managerial economics esayas aragaw dereal
TRANSCRIPT
Dilla University
School of Business and Economics
MBA program
Managerial Economics Group assignment on Monopoly market structure
Group member ID No.
Tesfaye Hailu 009/11Esayas Degago 004/11Aragaw Abibi 001/11
July, 2012
Dilla, Ethiopia
1. market structuresDefinition: Market structures refer to the specific social organization that exists between
buyers and sellers in a given market ie market structures are models of markets that describe a
specific social organization between buyers and sellers.
Market structure – identifies how a market is made up in terms of:
o The number of firms in the industry
o The nature of the product produced
o The degree of monopoly power each firm has
o The degree to which the firm can influence price
o Profit levels
o Firms’ behaviour – pricing strategies, non-price competition, output levels
o The extent of barriers to entry
o The impact on efficiency
Fig.1. Market structure
Perfect competition pure monopoly
More competitive (fewer perfection)
Perfect competition pure monopoly
Less competitive (greater degree of imperfection)
Perfect competition pure monopoly
The further right on the scale, the greater the degree of monopoly power exercised by the firm.
1.1. Why are market structures important to us?
There are several reasons why market structures are important to us ie the public. The
following are three of these reasons:
Households buy final goods and services or commodities in these commodity markets and firms
buy factor inputs in these factor markets. Thus it is useful that households and firms know the
markets in which they participate as buyers of goods and services
These markets dominate our lives as we purchase foods, airline tickets, clothes, houses, cars,
soaps, textbooks, financial services, electricity, cooking gas, health care services and a wide
array of other goods and services for our daily use from firms selling these commodities
These markets are dynamic and as such they are always changing their structures and as such
they need to be studied to understand their new structures i.e. a monopolist market does not
always remain a monopolist market they may change to become an oligopolistic market if for
example one or two other firms succeed to enter a monopolist market as competitors.
1.2. Types of market structures or market models
There are primarily four market structures or market models that we are interested in studying.
They are as follows:
1. Perfect Competition
2. Monopolistic Competition
3. Oligopoly
4. Monopoly
Monopolistic competition
Oligopoly Duopoly Monopoly
Our group assignment will focus only on the monopoly market structure, that is why we discuss
it under here:
2. Monopoly market structure Monopoly is a term used by economists to refer to the situation in which there is a single seller
of a product (i.e., a good or service) for which there are no close substitutes. The word is
derived from the Greek words ‘monos’ (meaning one) and ‘polein’ (meaning to sell ).
Definition: Monopolies are those markets in which there is a single firm. There is no
competition in these markets and the single firm sets its own profit maximizing price and
output where its marginal cost is equal to its marginal revenue. This type of monopolist market
is called a Pure Monopolist market or a single firm industry.
2.1. Characteristics of Monopolist Market Structures:
Single Seller: In a monopoly there is one seller of the monopolized good who produces
all the output. Therefore, the whole market is being served by a singlefirm, and for
practical purposes, the firm is the same as the industry..
There are no close substitutes for the product being sold by the monopolist firm
There are no competitors in this market i.e. competition is absent for the monopolist
firm.
Market Power: Market Power is the ability to affect the terms and conditions
of exchange so that the price of the product is set by the firm (price is not imposed by
the market as in perfect competition).
There are cost, technological and managerial barriers to entry in monopolist markets ie
monopolist firms make it extremely difficult for potential rival firms to dislodge their
monopolist status by erecting disincentives to entry
There is imperfect information between a monopolist firm and its customers regarding
price, product quality etc which in the absence of competition deepens
The monopolist may or may not incur advertising cost and the absence of competition
facilitates this option for monopolist i.e. there is no pressure to incur these costs for
marketing the product
Control of Natural Resources: A prime source of monopoly power is the control of
resources that are critical to the production of a final good.
Legal Barriers: Legal rights can provide opportunity to monopolize the market in a good.
Intellectual property rights, including patents and copyrights, give a monopolist
exclusive control over the production and selling of certain goods. Property rights may
give a firm the exclusive control over the materials necessary to produce a good. In
addition to barriers to entry and competition, barriers to exit may be a source of
market power. Barriers to exit are market conditions that make it difficult or expensive
for a firm to leave the market. High liquidation costs are a primary barrier to exit.
Examples of Monopolist Markets in the Ethiopia: electricity, water markets, airlines, and
telecommunication.
