Exercise: Let us use perfectly competitive

market analysis to model the pricing strategy

of these firms:
Microsoft Windows
OPEC
DeBeers
Answer: SORRY, we cant.
Why?
 Microsoft has no close competitors
85-90 % share of the PC operating system market
therefore, can influence the market price of its product

OPEC's oil exports represent about 60 % of the total

petroleum traded internationally

Monopoly
Firm that is the sole seller of a product
Product does not have close substitutes
Firm is Price maker

2
 A firm is a monopoly if it is the sole seller of its product and if its product
does not have close substitutes.

Monopoly leads to market power

Ability to choose price > MC

The marginal cost of Windowsthe extra cost that Microsoft would incur
by printing one more copy of the program on a CDis only a few dollars.

The market price of Windows >> marginal cost.

Objectives:
examine the production and pricing decisions of monopolies

examine the implications of market power of monopolies

implications of monopoly for the society

 Monopoly versus competition
Monopoly
Price maker
Sole producer
Downward sloping demand
Market demand curve

Competitive firm
Price taker
Demand horizontal line at market price

5
 2
Demand curves for competitive and monopoly firms
(a) A Competitive Firms Demand Curve (b) A Monopolists Demand Curve
Price Price

Demand

Demand

0 Quantity of output 0 Quantity of output

6
 Competitive firms are price takers: they face
horizontal demand curve

A monopoly firm is the sole producer in its

market
it faces the downward-sloping market demand curve
Implication: the monopoly has to charge a lower price
if it wants to sell more output
if the monopolist reduces the quantity of output, the
price of its output increases
 A monopolist would prefer to charge a high
price and sell a large quantity at that high
price.
Can it do so?
 A monopolist would prefer to charge a high price and sell a large
quantity at that high price.

- The market demand curve provides a constraint on a monopolys

ability to profit
- The market demand curve describes the combinations of price
and quantity that are available to a monopolist

By adjusting the quantity produced (or, equivalently, the price

charged), the monopolist can choose any point on the demand
curve

Q. What point on the demand curve will the monopolist choose?

 Assumption: Monopolists goal is to maximize
profit = R- C
 In the diagram, the area of
the rectangle anchored by
point A or B is the measure
of total revenue.
When the price changes
the rectangle changes from
P1 to P2, the change in
revenue caused by the
price change is called the
price effect, and the
change In revenue in the
opposite direction caused
by the resulting quantity
change ( from Q1 to Q2) is
called the quantity effect.
 When the price changes from P1 to P2 the magnitude of the price effect is
represented by the rectangle P1 P2 CA and the magnitude of the quantity
effect is given by rectangle Q1 Q2 BC.

The price effect is the loss of revenue from selling the original quantity at
the lower price; the quantity effect is the added revenue earned at the
new price on the newly induced units sold.

So, if the area of the rectangle giving the price effect is greater than the
area of the rectangle giving the quantity effect, demand is inelastic:
Ed < 1
If the reverse is true, demand is elastic: Ed > 1
If the sizes are equal, demand is unit elastic (or unitary elastic)
 1
A monopolists total, average, and marginal revenue

Quantity of water Price Total revenue Average revenue Marginal revenue

(Q) (P) (TR=P Q) (AR=TR/Q) (MR=TR/Q)
0 11 0 -
10
1 10 10 10
8
2 9 18 9
6
3 8 24 8
4
4 7 28 7
2
5 6 30 6
0
6 5 30 5
-2
7 4 28 4
-4
8 3 24 3

13
 Monopolists Production& Pricing Decisions
Monopolists revenue
Total revenue = price times quantity

Average revenue
Revenue per unit sold
average revenue always equals the price of the good

Marginal revenue
Revenue for each additional unit of output
Change in total revenue when output increases by 1 unit
Can be negative

14
 Monopolists Production& Pricing
Decisions
A monopolists marginal revenue is less than the price of its good: MR < P

For example, if the firm raises production of water from 3 to 4, it will

increase total revenue by 4, even though it will be able to sell each gallon
for 7
 Monopolists Production& Pricing Decisions

When a monopoly increases the amount it sells, it has two effects on total
revenue (P x Q): Output effect ( Q increases) and Price effect (P is lower)

Note: A competitive firm can sell all it wants at the market price, there is
no price effect.

