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AAEC 3315Agricultural Price Theory
Chapter 13
Price and Output Under Monopoly
Objectives
To learn: How the prices & quantities of goods & services
produced & consumed are determined under a monopoly market structure.
Characteristics of a Monopoly
Characteristics of monopolies are: Single seller but a large number of buyers Unique Product, i.e., there are no close substitutes Ability to Set Prices (monopolist is a price maker;
discriminating monopolists charge different prices to different classes of consumers)
Barriers to Entry (a monopoly generally has an economic, legal or technical barrier to entry to other firms)
Characteristics of a Monopoly
These characteristics of monopolies, clearly, make a monopolist a price-maker. However, a monopolist’s control over price is not absolute.
What causes Monopoly? Barriers to entry is the single most important factor that
contributes the existence of monopolies. A strong barrier for entry may exist because:
Control of the supply of key raw materials Patents on the product or on the production process A market franchise awarded by the government
The Monopolist’s TR, AR, and MR Curves
Since the monopolist is the only firm producing a product, the monopolist’s demand curve is precisely the same as the market demand curve. So, AR is the monopolist’s
demand curve And it is negatively sloped
Since AR is negatively sloped, AR & MR are not the same. MR is also negatively
sloped, and is twice as steep as the AR.
The Total Revenue curve is concave downward because the monopolist’s demand curve is downward sloping.
Q
P
MR AR
TR
The Monopolist’s Cost Curves
If the monopolist in the product market faces a perfectly competitive input market, then it can not affect input prices.
In that case, the concept of cost curves do not change.
The TC, TVC, TFC, ATC, AVC, AFC, and MC curves, therefore, are as discussed before for perfect competition.
Co
sts
Output
TOTAL COSTS
TC
TVC
TFC
ATC
AVCCosts/unit
Output
AFC
MC
Profit Maximizing Output Decisionunder Monopoly in the Short-run
The Total Curves Approach
Profit maximization output decision rule for a monopolist depends on two considerations.
One, whether there is any output level at which TR exceeds the TVC. If not, the profit maximizing strategy is to shut down.
If there are output levels at which TR > TVC, the monopolist will produce where the vertical distance between TR and TC is at its maximum.
$TR
TC
TVC
Q
Profit Maximizing Output Decisionunder Monopoly in the Short-run
The Total Curves Approach
In this case, the vertical distance between TR and TC is at maximum at the Q* level of output.
Note that at Q* units of output, TR and TC curves have the same slope, i.e., MR = MC. (This is called the Necessary Condition of profit maximization)
Further, the slope of MC exceeds that of the MR (MC has a positive slope and MR has a negative slope). (This is called the Sufficient Condition of profit maximization)
$TR
TC
TVC
QQ*
Profit Maximizing Output Decisionunder Monopoly in the Short-run
The Average & Marginal Curves Approach
Again, the same decision rules should be considered.
Does the AR lie above the AVC in some output range? If not, the best strategy in the short-run is to shut down.If yes, the profit maximizing output is where MR=MC and the slope of the MC is greater than the slope of the MR.This is the Q* level of output.
$/unit
Q
MR
AR
Q*
MC
AC
AVC
Price Determination under Monopoly
After deciding that Q* is the profit maximizing level of output, the monopolist must decide the price at which the output is to be sold.
The monopolist will sell the output at the maximum price at which he can sell the output.That maximum price is the price that the consumers are willing to pay (derived from the demand/AR Curve) – that is P*
At that price of P*, note that profit per unit is BA dollars and the total economic profit received by the monopolist is P*ABC.
$/unit
Q
MR
AR
Q*
MC
AC
AVCP*
A
BC
A Mathematical Example
Suppose that the Monopolist’s TR and TC curves are given by:
TR = 50 Q – 4 Q2
TC = 10 Q What is the Profit Maximizing level of output?