2.2. Classification / Kinds / Types of Monopoly
1. Perfect Monopoly
It is also called as absolute monopoly. In this case, there is only a single seller of product
having no close substitute; not even remote one. There is absolutely zero level of
competition. Such monopoly is practically very rare
2. Imperfect Monopoly
It is also called as relative monopoly or simple or limited monopoly. It refers to a single
seller market having no close substitute. It means in this market, a product may have a
remote substitute. So, there is fear of competition to some extent e.g. Mobile
(Cellphone) telcom industry (e.g. vodaphone) is having competition from fixed landline
phone service industry (e.g. BSNL).
3. Private Monopoly
When production is owned, controlled and managed by the individual, or private body
or private organization, it is called private monopoly. e.g. Tata, Reliance, Bajaj, etc.
groups in India. Such type of monopoly is profit oriented.
4. Public Monopoly
When production is owned, controlled and managed by government, it is called public
monopoly. It is welfare and service oriented. So, it is also called as 'Welfare Monopoly'
e.g. Railways, Defence, etc.
5. Simple Monopoly
Simple monopoly firm charges a uniform price or single price to all the customers. He
operates in a single market.
6. Discriminating Monopoly
Such a monopoly firm charges different price to different customers for the same
product. It prevails in more than one market.
7. Legal Monopoly
When monopoly exists on account of trademarks, patents, copy rights, statutory
regulation of government etc., it is called legal monopoly. Music industry is an example
of legal monopoly.
8. Natural Monopoly
It emerges as a result of natural advantages like good location, abundant mineral
resources, etc. e.g. Gulf countries are having monopoly in crude oil exploration activities
because of plenty of natural oil resources.
9. Technological Monopoly
It emerges as a result of economies of large scale production, use of capital goods, new
production methods, etc. E.g. engineering goods industry, automobile industry,
software industry, etc.
10. Joint Monopoly
A number of business firms acquire monopoly position through amalgamation, cartels,
syndicates, etc, it becomes joint monopoly. e.g. Actually, pizza making firm and burger
making firm are competitors of each other in fast food industry, But when they combine
their business that leads to reduction in competition. So they can enjoy monopoly
power in market.
2.3. Causes of Monopoly
By developing or acquiring control over a unique product that is difficult or costly
for other companies to copy. This can occur as a result of a purchase, merger
or research and development. An example is pharmaceuticals, which can be extremely
expensive and risky to develop (and which are also protected by patents), thereby
locking out all but a few large, well funded companies with ample talent. Closely related
to this is control over a unique input for a product, such as a unique natural resource.
By having a lower production cost than competitors. This can result from having a more
efficient (i.e., more output per unit of input) production technique or from having
access to a unique source of low cost inputs (e.g., a mine containing exceptionally high
grade ore). In some cases, a greater efficiency is the result of economies of scale ,
which means that the production cost per unit of product declines as the volume of
output increases due to the ability to use some resource more intensively (e.g., a steel
mill or railroad with lots of excess capacity).(3) integrations(5) By receiving a
government grant of monopoly status, i.e., becoming a government-granted monopoly.
Today this is usually accomplished through the acquisition of a license, patent, copyright,
trademark or franchise. Common examples include a franchise for cable television for a certain
city or region, a trademark for a popular brand, copyrights on certain cartoon characters or a
patent for a unique product or production technique.
2.4. Why Monopolies Can Be Beneficial?
Despite their reputation for evil, monopolies can actually generate a net benefit for society
under certain circumstances. These are usually situations in which the power and duration of
the monopoly are carefully limited. Natural monopolies can be particularly beneficial. This is
because of their ability to attain lower costs of production, often far lower, than would be
possible with competitive firms producing the same product in the same region. However, it is
almost always necessary for such monopolies to be regulated by a relatively uncorrupted
government in order for society to obtain the potential benefits. This is because such
monopolies by themselves, as is the case with all monopolies, have little incentive to charge
prices close to cost and, rather, tend to charge profit-maximizing prices and restrict output.
Likewise, there is often little incentive to pay much attention to quality. It has long been
recognized that government-granted monopolies (i.e., patents, copyrights, trademarks and
franchises) can benefit society as a whole by providing financial incentives to inventors, artists,
composers, writers, entrepreneurs and others to innovate and produce creative works. In fact,
the importance of establishing monopolies of limited duration for this purpose is even
mentioned in the U.S. Constitution
In addition to being for limited periods of time, such monopolies are also generally restricted in
other ways, including that there are often fairly good substitutes for their products.
