Chapter 1: Pure Monopoly
•Chapter Outline
• Introduction
•Characteristics of Monopoly Firm
•Demand and Revenue functions
• Short-run equilibrium
• Long run equilibrium
• Multi-plant Monopoly
• Price Discrimination
• Comparison with Perfect competition
• The social cost of monopoly ..the deadweight loss
[Link] is a Pure Monopoly?
• A pure monopoly exists when a single firm is the sole
producer of a product for which there are no close
substitutes.
• Monopoly is a market structure in which there is a single
seller of goods and services which has no close
substitutes in the market
• A monopoly is a market that has only one seller, but many
buyers.
• Monopsony is the opposite of monopoly: a market with
many sellers but only one buyer
• In a monopolised market structure, the industry is a
single-firm industry.
– Ethiopian electric utility, Ethiopian airlines, etc
[Link] of Pure Monopoly
1. Single seller/supplier – the firm and the
industry are synonymous.
2. No close substitutes – the product is unique
and unlike with any others product.
3. Price maker – the firm has considerable
control over price since it controls the total
quantity supplied.
4. Blocked entry – barriers to entry exist
because there is no immediate competition.
1.3. Sources or causes of monopoly power
• Barriers to entry are factors that prohibit firms from entering an
industry.
• The barriers to entry are the sources of monopoly power. They
include:
1. Size of the market
2. Economies of scale
3. Legal barriers to entry: Copy rights, patent rights and
licensing
4. Ownership or control of essential resources
5. Exclusive knowledge of production process
6. Pricing policies of existing firms…limit pricing
7. Mergers, takeovers and acquisitions
1.4. Monopoly Demand, Revenue and Cost Curves
• In pure competition, a firm faces a perfectly elastic
demand since it is a price taker.
• The market supply and demand curves determine
price, which determines the firm’s demand curve.
• In pure monopoly, the firm’s demand curve is the
market demand curve.
• The pure monopolist is the industry; therefore, the
demand curve is downward-sloping.
Demand ……cont’d
Pure Competition Pure Monopoly
Price Price
Ep>1
P
Firm’s demand Ep=1 same as Market
Demand
0<Ep<1
0 0
Quantity Quantity
Total Revenue
• Total revenue is the total sale received from
selling a specific amount.
• Mathematically
TR=PQ
TR=(a-bQ)Q
TR=aQ-bQ2, which is quadratic equation
and its graph is downward concave parabola
Continued…
TR
TR
Q
– TR=maximum when its slope MR=0
Average Revenue
• AR measures the revenue received from the sale of
one unit on average
• AR= = = P
• Thus, for pure monopoly P=AR
Marginal Revenue
• MR measures the revenue received from the sale of
one additional unit
• MR= = = = a-2bQ = MR
• MR is the slope of TR function
• MR is the first order derivative of the TR function w.r.t.
Q
• MR is less than price(the demand curve)
• P=a-bQ and MR=a-2bQ
• P>MR
DD, AR, MR, TR and ep
P
Ep>1
Ep=1
P1
Ep<1 DD P=AR
Q1 Q
TR MR
TR
Q1 Q
DD, AR, MR, TR and ep
P Q TR AR MR
$6 0 0 - -
$5 1 5 5 5
$4 2 8 4 3
$3 3 9 3 1
$2 4 8 2 -1
$1 5 5 1 -3
The relationship among AR , P, MR and price
elasticity of demand (ep)
• Given TR=P*Q,
TR P Q P
MR P' Q Q' P Q P P(1 )
Q Q P Q
Q P
• Note that is the reciprocal of the price elasticity
P Q
of demand(ep)
1
• Therefore , MR P (1 )
ep
• Since P= AR,
1
MR AR(1 )
ep
• The general relationship between AR and MR can
be summarized as follows
• When
– ep= 1, MR = 0 AR > 0 therefore, AR > MR
– ep < 1 >0 MR < 0, AR > 0 therefore, AR > MR
– ep > 1 < ∞ MR >0, AR > 0 but AR > MR
– ep = 0, MR < 0, AR = 0 therefore, AR > MR
– ep = ∞, MR > 0, AR > 0 and AR = MR
Graphically,
AR, e =∞
A
MR
e >1
e =1
e <1
AR e =0
Q
MR
Cost curves under monopoly
• In the short run, cost condition faced by a
monopoly firm are, for all practical purposes,
identical to those faced by a firm under
perfect competitions
• A monopoly firm is therefore faced with
usual U-shaped AC and MC curves
1.5. Short Run equilibrium
(Output and Price Determination)
• In perfect competition market profit maximizing price
is set by the DD & SS forces of the market and the firm
determine only the profit maximizing quantity, Q
• In pure monopoly market both profit maximizing P
and Q are set by the firm…two decision variables
• There are two approaches:
– TR-TC approach and
– MR-MC approach
[Link] Revenue Total Cost approach
• P & Q are set by comparing TR and TC
• At equilibrium point:
I. The (+) gap b/n TR and TC is maximum where
TR > TC
II. The (-) gap b/n TR and TC is minimum, where
TR<TC
TC
a’
a Lines aa’ and bb’
TR
are parallel and
TC
their slopes are
• equal
Thus slope of TR
b’
b TR (MR) and slope of
TC (MC) are equal
at the tangency
Q* points
Q
π
Q
Q*
π
1.5.2. Marginal Revenue- Marginal Cost Approach
• It is derived from total approach
• Profit maximizing Q is set where
MR=MC and MC is increasing (slope of MC >
slope of MR)
• MR curve–downward sloping (slope negative)
Graphically,
P, MC
MC
Pe
e
DD P=a-bQ
Q
Qe
MR
SR Equilibrium ….continued
• A monopolist produces a level of output where MR =
MC. This determines the profit maximizing output.
