Monopoly Theory

8/13/2019 Monopoly Theory

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UNIT TH ORY OF MONOPOLYStructure9.0 Objectives9.1 Introduction9.2 Causes of Monopoly9.3 Den la~ld nd Marginal Revenue Curve under Monopoly9.4 Pricing and Output Decisions under Monop oly9.5 Long Run Equilibrium of a Monopoly Firm9.6 Some Q uestions Regarding the Be haviour of a M onopolist

9.6.1 Does a Monopolist Always Make Profits?9.6.2 Does a Monopolist Always Benefit from a Price Rise?9.6.3 Does a Monopolist have a Unique Supply Curve?9.6.4 Does a Monopolist Produce With Optimum Scale of Plant?9.6.5 1s Mon opoly Compatible W ith Falling or Constant M arginal Cost ?9.6.6 Is Monopoly an Inefficient Type of Market Structure?

9 .7 Price Discri~nination nder Monopoly9.7.1 Degree of Price Discrimination9.7.2 Conditions for Price Discrimination9.7.3 Equilibrium under Price Discrimina tion

9.8 Equilibrium Price and Output of a Public Monopoly9.8. Marginal-cost Pricing9.8.2 Averag e-cost Pricing9.8.3 A Note on Mark-up Pricing

9.9 Let Us Sum Up9 10 Key Words9 11 Some llse fi~l ooks9.12 Hints and Answ ers to Check Your Progress Exercises

9 0 OBJECTIVESAn earlier unit (Un it 8) has already covered pricing and output decisions in oneextreme foun of market, that is, perfect competition. In this unit. s t ~ ~ d yf suchdecisions is taken up in another extreme form o fma rket, that is, in monopoly. wherethere is only a single seller.llelegoing through the unit, you should be able to :

define monopoly:describe the causes why ~llo nopolie s merge;discuss the demand and the cost conditions, and the pricing and o ~ t p u tecisionsunder monopoly;explain the short-run and the long-n ln equilibrium of a monopoly tirm:


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l hcury of Monopol y

describe various features and pricing techniques of ap ublic monopoly.9 1 JNTRODUCTIONIn general, monopoly is said to exist if there is one and only one seller Qrod ucer)of aprodu ct for which there is no close substitutes; this single seller is unaffectedby the prices and outputs of other products sold in the economy. The stress inthis definition is on absence of close substitutes. To understand this remem berthat one can often find substitutes, for goods and services. For example, if onewants to travel by train. Indian Railway is th e only option available. In that sense,Indian Railways is a monopoly concern. Howe ver, there are other modes oftransport, such as roadways and airlines to travel from one place to another.Substitutes to Indian Railways are available but c lose substitutesare lacking. Thus.Indian Railways meet our definition of monopoly. The following conditions prevailin monopoly market:a) There is only one seller i.e., producer) in the market but there are large numberof buyers.b) The product of the seller may be homogeneous, or, there may be differentiatedproducts but without close substitutes. When close substitutes are notavailable, it imp1 ies that the cross-elasticity of demand between the productof a i~lon opo list nd products of other firms is very low.c) There is no free entry to the marke t. Entry may be restricted by the naturalfactors such s control of raw materials, by legal and institutional factors suchas patent rights or by technological factors such s the eflicienisy of large scale

production.If all these conditions are met simultaneously, the market structure is referred to asmonopoly. The mo nopoly. like the perfect com petition, is more or less, anhypothetical situation because som e of the above conditions may not be met inpractice.

9 2 C USES OF MONOPOLYFor m onopoly to ex ist. there must be some way to keep competitors out o f theindustry. Among th e barriers tha t perpetu ate mono poly are i) patents andlicensing by governm ent agencies, ii) control of ra w material supplies, iii) theestablishment o f brand names, iv) pricing policy designed to keep rivals out ofthe industiy. v) large capital in ves tn~ent ecessary to enter the industry, and vi)size of the market. T he above factors may be grouped under three headings:a) natural. b) legal and institutional, and c) technological. Natural factors relatesto the ability of the monopolist to co~ltrol he supply of raw material or example,ownership of sites having co ncentra tion of deposits. Now a days, legal andinstitutional barriers and technologica l barriers have acquired greater importancefor the gr6wtl1 of monopoly. Pemlits and other legal rights granted by the governmentrestrict the ciltry of others in the business. Patent rights to protect produc tivetechniques or products are other examples of legal factors. Awarding of an exclusivefranchise to serve a market leads to monopoly situation. The most important onein the category of technical barriers is the efficiency of large scale production,particularly. when the size of th e market is not very large. The economies of large


