Ch 18 Pricing Under Simple and Discriminating Monopoly

WHAT IS MONOPOLY?
The word 'Monopoly' is a Latin word. It is composed of two words: (i) Mono-which means
single, (i) Poly-which means seller. Thus, monopoly is a market situation in which there is a
single seller of a good with no close substitutes. Good examples are public utilities such as
railways, electricity, water and telephone undertakings.
Since the monopolist is the sole seller, he has full control over the supply of the commodity.
The buyer can either purchase the commodity from the seller, who is the only supplier of that
commodity or go without it. A monopolist is thus a price-maker. He is not afraid of the actions
of the rivals.

Definitions
According to P.C. Dooley, "Pure monopoly is a market situation with one seller." Leftwitch
observes, "Pure monopoly is a market situation in which a single firm sells a product for which
there is a good substitute."
According to A.J. Braff, "Under pure monopoly, there is a single seller in the market. The
monopolist's demand is the market demand. The monopolist is a price-maker. Pure monopoly
suggests no substitute situation."
According to McConnell, "Pure or absolute Monopoly exists when a single firm is the sole
producer for a product for which there are no close substitutes."

Features or Necessary Conditions for the Existence of Monopoly

1. One Seller and Large Number of Buyers: Monopoly is said to exist when there is only one
seller of a product. The monopolist is a firm as well as an industry. The demand for the
monopolist is the market demand. In the simple monopoly, the number of buyers is assumed to
be large. No one buyer can influence the price by his individual actions.
2. No Close Substitutes: The second condition of monopoly is that there should not be any close
substitute of the product sold by the monopolist.
3. Restriction on the Entry of New Firms: In a monopoly type of market, there is strict barrier
on the entry of new firms. Monopolist faces no competition.
4. Informative Selling Costs: In monopoly selling costs are incurred in the beginning. These are
done to give information to the buyers about the product.

Nature of Demand Curve

In monopoly, there is only one firm producing a product. Since the demand curve of a
monopolist is the summation of the demand curves of all the buyers of the product sold by the
monopolist, the demand curve of a monopolist slopes downward. It means that a monopolist
can sell more of his output only at a lower price. On the contrary, if he raises the price of his
product, his sales will be reduced.
Consider the above Fig. DD is the demand curve facing a monopolist. At price OP, the quantity
demanded is OM, therefore, he would be able to sell OM quantity at price OP. If he wants to
sell a greater quantity OM1, then the price should fall to OP1. If he restricts his quantity of OM2,
the price will rise to OP2. Thus every quantity change by him causes a change in the price at
which the product can be sold. Thus the problem faced by the monopolist is to choose that
price-quantity combination which is optimum for him that is which yields him maximum
possible profit.
The downward sloping demand curve tells us that average revenue or price goes on falling as
sales are increased. When average revenue (AR) slopes downward, marginal revenue (MR)
always lies below AR. In other words, MR curve of a monopolist also slopes downward from
left to right and it lies below the AR curve.

Cost Curves Under Monopoly

Under monopoly the shapes of different cost curves is exactly like that under perfect
competition. Average cost of production refers to the cost per unit of output; while marginal
cost refers to the cost of producing an additional unit. In the short-run average cost will actually
consist of fixed and variable costs. When a firm produces more and more the average cost as
well as marginal cost of production decline and then rise. Under monopoly also, average cost
(AC), marginal cost (MC) and average variable cost (AVC) are U shaped.

Determination Of Price And Output Or Equilibrium Under Monopoly

Equilibrium is the situation in which the firm earns maximum profits or minimum losses.
Similarly, a monopoly firm will be in equilibrium at that level of output where it earns
maximum profits. As in the case of perfect competition, equilibrium of a monopoly firm can
also be studied in two different ways, viz:
(1) Total Revenue and Total Cost Approach (2) Marginal Revenue and Marginal Cost Approach.

