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Price Decision under Monopoly

Monopoly can be described as a market situation where a single firm controls the entire supply of a product which has no close substitutes. The market structure characteristics of monopoly are listed below: Single seller that produces a product with no close substitutes Many buyers Absolute control on prices Large profit potential Entry is blocked; in other words, there are barriers to entry Examples: CYTA (?), EAC, POST OFFICE

Though perfect competition and monopoly are the two extreme cases of market structure, they both have one thing in common they do not have to compete with other individual participants in the market. Sellers in perfect competition are so small that they can ignore each other. At the other extreme, the monopolist is the only seller in the market and has no competitors. The market or industry demand curve and that of the individual firm are the same under monopoly since the industry consists of only one firm. Managers of firms in a perfectly competitive market facing a horizontal demand curve would have no control over the price and they simply choose the profit maximising output. However, the monopoly firm, facing a downward-sloping demand curve (see Figure 12.3) has power to control the price of its product. If the demand for the product remains unchanged, the monopoly firm can raise the price as much as it wishes by reducing its output. On the other hand, if the monopoly firm wishes to sell a larger quantity of its product it must lower the price because total supply in the market will increase to the extent that its output increases. While an individual firm under perfect competition is a price-taker, a monopolist firm is a price-maker. It may, however, be noted that to have price setting power a monopoly must not only be the sole seller of the product but also sell a product which does not have close substitutes. Barriers to Entry: Economies of Scale (Natural Monopolies) Ownership/Control of Key Resources/Inputs or Sales Outlets Legal Protection (licensing agreements, patents, copyrights, franchise agreements) Large Capital Investment Requirements Brand Loyalty


This is both the short run and long run equilibrium position for a monopoly
Given the barriers to entry, the monopolist will be able to exploit abnormal profits in the long run as entry to the market is restricted.

AR (D) curve for a monopolist likely to be relatively price inelastic. Output assumed to be at profit maximising output (note caution here not all monopolists may aim for profit maximisation!) Output / Sales

PRICE-OUTPUT DETERMINATION UNDER MONOPOLY: A firm under monopoly faces a downward sloping demand curve or average revenue curve. Further, in monopoly, since average revenue falls as more units of output are sold, the marginal revenue is less than the average revenue. In other words, under monopoly the MR curve lies below the AR curve. The Equilibrium level in monopoly is that level of output in which marginal revenue equals marginal cost. The producer will continue producer as long as marginal revenue exceeds the marginal cost. At the point where MR is equal to MC the profit will be maximum and beyond this point the producer will stop producing.

It can be seen from the diagram that up till OM output, marginal revenue is greater than marginal cost, but beyond OM the marginal revenue is less than marginal cost. Therefore, the monopolist will be in equilibrium at output OM where marginal revenue is equal to marginal cost and the profits are the greatest. The corresponding price in the diagram is MP or OP. It can be seen from the diagram at output OM, while MP is the average revenue, ML is the average cost, therefore, PL is the profit per unit. Now the total profit is

equal to PL (profit per unit) multiply by OM (total output). In the short run, the monopolist has to keep an eye on the variable cost, otherwise he will stop producing. In the long run, the monopolist can change the size of plant in response to a change in demand. In the long run, he will make adjustment in the amount of the factors, fixed and variable, so that MR equals not only to short run MC but also long run MC. PROFIT MAXIMISING OUTPUT OF A MONOPOLY FIRM: Often students are tempted into thinking that since a monopolist is the only producer in the market, he will be able to charge any price for the product. While a monopolist will certainly charge a high price, it must also ensure that it is maximising profit. Our earlier discussion proves that a profit maximising monopoly firm determines its output at that level where its marginal cost (MC) curve intersects its downward sloping marginal revenue (MR) from below. Since the MR curve of the monopoly firm is below its average revenue or demand curve at all levels of output, and at the equilibrium output level marginal revenue is equal to marginal cost, the profit maximising monopoly price is greater than marginal cost. You may recall, the profit maximising price under perfect competition is equal to marginal cost. Since the demand curve of the monopoly firm is above the firms average cost curve, the price at equilibrium output is also greater than average cost. Therefore, super-normal profits are a distinguishing feature of equilibrium under monopoly. Figure 1.1: Equilibrium output and price under monopoly

The firm would enjoy such super normal profits even in the long run because it is very difficult for new firms to enter in a monopolized market. The determination of profit maximizing equilibrium output and price under monopoly is shown in figure 12.3. DD and MR are the downward sloping demand (or average revenue curve) and marginal revenue curves respectively of the monopoly firm. AC and MC are its average cost and

marginal cost curves. At point E, MC intersects MR from below. Corresponding to E, the profit maximizing equilibrium output is OQ. At OQ output, the price is OP = QR; and average cost is OC = QK. The monopoly profits are equal to price minus average cost multiplied by output i.e., (OP OC) * OQ = PC *CK = PCKR. The rectangle area PCKR represents the super normal profits of the monopoly firm. Monopoly: SR Equilibrium Demand curve for the firm is the market demand curve Firm produces a quantity (Q*) where marginal revenue (MR) is equal to marginal cost (MR) Exception: Q* = 0 if average variable cost (AVC) is above the demand curve at all levels of output

Suppose that a monopolist buys up all the firms in a competitive industry. The Industrys D-curve becomes the Monopolists D-curve, and the industrys S-curve becomes the monopolists MC curve. Optimum Q* (where MR=MC) for monopolist is now Q2 (not Q1 reached in the market under perfect competition).

