Monopoly

This Sunday, I went to purchase Economic times from the local newspaper dealer. He has a monopoly in our area. There are around 25 regular customers who purchase economic times every Sunday. But the newspaper dealer stocks only 20 papers. And he charges a higher price for the last few papers.
In short in order to earn higher prices he reduces the quantity supplied. My question to you Krunal is, Could he do the same if there were many newspaper dealers in our area? No he could not. Because customers would purchase from other dealers if he would raise the prices. If a monopolist wants to earn higher profits, he reduces the quantity supplied. And if he wants to sell a higher quantity, he has to reduce the prices. This is not possible in a competitive market. It happens only in monopoly.

When Microsoft designed windows for the first time many years ago, they applied for a patent from the government, which gave them the sole right to sell windows. So if a person wants to buy windows, it has to buy it any price that Microsoft charges. But Microsoft will not charge exorbitantly high prices as customers would stop using windows and also complementary products like computers. A firm in a Monopoly is a PRICE-MAKER. A monopoly has absolute MARKET-POWER.

In the scenario for competitive firms, they can maximize their profits. But because it is a competitive scenario a firm cannot do something that is unfair. But in the case of monopoly, since they have unlimited MARKET POWER they can charge high. But in order to keep them under check, there is government intervention. As one of the principles of economics say Government can at times improve market outcome.

The characteristics of a MONOPOLY ARE:

1) Single seller and many buyers.

2) Products do not have close substitutes.

3) There are barriers to entry. 4) Monopolists are price makers.

Why Monopolies arise? :

1) A key resource is owned by a single firm. (IIM- FACULTY)

2) The government gives a Single firm the exclusive right to produce and sell some good or service. (ONGC & RAILWAYS & GEB (GUVNL))
3) The costs of production make a single producer more efficient than a large number of producers. (Walmart- Supply Chain & Logistics)

MONOPOLY RESOURCES: The simplest reason for a monopoly to arise is for the firm to own a key resource. For eg the market for water in the old west. For eg if in the town there are a number of wells, then the situation would be that of competitive market. But if there are no wells then the market would be a monopoly. GOVERNMENT CREATED MONOPOLIES: At times monopolies arise when the government gives one firm or one person the exclusive right to sell a good or service. The patent and copyright laws are two ways by which a government creates monopolies. At times it gives monopoly to avoid other companies getting secret information. NATURAL MONOPOLIES: Natural Monopolies arise because of Economies of Scale i.e. when a firm is able to provide a good or service at the lowest possible cost. ATC

How Monopolies make production and pricing decisions Now that we know what monopolies are, lets now learn how a monopoly takes production and pricing decisions.

Monopoly versus competitive market:

The key difference between a competitive firm and a monopoly is the monopolys ability to influence the price of its output. A competitive firm will take the price as given. It cannot alter the prices or sell more by reducing the prices. Whereas in a monopoly a firm has power to alter the prices.

The demand curve for a competitive firm is perfectly elastic. Because it can sell any quantity of goods but at a given price. It cannot alter the price by changing the output.
The demand curve for a monopoly is a downward- sloping demand curve. If a person wants to sell more output, he has to

Perfectly elastic demand curve for a competitive firm

Downward sloping demand curve for a monopoly. If a monopoly wants to sell higher output, he has to lower the prices.

In a Competitive Market If you are selling a higher quantity at a same price, what will happen to Total revenue? (SHIVAM)
TOTAL REVENUE will increase. What will happen to MARGINAL REVENUE? (TANVI) It will remain the same. Confused? Want to test?

Price Quantity TR change in Q)

10 10 10 2 3 4 20 30 40

MR (Change in TOTAL Revenue by

10 10

Now in a MONOPOLY
If you are selling a higher quantity you will have to reduce price. What will happen to total revenue? (SHIVAM) TOTAL REVENUE will increase. What will happen to MARGINAL REVENUE? (TANVI) It will come down. Confused? Want to test?

