MonopolyMonopoly

The Monopoly ModelThe Monopoly Model• Sellers are price makers• Sellers do not behave strategically• Entry into the industry is completely blocked• Buyers are price takers

Market StructureMarket Structure• Many buyers• ONE seller• No close substitutes for the firm’s product• Well informed buyers• Blocked entry to the market

How does Monopoly Arise?How does Monopoly Arise?• Control over critical inputs

• Economies of scale and scope

• Intellectual Property Rights

• Regulation

The Profit-maximising MonopolistThe Profit-maximising Monopolist• Monopolist faces the industry demand curve

• Profit max. conditions imply that MR = MC and MR cuts MC in its rising part (as slope of MR < slope of MC)

• How do we get this MR curve of the monopolist?

• What’s the AR curve of the monopolist?

Marginal RevenueMarginal Revenue

Output per month

Price per unit (Rs.)

Total Rev (Rs)

Marginal Rev (Rs)

0 40 0  1 35 35 352 30 60 253 25 75 154 20 80 55 15 75 -56 10 60 -15

• Marginal revenue falls as output sold increases

• Marginal revenue is less than price (AR)

• After TR is max, MR becomes negative

Demand & MR CurvesDemand & MR Curves

-20

-10

0

10

20

30

40

50

0 2 4 6 8

Rs

Output per month

D

MR

TR = pq = f(q) * q, where p = f(q) is demand curve

AR = pq/q = p = f(q) = demand curve

MR = p (1 – 1/|e|)

Monopoly EquilibriumMonopoly Equilibrium

Qty

Rs

MC

ACP

Q

D

MR

Monopoly Profit

When will the monopolist shut When will the monopolist shut

down?down?• In the short run, the monopolist can earn profit,

make losses or just break even• It will continue to operate (i.e. min. losses) as

long as p exceeds AVC at the optimum level of output, i.e. p* < SAVC

P, R, C

Q

AR

MRQ*

P*

MC

SAC

SAVC

Short Run & Long Run Short Run & Long Run ??

• In the long run the firm is on its long run cost curves

• No entry of new firms takes place, so economic profit can exist in the long run

• Hence in long run also, the monopolist chooses output as in short run, i.e. at MR = LMC and sets the price from the cor. Demand curve

• But the monopolist stops producing if he incurs losses in the long run

What’s the supply What’s the supply curve of a monopolist?curve of a monopolist?• A monopolist does not have a supply curve

• He chooses output and then price corresponding to that output from the demand curve

• So, supply curve does not exist for a monopolist

Measurement of Monopoly PowerMeasurement of Monopoly Power• Price Elasticity of demand: the degree of

market power is inversely related to e. Fewer the substitutes, less is e, greater the firm’s market power

• Lerner Index: LI = (P – MC) / P where P is the price the monopolist setso Under perfect competition, P = MC, hence LI = 0o Under monopoly P > MC (as P> MR = MC), LI >0o Higher LI, higher is market powero LI is inversely related to price elasticity of demand

• Cross price elasticity: A high positive cross p-elasticity implies existence of close substitutes, hence lower market power

Monopoly v Competition: Social cost of Monopoly v Competition: Social cost of

monopolymonopoly

• Consider a perfectly competitive industry under constant returns to scale (implying horizontal long run supply curve of the industry)

• Suppose this industry is now converted into monopoly with same demand and cost curves

• The monopoly will charge a higher price and produce less output

• There will be a redistribution of income from consumers to the monopolist and

• A welfare loss due to less efficient resource use called ‘deadweight loss’

Monopoly v Monopoly v CompetitionCompetition

Qty

Rs

LAC = LMC

D = AR

MR

PM

QM

PC

QC

Deadweight loss of

monopolyMonopoly profit

Public Policy Toward MonopolyPublic Policy Toward Monopoly• Patent Policy

o Allow temporary monopoly power to encourage innovation

• Anti-Monopoly (Antitrust) Policyo Conduct Remedies – regulate firm behaviouro Structural Remedies – introduce/maintain competition (where possible)

• Regulation of existing monopolies

• In India, we had MRTP Act • Competition Act 2002 and CCI

Natural MonopolyNatural Monopoly• Economies of scale are extensive in relation to

the size of the market

• Hence, a single firm can produce the total industry output at less cost than any greater number of firms

• LAC curve might be falling over entire range of market demand or the MES is achieved at a very high level of output

Multiplant MonopolistMultiplant Monopolist• The monopolist operates more than one plant• Sup, there are two plants described by two

different cost structures TC1 and TC2• Hence the total cost will be TC = TC1 and TC2• From this we get MC = MC1 + MC2• The monopolist then equates MC with MR to

decide the total output to be produced • Then he would equate the MR with individual

MC’s to decide how much to produce in the two respective plants

• Hence, profit max. choice will occur at MR = MC1 = MC2

Multiplant MonopolistMultiplant Monopolist

Q1 Q2 Q

Plant 1 Plant 2 Multiplant Monopolist

MC1 MC2 MC

DD

MR

Total Q

Q1* Q2*

P*

Price DiscriminationPrice Discrimination• Price discrimination occurs when a firm

charges different prices to different customers for reasons other than differences in costs

• Price-discriminating monopoly does not discriminate based on prejudice, stereotypes, or ill-will toward any person or groupo Rather, it divides its customers into different

categories based on their willingness to pay for good

Conditions for Price Conditions for Price

DiscriminationDiscrimination• To successfully price discriminate, three

conditions must be satisfiedo The firm must have some degree of market

power facing a downward sloping demand curve

o Firm must be able to separate consumers into two or more groups (e.g. by age, sex, region etc.)

o Firm must be able to prevent arbitrage (i.e. prevent low-price customers from reselling to high-price customers)

