FMG 24: Monopoly Market

Monopoly Market
This an extreme market situation where there is only one seller and
many buyers.
In a monopoly market, as a sole producer of the product, firm can
control the price and quantity supplied but up to a certain extent.
This indicates that firm can not charge any price it wants at least
with an objective to maximize profit.
A monopolists individual demand curve possesses the same
general properties as the industry demand curve for perfectly
competitive market. Clearly, this indicates that firms Individual
demand curve is the industry demand curve.

Monopoly Market
The quantity of its sales is a single-valued function of the price which it charges:
q = f(p), where
dq
0
dp

Therefore the inverse demand curve will be a single valued function of quantity
p= f(q) , where
dp
0
dq

This indicates that firm can not set both p and q independently.

Reasons for Monopoly

A monopoly occurs when barrier to entry prevents a
second firm from entering a profitable market.
Among the possible barriers to entry are patents,
network externalities, government licensing, the
ownership or control of a key resources, large economies
of scale in production.
Another way to get monopoly power is to hire lobbyists
and other policy makers to grant monopoly power.
Rent seeking is a process of using public policies to gain
economic profit. Rent seeking is inefficient because it
uses resources that could be used in other ways. (e.g.,
Coca cola in campus, Casino in Kolkata)

AR and MR of Monopoly
Total revenue = TR = p.q
MR

Since

dq
0
dp

d (TR)
dp
dp
p q.
AR q.
dq
dq
dq

MR p
d (TR)
dp
MR
p q.
dq
dq

[ in case of perfect competition market

therefore an increase in the volume of sales increases the TR]

but

dp
0
dq

Here, monopolist must decrease his price if it wants to sale extra unit of its output.
This indicates that MR will be downward from left to right.
Since MR is downward sloping, AR will also be downward sloping.

AR and MR of Monopoly
Demand is monotonically decreasing.
MR < price for every output greater than zero.,
because

Price per
unit

MR

d (TR)
dp
p q.
dq
dq

in case of monopoly
MR

AR
(Demand)

Therefore from the slope of MR and AR

we can say slope MR is twice steeper
than the slope of AR. Thus MR passes
through the half of the distance from
intersection point between AR and
horizontal axes.

dp
0
dq

p a bq
TR aq bq 2

and AR
output

but

Therefore

MR

TR
a bq
q

dR
a 2bq
dq

dp
b Constant
And
dq
dp

q
bq
Since
dq

The distance between the two curves is a linear

function of output.

Output Decision of Monopoly

Price per
unit

Market equilibrium condition is MR=MC.

Here equilibrium output is Q*.
Is this profit maximizing output?
If monopoly produces an amount Q1 > Q* he will be
able to sell that at the price P1.
In this case MR>MC and firm will produce more to
increase its total profit.
Similarly if firm produces Q2 > Q* then MC> MR and in
this case firm can increase its profit by reducing the
level of production from Q2.
Therefore output will be maximum at MR=MC

Lost profit from producing

too little (Q1) and selling at
too high price( p1)

MC
AC

P1
P*
P2
MR

AR
(Demand)

Lost profit from producing too much

(Q2) and selling at too low price( p2)
Q1 Q* Q2

output

Output Decision of Monopoly

The monopolists total revenue and total cost can be expressed as a function of output.
TR f (q)
TC h(q)

therefore, = f (q) h(q)

d
d (TR) d (TC )

f ' (q ) h ' (q ) 0
dq
dq
dq

From F.O.C. of profit maximization we get

i.e., MR MC 0
Monopolist can increase profit by expanding or contracting its output, as long as the addition to its
revenue (i.e., MR) exceeds the addition to its cost (i.e., MC).
d 2
' '
' '

f
(
q
)

h
(q ) 0
to get the condition from the S.O.C. of profit maximization we get
2
dq
' '
' '
or, f (q) h (q) i.e., slope of MR < slope of MC
p

MC

MC

p0
MR
q0

MC

AR
q

MR

MR

AR

AR
q

Equilibrium Output of a Monopoly

If demand faced by a monopolist is p= 100-4q
And cost function is C= 50+20q
Then profit will be TR TC
Where
TR p.q 100q 4q 2
From profit max condition we get

d
d (TR)
d (TC )

MR MC 0
dq
dq
dq

Here in this problem MR 100 8q

MC 20
Therefore 100 8q 20
or, q 10
Now substituting the value of q in the demand function we get p 60
And from profit function we get 350
2
from the SOC we get d
8 0
2
dq

Effects on Price and Quantity: Monopoly Market Vs PC Market

Equilibrium in Monopoly attains at A where MR=MC and price is P1 and output is Q0
Equilibrium at PC market attains at C where equilibrium output and price are Q1 and P0
respectively.
This indicates that monopoly produces less than what it could produce in the perfectly competitive
market and charges higher price than the perfect competition market.
Clearly monopoly will produce less efficiently than what it could produce in the PC market.
We assume that industry is a constant cost industry.
Price

