Dilla University

School of Business and Economics

MBA program

Managerial Economics Group assignment on Monopoly market structure

Group member Tesfaye Hailu Esayas Degago Aragaw Abibi Submitted to Dr. Richards July, 2012 Dilla, Ethiopia ID No. 009/11 004/11 001/11

1. market structures
Definition: Market structures refer to the specific social organization that exists between buyers and sellers in a given market ie market structures are models of markets that describe a specific social organization between buyers and sellers. Market structure identifies how a market is made up in terms of: o The number of firms in the industry o The nature of the product produced o The degree of monopoly power each firm has o The degree to which the firm can influence price o Profit levels o Firms behaviour pricing strategies, non-price competition, output levels o The extent of barriers to entry o The impact on efficiency

Fig.1. Market structure

Perfect competition pure monopoly

More competitive (fewer perfection)

Perfect competition

pure monopoly

Less competitive (greater degree of imperfection)

Perfect competition
Monopolistic competition Oligopoly Duopoly

pure monopoly
Monopoly

The further right on the scale, the greater the degree of monopoly power exercised by the firm.

1.1.

Why are market structures important to us?

There are several reasons why market structures are important to us ie the public. The following are three of these reasons: Households buy final goods and services or commodities in these commodity markets and firms buy factor inputs in these factor markets. Thus it is useful that households and firms know the markets in which they participate as buyers of goods and services These markets dominate our lives as we purchase foods, airline tickets, clothes, houses, cars, soaps, textbooks, financial services, electricity, cooking gas, health care services and a wide array of other goods and services for our daily use from firms selling these commodities These markets are dynamic and as such they are always changing their structures and as such they need to be studied to understand their new structures i.e. a monopolist market does not always remain a monopolist market they may change to become an oligopolistic market if for example one or two other firms succeed to enter a monopolist market as competitors.

1.2. Types of market structures or market models

There are primarily four market structures or market models that we are interested in studying. They are as follows: 1. Perfect Competition 2. Monopolistic Competition 3. Oligopoly 4. Monopoly

Our group assignment will focus only on the monopoly market structure, that is why we discuss it under here:

2. Monopoly market structure

Monopoly is a term used by economists to refer to the situation in which there is a single seller of a product (i.e., a good or service) for which there are no close substitutes. The word is derived from the Greek words monos (meaning one) and polein (meaning to sell ). Definition: Monopolies are those markets in which there is a single firm. There is no competition in these markets and the single firm sets its own profit maximizing price and output where its marginal cost is equal to its marginal revenue. This type of monopolist market is called a Pure Monopolist market or a single firm industry.

2.1. Characteristics of Monopolist Market Structures:

Single Seller: In a monopoly there is one seller of the monopolized good who produces all the output. Therefore, the whole market is being served by a singlefirm, and for practical purposes, the firm is the same as the industry.. There are no close substitutes for the product being sold by the monopolist firm There are no competitors in this market i.e. competition is absent for the monopolist firm. Market Power: Market Power is the ability to affect the terms and conditions of exchange so that the price of the product is set by the firm (price is not imposed by the market as in perfect competition). There are cost, technological and managerial barriers to entry in monopolist markets ie monopolist firms make it extremely difficult for potential rival firms to dislodge their monopolist status by erecting disincentives to entry There is imperfect information between a monopolist firm and its customers regarding price, product quality etc which in the absence of competition deepens

The monopolist may or may not incur advertising cost and the absence of competition facilitates this option for monopolist i.e. there is no pressure to incur these costs for marketing the product

Control of Natural Resources: A prime source of monopoly power is the control of resources that are critical to the production of a final good. Legal Barriers: Legal rights can provide opportunity to monopolize the market in a good. Intellectual property rights, including patents and copyrights, give a monopolist exclusive control over the production and selling of certain goods. Property rights may give a firm the exclusive control over the materials necessary to produce a good. In addition to barriers to entry and competition, barriers to exit may be a source of market power. Barriers to exit are market conditions that make it difficult or expensive for a firm to leave the market. High liquidation costs are a primary barrier to exit.

Examples of Monopolist Markets in the Ethiopia: electricity, water markets, airlines, and telecommunication.

