Mark-up pricing|Deadweight loss|Inefficiency of Monopoly|Natural Monopoly|Liner Demand Curve

Mark-up Pricing

Businesses need to price products and services appropriately to make a profit. While
some items may have an arbitrary or exorbitant markup cost based on uniqueness or demand,
there is an actual formula to define markup based on either percentage or set price. Business
owners need to define pricing practices as a strategy that makes sense for the product or
service and the demographic targeted

The percentage or markup is decided by the company usually fixed at the required rate
of return. It is most often used in public utility pricing, product tailoring like designing jewellery,
and in government contracts, which has received criticism for encouraging wasteful expenses.

There are three facts about markup:

1. Markup is greater than or equal to zero—that is, the firm never sets a price below
marginal cost.
2. Markup is smaller when demand is more elastic.
3. Markup is zero when the demand curve is perfectly elastic: −(elasticity of demand) = •.

Since the monopolist always operates where the demand is relatively elastic, we are
assured that e > 1, and thus the mark-up is greater than 1. We also observe that larger the
value of e, the smaller would be mark-up over the MC, which is what is expected, for the larger
the price- elasticity of demand, the smaller would be the option before the monopolist to charge
a higher price.

 At the profit-maximizing price, marginal revenue equals marginal cost.

 Markup is the difference between price and marginal cost, as a percentage of marginal
cost.

 The more elastic the demand curve faced by a firm, the smaller the markup.

Deadweight Loss of Monopoly

Mark-up pricing|Deadweight loss|Inefficiency of Monopoly|Natural Monopoly|Liner Demand Curve

o The red triangle in the above graph represents producer surplus. Producer surplus
exists when the price goods are sold for is greater than what it costs the firms to
manufacture those goods. Producer surplus is defined by the area above the supply
curve, below the price, and left of the quantity sold.
o The yellow triangle in the above graph represents consumer surplus. Consumer
surplus exists when the price paid by a consumer is less than what the consumer would
be willing to purchase the good for. Consumer surplus is defined by the area below the
demand curve, above the price, and left of the quantity bought.

o The equilibrium price and quantity is at the point were marginal cost (MC) is equal to the
demand curve (also marginal revenue – MR). In a competitive market,
Demand=AR=MR=P. The competitive output is the efficient output for the market.

o In a monopoly, the firm maximizes profit by producing where marginal cost equates
marginal revenue. A firm in perfect competition has to produce where price equates
marginal cost and marginal revenue, as it is a price taker, and is unable to manipulate
the market. They key difference here is that in monopolized markets, the price of the
goods sold will always be higher than the marginal cost and marginal revenue.
o The monopolist quantity is less than the competitive quantity and the monopolist price is
greater than the competitive price. In a monopolistic market, consumer surplus is show
by the yellow triangle, which is the area below the demand curve, above the monopolist
price, and left of the monopolist quantity. The producer surplus is now the red area,
which is the quantity above the marginal cost curve (also supply curve), below the
monopolist price, and left of the monopolist quantity.
Mark-up pricing|Deadweight loss|Inefficiency of Monopoly|Natural Monopoly|Liner Demand Curve

o When a market does not produce at its efficient point there is a deadweight loss to
society. The yellow triangle represents the lost consumer surplus and the red triangle
represents the lost producer surplus when the market operates at the monopolistic
output instead of the competitive output. The lost consumer surplus plus the lost
producer surplus is the total deadweight loss to society.

o Offers inventors the exclusive right to benefit from their inventions for a limited period of
time. Thus a patent offers a kind of limited monopoly.
 Mark-up pricing|Deadweight loss|Inefficiency of Monopoly|Natural Monopoly|Liner Demand Curve

o The reason for offering such patent protection is to encourage innovation. In the
absence of a patent system, it is likely that individuals and firms would be unwilling to
invest much in research and development, since any new discoveries that they would
make could be copied by competitors.

Inefficiency Of Monopoly
Monopolies vs. Perfect Competitions

Monopolies Perfect Competitions

 Single seller  Many sellers
 High barriers of entry  Little to no barriers to entry
 Product of a monopolist cannot be  Homogeneous product
substituted readily results higher price
and still get sales

Most people criticize monopolies because they charge too high a price, but what economists
object to is that monopolies do not supply enough output to be allocative efficient.

Monopolistic markets do not meet the criteria for the most important kind of social efficiency -
allocative efficiency. If the market is allocatively efficient, firms will be producing at a point where
price equals marginal cost. This means all consumers who value the good at more than it costs
to produce the marginal unit of that good get to consume it.

Allocative inefficiency occurs when the consumer does not pay an efficient price. An efficient
price is one that just covers the costs of production incurred in supplying the good or service.
 Mark-up pricing|Deadweight loss|Inefficiency of Monopoly|Natural Monopoly|Liner Demand Curve

Why is Monopoly inefficient

Compared to PCM (perfectly competitive market), a monopolist sells lower Q at a higher P

In particular, the price charged by a monopoly is higher than the marginal cost of production,
which violates the efficiency condition that price equals marginal cost.

Monopoly is inefficient because it has market control and faces a negatively-sloped demand
curve.

The monopolist produces less than the efficient quantity, making the market price exceed the
efficient market price

Therefore, the monopoly equilibrium quantity, QM, is inefficient because of underproduction.

Monopoly results in a deadweight loss.

Linear Demand Curve

 P= a-bq

Where P is the is the good’s price and q is the quantity demanded. Constants in the
equation is represented by a and b - where a is the intercept of the demand curve (where the
demand curve intersects the vertical axis) and b is the demand curve’s slope.
 Mark-up pricing|Deadweight loss|Inefficiency of Monopoly|Natural Monopoly|Liner Demand Curve

Then the revenue function is :

And the marginal revenue function is:

Natural Monopoly
A natural monopoly is a distinct type of monopoly that may arise when there are extremely
high fixed costs of distribution, such as exist when large-scale infrastructure is required to
ensure supply.

In the case of natural monopolies, trying to increase competition by encouraging new entrants
into the market creates a potential loss of efficiency.

It may be more efficient to allow only one firm to supply to the market because allowing
competition would mean a wasteful duplication of resources.

Minimum efficient scale (MES) is the lowest level of output at which all scale economies are
exploited. If MES is only achieved when output is relatively high, it is likely that few firms will be
able to compete in the market.
 Mark-up pricing|Deadweight loss|Inefficiency of Monopoly|Natural Monopoly|Liner Demand Curve

With a natural monopoly, average total costs

(ATC) keep falling because of continuous economies of
scale. In this case, marginal cost (MC) is always
below average total cost (ATC) over the whole
range of possible output.

In order to maximize profits the natural monopolist

would charge Q, and make super-normal profits. If
unregulated, and privately owned, the profits are likely to
be excessive. In addition, the natural monopolist is likely
to be allocatively and productively inefficient.

A public utility’s losses could be dealt with in a number of ways, including:

1. Subsidies from the government.

2. Price discrimination, whereby additional revenue can be derived by splitting the market
into two or more sub-groups, and charging different prices to each sub-group.