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Monopoly and Price Discrimination Learning Outcomes: Detailed study of Monopoly Definition and meaning of Monopoly Kinds of Monopoly Monopoly Power Monopoly Equilibrium Price Discrimination Pricing under discriminating monopoly Concept of dead weight loss Price Discrimination under Dumping Difference between Monopoly and Perfect competition

Monopoly means absence of competition. It is an extreme situation in imperfect competition. Monopoly can be defined as a condition of production in which a single person or a number of persons acting in combination, have the power to fix the price of the commodity or the output of the commodity. Three characteristics define pure monopoly: 1. There is a single seller or single control 2. There are no close substitutes for the firms product. 3. There are barriers to entry. 4. The firm may use its monopoly power in any manner in order to realise maximum revenue. He may adopt price discrimination. Since there is only one seller, there is no distinction between firm and industry. Since there is no close substitute, cross elasticity between the product of the firm and that of other commodities is zero. (Understand the concept of cross elasticity and how it affects the demand in other market conditions!)

Kinds of Monopoly Private and Public Monopoly Pure Monopoly- this can exists only in public sector, Production of a special commodity with exclusive privilege of the state). Very rarely in private sector (single Doctor/ shop in a village). There are no substitute commodities. Simple Monopoly: Single produce where only remote substitute. Discriminating Monopoly: Monopolist may charge different prices from different customers or markets. He has not only the power to fix the price but also change the pricing between customers and markets

Monopoly Power: In practice, no monopolist will have absolute monopoly power. Let us see the factors how the monopoly gets the power: Power given by the Government Legal Power through Patent/Trade Mark/Copy Right Technical Powers- Control over exclusive raw material, technical knowledge, superior and special know-how, scientific secrets or formula Combinations: Combination of different firms producing the same commodity- Trusts/ Cartels/ Syndicate etc Bias of the Consumer: The bias and laziness or ignorance of the consumer may give some monopolistic privilege to the producer. But those are not monopoly in the real sense of the term

In this Analysis, we will focus on pure monopoly based on the definition given before. It would be a mistake to assume that a monopolist would always push up his prices, as the price is pushed up the demand decreases. It is very important to remember that unlike in the competitive firms, a monopoly firm will have a sloping down demand curve and his average revenue will dwindle as the output is increase, because buyers will buy higher quantity only at a lower price. Monopoly can charge high , but he will be able to sell only less. So the monopolist does not have absolute control over the market. Either he can fix the price and leave the quantity to be purchased or he can have control over the supply and price to fixed by the consumers. DD is the Demand Curve. The firm cannot fix its output at OM and expect to be sold at price K2M2 per unit. If it decides to fix the price at K2M2 then he can sell only OM2 quantity. Out of any number of possible K2 combinations, the monopoly firm will endeavour to choose that price , which maximises the NET MONOPOLY REVENUE.

Price determination depends upon two factors in monopoly. 1. Nature of Demand for the commodity 2. Cost of Production If the demand for the commodity is inelastic ( Steep), the price may be raised without the demand being appreciably reduced. (Understand this intuitively. If the commodity is desperately need and

only the monopoly firm can sell it, even if he raises the price, the demand will not come down drastically). If the demand is very elastic, an increased price will lead to reduced sales and revenue realised will be less. On the Cost side, if there are increasing returns( reducing cost), he can produce larger amounts of commodity at lower cost and sell at lower price. If the commodity has elastic demand and it is produced under reduced cost, the interest of the monopoly will be served if he fixes the price at a lower level. On the other side, if the demand is inelastic ( steep curve), and the cost is increasing ( diminishing returns), then the price can be fixed at higher level, so that the total sales amount will not reduce if it reduces a little and at that reduced output, the cost will also be lesser than the higher output. (Understand thoroughly). If the commodity is under law of constant returns, then the monopoly will exclusively concentrate on the demand side, since there are no changes in the cost side, which indicates only the lower limit of the price to be fixed according to elasticity or inelasticity of demand. If the demand is elastic, the price will be low, if the demand is inelastic, the price will be higher. In all cases, the monopoly firm, carefully weighs two main considerations 1) The nature of demand or average revenues realised 2) Cost of production per unit

Maximum Net monopoly revenue combination of Output and price.

MONOPOLY EQUILBRIUM Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram. (Equilibrium will at MR= MC is true for monopoly also) . The firm will sell more quantity than equilibrium since it wll start making lesser profit. The profit-maximising output can be sold at price P1 above the average cost AC at output Q1. The firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow shaded area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs equals average total cost multiplied by the output. The equilibrium in short period is equal to long period, since there will be no entry of another firm.