2.2. Classification / Kinds / Types of Monopoly

1. Perfect Monopoly
It is also called as absolute monopoly. In this case, there is only a single seller of product having no close substitute; not even remote one. There is absolutely zero level of competition. Such monopoly is practically very rare

2. Imperfect Monopoly
It is also called as relative monopoly or simple or limited monopoly. It refers to a single seller market having no close substitute. It means in this market, a product may have a remote substitute. So, there is fear of competition to some extent e.g. Mobile (Cellphone) telcom industry (e.g. vodaphone) is having competition from fixed landline phone service industry (e.g. BSNL).

3. Private Monopoly
When production is owned, controlled and managed by the individual, or private body or private organization, it is called private monopoly. e.g. Tata, Reliance, Bajaj, etc. groups in India. Such type of monopoly is profit oriented.

4. Public Monopoly
When production is owned, controlled and managed by government, it is called public monopoly. It is welfare and service oriented. So, it is also called as 'Welfare Monopoly' e.g. Railways, Defence, etc.

5. Simple Monopoly
Simple monopoly firm charges a uniform price or single price to all the customers. He operates in a single market.

6. Discriminating Monopoly
Such a monopoly firm charges different price to different customers for the same product. It prevails in more than one market. 7. Legal Monopoly When monopoly exists on account of trademarks, patents, copy rights, statutory regulation of government etc., it is called legal monopoly. Music industry is an example of legal monopoly.

8. Natural Monopoly
It emerges as a result of natural advantages like good location, abundant mineral resources, etc. e.g. Gulf countries are having monopoly in crude oil exploration activities because of plenty of natural oil resources.

9. Technological Monopoly
It emerges as a result of economies of large scale production, use of capital goods, new production methods, etc. E.g. engineering goods industry, automobile industry, software industry, etc.

10. Joint Monopoly A number of business firms acquire monopoly position through amalgamation, cartels, syndicates, etc, it becomes joint monopoly. e.g. Actually, pizza making firm and burger making firm are competitors of each other in fast food industry, But when they combine their business that leads to reduction in competition. So they can enjoy monopoly power in market.

2.3. Causes of Monopoly

By developing or acquiring control over a unique product that is difficult or costly for other companies to copy. This can occur as a result of a purchase, merger or research and development. An example is pharmaceuticals, which can be extremely expensive and risky to develop (and which are also protected by patents), thereby locking out all but a few large, well funded companies with ample talent. Closely related to this is control over a unique input for a product, such as a unique natural resource. By having a lower production cost than competitors. This can result from having a more efficient (i.e., more output per unit of input) production technique or from having access to a unique source of low cost inputs (e.g., a mine containing exceptionally high grade ore). In some cases, a greater efficiency is the result of economies of scale , which means that the production cost per unit of product declines as the volume of output increases due to the ability to use some resource more intensively (e.g., a steel mill or railroad with lots of excess capacity).(3) integrations(5) By receiving a government grant of monopoly status, i.e., becoming a government-granted monopoly. Today this is usually accomplished through the acquisition of a license, patent, copyright, trademark or franchise. Common examples include a franchise for cable television for a certain city or region, a trademark for a popular brand, copyrights on certain cartoon characters or a patent for a unique product or production technique.

2.4. Why Monopolies Can Be Beneficial?

Despite their reputation for evil, monopolies can actually generate a net benefit for society under certain circumstances. These are usually situations in which the power and duration of the monopoly are carefully limited. Natural monopolies can be particularly beneficial. This is because of their ability to attain lower costs of production, often far lower, than would be possible with competitive firms producing the same product in the same region. However, it is almost always necessary for such monopolies to be regulated by a relatively uncorrupted government in order for society to obtain the potential benefits. This is because such monopolies by themselves, as is the case with all monopolies, have little incentive to charge prices close to cost and, rather, tend to charge profit-maximizing prices and restrict output. Likewise, there is often little incentive to pay much attention to quality. It has long been recognized that government-granted monopolies (i.e., patents, copyrights, trademarks and franchises) can benefit society as a whole by providing financial incentives to inventors, artists, composers, writers, entrepreneurs and others to innovate and produce creative works. In fact, the importance of establishing monopolies of limited duration for this purpose is even mentioned in the U.S. Constitution In addition to being for limited periods of time, such monopolies are also generally restricted in other ways, including that there are often fairly good substitutes for their products.

