Micro Economics Theory II

 Course content
 chapter One: Monopoly And Monopolistic competition
 Chapter Two: Oligopoly
 Chapter Three: Introduction To Game Theory
 Chapter Four: Factor Pricing And Income Distribution
 Chapter Five: General Equilibrium Analysis And
Welfare Economics.
 Chapter Six: Market Failure
 Chapter One
Monopoly Market Structure
 Objectives
 After successful completion of this chapter, you will be able
to:
 Basic features of monopoly market and factors which give
rise to monopoly.
 The nature of demands and revenue curves under
monopoly.
 How to determine equilibrium price and output under
different conditions of monopoly such as Multiplan
monopolists and price discriminating monopolists.
 Different types of price discrimination and conditions
required to effectively exercise price discrimination.
 How monopoly results in welfare loss.
1.1 Definition and Characteristics
 In the last chapter we have seen perfectly competitive
market structure in which there is large number of firms
selling homogeneous products. Monopoly is quite opposite
to perfectly competitive market. And it is defined as: a
market situation in which a single seller sells a product or
provides a service for which there is no close substitute.
 In monopoly there are no similar products whose prices or
sales will influence the monopolist price or sales.
 In another words, cross elasticity between monopolist
product and other commodities is zero or low. Since there
is a single seller in monopoly market structure, the firm is
at the same time the industry.
 Common characteristics or features of monopoly
 Monopoly markets share the following common
characteristics.
 1.Single seller and many buyers: There is a single seller
who sells the product to many buyers.
 2.Absence of close substitutes: A product produced by a
monopolist has no close substitute so that consumers have
no alternative choices to substitute one product for another.
 3. Price maker: Dear learner, in perfectly competitive
market, we have said that, both sellers and buyers are price
takers. However, the monopolist is a price maker. Facing a
down ward sloped demand curve for its product, the
monopolist can change its product price by changing the
quantity of the Product supplied. For example, the
monopolist can increase the price of its product by
decreasing the quantity of supply.
 Cont’d…………
 4.Barrier to entry: In monopoly, new competitors cannot freely enter in
to the market due to some barriers which can be economical, technical,
legal or other type of barriers.

 5. Price discrimination: in a monopoly the firm can change the price

and quantity of the good or service. In an elastic market the firm will sell a
high quantity of the good if the price is less. If the price is high, the firm
will sell a reduced quantity in an elastic market.

 6. Profit maximizer: a monopoly maximizes profits. Due to the lack of

competition a firm can charge a set price above what would be charged in
a competitive market, thereby maximizing its revenue
 Sources of monopoly
 The major sources of barriers to entry are:
 i) Legal restriction: Some monopolies are created by law in
public interest. Such monopoly may be created in both
public and private sectors. Most of the state monopolies
in the public utility sector, including postal service, telegraph,
telephone services, radio and TV services, generation and
distribution of electricity, rail ways, airlines etc… are
public monopolies.
 ii) Control over key raw materials: Some firms acquire
monopoly power from their traditional control over certain
scarce and key raw materials that are essential for the
production of certain other goods. For example, Aluminum
Company of America had monopolized the aluminum industry
because it had acquired control over almost all sources of bauxite
supply; such monopolies are often called raw material
monopolies
 Cont'd…………..
 iii) Efficiency: a primary and technical reason for growth
of monopolies is economies of scale. The most efficient
plant (probably large size firm,) which produces at
minimum cost, can eliminate the competitors by
curbing down its price for a short period and can
acquire monopoly power. Monopolies created through
efficiency are known as natural monopolies.
 iv)Patent rights: Patent rights are granted by the
government to a firm to produce commodity of specified
quality and character or to use specified rights to
produce the specified commodity or to use the specified
technique of production. Such monopolies are called to
patent monopolies.
 Cont’d………
 V. Exclusive knowledge of production technique:-
 Most of the beverage (soft drink) companies such as Coca Cola
Company have maintained monopoly power over supply of their
product partly due to exclusive knowledge of the ingredient
chemicals required for the production of their product.
 VI. Government Franchise and License :-Another cause for the
emergence of monopoly is government franchise. Franchise is a
promise by the government for a firm to prohibit the establishment
of another firm (by another person) that produces the same product
or offers the same service as the original one.
 For example, when the first Bank in Ethiopia, Abyssinia Bank was
established, Emperor Minilik has promised for the Egyptian firms
(the owner of the Bank) that they will monopolize the Banking
service in Ethiopia for 50 years. Postal service in Ethiopia, Ethiopian
television, telecommunication service in Ethiopian etc. are other
examples of monopoly.
 Cont’d………..
 Source of monopoly power includes:
 Capital requirements
 Technological superiority
 No substitute goods
 Control of natural resources
 Network externalities
 Legal barriers
 Deliberate actions
Demand Curves for Competitive and Monopoly Firms
 Profit maximization of monopoly in short run
equilibrium

