Chapter Two

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.
2.1 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.

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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.
2.2 Sources / Causes for the emergence/ of monopoly

Dear learner, think of any monopoly firm in our country and try to analyze the reason why the
firm maintains its monopoly power. There are many factors that create monopoly and help the
monopolists to maintain monopoly power. Some of the factors will be discussed below.

1. Ownership of strategic or key inputs

A firm may own or control the entire supply of a raw material required for the production of a
commodity. Such firms are not willing to sell the raw materials to another firm. For example,
until the second world war, the aluminum Company of America (Aloca) controlled practically
the entire supply of Bauxite(the basic raw material necessary for the production of aluminum),
giving it almost a complete monopoly in the production of aluminum in the united states. To
come to our country, Ambo Mineral Water can be taken as an example. Ambo mineral water has
monopolized the natural mineral water.

2. 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.

3. Patents and copyright

Patents and copyrights are government supported barriers to entry. Patents are granted by the
government for 17 years as an incentive to investors. Authors of books, artistic works (such as
3 cassette, video, etc) are the best examples of such monopoly. For example, no one, except
Adama University, can copy and sell this course material as Adama University has an exclusive
copy right over the material.

4. 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.

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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

5. Economies of scale may operate (i.e. the long run average cost may fall)

Another cause for the emergence of monopoly is economies of scale in production. A firm is said
to have economies of scale if its long run average cost is declining. In such a situation, when the
incumbent firm observes that new firms are entering into the market, it will produce large
amount of output to minimize its unit cost of production and will charge a lower price than the
new firms to deter entry. Such a monopoly is called natural monopoly.
Aside from the few cases of monopoly mentioned above, pure monopoly is rare and most
governments discourage pure monopoly because monopoly is deemed to create inefficiency. For
example, had it been the case that the telecommunication services are not monopolized in our
country, their prices would have been lower. But through pure monopoly is rare, the pure
monopoly model is useful for analyzing situations that approach pure monopoly and for other
types of imperfectly competitive markets (i.e. monopolistic competition and oligopoly. Another
Source of monopoly power includes:

 Capital requirements
 Technological superiority
 No substitute goods
 Control of natural resources
 Network externalities
 Legal barriers
 Deliberate actions

Monopoly vs Competitive Market

Monopolies and competitive markets mark the extremes in regards to market structure. There are
a few similarities between the two including: the cost functions are the same both minimize cost
and maximize profit, the shutdown decisions are the same, and both are assumed to have
perfectly competitive market factors. However, there are noticeable differences between the two
market structures including: marginal revenue and price, product differentiation, number of
competitors, barriers to entry, elasticity of demand, excess profits, profit maximization, and the
supply curve. The most significant distinction is that a monopoly has a downward sloping
demand instead of the “perceived” perfectly elastic curve of the perfectly competitive market.

2.3 The demand and revenue curves of the monopoly firm

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In the previous unit, we have seen that the perfectly competitive firm is a price taker and faces a
demand curve that is horizontal or infinitely elastic at the price (determined by the intersection of
the industry or market demand and supply) of the commodity. But, remember that the market
demand curve is down ward sloping. However, a monopolist firm is at the same time the industry
and thus, it faces the negatively sloped market (industry) demand curve for the commodity. In
other words, because a monopolist is the sole seller of a commodity, it faces a down ward
sloping demand curve. This means, to sell more units of the commodity, the monopolist must
lower the commodity price.

Conversely, if the monopolist decides to raise the price of the product, it will reduce the quantity
of supply without worrying about the competitors, who by charging lower prices would capture
a large share of the market (customers) at the expense of him. So the monopolist can manipulate
the price of its commodity by changing the quantity of supply. To sell more units of the
commodity, the monopolist will charge lower price and vise versa. Hence, the demand curve
facing the monopolist is negatively sloped, showing the inverse relationship between market
price and quantity demanded.