1. Total Revenue and Total Cost Approach

The monopolist will maximize his profits at that output where the difference between TR and
TC is the greatest. This will be that level of output at which the slopes of TR and TC curves
are equal. It is explained with the help of Fig. In this figure TC is the total cost curve showing a
constant rise in the total costs as output increases. TR is the total revenue curve which goes on
rising to begin with, then flattens and later on slopes downward showing a fall in total receipts
after a given point. TP is the total profit curve. It begins from point R, signifying that initially
firm is faced with negative profits. Fig. shows that as the firm increases its production, total
revenue is also increasing however in the beginning TR is less than TC.

Thus RC portion of TP curve indicates that the firm is incurring losses. At point K, total revenue
is equal to total cost (TR=TC) meaning thereby that firm is in no profit and no loss situation as is
also indicated by point C of TP curve. Point K is called 'Break Even Point'. When firm
produces more than at point K, then its total revenue will be exceeding its total cost (TR>TC).
TP curve also slopes upwards from point C onwards. It indicates that firm is earning profits.
When TP curve will reach its highest point 'B' then the firm is earning maximum profits. This
amount of output (OQ) will be called equilibrium output.
If the firm produces more than the equilibrium output then the difference between TR and TC
curves will narrow down and again at point K1 both these curves will intersect each other, ie.
total revenue will become equal to total cost. It means the profit of the firm will go on
diminishing and at the said point the firm will be in no profit no loss situation as is indicated by
point 'D' on TP curve. Thus point K1 is also called break-even point. If the firm produces more
than this, then TR will be less than TC and the firm will incur losses. In short, the firm will earn
maximum profit at point E. In order to know the maximum profit of the firm, tangents are
drawn on TR and TC curves. The points at which tangents are parallel to their distance is
maximum. In the above figure, tangents are parallel at points 'A' and 'B' which also indicate
maximum distance between TR and TC.

2. Marginal Revenue and Marginal Cost Approach

According to this analysis, a monopolist will be in equilibrium when following two conditions
are fulfilled i.e.
(i) MC=MR
(ii) MC curve cuts MR Curve from below.
A monopolist earns either maximum profit or suffers minimum losses when he is in equilibrium.
If marginal revenue exceeds marginal cost (MR>MC), the monopolist can increase his profits by
increasing production. If marginal cost exceeds marginal revenue (MC>MR) at a particular level
of output, the monopolist can minimize his losses by reducing his production. So the monopolist
is said to be in equilibrium when his MC is equal to its MR or (MC=MR).

It is explained with the help of Fig. AR and MR are average and marginal revenue curves, MC is
marginal cost curve. Point E is an equilibrium point where MC=MR and also MC curve cuts
MR curve from below. OQ is the equilibrium output. In case, the monopoly firm decides to
produce OQ1 output which is less than the equilibrium level of output MR is P1Q1 while MC is
C1Q1. However the monopolist can earn larger profits, in case it decides to produce output more
than OQ1. The firm will raise the output until it reaches the equilibrium level OQ. And if the
monopolist produces OQ2 output, at this level of output MC(C2Q2) is greater than MR(P2Q2). The
firm will reduce the output till equilibrium level of output is reached.
Monopoly price-output determination can be studied under two different time periods (i) Short
Period (ii) Long Period

Short-run Equilibrium Or Price-output Determination in the Short Period

Short period is a time period in which there are two types of factors of production. One, the
fixed factors and the other are the variable factors. In short- run, production can be altered only
by changing the variable factors of production. Fixed factors of production cannot be changed. In
the short period, a monopolist, in equilibrium, can earn (1) Supernormal Profit (2) Normal
Profit and (3) Minimum loss.

1. Supernormal Profits: In above Fig. a monopolist is in equilibrium at point E, because at this

point MC=MR. His equilibrium output is OM and PM is the equilibrium price. In this situation
the monopolist firm is earning supernormal profits since the AR (PM) exceeds AC (QM) and
total supernormal profits of the monopolist are shown by the shaded area PQRS.