When it increases production by 1 unit, it receives the market price for

that unit, and it does not receive any less for the amount it was already
selling.

MR = P

16
 By contrast, when a monopoly increases production by 1 unit, it must
reduce the price it charges for every unit it sells

this cut in price reduces revenue on the units it was already selling.

MR < P
MR curve is below the demand curve
 3
Demand and marginal-revenue curves for a monopoly
Price
11
10
9
8
7
6
5
4
3
Demand
2 (average revenue)
1
0
-1 1 2 3 4 5 6 7 8 Quantity
of water
-2
-3
Marginal revenue
-4

The marginal-revenue curve shows how the firms revenue changes when the quantity increases
by 1 unit.
Because the price on all units sold must fall if the monopoly increases production, marginal
18
revenue is always less than the price.
How Monopolies Make Production& Pricing Decisions

Profit maximization
If MR > MC increase production
If MC > MR produce less
Maximize profit
Produce quantity where MR=MC
Intersection of the marginal-revenue curve and the
marginal-cost curve

19
 How does the monopoly find the profit-maximizing price for its product?

the demand curve relates the price that customers are willing to pay for
the profit maximizing quantity

Thus, after the monopoly firm chooses the quantity of output that
equates MR and MC, it uses the demand curve to find the price consistent
with that quantity
 4
Profit maximization for a monopoly
Costs 2. . . . and then the demand curve shows the
price consistent with this quantity.
and
Revenue Marginal cost

1. The intersection of the marginal-revenue

curve and the marginal-cost curve
Monopoly B determines the profit-maximizing quantity . . .
price
Average total cost
A

Demand

Marginal revenue

0 Q1 QMAX Q2 Quantity

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost (point A). It then uses the demand curve to find the price that will induce
consumers to buy that quantity (point B). 21
How Monopolies Make Production& Pricing Decisions

key difference :
In competitive markets, price equals marginal
cost.
In monopolized markets, price exceeds marginal
cost

Profit maximization
Perfect competition: P=MR=MC
Price equals marginal cost
Monopoly: P>MR=MC
Price exceeds marginal cost

22
 5
The monopolists Profit = TR TC = (P ATC) Q

Costs
and
Revenue Marginal cost

Monopoly E B
Average total cost
price

Monopoly
profit
Average Demand
total
cost D C

Marginal revenue

0 QMAX Quantity

The area of the box BCDE equals the profit of the monopoly firm. The height of the box
(BC) is price minus average total cost, which equals profit per unit sold. The width of the
box (DC) is the number of units sold. 23
Monopoly drugs versus generic drugs

When a pharmaceutical firm discovers a new drug, patent laws give the
firm a monopoly on the sale of that drug for 20 years.

Eventually the firms patent expires and any company can make and sell
the drug.

At that time, the market switches from being monopolistic to being

competitive

Assume: MC of producing the drug is constant. (This is approximately

true for many drugs)

Q. What would happen to the price of a drug when the patent expires?

24
 New drug, patent laws monopoly
Produce Q where MR=MC
P>MC

Generic drugs competitive market

Produce Q where MR=MC
And P=MC
Price (competitively produced generic drug) < price (monopolist)
 6
The market for drugs
Costs
and
Revenue

Price
during
patent life

Price after Marginal cost

patent
expires

Demand
Marginal revenue

0 Monopoly Competitive Quantity

quantity quantity

When a patent gives a firm a monopoly over the sale of a drug, the firm charges the
monopoly price, which is above the marginal cost of making the drug. When the patent on a
drug runs out, new firms enter the market, making it more competitive. As a result, the price
falls from the monopoly price to marginal cost. 26
 The Welfare Cost of Monopolies
Is monopoly a good way to organize a market?