Figure 2.1 the demand curve facing the monopolist firm is down wards sloping. At price p1, the
firm sells only Q1 outputs. To sell more units the firm should reduce the price.

Mathematically, assuming that the demand curve is linear, it can be written in the following
form.
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P = a – bQ
Where P – is the market price
Q – is the quantity of sales (quantity demanded)
a&b – are any positive constants
The total revenue of the monopolist can be obtained by multiply the market price with the
quantity of sales
That is,
TR = P.Q
Substituting (a – bQ) for P
TR = (a - bQ) Q
TR = aQ – b Q2
Hence the total revenue curve of the monopolist firm has an inverse U- shape. The total revenue
of a monopolist firm first increases with the quantity of sales (over the elastic range of the
demand curve), reaches its maximum (when the demand curve is unitary elastic), and finally
decreases when quantity of sales increases (over the inelastic range of the demand curve) the
following figure illustrates this fact.

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Fig: 2.2 the shape of total revenue curve and its relationship with the price elasticity of demand.
When Ep>1 TR and Q have positive relation, at a point where Ep=1, TR curve reaches its
maximum and when EP<1, TR and Q have negative relation.

The MR curve of monopolist firm is down ward sloping (decreases with quantity of sales). The
fact that the monopolist must lower the price to increase its sales causes the MR to be less than
price except for the first unit. This is so because when the firm reduces the commodity price to
sell one more unit all units which would have been sold at the original higher price will now be
sold at the new (lower) price. The following table may help you better understand this fact.

The above table shows that as output increases the TR first increases, reaches its maximum
(when the firm sells the third unit) and then starts to fall.
The MR is less P except for the first unit. For example, when the firm decreases the price from$5
to $4 marginal revenue decreases from $5 to $3. That is, at the second unit MR ($3) is less than
the P ($4). This is because, when the market price is $5, the firm will sell one unit and will get a
TR of $5 and the MR of this first unit is $5. When the price decreases to $4, both the first and the
second unit are sold at $4 and the firm receives total revenue of $8. Now, the MR that the firm
obtains from the second unit is only $3. Hence for a down ward sloping demand curves (in
monopoly) the MR of the firm is less than the market price. Note that the AR of a monopolist is
always identical to the P or demand curve. In general, the MR curve of a monopolist firm is
negatively sloped. The MR will be positive over the elastic range of the demand curve (because
TR is increasing over this range), zero when the price elasticity of demand is unitary ( because
the TR is at its maximum level) and will have a negative sign over the inelastic range of the
demand curve( because TR is decreasing)

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The following figure illustrates the relationship between price elasticity of demand and MR

Fig: 2.3 the relationship between MR and P. The MR of a monopolist lies below the commodity
price for each unit sold (except the first unit) and it is negative over the inelastic range of the
demand curve.

Mathematically, it can be shown that MR is less (steeper) than the AR or demand curve.
Suppose a monopolist’s demand curve is given by

Thus, MR = (a – 2bQ) has a slope which equals twice the slope of demand (average revenue)
curves. This implies that MR is less than AR or demand or price. We have seen that a monopolist
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firm faces a down ward sloping demand curve. Exception to the law of demand under monopoly
is that the firm can increase the quantity of sales only through promotional activities (without
price cut).

Check your progress Activities

1. How do you define monopoly? What are the basic differences between the characteristics
of monopoly and perfectly competitive markets?
________________________________________________________________________
______________________________________________________________________
2. Explain the reasons for the existence of monopoly and give at least two local examples
for each.
________________________________________________________________________
________________________________________________________________________

3. Explain how the demand and revenue functions of a monopolist firm differ from that of
a perfectly competitive firm.
_____________________________________________________________________________

4. Suppose a monopolist firm faces the following market demand function:

P = 120 – Q
a) Determine the range of output over which TR is increasing
_________________________________________________________________________
___________________________________________________________________________

b) Determine the range of output over which the MR is negative

______________________________________________________________________________
______________________________________________________________________________

