SREE NARAYANA GURUKULAM COLLEGE OF ENGINEERING

DEPARTMENT OF MANAGEMENT STUDIES

ECONOMICS FOR MANGERS

TOPIC: Pricing Under Monopoly

Submitted By:NAHIDH.N.A. Semester: 1st Semester (G1) Date of Submission: 18-10-11

MONOPOLY MEANING: The word monopoly has been derived from the combination of two words i.e,mono and poly.Mono refers to a single and poly to control. In this way, monopoly refers to the situation in which there is only one seller of a commodity. There are no close substitutes for the commodity it produces and there are barriers to entry. The single producer may be in the form of individual owner or a single partnership or a joint stock company. Thus, in monopoly there is no difference between firm and industry. Monopolist has full control over the supply of commodity. Thus, as a single seller monopolist may be a king without a crown. If there is to be monopoly, the cross elasticity of demand between the product of the monopolist and the product of any other seller must be very small. DEFINITION: "Monopoly refers to a market where there is a single seller for a product and there is no close substitute of the commodity that is offered by the sole supplier to the buyers. The firm constitutes the entire industry". According to Koutsoyiannis:Monopoly is a market situation in which there is a single seller. There are no close substitutes of the commodity it produces; there are no barriers to entry. Pure or absolute competition exists when a single firm is the sole producer for product for which there are no close substitutes. -Mc Connel FEATURES: 1. 2. 3. 4. 5. One seller and Large number of buyers. No close substitutes. Difficulty of Entry of new firms. Monopoly is also an industry. Price maker.

EXPLANATION: Monopoly, therefore, indicates a case where: (i) There is only a single seller of a product or service in the market. (ii) The goods produced by a sole seller have not close substitutes. (iii) The entry of new firms into the industry is effectively barred by legal or natural barriers. (iv) The firm being the sole supplier of a product constitutes industry. Firm and industry thus have single identity. Or we can say monopoly is a single firm identity.

(v) The single seller affects no other seller by its own action in the market. The other sellers too cannot affect the price and output of the monopolist. (vi) The demand curve facing the monopolist is negatively sloped. The monopolist being the only seller of the commodity in the market can increase the total sale by lowering the price and if, he raises the price, he would not lose his entire sale. The demand curve facing a monopolist is less than perfectly elastic, i.e., it slopes downward from left to right. For the monopoly to exist, it is not necessary that the size of a firm should be large. Even a small firm may have a monopoly. For instance, a local water company or a local electricity company, supplying water and electricity in the city possesses all the characteristics of a monopoly. SHORT RUN EQUILIBRIUM UNDER MONOPOLY In the short period, the monopolist behaves like any other firm. A monopolist will maximize profit or minimize losses by producing that output for which marginal cost (MC) equals marginal revenue (MR). Whether a profit or loss is made or not depends upon the relation between price and average total cost (ATC). It may be made clear here that a monopolist does not necessarily makes profit. He may earn super profit or normal profit or even produce at a loss in the short ran. Conditions for the Equilibrium of a Monopoly Firm: There are two basic conditions for the equilibrium of the monopoly firm to fulfill: I. II. MC = MR. MC curve cuts MR curve from below.

Explanation: (a) Short Run Monopoly Equilibrium with Super Normal Profits: In the short period, if the demand for the product is high, a monopolist increases the price and the quantity of output. He can increase the, output by hiring more labor, using more raw materials, increasing working hours etc. However, he cannot change his fixed plant and equipment. In case, the demand for the product falls, he then decreases the use of variable inputs, (like labor, material etc.). As regards the price, the monopolist is a price maker. There is a greater tendency for the monopolist to have a price which earns positive profits. This can only be possible if the price (AR) is higher than average total cost (ATC). The short run profit earned by the monopolist is now explained with the help of the diagram (16.3) below.

In this diagram, the monopoly firm is in equilibrium at point K where SMC = MR. The short run marginal cost (SMC) curve cuts MR from below. At point K both the equilibrium conditions are fulfilled. As a result, therefore, OE is monopoly price and OB, the monopoly output. At the monopoly output OB, the average total cost OF = BN. The profit per unit is FE. The short run monopoly profit is ETNF, It is represented by the area of shaded rectangle in figure 16.3. At the output smaller than OB (say at point P) MR > SMC. Therefore, increased output up to B adds more to total receipts than to total costs. In case, the output is increased beyond OB, the MR < SMC. Hence, the increased outputs beyond OB add more to total cost than to total receipts. This causes profits to decrease. So the best level of output for the monopolist firm is that where SMC curve cuts the MC curve from below.

