This is a market structure in which a single company makes up the entire market. It is on the opposite end of the spectrum as compared to perfect competition.
Ex: Government created monopolies such as electricity or water supply in a major city.
How monopolies are created:
A natural monopoly is one where cost decreases with quantity. The firm is able to meet most of the quantity demanded at a low cost, making it difficult for new firms to enter the market.
The demand curve in a monopoly is downward sloping. Let us take the example of electricity. As a consumer, the quantity demanded is still dependent on the price. To sell an additional unit of the good, the producer must lower the price to increase quantity. This explains why the demand curve is downward sloping.
Let us say the quantity demanded is given by:
Q = 400 – 0.5P
Rewriting the demand function, we get P = 800 – 2Q
TR = P * Q = 800Q – 2Q2
MR = = 800 – 4Q
AR = 800 – 2Q
The average revenue for a demand curve is the same as the demand curve.
The graph below shows the demand, MR, AC, and MC curves for a monopoly firm.
The profit maximizing level of output, Q, is when MR = MC. The corresponding price, PE, at this level of output is determined by the demand curve.
Profit is based on the demand curve = TR – TC. Let’s say TC is given by:
TC = 20000 + 50Q + 3Q2 (the TC equation will be given; you need not derive it)
From TC, we can derive MC = = 50 + 6Q.
Given the total cost function, you can derive the MC curve as shown above. Supply and demand can be equated to determine the profit-maximizing output.
800 – 4Q = 50 + 6Q
Q = = 75
In the previous section, we calculated the optimal output by equating MR = MC.
Another way of determining the profit-maximizing output is to equate = 0. At this point there is no change in profit when output changes.
The price at the profit-maximizing output level of 75 is:
P = 800 – 2 (75) = 650
If π = -20000 + 750Q – 5Q2, at what quantity is profit maximized?
= 750 – 10 Q.
Equating it to 0, we get 750 – 10Q = 0 → Q = 75.
Relationship between MR and price elasticity is: MR = P [1- ]
Profit maximization condition in monopoly: MR = MC
MC = P [1- ]
Profit-maximizing price =
If MC = 75 and the own price elasticity of demand = 1.5, what is the profit-maximizing price?
Profit-maximizing price = = 225.
Natural Monopoly in Regulated Pricing Environment
A natural monopoly is a market where the average cost of production falls over the relevant range of consumer demand. There are three possible cases for output and pricing:
|Natural Monopoly Under Different Environments|
|No regulation of monopoly.||LRMC = MR||QM||PM (the corresponding price on the demand curve)||Profit is maximized by producing this output. Notice that the price is highest and quantity produced is lowest.|
|Perfect competition||P = MC||QC||PC||Quantity produced is higher while the price is lower. Price does not cover the average cost of production, and there is an economic loss. So the government must subsidize the monopoly: LRAC- PC|
|Regulated monopoly||Set price such that LRAC = AR||QR||PR||The monopoly earns a normal profit, i.e. economic profit is zero at this output level.|
15. Price Discrimination and Consumer Surplus
What a monopolist charges for their product and how much quantity is supplied lie on two extremes: on one end the price and quantity supplied may be equal to that of perfect competition where there is a uniform price, and on the other end is discriminating consumers on some grounds, which leads to different prices for the same product.
Ex: In restaurants, lunch is cheaper than dinner, or weekday prices are different than Friday-Sunday prices.
First degree price discrimination:
Second degree price discrimination:
Third degree price discrimination:
My monthly demand for visits to the local gym is given by: Q = 25 – 5P where Q is the number of visits per month and P is the price per visit. The gym’s marginal cost is 1 per visit.
X-axis intercept when P = 0 is Q = 25.
Y-axis intercept when Q = 0 is P = 5.
I would make 20 visits per month.
Monopolists have considerable pricing power and may charge consumers in different ways. Exporters charging higher prices for denim jeans in the international market compared to local markets is an example of:
Third-degree price discrimination occurs when customers are segregated by demographics. Dividing the customers into two groups, local and international; and charging two different prices is an example of third-degree price discrimination. The first degree of price discrimination allows a monopolist to charge the highest price each customer is willing to pay. The second degree of price discrimination is when the monopolist charges different people different prices using the quantity purchased as an indicator of how highly the customer values the product.
Unregulated monopolies can earn economic profits in the long run as all factors of production are variable in the long run.
For regulated monopolies, there are several possible solutions in the long run: