1 Microeconomics - II

CHAPTER ONE

MONOPOLY MARKET STRUCTURE

Chapter Objective

1. Definition and Reason for existence of monopoly

1.1 Demand & Review of monopoly firm
1.2 Equilibrium of monopoly
1.3 The Multiplan firm
1.4 Price discrimination

1. Definition
Mono means Single while Poly means Seller and hence monopoly means a market structure
where only one sells the good and many buyers buy same. Hence;

 Monopoly is one seller of a product for which there is no close substitute.

 It is an industry in which there is only one firm.

 Monopoly in its strict sense means the concentration of economic powers in a single
hand.

Monopoly lies at the opposite extreme from perfect competition on the market structure
continuum. A firm produces the entire supply of a particular good or service that has no close
substitute. Pure monopoly is a market structure in which one firm is the only seller of a product or
service. Some examples of pure monopoly include EEU (Ethiopian Electric Utility), Ethiopian
Postal Service, Local water supply companies and others.

Local monopolies are more common than national monopolies, and single sellers serve local
markets often. However, few products have no close substitutes. A local electric power company
may be the sole seller of electricity in an area, similarly the Ethiopian postal agency is the sole
supplier of letter delivery.

1.1. The Basic Features of Monopoly are:

i. One seller and many buyers: There is a single seller in an industry, and as a result, the
monopolists are a price-maker. In fact, firm and industry are the same in pure monopoly.
ii. No close substitutes: There are no close substitutes for the good or service the monopolist
produces.
iii. Price maker: The pure monopolist controls the total quantity supplied and thus has consid
erable control over price; it is a price maker (unlike a pure competitor, which has no such
control and therefore is a price taker).

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iv. Barriers to entry:

A pure monopolist has no immediate competitors because certain barriers keep potential
competitors from entering the industry. Those barriers may be economic, technological, l
egal, or of some other type. But entry is totally blocked in pure monopoly.

1.2.Reason of monopoly power (Causes for barriers to entry)

For a monopoly to be stable there must be some barriers to entry. Monopolies exist because
barriers to entry exist in the market and the stronger the barriers to entry, the more complete the
monopoly will be. Barriers take various forms, legal and illegal, and some of the major include:

1. Patents, copyright and trademark

A patent is a legal protection which prevents original inventions from being copied, and once a
patent is granted it is protected by law for a period of time. Copyright protects written work like
plays, books, music, and films which are all protected from copying by copyright laws.
Trademarks can be names of logos, and sometimes shapes. The Coca-Cola bottle, for example, is
actually a trade mark and it is illegal to copy it without permission.

Protection of patents, copyrights, and trademarks come from a country’s legal system and from
international agreements. Some countries have no such laws and copying is, therefore, not illegal.
In countries where we have these laws, owners of the indicated intellectual property rights will
have some monopoly power on their products or services.

2. Government License

Some businesses are illegal unless a government license has been granted. Television, Telephone
and electricity are some of the examples of businesses that in most countries require government
permission. These services, in country for example, are monopolized by the government and no
one is entity to provide them unless licensed

3. Natural Monopolies

This situation is likely to occur either when the market is small or when fixed costs are
necessarily very large. For example, if market for a given product is very restricted in a small
town with small population size, having two suppliers of a given product may not be profitable. A
good example where high fixed costs exist is for railways or water works. Hence, it would seem
to be absurd to have two railways alongside each other or to have two sets of water pipe running
into your home.

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A natural monopoly is a monopoly that exists because of economies of scale, that is, the market
demand is too small to support many firms, each producing at minimum ATC.
An industry is a natural monopoly when a single firm can supply a good or service to an entire ma
rket at a smaller cost than could two or more firms. Natural monopoly caused by economies of
scale usually associated with a cost structure with a high fixed cost relative to variable costs. Nat
ural monopolies often arise in industries where the marginal cost of adding an additional custom
er is very low, once the fixed costs of the overall system are in place. Once the main water pipes a
re laid through a neighborhood, the marginal cost of providing water service to another home is fa
irly low. Once electricity lines are installed through a neighborhood, the marginal cost of providin
g additional electrical service to one more home is very low.

Example: 1000 homes need electricity

Cost Electricity
ATC slopes down ward due
to huge FC and small MC
80 ---------
50 ---------------------
500 1000 Q
ATC is lower if one firm services all 1000
homes than if two firms each service 500
homes because of IRS

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4. Ownership of strategic or key inputs.