2.5. Why Monopolies Can Be Harmful?Large monopolies have considerable potential to damage both economies and democratic
governments (although they can be very beneficial for other types of
governments ).Unfortunately, the full extent of the damage is usually not as obvious, at least to
the general public, as are the seemingly beneficial effects. And monopolists often go to extreme
lengths to disguise or hide such harmful effects. Among the ways in which unregulated
monopolies can harm an economy are by causing:(1) Substantially higher prices and lower
levels of output than would exist if the product were produced by competitive companies.(2) A
lower level of quality than would otherwise exist. This includes not only the quality of the goods
and services themselves, but also the quality of the services associated with such goods and
services.(3) A slower advance in the development and application of new technology. Advances
in technology can improve the quality (e.g., ease of use, durability, environmental friendliness)
of products, and they can also reduce their costs of production. Innovation is not as necessary
for a monopolist as it is for a highly competitive firm, and, in fact, it can be a bad business
strategy. Research and development by monopolists is often largely focused on ways of
suppressing new, potentially competitive technologies (and includes such techniques as
stockpiling patents) rather than true innovation. This can be a serious disadvantage, because
economists have long recognized that innovation is a key factor (and possibly the single most
important factor) in the growth of an economy as a whole .The adverse effects of monopolies
can be much more noticeable on an individual level than in the aggregate. These effects include
the destruction of businesses that would have survived had competition been based solely on
quality and price (with a consequent loss of assets of the owners and jobs of the employees)
and prices for products so high as to cause hardship or be unaffordable for some people. It is
often said, even by those who have negative opinions about monopolies, that" monopoly itself
is not necessarily bad, but rather it is the abuse of monopoly power that is harmful." This
statement is an excessive simplification, and it can be indicative of alack of understanding of
the full extent of harm that can be caused by monopolies. The abuse of monopoly power clearly
can be harmful to an economy. The term abuse in this context refers to such tactics as
predatory pricing, colluding with suppliers and the leveraging of a monopoly in one product to
gain a monopoly for another product. But what is often overlooked, even by legislation whose
supposed purpose is to restrain or regulate monopolies, is the fact that monopolies can be
harmful even if they do not engage in such practices.
If a monopolist engages in behavior that produces results similar to that by firms in an industry
that is characterized by intensive competition (i.e., charges prices close to cost and does not
engage in price discrimination), then there might not be a problem. Unfortunately, however,
this is rare even for a seemingly benevolent monopolist. The reason is that the very strong
incentives to maximize profits that exist for virtually any business, whether pure monopolist,
perfect competitor or somewhere in between, produce very different results for a monopolist
than they would for a firm in a highly competitive industry. And monopolists (as is the case with
competitive firms) usually do not rank benevolence as a top corporate priority. Thus, the
management and employees in a monopoly might not at all be aware that they are harming the
economy, especially if their behavior is similar to that by a non-monopoly. In fact, they may
even genuinely believe that they are benefiting the economy because of their conviction that
they are more efficient and productive than a number of firms competing with each other
would be. Another reason that the positive effects of even a benevolent monopolist would not
be as great as for a competitive company is that innovations that improve quality and
reduce production costs are often the result of desperation. (This is something that is easy
for many owners of struggling businesses to understand, but is often difficult for others to fully
grasp without experiencing it firsthand.) Monopolists generally consider themselves successful,
and thus, although they often are innovators to some extent (typically mainly in their earlier
years), they usually just do not have that extra motivation to produce truly breakthrough
innovations that smaller companies desperate to gain market share (or to just survive) have.
2.6. Pricing in monopoly
In a monopoly, an account of a single market entity controlling supply and demand, degree of
price and supply control exerted by the enterprise or the individual is greater. The absence of
competition spares the monopolizing company from price pressure. Nevertheless to evade of
entry from new market participants and the company needs to regulate the set of product or
service price within the paradigm of monopoly theorem.
Monopoly has a scope of entrepreneurship to make available limited products and services at a
higher price. The price and production decision of such firms target profit maximizing via
predetermined quantity choice. This helps to cut even on marginal and revenue outcomes.
TR= P.Q
AR= TR/Q=AR=P
MR=dTR/dQ
Note: MR does not equal AR
2.6.1. Monopoly Pricing and Output Decision in the Short-Run.
As in the case of perfect competition, pricing and output decision under monopoly are based on
revenue and cost conditions. The cost conditions (AC and MC curves) are same for both perfect
competition and pure monopoly. The difference is basically in the revenue conditions (AR and
MR curves). This is so because, unlike the competitive firm, a monopoly firm faces a downward-
sloping demand curve. A monopolist can reduce its product price and sell more, and raise its
product price and still retain some customers.