Price
Market
Demand

P1

Market
Demand

P0

LAC=LMC

MR
Q0

P0

AR
Q(drugs/hour)

LAC=LMC
AR

Q1

Q(drugs/hour)

Monopoly and Elasticity of Demand

In case of monopoly MR will be positive.
again from the relation between MR and Elasticity we know that

q dp
1
MR p 1
1

p
dq
e

Since a producer will produce the unit for which MR > 0

1
Therefore p
1 e
0

1
or,
1 e
0, since p > 0

1
or, 1>
e

or, e 1
This indicates that monopoly will produce at a point where its demand curve is elastic

Supply Curve of Monopoly

Monopoly does not have a supply curve. There is no function of price that
determines what quantity a firm will offer given a price. Instead, the quantity a firm
offers is determined by the entire demand curve it faces.
In a competitive market supply decisions are made based on just price (the
demand curve faced by a single firm is horizontal at some price). In a monopoly,
supply decisions need more than just the knowledge of one price.

Since there is no supply curve how a monopolist will set the price?

A Rule of Thumb for Pricing

How a manager of a firm find the correct price and output?
Most managers have limited information about AR and MR that their firms face.
Similarly, they might know the firms marginal cost only over a limited output range.
We therefore want to translate the condition that MR = MC into a rule of thumb that can be more
easily applied in practice.
We know MR dTR d ( P.Q)
dQ

dQ

Note that extra revenue from an incremental unit of quantity,

1.
2.

d ( P.Q )
has two components:
dQ

Producing one extra unit and selling it at price p brings in revenue (1)(P)=P.
Because of the downward-sloping demand curve one extra unit of sell results a small drop in

price dP , which reduces the revenue from all units sold ( i.e., changes in revenue Q. dP

dQ

q dp
dp
Therefore MR p q.
p p

dq
p
dq

1
or , MR p p

e
D

dQ

A Rule of Thumb for Pricing

From profit max condition MR=MC we get
1
Therefore, MC p p

e
D

1
p MC
or ,

e

p
D

LHS shows the mark up over marginal cost as a percentage of price. Rearranging the term
we get
MC
p
1
1

e
D
A Monopolist with the help of its cost structure and elasticity of demand can set the price

Monopoly Power
In a perfectly competitive market price equals to MC whereas in Monopoly price exceeds MC.
Therefore we can measure monopoly power by examining the extent to which the profitmaximising price exceeds MC. This measure was introduced by Learner.

Learners Index of Monopoly

( P MC )
P

1
or , L
eD
Sources of Monopoly Power
From the Learners equation we observed that lesser the elasticity of demand higher will be the
monopoly power.
This elasticity depends on1. Nature of the demand of the product
2. Numbers of firms producing close substitute (greater number of firms reduces the monopoly
power)
3. Interaction among the firms ( less aggressive attitude can help the firms to earn more profit).

Price Discrimination
The monopolist need not always sell her entire output in a single market for a uniform
price.We can discuss two different cases here.
Market Discrimination

There are two markets. Revenue earned from each markets are R1(q1) and R2(q2).
Total cost of producing q1 and q2 units in two different markets is C(q1 +q2 )
Therefore R1 (q1 ) R2 (q2 ) C (q1 q2 )
Now from the F.O.C. we get
d
R1' (q1 ) C ' (q1 q2 ) 0
dq1
d
R2' (q2 ) C ' (q1 q2 ) 0
dq2

'
'
'
'
Equating these two get R1 (q1 ) C (q1 q2 ) R2 (q2 ) C (q1 q2 )
or , R1' (q1 ) R2' (q2 ) C ' (q1 q2 )

Or, MR1= MR2=MC

This implies that MR in each market must be equal to the MC of total output as a whole

Price Discrimination
Sometimes monopoly firm charge different price for different consumer.
Basic idea of price discrimination is to increase total revenue. Depending on the pattern of the
price charged price discrimination can be classified as

1st order price

discriminationEvery consumer pays a
different price which is
equal to his or her
willingness to pay.

2nd order price

discriminationin this case consumer
pays the minimum
amount that he/she is
willing to pay for a
particular product.

3rd order price

discrimination- in this
case monopoly charge
different price for
different groups of
customer.

A monopolist may charge different price in the different price in the

different market depending on the nature of the market.