A firm may own or control the entire supply of a raw material required for the production of a co
mmodity. Such firms are not willing to sell the raw materials to another firm. For example, until t
he second world war, the aluminum Company of America (Aloca) controlled practically the entir
e supply of Bauxite(the basic raw material necessary for the production o f aluminum), givi
ng it almost a complete monopoly in the production of aluminum in the united states. To come
to our country, Ambo Mineral Water can be taken as an example. Ambo mineral water has mon
opolized the natural mineral water.

5. Exclusive knowledge of production technique.

Most of the beverage (soft drink) companies such as Coca Cola Company have maintained mono
poly power over supply of their product partly due to exclusive knowledge of the ingredient chem
icals required for the production of the product.

1.3. Demand and Revenue for the firm

A monopolist is the only seller, so it faces the market demand curve. It can set the value of one
and only one of the two variables: price and quantity, and the value of another one is determined
by the market. To sell a larger Q, the firm must reduce p.

Under pure monopoly, the firm is the industry and faces the negatively sloped industry demand c
urve for the commodity. As a result, if the monopolist wants to sell more of the commodity, it m
ust lower its pric.Thus, the monopolist’s MR curve lies below the demand curve, indicating that
marginal revenue is less than price (average revenue) at every output quantity but the very first
unit.

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P
Monopolistic Demand
Curve

D
Q

Figure 1.1: A monopolists demand curve

Illustration: Ambo Mineral Water is the only seller of Ambo water in the country. The table
shows the market demand for Ambo Mineral Water.

Table 1.1: Demand for Ambo water

Q P TR AR MR
0 4.5 Birr 0 n.a -
1 4 4 4 4
2 3.5 7 3.5 3
3 3 9 3 2
4 2.5 10 2.5 1
5 2 10 2 0
6 1.5 9 1.5 -1

P
4 Demand curve (P) = AR
MR < P
3
2 D

0 1 2 3 4 5 6 Q
MR
Figure 1.2: Monopoly MR and demand curve

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Understanding the Monopolist’s MR

 Increasing Q has two effects on revenue:
 Output effect: higher output raises revenue.
 Price effect: lower price reduces revenue
 To sell a larger Q, the monopolist must reduce the price on all the units it sells.
 Hence, P > MR
 MR could even negative if the price effect exceeds the output effect (e.g., when Ambo Water
increases Q from 5 to 6).
 Note that a competitive firm has the output effect but not the price effect; since P = MR for a
competitive firm.

1.4. Equilibrium under monopoly

The equilibrium under monopoly market or monopolist maximizes it’s profit in the short run
followed by the long run situation.

A. Short run equilibrium under monopoly

In order to simplify the analysis of monopoly equilibrium lets us assume that the shape of cost
and revenue curves in monopoly. However, the revenue price is not constant.

A monopolist, with an objective of profit maximizing, is expected to look for the maximum gap
between revenue R and cost (TC) curves. The short-run equilibrium output of the monopolist is
the output at which either total profit are maximized or total losses are minimized (provided TR
> TVC).

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From the above graph it is seen that the demand curve D and average revenue curve AV are
depicted as a single curve. The marginal revenue curve MR also slopes the same but the MR
curve is below the AR curve. The short-run marginal cost curve SMC looks like a tick mark and
the boat shaped average cost. The profit maximization criteria of MR = MC is followed in the
monopoly market and the equilibrium point “E” is derived from the intersection of MR and SMC
curves in the short run. i.e. MC curve or SMC here intersects the MR curve from below. Based
on the equilibrium point, the output is the optimum level of production i.e., at OM quantity. The
price of the commodity is determined as OP. on average the firm receives MQ amount as
revenue. The total revenue of selling OM quantity gives OMQP amount of total revenue (OM
quantity x OP price). The firm has spent MR as an average cost to produce OM quantity and the
total cost of production is OMRS (OM quantity x MR cost per unit).

In the short run the monopoly firm will earn profit continuously even with various returns. In the
long –run, all inputs and costs are variable, and the monopolist can make his optimal scale of
plant to make best level of output.