When a demand curve slopes downward, the associated marginal revenue (MR) curve lies
below the average revenue (AR) curve, and the slope of the MR curve is two times the slope of
the AR curve.
The revenue and cost conditions faced by a monopoly firm in the short-run are presented in
figure 3.2.1 below. The monopoly average and marginal revenue curves are represented by AR
and MR curves, respectively. The short-run average and marginal cost curves are represented
by SAC and SMC curves, respectively. The price and output decision rule for a profit-maximizing
monopolist is same as that of a firm under perfect competition. The profit-maximizing
monopoly firm chooses a price-output combination at which MR = SMC. Given the monopolist’s
cost and revenue curves in figure 3.2.1, its MR and SMC intersect each other at point E. An
ordinate drawn from point E to the X-axis determines the profit-maximizing level of output for
the firm at Q*. At this output, firms’ MR = SMC. Given the demand curve, AR = D, the output,
Q* can be sold in a given time at only one price, P*. It follows that the determination of output
simultaneously determines the price for the monopoly firm. For any given price, the unit and
total profits are also simultaneously determined. This defines the equilibrium condition for the
monopoly firm.
Figure 2: Short-Run Price Determination under Monopoly
P,C,R
SMC SAC
P*
F (MR=SMC)
MR AR=D
0 Q* Output
The Algebraic Determination of Monopoly Price and Output
Example: Suppose demand and cost functions for a monopoly firm are given as:
Demand function: Q = 100 – 0.2P……………………………………………. (1)
Price function: P = 500 – 5Q……………………………………………………. (2)
Cost function: C = 50 + 20Q + Q2 ……………………………………………… (3)
The problem is to determine the profit-maximizing level of output and price. This can be solved
in the following way.
Recall that profit is maximised at an output for which MR = MC. The first step is therefore to
find MR and MC using the demand and cost functions as given in equations
(1) and (3), and formulate the revenue function using equations (2):
Total Revenue (R) = PQ, so that,
R = (500 – 5Q) Q = 500Q – 5Q2
MR = dR = 500 – 10Q
dQ
Similarly,
MC = dC = 20 + 2Q
dQ
Equating MR to MC, the profit-maximising condition, we get:
MR = 500 – 10Q
MC = 20 + 2Q, and,
500 – 10Q = 20 + 2Q
480 = 12Q
Q* = 40.
It follows that the profit-maximising level of output is Q* = 40 units.
The profit-maximising price can be obtained by substituting Q* = 40 in the price function,
equation (3.2.2) to get:
P* = 500 – 5(40) = 300.
Thus, the profit-maximising price, P* = N300.
With these information, the total (maximum) profit can be calculated as follows:
Profit (π) = R – C
= 500Q – 5Q2 – (50 + 20Q + Q2)
= 500Q – 5Q2 – 50 – 20Q – Q2
= 480Q – 6Q2 – 50
Substituting for Q = 40, we obtain:
Π = 480(40) – 6(40)2 – 50
= 19200 – 9600 – 50
= 9550.
Thus, the maximum profit (π*) = 9,550.
2.6.2. Monopoly Pricing and Output Decision in the Long-Run.
The decision rules guiding optimal output and pricing in the long-run is same as in the short-
run. In the long-run however, a monopolist gets an opportunity to expand the size of its firm
with the aim of enhancing the long-run profits. Expansion of the plant size may, however, be
subject to such conditions as:
(a) the market size;
(b) expected economic profit; and,
(c) risk of inviting legal restrictions.
All things being equal, the equilibrium monopoly price and output determination in the long-
run is illustrated by figure 3.3.1 below. According to the figure 3.3.1, the AR and
MR curves show the market demand and marginal revenue conditions facing the monopolist.
The long-run average cost (LAC) and the long-run marginal cost (LMC) curves indicate the long-
run cost conditions. As you can observe from figure 3.3.1, the monopolist’s LMC and MR
intersect at point P, where output is represented as Q*. This represents the profit-maximising
level of output. Given the AR curve, the price at which the output, Q* is represented by P*. It
follows that, in the long-run, the monopolist output will be Q* and price, P*. This output-price
combination will maximise the longrun profit. The total profit is shown by the shaded area.
Figure 3.3.1: Monopoly Equilibrium in the Long-Run.
P,R,C
LMC LAC
P*
MR AR=D
0 Q* Q
2.6.3. Price Discrimination (PD)
A monopolist may be able to engage in a policy of price discrimination.
