19 Monopoly and Price Descrimination

8/22/2019 19 Monopoly and Price Descrimination

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19. Monopoly and Price Discrimination

Learning Outcomes: Detailed study of Monopoly

Definition and meaning of Monopoly Kinds of Monopoly Monopoly Power Monopoly Equilibrium Price Discrimination Pricing under discriminating monopoly Concept of dead weight loss Price Discrimination under Dumping Difference between Monopoly and Perfect competition

Monopoly means absence of competition. It is an extreme situation in imperfect competition.

Monopoly can be defined as a condition of production in which a single person or a number of

persons acting in combination, have the power to fix the price of the commodity or the output of the

commodity.

Three characteristics define pure monopoly:

1. There is a single seller or single control

2. There are no close substitutes for the firms product.

3. There are barriers to entry.

4. The firm may use its monopoly power in any manner in order to realise maximum revenue. He

may adopt price discrimination.

Since there is only one seller, there is no distinction between firm and industry. Since there is no close substitute, cross elasticity between the product of the firm and that

of other commodities is zero. (Understand the concept of cross elasticity and how it affects

the demand in other market conditions!)

Kinds of Monopoly

Private and Public Monopoly Pure Monopoly- this can exists only in public sector, Production of a special commodity with

exclusive privilege of the state). Very rarely in private sector (single Doctor/ shop in a

village). There are no substitute commodities.

Simple Monopoly: Single produce where only remote substitute. Discriminating Monopoly: Monopolist may charge different prices from different customers

or markets. He has not only the power to fix the price but also change the pricing between

customers and markets


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Monopoly Power:

In practice, no monopolist will have absolute monopoly power. Let us see the factors how the

monopoly gets the power:

Power given by the Government Legal Powerthrough Patent/Trade Mark/Copy Right Technical Powers- Control over exclusive raw material, technical knowledge, superior and

special know-how, scientific secrets or formula

Combinations: Combination of different firms producing the same commodity- Trusts/Cartels/ Syndicate etc

Bias of the Consumer: The bias and laziness or ignorance of the consumer may give somemonopolistic privilege to the producer. But those are not monopoly in the real sense of the

term

In this Analysis, we will focus on pure monopoly based on the definition given before.

It would be a mistake to assume that a monopolist would always push up his prices, as theprice is pushed up the demand decreases.

It is very important to remember that unlike in the competitive firms, a monopoly firm willhave a sloping down demand curve and his average revenue will dwindle as the output is

increase, because buyers will buy higher quantity only at a lower price.

Monopoly can charge high , but he will be able to sell only less. So the monopolist does nothave absolute control over the market. Either he can fix the price and leave the quantity to

be purchased or he can have control over the supply and price to fixed by the consumers.

DD is the Demand Curve. The firm cannot

fix its output at OM and expect to be sold at

price K2M2 per unit. If it decides to fix the

price at K2M2 then he can sell only OM2

quantity.

Out of any number of possible

combinations, the monopoly firm will

endeavour to choose that price , which

maximises the NET MONOPOLY REVENUE.

Price determination depends upon two factors in monopoly.

1. Nature of Demand for the commodity2. Cost of Production

If the demand for the commodity is inelastic ( Steep), the price may be raised without the demandbeing appreciably reduced. (Understand this intuitively. If the commodity is desperately need and

K2


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only the monopoly firm can sell it, even if he raises the price, the demand will not come down

drastically). If the demand is very elastic, an increased price will lead to reduced sales and revenue

realised will be less.

On the Cost side, if there are increasing returns( reducing cost), he can produce larger amounts of

commodity at lower cost and sell at lower price. If the commodity has elastic demand and it is

produced under reduced cost, the interest of the monopoly will be served if he fixes the price at a

lower level.

On the other side, if the demand is inelastic ( steep curve), and the cost is increasing ( diminishing

returns), then the price can be fixed at higher level, so that the total sales amount will not reduce if

it reduces a little and at that reduced output, the cost will also be lesser than the higher output.

(Understand thoroughly).

If the commodity is under law of constant returns, then the monopoly will exclusively concentrate

on the demand side, since there are no changes in the cost side, which indicates only the lower limitof the price to be fixed according to elasticity or inelasticity of demand. If the demand is elastic, the

price will be low, if the demand is inelastic, the price will be higher.