(b) Short Run Equilibrium with Normal Profit There is a false impression regarding the powers of a monopolist. It is said that the monopolistic entrepreneur always earns profits. The fact, however, is that there is no guarantee for the monopolist to earn profit in the short run. If a monopolist firm produces a new commodity and attempts to change the taste pattern of the consumers through advertising campaigns etc., then the firm may operate at normal profit or even produce at a loss minimizing price in the short run (Covering variable cost only). The normal profit short run equilibrium of the monopoly firm is explained, in brief, with the help of the diagrams.

In figure (16.4), a firm is in the short run equilibrium at point K, where SMC = MR. The price line is tangent to SAC at point C. The firm charges CB price per unit for units of output OB. The total revenue of the firm is equal to the area OPCB. The total cost of the firm is also equal to the area OPCB. The firm earns only normal profits and continues operating.

(c) Short Run Equilibrium With Minimum Losses A monopolist also accepts short run losses provided the variable costs of the firm are fully covered. The loss minimizing short run equilibrium analysis is presented graphically.

In this figure (16.5), the best short run level of output is OB units which is given by the point L where MC = MR. A monopolist sells OB units of output at price CB. The total revenue of the firm is equal to OBCF. The total cost of producing OB units is OBHE. The monopoly firm suffers a net loss equal to the area FCHE. If the firm ceases production, it then has to bear to total fixed cost equal to GKHE. The firm in the short run prefers to operate and reduces its losses to FCHE only. In the long, if the loss continues, the firm shall have to close down.

LONG RUN UNDER EQUILIBRIUM MONOPOLY The monopolist creates barriers of entry for the new firms into the industry. The entry into the industry is blocked by having control over the raw materials needed for the production of goods or he may hold full rights to the production of a certain good (patent) or the market of the good may be limited. If new firms try to enter in the field, it lowers the price of the good to such an extent that it becomes unprofitable for new firms to continue production etc. When there is no threat of the entry of new firms into the industry, the monopoly firm makes long run adjustments in the scale of plant. In case, the demand for the product is limited, the monopolist can afford to produce output at sub optimum scale. If the market size is large and permits to expand output, then the monopolist would build an optimum scale of plant and would produce goods at the minimum cost per unit. However, the monopolist would not stay in the business, if he makes losses in the long period. The long run equilibrium of a monopoly firm is now explained with the help of the following diagram.

In the long run, all the factors of production including the size of the plant are variable. A monopoly firm will maximize profit at that level of output for which long run marginal cost (MC) is equal to marginal revenue (MR) and the LMC curve intersects the MR curve from below. In the figure (16.6), the monopoly firm is in equilibrium at point E where LMC = MR and LMC cuts MR curve from below. QP is the equilibrium price and OQ is the equilibrium output. At OQ level of output, the cost per unit is QH (LAC), whereas the price per unit of the good is QP. HP represents the per unit super normal profit. The total super normal profit is equal to KPHN. It may here be noted that at the equilibrium output OQ, the plant is not being fully utilized. The long run average cost (LAC) is not minimum at this level of output OQ. The firm will build an optimum scale of plant only if the demand for the product increases. PRICE DISCRIMINATION The practice on the part of the monopolist to sell the identical goods at the same time to different buyers at different prices when the price difference is not justified by difference in costs in called price discrimination. "Price discrimination is the act of selling the same article produced under single control at a different prices to the different buyers". -Mrs. John Robinson

Types and Examples of Price Discrimination: Price discrimination may be of various types. It may either be (i) personal (ii) trade discrimination (iii) local discrimination. (1) Price discrimination: - It is persona!, when separate price is charged from each buyer according to the intensity of his desire or according to the size of his pocket. For instance, a doctor may charge $20000 from a rich person for an eye operation and $500 only from a poor man for the similar operation. (2) Trade discrimination:- It may take place when a monopolist charges different prices according to the uses to which the commodity is put. For example, an electricity company may charge low rate for electric current used in an industrial concern than for the electricity used for the domestic purpose.

