foreign market as it faces competition there. Here DEF is combined marginal

revenue curve. MC cut it at point B. So it will charge P1 price in foreign market and OP price

at domestic market.

Summary

Monopoly is a market in which there is only one producer of a product which has no close

substitution. There is no difference between firm and industry under monopoly. The

monopolistic while determining price and output can either fix the price or let the output are

determined in the market or he may have the second option that he fixes the output and price

will determine the market. Generally he is a price maker. Price discrimination is the main

feature of monopoly.

Figure 13: Dumping