2.5 Profit maximization of monopoly in short run equilibrium

In this section, we examine the determination of equilibrium price and output by a monopolist
in the short run. We will also show that a monopolist, like a perfectly competitive firm, can
incur losses in the short run. Finally, we demonstrate that, unlike the case of the perfectly
competitive firm, the monopolist’s short run supply curve cannot be derived from its short run
marginal cost curve (the supply curve of the monopolist is indeterminate)

To start with, it was discussed in the last chapter that in a perfectly competitive market price is
given and profit maximization involves only looking for the profit maximizing unit of output,
given the market price. But, under monopoly, the firm is a price maker and has a power to alter
the level of output. Thus, profit maximization under monopoly involves determination of the
price and output combination that yields the firm the maximum possible profit.
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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
now let us see the two approaches one by one.

1. Total approach

In this approach the profit maximizing unit of output is defined as that level of output where the
positive difference between TR and TC is maximal or the negative difference between TR and
TC is minimal. The equilibrium price can be determined by dividing the TR corresponding to the
equilibrium output level to the equilibrium output. The following figure tells more about this
approach.

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Fig 2.4 Short –run equilibrium of the monopolist Total approach: The TR of the monopolist has
an inverse U shape because the monopolist must lower the commodity price to sell additional
units. The STC has the usual shape. The total profit is maximized at Q2, where the positive
difference between the TR and STC is the greatest. Profit is negative for output levels below Q1
and above Q .In this approach the profit maximizing price is given by the ratio of TR* to Q2.

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 2. Marginal approach

In this approach the profit maximizing level of output is that level of output at which marginal
cost curve cuts the marginal revenue curve from below. The equilibrium (profit maximum) price
is the price corresponding to the equilibrium price from the demand curve.

Fig. 2.5 Short- run equilibrium of the monopolist: marginal approach. Equilibrium output is Q2,
where MC and MR curves intersect each other and MC curve is up ward sloping. Equilibrium
price is the price corresponding to the equilibrium quantity, Q2 (i.e. p2).
Note that, a monopolist charges a price which exceeds the MC of production, unlike the case of
the perfectly competitive firm. Now, how can we be sure that Q2 is the profit maximizing unit of
output? To answer this question, note that in the total approach the level of profit at a given
level of output is the vertical distance between the TR and TC (i.e, ∏ = TR - TC.)

In the marginal approach, however, the level of profit at a given level of output is not the
distance between the MR and MC curves. Rather it is the area between marginal revenue and
marginal cost curves starting from the origin up to the given level of output. Symbolically, the
level of profit say at Q2 level of output is:

Given the level of profit as the area between the MR and MC, let’s come back to our question
above.
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In the above figure, we have said that the equilibrium price is Q2 and the level of profit is the
area between that part of MR and Mc curves between the origin and Q2 (area abE).
Now we are going to prove whether this level of output is actually the profit maximizing level of
output. To prove this, suppose initially that the monopolist produces a smaller quantity Q1 and
receives the higher price, P1. The level of profit at this level of output the area between that part
of MR and MC curves ranging from the origin up to Q1 ( i.e. area abcd). Hence the firm loses
the level of profit given by the area cde by producing Q1 level of output instead of Q2.Thus, any
level of output below Q2 cannot yield the firm the maximum profit. Similarly, it can be shown
in the same way that any level of output above Q2 cannot maximize the firm’s profit.

In other words, for any level of output below Q2, MR is greater than the MC, implying that each
additional unit of output yields larger additional (marginal) revenue to the firm than the
additional cost of producing it. Hence the firm should produce additional units until Q2. On the
other hand, for all levels of output above Q2, the MC of producing additional unit of output is
greater than the MR obtained from it. Hence, the firm should not expand its output above Q2.
This argument can prove the fact that Q2 is the profit maximizing level of output.