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Marker Struc tu rc scale production enable an existing firm to expan d its level of output and to gainfrom the cost reductions. The minimum cost of production occurs at a rate ofoutpu t more than sufficient to supply the entire market at a price covering full cost.New firms find it unprofitable to compete with an established large irm in suchcircumstances. Monopoly is inevitable in industries that require to install elabora tenetwork of pipes or cables for taking its p roduct or service to consumers suchas water supply, electricity, telegraph and telephone.

9.3 DEMAND AND MARGINAL REVENUE CURVEUNDER M ONOPOLY

You have noted earlier in Unit 8) that under perfect competition, price and marginalrevenue are sam e, since each firm accepts the price determined in the market (bythe market forces of demand and supply). How ever, the demand curve facing themonop olist is the industry demand curve. Rem ember that there is a single firmproducing the comm odity and thus there is no difference between a firm and anindustry. The market demand curve generally slopes down ward to the right(excep t for the rare case of Giffen good). Demand, marginal revenue and elasticityhave already been explained in earlier units (Units4 and 5). There is need to probea little farther into the relationships among them to get some u se h l propositions.When demand curve is negatively sloped, marginal revenue curve lies below itsuggesting that the marginal revenue falls at a faster rate than that of average revenue.If demand curve is linear, i.e., straight line, marginal revenue falls at twice the rateof average revenue. For exam ple, a s price goes down by Re. 1 at a time, marginalrevenue goes dow n by Rs.2 at a time (see Fig. 9.1

AR, MR Fig 9.1

Fig. 9 1 shows inverse relationship between price o f a commodity an d its quantitydemanded. Th e monopolist alone constitutes the entire indu stry. Thereforeher deman d curve coincides with the indus try dem and curve tha t i s i t i sdownwards sloping. In other words a monopolist can sell larg er quantities atrelatively lower prices only. Also note tha t as price falls from OF to OE themarg inal revenue declines from OF to OH But EH =2EF Therefore M R fallstwice as sharply as AR.


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Let us recapitulate the relationship among average revenue AR),marginal revenue Theo ry o Monopol(MR ) and elasticity (e), namely, MR =AR AR / e AR( 1 1 / e . If e > 1, aswe lower the price, total revenue increases. Since marginal revenue is the additionto total revenue, it follows that marginal revenue must be positive. If, on the otherhand. total revenue falls with low er price, e < and marginal revenue must benegative. If e 1, total revenue do es not change w ith a change in price, marginalrevenue must be zero. Thu s, we can say that, when M R > 0, then e > 1; whenMR=O, then e 1. and when MR < 0, then e < 1. This is show n in the Fig. 9.2.

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Fig. 9.2: Restates relationship between AR, M Ra nd elasticity of demand. Recall thatelasticity at any point on the demand curve is the ratio of its lower segmen t tothe upper. Also note that when elasticity is unity M Rd rop s down to zero. Ifpoint E is on the deman d curve AB, then over the range EB, e 1

Using the above formu la, if e > 1, say 2, when MR AR AR / 2, and so M R isp os it i ve .I f e= l , t h e n M R = A R - A R / l =O. I f e < 1 ,sa y , t h e n M R = A R -AR / 112 AR 2AR < 0; and so MR is negative.