2.5. Why Monopolies Can Be Harmful?

Large monopolies have considerable potential to damage both economies and democratic governments (although they can be very beneficial for other types of governments ).Unfortunately, the full extent of the damage is usually not as obvious, at least to the general public, as are the seemingly beneficial effects. And monopolists often go to extreme lengths to disguise or hide such harmful effects. Among the ways in which unregulated monopolies can harm an economy are by causing:(1) Substantially higher prices and lower levels of output than would exist if the product were produced by competitive companies.(2) A lower level of quality than would otherwise exist. This includes not only the quality of the goods and services themselves, but also the quality of the services associated with such goods and services.(3) A

slower advance in the development and application of new technology. Advances in technology can improve the quality (e.g., ease of use, durability, environmental friendliness) of products, and they can also reduce their costs of production. Innovation is not as necessary for a monopolist as it is for a highly competitive firm, and, in fact, it can be a bad business strategy. Research and development by monopolists is often largely focused on ways of suppressing new, potentially competitive technologies (and includes such techniques as stockpiling patents) rather than true innovation. This can be a serious disadvantage, because economists have long recognized that innovation is a key factor (and possibly the single most important factor) in the growth of an economy as a whole .The adverse effects of monopolies can be much more noticeable on an individual level than in the aggregate. These effects include the destruction of businesses that would have survived had competition been based solely on quality and price (with a consequent loss of assets of the owners and jobs of the employees) and prices for products so high as to cause hardship or be unaffordable for some people. It is often said, even by those who have negative opinions about monopolies, that" monopoly itself is not necessarily bad, but rather it is the abuse of monopoly power that is harmful." This statement is an excessive simplification, and it can be indicative of alack of understanding of the full extent of harm that can be caused by monopolies. The abuse of monopoly power clearly can be harmful to an economy. The term abuse in this context refers to such tactics as predatory pricing, colluding with suppliers and the leveraging of a monopoly in one product to gain a monopoly for another product. But what is often overlooked, even by legislation whose supposed purpose is to restrain or regulate monopolies, is the fact that monopolies can be harmful even if they do not engage in such practices.

If a monopolist engages in behavior that produces results similar to that by firms in an industry that is characterized by intensive competition (i.e., charges prices close to cost and does not engage in price discrimination), then there might not be a problem. Unfortunately, however, this is rare even for a seemingly benevolent monopolist. The reason is that the very strong incentives to maximize profits that exist for virtually any business, whether pure monopolist, perfect competitor or somewhere in between, produce very different results for a monopolist

than they would for a firm in a highly competitive industry. And monopolists (as is the case with competitive firms) usually do not rank benevolence as a top corporate priority. Thus, the management and employees in a monopoly might not at all be aware that they are harming the economy, especially if their behavior is similar to that by a non-monopoly. In fact, they may even genuinely believe that they are benefiting the economy because of their conviction that they are more efficient and productive than a number of firms competing with each other would be. Another reason that the positive effects of even a benevolent monopolist would not be as great as for a competitive company is that innovations that improve quality and reduce production costs are often the result of desperation. (This is something that is easy for many owners of struggling businesses to understand, but is often difficult for others to fully grasp without experiencing it firsthand.) Monopolists generally consider themselves successful, and thus, although they often are innovators to some extent (typically mainly in their earlier years), they usually just do not have that extra motivation to produce truly breakthrough innovations that smaller companies desperate to gain market share (or to just survive) have.

2.6. Pricing in monopoly

In a monopoly, an account of a single market entity controlling supply and demand, degree of price and supply control exerted by the enterprise or the individual is greater. The absence of competition spares the monopolizing company from price pressure. Nevertheless to evade of entry from new market participants and the company needs to regulate the set of product or service price within the paradigm of monopoly theorem. Monopoly has a scope of entrepreneurship to make available limited products and services at a higher price. The price and production decision of such firms target profit maximizing via predetermined quantity choice. This helps to cut even on marginal and revenue outcomes. TR= P.Q AR= TR/Q=AR=P