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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

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2. 6 Mark up pricing
Although prices can be determined by equating MC and MR, most managers have only limited
knowledge of the AR and MR functions that their firm faces. Mark- up pricing helps us to
translate the equilibrium condition MR = MC into a convenient form that can easily be applied in
practice. Accordingly,
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2.7 Absence of unique supply Curve under Monopoly
Under Perfect competition, you remember that firms have unique supply curve. That is there is
unique supply price for each unit of output supplied. In monopoly supply price is not unique. A
given quantity could be supplied at different prices and different quantities can be sold at the
same price, depending on market demand and marginal revenue. Hence there is no one to one
correspondence between P and Q under monopoly. Consider the following figures.

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Therefore, there is no unique supply curve under monopoly.

2.7 Long – run Equilibrium under Monopoly

The monopolist’s long run condition is different from the perfectly competitive firms’ long run
situation in respect of the entry of new firms into an industry. In perfectly competitive market
there is free entry in the long run. Nevertheless, entrance is barred by several factors in
monopoly. Moreover, we have seen that a perfectly competitive firm can earn only normal profit
in the long run. The monopolist firm can, however, get a positive profit even in the long run
because there are entry barriers that discourage new firms to enter the industry, attracted by the
positive profit.

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Let us now examine the long run equilibrium situation for single plant monopolist. If the
monopolist incur loss in the short run (SAC>P) and if there is no plant size that will result in
super normal profit in the long run given the market size, the monopolist must stop operation
(shut down). If the monopolist makes (P> SAC) in the short run in a given plant, the monopolist
not only continue its operation but also looks for different plant size to expand, so that could
maximize profit in the long run. But at what output level the monopolist maximizes its profit? A
monopolist maximizes its long run profit when it produces and sells that output level where
LMC = MR , slope of LMC being greater than the slope of MR at the point of intersection, and
the optimal plant size is the one whose SAC curve is tangent to the LAC at the point
corresponding to long run equilibrium output.

Fig 2.6 Suppose initially the monopolist builds the plant size having the costs SAC1 and SMC1 the
equivalence of SMC1 and MR leads into producing and marketing output levels Q1 and P1, making a unit
profit of P1 – C, since the monopolist is making a positive profit, it decide to continue its operation and
looks for a more profitable plant size in the long run. This long run plant is attained when LMC = MR,
and the corresponding output level and price are Qe and Pe respectively.
Finally, it should be noted that there is no certainty in the long run that the monopolist will reach
the optimal plant size (minimum LAC), as in perfectly competitive case. The monopolist may
reach optimal plant size or even may exceed the optimal size if the market demand allows him
(or if there is enough demand which absorb that level of output).

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 2.8 Monopoly Power

Pure monopoly is rare. It is common to see market in which several firms compete with one
another. Although many firms compete with one another some firms may have greater monopoly
power than the others. Hence they can affect the market price more than other firms. You may
think that firms which share the larger part of the market supply have greater monopoly power.
But this cannot be necessarily true. What matters is the consumers’ preference for the firm’s
product. If most consumers prefer the product of the firm to other substitutes, the firm has greater
monopoly power than other firms in the market and the firm can slightly increase the price of his
commodity being confident that he will not lose its customers.

Now let us come to discuss measurement of monopoly power. The important distinction between
a perfectly competitive firm and a monopolist is that: for the competitive firm price equals
marginal cost; and for the firm with some monopoly power price exceeds marginal cost.
Therefore, a natural way to measure a monopoly power is to examine the extent to which the
profit maximizing price exceeds marginal cost. In particular, we can use the mark up ratio of
price minus marginal cost to price that we introduced earlier. This measure of monopoly power,
introduced by an Economist Abba Lerner in 1934, is called Lerner index of monopoly power.
Lerner index (L) is the difference between price and marginal cost, divided by price.

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 2.9 The multi- plant monopolist
A Multiplan monopoly is given in monopolistic firms that have their production divided into
more than one production plant, each one having its own cost structure.

