CA Foundation Business Economics Study Material – Monopoly

CA Foundation Business Economics Study Material Chapter 4 Price Determination in Different Markets – Monopoly

MONOPOLY

Introduction:

• ‘Mono’ means single and ‘Poly’ means seller.
• So monopoly refers to that market structure where there is a single firm producing and selling a commodity which has no close substitute.
• As there is no rival firms producing close substitute,
  – the monopoly firm itself is industry, and
  – its output constitutes the total market supply.

Features of Monopoly Market:

Following are the main features of the monopoly market:

1. Single seller and Large number of buyers
   • There is only one seller or producer of a commodity in the market but there are many buyers.
   • As a result, the monopoly firm has full control over the supply of the commodity.
2. No close substitutes.
   • The commodity sold by the monopolist generally has no close substitutes.
   • Therefore, the cross elasticity of demand between monopolist’s commodity and other commodity is zero or less than one.
   • As a result monopoly firm faces a downward sloping demand curve.
3. Restrictions to entry for new firms.
   • The monopoly firm controls the situation in such a way that it becomes difficult for new firms to enter the monopoly market and compete with monopoly firm.
   • There are many barriers to the entry of new firm which can be economic, institutional or artificial in nature.
4. Price maker
   • A monopoly firm has full control over the supply of the commodity
   • Price is solely fixed by the monopoly firm.
   • So, a monopoly firm is a “price maker”.

Sources of Monopoly:

The sources of monopoly may be listed as follows:

1. Patents, copyrights and trade marks.
   • Legal support provided by the government to promote inventions, to produce a particular commodity, etc. by granting patents, copyrights, trademarks, etc. creates monopoly.
2. Control of raw materials.
   • If one firm acquires the sole ownership or control of essential raw materials, then the other firms cannot compete.
3. Economies of large scale.
   • The monopoly firm may be very big and enjoy economies of large scale of production.
   • The cost of production is therefore low, hence it may supply goods at low prices.
   • This leaves no scope for new firms to enter the market.
4. Government control on entry
   E.g. – In defense production; public utility services like water, transportation, electricity, etc.
5. Business combines.
   • Monopolies are created by forming cartels, pools, syndicates, etc. by the firms producing the same goods to control price and output.

Average Revenue and Marginal Revenue Curves under Monopoly

• Monopoly firm constitutes industry.
• Therefore, the entire demand of the consumers faces the monopolist.
• The demand curve of a monopoly firm is the same as the market demand curve of the commodity.
• As the demand curve of the consumers for a commodity slopes downward, the monopolist faces a downward sloping demand curve.
• This means that monopolist can sell more quantity only by lowering the price of the commodity
• The demand curve facing the monopolist is also his average revenue curve. Thus, average revenue curve of the monopolist slopes downwards
• As the demand curve i.e. average revenue curve slopes downwards, marginal revenue curve will be below it.

• In the figure above, AR curve of the monopolist slopes downward and MR curve lies below it.
• At a quantity OQ, average revenue ie. price is OP (=QT) and marginal revenue is QK which is less than average revenue OP (=QT).

Thus, in case of monopoly —

1. AR and MR are both negatively sloped curves,
2. MR curve lies half way between the AR curve and the Y-axis,
3. AR cannot be zero i.e. AR curve cannot touch X-axis,
4. MR can be zero or even negative i.e. MR curve can touch or cut the X-axis.

Short Run Equilibrium of the Monopoly Firm (Price – Output Equilibrium)

• A monopolist will produce an output that maximizes his total profits.
• A monopolist will maximize his total profits when —
  1. Marginal Cost = Marginal Revenue (MC = MR), and
  2. Marginal cost curve cuts the marginal revenue curve from below.
• When a monopoly firm is in the short run equilibrium, it may find itself in the following situations —
  1. Firm will earn SUPER NORMAL PROFITS if its AR > AC;
  2. Firm will earn NORMAL PROFITS if its AR = AC, and
  3. Firm will suffer LOSSES if its AR < AC.

1. Super Normal Profits (AR > AC):
The monopoly firm would earn super normal profits if at the equilibrium output AR > AC.

2. Normal Profits (AR = AC):
The monopoly firm would earn normal profits if at the equilibrium output AR = AC.

3. Losses (AR < AC):
The monopoly firm would suffer losses, if at the equilibrium output its AR < AC.

If monopoly firm’s AR > AVC or AR = AVC, it can continue to produce though it suffer losses at the equilibrium level of output. .

