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Microeconomics I
Monopoly Market
By
Kwame Agyire-Tettey (PhD)
Learning outcomes
• Identify the characteristics and sources of monopoly power.
• The monopolist faces a downward sloping demand and marginal
revenue curves.
• A monopolist sets marginal cost equal to marginal revenue, but marginal
cost is less than price.
• Changes in cost alters the equilibrium situation.
• Analysis a monopolist that operates more than one plant.
• Profit can be increased for a monopolist if it is possible to charge
different prices to different customers or in separate markets.
• Pure profits exist in the long run under monopoly, so long as there are
entry barriers.
Definition of Monopoly
• This is a market structure in which a firm has absolute power to
produce and sell a commodity of which there are no close substitutes
and there are barriers to entry. What will be the cross-price
elasticity?
• For a firm to be a monopolist it should possess monopoly power.
• Monopoly power is the firm’s ability to control the market. That is the
degree to which the firm can increase price above the marginal cost.
• Though the firm may have monopoly power, it is restricted by the
extent to which it can increase price above the marginal cost by two
factors:
• Indirect competition
• Potential competition
Source of monopoly
• The existence and survival of monopolies is due to factors which
prevent the entry of other firms into the market.
• Barriers to entry are the major causes or sources of monopoly power.
• The sources of barriers to entry can be grouped into two broad groups:
• Legal barriers
• Technical barriers
Legal barriers
• Monopolies are created out of legal reasons:
• Laws or acts that are passed to protect public interest:
• When government enacts laws establishing monopolist firms because it believes the
commodity in question is important to society as a whole and leaving it to the dictate of
market forces won’t be in the interest of society (leads to Franchise Monopolist).
• Patent rights
• This is where exclusive rights to a firm to solely produce a specified commodity using a
specified technology. Patents are awarded to firms for being innovative and inventing the
commodity or technology used in the production process. This will define the specific
property rights and it lasts for some years.
• The rationale of the patent system is to make innovations profitable in order to
encourage technical advancement. – Patent monopolies
Technical Barriers
• Control over key inputs
• ownership or control over key factors
• ownership or control over outlets
• Efficiency
•
•
•
•
•
•
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economies of scale
lower costs for an established firm
legal restrictions
mergers and takeovers
aggressive tactics
intimidation
product differentiation and brand loyalty
• Monopolies resulting from efficiency is known as natural monopolies.
Demand and revenue functions
• Since there is a single firm in the market/industry, it implies that the
demand facing the firm is the same as the market/industry demand.
• The demand curve is download sloping and this implies that for the firm to
sell an additional unit of the good it should reduce the price it charges.
• It also implies the monopolist can control price and consumers will
determine the output they purchase.
• And when the monopolist decides on output to supply consumers will
decide on the price to pay.
Relationship between demand, MR and AR under
monopoly
Price, revenue
D=AR
O
MR
Q
Relationship between demand, MR and AR
• Relationship between Average revenue (AR) and demand function.
• Marginal revenue (MR) function and that of the Demand function.
• Slope of the demand function and that of the marginal revenue.
• Relationship between price and marginal revenue.
• The marginal revenue of the firm is positively related to price elasticity of
demand.
• At the mid-point of the demand curve price elasticity is equal to 1
Relationship between price elasticity of demand and MR
Price, revenue
e>1
e=1
0<e<1
MR
O
D=AR
Q
Revenue curves and demand elasticity
Elasticity
greater
than one >1
Elasticity between
zero and one
0 <  <1
AR
0
50
Unity elasticity
=1
100
MR
Quantity
TR
0
50
100
Quantity
A profit maximizing
monopolist will never
produce and along the
inelastic portion of the
demand curve.
The Equilibrium of a Monopoly
MC
ATC
p0
AVC
c0
MR
0
q0
Profit-maximizing quantity
D = AR
Quantity
Supply curve of the monopolist
• Supply curve or function shows a unique relationship between price and the
output that a firm is will and able to supply onto the market.
