Monopoly

Number of Firms
Many
firms
Type of Products

One Few Differentiated Identical

firm firms products products

Monopolistic Perfect
Monopoly Oligopoly Competition Competition

• Tap water • Tennis balls • Novels • Wheat

• Indian Railways • Crude oil • Movies • Milk

Copyright © 2004 South-Western

 Monopoly
• Sole producer of a commodity with no close substitutes
(low c.p.elasticity)
• “price-maker”
• Substantial barriers to entry
• Constrained by downward sloping demand curve → set
P, choose Q, or set Q, choose P <output expansion vs
price reduction effect>

• Sources of Market Power (= ability of a firm to raise price

without losing ALL its sales)
– Control over critical inputs
– Economies of scale
– Patents
– Licenses
– Gestation lags
– Consumer loyalty
 Monopoly Profit Maximization
• When a monopolist maximizes its profit by selling a positive amount, its
marginal revenue must equal its marginal cost at that quantity
– If marginal revenue exceeded marginal cost the firm would be better off selling
more
– If marginal revenue were less than marginal cost the firm would be better off
selling less
• Two-step procedure for finding the profit-maximizing sales quantity
• Step 1: Quantity Rule
– Identify positive sales quantities at which MR=MC
– If more than one, find one with highest profit
• Step 2: Shut-Down Rule
– Check whether the quantity from Step 1 yields higher profit than shutting down
 The Profit Maximising Monopolist

• The monopolist operates on elastic portion of demand

curve because MR becomes negative in the
inelastic region
• Shutdown condition
Short run: p<SAVC, i.e. demand curve
everywhere lies below the SAVC curve
Long run: p<AC, i.e. demand curve everywhere
lies below the AC curve
Monopoly Profit Maximization
 Markup
• A monopolist facing a downward sloping demand curve will set
its price above marginal cost
– Firm in a perfectly competitive market sets price equal to marginal
cost, meaning that the firm has no market power
• Extent to which price exceeds marginal cost is a measure of
monopolist’s market power --- markup, price-cost margin, or
Lerner index P  MC 1
 d
P E
• less elastic the demand curve, greater the firm’s markup
• less elastic the demand is, more attractive raising the price is
• This also implies that demand must be elastic at the profit-
maximizing price
 The Profit Maximising Monopolist-II
• Monopolies in the long run

– Economic profits are not eliminated

– Monopoly firm adjusts its plant size according to
changes in demand in the long run
– Short run – change in demand→ move along MC for
new (P,Q)
– Long run - change in demand→ adjust plant size so
that cost of producing optimal level of output is least
– LRAC > P→ exit the market
 Welfare Effects of
Monopoly Pricing
• By charging a price above marginal cost, the monopolist makes
consumers worse off than under perfect competition
– Consumers who buy the product pay more for it
– Some who would have bought it under perfect competition will not buy
it at the higher price
• Welfare effects of monopoly pricing:
– Firm gains
– Consumers lose
– Deadweight loss incurred
• Deadweight loss from monopoly pricing is the amount by which
aggregate surplus falls short of its maximum possible level, which
is attained in a competitive market
 Public Policy Towards Monopolies
• Political pressure and • Regulating existing
economic concern about monopolies
market dominance – Price regulation
• First Best -perfect
• Cartels and multiplant information
• Second Best
monopolies- “fewer”
– Natural monopolies
members → more π
• State ownership
• Marginal cost pricing
• Prevention of formation of • Average cost pricing
monopolies – MRTP Act / • Rate of return
Competition policy regulation
• Auction monopoly
rights
A Natural Monopoly

Since MC=10 when MC intersects

demand, set P=10? (first best
solution)
Firm will make loss.
• subsidise till firm makes zero 
• set price at AC(80) = 20
• use rate of return
• auction monopoly rights and
leave firm to set its own price
 Concept of Double
Marginalisation
– Q: What’s worse than one monopolist?
– A: Two monopolists
• Each firm then prices at a mark-up over
marginal cost.
• Recall that pricing above MC yields
deadweight losses
• Now these are being incurred twice!
• E.g. : Retailer and wholeseller are
monopolies