We have seen that a monopolist maximizes its profit by producing that level of output where MR
equals MC. For many firms, however, production takes place in two or more different plants
whose operating costs can differ. To minimize transport cost, to approach the consumers or for
different reasons a monopolist may establish more than one plant in different areas. The
operating costs of these plants can also vary due to many reasons such as variation in prices of
raw materials, wage of labors etc. Now let's examine how a monopolist facing such cases
maximizes its profit by taking the following a two- plant monopoly firm as an example. Data
regarding cost and revenue is given in a table below.

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Given this information, how can the monopolist decide the total production and how much of
that output each plant should produce?

The logic used in choosing output levels is very similar to that of the single-plant firm. We can
find the answer intuitively in two steps.

Step 1 - Whatever the total output, it should be divided between the two plants so that marginal
cost is the same in each plant. Otherwise, the firm could reduce its cost by reallocating
production. For example, if marginal cost at Plant-1 were higher than at Plant-2, the firm could
produce the same output at a lower total cost by producing less output at plant -1 and more
output at plant-2. Thus, for equilibrium to occur marginal cost at firm-1 (MC1) must equal
marginal cost at firm- 2 (MC2) i.e. MC1 = MC2

Step-2 We know that the total output must be such that marginal revenue equals the multi plant
marginal cost. Now it is essential to know first how the multi -plant marginal cost is derived
from each plant marginal costs. If the firm wants to produce the first unit, it should produce it in
plant 1 because, the MC is lower in plant 1 than in plant 2 (i.e. 1.92 < 2.04). Hence, MC of
producing the first unit for the multi –plant monopolist is 1.92.

If output is to be two units or if the firm wants to add one more units, the second unit should also
be produced in plant 1 because the MC of the second unit in plant 1 is less than MC of producing
one unit in plant 2 (i.e. 2.00 < 2.04). Hence, multi-plant marginal cost for the second unit is $2. If
three units are to be produced, plant 2 will enter into production since the MC of producing one
unit in plant 2 (2.04) is less than marginal cost of producing the third unit in plant 1, & 2.08.

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Hence, multi-plant MC for the third unit is 2.04, the derivation of multi-plant marginal cost
continues in the same manner.
Once, multi-plant marginal cost is derived, the only thing left to obtain equilibrium total output is
equating the multi plant MC with the marginal revenue. So in the above table, equilibrium output
is 8 units where MC of multi-plant = Marginal revenue (i.e. 2.24 = 2.24).
Now the remaining issue will be how to allocate the total production between plants 1 and 2. The
multi plant monopolist allocates production in a way that each plants MC equals common value
of multi plant MC and marginal revenue. The common value of multi plant MC and marginal
revenue is 2.24. Thus it follows that the allocation of production is in a way that MC of plant-1 =
2.24 and MC of plant-2 = 2.24
i.e. Plant 1 produces 5 Units (because at 5 units MC1 = 2.24)
Plant 2 produces 3 units (because at 3 units MC2 = 2.24)
In short, the condition of equilibrium in multi- plant monopolist is: MR = MC of multi plant
monopolist and to allocate the total output among each plant, the condition must satisfy:

MC1 = MR = MC of multi plant monopolist

MC2 = MR = MC of multi plant monopolist
MR = MC1 =MC2
graphically, the above table (problem) can be represented as follows
P, MC, MR

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Fig 2.7 Multi-plant monopolist equilibrium. MC1 and MC2 denote the MCs of production in
plants 1&2 respectively. MCm denotes the marginal cost of multi-plant firm which is derived
from MC1 and MC2. Note that, MCm is obtained from MC1 and MC2 by adding the levels of
output produced in the two plants at equal marginal costs. E.g. when marginal cost is MCa, the
firm produces 3 units in plant 1 and 5 units in plant 2 and the monopolist marginal cost of
producing the 8th unit is MCa. The Multiplan monopolist’s equilibrium is defined by point E and
the two firms 1and2 produce 5 and 3 units respectively.

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2.10 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.