Note that at the profit max level of output, MR must equal to MC (the Necessary Condition of profit maximization)MR = ∂TR/∂Q = 50 – 8QMC = ∂TC/∂Q = 10At MR = MC, 50 – 8Q = 108Q = 40 or Q = 5
Also note that at the profit max level of output, the slope of MC must exceed the slope of the MR (the Sufficient Condition of profit maximization)Slope of MR = ∂MR/∂Q = – 8Slope of MC = ∂MC/∂Q = 0Thus the Slope of MC > the slope of MR
A Mathematical Example
The Monopolist’s TR and TC curves are given by:
TR = 50 Q – 4 Q2
TC = 10 Q What is Equilibrium Price?
Note that TR = P*Q = 50Q - 4Q2
So, P = 50 – 4Q
Since Q = 5, then P = 50 – 20 = $30
What is the Profit? Note that Profit = TR – TC
TR = 50 (5) – 4 (5)2 = $150
TC = 10 (5) = $50
So, Profit = $150 - $50 = $100
Multiplant Monopolist
This section extends the analysis to cover the case where the monopolist operates more than one plant.
How does a monopolist determine the profit maximizing allocation of production between multiple plants when it has multiple plants to produce the output that he sells in a single market?
The profit maximizing multiplant monopolist allocates the production of output between two plants by equalizing the MC in each plant.
Multiplant Monopolist
Let’s assume that the monopolist operates two plants. MCA and MCB show the MCs of two plants A & B, and MCt represents the firm’s MC.
Note that MCt is the horizontal summation of MCA and MCB and shows the firm’s MC when it uses either plant A or B, whichever has a lower MC.
AR and MR represent the monopolist’s Average Revenue and Marginal Revenue curves.
Plant A
Plant B
Firm
$/unit $/unit $/unit
Q Q Q
MCA MCB MCt
AR
MR
Multiplant Monopolist
By equating its MR and MCt, the monopolist determines the profit maximizing output of q t and price of Pt.
To produce qt at the least cost, the monopolist allocates production between the two plants such that the MC of production in each plant is the same.
That is, plant A produces qA and plant B produces qB, where qA + qB = qt.
Plant A
Plant B
Firm
$/unit $/unit $/unit
Q Q Q
MCA MCB MCt
qA qB qt
AR
MR
Pt
A Mathematical Example of Multiplant Monopolist
Suppose that the Monopolist’s TR and TC curves for two plants are given by:
TR = 136 Q – 4 Q2, TC1 = 20 Q1 + Q12, and TC2 = 10Q2 + 2.5 Q2
2
Now then MR = 136 – 8 Q = 136 – 8 (Q1 + Q2)
AR = 136 – 4 (Q1 + Q2)
MC1 = 20 + 2Q1
MC2 = 10 + 5Q2
To maximize profit, the multiplant monopolist will equate MC1 with MR and MC2 with MR.
That is 20 + 2Q1 = 136 – 8 (Q1 + Q2) ------ (1)
and 10 + 5Q2 = 136 – 8 (Q1 + Q2) ------ (2)
A Mathematical Example of Multiplant Monopolist
Taking equation (1), we have 20 + 2Q1 = 136 – 8Q1 - 8Q2
Or, 2Q1 + 8Q1 = 136 – 20 - 8Q2
Or, 10Q1 = 116 - 8Q2
Or, Q1 = 11.6 – 0.8Q2 -------- (3)
Note that equation (2) is 10 + 5Q2 = 136 – 8 (Q1 + Q2)
Or, 10 + 5Q2 = 136 – 8Q1 - 8Q2
Now substituting (3) in equation (2), we have10 + 5Q2 = 136 – 8(11.6 – 0.8Q2) - 8Q2
Or, 10 + 5Q2 = 136 – 92.8 + 6.4Q2 - 8Q2
Or, 5Q2 - 6.4Q2 + 8Q2 = 136 – 10 - 92.8
Or, 6.6 Q2 = 33.2
Or, Q2 = 5.03 units
Now substituting Q2 = 5.03 into equation (3), we calculate Q1 = 7.576
A Mathematical Example of Multiplant Monopolist
The profit maximizing production levels in plant 1 and plant 2 are then 7.576 and 5.03 units, respectively.