Managerial Implications:
Perfect Competition Profit potential in Perfect Competition is very low Being cost efficient is key to survival Timing of entering the market is key for making SR profits. Failure rate is high because of overestimating demand potential IT revolution (internet, e-commerce) and market changes reduce the pricing power of monopolies Barriers to entry are less effective Deregulation & privatizations lead to the extinction of monopolies Generic brands increase competition


Monopoly Power
The above analysis shows that whereas under perfect competition, price is equal to marginal cost and profits are normal in the long run; under monopoly, price is greater than marginal cost and profits are above normal even in the long run. Therefore, the monopolist has power to charge a price which is higher than marginal cost and earn super normal profits. The extent of monopoly power of a firm can be calculated in terms

of how much price is greater than marginal cost. Recall that a perfectly competitive firm sets P = MC. Thus the greater the difference, the greater is the monopoly power. Economist A.P. Lerner devised such an index to measure the degree of monopoly power and which has come to be known as the Lerner index. According to this index, the monopoly power of a firm is = (P MC)/P where P = Price of the firms product MC = Firms marginal cost We know that at equilibrium output MC = MR and MR = P(1 1/e) where e is the price elasticity of demand. = (P MC)/P = (P MR )/P = 1 (MR/P) But (MR/P) = (1-1/e) = 1 (1 1/e) = 1/e The monopoly power of a firm is inversely related to elasticity of demand for its product. The less elastic the demand for its product, the greater would be its monopoly power, and vice versa. As we have discussed in Block 2, elasticity of demand depends on the number and closeness of the substitutes available for a product. In the real world we find some essential goods and services like life saving medicines, petroleum, cooking gas, railways etc. enjoy a high degree monopoly power because the demand for these products is highly inelastic. Left to itself the monopoly could price such inelastic products at rates that do not meet the social objectives of the government and policy makers. Thus we often witness government intervention in monopolies. For example, Railway ticket prices are fixed by the government and electricity tariffs are set by a regulatory authority. The reason why monopolies need to be regulated is discussed in the next section. Besides, an evaluation of monopoly is also done.

Our discussion reveals that in a pure monopoly price will generally be greater than marginal cost and that the firm is able to generate super normal profits even in the long run. Recall that key conditions that give rise to monopolies are economies of scale and barriers to entry. On the other hand, production processes like food processing, textiles, garments, wood and furniture, it is relatively easy to enter the market as a supplier for example, capital requirements are low and sunk costs are also low. Many service industries like travel agencies fall into this category. In such industries, competition ensures that prices are set right and moreover the threat of entry ensures that prices never exceed long-run average cost (for example, marginal companies in the industry cannot

persistently earn above average profits). Moreover, competition also ensures that price equals long-run marginal cost. Hence the price of a good accurately reflects the opportunity cost of manufacturing it. Problems arise from leaving everything to the market, however when a situation of monopoly occurs. In economists jargon, there are economies of scale to be exploited when one company meets market demand. There are typically also major barriers to entry in such industries. Most public utilities electricity generation, water supply, gas supply and perhaps national telecommunications systems have technologies of this sort. There are several special problems for these industries. First, their size and capital intensity often puts particular strain on private capital markets in satisfying their investment needs. In India, in the 1990s strain was felt instead on the public coffers, and this was a major factor behind the move towards disinvestment and privatization. Hence, while for example automobile or chemicals manufacture are also characterized by huge scale economies, governments have rarely seen it as their role to regulate companies in these industries. The question for policy makers is what to do about natural monopolies like power and water supply. Left to themselves, they will charge monopoly prices and restrict output. The absence of any competitive threat will also probably leave such organizations wasteful, inefficient and sluggish. Since all costs can be passed on to the consumers, there will be little incentive for managers to keep them under control. Experience from, for example, the railways suggests that it will not be long before the absence of competitive pressures may damage the motives for innovation and change, so crucial in such capitalintensive sectors. Thus in some cases a regulator is appointed who must fix the natural monopolists price. In India, privatisation of power and telecommunications has been accompanied by the creation of a regulator, while there is no such institution for cement, automobile or chemical industry. The above discussion can also be illustrated with the help of Figure 12.4. Assume a perfectly competitive industry. We know that price would be Pc and quantity Figure 12.4: Evaluation of Monopoly

supplied Qc. The consumers surplus will be the area Pc AD. Now consider output and price of the profit maximising monopolist. As indicated in the figure, price would be Pm and quantity would be Qm . Notice that the monopolist will charge a higher price and produce a lower quantity as expected. The consumer surplus is reduced to PmAB. The rectangle Pc Pm BC that was part of consumer surplus under competition is now economic profit for the monopolist. This economic profit represents income redistribution from consumers to producers. Further, there is also a deadweight loss to society represented by the area BCD that represents loss of consumer surplus that accrued under competition, but is lost to society because of lower production levels under monopoly. If we now consider the reverse case i.e. a monopoly being broken to foster competition, the result will be transfer of income from producers to consumers and elimination of deadweight loss. Herein lies the economic basis for regulation of monopoly firms. It is to generate the outcomes of competitive markets and pass these benefits to consumers in the form of lower prices. If competition exists in markets then arguably, that is the best regulation. If it does not, and the industry is envisaged to play a social role, regulation of monopoly becomes an important policy objective.