In all cases, the monopoly firm, carefully weighs two main considerations

1) The nature of demand or average revenues realised2) Cost of production per unit

Maximum Net monopoly revenue combination of Output and price.


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MONOPOLY EQUILBRIUM

Assuming that the firm aims to maximise profits

(where MR=MC) we establish a short run

equilibrium as shown in the diagram. (Equilibrium

will at MR= MC is true for monopoly also) . Thefirm will sell more quantity than equilibrium since

it wll start making lesser profit.

The profit-maximising output can be sold at price

P1 above the average cost AC at output Q1. The

firm is making abnormal "monopoly" profits (or

economic profits) shown by the yellow shaded

area. The area beneath ATC1 shows the total cost

of producing output Qm. Total costs equals

average total cost multiplied by the output.

The equilibrium in short period is equal to long

period, since there will be no entry of anotherfirm.

MONOPOLY PRICE AND ELASTICITY OF DEMAND

Elasticity is defined as

(% of change in the quantity Q/Q)--------------------------------------------------

(% change in the Price P/p)This means rate of change in the quantity

compared with rate of change in the Price. Atequilibrium then this is equal to 1. (If the

demand changes by 5% then price also changes

by 5%).

Above the point Q in the figure, the ratio will be

greater than 1 (Elastic) and below the point E, it

will be less than 1 (Inelastic). A monopolist will

never put the output where the elasticity of

demand ( AR curve) is less than 1 (in other

words inelastic). If he does so, then he cannot

maximise his net monopoly revenue, becausemarginal revenue will be negative.

Please note here the following relationship

When Elasticity of demand is 1, the MR= 0. The monopoly firm can maximise profit in the regionwhere E >1, which is also equal to where MR is positive.

If MR cannot be negative, then marginal cost also cannot be negative, since equilibrium isachieved when MR=MC.

From this we can conclude that the equilibrium for the monopoly will always lie at that level of

output where the elasticity of demand is greater than 1, provided his Marginal cost is positive.


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Some Questions?

Will there be any situation where cost are negative or cost have no relevance to pricing ofcommodity?

Can Marginal come to Zero

This is possible in monopoly, where the control of certain natural resources may result in getting the

commodity freely.

From these analyses we can summarise the following points

1) Monopolists will never produce at a price where demand is inelastic2) Where there is no marginal cost for the monopolist, he will produce where elasticity of

demand is unity.

3) Where monopolist has marginal cost, he will produce at a price where demand is elastic. IfMR equals MC, marginal revenue will also be positive.


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Monopoly Equilibrium under different cost conditions;

Decreasing Returns (increasing cost)

The curve MC and AC are sloping upwards showing increasing cost or diminishing returns. The

equilibrium point is G and the quantity is Qm. The net monopoly revenue is Green shaded

portion and the price Pm.

Increasing Returns

AC and MC curves are decreasing. The decreasing MC curve cuts the MR curve from below at a

point E1 the equilibrium point At this level output, OM1, the profit is maximum P1Q1R1S1 and

the price is OP1.Constant Returns

Since the firm is working under constant cost AC=MC and the latter cuts MR curve at E2, theequilibrium point. At this level of output the profit is P1Q2E2S2 and the price is OP2

E1

E2

F2F1

E

AC, MC

ARMR

Q2P2

S2 E2

M


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PRICE DISCRIMINATION

Charging different prices for different customer is called Price Discrimination or Discriminating

Monopoly.The idea is to squeeze the maximum profit wherever possible from the customer

depending upon the customer and demand. Discrimination is not possible in ordinary competitive

conditions unless there is product differentiation.

Price discrimination can also be defined as The sales of similar products at different prices which

are not proportional to marginal cost.

Types of price discriminations Basis

Personal Discrimination Ability to pay by the customer.

Rich customers will be asked to

pay more.

Possible in specialised services

like doctors and lawyers.

Disguised discrimination like

Delux edition of a book with

paperback edition. Though the

content is same in both by theauthor.(superficial changes)

Place Discrimination Locality in which the market is

situated will be the criterion.

Charging higher prices in richer

class locality. Monopolist may

charge lesser price in foreign

country than local

markets.(also known as

dumping goods)

Superficial add ons like door

delivery, very courteous

behaviour for which richer

classes are particular may

willing to pay higher price for

the same commodity.