(3) Place discrimination:- It occurs when a monopolist charges different prices for the same commodity at different places. This type of discrimination is called dumping. CONDITIONS FOR PRICE DISCRIMINATION: The basic condition required is:1. Difference in elasticity of demand- Price discrimination is possible only when elasticity of demand will be different in different markets. 2. Market Imperfections-Generally, price discrimination is possible when there is some degree of market imperfections. 3. Differential Product-Price discrimination is possible when buyers need the same service in connection with differentiated products. 4. Legal Sanction- Price discrimination is legally sanctioned. As, Electricity Board charges lowest for electricity for domestic use and highest for commercial houses. 5. Monopoly Existence- Price Discrimination is also called discrimination monopoly. DEGREES OF PRICE DISCRIMINATION:There are three main degrees of price discrimination:(1) First degree price discrimination. The monopolist charges a different price equal to the maximum amount for each unit of the commodity from each consumer separately. The price of each unit is equal to its demand price so that the consumer is unable to enjoy any consumer surplus. Such prices are charged by doctors, lawyers etc. In fact, the first degree price discrimination manifests itself in the form of as many prices as many consumers. (2) Second degree price discrimination. Here the monopolist divides his market into different groups of customers and charges each group the highest price which the marginal consumer belonging to that group is willing to pay. The railway, airlines etc., charge the fares from customers in this way. (3) Third degree price discrimination. In the third degree price discrimination, the monopolist divides the entire market into a few sub-markets and charges different prices for the same commodity in different sub-markets. The division here is among classes of consumers and not among individual consumers. Third degree price discrimination is possible only if the classes of consumers can be kept separate. Secondly, the various groups of customers must have different elasticity of demand for his commodity. The segment with a less elastic demand pays a higher price than the segment with a more elastic demand. The consumer faces a single price in each category of consumers. He can purchase as much as desired at that price. It is the most common type of price discrimination. For example, movie theaters, railways, typically charge lower prices to senior citizens, students etc. Conditions of Price-Discrimination: There are three main types of situation: (a) When consumers have certain preferences or prejudices. Certain consumers usually have the irrational feeling that they are paying higher prices for a good because it is of a better quality, although

actually it may be of the same quality. Sometimes, the price differences may be so small that consumers do not consider it worthwhile to bother about such differences. (b) When the nature of the good is such as makes it possible for the monopolist to charge different prices. This happens particularly when the good in question is a direct service. (c) When consumers are separated by distance or tariff barriers. A good may be sold in one town for Re. 1 and in another town for Rs. 2. Similarly, the monopolist can charge higher prices in a city with greater distance or a country levying heavy import duty. CONDITIONS MAKING PRICE DISCRIMINATION POSSIBLE AND PROFITABLE: The following conditions are essential to make price discrimination possible and profitable: (a) The elasticity of demand in different markets must be different. The market is divided into submarkets. The sub-market will be arranged in ascending order of their elasticity, the higher price being charged in the least elastic market and vice versa. (b) The costs incurred in dividing the market into sub-markets and keeping them separate should not be so large as to neutralize the difference in demand elasticity. (c) There should be complete agreement among the sellers otherwise the competitors will gain by selling in the dear market. (d) When goods are sold on special orders because then the purchaser cannot know what is being charged from others. PRICE DISCRIMINATION BY DUMPING:Dumping is a special case of price discrimination. Dumping is a situation in which the price, firm charges for its goods in a foreign market is lower than either the price it charges in its home market or the production cost. Dumping thus is the sale of surplus output of a firm on foreign markets at below cost price. Dumping also occurs when a firm sells its products at a higher price in the home market and at a lower price in the foreign market. In Economics, a monopolist sells the same commodity at a higher price in one market and at a lower price in the other. Dumping may be undertaken due to several reasons:(a) A monopolist may resort to dumping in order to dispose off the accumulated stock or (b) He may, dump the commodity with a desire to capture the foreign market, (c) Dumping may also be done to drive the competitors out of the market, (d) The motive may also be to reap. The economies of large scale production, etc. Misconceptions Concerning Monopoly Pricing: 1. Monopolist is interested in maximum profit and not in maximum price:

Because monopolist can manipulate output and price so it is often alleged that a monopolist will charge the highest price he can get. It is believed that price under free competition are lower than monopoly. This is clearly a misguided assertion. Under certain conditions, things may be altogether different. 2. Maximum total profit and not maximum profits per unit: The profit per unit may be higher at higher price but the total profit will be higher at lower price.it is therefore better to sell lower price than to sell less at a higher price. 3. Economies of scale: The monopolist may enjoy certain economies like a better and cheaper utilization of by-products, cheaper raw material, better and cheaper methods of production, lower cost of advertisement and so on than under free competition. 4. Law of increasing returns: If the commodity is produced under the Law of Increasing Returns, the monopolist may be producing more at lower costs and selling at lower prices. The policy may help him to earn higher total revenue. The consumer may also buy larger output at lower prices. MONOPOLY REGULATIONS:A monopolist, being the sole supplier creates some undesirable aspects in the market: (i) Monopoly leads to concentration of price and output of wealth which is against the spirit of equality in the society. (ii) The monopoly price of a good is usually higher than that prevailing under competition. The consumer has to pay higher prices for the products. (iii) Monopoly is an inefficient type of market structure. (iv) A monopoly firm does not bother to improve the quality of the product as there is no effective threat of the new firms to enter into the industry. (v) A monopoly firm exploits the workers and pays them less wages.