Price Discrimination: Example of First Degree Price Discrimination

In Sarojini Nagar Market or at Lajpat
Nagar Market or any other flea market
buyers often need to bargain to show that
his/her willingness to pay is minimum
for a specific good. Seller normally sells
at a max price that a consumer willing to
pay given that the price is above his cost
of production.
This helps to increase sell

Price Discrimination: Example of Third Degree Price Discrimination

In the year 2004 one Financial Times reporter pretended to book a car rental
through Avis Website for four days from Los Angeles International Airport. As a
part of the booking process you are asked for your home country. The reporter
examined with different countries and received the following rate quotes.
Country

Rate

Australia

$198

India

$198

UK

$162

France

$159

Germany

$156

South Africa

$156

United States

$153

Canada

$132

Brazil

$120

Price Discrimination: Math Problem(Demonstration)

Suppose market demand in market 1 and market 2 are p1 80 5q1 and
And Cost function is C 50 20(q1 q2 ) where, q q1 q2

p2 180 20q2

Therefore R1 80q1 5q 21 and R2 180q2 20q 2 2

Or,
MR1 80 10q 1
MR2 180 40q 2
And MC of total output as a whole MC

dC
20
dq

Therefore from equilibrium condition we get MR1 80 10q 1 20.........(i)

MR2 180 40q 2 20.......(ii )
Solving equation (i) and (ii) we get

q1 6

p1 50

q2 4

p2 100

450

What are the conditions of Price Discrimination?

Price Discrimination: Math Problem

Problem: A monopoly sells in two markets:
p1(x1)=100-x1 and p2(x2)=80-x2.
a) Calculate the profit-maximizing quantities and the profit at these quantities, if the cost
function is given by C(X)=X2.
b) Calculate the profit-maximizing quantities and the profit at these quantities, if the cost
function is given by C(X)=10X.
c) What happens if price discrimination between the two markets is not possible anymore?
Consider C(X)=10X.
Hints: Differentiate between quantities below and above 20.

Solution :a) M 1400,

b) M 3250,
c) M 3200

Price Discrimination: Discount Coupon for Price Discrimination

Very often we find firms distribute coupons (by mail or in newspapers) which give
a rebate for the product.
Why is it better to give out coupons as compared to a general price cut??

1
2
3

Coupon users are more price-sensitive

Only a small proportion of coupon receivers actually use them

to claim the rebate

Coupon reminds the customer each time that she gets lower
price

How to set an optimal coupon?

Price elasticities of rich (R) and poor (P) clients: eR 2 and eP 5
Now let regular price = P
And Price with coupon = P-X
Also assume that MC = 2
When a firm sets price in two different market, equilibrium attains at MR1 MR2 MC
Now if elasticity of demand with rich and poor people are eR and eP respectively
then from the equilibrium condition we get
1
1
or, P 1 P X 1 MC
eR
eP

Solving this we get P=4, X=1.5

Multi-plant Monopolist
A monopolist selling in a single market but producing at different location
In this case his profit function will be R (q1 q2 ) C1 (q1 ) C2 (q2 )
From F.O.C. we getd
dq1

R ' (q1 q2 ) C1' (q1 ) 0

d
R ' (q1 q2 ) C2 ' (q2 ) 0
dq2

From the above two equation we get

R' (q1 q2 ) C1' (q1 ) C2' (q2 )

Or, MR = MC1 = MC2

This indicates that MC in each plant must be equal the MR of the output as whole

Multi-plant Monopolist: Math Problems

Problem: Suppose the inverse demand for a monopolists product is given by
P(Q) 70 0.5Q
The monopolist can produce output in two plants. The marginal cost of producing
in plant 1 is MC1 = 3Q1,
and the marginal cost of producing in plant 2 is MC2 = Q2.
How much output should be produced in each plant to maximize profits, and what
price should be charged for the product?
Solution: Do it Yourself

Taxation and Monopoly Output

Types of tax can be
1. Lump-sum tax
2. Profit tax
3. Sales tax based upon the quantity sold or value of sales
Lump-sum Tax

Monopolist cannot avoid lump-sum tax regardless the physical quantity or value of
its sales.
In this case R(q) C (q) T
From FOC we get

d
R ' (q ) C ' (q ) 0
dq

Therefore R' (q) C ' (q) 0

Or, MR=MC

Taxation and Monopoly Output

Profit Tax

A profit tax requires that the monopolist pay the government a specified
proportion of the difference between its TR and TC. If the tax is a flat rate t of profit
then
R( q ) C ( q ) t R ( q ) C ( q )
or , (1 t ) R(q) C (q)

where, 0< t 1

d
'
'

(1

t
)
R
(
q
)

C
(q )
From the FOC we get dq

or , R' (q) C ' (q) 0

since (1 t ) 0

Therefore MR= MC
In this case total volume of profit will be less

Taxation and Monopoly Output

Specific Tax

If a specific sales tax of t Rs. Per unit of output is imposed then

R(q) C (q) t.q
From FOC we get

d
R ' (q) C ' (q) t 0
dq

or , R' (q) C ' (q) t

therefore monopolist maximizes profit after tax payment by equating MR with MC

plus the unit tax

In this case equilibrium price and output will change

Now we can deal with some real world problems

Thank You!