9 4 PRICINGAND OUTPUT DECISIONS UNDERMONOPOLYThe pricing and output decisions of a monopolist are arrived at the same way asthat ofaperfectly competitive firm. That is, the m onopolist wants to m aximise profitin the long run. In the short run, the producer attempts to maximise the differencebetween total revenue and total cost, provided that variable costs G e covered.At the o utset, it may be noted that monopo list will not determ ine the outpu t o fher product at any level where the elasticity of demand is le ss than unity. Asdiscussed above, if e < 1, MR is negative. The total revenue can be increased byrestricting output. Since marginal cost is always positive, a reduction in outputwill reduce total c ost. Thu s, profits must rise as output is reduced (or price israised). here fore a monopolist canno tbe in equilibrium if elasticity of demand isless than one.To sum up the above discussion, a mono polist's equilibrium will always be wherethe elasticity of denland for her product is greater than one. A profit-maxim isingmonopolist will never sell at a price where demand is inelastic. She will operate in


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X l r r L e t S t r u c t u r e its elastic range. In the sh ort-run, given the assum ption ofp rofit m aximisation. theequilibrium position ofthe monopolist is deduced rom the cost and revenue fimnctiom.The equilibrium cond itions for a firm discussed in earlie runits apply to n~ ono polyfilm also. A m onopoly firm will e in equilibrium when (a) MR ofth e firm is equalto its M C, and (b) MC curve intersects the MR curve from below. In the short-run, marginal cost curv e reflects the relationship between marginal cost andchange in output from given plant and other facilities.

Fig. 9 3AC , MC, Price

X Quantity

Fig.9.3 shows short run equil ibrium of the monopolist f i rm. The usual ~ p d i t i o n fequilibrium rising M C cuts M R fro m below applies to the monopolist as well.However this firm s able to charge the highest price that the consumer may bewilling to pay. Th e level of output is determined at OX the po int that coincideswith the ordinate of the point of intersection of M R and M C curves. At illis levelof output the ma ximum price that consumers ar e willing to pay isOP and themonopolist charges this very price to masimise his profits.

Fig. 9 3 depicts average revenue (AR ) and marginal revenue (MR ) curves, averagetotal cost curve (SR AC ) and m arginal cost curve (SR M C) respectively. Theequilibrium occurs at p o k t E where both the conditions ofequilibrium. i.e. MRequals SRM C and SRM C intersects MR from below are m et. l he equilibriumoutput and price are O X and OP. This show s that price is greater than averagecosts, and so a profit is being made. It also tells that profits are being max imised.since MC and MR are equal. If ou tput were to increase beyond OX. the additionto total cost would be greater than the additions to total revenue. resulting in ad e c re a ~ e f profit. If output were less than OX , the additions to total revenuewou ld be greater than the additio n to total co st and profit would increase byexpanding output. So, profits are maxim ised at OX and are show n by the rectanglePABC in the Fig. 9.3 above .

9.5 LONG RUN EQUILIBRIUM OF A MONOPOLYFIRM

111he long riun. ain onop olist ha s to determ ine whether a plant of different size andthus a different price and output com bination will enable him to earn larger profit.For this pui-pose, she will consider long-run marginal cost w l ~ i c l ~eflects the cost


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associated w ith a change in output when all factors, including the scale of plant,vary. A profit-maxim ising monopoly will be in equilibrium at that level of outputwhere long-run marginal cost and long run marginal revenue are equal and long-runmarginal cost intersects corresponding marginal revenue curve from below. Suchlong-mn equilibrium for the firm must also imp short-run equilibrium. The firm,therefore, makes the choice of the size of its plant in such a way that (i) A RAC , i.e., it gets positive profit, or, (ii) A R AC , it gets no 'extra', profit.Situation like AR AC is ruled out in the long period (Why?) In apu re monopoly,no potential com&titor can enter the m arket, by definition, and thus economic profitcannot be eliminated even in the long-run.

heck Your ProgressWhat do you understand by mono poly? What conditions must prevail formonopoly to e established?

What are the conditions that might give rise to a monopoly?

The demandcurve facing a n~on opolists downw ard sloping, Explain.

Discuss the relationship between average revenue curve and marginal revenuecurve of a monopoly firm.

Draw a linear demand curve and its associated marginal revenue curve. Statethe formula that relates marginal revenue, price and elasticity of demand , andexplain how the curves illustrate the relationship identified by the formula.

A mono polist is not free to determ ine-bo th price and quantity to be soldaccording o her whims and fancy. Explain.

Theo ry o f onopoly


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a r k e t S t r u c tu r e 7 Explain how price is determined under simp le monopoly?~-~...................................................................................................................