Also, notice that it is not in the interest of a monopoly firm to charge the highest possible price.
The monopolist that maximizes profits realizes it loses sales by increasing price and considers
this in making its price decisions.

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Monopoly firms maximize profits by always setting price to achieve the output over any period
for which marginal revenue equals marginal cost.

A monopolist seeking to maximize total profit will employ the same rationale as a profit-seeking
firm in a competitive industry. If producing is preferable to shutting down, it will produce up to
the output at which marginal cost (MR = MC), and MC is increasing).

Depending on the level of AC at this output, the monopolist can have profits, break even, or
minimize the short-run total losses.

Thus, equilibrium demands two conditions to be fulfilled:

i) MR = MC and
ii) Slope of MC greater than slope of MR.

 In monopolist market
Revenue R= PxQ (OP x OM from the above figure).
Cost C = Ac x Q (OMRS area from the above figure).
 = R- C

Example- if the demand curve of a profit maximizing monopolist is given Q= 40- Q.2p and cost
function as C = 30+30Q. Find equilibrium output level, monopolist price and profit solving the
demand equation for price we have P = 200 – 5Q

1st Find MR and MC P=200-5Q 2nd Equate MR with MC, we have

TR = PQ = (200 – 5Q) Q = 200-10Q= 30
= 200Q – 5Q2 200-30 = 10Q
10 10
MR = d(TR) = 200 -10Q Q = 17
d(Q)
MC =d(Tc) = 30
d (Q)

3rd substitute in demand equation Profit II = R – C

P = 200 – 5Q (Substitute Q=17) = PQ – (30+30Q)

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200 – 5(17)  = 115 x 17 – (30+ (30x17)

200 – 35 = 1955 – 540 = 1415

P = 115  = 1415

Activity :
If the demand curve of profit maximizing monopolist is given as P= 1200 -2Q and cost
function as C = Q3 – 60Q2 + 1528.5Q+2000,
Find equilibrium output level, monopolist price and profit.

B. Long Run equilibrium of the monopoly

The monopolist’s long run condition is different from the perfectly competitive firms’ long run sit
uation in respect of the entry of new firms into an industry. Unlike a competitive firm, the monop
olist firm can enjoy a positive profit even in the long run because there are entry barriers that disc
ourage new firms to enter the industry, attracted by the positive profit. A monopolist maximizes
its long run profit when it produces and sells that output level at the falling part of its LAC wher
e LMC = MR (P >MC), slope of LMC being greater than the slope of MR at the point of intersec
tion, and the optimal plant size is the one whose SAC curve is tangent to the LAC at the point corr
esponding to long run equilibrium output.

- Since entry is blocked, the monopolist can maintain his/her short run abnormal profit in long
run. In long run the monopolist has the time to expand his/her plant or to use the existing plant
to any level which will maximize profit.
- In long run, with entry is blocked: it’s unnecessary for the monopolist to reach an Optimal
(minimum point of LRAC). If in long run the monopoly makes loss the business not stay and
the minimum price acceptable by monopolist can use in three different scale
I. At Sub Optimal scale-,this is a falling part of LRAC. The monopolist is not induced to
expand the existing plant is underutilized and hence there is excess capacity.
II. At Optimal Scale: -This is at minimum point of LRAC curve. Here, the market size is just
large enough to permit to monopolist to build the optimal plant and use at full capacity
III. Surpass the Optimal Scale-It is beyond the minimum point of LRAC
- The Size of the market is so large that the monopolist in order to maximize his output
- The plant must build than optimal and over utilize it.

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1.4. Multi plant Monopolist

The multi plant monopolist is a monopolist having more than one plant. And it’s focused for
maximizing profit and decisions to be made by monopolist will be discussed equilibrium
determination by the multi plant monopolist

It considers a monopolist with two plants each with different cost structure at two different
locations.

That means we have two different marginal cost where the total marginal cost is equal to the
horizontal summations of individual marginal cost. The monopolist now is expected to make two
decisions.

 How much output to produce together and at what price to sell it so as to maximize
profit
 How to allocate the production of the optimal (Profit maximizing) output between the
two plants.
 The monopolist maximizes output by utilizing each plants up to the level of which the
marginal cost are equal to each other and to Tv common marginal revenue

MC1 = MC2 = MR

 The monopolist maximizing output by utilizing each plant MC are equal to common MR

 Means:- If MC1 is less than MC2, the monopolist would increase his profit by increase the
production in plant 1 and decrease it in plant 2, until the condition of MC1= MC2= MR is
satisfied.