Price Quantity TR change in Q)

MR (Change in TOTAL Revenue by

This happens because in a monopoly, if a firm wants to sell a higher Q, it has to reduce the prices, which brings down the revenue on every additional unit of output. (MR)

10
9 8

2
3 4

20
27 32

7 5

A Monopolys Revenue
Quantity 0 1 2 Price 11 10 9 Total Revenue 0 10 18 Average Revenue 0 10 9 Marginal Revenue 10 8 P=AR P> MR MR<P, BECAUSE WHEN A FIRM WANTS TO SELL A HIGHER QUANTITY IT HAS TO REDUCE PRICES.

3
4 5 6 7 8

8
7 6 5 4 3

24
28 30 30 28 24

8
7 6 5 4 3

6
4 2 0 -2 -4

12

10

AR
2

Average Revenue
Marginal Revenue

0 1 2 3 4 5 6 7 8 9

-2

-4

MR

-6

From the earlier schedule we find out that as the output increases, the price comes down, in other words if a monopolist wants to sell more, it has to reduce the price. The marginal revenue is always less than the price. As a monopoly increases its output , there are two effects on its revenue: 1) The output effect : The output sold is more. Hence Q is more. 2) The price effect: The price falls. Hence P is lower. In the case of a competitive firm there is no price effect, because no matter what is the quantity sold, the price will remain the same.

But in a monopoly, if a firm wants to sell more, it has to reduce its price. This the price effect.
AT TIMES MR CAN GO IN NEGATIVE IF PRICE EFFECT IS MORE THAN OUTPUT EFFECT

PROFIT MAXIMIZATION Now that we know what the revenue of a monopoly, we have to find out how does a monopoly maximize its profit.

MC

ATC

MONOPOLY PRICE

PROFIT MAXIMISATION QUANTITY:

P=MR=MC
A DEMAND AR IN A MONOPOLY P> MR=MC HENCE MONOPOLY PRICE WOULD BE AT POINT B

MR Q1 Q MAX Q2

A MONOPOLYS PROFIT
Profit= ( P-ATC ) X Q

MC
Monopoly Price

c ATC

ATC

DEMAND MR

Q Max

The welfare cost of monopoly

In a competitive market a firm charges a price which is equal to its MC and MR. But monopoly charges a price which is more than its MC and MR. So from the standpoint of sellers it is good, but the buyers have to suffer. So is Monopoly desirable from the viewpoint of society. We can answer this question using welfare economics. Efficient allocation is at the point where consumer surplus is equal to producer surplus. A point where cost to sellers and value to buyers is same. Deadweight loss MC mc Value to buyer is more than Cost to seller Value to buyer is less than Cost to seller DEMAND

atc mr demand

Efficient quantity

Mon q

Efficient q

The Monopolys profit: A Social Cost

Because of market power, a monopoly is able to charge an extra dollar and a buyer looses an extra dollar. But it ultimately does not reduce the total surplus. In other words it does not affect the size of the pie. But when a monopoly in order to earn a higher price reduces its quantity, it is here where the economic well being is effected.

Public Policy towards Monopolies:

A monopoly fails to allocate resources efficiently. Monopolies produce less than the socially desirable quantity and hence are able to raise their prices. Policy makers in the government can respond to this problem in the following ways:

1) By trying to make this monopolized markets more competitive. (Increasing Competition). 2) By regulating the behavior of monopolies.

Increasing Competition with antitrust laws

If pepsi and coca-cola wanted to merge, the deal would be closely examined by the federal government before it went into effect. The lawyers and economists in the department of justice might well decide that a merger between these two companies will make the U.S cold drink market less competitive and would reduce the economic well being as a whole. The government derives this power over private industry from these anti-trust laws, a collection of statues aimed at curbing monopoly power. The anti trust laws give the government various ways to promote competition. They allow the government to prevent

Regulation

Another way in which the government deals with the problem of monopoly is by regulating the behavior of monopolists. This solution is common in the case of natural monopolies, such as water and electric companies. These companies are not allowed to charge any price they want. Instead government agencies regulate their prices.

Public Ownership
The third policy used by the government to deal with monopoly is public ownership. That is rather than regulating a natural monopoly that is run by a private firm, the Government can run the monopoly itself.