P> MC
From the standpoint of consumers, this high price
makes monopoly undesirable.
At the same time, the monopoly is earning profit
from charging this high price. From the standpoint
of the owners of the firm, the high price makes
monopoly desirable.
 The Welfare Cost of Monopolies

Total surplus
Economic well-being of buyers & sellers in a
market
Sum of consumer surplus & producer surplus
Consumer surplus
Consumers willingness to pay for a good
Minus the amount they actually pay for it
Producer surplus
Amount producers receive for a good
Minus their costs of producing it

28
 The Welfare Cost of Monopolies
Suppose the monopoly firm were run by a benevolent planner /govt.

The social planner cares not only about the profit earned by the firms
owners but also about the benefits received by the firms consumers.

The planner tries to maximize total surplus, which equals producer surplus
plus consumer surplus

Produce quantity where

Marginal cost curve intersects demand curve
Charge P=MC

29
 7
The efficient level of output
Costs
and
Revenue
Marginal cost

Value Cost to
to monopolist
buyers

Value
to Demand
Cost to
buyers (value to buyers)
monopolist
0 Quantity
Value to buyers is greater Efficient Value to buyers is less
than cost to sellers quantity than cost to sellers

A benevolent social planner / govt will maximize total surplus = PS +CS

- choose the level of output where the demand curve and MC intersect.
30
 The Welfare Cost of Monopoly
Monopolist produces less than the socially efficient quantity of
output.

Produce quantity where MC = MR

Charge P>MC

Deadweight loss to the society ?

31
 The Welfare Cost of Monopoly
Note: a monopolist charges P > MC

There are some potential consumers who value the good at more than
its marginal cost, but that value less than the monopolists price.

These consumers do not buy the good.

However, the value these consumers place on the good is greater than
the marginal cost

Hence the output produced by monopolist is inefficient.

This is the source of inefficiency in monopoly case

 8
The inefficiency of monopoly
Costs
and
Revenue
Marginal cost
Deadweight
loss
Monopoly
price

Demand

Marginal revenue

0 Monopoly Efficient Quantity

quantity quantity

33
Take Away points:

Monopolist produces less than the socially desirable quantity

of output and

Monopolist charges P > MC

-Leads to inefficiency
 Price Discrimination
So far we have been assuming that the monopoly firm charges the same
price to all customers.

Price discrimination
the business practice of selling the same good at different prices to
different customers

Eg. 1) Lipsey Chrystal (your text !)

Indian edition price = Rs 375
UK edition price = 50 pounds = Rs 4500

35
 Price Discrimination
2) hardcover books and paperbacks:
publisher initially releases an expensive hardcover edition and
later releases a cheaper paperback edition

3) Train tickets: charge low price for students and senior citizens

4) Airline prices: seats on airplanes are sold at many different prices

36
 Price Discrimination
Perfect price discrimination
describes a situation in which the monopolist knows exactly the willingness
to pay of each customer and can charge each customer a different price.

Charge each customer a different price

Exactly his or her willingness to pay
Consumer surplus =?
Producer surplus = ?

Deadweight loss =?

Without price discrimination

Single price > MC
Deadweight loss = ?

37
 9
Welfare with and without price discrimination
(a) Monopolist with Single Price (b) Monopolist with Perfect Price Discrimination

Price Price
Consumer
surplus

Deadweight
Monopoly
loss
price
Profit
Profit
Marginal cost Marginal cost

Marginal Demand Demand

revenue

0 Quantity Quantity 0 Quantity Quantity

sold sold

38
Panel (a) shows a monopolist that charges the same price to all
customers.

Total surplus = producer surplus + consumer surplus.

