CHAPTER SIX

PURE MONOPOLY

DEFINITION: -Monopoly is a market structure in which there is a single seller, there are not
close substitutes for the commodity it produces and there are barriers to entry.

CAUSES:
1. Ownership of strategic raw materials, or exclusive knowledge of production
techniques.
2. Patent rights for a product or for a production process.
3. Government licensing of the imposition of foreign trade barriers to exclude foreign
competitors.
4. The size of the market may be such as not to support more than one plant of optimal
size. The technology may be such as to exhibit substantial economies of scale, which
require only a single plant.

Example: In transport, electricity, communications, there are substantial economies

which can be realized only at large scales of output. The size of the market may not
allow the existence of more than a single large plant. In these conditions it is said that the
market creates a ‘natural’ monopoly, and it is usually the case that the government
undertakes the production of the commodity or of the service so as to avoid exploitation
of the consumers. This is the case of public utilities.

5. The existing firm adopts a limit-pricing policy, that is, a pricing policy aiming at the
prevention of new entry. Such a pricing policy may be combined with other polices such
as heavy advertising or continuous product differentiation, which render entry
unattractive. This is the case of monopoly established by creating barriers to new
competition.

SHORT-RUN EQUILIBRIUM OF THE MONOPOLIST

The monopolist maximizes his short-run profits if the following two conditions are fulfilled:
1. The marginal cost is equal t the marginal revenue.
2. The slope of marginal cost is greater than the slope of the marginal revenue at the point
of the intersection.
P D
SMC SATC

C
PM
A B

MC=MR
ε
D|

0 XM MR X
In fig.1 the equilibrium of the monopolist is defined by point ε, at which the MC intersects the
Fig. 1 for equilibrium are fulfilled. Price is P M and the
MR curve from below. Thus both conditions
quantity is XM. The monopolist realizes excess profits equal to the shaded area AP MCB. Note
that the price is higher than the MR. Note that the price is higher than the MR.

1
In pure competition the firm is a price taker, so that its only decision is output determination.
The monopolist is faced by two decisions: setting his price and his output. However, given the
downward-sloping demand curve, the two decisions are interdependent. The monopolist will
either set his price or sell the amount that the market will take at it, or he will produce the output
defined by the intersection of MC and MR, which will be sold at the corresponding price P. The
monopolist cannot decide independently both the quantity and the price at which he wants to sell
it. The crucial condition for the maximization of monopolist’s profit is the equality of the MC
and MR, provided that MC cuts the MR from below.

Formal derivation of equilibrium of the monopolist.

Given the demand function

X = g(P)
which may be solved for P
P = f1 ( X )
and given the cost function
C = f2 ( X )
The monopolist aims at the maximization of his profit
Π=R–C
(a) The first – order condition for maximum profit Π

0
X

 R C
  0
X X X
or
R C

X X
That is MR = MC

(b) The second – order condition for maximum profit

2 
0
X 2
 2   2 R  2C
 X 2  X 2 0
X 2
 2 R  2C
or 
X 2 X 2

[Slope of MR] < [Slope of MC]

A Numerical Example

Given the demand curve of the monopolist

X = 50 – 0.5P

2
Which may be solved for P

P = 100 – 2X
Given the cost function of the monopolist

C = 50 + 40 X
The goal of the monopolist is to maximize profit

Π=R–C
(i) We first find the MR
R = XP = X(100-2X)

R = 100 X – 2X2

R
MR = = 100 – 4x
X

(ii) We next find the MC

C = 50 + 40X

C
MC =  40
X

(iii) We equate MR = MC

100 – 4X = 40

X = 15

(iv) The monopolist’s price is found by substituting X = 15 into the demand-price equation
P =100 – 2X = 70

(v) The profit is Π = R – C = 1050 – 650 = 400

This profit is maximum possible, since the second-order condition is satisfied:

C
(a) from  40
X
 2C
we have 0
X 2
R 2R
(b) from  100  4 X we have  4 ..
X X
Clearly -4 < 0.
Let’s re examine the statement that there is no unique supply curve for the monopolist derived
from his MC. Given his MC, the same quantity may be offered at different prices depending on
the price elasticity of demand. Graphically this is shown in fig.2.

3
 P

The quantity X will be sold at P1, if

SMC
demand D1, while the same quantity X
P2 will be sold at price P2 if demand is D2.
P1 Thus there is no unique relationship
D1
between price and quantity.
D2

0 X X
MR2 MR1
Fig. 2

P
SMC

D1
D2
0 X1 X2
X
Fig. 3 MR2 MR1

Given the MC of the monopolist, various quantities may be supplied at any one price, depending
on the market demand and the corresponding MR curve. In fig. 3 we depict such a situation.
The cost conditions are represented by the MC curve. given the costs of the monopolist, he
would supply OX1, if the market demand is D1, while at the same price, P he would supply only
OX2 if the market demand is D2.