Trade Discrimination (Use

discrimination)

Different prices for different

usages of the same commodity.

Electricity sold at cheaper rates

for homes and higher forIndustry.

Three Degrees of Price Discrimination:

First Degree

Perfect Discrimination

The producer exploits the

customer to pay the maximum

he could afford, rather than

going without the commodity

Seller has to deal individually

with each buyer.

Zero consumer surplus for the

buyer.

Second Degree The maximum that can be paid

by the poorest will decide thelowest price

Poorest will have zero

consumer surplus which rich,who are actually willing to pay

more, will get consumer

surplus. (Railways. Second class

ticket price is based on the

common man, which the rich

who travels by the second class

gets the consumer surplus)

Third Degree (commonly

practiced)

Markets are divided into many

sub markets, price will not be

the minimum price, but

depending upon the output anddemand in the sub market.

With the quantum on hand

which is fixed, the price will

depend on the demand curve

as shown below


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The market is broken in to demand curves for three separate market segments under monopoly

control. Assuming that the same quantity is demand across the sub markets, the monopoly will

charge OP1 in the market I and demand represented by D1 and similarly in Market II and Market III.

When the producer undertakes Dumping and charges for the same commodity one price in one

country and a different price in another country, it is also a case of price discrimination of third

degree.

Conditions for Price Discrimination

Monopolist must be sure that it is possible to practice price discrimination

Whether it will be worthwhile practicing the sameThis depends upon the following three factors

1. Preferences and prejudices of the consumers2. Apparent product differentiation3. Distance and Tariff barriers.

Price discrimination is possible only if the following two conditions are satisfied

Transferability of Demand Demand must not be transferable from high priced market tolow priced market. If people do not buy high priced deluxe

edition and wait for popular edition, the discrimination will fail

Separation of Markets Monopolist should keep the different markets separate so that

commodity will not move from one market to another.

But the price discrimination is possible in the following cases also

Ignorance, Laziness, preferences of consumer may be exploited by producer Superficial discrimination like better packaging giving apparent feeling of better quality,

better treatment, drive-in facilities- consumer think that they are getting better quality Price discrimination is easy in personal services which cannot be resold.

Quantity X

Price Y

P3

P2

P1

D1 Market I

D2 Market II

D3 Market III

O


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When the price discrimination is Profitable?

The demand can be split across the different markets, so that elasticities of demandare different for each market

Cost of keeping various markets and sub markets should not be very high. This costshould not be large relative to the differences in the demand elasticities

The first condition is very vital. If the demand elasticities in different markets are equal, then there is

no scope for price discrimination at all.

The price obtained by the monopolist in each market depends upon the output offered and the

shape of the demand curve ( AR curve). Generally the markets will be arranged in ascending order of

the elasticities of demand. The highest price will be charged in the least elastic market. Lowest Price

will be charged in most elastic market.

Pricing under Discriminating Monopoly

To simplify, let us have two markets, called domestic and foreign where price discrimination can take

place. You can also observe that the elasticity of demand are different for each of the market,

satisfying the conditions.

The two markets have respective marginal curve and respective Demand Curve (AR). The aggregate

market is the summation of the market A and Market B. Since the production is ontrolled from single

source, the Marginal Cost is same for the product and the equilibrium production is obtained whenMC= MR at Qt for the Firm. At this equilibrium extended to the sub-markets , where MR1 = MC and

MR2 = MC at E1 and E2 respectively. Therefore quantity Qa and Quantity Qb are the equilibrium

quantity that can be sold at the market at the P1 and P2. ( SNP is super normal profit).

SNPa + SNPb= SNP total

E

E1E2

P2

P1


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Concept of Dead Weight LossTo contrast the efficiency of the perfectly competitive outcome with the inefficiency of the

monopoly outcome, imagine a perfectly competitive industry whose solution is depicted in Figure

The short-run industry supply curve is the summation of individual marginal cost curves; it may be

regarded as the marginal cost curve for the industry. A perfectly competitive industry achieves

equilibrium at point C, at price Pc and quantity Qc.

Now, suppose that all the firms in the industry merge and a government restriction prohibits entry

by any new firms. Our perfectly competitive industry is now a monopoly. Assume the monopolycontinues to have the same marginal cost and demand curves that the competitive industry did. The

monopoly firm faces the same market demand curve, from which it derives its marginal revenue

curve. It maximizes profit at output Qm and charges price Pm. Output is lower and price higher than

in the competitive solution.