8 Discuss the determination of price and ou tput of a monopoly firm in the long-ml.

9.6 SOME QUESTIONS REGARDING THEBEHAVIOCTR OF MONOPOLISTSome questions might arise in your mind regarding the behaviour of a monopolist.For example, a) does a monopolist always make profits? b) does a monopolistalways benefit from a price rise? c) does a monopolist have unique supply curve?d) does a m onopolist, since she is the only producer in the industry, produce withthe optimuni scale of plant at optimum rate of output? e) is monopolycompatible with a downward sloping/constant marginal cost curve? f) ismonopoly an inefficient type of market structure? These questions will bediscussed in turn.9 6 1 Does a Monopolist Always Make Profits?There is certainly no reason to believe that the monopolist always makes aprofit. If,demand is sufficiently low relative to cost, the monopolist may incur a loss. For .example, in the foIlowing Fig. 9.4 AC curve is above the demand curve AR ) atthe point of equilibrium. The firm is incurring losses as shown by the rectangleABCD. i

AC, MC , Price Fig. 9.4

Fiz. 9.4 shows a situation where the monopoly firm may be forced to toleratesome lossin theshort r h . t w il l continue to produce so long as AR AVC. I fdemandcurveslides lower, the fi rm wi ll be forced toshut down even in the short run. Ifin the long run, the fi rm is able to adjust its plant to the size of the market


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a monopoly firm will go out of the business in the long-run unless Theo r y O T onopolyswitches over to an appropriate sized plant. In the short-run, it stays in thet is able to cover its variable cost. If the equilibrium price is less than thevariable cost, the monopoly firm will close dow n its plant even in therun ust like aperfectly competitive firm.

Does a M onopolist Always Benefit from a Rise in Price?explained above, a price rise and thus, a reduction in output )would invariably

it the monopolist if she operates over the range of deman d curve where thedem and is less than unity. In case elasticity is less than one, marginalnegative. rise in price causes fall in demand which results in rise n totalhand and fall in total cost (assuming marginal cost is positive)

e other. Thus, rise in price is beneficial to the m onopo list if e < 1.ever, if the mon opolist is operating in the elastic rang,e of deman d, thesitive when price is raised in this range, total revenue as well

Rise in price would be beneficial if fall in total cost is more than falltotal revenue. Otherw ise, the producer may have to lower prices to increase

3 Does a M onopolist have a Unique Supply Curve?onopoly firm does not have a unique supply curve since price is not equal to

marginal cost. Given a marginal cost, the sam e quantity may be offered atent prices depending on the price elasticity of demand. This can be said as the

e quantity will be so ld at different prices depending on the elasticities of variouscurves. Similarly, at the sam e price, different quantities would be

ies of the demand curve. Thus, there is no u niqueionship between price and quantity.

Does a M onopolist Produce with Optimum S cale of Plantat Optimum Rate of Output?produces with optimum scale of plant at the optimum rateoutput depends upoil the position of the market dema nd curve relative to the

of the firm. Given cost curve, the scale of plant depends upon th ethe market dem and curve and its associated marginal revenue curve.

he entry of new firm is blocked, there is no pressure for the mono polist tooptimal scale or to use her existing plant at optimum. It is not necessary

the monopolist to reach the minim um point of LA C. The size of plant andof utilisation of any given plant size depend entirely on the market demand .

ch the minim um point of LAC (optimal scale), remain at fallingLAC (less than optimal scale), or expand beyond the minimum LACthan optim al scale) depending on the market conditions.be noted that because of en try barriers under monopoly, there areof market forces which compel the firms to operate ptimum plant size

utilise it at its full capacity in the long run. Any of the above case can occuring on the size of the market.6 5 Is M onopoly Com patible with Falling/Constant

Marginal Cost ?incom patible with a continuously dow nward -sloping

cost curve. The marginal cost curve of the perfect competitivemust rise at the point of equilibrium output.. But this need not be so in case


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a r k e t S t r u c t u re ofmonopoly. monopolistic fm can be in equilibriumwith rising, falling or constantmarginal costsprovided that (a) marginal cost is equal to marginal revenue, and (b)marginal cost curve shall cut marginal revenue from below .Fig. 9.5 depicts the equilibrium o f a monopolist firm whose marginal costs areconstant and are equal to average costs.Monopoly equilibrium is also possible with falling marginal costs to ensure that themarginal cost curve cuts the marginal revenue curve from below. Moreover. themarginal cost must not be falling more rapidly than marginal revenue. To sum up,equilibrium under monopoly can occur whether marginal costs are rising, falling orconstant. The only situation in whichm onopoly equilibrium is impossible is whererriarginal costs are falling more swiftly than marginal revenue.

