BBA I Semester Managerial Economics Monopoly Pricing Study Material Notes

BBA I Semester Managerial Economics Monopoly Pricing Study Material Notes: Meaning Sources and Types of Monopoly Price Determination Its Assumptions Price and  Output Determination Short Run Monopoly Equilibrium Total Revenue Total Cost Approach Marginal Revenue Marginal Cost Approach Super Normal Profit Comparison between Monopoly and Perfect Competition Differences Exercises

]MCom I Semester Statistical analysis Decision Theory Study Material Notes

MONOPOLY PRICING

MEANING

A monopoly is a market situation in which there is only one seller of a product with barriers to entry of others. The product has no close substitutes. The cross elastic demand with every other product is very low. This means that no other firms produce a similar product. Thus the monopoly firm is itself an industry and the monopolist faces the industry demand curve. The demand curve for his product is, therefore, relatively stable and slopes downward to the right, given the tastes, and incomes of his customers. It means that more of the product can be sold at a lower price than at a higher price. He is a price-maker who can set the price to his maximum advantage. However, it does not mean that he can set both price and output. He can do either of the two things. His price is determined by his demand curve, once he selects his output level. Or, once he sets the price for his product, nis output is determined by what consumers will take at that price. In any situation, the ultimate aim of the monopolist is to have maximum profits.

SOURCES AND TYPES OF MONOPOLY

Monopoly may arise from a number of sources and is of various types:

(1) grant of a patent right to a firm by the government to make, use or sell its own invention,

(2) control of a strategic raw material for an exclusive production process.

(3) a natural monopoly enjoyed by a firm when it supplies the entire market at a lower unit cost due to increasing economies of scale, just as in the supply of electricity, gas, etc.,

(4) government may grant exclusive right to a private firm to operate under its regulation. Such privately owned and government regulated monopolies are mostly in public utilities and are called legal monopolies such as in transport, communications, etc..

(5) there may be government owned and regulated monopolies such as postal services, water and sewer systems of municipal corporations, etc.

(6) government may grant license to a sole firm and protect it to exclude foreign rivals. and

(7) the sole manufacturer of a product may adopt a limit-pricing policy in order to prevent the entry of new firms.

The type of monopoly described above is simple or perfect me

MONOPOLY PRICE DETERMINATION

We study the determination of monopoly price under perfect or simple monopoly in the short run and the long run.

Its Assumptions

The analysis of the determination of the price, output and profit under monopoly is based on the following assumptions:

(1) There is one seller or producer of a homogeneous product

(2) There are no close substitutes for the product.

(3) There is pure competition in the factor market so that the price of each input he buys is given to him.

(4) The monopolist is a rational being who aims at maximum profit with the minimum of costs.

(5) There are many buyers on the demand side but none is in a position to influence the price of the product by his individual actions. Thus the price of the product is given for the consumer.

(6) The monopolist does not charge discriminating price. He treats all consumers alike and charges a uniform price for his product.

(7) The monopoly price is uncontrolled.

(8) There are no restrictions on the power of the monopolist.

(9) There is no threat of entry of other firms.

Price and Output Determination

Given these assumptions, the price, output and profits under monopoly are determined by the forces of demand and supply. The monopolist has complete control over the supply of the product. He is also a price-maker who can set the price to his maximum advantage. But he cannot fix the price and output simultaneously. Either he can fix the price and leave the output to be determined by the consumer demand at that price. Or, he can fix the output to be produced and leave the price to be determined by the consumer demand for his product. Thus, whatever price he fixes and whatever output he decides to produce are determined by the conditions of demand.

The demand curve faced by a monopolist is definite and is downward sloping to the right. It is his average revenue curve. Its corresponding marginal revenue curve is also downward sloping and lies below it. But the manner and extent to which the monopolist will be able to influence price or output will depend upon the elasticity of demand for his product. If the demand for his product is highly elastic, he can sell more by a small reduction in price. If, on the other hand, the demand is less elastic, the tendency will be to raise the price and profit more by selling less.

(A) Short-Run Monopoly Equilibrium

In the short run, the monopoly firm attains equilibrium when its profits are maximized or losses are minimised. Like the competitive equilibrium, this analysis can also be discussed in terms of the total revenue-total cost approach and the marginal revenue-cost approach.

Total Revenue-Total Cost Approach

In this approach, the monopolist will be earning maximum profits at the price where the difference between total revenue (TR) and total costs (TC) is the maximum, i.e. TR-TC.