LONG RUN EQUILIBRIUM

In the long run the monopolist has the time to expand his plant, or to use his existing plant at any
level which will maximize his profit. With entry, blocked, however, it is not necessary for the
monopolist to reach an optimal scale. The size of his plant and the degree of utilization of any
given plant size depend entirely on the market demand. He may reach the optimal scale

4
(minimum point of LAC) or remain at suboptimal scale (falling part of his LAC) or surpass the
optimal scale (expand beyond the minimum LAC) depending on the market conditions. In fig. 1
we depict the case in which the market size does not permit the monopolist to expand to the
minimum point of LAC.

P
C

SMC LMC
P SAC

E LAC

0 Xc
X
MR
Fig.1. Monopolist with suboptimal plant and excess capacity.

In this case not only is his plant of suboptimal size but also the existing plant is underutilized.
This is because to the left of the minimum point of the LAC the SRAC is tangent to the LAC at
its falling part and also because the short-run MC must be equal to the LRMC. This occurs at ε,
while the minimum LAC is at b and the optimal use of the existing plant is at a. Since it is
utilized at the level ε, there is excess capacity.

In fig. 2 we depict the case where the size of the market is so large that the monopolist, in order
to maximize his output, must build a plant farther than the optimal and overutilise it. This is
because to the right of the minimum point of the LAC the SRAC and the LAC are tangent at a
point of the positive slope, and also because the SRM must be equal to the LAC. Thus the plant
that maximizes the monopolist’s production leads to higher costs for two reasons: firstly because
it is the case with public utility company operating at national level.

P
C
LMC

A
LAC
P

D
SAC SMC
E

MR
0
X ε X
5
Fig.2 Monopolist operating in a large market: his plant is large
than the optimal (e) and it is being overutilised (at ε|).
Finally in fig.3 we show the case in which the market size is just large enough to permit the
monopolist to build the optimal plant and use it at full capacity.

It should be clear that which of the above situations will emerge in any particular case depends
on the size of the market (given the technology of the monopolist). There is no certainty that in
the long run the monopolist will reach the optimal scale, as in case in a purely competitive
market. In monopoly there are no market forces similar to those in pure competition which lead
the firm to operate at optimum plant size in the long run.

P
C

LMC
SMC
LAC
P SAC

0 Xε X

Fig. 3 MR

6.3 PRICE DISCRIMINATION

Price discrimination exists when the same product is sold at different prices to different buyers.
The cost of production is either the same, or it differs but not as much as the difference in the
charged prices. The product basically is same, but it may have slight differences (for example,
different binding of the same book; different location of seats in a theatre; different seats in an
aircraft or a train).

The necessary conditions, which must be fulfilled for the implementation of price discrimination,
are the following:

1. The market must be divided into sub-markets with different price elasticities.

2. There must be effective separation of the sub-markets, so that no reselling can take place from
a low-price market to a high-price market. This condition shows why price discrimination is

6
 easier to apply with commodities like elasticity or gas, and services, which are consumed by the
buyer and cannot be resold.

The Model:

The reason for a monopolist to apply price discrimination is to obtain an increase in his total
revenue and his profits. By selling the quantity defined by the equation of his MC and his MR at
different prices the monopolist realizes a higher total revenue and hence higher profits as
compared with the revenues he would receive by charging a uniform price. Let us form a
simplest case of monopolist who sells his product at two different prices.

It is assumed that the monopolist will sell his product in two segregated markets, each of them
having a demand curve with different elasticity. In fig. 1 the demand curve D1 has higher price
elasticity than D2 at any given price. The total-demand curve D is found by the horizontal
summation of D1 and D2. The aggregate marginal revenue (MR) is the horizontal summation of
the marginal revenue curves MR1 and MR2. The marginal cost curve is depicted by the curve
MC.

The price discriminating monopolist has to decide (a) the total output that he must produce, (b)
how much to sell in each market and at what price, so as to maximize his profits.

The total quantity to be produced is defined by the point of intersection of the MC and the
aggregate MR curves of the monopolist. In fig.1 the two curves intersect a point ε, thus defining
a total output OX which must be produced. If monopolist were to charge a uniform price this
would be P, and his total revenue would be OX AP.