AC, MC, MR, AR Fig. 9.5

X QuantityFig. 9.5: Shows a special case where MC =AC =constant. The monopolists equilibrium

is still at point E where MC cuts MR from below. The firm produces OX outputand sells it at OP =AR) price.

9 6 6 Is Monopoly an Inefficient Type of Market Structure?Monopoly is an inefficient type of market structure in the sense that gains to thefirm from a lllonopoly position. its ability to charge higher price than the nlarginalcost, would be less than the loss of consu me r s surplus due to rise in price. Thedifference between the gains to the firm and the loss o f consume r s surplus onaccount of higher price under monopoly is termed as dead-weight loss.

AC, MC, A R, M R Fig 9 6

Fig.9.6: There ar e two prices, the competitive price, PC nd the monopolist s price,P,,. The loss ofconsumer s surplus attributable to the higher monopoly priceis the sum of rectangular area, PmAEIAPc nd the triangle EIE2A.But gain tothe monopolist isconfined to the rectangle only. The consumer s loss equal tothe triangle referred to above is dead weight loss . Also note that the consumeris worse off in one more sense she has to remain contented with a smallerquantity under monopoly than was available in perfect competition.


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A monopolist can increase profit through price discrimination. Price discriminationoccurs when the monopolist charges different prices for different units of ahomogeneous commodity. That is, in general, price discrimination means that afirm charges two or more prices for the same product at the same time. If theproduct is not homogeneous, it can also mean that the differences in the prices ofa firm s products are greater than differences in their cost of production.9 7 1 Degrees of Price Discrimination

ow far can a monopolist go on charging different prices for the same product?What is the limit? The-degree of price discrimination sets the limits within whicha monopolists can charge different prices. We can distinguish between 3 degreesof price discrimination. Look into the following discussion in this regard.First Degree Price DiscriminationDiscrimination of the first degree defines the maximum possible limit of a monopolistin charging different prices for the same product. By setting the price accordingly,the monopolist extracts from each consumer the entire amount of consumersurplus. For this reason, first degree discrimination is also called perfectdiscrimination.Second Degree Price DiscriminationIn case of second degree of price d iscrimination the monopoly irm sellsto the consumer block of output at one price and additional block of output ata different price. In this way, the monopolist captures a part of the consumerssurpluses, but not all of them. The schedules of rates charged by public utilitiesprovide examples of second-degree discrimination. Observe the rates you payfor electricity and water supply. Cl~argesre in different slab rates. Such structurescome close to the underlying idea behind second degree price discrimination.Third D egree Price DiscriminationThird-degree price discrimination means that the monopolist divides customersinto two or more groups, charging a different price to each group of customers.Each class is treated as aseparate market. This is the most common type ofprice discrimination and orm the subject matter of study in the following pages.9 7 2 Conditions for Price DiscriminationLet us consider the conditions under which price discrimination it is possible.The fundamental condition which must be f~~lfilled,fdiscrimination is to takeplace. is that there can be no possibility of resale of product from one consumerto another. The discriminatioil may be owing to consumers @culiarities, may bebased on the nature ofthe good, or may be because of distances and tariff orother barriers. This may happen if consumers in one part of the market do notknow that prices are lower in another, that is, lack of communication in differentparts of the market or if the consumer has an irrational feeling that she is paying ahigher price for a better good. The nature of the good may facilitate discrimination.For example, if the good in question is a direct service, hair cuts or manicures,services of a doctor or of a teacher. It is not possible for these services to beresold by a consumer who is charged a lower price to one who pays a higher price.