 Price and output combination that maximizes the

monopolist profit can be determined in the similar
fashion as that of the perfectly competitive firm. That
is, price- output combination that yields the
monopolist the maximum profit can be determined
in two ways:
 1. Total approach
 2. Marginal approach
 Monopoly's Revenue
 Total Revenue TR=P Q
 Average Revenue TR/Q = AR = P
 Marginal Revenue dTR/ dQ = MR
 A monopolists marginal revenue is always less than the price
of its good.
 The demand curve is downward sloping.
Profit Maximization
 A monopoly maximizes profit by producing the quantity at which
marginal revenue equals marginal cost.
 It then uses the demand curve to find the price that will induce
consumers to buy that quantity.
 Comparing Monopoly and Perfect Competition
 For a perfectly competitive firm, price equals marginal cost
at equilibrium. P = MR = MC
 For a monopoly firm, price exceeds marginal cost .
P > MR,P> MC
Figure: Profit Maximization for a Monopoly
 The Monopolist's Profit
The monopolist will receive economic profits as
long as price is greater than average total cost.
Zero-profit monopolist
Monopolist receiving economic loss
Monopolist that shuts down in the short run
 Decision Rule in the Marginal Approach

1. When P > ATC, the monopolist enjoys positive

profit.
2. When P = ATC, the monopolist is at breakeven
point (earns zero economic profit).
3. When P < ATC, the monopolist faces negative profit
(loss).
4.When ATC > P > AVC, the monopolist should
continue operation under loss in the short run to
minimize its total loss.
5.When ATC > P = AVC, the monopolist is indifferent
6.When ATC > AVC >P, the monopolist must shut
down in the short run.
18
 Numerical Example
19