MONOPOLY PRICE AND ELASTICITY OF DEMAND Elasticity is defined as (% of change in the quantity Q/Q) -------------------------------------------------(% change in the Price P/p) This means rate of change in the quantity compared with rate of change in the Price. At equilibrium then this is equal to 1. (If the demand changes by 5% then price also changes by 5%). Above the point Q in the figure, the ratio will be greater than 1 (Elastic) and below the point E, it will be less than 1 (Inelastic). A monopolist will never put the output where the elasticity of demand ( AR curve) is less than 1 (in other words inelastic). If he does so, then he cannot maximise his net monopoly revenue, because marginal revenue will be negative. Please note here the following relationship When Elasticity of demand is 1, the MR= 0. The monopoly firm can maximise profit in the region where E >1, which is also equal to where MR is positive. If MR cannot be negative, then marginal cost also cannot be negative, since equilibrium is achieved when MR=MC. From this we can conclude that the equilibrium for the monopoly will always lie at that level of output where the elasticity of demand is greater than 1, provided his Marginal cost is positive.

Some Questions? Will there be any situation where cost are negative or cost have no relevance to pricing of commodity? Can Marginal come to Zero

This is possible in monopoly, where the control of certain natural resources may result in getting the commodity freely. From these analyses we can summarise the following points 1) Monopolists will never produce at a price where demand is inelastic 2) Where there is no marginal cost for the monopolist, he will produce where elasticity of demand is unity. 3) Where monopolist has marginal cost, he will produce at a price where demand is elastic. If MR equals MC, marginal revenue will also be positive.

Monopoly Equilibrium under different cost conditions; Decreasing Returns (increasing cost)

E2 E1

F1 F2 E

The curve MC and AC are sloping upwards showing increasing cost or diminishing returns. The equilibrium point is G and the quantity is Qm. The net monopoly revenue is Green shaded portion and the price Pm. Increasing Returns

AC and MC curves are decreasing. The decreasing MC curve cuts the MR curve from below at a point E1 the equilibrium point At this level output, OM1, the profit is maximum P1Q1R1S1 and the price is OP1. Constant Returns

P2 S2

Q2 E2 MR M AC, MC AR

Since the firm is working under constant cost AC=MC and the latter cuts MR curve at E2, the equilibrium point. At this level of output the profit is P1Q2E2S2 and the price is OP2

PRICE DISCRIMINATION Charging different prices for different customer is called Price Discrimination or Discriminating Monopoly.The idea is to squeeze the maximum profit wherever possible from the customer depending upon the customer and demand. Discrimination is not possible in ordinary competitive conditions unless there is product differentiation. Price discrimination can also be defined as The sales of similar products at different prices which are not proportional to marginal cost. Types of price discriminations Personal Discrimination Basis Ability to pay by the customer. Rich customers will be asked to pay more.

Place Discrimination

Trade Discrimination (Use discrimination)

Locality in which the market is situated will be the criterion. Charging higher prices in richer class locality. Monopolist may charge lesser price in foreign country than local markets.(also known as dumping goods) Different prices for different usages of the same commodity.

Possible in specialised services like doctors and lawyers. Disguised discrimination like Delux edition of a book with paperback edition. Though the content is same in both by the author.(superficial changes) Superficial add ons like door delivery, very courteous behaviour for which richer classes are particular may willing to pay higher price for the same commodity.

Electricity sold at cheaper rates for homes and higher for Industry.

Three Degrees of Price Discrimination: First Degree Perfect Discrimination The producer exploits the customer to pay the maximum he could afford, rather than going without the commodity The maximum that can be paid by the poorest will decide the lowest price Seller has to deal individually with each buyer. Zero consumer surplus for the buyer. Poorest will have zero consumer surplus which rich, who are actually willing to pay more, will get consumer surplus. (Railways. Second class ticket price is based on the common man, which the rich who travels by the second class gets the consumer surplus) With the quantum on hand which is fixed, the price will depend on the demand curve as shown below

Second Degree

Third Degree (commonly practiced)

Markets are divided into many sub markets, price will not be the minimum price, but depending upon the output and demand in the sub market.

Price Y

P3

P2 P1 D3 Market III D2 Market II D1 Market I O Quantity X

The market is broken in to demand curves for three separate market segments under monopoly control. Assuming that the same quantity is demand across the sub markets, the monopoly will charge OP1 in the market I and demand represented by D1 and similarly in Market II and Market III. When the producer undertakes Dumping and charges for the same commodity one price in one country and a different price in another country, it is also a case of price discrimination of third degree.