MR=dTR/dQ Note: MR does not equal AR

2.6.1. Monopoly Pricing and Output Decision in the Short-Run.

As in the case of perfect competition, pricing and output decision under monopoly are based on revenue and cost conditions. The cost conditions (AC and MC curves) are same for both perfect competition and pure monopoly. The difference is basically in the revenue conditions (AR and MR curves). This is so because, unlike the competitive firm, a monopoly firm faces a downwardsloping demand curve. A monopolist can reduce its product price and sell more, and raise its product price and still retain some customers. When a demand curve slopes downward, the associated marginal revenue (MR) curve lies below the average revenue (AR) curve, and the slope of the MR curve is two times the slope of the AR curve. The revenue and cost conditions faced by a monopoly firm in the short-run are presented in figure 3.2.1 below. The monopoly average and marginal revenue curves are represented by AR and MR curves, respectively. The short-run average and marginal cost curves are represented by SAC and SMC curves, respectively. The price and output decision rule for a profit-maximizing monopolist is same as that of a firm under perfect competition. The profit-maximizing monopoly firm chooses a price-output combination at which MR = SMC. Given the monopolists cost and revenue curves in figure 3.2.1, its MR and SMC intersect each other at point E. An ordinate drawn from point E to the X-axis determines the profit-maximizing level of output for the firm at Q*. At this output, firms MR = SMC. Given the demand curve, AR = D, the output, Q* can be sold in a given time at only one price, P*. It follows that the determination of output simultaneously determines the price for the monopoly firm. For any given price, the unit and total profits are also simultaneously determined. This defines the equilibrium condition for the monopoly firm.

Figure 2: Short-Run Price Determination under Monopoly P,C,R

SMC SAC

P*

(MR=SMC) MR AR=D Output

Q*

The Algebraic Determination of Monopoly Price and Output Example: Suppose demand and cost functions for a monopoly firm are given as: Demand function: Q = 100 0.2P. (1) Price function: P = 500 5Q. (2) Cost function: C = 50 + 20Q + Q2 (3) The problem is to determine the profit-maximizing level of output and price. This can be solved in the following way. Recall that profit is maximised at an output for which MR = MC. The first step is therefore to find MR and MC using the demand and cost functions as given in equations (1) and (3), and formulate the revenue function using equations (2): Total Revenue (R) = PQ, so that, R = (500 5Q) Q = 500Q 5Q2 MR = dR = 500 10Q dQ Similarly,

MC = dC = 20 + 2Q dQ Equating MR to MC, the profit-maximising condition, we get: MR = 500 10Q MC = 20 + 2Q, and, 500 10Q = 20 + 2Q 480 = 12Q Q* = 40. It follows that the profit-maximising level of output is Q* = 40 units. The profit-maximising price can be obtained by substituting Q* = 40 in the price function, equation (3.2.2) to get: P* = 500 5(40) = 300. Thus, the profit-maximising price, P* = N300. With these information, the total (maximum) profit can be calculated as follows: Profit () = R C = 500Q 5Q2 (50 + 20Q + Q2) = 500Q 5Q2 50 20Q Q2 = 480Q 6Q2 50 Substituting for Q = 40, we obtain: = 480(40) 6(40)2 50 = 19200 9600 50 = 9550. Thus, the maximum profit (*) = 9,550.

2.6.2. Monopoly Pricing and Output Decision in the Long-Run.

The decision rules guiding optimal output and pricing in the long-run is same as in the shortrun. In the long-run however, a monopolist gets an opportunity to expand the size of its firm with the aim of enhancing the long-run profits. Expansion of the plant size may, however, be subject to such conditions as:

(a) the market size; (b) expected economic profit; and, (c) risk of inviting legal restrictions. All things being equal, the equilibrium monopoly price and output determination in the longrun is illustrated by figure 3.3.1 below. According to the figure 3.3.1, the AR and MR curves show the market demand and marginal revenue conditions facing the monopolist. The long-run average cost (LAC) and the long-run marginal cost (LMC) curves indicate the longrun cost conditions. As you can observe from figure 3.3.1, the monopolists LMC and MR intersect at point P, where output is represented as Q*. This represents the profit-maximising level of output. Given the AR curve, the price at which the output, Q* is represented by P*. It follows that, in the long-run, the monopolist output will be Q* and price, P*. This output-price combination will maximise the longrun profit. The total profit is shown by the shaded area. Figure 3.3.1: Monopoly Equilibrium in the Long-Run. P,R,C LMC LAC

P*

MR 0 Q*

AR=D Q

2.6.3.