Society would gain by moving from the monopoly solution at Qm to the competitive solution at Qc.

The benefit to consumers would be given by the area under the demand curve between Qm and Qc;

it is the area QmRCQc. An increase in output, of course, has a cost. Because the marginal cost curve

measures the cost of each additional unit, we can think of the area under the marginal cost curve

over some range of output as measuring the total cost of that output. Thus, the total cost ofincreasing output from Qm to Qc is the area under the marginal cost curve over that rangethe

area QmGCQc. Subtracting this cost from the benefit gives us the net gain of moving from the

monopoly to the competitive solution; it is the shaded area GRC. That is the potential gain from

moving to the efficient solution. The area GRC is a deadweight loss.

Given market demand and marginal revenue, we can compare the behavior of a monopoly to that of

a perfectly competitive industry. The marginal cost curve may be thought of as the supply curve of a

perfectly competitive industry. The perfectly competitive industry produces quantity Qc and sells the

output at price Pc. The monopolist restricts output to Qm and raises the price to Pm.

Reorganizing a perfectly competitive industry as a monopoly results in a deadweight loss to society


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given by the shaded area GRC. It also transfers a portion of the consumer surplus earned in the

competitive case to the monopoly firm.

Price Discrimination under Dumping

The firm can still practice price discrimination, if, it has a monopoly in the domestic market, butfaces perfect competition in the international market for his product. Here, the monopolist sells his

product at a higher price in the home market and at a very low price in the foreign market. This is

called dumping, as the firm virtually dumps his product at a very low price in the foreign market,

wherein it faces perfectly elastic demand curve. The price in the foreign market may even be lower

than the average cost of production. The firm then suffers losses here.

However, the monopolist does not suffer an overall loss. By exploiting the home market, it can raise

price above the average cost and earn monopoly profit, which might more than compensate for the

foreign market losses.

Domestic Market:

In protected domestic market, this monopolist faces downward sloping demand curve ARD The

corresponding marginal revenue curve MRD is also downward sloping.

Foreign Market

The demand curve ARF of the concerned firm in the foreign market is horizontal straight line at the

level of OPF price, its marginal revenue curve MRF coincides with the demand curve ARF due to

perfect competition there. On account of perfect competition in the foreign market, the firm has no

freedom to determine price in the international market. Rather, it is a price taker here. However, the

firm can fix the profit maximizing price in the domestic market. Here, the price cannot fall below OPF

level.

The price determination under dumping is slightly different from the one explained previously in

different submarkets, where the firm enjoys monopoly power in each sub-market.

Under dumping, instead of taking just lateral summation of the two marginal revenue curves, we

take the composite curve BCE as the aggregate marginal revenue (AMR) curve. The firm will be inequilibrium at point 'E where this curve is intersected! by its given marginal cost curve MC from


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below.

The equilibrium out will be OQF for foreign market and Domestic market together since the MC is

the combine curve since commodities is produced from single firm. The total output in the two

markets is OQD + QDQF = OQF

The profit maximizing equilibrium condition of the firm can be written as MRD = MRF = AMR = MC.

The total profit of the firm is given by the shaded area shown in Figure between the aggregate

marginal revenue curve BCE and the combined marginal cost curve MC.

Even under dumping, the relationship between price and the price elasticity of demand is clearly

established. The concerned firm sells more output at a lower price in the foreign market (which has

highest possible elasticity of demand) and less output at a higher price in the domestic market

(which has less elastic demand).

Difference between Monopoly and Perfect competition

Characteristics Perfect Monopoly

Differences AR curve is a straight curve

MR=AR=Price

AR and MR Sloping Down Curve

MR is always lies below the AR

at all levels of output

Hence, at equilibrium, when

MC cuts MR, it will be less than

AR or Price.

Equilibrium Conditions MR=MC

But MR=MC=AR=Price

MC=MR


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Heads Up!

Dispelling Myths About Monopoly

Three common misconceptions about monopoly are:

1.Because there are no rivals selling the products of monopoly firms, they can charge whateverthey want.

2. Monopolists will charge whatever the market will bear.3. Because monopoly firms have the market to themselves, they are guaranteed hugeprofits.