Th e o r y o Monopol


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M a r k e t S t r u c t u r e onditions under which it is Profitable to harge Different PricesIf above conditions are met, it is possible for the monopolist to engage in pricediscrimination. How ever, it will be profitable to discriminate only if elasticity ofdemand in the one market (e l) s different from elasticity of demand in the other(ei), that is, e , e,. This needs further elaboration.Assum e a monopolist who divides her market into two distinct segments, market1 and market 2 and has a fixed quantity of the product to be sold in one or both ofthe two markets. How should the given quantity be allocated between the marketsso as o maximise the m onopolist's total revenue? The total revenue will e maxirnisedfrom the sale of a given total quantity of a comm odity if marginal revenue inmarket A is equal to the marginal revenue in market B, that is, MR, = MR,.Now it is simple to understand that, if th e coefficient of price elasticity of demand(e) is same in both the markets, it will not be profitable to attempt to separate themarkets. Since marginal revenue in the two markets is to be equalised foroptimum allocation of given outpu t and when elasticity is the same in 60th themarkets, that is, e l= e,, it follows that

Thus PI = P2 and so, there is no price discrimination.How ever, if elasticity of demand is different, price discrimination w ill pay.When e I< e,, a rise in price in market 1 will not cause much fall in demand,whereas, a reduction in price in market 2 will add more to revenue than it does tocost. It will pay the monopolist who is charging the single monopoly price totransfer goods from market 1 with the inelastic demand to markef 2 with theelastic demand. The loss of revenue from reducing sales nmarket will be smallerthan the gain in revenue from expanding sa les in the market 2.Consequently, price will rise in market and fall in market 2. Higher price occursinthe market having more inelastic demand curve. The result may be shown with thehelp of formulaMR = P (1 -1 e). For optimum allocation of given output in the two markets, M R,=MR,, that is,

Thus if e l s greater than e,, then P, m u& be less than P2 n order to maintain theequality between the two sides of the above expression. So, the price is higher inthe market which has less-elastic demand . How ever, the abov e result hold goodsubject to the following conditions:a) that the coefficient of elasticity of dem and is greater than one in both themarkets, andb) it is profitable to sell in both the market, that is, marginal revenue in both themarket is greater than marginal cost.9 7 3 Equilibrium under Price DiscriminationTo determine the profit max imisin g total output to be produced by the pricediscriminatory monopolist, the marginal revenue should be equal to marginal costofproducing the whole output. This is explained with help of Fig.9.7. Let the averagea d marginal revenue curves of the firm for two separate markets having different


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elasticities of demand be A R I,AR 2 and M R , and MR2 respectively. The totaldemand curve D is obtained by horizontal summation of individualAR curves in thetwo markets. The aggregate marginal revenue (M R) is the horizontal sum mation ofM R, and MR2. M C is the marginal cost curve.Fig. 9 7

A C M C A R M RI I I l l

-Fig. 9 7: Panel I of the figure AR, D, and MR, curves in the market A. The corresponding

curves for market Bareshown in panel 11. Notice that demand curve in market Bis moreelastic of the two. The third panel shows aggregate demand curve D =DlD and aggregate marginal revenue curve associated with D The marginal

cost curveof the firm, MC cuts theMR at point E and therefore, firms total outputis OQ n panel Ill. The firm equates marginal revenue in each market to thisequilibrium level of MC MR Q E . Thus, it sells OQ, and OQ2quantities inmarkets Aand B respectively. The prices in two markets a re OPA and OPB .Themarket A, where elasticity of demand is lower, pays a higher price compared tomarket B.

To illaximise her profits. the price discriminating ino nop lis t has to take two decisions:a) How much total output to produce?b) How much to sell in each ~ na rk et nd at what price?l h e equilibrium level output oftlie price discriminating monopolist is at point whereMC equals aggregate MR . Since elasticities in two market segments aredifferent, her profit are maxim ised if M R, MR 2 MR MC . The producercharges less price in ~na rk etwhere dem and is more elastic.Check Your ProgressI What is pricediscrimination

2) What are the necessary conditions for price discrimination


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3 ) Explain howwilla profit ii~axim ising iscriminating inonopolist distribute oi~ tpu~tin different markets? W hat prices will she charge in those m arkets?

4) Discuss the relationship between price elasticity of demand and pricediscrimination.