DOING NOTHING
Each of the above mentioned remedies have drawbacks. At times it is best for the government to do nothing.

Price Discrimination
At times firms charges different prices to different customers for the same good. Even if the price of producing those goods is same. Discrimination is not possible if a firm is operating in a competitive environment. It is possible in a monopoly because a firm in a monopoly has market power. To understand why a monopolist wants to price discriminate, let us consider the following example. Suppose chintan is the owner of a publishing house. He purchases the rights to publish a novel for 2million. Now he has found from the marketing department that there are 1,00,000 die-hard fans who can pay upto Rs.30 for the book.

Now suppose the marketing department makes an another discovery, the two categories of customers are from two different countries, then chintan can sell to both of them at Rs.30 as well as Rs.5. Hence he does not loose any surplus and also no deadweight loss

occurs. Hence by price discrimination he increases

economic welfare.

In Buses there is a concept of HALF-TICKET. Suppose an adult is charged Rs.10 for travelling. If he is with a kid who is 5 years old. The person will not be willing to pay Rs.10 for a kid, he might be willing to pay Rs.5. If the government does not allow a price of Rs.5 then everyone who wants to travel will not travel. But if the government price discriminates on the basis of AGE. Then there will be no deadweight loss and everyone will be able to travel. Hence Price discrimination increases total welfare.

The Moral of the story

There are three lessons to be learned from the above story: 1) Price discrimination is a profit maximization strategy for a monopolist. 2) In order to price discriminate the monopolist needs some criteria to segment customers. Like in the above story it was geography. Similarly other criterias can be age, sex etc. 3) Price discrimination can increase economic welfare. By providing the book to the 400000 less enthusiastic readers. Thus price discrimination can eliminate the inefficiency inherent in monopoly pricing.

The Analytics of Price Discrimination

Lets consider a bit formally the analytics of how price

discrimination affects economic welfare. We begin our

discussion by assuming that a monopolist price discriminates perfectly. Perfect price discrimination means a situation in which the monopolist knows exactly how much a customer is willing to pay and charges differently to every customer.

The monopolist gets the entire surplus in every transaction.

Welfare with and without price discrimination

Suppose that a monopolist

charges a single price to all the customers.

price

Consumer surplus
Because the price is above the marginal cost, some customers do not buy the goods, hence there is deadweight loss.

MONOPOLY PRICE

Producer surplus

Deadweight loss MC

AR
Quantity sold MR quantity

If a monopolist can price discriminate perfectly then consumer surplus is zero, total surplus now equals the profit.

profit Because the monopolist price discriminates and knows exactly the willingness of every customer. He is able to sell to all t he customers and there is no deadweight loss.

Marginal cost

demand

Quantity sold

In reality however perfect price discrimination is not possible. Because consumers do not walk around with hangers in their neck expressing their willingness to pay. Instead Monopolists divide consumers in groups like

YOUNG,OLD,MALE, FEMALE and so on.

Hence there is no perfect price discrimination but imperfect price discrimination.

Examples of price discrimination

Movie tickets: For children and senior citizens a theater charges less. Hence it increases its profit by doing so. Airline tickets: Airlines also charge differently to different clients. For eg a client who prefers a two way travel, will be charged less in comparison to a one way traveler.

Discount coupons: Many companies offer discount coupons to customers, in newspapers, on bulk purchases and so on.
Financial Aid: A college for example can charge a lower fee form a needy student.

Quantity Discounts: Till now we have studied that a firm can discriminate from different customers, but at times a firm can charge different prices to the same customer on the basis of his purchase.

Competition versus Monopoly: A summary comparison

Similarities : Goal of firms Competition Profit Maximization Monopoly Profit Maximization

Rule For Maximizing

Can earn economic Profits in the short run? Differences: Number of firms Marginal Revenue Price Produces welfare maximizing level of output? Entry in the long run? Can earn economic profits in the long run? Price discrimination possible?

MR=MC

MR=MC

YES

YES

MANY MR = P P=MR YES YES NO NO

ONE MR<P P>MR NO NO YES YES