Price DiscriminationPrice Discrimination• Basic model: a monopolist charges:

A. Same price for all units.B. Same price to all customers.

• Changing one or both of these is called Price Discrimination. Can one profit from this?o 1st degree is different prices for different

consumers and different units (both A and B are changed)[doctor charging different fees to different patients and for different consultations]

o 2nd degree is different prices for different units (A changed). [ journal subscription rates different for 1 yr, 2 yr etc.]

o 3rd degree is different prices to different consumers (B changed)[ journal subscription rates different for individuals and libraries]

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3rd-degree price discrimination3rd-degree price discrimination

• There are two markets where resale is not possible between them

• Hence two demand curves D1 and D2• Hence, he has MR1 and MR2• He obtains MR = MR1 + MR2• Monopolist produces in a single plant• For profit max, he equates MR = MC• How much he sells in market 1 and

market 2 is determined by equating MR1 = MR2 = MC

Price DiscriminationPrice Discrimination

Market 1 Market 2 Monopolist MC

P1P2 D

MR1 D1 MR2 D2 MR

Q1 Q2 Q

•Monopolist will set higher price in the market where price elasticity of demand is low•In this case it is Market 1

22ndnd Degree Price Discrimination Degree Price Discrimination

• All consumers face same price “menu”• Actual price paid depends on consumer’s

preferences or type• Usually used when consumers cannot be

distinguished ex ante• Consumers self-select themselves for different

schemes• Ex: Quantity discount• Journal subscriptions for 1 year, 2 years etc.• Pricing of cinema hall tickets by time of day or

day of the week

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22ndnd degree Price Discrimination degree Price Discrimination• Aryan values 1 umbrella at 100 rupees and

has no need for another umbrella.• Varun values 1 umbrella at 110 rupees and

also values 2 umbrellas at 150 (together).• They each want to maximize the difference

between their value and the price they pay.• What is the maximum a monopolist with zero

marginal cost could make charging the same price per umbrella?

• What is the max it could make charging a price for 1 and a special for two together?

o Hint: what would happen if they charge 100 for one and 150 for two?

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1st-Degree Price Discrimination1st-Degree Price Discrimination• Different prices for both consumers and

units.• To do this properly, a monopolist must

have strong information on:oConsumers’ preferencesoWho is who

• 1st degree captures the whole consumer surplus.

• 1st degree is efficient.• It’s also called perfect price

discrimination• Difficult to implement in reality

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Examples of Price Examples of Price DiscriminationDiscrimination..

• Book publisher having different prices for different country editions of a book

• How about paperbacks• Publisher charging libraries a higher rate to

libraries than to individuals. • Frequent Flyer Programs• First Class Train tickets• Entry Fee Packages at Amusement Parks

Monopoly PricingMonopoly Pricing

• Dumping (international price discrimination)

• Two-part Tariff (another practice to extract consumer surplus)

• Tying and Bundling

• Discrimination over time (durable good monopoly/ peak-load and off-load pricing)

DumpingDumping

• Charging of lower price abroad than at home for the same commodity due to higher price elasticity of demand in the foreign country

• It’s like third degree price discrimination to increase profits

• Persistent, Predatory and Sporadic Dumping

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Two-Part TariffsTwo-Part Tariffs• Definition: A two-part tariff a lump sum fee, F

(for the right to purchase a product)plus a per unit fee, r (as the price for each unit of product they purchase)

• Example: The sports center charges a fee to join and then a per usage fee; or Fee at Nicco Park; telephone charges etc.

• Charge a price per unit that equals marginal cost plus a fixed fee equal to the consumer surplus each consumer receives at this per unit price.

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Example: Surplus Extraction w/ Two-Part Tariff

14

14 Q

P

2

12

72

Optimal two-part tariff:

(1) maximize surplus by r =2. (2) set F=surplus=72.

Why?

10

55

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Tying and BundlingTying and Bundling• A consumer can buy one good only by purchasing

another good as well

• Polaroid film with polaroid camera

• Bundling is a special case of Tying where two or more commodities are sold in the situation where customers have different tastes but the monopolist cannot price discriminate

E.g. Buffet at restaurants;

• Pure and Mixed bundling

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Bundling Bundling • Pure bundling occurs when a firm sells two or

more products only in a bundle and not individually

• Mixed bundling means commodities are available both in bundles and individually

• By bundling products, the monopolist increase profits by extracting more consumer surplus

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Bundling Bundling • Two types of people:

o A values $120 for Word, $100 for Excel.o B values $80 for a Word, $120 for Excel.

• Microsoft has zero marginal cost.

• If Microsoft charges separately for each program, it should price both the products at $ 80 for Word and $ 100 for Excel so that each consumer can buy both the products.

• It can make a profit of $80 x 2 + $100 x 2 = $ 360

• They could package both together (and stop selling it individually) at the price of $ 200. This will make a total profit of $200 x 2 = $ 400.

• But he still could not extract the entire consumer surplus, i.e. $220 + 200 = $420.

Caselet 1Caselet 1Chalchitra Cinema is the only movie theater in Sunderbans. The nearest rival movie theater the Chhayachitra, is 35 miles away. Thus Chalchitra Cinema possesses a degree of market power. Despite having market power, it is currently suffering losses. In a conversation with the owner of the Chalchitra Cinema, manager of the movie theater made the following suggestions: “Since Chalchitra is a local monopoly, we should just increase ticket prices until we make enough profit.”

•Is it a correct strategy? Comment.

Caselet 2Caselet 2• Interior Style is a monopolist in its state in interior

designing. With more consciousness among the higher middle class people these days, the company faces an increase in demand recently. Graphically illustrate the impact of an increase in demand on price and quantity under monopoly.

•