 Numerical example

 Suppose the monopolist faces a market demand

function given by P=40-Q. The firm has a fixed cost
of $ 50 and its variable cost is given as TVC=Q2
determine:
 a) the profit maximizing unit of output and price
 b) the maximum profit
Cont’d…..
Cont’d………..
1.2 Price Discrimination
 Price discrimination refers to the charging of different
prices for the same good. But not all price differences are
price discrimination. If the costs of offering a certain
uniform commodity (service) to different group of
customers are different (say due to difference in
transport costs), price of the commodity may differ for
each group owing to this cost difference. But this cannot
be considered as price discrimination.
 A firm is said to be price discriminating if it is charging
different prices for the same commodity without any
justification of cost differences. By practicing price
discrimination, the monopolist can increase its total
revenue and profits.
1.3 Degrees (types) of price discrimination
 The degree of price discrimination refers to the extent
to which a seller can divide the market and can take
advantage of it in extracting the consumer Surplus. In
economics literature, there are three degrees of price
discrimination. These are discussed one by one here under.
 1-First degree price discrimination (Perfect price
discrimination)
 The practice of charging each customer his/her reservation
price is called first degree price discrimination.
 Note that the consumer’s willingness to pay reservation
price for a given commodity varies with the quantities of
the commodity the consumers own.
Cont’d……
 For example, a doctor who knows his patients’ paying
capacity charges high price for the richest patients’ and low
price for the poor patients for identical services. This is
practiced to increase revenue. If the doctor fixes the price at
the richest patients’ level, no poor will afford to pay and the
doctor will not get revenue from the poor. On the other
hand, the doctor would not fix the price at the poorest
patients’ level for all patients because he knows that the rich
can pay more and he will exploit the rich.
 Lawyers also practice the same discrimination for identical
legal service
2-Second degree price discrimination (block pricing)
 The act of charging different prices for different
quantities of purchases is called second degree price
discrimination or sometimes called quantity
discrimination. In second degree price discrimination
the price various only with quantity: all customers pay
the same price for a given quantity.
 In second degree price discrimination, the
monopolist attempts to take the major part of the
consumer surplus instead of the entire of it. Block
pricing can feasibly be implemented where:
Cont’d…….
 -the number of consumers is large and price rationing can
be effective e.g. electricity and telephone services.
 -the demand curves of all customers are identical and In
second degree price discrimination, the monopolist attempts
to take the major part of the consumer surplus instead of the
entire of it.
3-Third degree price discrimination (multi-market price discrimination)
 Typically, a firm does not know the reservation price
for each of its customers. But, the firm may know
which groups of customers are likely to have higher
reservation prices than others. In such a situation the
firm may divide potential customers in to two or more
groups and set a different price for each group. Such an
action of charging different prices in different markets
is called third degree price discrimination.
Cont’d…………..
 Thus we can conclude that to maximize the total
revenue received from the sale of a given quantity a
commodity, the monopolist should allocate the total
quantity in each sub market in such a way that the
marginal revenue of the last unit sold in each sub
market is the same.
 Symbolically, the equilibrium condition for a third
degree price discriminating monopolist is:
MC=MR1=MR2.
Cont’d………
Cont’d…………
Cont’d………..
Cont’d……………
 MONOPOLISTIC COMPETITION
• Monopolistic Competition Defined :-As the name implies,
monopolistic competition is a blend of competition and
monopoly.
• The major elements of perfect competition found in
monopolistic competition are:
• the existence of many small firms which are unable to
significantly affect each other (when seen individually), and
• the possibility of entry and exit.
• Examples of monopolistic competition include the markets
of the numerous brands of
• soap (B-29, Wabel, 777 …),
• toothpaste (Aquafresh, Colgate, …),
• Stationeries (SinarLine, MAMCO …),
• cigarettes (Rothmans, Marlboro, Nyala, Dunhill …), etc.
Monopolistically competitive market
 Product Differentiation, the Demand Curves and
Costs of the Firm
• Product differentiation is generally intended to
distinguish the product of one producer from that of
the others in the ‘industry’.
• This product differentiation might be attributed to:
 The subjective judgment of the consumer,
 The quality (for instance, the durability) of the product,
 The characteristics of the product such as taste, color --
 Sales promotion, packaging, trademarks, etc.
 Product differentiation can be real or fancied.
 Real product differentiation: exists when there are
differences in the specification of the products (chemical
composition/ingredients),or differences in the factor
inputs, or the location of the firm that determines the
convenience with which the product is accessible to the
consumer, or the services offered by the producer during
times of sale.
 For more clarity, two brands of soap (say, B-29 and
Peacock) are said to be really differentiated either:
 if they are made of different ingredients, or
 if the producer (or retailer) of one is more conveniently
accessible to consumer than that of the other, or else
 if there is a difference only in the quality of services say the
whole distributors of the two brands offer to their buyers.
 Cont’d……..
• Fancied (spurious/imaginary) product differentiation:
exists when the products are basically the same but the
consumer is persuaded, via advertising or other selling
activities, that the products are different. It is established by
advertising, difference in packaging, difference in design, or
simply by brand name.
• As a hypothetical example, even if Fine and Abyssinia
pocket tissue papers might be of the same quality for an
individual in all aspect, the individual may still tilt towards