Example – Assume that the demand equation of the multi plant monopolist is given as Q=200-
2P (P = 100- 0.5Q) and cost of the two plants are given as C1 =10Q1 and C2 = 0.25Q22. Find
equilibrium level of price and maximum level of profit

First, calculate marginal Revenue (MR) & Marginal Most (MC1 MC2)

R = PQ

= (100-0.5Q)Q

= 100Q-0.5Q2

MR = d(R)
d(Q)

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=d (100Q -0.5Q2)

= 100-Q

MC1 = d(C1) = d(10Q1) = 10

d(Q) d(Q)

MC2 = d(C2) = d(0.25Q22) = 0.5Q2

d(Q) d(Q)

2nd. Equate MC1 = MC2 and MC1 = MR since Q1+Q2 = Q

MC1 = MC2 MC1 = MR Q = Q1+Q2
10 = 0.5Q2 10 = 100-Q Q1= Q-Q2
0.5 0.5 Q = 100-10 Q1 = 90-20
Q2 = 20 Q = 90 Q1 = 70

3rd – to calculate equilibrium price substitute “Q” in demand equation

P= 100-0.5 Q
= 100-0.5 (90)
= 100 -45
= 55

4th – The monopolists profit can be calculated as:-

II = R-C1-C2
= PQ – C1-C2
= (PQ) – (10Q1) – (0.25Q22)
= (55 x90) – (10x 70) – ((0.25 (20)2)
= (4950) – (700) – (100)
= 4150
 To check MC1 = MC2 = MR
10 = 0.5 (Q2) = 100 –Q
10 = 0.5 (20) = (100-90)
10 = 10 = 10

1.5. Price Discrimination

Monopolist can increase TR and profits at a given level of output and TC by practicing price dis
crimination. It’s defined as Charging different Prices to different Customers for different unit of
the same Product on the basis of non- Cost- Related Characteristics of consumers.

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To engage in price discrimination a seller must meet the following conditions:

1. The seller must be able to control the price of its product. A monopoly firm can engage in
price discrimination because it can control prices. The product that will be sold at more than
one price must not be resalable. It is not possible to charge different prices to different
buyers if the good is resalable. Individuals who buy it at low prices could resell it to people
who would pay higher prices. Eventually such a process would lead to the establishment of a
single price in the market. The seller must be able to determine how willingness and ability
to pay vary among prospective
2. Price discrimination will result in some people paying more and some paying less than w
ould be the case is one price were announced for the product. The seller must be able to d
istinguish among buyers in a way that allow it to charge higher prices only to buyers whose
marginal benefit for the good would exceed the single price. Monopolists engage in price dis
crimination when they can increase their profit by doing so.

For example, a telephone company may charge individuals 15 cents for each of the first 50
telephone calls made during each month, 10 cents for each of the next 100 calls, and so on.
Electrical companies usually charge less per kilowatt hour to industrial users than to
households because industrial users have more substitutes available (such as generating their
own electricity) and thus have a more elastic demand curve than households. Airlines are
notorious price discriminators, as shown by the multitude of fares available for similar seats on a
given flight.

The Degree of Price discrimination

 A Seller with the degree of monopoly power and any time that faces down weld sloping
demand can have a power of price
 The reason for the Monopolist to apply price discrimination is to obtain an increase in his
total revenue and profit
 The Increase in total Revenue is archived by taking away part of the consumer’s Surplus.
Depending on the amount of consumer’

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I. First degree Price discrimination

- This involves changing different price for every seller.
- The aim of first-degree Price discrimination is to appreciate the entire consumer Surprise.
- In this degree the producer charges the highest price that the consumer is willing to pay for
each unit sold.

It’s the limited case in which the monopolist negotiates individually with each buyer. Also call

ed Perfect price discrimination or “take-it- or Leave it” Price discrimination

P Consumer Surplus Firm’s revenue

Firm’s revenue

Q Q

No discrimination 1st degree price description

- There is no price discrimination - If we have 1st degree price

- The consumer will have a surplus discrimination, the entire
surplus of consumers will taken
away by monopolist.