Price Discrimination (PD)

A monopolist may be able to engage in a policy of price discrimination. Definition: PD is the sale of a homogenous product or service at different prices to different customers in different markets. PD occurs when a firm charges different price to different groups of customers for an identical good or service, for reasons not associated with costs of production. It is important to stress that charging different prices for similar goods is not PD. e.g. PD does not occur when a rail company charges a higher price for a first class seat. This is bec. the price premium over a second-class seat can be explained by differences in the cost of providing the service.

2.6.3.1. Conditions necessary for PD to operate:

There are basically 3 main conditions required for PD to take place: 1. The firm must be able to set its price i.e. the firm must be a monopoly. PD will be impossible under perfect condition where all firms are price takers. 2. The markets must be separate. Consumers in the low priced market must not be able to resell the product in the high price market. Eg children must not be able to resell a half priced childs cinema ticket for use by an adult. The cost of separating the market and selling to different sub-groups or market must not be prohibitive 3. Demand elasticity must differ in each market. The firm will charge the higher price in the inelastic market which is less sensitive to price changes and a lower price in the elastic market. This allows the firm to extract consumer surplus by varying the price leading to additional revenue and profit. Examples of PD There are numerous good examples of discriminatory pricing policies. We must be careful to distinguish between discrimination (based on consumers willingness to pay) and product

differentiation where pr differences might also refelect a different quality or standard of service. Some examples of PD are: cinemas and theatres cutting prices to attract younger and older audiences students discounts for rail travel, restaurant meals and holidays car rental firms cutting prs at weekends hotels offering cheap weekend breaks and winter discounts

2.6.3.2.

The aims of PD:

Main aim of PD is to increase the total revenue and /or profits of the supplier. It helps them to off-load capacity and can be used as a technique to take market share away from rival firms. Some consumers do benefit from this type of pricing they are priced into the market when with one price they might not have been able to afford a product. For most consumers however, the price they pays reflects pretty closely what they are willing to pay. In this respect, PD seeks to extract consumer surplus and turn into producer surplus (or monopoly profits).

2.6.3.3.

Price discrimination and economic efficiency:

There are arguments on both sides of the coin indeed the overall impact of PD on economic welfare seems bound to be ambiguous. 1) Consumer surplus is reduced in most cases representing a loss of consumer welfare. For the majority of consumers, the price charged is significantly above MC. Those consumers in segments of the market where DD is inelastic would probably prefer to return to uniform pricing by firms with monopoly power. 2) However some consumers who can buy the product at a lower pr may benefit. Previously they may have been excluded from consuming it. Low-income consumers may be priced into the market if the supplier is willing and able to charge them a lower price. Good examples to use might include legal and medical services where charges are dependent on income levels.

3)

PD is clearly in the interests of businesses who achieve higher profits. A discriminating monopoly is extracting consumer surplus and turning it into extra super normal profit or producer surplus.

4)

The profits made in one market may allow firms to cross-subsidies loss-making activities /services that have important social benefits, e.g. profits made on commuter rail or bus services may allow transport co. to support loss making rural or night-time services. Without the ability to price discriminate, these services may have to be withdrawn and employment may suffer. In many cases, aggressive PD is seen as inimical to business survival during an economic Recession or sudden market downturn.

5)

The premium price paid by business purchases of software licenses might allow a software co. to offer educational users a lower-price for similar identical products

6)

An increase in total output resulting from selling extra units at a lower price might help a monopoly supplier to exploit EOS thereby reducing LRAC.

2.4. Regulations of monopoly:

Because of the potential economic welfare loss arising from the exploitation of monopoly power, the government regulates some monopolies. Regulators can control annual price increases and introduce fresh competition into particular industries.

2.5. Pros and cons of monopoly market structure advantages of monopoly

1 no risk of overproduction 2 there is enough capital for research 3 In a monopoly, besides the seller, profits can also be enjoyed by customers, in terms of low prices for a particular product or service (reduction in price of good). 4 efficiently use of recourses 5 control over entire market 6 others are price takers 7 only producer of a particular product or service

disadvantages of monopoly
1 exploitation of consumers 2 Customers are not able to enjoy the benefit of choice, had there been another or equally competitive market player for the same product or service (restriction of consumers choice) 3 absence of competition leads to inefficiency 4 Prices of products or services can be unreasonably high (increase in price of product) 5 exploitation of labor i.e. when price is greater than marginal cost