• Price is determined by the market demand curve.
– A vertical line is drawn from Qe to the demand
curve.
– Pe is the profit-maximizing price.
Exercise
Price MC
ATC
P=10
Q: Find Profit for the
AC=8
firm whose graph
e
DD
20 MR Quantity of output
Short run equilibrium profit: the three possibilities
Case A: Positive profit
P MC
P > AC at
equilibrium
P B AC
Monopolist
AC Profit A
MC e
DD
MR
Q
Case B: negative profit( Loss)
P MC AC
AC Mon B
opo
list L P < AC at
os s
equilibrium
P A
MC
e
DD
MR
Q
Case C: zero economic profit (Normal Profit)
P MC
P = AC at
AC equilibrium
P= AC
MC
DD
MR
Q
Mathematically
• An Equation reach its maximum where
– its slope is Zero and
– Slope of the first equation slope is less than zero
or
– First order derivation is = 0 (necessary)
– Second order derivation < 0 (sufficient)
Continued…
• π = TR – TC
• F.O.C
d d dTR dTC
0 0
dQ dQ dQ dQ
MR MC 0
MR MC
Continued…
• S.O.C
d
2
d d (TR TC )
2 2
2
0 2
2
0
dQ dQ dQ
d ( MR MC ) dMR dMC
0
dQ dQ dQ
slope...of ( MR ) slope...of ( MC )
Numerical example #1
• Assume a pure monopoly firm with Demand,
p=40-Q, TFC=50, and TVC=Q2
• Required:
a) the profit maximizing unit of output and price
b) the maximum profit
• Answer
a) Q=10, P=30
b) π= 150
1.7. Supply Curve under Monopoly
• For a perfect competitive firm
– its supply curve is the segment of MC curve above the
minimum of AVC and
– there is one to one correspondence b/n P&Q
• For pure monopoly firm
• There is no unique supply curve due to the fact that,
I. The same Q can be sold at different P
II. Different Q can be sold at the same P based on the
elasticity of the DD curve
• A monopolistic market has no supply curve
• There is no one-to-one relationship between price arid the
quantity produced.
1.8. Long – run Equilibrium under Monopoly
• In perfect competition, there is free entry and exit of
firms– thus, normal profit in the LR
• In monopoly, there are barriers to entry and thus, in
the LR the firm can get:
– (+) profit
– (0)profit
• It can also build a plant which is:
– Less than optimal plant(small)
– Optimal plant
– Greater than optimal plant(large)
LR Equilibrium …..cont’d
• At what output level the monopolist maximizes its
profit?
• A monopolist maximizes its long run profit where
LMC = MR ,
slope of LMC > the slope of MR at the point of
intersection, and
SAC curve is tangent to the LAC at the point
corresponding to long run equilibrium output.
1.9. The multi- plant monopolist
• It is a monopoly which operates in more than one
plant
• The cost conditions may differ from one plant to
another.
• Firms produce the same product in different plants
which sold in the same market
• Reasons – to minimize cost of transportation
- to make the product accessible quickly etc
Assumptions of Multi-plant monopoly
• Two plants
• Homogeneous product
• Different Marginal cost of production in the two
plants
• The firm knows its average and marginal revenue
functions ( single AR=DD)
The firm decision
• Equilibrium quantity( Qe)
• Equilibrium price(Pe)
• Allocation of the output between
the two plants(q1 and q2)
The new Equilibrium
MC=MC1+MC2
P, MC P, MC
P, MC
MC1
MC2
AC1 AC2
P
AC2
AC1
DD
e
MR
0 Qe=q1+q2
0 q1 0 q2
Firm level Plant 1 Plant 2
Note that the MC of the firm is not horizontal summation of the MC of the plants
Equilibrium ……. Cont’d
• How can the monopolist decide the total production
and how much of that output each plant should
produce?