As shows, once the monopoly firm decides on the number of units of output that will

maximize profit, the price at which it can sell that many units is found by reading off the

demand curve the price associated with that many units. If it tries to sell Qm units of output

for more than Pm, some of its output will go unsold. The monopoly firm can set its price, but

is restricted to price and output combinations that lie on its demand curve. It cannot just

charge whatever it wants. And if it charges all the market will bear, it will sell either 0

or, at most, 1 unit of output.

Neither is the monopoly firm guaranteed a profit. Consider . Suppose the average total cost

curve, instead of lying below the demand curve for some output levels as shown, were

instead everywhere above the demand curve. In that case, the monopoly will incur losses

no matter what price it chooses, since average total cost will always be greater than any

price it might charge. As is the case for perfect competition, the monopoly firm can keep

producing in the short run so long as price exceeds average variable cost. In the long run, it

will stay in business only if it can cover all of its costs.

VIDEOS TO SEE AFTER READING THE NOTES:

http://www.youtube.com/watch?v=_Txn4-wZXqg&feature=relmfu

http://www.youtube.com/watch?v=s3wFJHIuJPs

http://www.youtube.com/watch?v=fg08G21ZiV0&feature=related

http://www.youtube.com/watch?v=7UWgKZsKZOc

http://www.youtube.com/watch?v=jXHkKK0u21o

http://www.youtube.com/watch?v=fqN3Ok6PhfM&feature=plcp

http://www.youtube.com/watch?v=pJmdNBsvGMQ&feature=plcp

http://www.youtube.com/watch?v=9T9TN3OuTjc&feature=plcp

http://www.youtube.com/watch?v=Q7cKAmkhgto&feature=plcp

http://www.youtube.com/watch?v=oxEoLGfhUKw&feature=plcp
http://www.youtube.com/watch?v=_Txn4-wZXqg&feature=relmfuhttp://www.youtube.com/watch?v=_Txn4-wZXqg&feature=relmfuhttp://www.youtube.com/watch?v=s3wFJHIuJPshttp://www.youtube.com/watch?v=s3wFJHIuJPshttp://www.youtube.com/watch?v=fg08G21ZiV0&feature=relatedhttp://www.youtube.com/watch?v=fg08G21ZiV0&feature=relatedhttp://www.youtube.com/watch?v=7UWgKZsKZOchttp://www.youtube.com/watch?v=7UWgKZsKZOchttp://www.youtube.com/watch?v=jXHkKK0u21ohttp://www.youtube.com/watch?v=jXHkKK0u21ohttp://www.youtube.com/watch?v=fqN3Ok6PhfM&feature=plcphttp://www.youtube.com/watch?v=fqN3Ok6PhfM&feature=plcphttp://www.youtube.com/watch?v=pJmdNBsvGMQ&feature=plcphttp://www.youtube.com/watch?v=pJmdNBsvGMQ&feature=plcphttp://www.youtube.com/watch?v=9T9TN3OuTjc&feature=plcphttp://www.youtube.com/watch?v=9T9TN3OuTjc&feature=plcphttp://www.youtube.com/watch?v=Q7cKAmkhgto&feature=plcphttp://www.youtube.com/watch?v=Q7cKAmkhgto&feature=plcphttp://www.youtube.com/watch?v=oxEoLGfhUKw&feature=plcphttp://www.youtube.com/watch?v=oxEoLGfhUKw&feature=plcphttp://www.youtube.com/watch?v=oxEoLGfhUKw&feature=plcphttp://www.youtube.com/watch?v=Q7cKAmkhgto&feature=plcphttp://www.youtube.com/watch?v=9T9TN3OuTjc&feature=plcphttp://www.youtube.com/watch?v=pJmdNBsvGMQ&feature=plcphttp://www.youtube.com/watch?v=fqN3Ok6PhfM&feature=plcphttp://www.youtube.com/watch?v=jXHkKK0u21ohttp://www.youtube.com/watch?v=7UWgKZsKZOchttp://www.youtube.com/watch?v=fg08G21ZiV0&feature=relatedhttp://www.youtube.com/watch?v=s3wFJHIuJPshttp://www.youtube.com/watch?v=_Txn4-wZXqg&feature=relmfu

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19 Monopoly and Price Descrimination

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