Conditions for Price Discrimination Monopolist must be sure that it is possible to practice price discrimination Whether it will be worthwhile practicing the same

This depends upon the following three factors 1. Preferences and prejudices of the consumers 2. Apparent product differentiation 3. Distance and Tariff barriers. Price discrimination is possible only if the following two conditions are satisfied Transferability of Demand Demand must not be transferable from high priced market to low priced market. If people do not buy high priced deluxe edition and wait for popular edition, the discrimination will fail Monopolist should keep the different markets separate so that commodity will not move from one market to another.

Separation of Markets

But the price discrimination is possible in the following cases also Ignorance, Laziness, preferences of consumer may be exploited by producer Superficial discrimination like better packaging giving apparent feeling of better quality, better treatment, drive-in facilities- consumer think that they are getting better quality Price discrimination is easy in personal services which cannot be resold.

When the price discrimination is Profitable? The demand can be split across the different markets, so that elasticities of demand are different for each market Cost of keeping various markets and sub markets should not be very high. This cost should not be large relative to the differences in the demand elasticities The first condition is very vital. If the demand elasticities in different markets are equal, then there is no scope for price discrimination at all. The price obtained by the monopolist in each market depends upon the output offered and the shape of the demand curve ( AR curve). Generally the markets will be arranged in ascending order of the elasticities of demand. The highest price will be charged in the least elastic market. Lowest Price will be charged in most elastic market. Pricing under Discriminating Monopoly

P2

P1

E2

E1

To simplify, let us have two markets, called domestic and foreign where price discrimination can take place. You can also observe that the elasticity of demand are different for each of the market, satisfying the conditions. The two markets have respective marginal curve and respective Demand Curve (AR). The aggregate market is the summation of the market A and Market B. Since the production is ontrolled from single source, the Marginal Cost is same for the product and the equilibrium production is obtained when MC= MR at Qt for the Firm. At this equilibrium extended to the sub-markets , where MR1 = MC and MR2 = MC at E1 and E2 respectively. Therefore quantity Qa and Quantity Qb are the equilibrium quantity that can be sold at the market at the P1 and P2. ( SNP is super normal profit). SNPa + SNPb= SNP total

Concept of Dead Weight Loss

To contrast the efficiency of the perfectly competitive outcome with the inefficiency of the monopoly outcome, imagine a perfectly competitive industry whose solution is depicted in Figure The short-run industry supply curve is the summation of individual marginal cost curves; it may be regarded as the marginal cost curve for the industry. A perfectly competitive industry achieves equilibrium at point C, at price Pc and quantity Qc.

Now, suppose that all the firms in the industry merge and a government restriction prohibits entry by any new firms. Our perfectly competitive industry is now a monopoly. Assume the monopoly continues to have the same marginal cost and demand curves that the competitive industry did. The monopoly firm faces the same market demand curve, from which it derives its marginal revenue curve. It maximizes profit at output Qm and charges price Pm. Output is lower and price higher than in the competitive solution. Society would gain by moving from the monopoly solution at Qm to the competitive solution at Qc. The benefit to consumers would be given by the area under the demand curve between Qm and Qc; it is the area QmRCQc. An increase in output, of course, has a cost. Because the marginal cost curve measures the cost of each additional unit, we can think of the area under the marginal cost curve over some range of output as measuring the total cost of that output. Thus, the total cost of increasing output from Qm to Qc is the area under the marginal cost curve over that rangethe area QmGCQc. Subtracting this cost from the benefit gives us the net gain of moving from the monopoly to the competitive solution; it is the shaded area GRC. That is the potential gain from moving to the efficient solution. The area GRC is a deadweight loss. Given market demand and marginal revenue, we can compare the behavior of a monopoly to that of a perfectly competitive industry. The marginal cost curve may be thought of as the supply curve of a perfectly competitive industry. The perfectly competitive industry produces quantity Qc and sells the output at price Pc. The monopolist restricts output to Qm and raises the price to Pm. Reorganizing a perfectly competitive industry as a monopoly results in a deadweight loss to society

given by the shaded area GRC. It also transfers a portion of the consumer surplus earned in the competitive case to the monopoly firm. Price Discrimination under Dumping The firm can still practice price discrimination, if, it has a monopoly in the domestic market, but faces perfect competition in the international market for his product. Here, the monopolist sells his product at a higher price in the home market and at a very low price in the foreign market. This is called dumping, as the firm virtually dumps his product at a very low price in the foreign market, wherein it faces perfectly elastic demand curve. The price in the foreign market may even be lower than the average cost of production. The firm then suffers losses here. However, the monopolist does not suffer an overall loss. By exploiting the home market, it can raise price above the average cost and earn monopoly profit, which might more than compensate for the foreign market losses.

