economics for managers - session 12

8/3/2019 Economics For Managers - Session 12

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PSG INSTITUTE OF MANAGEMENT

MBA 2011-13 BATCH

I TRIMESTERSESSION XII- FOR BATCH C AND D

MARKETS AND COMPETITION- MONOPOLY

ECONOMICS FOR MANAGERS

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EMF Faculty P.Uday Shankar


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What is Monopoly ?

Monopoly exists when a firm produces agood or service for which there are no closesubstitutes and other firms are preventedby some type of entry barrier from

entering the market. (Thomas & Maurice) Baumol and Blinder attribute only one firm can be

present in the industry and no close substitutes for themonopolists product may exist to what is called as

Pure Monopoly. ( For instance, a citys sole providerof cooking gas cannot be called a pure monopoly asthere are other firms providing close substitutes likekerosene, fire wood and electricity.)

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EMF Faculty P.Uday Shankar


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Monopoly- Characteristics

1. Single seller in the market.

2. No close substitutes.

3. No entry for new firms.

4. One firm industry- monopoly industry isessentially one-firm industry. This

signifies that under monopoly there is nodifference between a firm and an industry.

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5) Profit in the Long Run:A monopolist can earnabnormal profit even in the long run because hehas no fear of a competitive seller. In other words,if a monopolist gets abnormal profits in the long

run, he cannot be dislodged from this position.However, this is not possible under perfectcompetition. If abnormal profits are available to acompetitive firm, other firms will enter the

competition with the result abnormal profits willbe eliminated.


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6) Losses in the Short Period: Generally, acommon man thinks that a monopoly firm cannot incurloss because it can fix any price it wants. However, thisunderstanding is not correct. A monopoly firm cansustain losses equal to fixed cost in the short period.

Therefore, anybody who would like to buy thatcommodity will buy it from the monopolist only.However, if a firm has monopoly of such a commodity

which people buy less or do not buy, it can incur losses

or it may have to stop production even. For example, ifsomeone has the monopoly of yellow hair dye, it isnatural that the firm has the possibility of incurringlosses because it is a product which people generallydon't buy.


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7) Nature of Demand Curve: Under monopoly thedemand for the commodity of the firm is less thanbeing perfectly elastic and, therefore, it slopesdownwards to the right. The main reason of thedemand curve sloping downwards to the right is the

complete control of the monopolist on thesupply ofthe commodity.

8) Price-discrimination: From the point of view of profit amonopolist can change different prices from different

consumers of his commodity. This policy is known as pricediscrimination. He adopts the policy of price discriminationon various bases such as charging different prices fromdifferent consumers or fixing different prices at differentplaces etc.


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8) Firm is a Price-Maker

9) Price-discrimination: From the point ofview of profit a monopolist can change

different prices from different consumersof his commodity. This policy is known asprice discrimination. He adopts the policyof price discrimination on various bases

such as charging different prices fromdifferent consumers or fixing differentprices at different places etc.


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10) Increased Scope for Mergers: In a monopoly, due to thedictates of a single entity, scope for vertical and/or horizontalmergers increase. The mergers take on coercive form toeffectively blot out competitors and carry on supply chainmanagement.

11) Lack of Innovation:On account of absolute market control,monopolies display a tendency to lose efficiency over a periodof time.

12) Legal Restrictions: Some entities like for eg. thegovernment run postal department has a restriction onanyone doing the same business.

13) Control over a Scarce Resource:A monopolist can have anabsolute control of a raw material. The South AfricanSyndicate is an example close to this case.


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19/09/11EMF Faculty P.Uday Shankar 9

Schedule for profit maximisation under Monopoly (T&M Part IV-Table 12.1.)

Output(Q)

Price(P)

TotalRevenue

(TR=PQ)

TotalCost

(TC)

MarginalRevenue

MR=TRQ

MarginalCost

MC=TCQ

Profit

0 40.00 0 40000 - - -40000

1000 35.00 35000 42000 35.00 2.00 -7000

2000 32.50 65000 43500 30.00 1.50 21500

3000 28.00 84000 45500 19.00 2.00 38500

4000 25.00 100000 48500 16.00 3.00 51500

5000 21.50 107500 52500 7.50 4.00 55000

6000 18.92 113520 57500 6.02 5.00 56020

7000 17.00 119000 63750 5.48 6.25 55250

8000 15.35 122800 73750 3.80 10.00 49050

9000 14.00 126000 86250 3.20 12.50 39750


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Monopoly

Draw a graph using the schedule given above andplot all the three curves viz. Average Revenue-AR,Marginal Revenue MR, Short-run Marginal Cost-SMC in the same graph.

Assumptions: The monopolist maximises profit at MR=MC.

Patents, economies of scale, or resourceownership secure the monopolist's status.

No unit of government regulates the firm.

The firm is a single-price monopolist; itcharges the same price for all units of output.


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Monopoly- Profit


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Monopoly- Demand Curve

The three implications of the downward-sloping demandcurve are:

Marginal revenue is less than price: The monopolist's downward sloping demand curve

means that it can increase sales only by charging alower price.

MR is less than price for every level of output exceptthe first

This is because the lower price applies not only to theextra unit sold but also to all prior units of output.Thus, the MR decreases because the monopoly hassacrificed this price for greater output.


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Monopoly and price setting power

To say that "monopolies can charge anyprice they like is wrong.