In Figure 1, 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 attens and later on slopes downward, showing fall in total receipts after a given point. The is the greatest. This will be the level at which the slopes of TR and TC curves equal. Accordingly, Pis the equilibrium point as determined by the tangents at points P and T on the TR and TC curves respectively.

The monopolist will sell OM output at MP price. His profits will be PT. A and B are the breakeven points where TRETC. To the left of A and right of B, the monopolist is incurring loses because TC> TR at these points. Therefore, his maximum profits are PT where the difference between TR and TC is the maximum.

Marginal Revenue – Marginal Cost Approach

In the short-run, the monopolist can change the price as well as the quantity of his product. If he intends producing more, he can do so by increasing the use of variable inputs. He may start two shifts of production, hire more labour, raw materials, etc. But he cannot change his fixed plant and equipment. On the other hand, if he wants to restrict his output, he may remove certain workers, work for less hours and use less of the variable factors. In any case, his price cannot be below the average variable costs. Thus the monopolist can be in any one of the following situations: super-normal profit, normal profit or minimum loss. For this two conditions must be satisfied:

(1) P>SMC = MR, and

(2) SMC curve cuts MR curve from below.

1 Super-normal Profit

In the short run, SAC and SMC are the short-run average and marginal revenue curves, and AVC is the average variable cost curve of the firm. For simplicity, the AVC curve is not shown in Figure 2. D= AR is the demand curve whose corresponding marginal revenue curve is MR. The short-run monopoly equilibrium is at point E where the SMC curve cuts the MR curve from below. The monopolist sells OM output at MP price. The price MP, being above the short-run average cost MA, the monopolist earns AP profit per unit of output. Thus total monopoly profits are AP CA = the area CAPB.

2. Normal Profit

In Figure 3, the short-run equilibrium of the monopolist is shown when he earns only normal profit. The equality of SMC curve and MR curve at point E determines OM output which is sold at MP price. Since the SAC curve is tangent to the AR curve at this level of output, the monopolist earns normal profit. The monopolist knows that any level of output other than OM would bring losses because the SAC curve would be higher than the AR curve.

3. Minimum Loss

Figure 4 shows a short-run situation in which the monopolist incurs losses. As usual, the equilibrium point E is determined by the equa Minimum Loss SMC tion SMC = MR. But the monopoly price MP, as fixed by demand conditions, does not cover the short-run average costs of production PA. It just covers the average variable costs MP, represented by the tangency of the demand curve D and the AVC curve at point P. PA is thus per unit loss which the monopolist incurs.

Total losses are equal to BP In this figure, P is the shut-down point for this firm. If the market demand conditions MR lower the price from MP downwards, the monopolist will temporarily stop production. The firm will close down.

 (B) Long-Run Monopoly Equilibrium

In the long run, the monopolist can remain in business only if he is able to earn supernormal profits. If he was incurring losses in the short run, he has enough time to make changes in his existing plant in the long run so as to maximise his profits. With entry of new firms ruled out, he can install a plant which gives him maximum profits. The scale of his plant which gives him maximum profits. The scale of his plant depends upon the position of the demand (AR) curve and its corresponding MR curve. The most profitable level of output is at the point where the LMC curve intersects the MR curve from below and the SMC curve passes through this point. Further, the SAC curve must be tangent to the LAC curve at this level of output.

Suppose in the long-run, the monopolist installs an efficient plant represented by the curve SAC, and SMC, in Figure 5. On this plant, the long-run profits are the maximum at the output OM where MR at point E. Since at this level the short-run average cost curve SAC is tangent curve at point, A, the SMC curve is also equal to the LMC curve and to the MR curve (SMC, = LMC = MR) at the equilibrium point E.Thus when the monopoly firm is in long-run equilibrium, it is also in short-run equilibrium. By changing its scale tong-run, the monopolist charges the price OB (EMP), sells the output OM and can run equilibrium. By changing its scale of plant in the monopoly profits. However, this plant is less than the optimum size because the monopoly is not producing at the lowest point L of the LAC curve. It has some excess or idle capacity. It is not in a position to take full advantage of the economies of scale due to man size of the market for his product.

COMPARISON BETWEEN MONOPOLY AND PERFECT COMPETITION

Monopoly and perfect competition are two different market conditions. There are some similarities and dissimilarities between them.