Given TC=5Q+20, TC = 5

Q
q1=55- p1 – The DD function in market 1
q2=70- 2p2 – The DD function in market 2
1. Determine q1, q2, p1, and p2 that maximizes profit
2. Find the elasticity of DD in the two markets?
3. Calculate the total profit the monopolist will obtains from its sell in the two markets
4. Present the outputs and prices in the two markets in the back to back diagram

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 Solution
1. For market 1  Inverse DD function
1st Find the inverse DD function q2=70-2q2
q1=55-p1 q2-70= -2q2
q1-5 p2=35-0.5q2
p1=55-q1  TR2=p2q2
2nd Find TR1=p1q1 =(35-0.5q2) q2
(55-q1) q1 =35q2-0.5q22
55q1-q12  MR2= TR2
3 Find MR1= TR1
rd
q2
q1 35-q2
=55-2q1  MR2=MC
4th Equate MR1=MC 35-q2=5
=55-2q1=5 -q2=5-35
-2q1=5-55 -q2= -30
-2q1= -50 q2=30
q1=25  Substitute q2=30 in the inverse DD fun.
5th Substitute q1=25 in the inverse DD fun. P2=35-0.5q2
p1=55-q1 P2=35-0.5 (30)
p1=55-25 P2=35-15
p1=30 P2=20
 For market 2

2. Price elasticity of DD in market 1

q1=55-p1 q2=70-2p2
1= q1 x p1 2=q2 x p2
p1 q1 p2 q2
-1 x 30 -2 x 20
25 30
-1.2=1.2 -1.33=1.33
The above result tells us that DD is more elastic in market 2. Therefore, the monopolist charge lower
price than market 1.
3. The profit of the monopolist
= (TR1 + TR2) – TC or
= (p1q1 + p2q2) – (5Q + 20), where Q is q1+q2
= 30 (25) + 20 (30) – (5 (25 + 30) + 20)
= 750 +600 – (5 (55) +20)
=1350 – (275 +20)
=1370 – 295
= 1055
4. Back to back diagram

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  From the figure, the market with less elastic of DD curve (DD1) has higher price. This implies
that the monopolist will charge high price in the market in which quantity purchased is less
responsive to price changes. The necessary conditions for price discrimination are
1. The existence of different consumers (separate markets) with different price
elasticity
2. The ability of the monopolist to identify these consumers
3. No reselling of products should take place by consumers from lower price market to a
higher price market. For further reading, refer, Modern Microeconomics, A.
Koutsiannis, PP 197.

6.3. MULTI P-LANT MONOPOLIST

 So far we have assumed that a monopolist own and produce an output by means of only one
plant. This is not all the case. It is possible for the monopolist to install more than one plant and
hence cost conditions may differ from one plant to another. The cost curves associated to each
plant are different. The problem faced by monopolist is the allocation of production between
plant 1 and 2. The monopolist maximises profit by equating MR equal to MC. However, there
is one MR and three MC curves when we assume the monopolist have two plants. That is,
MC1 for plant1, MC2 for plant 2, and MC common marginal cost (multi-plant MC). The
monopolist maximises profit by producing output level where each plant’s MC is equal to MR.
 Consider the following table to examine how a monopolist with two plants having different
cost of production first determines total output and then decides how much to be produced sing
each plan.
Q P MR MC1 MC2 MC
1 3
1 5.00 - 1.92 2.04 1.92
2 4.50 4.00 2.00 2 2.14 5 2.00
4 8
3 4.10 3.30 2.08 2.24 2.04
4 3.80 2.90 2.16 6 2.34 10 2.08
7
5 3.55 2.55 2.24 2.44 2.14
9
6 3.35 2.35 2.32 2.54 2.16
7 3.20 1.30 2.40 2.64 2.24
8 3.08 2.24 2.48 2.74 2.24
9 2.98 1.18 2.56 2.84 2.32
10 2.89 2.08 2.64 2.94 2.34
 The total output level that maximises the profit of the monopolist is 8, MR=MC. The
monopolist will produce 5 units using plant 1 while 3 units using plant 2. This, is because
profit is maximized when MR=MC1=MC2=MC.
 Mathematical example: Given, Q=200 - 2P, TC 1=10q1 and TC2=0.25q22, find q1, q2, Q and
profit of the firm.
 Solution:
1st find the inverse fun
Q=200 – 2P 7th Apply simultaneous equ. for
Q – 200= -2P MR=MC1 and MR=MC2
P= 100 – 0.5Q, where Q is q1 +q2 100-q1-q2=10
2nd TR=PQ -(100-q1-q2=0.5q2)
= (100 – 0.5Q) Q 10- 0.5q2=0
2
= 100Q – 0.5Q 10=0.5q2