witnessing the superiority of one only because of the
difference in color of packaging. This is just one example of
spurious product differentiation; think of such differences
between/among close substitutes in your locality.
• Whatever the case, the aim of product differentiation is to
make the product unique in the mind of the consumer.
 The Demand Curves:
• Two types of demand curves in the theory of
monopolistic competition – the planned sales
curve and the actual sales curve.
• The planned sales curve – this is a demand curve
that shows how much the firm will sell if it varies
its price from the ongoing level under the
assumption that other firms maintain their existing
prices
• Example:- If the firm reduces its price and other
firms maintain their prices, the firm can expect a
considerable increase in sales since it will be able
to attract buyers away from other firms in the group
(‘industry’) and increase sales to existing
customers. E.g Bedele Brewery
 Cont’d……….
• The actual sales curve – this is the demand curve
based on the supposition that all firms raise or lower
their prices by the same amount as this firm under
consideration. This demand curve, also known as the
share-of-the-market curve, is shown as DD in Figure
1.1.
 The Concept of Industry and Product Group
• How we define industy in three matket?
• under perfect competition, an industry
encompasses all firms producing exactly identical
(homogenous) products.
• Under pure monopoly, since there are no two
firms which produce the same product, a given firm
is an industry in itself.
• When products are differentiated, one cannot
define an industry as a collection of firms producing
identical (homogeneous) products. In this narrow
sense, each firm having a distinct product is an
industry in itself, exactly as a pure monopolist is.
 Cont’d………..
• However, unlike the pure monopolist which
produces a completely unique product, in
monopolistic competition, there are firms which
produce closely related (or very similar) products
that satisfy the same need.
• Chamberlin was (perhaps) the first economist who
tried to define industry in monopolistic competition
by lumping together firms producing very closely
related commodities (in terms of their use).
• He referred to such group of firms as a ‘product
group’. Thus, whenever the term industry is used in
reference to monopolistic competition, it is to mean
a product group.
 Equilibrium of the Firm
• In perfectly competitive firm is a price-taker. It can
choose the level of output only. This means that
quantity of output is the only choice variable for a
perfect competitor.
• On the other hand, a pure monopolist can choose
either the price it charges or the quantity of output it
produces, but cannot simultaneously choose both.
• What about a monopolistically competitive firm?
• The choice-related variables for a monopolistically
• competitive firm are:
• (i) price (or quantity),
• (ii) product variation, and
• (iii) selling expenses.
 Cont’d…..
• There are three possible situations (profit levels)
for a monopolistically competitive firm in a short
run equilibrium:
• production at positive profit, (P > ATC)
• production at normal (zero) profit,(P =ATC )and
• production at loss. (P < ATC)
• Note :Price adjustments of the existing firms are
shown by shift in the planned sales (dd) curve,
while entry (or exit) cause shifts in the actual
sales (DD) curve.
 Cont’d……….
• In order to be able to analyze the equilibrium of
the firm and that of the industry on the same
diagram, Chamberlin made two ‘heroic
assumptions’, namely:
i. that firms have identical costs, and
ii. that consumers’ preferences are evenly
distributed among the different products.
• Under these assumptions, the price in the market
will be unique. If all firms have the same cost and
demand curves, then the equilibrium of one of the
firms is also the equilibrium of every other firm.
 Cont’d…………
• According to Chamberlin stable equilibrium is
achieved when the planned sales curve is
tangent to the LAC curve and the planned
(expected) sales are equal to the actual sales.
That is, equilibrium attains if the actual sales
(DD) curve cuts the planned sales (dd) curve at
the point of tangency of the later (dd) with the
LAC curve (See Figure 1.3 below).
cont’d………….
 Excess Capacity and Welfare Loss
• The social welfare aspects of monopolistic competition
are generally ambiguous.
• On the one hand, each unit is produced at a cost below
the price that consumers are to pay (P > MC). On the
other hand, the existence of product variety (freedom of
choice) – the quality of ‘differentness’ – in monopolistic
competition contributes positively to social welfare.
• The net of these two effects should be taken, and the
impacts (advantages and disadvantages) of advertising
(and other selling activities) associated with product
differentiation must be added to this net.
• The social welfare impacts of a specific monopolistically
competitive market could be commented on, whereas that
of monopolistic competition in general is inconclusive
 Criticisms of Chamberlin’s Theory of Monopolistic
Competition
A. The definition of the set of firms to be included in
the product group is extremely ambiguous. Shall
we include producers of B-29, 777, Wabel, and
OMO together, or put producers of OMO into a
different category (product group)? It is not easy!
B. It is unrealistic to assume that firms selling
differentiated products have the same demand and
cost curves.
C. In markets where there are many small sellers,
product differentiation has been found to be slight.
As a result, the demand curve facing the
monopolistic competitor is close to being
horizontal. This renders the model of monopolistic
competition unnecessary.
 Con’t, d……
4.In many markets where there are strong brand
preferences, it usually turns out that there are only a few
producers, so that the market is oligopolistic rather than
monopolistically competitive. Those monopolistically
competitive markets which are not approximated by
perfect competition are rather oligopolistic; and not really
monopolistically competitive.
5. Even in a market where there are many small sellers
of a product, a change in price by one seller may have
little impact or no effect on most other sellers of the
product located far away from it, but the price change will
have a significant impact on competitors in the immediate
vicinity.
• Thank you
• End !!!