Similarities

Monopoly and perfect competition have the following similarities:

1 Goals. The main aim of both is to earn maximum profits.

2. Equilibrium. In both, a firm is in equilibrium where MC = MR and MC curve cuts the MR curve from below.

3. Cost Curves. Both have the same cost curves in the short-run and long-run: SMC, AVC, SAC and LMC, LAC.

4. Perfect Knowledge. Firms have perfect knowledge in both markets as to where the product can be sold and resources can be purchased at what prices.

Monopoly Pricing Study Material

Differences

The following are the differences between monopoly and perfect competition.

(1) Nimber of Sellers. In the perfectly competitive market, the number of buyers and sellers is very large. Price is determined for the entire industry. No firm can influence price by its single action. It has to accept the price fixed by the industry and to adjust its output to that price. Thus every firm is a price-taker and quantity adjuster. On the other hand, under monopoly only one firm or seller sells a particular commodity. The firm is an industry under monopoly which itself fixes the price for its product. It is, therefore, a price-maker.

(2) Demand Curve. The demand curve or the average revenue curve (AR) of a competitive firm is a horizontal straight line parallel to the X-axis and the MR curve coincides with it. But as the AR curve of the monopoly firm slopes downward from left to right, its MR curve is below this.

(3) Price Determinotion. When under perfectly competitive equilibrium MC = MR. price also equals them at that point because MR and AR curves coincide with each other and are a straight line curve parallel to the X-axis: MC = MR = P.

Since the AR curve slopes downward to the right under monopoly, the MR curve is helow it. So when equilibrium takes place price (average revenue) is above the marginal cost, i.e., MC=MR< Price (AR).

(4) Entry of Firms. Under perfect competition, firms can enter the industry to earn

stand leave the industry in case of loss. But under monopoly, it is not possible for a firm to enter the market because the monopoly firm is itself an industry.

(5) Profits. Under both perfect competition and monopoly, a firm can earn super normal profits, normal profits and incur losses in the short-run. But in the long-run a competitive firm can earn only normal profits. In the long-run a monopoly firm earns supernormal profits because new firms cannot enter the monopoly market.

(6) Size. Competitive firms in the long-run are of the optimum size and they produce to their full capacity because in equilibrium : Price = AR = MR=LMC=LAC at its minimum profit. While the monopoly firm is of less than the optimum size, because even though the equilibrium point is LMC = MR, yet the LAC curve is not at its minimum point at that level.

(7) Selling Costs. There are no selling costs under perfect competition because the products are homogeneous. But there is always the fear of close substitutes to the monopolist. Therefore, he spends on advertisements to show that his product is different from other producers.

(7) Price Discrimination. The monopolist can charge different prices for the same commodity from his customers because he has no rival. But a competitive producer cannot practice price discrimination because it he tries to charge a higher price from some of his customers, they will buy the commodity at the market price from some other seller. Thus price discrimination is possible only under monopoly.

(8) Is Monopoly Price higher than Competitive Price? Theoretically, monopoly price is higher than competitive price and the level of output is less than that under competition. The equilibrium of a perfectly competitive industry is determined by the intersection of the industry’s demand (AR) curve and supply (MC) curve. A firm’s demand curve (AR) is perfectly elastic. It will continue to produce till its marginal cost (MC) does not equal the price fixed by the industry: MC =P=AR EMR. A monopolist’s demand curve also slopes downward to the right. & Its corresponding marginal revenue curve (MR) lies below it. Therefore, the equilibrium between the MC curve and the MR curve takes place at a lower level of output. Thus production under monopoly is less than under perfect competition but the monopoly price is higher than competitive price, price

This is shown in Figure 6 where under perfect competition industry, the equilibrium point P is arrived at by the equality of the demand curve D and the supply curve MC. At Q,P price, quantity of the product is bought and sold. Supposing that the cost conditions are identical both under perfect competition and monopoly, we take these curves for monopoly price determination also. Accordingly, monopoly equilibrium is at point E, monopoly output is OQ which the monopolist sells at OM price. As is clear from the figure, monopoly price QM is higher than the competitive price O.P. but the monopoly output og is less than the competitive output

EXERCISES

1 How are price and output determined under monopoly?

2. How does a monopolist fix the price of the product? Is it inevitable that the monopoly price is higher than the competitive price?

3. Compare and contrast monopoly equilibrium with equilibrium under at monopoly equilibrium with equilibrium under perfect competition.

Monopoly Pricing Study Material