• Total Q produced where MR=MC, but there are
two different MC (MC1 & MC2)
MR=MC1=MC2
If their MC are equal, the firm produces in both plants
equal units.
Algebraically
• TR=PQ where Q=Q1+Q2
• TC=TC1 + TC2
TC1 =f(Q1)
TC2=f(Q2)
π= TR-TC
π= TR-(TC1+TC2)
π= TR- TC1-TC2
Continued…
• Profit is maximum where first derivation is equal to zero
d d
0 0 or
dQ dQ Q1 Q 2
dTR dTC1 dTC 2
0 MR1 MC 1 0
Q1 dQ1 dQ1 dQ1
dTR dTC1 dTC 2
0 MR 2 MC 2 0
Q 2 dQ 2 dQ 2 dQ 2
Continued…
Thus, MR 1 MC 1 MR 2 MC 2
But , MR 1... and .. MR 2 , are...equal
thus , MR 1 MR 2 MR MC 1 MC 2
• Then the above equilibrium condition can be
written as:
MR = MC1 and MR = MC2
Numerical example #1
• Given of the cost functions in the two plants and demand
curve as follows answer questions that follow.
Answer Key:
a)________
b)________
C)________
• Required: d)_______
– Equilibrium output (Q)
– Equilibrium price(P)
– Corresponding output at each plant(q1, q2)
– Profit generated from each plant and total profit .
1.10. Price Discrimination
• Price discrimination is the business practice of selling the
same good at different prices to different or same
consumers
• It is selling same or slightly differentiated products at
different prices
• The price differences are not justified by differences in
costs.
• The characteristic used in price discrimination
is willingness to pay (WTP)
• A firm can increase profit by charging a higher price
to buyers with higher WTP.
Examples of price discrimination
• Firms use common variables for price discrimination
( discriminating variables) such as:
– Age, sex, location of consumer, quantity bought, income,
time of purchase etc.
• Examples of price discrimination in reality:
– Movie tickets: Discounts for seniors, students, and people who
can attend during weekday afternoons.
• Example: Hyper Cinema: different P at 8:00, 10:00 and 12:00
– Transportation fee: for students, for children,
– Night club entrance fee: for female
– Price of Books: hard/soft cover, EEE, low price edition
– Unit price of pipe water consumed
– Unit price of electricity consumed, etc
– Quantity discounts
Goal and types of Price Discrimination
• What do you think is the aim of applying PD?
• The major goal of price discrimination is to raise
profit of the firm
• There are three types/ degrees/ of price
discrimination
1. Degree I
2. Degree II
3. Degree II
First degree (Perfect) price discrimination
• The firm charges each consumer the maximum price it is
willing to pay for each unit of output
• Reservation price= willingness to pay = maximum price
the consumer is willing to pay
• Reservation price varies with the amount bought due to the
law of diminishing MU
• Seller negotiate with each buyer on each unit bought
• Seller charges the maximum price on the demand curve
e.g. A doctor who charges poor and rich different prices
according to their willingness to pay
Degree I ….Continued
• Consumers are willing to pay less and less as
the amount bought increase due to LDMU
• This is shown by down ward sloping DD curve.
p
7
Price for different consumer
6 and different unit is different
5
4
3
1 2 3 4 5 Q
Effects
• The producer captures the whole consumer
surplus
• It is more or less ideal and less common
Second degree price discrimination
• It is sometimes called block pricing or quantity
discrimination
• The seller charges different prices for different
category of quantities purchased
• If the consumer buys less, price will be high but if the
consumer buy high amount there will be a discount
• For public utilities such as electricity and water
consumption, prices increase with quantity consumed
• The goal is to discourage increased consumption
Graphically
• In second degree price discrimination price for the consumers
buying in the same block is equal and price of different blocks
are different
• For example consumer who buy between 10 and 20 units will
pay birr 5 for each.
p
7
6
5
4
3
10 20 30 40 50 Q
Effects
• Only part of consumer surplus is taken
away
• It may encourage efficient utilization of
resources for public utilities such as
electricity, water.
• For these services, higher prices are used
to discourage further consumption
Examples of Degree II price Discrimination
Water Supply and Sewerage Ethiopian Electric Power
Service Enterprise Corporation(EEPCo)
Block No Consumption Rate
per m3 Block No Consumption Rent Rate
per KWH
Block 1 0-5 4.05
Block 2 6 - 10 5.05 Block 1 1 - 25 1.40
Block 3 11 - 30 6.30 Block 2 26 - 50 3.40
Block 4 > 30 7.90 Block 3 51 - 100 6.82
Block 4 101-150 10.23
Third Degree (multi-market) price discrimination
• Sometimes called multi-market price discrimination
• The seller group the market (potential consumers) into
different groups according to the ability to pay and charge
different prices
• The market group with high price elastic are charged
lower price and with less elastic charged higher price
• To maximize profit, the seller sell more in the market
with high MR and redistribute until MR in all market
segments are equal
Necessary conditions for price Discrimination
( Degree III)
• There are three necessary conditons for this type of
price discrimination to be successful
1. There should be effective division of the market in
to sub markets
buyers of low price market should not resale the
commodity in high price market.