9
 3rd MR= TR1 q2= 10/0.5=20
q1
=100 –Q 8th MR=MC1=100-q1-q2-10
4th MC1= TC1 = 100- q1-20-10
q1 q1=100-30
= 10 q1= 70
MC2=TC2 9th The profit of the monopolist
q2 Π=TR-TC
=0.5q2 =(TR)-(TC1+TC2)
5th Equate MR=MC1 =(100Q-0.5Q2)-(10q1+0.25q22)
100 – Q=10 =(100(90)-0.5(90)2)-(10(70)+0.25(20)2)
100 – q1 – q2 –10=0 =(9000-4050)-(700+100)
6th Equate MR=MC2 = 4950 - 800
100 – Q=0.5q2 = 4150
100-q1-q2=0.5q2

6.4. SOCIAL COST OF MONOPOLY

 Is the existence of a monopolist evil? The answer to this question is no and yes. No if the
monopolist charges different prices based on the marginal WTP, bulk discount, and elasticity of
DD. That is, as we have seen in the three types of price discrimination that a monopolist charge
higher and lower price for those who have high and low willingness to pay for its product-
discrimination across person, on the basis of bulk discount-discrimination across product
consumed, and elasticity of DD-across group of people in first, second, and third degree price
discrimination, respectively are Pareto efficient.
 We have seen in chapter 5 that a remarkable outcome of perfect competitive market is resource
allocation efficiency, which results to social welfare and increase in employment. This is
because at competitive equilibrium, the marginal utility of the consumed good (MU=DD)
equals price (P), which in turn equals the MC of producing the good. Hence, if MU=P (social
welfare) and P=MC (allocation efficiency), then MU=MC.
 An alternative way to understand the efficiency of competitive market is through the concept of
Consumers surplus. Consumers’ surplus is willing to pay (proportional DD curve) for and the
amount actually paid (prorata DD curve). In other words, it is the area to the left of the
perceived DD curve above the equilibrium price or since equilibrium represents the money not
spent by consumers who would have been willing to pay a price higher than equilibrium. In
short, it is the savings of the consumer for buying Qe at Pe.
 Clearly, an economy is performing well when it generates much to the consumer surplus and
an efficient situation is one in which the maximum amount of consumers’ surplus is squeezed
out of the system.

P P

CS E CS E

MU=DD=ƒ(Qd) MU=DD= ƒ(Qd)

Qe Qe
Linear DD curve Non-linear DD curve

10
 The MC of goods represents supply. Equating the MC curve that passes through point E in the
above graphs shows producers’ surplus. Producers’ surplus is the area above the MC curve but
below the equilibrium Price (Pe). In other words, it indicates the difference between the
additional cost (MC) firms are willing to incur and what they actually incurred (Pe=MC). In
short, it is the money that suppliers would not have received if demand had been less than Qe.

CS

PS

Qe
 Given Pd=25-Q2 and Ps=2Q+1 as demand and supply function, respectively calculate the
consumers’ and producers’ surplus.
 1st find the equilibrium Q and P
Pd=Ps -2±10
25-Q2=2Q+1 2
2
25-1=2Q+Q -2+10 and –2-10
24=2Q+Q2 2 2
2
Q +2Q-24=0 Q=4 and Q= -6
2nd Use the quadratic formula to get Q 3rd find equilibrium P
-b±√b2-4ac Pd=25-Q2 or Ps=2Q+1
2a Pd=25-(4) 2 or Ps=2(4)+1
2
-2±√2 - (4(1)(-2) Pd= 25-16 or Ps=8+1
2(1) Pd=Ps=9
-2±√4+96
2
-2±√100
2
4th Show the equilibrium Q and P graphically

11
 Qe Qe
5th CS=  0
f (Qd ) dQ -PeQe 6th PS=PeQe- 0 f ( ps) dQ
4 4
=  0
( 25  Q 2) dQ  9( 4) =9(4)- 0 (2Q  1)dQ
4 4
=(25Q-Q3/3)/ 0 -36 =36-(2Q2/2+Q) 0
=25(4)-43/3-36 =36-(2(42/2)+4)
=100-64/3-36 =36-(32/2)+4)
=100-21.3-36 =36-20=16
=42.7
 Exercise
 Given the inverse DD and SS function as Pd=90-Q and Ps=(2Q+2) 2 find the CS for Qd=30and
Pe=40 and PS for Qs=5 and 42, respectively.
 Answer =CS is 1050 and PS is –76.7.
 These being the CS and PS in perfectly competitive market, the social cost of monopoly arises
due to the fact that a monopolist operates inefficiently as compared to perfect competition in
the sense that Pm>Pc and Qm<Qc. This is because a monopolist determines its Q and P by
equating MR=MC unlike sellers in perfect competition market that equate P=MC. As a result
some part of CS and PS obtained in perfectly competitive market are lost. To understand the
social cost (DWL) of monopoly, consider the graph below.