Definition: PD is the sale of a homogenous product or service at different prices to different
customers in different markets.
PD occurs when a firm charges different price to different groups of customers for an identical
good or service, for reasons not associated with costs of production.
It is important to stress that charging different prices for similar goods is not PD. e.g. PD does
not occur when a rail company charges a higher price for a first class seat. This is bec. the price
premium over a second-class seat can be explained by differences in the cost of providing the
service.
2.6.3.1. Conditions necessary for PD to operate:
There are basically 3 main conditions required for PD to take place:
1. The firm must be able to set its price i.e. the firm must be a monopoly. PD will be
impossible under perfect condition where all firms are price takers.
2. The markets must be separate. Consumers in the low priced market must not be able to
resell the product in the high price market. Eg children must not be able to resell a half
priced child’s cinema ticket for use by an adult. The cost of separating the market and
selling to different sub-groups or market must not be prohibitive
3. Demand elasticity must differ in each market. The firm will charge the higher price in the
inelastic market which is less sensitive to price changes and a lower price in the elastic
market. This allows the firm to extract consumer surplus by varying the price leading to
additional revenue and profit.
Examples of PD
There are numerous good examples of discriminatory pricing policies. We must be careful to
distinguish between discrimination (based on consumer’s willingness to pay) and product
differentiation – where pr differences might also refelect a different quality or standard of
service. Some examples of PD are:
- cinemas and theatres cutting prices to attract younger and older audiences
- students discounts for rail travel, restaurant meals and holidays
- car rental firms cutting prs at weekends
- hotels offering cheap weekend breaks and winter discounts
2.6.3.2. The aims of PD:
Main aim of PD is to increase the total revenue and /or profits of the supplier. It helps them to
off-load capacity and can be used as a technique to take market share away from rival firms.
Some consumers do benefit from this type of pricing – they are ‘priced into the market’ when
with one price they might not have been able to afford a product. For most consumers
however, the price they pays reflects pretty closely what they are willing to pay. In this respect,
PD seeks to extract consumer surplus and turn into producer surplus (or monopoly profits).
2.6.3.3. Price discrimination and economic efficiency:
There are arguments on both sides of the coin – indeed the overall impact of PD on economic
welfare seems bound to be ambiguous.
1) Consumer surplus is reduced in most cases – representing a loss of consumer welfare.
For the majority of consumers, the price charged is significantly above MC. Those
consumers in segments of the market where DD is inelastic would probably prefer to
return to uniform pricing by firms with monopoly power.
2) However some consumers who can buy the product at a lower pr may benefit.
Previously they may have been excluded from consuming it. Low-income consumers
may be ‘priced into the market’ if the supplier is willing and able to charge them a lower
price. Good examples to use might include legal and medical services where charges are
dependent on income levels.
3) PD is clearly in the interests of businesses who achieve higher profits. A discriminating
monopoly is extracting consumer surplus and turning it into extra super normal profit or
producer surplus.
4) The profits made in one market may allow firms to cross-subsidies loss-making activities
/services that have important social benefits, e.g. profits made on commuter rail or bus
services may allow transport co. to support loss making rural or night-time services.
Without the ability to price discriminate, these services may have to be withdrawn and
employment may suffer. In many cases, aggressive PD is seen as inimical to business
survival during an economic Recession or sudden market downturn.
5) The premium price paid by business purchases of software licenses might allow a
software co. to offer educational users a lower-price for similar identical products
6) An increase in total output resulting from selling extra units at a lower price might help
a monopoly supplier to exploit EOS thereby reducing LRAC.
2.4. Regulations of monopoly:
Because of the potential economic welfare loss arising from the exploitation of
monopoly power, the government regulates some monopolies. Regulators can control
annual price increases and introduce fresh competition into particular industries.
2.5.Pros and cons of monopoly market structure
advantages of monopoly1 no risk of overproduction
2 there is enough capital for research
3 In a monopoly, besides the seller, profits can also be enjoyed by customers, in terms
of low prices for a particular product or service (reduction in price of good).
4 efficiently use of recourses
5 control over entire market
6 others are price takers
7 only producer of a particular product or service
disadvantages of monopoly1 exploitation of consumers
2 Customers are not able to enjoy the benefit of choice, had there been another or
equally competitive market player for the same product or service (restriction of
consumers choice)
3 absence of competition leads to inefficiency
4 Prices of products or services can be unreasonably high (increase in price of product)
5 exploitation of labor i.e. when price is greater than marginal cost