• The monopolist, unlike the prefect competitive firm is not a price taker implying
the absence of a unique correspondence between price and marginal revenue
when market demand shifts.
• Note also that the monopoly firm is a price maker, not a price taker.
• Asking such a firm about the quantity it would produce at any price is
meaningless, as both price and quantity to supply are determined simultaneously.
• Indeed, the monopolist’s decision about how much to supply is impossible to
separate from the demand curve it faces. The shape of the demand curve
determines the shape of the marginal revenue curve, which in turn determines the
monopolist’s profit maximizing quantity.
• In a gist the monopolist has no supply curve
Long-run equilibrium
• The monopolist in the long run can expand its plant size or make use of the
existing plant at any level which maximises its profit.
• Note that there barriers to entry so there is no threat of competition. Thus the
firm does not necessary have to adjust its plant size to produce at the optimal
level (producing at the minimum point of the LAC).
• Sub-optimal level
• Optimal level
• Surpass optimal level
Types of Monopolist firms
• Multi-plant monopolist
• This is a monopolist which produces a homogenous product using different
plants. This type of monopolist will behaviour differently from a single plantoperating monopolist. In this case the firm faces two separate cost structures.
• Price discriminating monopolist
• This is a monopolist who sell the same products to different consumers at
different prices.
Multi-plant monopolist
• Assumptions:
• To simplify our analysis we are assuming that the firm operates only two plants – A and B.
• Each of these plants have different cost structure.
• The monopolist know its demand curve and by extension knows the market demand as
well.
• Since it knows the market demand it also knows the marginal revenue function.
• We also assume that the firms knows the cost structure of each plant.
• Given these assumptions for the monopolist to maximise profit it has to make
two decisions
• The total output to produce using both plants in order to maximise profit.
• How to distribute the total output among the two plants. That is, what quantity
should each plant produce.
• Note MC = MCA + MC
B
Equilibrium of the multi-plant monopolist
Price Discrimination
• This is a market condition which allows a monopolist to sell the same (or slightly
differentiated) product to different consumers at different prices.
• The difference in price is not as a result of differences in cost of production.
Actually, the cost of producing for the two consumers/markets is the same.
• The monopolist will discriminate on the basis of:
• income; purchasing power; geographical location; age; sex; quantity of the commodity
purchased; etc
Conditions necessary for price discrimination
• The market for the commodity should be divided into sub-markets. This implies
that the two groups must have different demand curve/functions, that is, price
elasticity of demand must be different for the two markets or individuals.
• Markets for the two groups of consumers must be separated, so that there is no
seepage of information from one market to another. That is consumers in low
priced market should not be able to resell in the high priced market, that is, no
room for arbitrage.
• The firm/seller must possess monopoly power over the supply of the product,
without which it won’t be able to discriminate
Why discriminate
• Increase its total revenue and given cost increase profit. The firm make
higher profit when it discriminate compare to selling a single market.
• The firm discriminate in order to realise normal profit which makes the
firm’s existence feasible.
• It will also discriminate in order to make the product more affordable to
consumers who can’t purchase the product at the market price.
Profit Maximisation
• Note market demand is the horizontal summation of the individual demand
functions.
• The marginal revenue is also the horizontal summation of the individual
marginal revenue functions.
• D = DA + DB , D = MRA + MRB
• To maximise profit the firm will have to make 3 critical decisions:
i. The total output to produce.
ii. The quantity to sell in each of the markets.
iii. The price it should charge in each of the markets.
• To maximise profit the firm will first equate it total market demand to
that of the marginal revenue and determine the total output to produce.
• The firm then distributes the total output produced among the markets
by equating the MR in each market to the MC.
Equilibrium of the price discriminating monopolist
Types of price discrimination
• Third degree
• This involves charging a different price to different groups of consumers.
These groups of consumers can be identified by particular characteristics
such as age, sex, location.