• Effective division could be possible through
Geographical variation with high transport cost
Exclusive use of the commodity..non transferable
Lack of distribution channels
Conditions …..continued
2. The price elasticity of demand should be different in each
sub market.
– If the price elasticity of demand is the same in the submarkets,
it is not possible to apply price discrimination
– The consumer with high price elasticity is charged less price
– The consumer with high price elasticity is charged less price
3- Lastly, the market should be imperfectly competitive
– Price discrimination is the extent to which firms extract
consumer surplus and this is not possible in perfect competition
• Example : movie & theatre halls charge college
students and other people different prices
Decisions of the firm
• Equilibrium output to be produced
• The corresponding amount of the good or service to be sold
in each market
• Equilibrium price charged in each market
• Profit generated from each marker
• Total equilibrium profit generated due to discrimination
• Equilibrium condition:
• Since the goods are produced in the same plant So MC is the same
Graphical Analysis
MC
P2
P P
P1
e1 e2 e DD
DD1 DD2
MR1 MR2 MR
q1 Q q2 Q Qe=q1+q2 Q
Market I Market II Firm Level
Numerical Example #1
• Suppose a monopolist sells its product in two
markets (A and B) and total out put is 55
• Demand for market A PA=100-QA
• Demand for market B PB=80-2QB
a) How many units should be sold in each markets?
b) In which market higher price should be charged?
– Hint:
» at equilibrium MR1=MR2=MC
» High ep implies less price
Comparison of Monopoly with Perfect
Competition
• In general, monopoly firm, compared to
a competitive firm,
1. Charges higher price at equilibrium
2. Produces smaller output
1.11. The Social Cost of Monopoly:
The Deadweight Loss
• It measures the net loss in consumer surplus when the
market is monopolized
• Consumer surplus= willingness to pay – actual payment
• Producer surplus=actual receipt – willingness to receive
• Total welfare of the society = consumer surplus +
producers producer surplus
• To see the efficiency of pure monopoly, we compare the
welfare of the society in perfect competition against
that of monopoly
Continued…
• Assume there a perfect competition
firm
• In the LR P=MC
• Thus area a is consumer surplus and
area b is producer surplus in the
following graph.
Continued….
Equilibrium of perfect
competition is where
P MC=MR
a MC
DD P=MR=AR
Pc
b
DD
Qc Q
Continued…
• Assume due to a certain reason if the firm
is monopolized
• Its DD curve become market demand
curve DD
• MR become less than DD
• P > Mc
• Both producer and consumer surpluses
decrease
Continued….
Equilibrium of perfect
competition is where
MC=MR
P
a MC
Pm f
c i d g dd P=MR=AR
Pc e
b
h DDm Equilibrium of
pure monopoly is where
MC=MR
0 Qm Qc Q
MR
Comparison …cont’d
• PC features Monopoly Features
• Q = Qc • QQm=Qm
• P =Pc • P =Pm
• TR= 0QcgPC • TR =0QmfPm
• CS=PcgP • CS = PmPf
= PmPf +PcPmfi+gif
• PS = 0hgiPc
= 0hiPc+hgi
The deadweight Loss ( loss in CS)
• Area PmPf remains as consumer surplus
– No change in welfare
• Area PcPmfi has been captured as
revenue by the monopoly firm
– No change in welfare
• Area gif is lost due to change in market
structure
– There is change(loss) in welfare
The deadweight Loss ( loss in PS)
• PS= 0hgiPc
= 0hiPc+hgi
• Area ohiPc is now part of the TR of the monopolist
– No change in welfare
• Area hgi has been lost due to the change in the
market structure
– There is loss in welfare
• Total welfare Loss is the sum of the loses in CS & PS
• Deadweight loss= area (gfi)+area (hgi)
= area(e)+area(d)
Is monopoly Good or Bad?
•What Do
YOU Think?
Monopoly is Good
• Because:
1. It may lead to innovation and new
product development
2. It may lead to efficiency: large firms
can be efficient than small firms
3. Naturally created
Monopoly is Bad
• Because:
1. The effect on price
– Firms with monopoly power are likely to charge higher prices
than would be the case if there was greater competition
2. The effect on choice
– The fewer firms there are in a market, the less
choice the consumer has
3. The effect on new entering firms
– Monopoly firms make it difficult for new firms to
enter the industry