Now we can calculate the Price that the multiplant monopolist will charge in the market.
Note that:
AR = P = 136 – 4 (Q1 + Q2)
Or, AR = P =136 – 4(7.576+5.03)
Or, P = 136 – 50.424 = $85.576 Thus, we have this multiplant monopolist who produces 7.576 units of
the output in Plant 1 and 5.03 units of the output in Plant 2 at the least cost of production and sells the product in the marketplace for $85.576 per unit.
Can you calculate the amount of profit for this multiplant monopolist?
Price Discrimination
Price Discrimination is said to exist when an identical good is sold at different prices or when two similar goods are sold at prices that are in different ratios to marginal costs.
Prerequisites of Discriminatory Pricing The seller must have a monopoly or market power The market can be separated (i.e., product can’t be transferred from
one market to another) The elasticities of demand in different markets must be different
First Degree orPerfect Price Discrimination
The discriminatory pricing that attempts to take away the entire Consumers Surplus is called first degree price discrimination.
It assumes that the monopolist knows the demand of each customer and attempts to extract the maximum amount possible from each customer.
The monopolist charges different prices to each of the customers and takes away the entire consumer surplus.
This is a limiting case unless customers are few in numbers and can be well separated.
$/unit
Q
MR
AR
Q*
MC
Second Degree orPerfect Price Discrimination
The discriminatory pricing that attempts to siphon off a part of the CS is called the second degree price discrimination.
It charges different prices for different size purchases, as in the case of electric or gas utilities.
The monopolist charges P1 for up to Q1 units, P2 for between Q1 and Q2, and P3 for purchases exceeding Q2.
Note that the shaded triangles represent CS retained by the consumers.
$/unit
Q
MR
AR
Q3
MC
Q2Q1
P3
P2
P1
Third Degree orPerfect Price Discrimination
Third degree price discrimination refers to a discriminatory pricing by which a monopolist sells his good at different prices in different markets, but keeps the price uniform within each separate market.
In the figure below, the two markets are identified separately. The MRt is the MR for the firm and is obtained by summing the MR1 and MR2 horizontally.
$/unit $/unit $/unit
Q Q Q
MR1
D1MR2 D2 MRt
Market 1 Market 2 Firm
Third Degree orPerfect Price Discrimination
The MRt (MR for the firm) shows the additional revenue the firm can secure by selling an additional unit of the output either in Market 1 or Market 2, whichever has a higher MR.
To maximize profit, the monopolist must produce Qt – the level of output at which MRt = MC.
$/unit $/unit $/unit
Q Q Q
MR1
D1MR2 D2 MRt
MC
Qt
Market 1Market 2 Firm
Third Degree orPerfect Price Discrimination
The monopolist must now allocate this output between Markets 1 and 2 in such a way as to equalize the MR in the two markets.
This is the case at Q1 level of output in Market 1 and Q2 level of output in Market 2.
Note that Q1+Q2 = Qt (This is necessarily true because MRt curve is obtained as the summation of MR1 and MR2)
$/unit $/unit $/unit
Q Q Q
MR1
D1MR2 D2 MRt
MC
QtQ2Q1
Market 2Market 1 Firm
Third Degree orPerfect Price Discrimination
The prices charged in the two markets are P1 in Market 1 and P2 Market 2 as determined from their respective AR curves.
Note that the monopolist is charging a higher price in Market 1 than in Market 2.
That is because demand in Market 1 is relatively inelastic and demand in Market 2 is relatively elastic.
$/unit $/unit $/unit
Q Q Q
MR1
D1MR2 D2 MRt
MC
QtQ2Q1
Market 2Market 1 FirmP1
P2
Relatively Inelastic Relatively Elastic