Domestic Market: In protected domestic market, this monopolist faces downward sloping demand curve ARD The corresponding marginal revenue curve MRD is also downward sloping. Foreign Market The demand curve ARF of the concerned firm in the foreign market is horizontal straight line at the level of OPF price, its marginal revenue curve MRF coincides with the demand curve ARF due to perfect competition there. On account of perfect competition in the foreign market, the firm has no freedom to determine price in the international market. Rather, it is a price taker here. However, the firm can fix the profit maximizing price in the domestic market. Here, the price cannot fall below OPF level. The price determination under dumping is slightly different from the one explained previously in different submarkets, where the firm enjoys monopoly power in each sub-market. Under dumping, instead of taking just lateral summation of the two marginal revenue curves, we take the composite curve BCE as the aggregate marginal revenue (AMR) curve. The firm will be in equilibrium at point 'E where this curve is intersected! by its given marginal cost curve MC from

below. The equilibrium out will be OQF for foreign market and Domestic market together since the MC is the combine curve since commodities is produced from single firm. The total output in the two markets is OQD + QDQF = OQF The profit maximizing equilibrium condition of the firm can be written as MRD = MRF = AMR = MC. The total profit of the firm is given by the shaded area shown in Figure between the aggregate marginal revenue curve BCE and the combined marginal cost curve MC. Even under dumping, the relationship between price and the price elasticity of demand is clearly established. The concerned firm sells more output at a lower price in the foreign market (which has highest possible elasticity of demand) and less output at a higher price in the domestic market (which has less elastic demand). Difference between Monopoly and Perfect competition Characteristics Differences Perfect AR curve is a straight curve MR=AR=Price Monopoly AR and MR Sloping Down Curve MR is always lies below the AR at all levels of output Hence, at equilibrium, when MC cuts MR, it will be less than AR or Price. MC=MR<AR(Price) the difference between the AR-MC is the monopoly power. Not at the lowest point of LAVC, but some where higher. Here it is possible since MR is a falling curve and MC can cut and rise above MR and still be a falling curve. Equilibrium I possible in all three conditions of increasing, decreasing and constant In the short run there is supernormal profit and there is no competition to take away the profit. Price is set higher and out put will be smaller. Price maker by restricting the output.

Equilibrium Conditions

MR=MC But MR=MC=AR=Price At lowest point in the long run average cost curve Equilibrium can be conceived only in increasing cost conditions since MC should cut MR from below ( and MR is a straight line) and this is possible only when MC is rising. Only normal profits in long run and super profit in the short run. Price lower and output larger with given cost revenue situation. Firm is a price taker

Long Run Differences in equilibrium and price Decreasing Cost conditions

Long run Profits

Price and Output conditions

Heads Up!
Dispelling Myths About Monopoly Three common misconceptions about monopoly are:
1. Because there are no rivals selling the products of monopoly firms, they can charge whatever they want. 2. 3. profits. Monopolists will charge whatever the market will bear. Because monopoly firms have the market to themselves, they are guaranteed huge

As shows, once the monopoly firm decides on the number of units of output that will maximize profit, the price at which it can sell that many units is found by reading off the demand curve the price associated with that many units. If it tries to sell Qm units of output for more than Pm, some of its output will go unsold. The monopoly firm can set its price, but is restricted to price and output combinations that lie on its demand curve. It cannot just charge whatever it wants. And if it charges all the market will bear, it will sell either 0 or, at most, 1 unit of output. Neither is the monopoly firm guaranteed a profit. Consider . Suppose the average total cost curve, instead of lying below the demand curve for some output levels as shown, were instead everywhere above the demand curve. In that case, the monopoly will incur losses no matter what price it chooses, since average total cost will always be greater than any price it might charge. As is the case for perfect competition, the monopoly firm can keep producing in the short run so long as price exceeds average variable cost. In the long run, it will stay in business only if it can cover all of its costs. VIDEOS TO SEE AFTER READING THE NOTES:

http://www.youtube.com/watch?v=_Txn4-wZXqg&feature=relmfu http://www.youtube.com/watch?v=s3wFJHIuJPs http://www.youtube.com/watch?v=fg08G21ZiV0&feature=related http://www.youtube.com/watch?v=7UWgKZsKZOc http://www.youtube.com/watch?v=jXHkKK0u21o http://www.youtube.com/watch?v=fqN3Ok6PhfM&feature=plcp http://www.youtube.com/watch?v=pJmdNBsvGMQ&feature=plcp http://www.youtube.com/watch?v=9T9TN3OuTjc&feature=plcp http://www.youtube.com/watch?v=Q7cKAmkhgto&feature=plcp http://www.youtube.com/watch?v=oxEoLGfhUKw&feature=plcp