9 8 EQUILIBRIUM PRICE A N D OUTPUT O F APUBLIC MONOPOLY

So far we have discussed the behaviour o f a private monopolist w l~ os e bjective isto n~ ax iin ise er profits, given the econom ic and technical constraints. In this section,we analyse the behaviour of apu blic nlonopoly a firm owned and controlled by thcgovernmen t. The objective of a public monopoly is to provide more output andcharge lower price so as to increase tlie welfare of people. The o ptimal pricing andoutpu t decisions by such an iundertaking is not based on profit or sales maxim isationprinciples but on maxim isation of welf xe.Average-cost-pricing and n~arg il~al-cost-p ricingre the two possible options forthe determ inatio~i f output and price by a public utility fi rii ~.n fact, t lese t\voop tio ~l s an become policy guidelines for the governm ent for price regulation of aprivate ~ ~io nop olyilm as well.r here is a need to regulate mon opoly because monop olists hav e ability to restricto~ ltp ut nd raise prices of their product and this way earn super iiormal proiits. Suchbcli:~vior ncreases inequalities in the distribution of incom e and wealth. leads toexploitation of the consu mers and also causes inefficiency in allocation of resources.A net result of all these actions is reduction of con sum er welfare in tlie society.Tliereforc. the main ob.iective behind regulation of inollopoly is the maximisation of\$elfare. A monop oly may be regulated either tl~rou gh ixation of a m aximum pricethat a ~nonop olistmay charge or appro priate taxation policy. In this unit, we areconce rned with price regulation of monopo ly only. The issues involved in averageand m arginal cost pricing discussed here are useful in fixing of prices in a publicutility as well.9 8 1 Marginal ost PricingAs discussed above, a nio~ iopolist ets price of its product high er than marginalcos t, that is P MC. As sh own in Fig.9.6. mono polist maximises profit at OQIllevel of output and charges OP in price. The governnlent may dec ide to regulate an~onopoly y fixing niaxim iun price that equals marginal cost of production. Thus,the n1onopolist will be forced to raise the output to OQ, and the price correspond ingto t l~ i sevel of output will be OPc price. whicl~ ould have prevailed had themarket been pell'ectly competitive. Such a price would ensure efficiency in allocationof resources as wcll, since it is equal to marginal co st. It also enhances welfare of


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the consum ers, as they get larger output at lower price. The co n su n~ er 's urplusunder non-regulated monopoly is shown by area of t~ ia ng leAPIllEI .When marginalcost pricing is enforced. it rises to APcEZ Fig. 9.6).It may be noted that given the conditions of dem and and co st as presented in thea b o ~ ~ eigure. marginal cost pricing may still nllou a n~ ono pol isto eam super normalprofits a s the price ma still be higher than the average cost. Thi s is a case of'capacity-con strail~eil ituation', that is, the dem and for the product is quite high a scompared to the production capacity. But. in different a situation. uh en there isexcess capacity. m arginal co st pricing results in direct loss to the tin11 as its averag ecost is hig her than margina l co st. Th us the fir111 will p rodu ce ma rginal c os t priceoutput only if it is compenca ted by tlie go\lernm cnt for the direct loss at this Ic\,elolproduction.9 8 2 Average Cos t Pr ic ing*Theaim oft he public policy i b to regillate mono poly in such a mann er that it ispossible to providc maximu m output at min im i~ m rice. On e policy option in such acontex t is to fix pricc according to the average cost, that is. at a point \\here AR=A C. Th is allows the Iirm to earn normal profit. In case o f capacity-constrail~eclsituation, average cost pricing leads to hig l~ er i~ tp ut nd lower price. l'llis meanstherc will be higher level ol'consumer's su ~ p lu somp ared to marginal cost pricing,l luwev er. in excess cal,acity situa tion . there shall be a some what higher price withaverage cost pricing but thcre shall be no direct loss to the producer as I =AC.h4arginal cost pricing is adopted to reach full economic eiliciency or maxim um social\\ el Care. But in cas e of excess capac itj , where AC >MC. m arginal cost pricingnecessitates stale subsidies to indu ce the mon opolist to stay in thc mark et.9 8 3 A Note on Mark up Pr ic ingIt is suggested that, in practical life, prices are not fixed by marginal analysis, thatis. by thc use of marginal rc.\,enue and m arginal cost concep ts. An alternativeapproa ch is to sct the l7riccs in accord anc e with the aver age cost principle.I'hc lirm sets a price eclual lo its total ave rage cost whic h incIudes a certain net17rofitmargin , that is.