• In the real world, third degree price discrimination is quite common. This is
based on the firm’s:
• Ability to set prices. Some market power
• Ability to segment different classes of consumers
• Ability to prevent resale. E.g. stop adults using student tickets.
• Examples of Third Degree Price Discrimination
• Students frequently get 10% discount in shops and Cinemas.
• Pensioners and school pupils get discounted bus tickets.
• A nightclub may offer discount to female consumers on certain nights.
Second degree Price Discrimination
• The firms discriminate on the basis of quantity purchased. This type of
discrimination can easily be seen in the bulk purchases by large shops, who in
turn pass the savings onto the eventual consumer. This can also be seen in
quantity discounts, the more you purchase the more you save. In some cases the
more you consume the more you pay.
• A family pack of soap powder or biscuits tends to cost less per kg than smaller
packs. This of course discriminates against people living alone, often pensioners
and students. In some supermarkets the price per kg of product is listed, which
helps the customer by providing information on which to base decisions on.
• This practice creates a schedule of declining prices for different quantities.
• Using this strategy the company can extract some of the consumer surplus
without knowing much about the individual consumer.
Second degree Price Discrimination
First degree price discrimination
• This is also known as perfect price discrimination.
• In this type, the firm essentially charges the consumer the maximum
possible price that individual is willing to pay for the commodity. Thus,
the firm extracts all the consumer surplus and earns the firms the
highest possible profits.
• First degree price discrimination is the most difficult to adopt as it
requires the firms to know each consumer perfectly at each level of
consumption.
• The aim of first degree price discrimination is for the firm to
appropriate the entire consumer surplus.
First degree price discrimination
Benefits of Price Discrimination
• Allows an unprofitable firms to breakeven or profit.
• In some cases, it may be possible that there is no one price that would enable a firm to
make normal profits. (i.e. average costs would always be higher than demand curve)
However, price discrimination may enable the firm to turn a loss into a small profit. This
means that a business activity can keep going, rather than closing down. This is obviously
beneficial for consumers because it increases their choice of goods and services.
• Some groups of consumers gain from lower prices.
• Price discrimination means that firms have an incentive to cut prices for groups of
consumers who are sensitive to prices (elastic demand). For example, firms often offer
students a 10% discount. Students typically have lower income so their demand is more
elastic. The downside is that some consumers will face higher prices.
• Avoid Congestion.
• Price discrimination is one way to manage demand. If there was no price discrimination
rush hour trains would be more overcrowded. Price discrimination gives an incentive for
some people to go later in the day. This means that those who have to travel at rush hour
benefit from less congestion.
Disadvantages of price discrimination
• Some consumers will end up paying higher prices. These higher prices are
likely to be allocatively inefficient because P > MC.
• Decline in consumer surplus.
• Those who pay higher prices may not be the poorest. E.g. adults could be
unemployed.
• There may be administration costs in separating the markets.
• Profits from price discrimination could be used to finance predatory pricing
(the situation where firms sets low prices in an attempt to eliminate
competition in the market).
Question
Assume the market demand for price discriminating monopolist is given as:
P = 16 – 0.5Q, where Q = QA + QB
This is made up of two segmented markets A and B. Assume the demand for
market A is P = 12 – QA and the demand for market B is given as P = 20 - QB .
Assume further that the total cost of the firm is given as:
TC = 3 + 2Q, where Q = QA + QB
i. Find the profit maximising output level
ii. Output sold in each of the markets
iii. Profit of the firm
iv. The price charged in each of the markets
Efficiency of Perfect Competition and Monopoly
• Technically efficient
• PC’s in the long-run minimize the cost of producing a given quantity in order
to maximise profit and produces at the lowest possible cost. This may not be
the situation in the case of the monopolist.
• The firm’s profit equals zero in the long-run for a perfectly competitive
market but in the monopolist make supernormal profit in the long-run
• Allocative efficiency
• The perfectly competitive firm will also produce and charge a price that
equates to the marginal cost of producing the commodity. Under monopoly
the price exceeds the additional cost of producing the last unit.