2. Normal Profit: In above Fig, E is the point of equilibrium where MR=MC. OM is the
equilibrium output. Price PM is equal to average cost. The firm is earning normal profits in
equilibrium situation, as an equilibrium output AR=AC. And normal profits are included in
short-run average cost.
3. Minimum Loss: In the short-run, the economist firm may incur loss also. But in case of
losses, monopolist price must be covering at least the average variable costs (AVC),
otherwise the firm will stop production. In below Fig, the firm shown is suffering losses.
Equilibrium is established at point E where MR=MC. OM is equilibrium output. Price is
fixed at PM. Monopolist firm is earning losses shown by the shaded area PQRS since AC
exceeds price (AR<AC). But here the losses are minimum because equilibrium price (AR) is
equal to average variable cost (AVC) and the monopolist bears the loss of fixed costs. The
monopolist will have to bear this loss even if he chooses to close down the production in the
short-time. If the monopolist's price falls below PM, he would shut-down production.
Therefore, at price PM the firm will continue production, since price is higher than AVC.

Long-run Equilibrium Or Price-Output Determination in Long Period

Long period is period which is long enough to fully adjust the supply to the changes in demand
of a product. In this period, all factors of production are variable. Volume as well as capacity of
production can be changed. Monopolist firm in the long-run also is in equilibrium at a point
where its marginal revenue is equal to its long-run marginal cost. In the long- run, a
monopolist firm earns only profits. If the price is less than the long-run average cost, the
monopolist would like to close down the unit rather than suffer the loss.

The long period equilibrium or price-output determination of a monopolist firm can be shown in
above Fig. Point E is the equilibrium point because here in MR=LMC. OM is the
equilibrium output and PM is the equilibrium price. Firm is earning supernormal profits
equal to shaded area PQRS since its AR exceeds AC by PQ. It is earning supernormal profits
even in long period. The monopolist is producing less than optimum output. The optimum
output level is OM1 which is produced at the lowest AC which is at point L. The monopolist
in this case is in equilibrium at less than optimum output which is OM.
Above Fig shows that the monopolist is producing optimum level of output OM which is at the
lowest LAC. The plant of the firm is optimum plant and that the monopoly firm is utilizing its
full capacity but he is enjoying the supernormal profits equal to SPER.

When the market size is so large as in shown in above Fig that the monopolist must build a
plant larger than the optimal and over utilize it, the equilibrium output is OM which is more
than optimum output OM1. The profits however enjoyed by the firm are supernormal equal to
SPQR. Thus in long period, the monopolist in equilibrium may operate at less than optimum
plant, at optimum plant or at more than optimum plant.

PRICE DISCRIMINATION OR DISCRIMINATING MONOPOLY

Sometimes a monopolist charges different prices of the same product from different buyers.
This price policy of the monopolist is called price discrimination. The monopolist practicing it
is called discriminating monopoly.

Definitions
In the words of J.S. Bain, "Price discrimination refers strictly to the practice by a seller of
charging of different prices from different buyers for the same goods."
According to Mrs. Joan Robinson, "The act of selling the same article, produced under single
control at different prices to different buyers is known as price discrimination."
In the words of Koutsoyiannis, "Price discrimination exists when the same product is sold at
different prices to different buyers."
According to Dooley, "Discriminating monopoly means charging different rates from different
customers for the same good or service."
In the words of Prof. Schneider, "One may speak of price discrimination if a seller offeres the
same good to different buyer or a group of buyers at different prices."
The idea of the monopolist behind price discrimination is to get from each buyer whatever profit
that could be squeezed on the basis of the buyer's intensity of demand and supply of his product.
So, it is a technique followed by the monopolist to make the buyers pay according to their ability.

Degrees of Price Discrimination

Prof. Pigou in his book "Economics of Welfare" has explained three degrees of price
discrimination:
1. Price Discrimination of the First Degree: In this type of discrimination a seller charges price
according to the maximum paying capacity of the buyer. As a high price is extracted from the
buyer, he is left with no consumer's surplus.
2. Price Discrimination of the Second Degree: Under this type of discrimination a monopolist
fixes the price at such a level that the buyers are left with some amount of consumer's surplus.
3. Price Discrimination of the Third Degree: Under this third degree discrimination, a
monopolist charges different prices from different buyers by classifying them into different
sub-groups or sub-markets. For instance, a monopolist charging a higher price of a product in
the domestic market and lower price in the foreign market.
This third degree of price discrimination is generally found in practice.