I AVC (;I'M.m.11ere I is the price. AVC' is the average \x ia b l e cost, and GPM is the grossprofit ~ n ar gi n hich include average tixed cost and net profit margin.Th e purpose of this note is to s11our that a \ erage cost principle and marginalanalysis ~ o u l dive the same long-run profit maximisation solution. T he setting ofthe price o the basis of the average cost principles incorporates an estinlation ofthe elasticity of demand in the long-run eqi~ illbriu m.Recall that the necessarycondition for profit masimisatio n is MC M R. It has all-eady been proved that MR

P (1 -1le). G iven that b1C > 0. MR must be positive for protit maxim isation.This i~mpliese . I'rovided that AVC is constant over the relevant range ofou tput .thdt is. AV C MC . For ecluilibrium, AV C M R, that is, AV C P (1 - l l e )I (e -l) /e ). In other words. P AVC {e/(e-1)) . Given that e > I . we may write

e/(e- ki . \z here k >O. Therefore, P AVC 1+k). where k is the grossprofit margin. I'or e ~ a m p le . f the lirm sets a 20 per cent of AV C as its profitmargin, we have I +k) I ( t ) 0.20 (e/(e-I ) ) .TIIL~s,lie elasticity of dema ndis 6. Setting a gross profit margin is equivalent to estimating the price elasticity ofdemand and applying marginulist analysis. So when the businessman establishes


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a mark-up on average costs, he is guessing at the coefficient of price elasticity ofdemand.heck Your Progress 3

1) In w ha t respect a public monopo ly is different from a private monopoly?How does a public monopoly irmmake pricing and output decisions?

2) Write a sho rt note on mark-up pricing.

9 9 LET US SUM UPWe commenced t li s unit with a discussion of factors wh ichgive rise to monopoly inthe market. In som e cases it may be a result of march of technology . but moreoften, it arises on accoulit of legal provisions like patents, if it has not bee11created by law (public monopoly). The subsequent discussion was f o lr h e d with adesc iiption of demand and marginal revenue curves of such a firm and its equilibrium.Then we took up questions like whether a nionopoly always makes profits or. benefitsa rise in price. Nature of the supply curve, efficiency in production etc.. were tlieother aspects we touched upon.Price discriinina tion is ano ther aspect of a monopolist s beliaviour aiid it has beendwelt upon in Section 9.7. We have exam ined two alternative approaches to pricedetermination in a public monopoly, wh ich can be used to regulate prices in private~no iiopolies s well. We have concluded the unit by dem onstrating eqi~ ivalen ce fmark-up pricing with p rior estima tion of price elasticity of demand.

9 10 KEY WORDSMonopoly Existence of only one pro ducer/ seller of a good inthe market.Legal monopoly Monopoly created by som e legal provisions.Technological Monopoly Techn ology is such that it makes feasible for tlieproduction by one producer on ly.Price Discrimination Ability of a firm to charge different prices fromdifferent consum ers for tlie sanie product.Public Monopoly A governm ent sets up moilopoly to ensure greater

availability of some good or service at a reasonableprice.


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g i n i t i i I sicing policy nhi ch cov ers only the malpin:ll cost ofproduction.

A\ ,cn~ gc ost Pricing I olicy under wh ich the price cover s averag e cost ofproduction.

Mark-up Pricing Pricing technique w hich futes price at average variablecost plus a proportion of the fixed costs and a profitmargin.

9 11 SOM E U S E F U L BOOKSVarian. l u i 1005) . l ~ r / c l . ~ ~ r c r l i ~ ~ / e21 i c~~o i~co~on~ i c . r ,.W Norton Co, New) orI,I i ~ ~ t l q ~ l i .tobcrt S nt1 Ilanicl Ri~ binfe ld 198 9) iMicl.occononiics, CollierMacmillan. ,ondon

9 12 HINTSIANSWERSTOCHECKYOURPROGR ESS EXERCISES

C hecli Your l rogrcss, ) Read S cction 9.1 and 9 .2 and ansner2 [

Monopoly Theory

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