Long Run Equilibrium of a Monopoly Firm:

• The long run equilibrium of the monopoly firm is attained where its MARGINAL COST = MARGINAL REVENUE ie. MC = MR.
• The monopoly firm can continue to earn super normal profits even in the long run.
• This is because entry to the market for new firms is blocked.
• All costs are variable costs in the long run and these must be recovered.
• This means that monopoly firm does not suffer loss in the long run.
• However, if it is unable to recover variable costs, it should shut down.

Fig. Shows the long run equilibrium of a monopoly firm.

• Thus, we find that monopoly firm continue to earn super normal profits in long run.
• A monopoly firm does not produce at the lowest point of LAC curve ie. does not produce at optimum level because of absence of competition.
• In other words, it operates at sub-optimum level and therefore, does not produce optimum output.

Price Discrimination:

• A monopoly firm is also the industry.
• A single firm controls the entire supply.
• Therefore, the firm has the power to sell the same commodity to different buyers at different prices.
• When the firm charge different prices to different customers for the same commodity, it is engaged in price discrimination.
  E.g. – Electricity supplying firm charge higher rate per unit of electricity from industrial units than domestic consumers.

Conditions for price discrimination:
Price discrimination is possible under the following conditions:

1. Existence of two or more than two sub-markets.
   • The monopolist should be able to divide the total market for his commodity into two or more sub-markets.
   • Such division of market may be on the basis of income, geographic location, age, sex, etc.
   • E.g. on the basis of income, a doctor may charge high fees from rich patients than from poor.
2. Different markets should have different price elasticity of demand.
   • The difference in price elasticity of demand in different markets enables the monopolistto discriminate among customers.
   • He can charge higher price in inelastic market and lower price in elastic market.
3. No possibility of resale.
   • It should not be possible for buyers to purchase the commodity from a cheaper market and sell it in the costlier markets.
   • In other words, there should be no contact among the buyers of the two markets.
4. Control over supply.
   • The supply should be in full control of the monopolist.

Price-output determination under price discrimination

• Suppose a discriminating monopolist sell his output in market ‘A’ and market ‘B’.
• Market ‘A’ has less elastic demand and market ‘B’ has more elastic demand.
• Suppose the monopolist has only one production facility then he is faced with the questions—
  • How much to produce?
  • How much to sell in each market?
  • How much price to charge in each market?
• The monopolist will first decide profitable level of total output (ie. where MR = MC) and then allocate the quantity between two markets.
• The condition for equilibrium here would be —
  1. MC = MRa = MRb. It means that MC must be equal to MR in individual markets separately.
  2. MC = AMR (aggregate marginal revenue). It means that the monopolist must be in equilibrium not only in individual markets but also when the two markets are treated as one.

The process of price determination under price discrimination is shown in the following figure —

• In the fig. – MC curve intersect the AMR curve at point E
• Point E shows the total output is OQ.
• When a perpendicular EH is drawn, it intersect MR_a at E₁ and MR_b at E₂. These are the equilibrium point of market A and B
• Point Et shows that quantity sold in market A is OQ₁ and the price charged is OP₁
• Point E2 shows that quantity sold in market B is OQ₂ and the price charged is OP₂
• Price charged in market ‘A’ is higher than in market ‘B’.
• Thus, a discriminating monopolist chargers a higher price in the market ‘A’ having less elastic demand and a lower price in the market ‘B’ having more elastic demand.
• The marginal revenue is different in different markets.

E.g. – Suppose the single monopoly price is Rs. 40 and elasticity of demand in market A and B is 2 and 4 respectively.

• It is clear from the above example that the marginal revenue is different in different markets when elasticity of demand at the single price is different.
• MR is higher in the market having high elasticity and vice versa.
• In the above example, since marginal revenue in market ‘B’ is more, it will be profitable for monopolist to transfer some units of the commodity from market ‘A’ to ‘B’.
• When monopolist transfers the commodity from market A to B, he is practicing price discrimination.
• As a result, the price of commodity will increase in market A and will decrease in market B.
• Ultimately the marginal revenue in the two market will become equal.
• When marginal revenue becomes equal in the two markets, it will no longer be profitable to transfer the units of commodity from market A to B.

Objectives of Price discrimination:
To earn maximum profit; to dispose off surplus stock; to enjoy economies of scale; to capture foreign markets etc.

Degrees of price discrimination:
Pigou classified price discrimination as follows:

1. first degree price discrimination where the monopolist fix a price which take away the entire consumer’s surplus,
2. second degree price discrimination where the monopolist take away only some part of consumer’s surplus. Here price changes according to the quantity sold. E.g. large quantity sold at a lower price,
3. third degree price discrimination where the monopolist charges the price according to location customer segment, income level, time of purchase etc.