It is true that a firm with monopolyhas price-setting power and will look toearn high levels of profit. However the firmis constrained by the position of its demand

curve. Ultimately a monopoly cannotcharge a price that the consumers in themarket will not bear.


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Monopolists Demand Curve

A pure monopolist is the sole supplier in an industryand, as a result, the monopolist can take the marketdemand curve as its own demand curve.

A monopolist therefore faces a downward sloping ARcurve with a MR curve with twice the gradient of AR.

The firm is a price maker and has some power over thesetting of price or output.

The profit-maximising output can be sold at price P1above the average cost AC at output Q1. The firm ismaking abnormal "monopoly" profits (or economicprofits) shown by the yellow shaded area. The area

beneath ATC1 shows the total cost of producing outputQm. Total costs equals average total cost multiplied bythe output.


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Monopoly- Shift in Demand


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Monopoly- Shift in Demand

Total monopoly profits have increased. The gain inprofits compared to the original price and output isshown by the light blue shaded area.

A change in demand will cause a change in price, output

and profits.

In the graph above, there is an increase in the marketdemand for the monopoly supplier. The demand curveshifts out from AR1 to AR2 causing a parallel outward

shift in the monopolist's marginal revenue curve (MR1shifts to MR2). We assume that the firm continues tooperate with the same cost curves. At the new profitmaximising equilibrium the firm increases productionand raises price.


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Monopoly- Reduction in Demand

Not all monopolies are guaranteed profits - therecan be occasions when the costs of production aregreater than the average revenue a monopolist can

charge for their products. This might occur forexample when there is a sharp fall in marketdemand (leading to an inward shift in the averagerevenue curve). In the diagram below notice that

ATC lies AR across the entire range of output. Themonopolist will still choose an output whereMR=MC for this reduces their losses to theminimum amount.


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Monopoly- Reduction in Demand


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Monopoly- Economic case against monopoly

The usual textbook argument against monopoly power inmarkets is that existing monopolists can continue toearn abnormal (supernormal) profits at the expenseofeconomic efficiencyand the welfare of consumers and

society.

The standard case against monopoly is that the monopoly priceis higher than both marginal and average costs leading to a lossof allocative efficiencyand a failure of the market

mechanism. The monopolist is extracting a price fromconsumers that is above the cost of resources used in making theproduct and, consumers needs and wants are not being satisfied,as the product is being under-consumed.


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Monopoly- Economic case against monopoly

The higher average cost of production if there areinefficiencies in production also means that the firm is notmaking optimum use of its scarce resources. Under theseconditions, there may be an economic case for some form ofgovernment intervention to limit or reduce the scale ofmonopoly power, for example through the rigorousapplication of competition policy or by a process of marketderegulation (liberalisation).

X inefficiency is a term first coined by Harvey Libenstein. Thelack of real competition may give a monopolist less of anincentive to invest in new ideas or consider consumerwelfare. It can also be argued that even if the monopolistbenefits from economies of scale, they will have littleincentive to control production costs and 'X' inefficiencieswill mean that there will be no real cost savings.


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Monopoly- Profit in the long run

The monopolist creates barriers of entry for the newfirms into the industry. The entry into the industry is

blocked by having control over the raw materialsneeded for the production of goods or he may holdfull rights to the production of a certain good(patent) or the market of the good may be limited. Ifnew firms try to enter in the field, it lowers the price

of the good to such on extent that it becomesunprofitable for new firms to continue productionetc.


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When there is no threat of the entry of new firms into theindustry, the monopoly firm makes long run adjustments inthe scale of plant. In case, the demand for the product islimited, the monopolist can afford to produce output at sub

optimum scale. If the market size is large and permits toexpand output, then the monopolist would build anoptimum scale of plant and would produce goods at theminimum cost per unit. However, the monopolist would

not stay in the business, if he makes losses in the longperiod. The long run equilibrium of a monopoly firmis now explained with the help of the following diagram.


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In the long run, all the factors of productionincluding the size of the plant are variable. Amonopoly firm will maximize profit at that level ofoutput for which long run marginal cost (MC) isequal to marginal revenue (MR) and the LMC curveintersects the MR curve from below. In the figureabove, the monopoly firm is in equilibrium at point E

where LMC = MR and LMC cuts MR curve frombelow. QP is the equilibrium price and OQ is theequilibrium output.


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At OQ level of output, the cost per unit is QH (LAC),whereas the price per unit of the good is QP. HPrepresents the per unit super normal profit. The totalsuper normal profit is equal to KPHN. It may here benoted that at the equilibrium output OQ, the plant isnot being fully utilized. The long run average cost(LAC) is not minimum at this level of output OQ. Thefirm will build an optimum scale of plant only if thedemand for the product increases.


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Threat of Entry of New Firms:If there is a threat of entry of new firms into the market, the monopolistadopts price reduction strategy. He instead of charging QP price perunit, lowers the price to BR. Since the per unit price BR is equal to thecost per unit at R, the monopoly firm is earning only normal profit in

the long run. The reduction in price and so in profits is adopted toprevent the entry of new firms in the market.

Summing up: If a monopoly firm is in a position tomaintain its monopoly status, it can earn super normal profitin the long period. However, if there is an effective threat of

the entry of potential firms in, the industry, then the firm canearn just normal profit by reducing the price. The reductionin price depends on how strong is the threat of potentialentry into the industry.


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Thanks

Courtesy: tutor2u

Economicsconcepts.com

Welkerswikinomics


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economics for managers - session 12

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