II. Second Degree price discrimination

 This involves changing different price for different blocks of Consumption. The aim of
monopolist; say a Public utility, it’s to charge a relatively high price for the 1st block of
consumption, a lower price for the Next block and so on.

P1 ------ A

P2 ------B------ C

P3 ------------D--------- E

D1
Q1 Q2 Q3

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Second-degree price discrimination

 The Producer charges price OP for units up to quantity Q1

 F1 Unit Between Q1and Q2, The producer Changes Price OP2, The monopolist earns area
of total revenue OP1AQl+Q1BCQ2+Q2DEQ3
 With Out the 2nd degree price discrimination the revenue earned given by the area OP3EQ3
at price of OP3, which is, Less than revenue under discrimination

III. Third Degree Price Discrimination

 In this case, the monopolist able to separate two or more markets with different
demand & charge different price in separate market.
 Consider the profit maximizing output & price of discriminating monopolist who
operates in two completely independent markets.
 Below Which shows AR & MR of two (A&B) market and Combined MR Curve to both
market at “C”, at given price, elastic in, of demand is greater in market B than “A”
 For profit maximization, MRA & MRB must equal. If there were not so, then profits
could be increased by selling extra unit of output in the market with the higher MR.

R R

Market A Market B Overall Situation

As usual, The profit Maximizing Levels of Output OQ1 is found where MR total is equal to MC,
The Output price is divided between two market with OQA being sold in market A at price OPA
and OQB Being Sold in market B at price OPB. Notice that OQA+OQB=OQ1

Price Discrimination and price elasticity of Demand

The price discriminating monopolist has to decide on the total output that he/she must produced,
haw much to sell in each market to a high – price Market

&
MC=MR1=MR2 P1<P2 but E1>E2

The equilibrium Condition is to equate the two MR

(MR1=MR2=MC which is the same as P1 (1-1/E )=P2 (1-1/E2)

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Example- Assume the following price discriminating Monopolists aim at maximizing profit.
The total demand for the producer of monopolist is Q=50-5P (P=100-2Q)
 The demand in market one is Q1=32-0.4 P1=80-2.5Q1)
 The demand in market two is Q2=18-0.1 P2=180-10Q2)
 Cost function is C=50+10Q (Where Q=Q1_Q2)
 Find equilibrium (Q1 & Q2), equilibrium Prices (P1 & p2), Profit (II) and elasticity’s (E1, E2)

Solution

1st Compute R & MR for two markets & MC

R1=P1Q1 R2=P2Q2
=(80-2.5Q1)Q = (180-10Q2)Q
= 80Q-2.5Q2) = (180Q-10Q22)
MR1= D (R1)d(80Q1-2.5Q2) MR2=d(R2)
D (Q) d(Q) d(Q)
MR1 = 80-5Q1 MR2= d(180Q-10Q22)
d(Q2)
MR2 = 180-20Q2
Mc=d(C)
d(Q)
MC=d(50+4Qc) = MC= 40
d(Q )

2nd Equate Condition of MC=MR1=MR2 since Q=Q1+Q2

Mc=MR1 MC=MR2

40=80-5Q1 40=180-20Q2
5Q1=80-40 20Q2=180-40

5Q1 = 40 20 Q2= 140

5 5 20 20

Q1=8 Q2 = 7

Q = Q1+Q2 Q = 8+7 ==== Q = 15

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3rd Calculate equilibrium price = (Substitute Q1+Q2) in to P1 & P2 function

P1=80-2.5Q1 P2= 10Q2

P1 = 80 – 2.5 (8) = P1=60 =180-10(7) = P2=110

4thEquilibrm profit (II=R1+R2-C

II=P1Q1 + P2xQ2 – (50+40Q)

II = 60x8 +110x7 - 50+40X15)

= (430+770)-650

= 1250-650 = = II = 600

 Elasticity= (E1&E2)

E1= /dQ1.P1/ E2= /dQ2. P2/

dp1 Q1 dp2 Q2

E1=/d(32-0.4P1)60/ E2 = /d/18-0.1P2).110/
d(P1) 8 d(P2) 7
E1 = /C-0.4).60 E2=/-0.1)110/
3 7
E1 = 3 E2 =1.57

MC =MR1=MR2
40=80-5Q1=180-20Q2
40=80-5(8) =180 – 20(7)
40 = 40 = 40

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