WHEN IS PRICE DISCRIMINATION PROFITABLE ?

Price discrimination is profitable when the price elasticity is different in different markets,
at the single monopoly price. If price elasticity of demand in two markets at the single
monopoly price is the same, then price discrimination will not be profitable. It is so because
when price elasticity of demand in two markets is the same then marginal revenue of the product
in both the markets will also be equal. On the contrary, if price elasticity of demand in two
markets is different then the marginal revenue of the product in these markets will also be
different. It will be more in one market and less in the other. In such a situation, it would be
profitable to transfer the commodity from less-marginal revenue market to more marginal
revenue market. Thus differences in elasticity of demand for the product in two different markets
make price discrimination profitable.

Supposing monopoly price of a product is the same i.e. Rs. 10 in two markets 'A' and 'B', but
elasticity of demand is 2 and 5 respectively. On the basis of the above formula marginal revenue
in both the markets can be calculated as under.
In market 'A' where elasticity of demand is less i.e. 2 marginal revenue is also less i.e. Rs. 5. On
the other hand, in market 'B' where elasticity of demand is more i.e. 5 marginal revenue is also
more i.e. Rs. 8. So the monopolist will transfer some units of the commodity from market 'A'
where MR is Rs. 5 to market B where MR is Rs. 8. By selling one unit less in market 'A' the
monopolist will lose Rs. 5 but by selling one unit more in market 'B' he will gain Rs. 8. Such a
transfer of goods will continue withdrawing the commodity from market 'A' and selling the
same in market 'B' till marginal revenue in both the markets become equal, i.e. MRA = MRB.

COMPARISON BETWEEN MONOPOLY AND PERFECT COMPETITION

Comparison between monopoly and perfect competition can be made on the basis of the
following:
1. Aim of the Firms: The main aim of firms under monopoly and perfect competition is to earn
maximum profits. In both, a firm is in equilibrium at that level of output where marginal cost
equals marginal revenue.
2. Nature of Product: Under perfect competition all firms produce or sell homogeneous
identical goods. A monopoly firm may or may not produce homogeneous goods.
3. Entry of Firms: Under perfect competition, firms can freely enter the market in the
long-run. Similarly, firms can leave the market if they suffer losses. But under monopoly, there
are restrictions on the entry of other firms. No new firm can enter the industry or market under
monopoly situation.
4. Number of Sellers and Buyers: In the perfectly competitive market, the number of buyers
and sellers is very large. There is perfect competition among them. Price is determined for the
entire industry by forces of demand and supply. All firms have to sell their product at that price.
No single buyer or seller can influence the price prevailing in the market. On the other hand, the
distinction between firm and industry disappears under monopoly. The firm is an industry under
monopoly which itself fixes the price for its product. It is, therefore, called a 'price maker'.
5. Shape of Demand Curve: Under perfect competition the demand curve or the average
revenue curve (AR/D) of a firm is a horizontal straight line parallel to the x-axis. In other words,
the average revenue (AR) curve of the firm is perfectly elastic and the marginal revenue
coincides with it. But the average revenue curve of the monopoly firm slopes downward from
left to right and the marginal revenue curve is below this. As is shown in the Fig. below:

6. Price Discrimination: The monopolist can charge the different prices for the same product
from his customers, firstly, because he has no rival and secondly, when he finds that the elasticity
of demand for his product is different in different markets. But a competitive firm cannot
practice price discrimination, because the demand curve for his product is perfectly elastic. If he
tries to change a higher price from some of his customers, they will buy the commodity at the
market price from another seller. Thus price discrimination is possible only under monopoly.
7. Comparison Regarding Profit: In the short period, a firm whether operating under perfect
competition or monopoly, may earn supernormal profit, normal profit or suffer losses. But in the
long period, a firm under perfect competition earns only normal profit. On the other hand, a
monopoly firm under long period, continues to earn supernormal profit.
8. Utilization of Resources: A firm under competition makes optimum use of available
resources. Firm produces optimum level of output. On the other hand, a monopolist produces
generally a less than optimum output. Since the output is deliberately restricted in monopoly,
hence there is no full utilization of available resources.
9. Price and Marginal Cost Relationship: We know that AR=MR under perfect competition,
but MR lies below AR under monopoly. Under perfect competition when a firm is in
equilibrium, its price = AR = MR = MC. But under monopoly AR and MR are downward
sloping and MR curve lies below AR curve. When a monopolist firm attains equilibrium through
the equality of MR and MC, price that is AR is more than the marginal cost. Fig given below:

The Fig (a) shows the equilibrium of a firm under perfect competition. E is the point of
equilibrium of a firm where its MC=MR and MC is rising also. On this point of equilibrium,
price is equal to marginal costs ie. OP=ME. Fig. (b) shows the case of a monopoly firm. A
monopolist firm is in equilibrium at point E where its MR=MC. Price here is PM but marginal
cost is EM or price (PM)> marginal cost (EM).

10. Difference Regarding Price and Output: monopoly price is higher and output is lower than
that of a competitive firm, conditions of cost and demand for both being the same. The
comparison regarding price and output of the firms under these two types of market forms is
made with the help of above Fig. D(AR) is the demand curve of the product or the average
revenue curve. S is the supply curve or the marginal cost curve of the industry. Under perfect
competition, price- output is determined by the interaction of the forces of demand and supply of
the industry. P1 is the point where the demand curve (D) for the product of industry is intersected
by the supply curve S. Therefore, P1M2 is the equilibrium price and OM2 is the equilibrium
output under perfect competition. In this diagram, the monopoly firm is in equilibrium at point
E where the MC curve cuts the MR curve from below and the monopoly price PM (=OQ) is
determined at which OM output is sold. Monopoly price PM is higher than the competitive price
P1M2 and the monopoly output OM is less than the competitive output OM2.

11. Comparison of Equilibrium Conditions: under perfect competition the MC curve of the
firm must be rising at the point of equilibrium. Whereas under monopoly, equilibrium marginal
cost may be falling, constant or rising, but the marginal cost curve must cut the marginal revenue
curve from below.

Under perfect competition it is only possible in the case of left to right upward rising MC curve
since MR curve is horizontal to x-axis. This equilibrium is shown in Fig. where the competitive
firm is in equilibrium at Point P. It earns PQRS profits by selling OM of output at MP price.
The three different equilibrium situations under monopoly are depicted in Fig.

Fig. (a) shows monopoly equilibrium falling costs where the falling MC curve cuts the MR curve
from below at point E. In Fig. (b) a horizontal MC=AC curve cuts the MR curve from below at
point E while in Fig. (c) an upward rising MC curve cuts the MR curve from below at Point E.

12. Size of Firms: under perfect competition in the long-run a firm is in equilibrium where price
is equal to long-run marginal cost and minimum long-run average cost (ie. Price=LMC = Min.
LAC). Competitive firms in the long-run are of the optimum size and they produce to their full
capacity. But under monopoly, a firm is in equilibrium where MR=LMC but LAC at the point of
equilibrium is still falling. Equilibrium of a monopolist takes place before the minimum LAC
point. So the firm is less than of the optimum size. Both the situations are shown below.

The competitive equilibrium position is shown in Fig.(a) where LMC = MR = AR=Min LAC at
point E. But under monopoly the price QP is not equal to the minimum LAC. The minimum
point M of the LAC curve is to the right of the equilibrium point E. It implies that the monopoly
firm possesses excess capacity from E to M and it does not produce to its full capacity.

13. Consumer's Welfare: it is believed that consumer's welfare is promoted under perfect
competition. The reason is that every firm produces at its optimum point and each competitive
firm gets his profit by increasing output rather than by raising price. On the other hand, a
monopolist produces, generally, a sub- optimum output. Therefore, the price is higher than that
under perfect competition. But a monopoly is not always a bad thing. It is rather desirable under
some situations. For example, in case of public utility services and for defense purposes, state
monopolies are not desirable but necessary also.