Pm A

Pc B Ec

Em

DDm
MRm

Qm Qc Q

 The above graph shows the change in the CS and PS for a movement from competitive
(monopoly) to monopoly (competitive) output. The CS goes down (up) by area PcEcAPm.
That is, it goes down (up) by rectangle PcBAPm since consumers are not (now) getting all the
units they were buying before at a higher (cheaper) price; and it goes down by a triangle ABEc
since they loose (get) some surplus from the lower (extra) units that are being sold.
 The PS on the other hand, goes up (down) by area PcBAPm due to the higher (lower price) on
the units he was already selling. It goes down (up) by EmBEc due to looses (profits) on the
lower (extra) units it is now selling. The area PcBAPm is just a transfer from the consumers
(monopolist) to the monopolist (consumers) and hence one side of the market is made better
off while the other worse off, but the total surplus does not change as a result of the transfer.
However, the area ABEc and EmBEc represent the DWL due to monopoly behaviour (a true
increase in surplus-measure the value that the consumers and the producers place on the extra
output that has been produced).
 The DWL provides a measure of how much worse off people are paying the monopolist than
paying the completive price. The DWL due to monopoly like that of the DWL due to tax

12
 increase measures the value of the lost output by valuing each unit of lost output at a price that
people are willing to pay for a unit. In other word, as we move from competitive to monopoly
output, the sum of the distance between the demand curve and the MC curve generates (gives)
the value of the lost output (Qc-Qm) due to monopoly behaviour. The total area between the
two curves is the DWL when moving from competitive to monopoly output.
 Numerical Example:
 Assume there is a tendency of moving from competitive to monopoly output. If the demand
and total functions are Q=100-2P and TC=14Q+2Q2, respectively
A. Determine Pc, Qc, Pm, and Qm.
B. Show the equilibrium Q and P you obtained in A above graphically.
C. Calculate the CS and PS under competitive and monopoly market structure.
D. Calculate part of CS transferred to the monopolist due to inefficiency of monopoly.
E. Calculate the social cost (net loos or DWL) of monopoly.
 Solution:
Equilibrium Q and P in perfectly competitive Consumers’ and producers’ surplus in perfect
market competition
A. P=MC C. CS=1/2 (50-46) x 8
50-0.5Q=14+4Q =1/2(4) x 8
50-14=4Q+0.5Q =16
36=4.5Q PS=1/2(46-14) x 8
Qc=8 =1/2(32) x 8
Pc=50-0.5Q or 14+4Q =16 x 8=128
=50-0.5(8) or 14+4(8) CS and PS under monopoly
=50-4 or 14+32 CS =1/2(50-46.4) x 7.2
=46=46 =1/2(3.6) x 7.2
Equilibrium Q and P in monopoly market =1.8 x 7.2=12.96
TR=PQ PS = ½((42.8-14) x (7.2))+((46.4-42.8) x
=(50-0.5Q) Q 7.2)
=50Q-0.5Q2 =1/2((28.8) x (7.2))+(3.6 x 7.2)
MR=∂TR=50-Q =14.4(7.2)+ 25.92
∂Q =103.68+25.92=129.6
MC=∂TC=14+4Q The CS transferred to the monopolist and DWL
∂Q due to monopoly output
MR=MC D. Consumers’ loss due to monopoly =CS
50-Q=14+4Q under perfect –CS in monopoly
50-14=4Q+Q 16-12.96
36=5Q 3.04
Qm=7.2 E. The amount of surplus transferred from
Pm=50-0.5Q consumers to the monopolist is
=50-0.5(7.2) (Pm-Pc) x Qm
=50-3.6 =46.4 (46.4-46) x 7.2
0.4 x 7.2
B. 2.88
Pm
DWL= CS not transferred + PS lost
Pc =1/2(((Pm-Pc) x (Qc-Qm)) + ½
((Pc-MC at Qm) x (Qc-Qm)
MRm =1/2(46.4-46) x (8-7.2) + ½((46-
42.8) x (8-7.2)
Qm Qc =1/2 ((0.4) x (0.8)) + ½ ((3.2) x
(0.8))

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=0.2(0.8) + 1.6(0.8)
=0.16+1.28=1.44

14
Micro Economics I, Econ 111 Pure Monopoly

AMU, FBE, Department of Economics 1