There is deadweight loss

Panel (b) shows a monopolist that can perfectly price discriminate.

Consumer surplus = 0

Total surplus = producer surplus +0

Total surplus goes to the monopoly producer in the form of profit

Comparison:
perfect price discrimination raises monopolists profit,
raises total surplus,
and lowers consumer surplus.
1st Degree Price Discrimination
This type of discrimination,
also known as perfect price
discrimination.

Monopolist charges the

consumer the maximum price
that individual is willing to pay
for that product.

This extracts all the consumer

surplus and earns the firms
the highest possible profits.

This method of discrimination

is also one of the most difficult
to adopt because it requires
the company knows each of its
customers perfectly at each
level of consumption.

Really impossible?
2nd Degree Price Discrimination
In this type of discrimination the companies
are actually not able to differentiate
between the different types of consumers.

This practice creates a schedule of

declining prices for different quantities.

Using this strategy the company can

extract some of the consumer surplus
without knowing much about the individual
consumer.

The consumer chooses the amount of

product they wish to consume with the
posted prices, and this allows consumers
to differentiate themselves according to
preference.

Example: Electric utilities, cable

companies, water & sewage companies,
trash collection.
3rd Degree Price Discrimination
This type of price discrimination, is based around the idea that the firm sets
prices that will accommodate the consumer.

The firms know broad demographics about the particular types of

consumers they will supply, and charge prices such that everyone will be
able to consume the product.

In order for this form of discrimination to work the firm must be able to
predict the elasticity of demand in various consumers.

This type of discrimination can be seen in the movie theater business.

Student and senior discounts are given because these groups of
consumers have more elastic price elasticity of demand.

It is because of this discrimination that the firm is able to extract the

consumer surplus of those who might not otherwise pay the standard rate.

Third degree price discrimination relies on the firm being able to separate
the segments.
Example: Consider the total market for public transport journeys during peak
office hours 8 am to 9 am.

The total market demand (Dm) is the sum of the demand of two segments,
adults (Da) and students (Ds).

For adults the price of a bus ticket is only a small part of their income and this
means that their demand (Da) is more inelastic than that of students for whom
a bus ticket is a larger part of their income.
In this example, the firm once again decides on their output by equating MC with
MR. However there is not just one price.

By drawing a horizontal line through the MC=MR point until it intersects with the MR
curves for adults and students and then reading the price off the respective demand
curves Da and Dr the price in each segment is determined, Pa and Pr.

Not surprisingly the price in the adult market is higher. This discrimination allows
the firm to appropriate more, but not all, of the consumer surplus as seen below.
 Price Discrimination
1. Rational strategy for monopolist

Increase profit
Charge each customer a price closer to his or her willingness to
pay
Sell more output than it is possible with a single price

Note:
In reality, a monopolist may not practice perfect price discrimination
Monopolist may not have exact information regarding consumers
willingness to pay.
Hence, firms often practice price discrimination by dividing customers into
different groups
45
 Price Discrimination
2. Requires the ability to separate customers according to their willingness
to pay
Certain market forces can prevent firms from price discriminating
Arbitrage: buy a good in one market, sell it in other market at a
higher price
Eg. Often books cannot be sold outside the countries mentioned on
cover

3. Can raise economic welfare

Can eliminate the inefficiency of monopoly pricing (and low quantity)
More consumers get the good (each consumer who values the good at
more than marginal cost buys the good and is charged his willingness to
pay)

46
Is price discrimination possible in a competitive market?

There are many firms selling the same good at the market price.

No firm is willing to charge a lower price to any customer

because the firm can sell all it wants at the market price.

And if any firm tried to charge a higher price to a customer, that

customer would buy from another firm.
Problem

Consider inverse demand curve: P = 120 -0.02 Q

Cost of production = 60 Q + 25000

Find profit earned by monopolist

Find perfectly competitive output and price.
What is deadweight loss under monopoly situation?