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2.11 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)

This is a price discrimination in which the monopolist attempts to entirely take away the
consumers surplus. Ideally, a firm would like to charge each customer the maximum price that
the customer is writing to pay for each unit bought. We call this maximum price the consumer’s
reservation price and obviously, the consumers’ reservation prices are different due to the
differences in their economic status or the value they attach to a commodity. 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. The law of diminishing marginal utility implies
that a consumer’s willingness to pay for successive units of a commodity declines because the
marginal utilities of these successive units decline. Hence, in the first degree price discrimination
prices differ across customers, and a given customer may pay more for the initial units than for
others (successive units). First degree price discrimination is the limiting case of price
discrimination, the monopolist, in this case, individually negotiate with each buyer and sell each
unit of the output at the corresponding price given on the demand curve of the consumer, then
receiving the entire of consumer’s surplus.

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.
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Perfect price discrimination is efficient as it maximizes the total welfare, where welfare is
defined as the sum of consumer surplus and producer surplus. That is, there is no welfare loss
associated with first degree price discrimination equilibrium. The problem with perfect price
discrimination is that it hurts consumers because the monopolist will take the entire of the
consumer surplus. The other problem with perfect discrimination is that it involves high
transaction costs; it is too difficult and costly to gather information about each customer’s price
sensitively.

2-Second degree price discrimination (block pricing)

Many firms are unable to determine which customers have the highest reservation prices. Such
firms may know, however, that most customers are willing to pay more for the first unit than for
successive units. This is due to the fact the typical customer’s demand curve is down ward
sloping. Such a firm can price discriminate by letting the price each customer pays vary with the
number of units the customer buys. 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:

-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.

Block pricing can feasibly be implemented where:

-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-a single rate is applicable for a large
number of buyers.

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Fig.2.8 Second degree price discrimination. The monopolist receives a price OP1, for each unit sold to a
given customer for the first OQ, units, OP2 for the next Q1 Q2 units and OP3 for the next Q2 Q3 units.
By so doing, the monopolist will receive total revenue of OP, A B C D E. If the monopolist charges a
uniform price of OP3, its total revenue will only be OP3 EQ3. Hence, block pricing will enable him
receive large total revenue than uniform pricing. Note that not all quantity discounts are a form of
price discrimination. Sometimes selling in large quantities may reduce the unit costs of sales and
as a result a firm may charge a relatively. Lower per unit price for large sales than small sales.
Such an action cannot be regarded as price discrimination.

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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. All units of the good sold to customer with in a group (in one
market) are sold at a single price, but prices will differ among the different groups or markets

For simplicity, let us assume that there are only two markets. To maximize profits, the
monopolist must produce the level of output (defined by MC=MR) and sell that output in the two
markets in such a way that the marginal revenue of the last unit sold in each market is the same.
This will require the monopolist to sell the commodity at higher price in the market with the less
elastic demand.

For example, suppose that a monopolist has 100 units of a commodity to be sold in one or both
of two sub markets. How should the monopolist allocate the 100 units between the two markets
to maximize its profit? Suppose, initially, that the monopolist simply sold 50 units in each
market and also assume that the marginal revenue of the last unit sold in market 1 is 5 and the
marginal revenue of the last unit sold in market 2 is 3.

In this case, the monopolist can increase its total revenue by decreasing the number of units sold
in market 2 and increasing the number of units sold in market 1. Hence, if one less unit is sold in
market 2, total revenue falls by $3. But by selling this unit in market 1 total revenue increases by
$5.So, by reallocating it sales from market 2 to market 1 the monopolist can increase its total
revenue by $2 ($5-3$). Obviously, reallocation of sales will increase the firm’s total revenue
until the marginal revenue of the last unit sold in each market gets equal.

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.

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2.12 Social costs of monopoly: the dead weight loss
In a competitive market, price equals marginal cost of production. Monopoly power, on the other
hand, implies that price exceeds marginal cost. Because monopoly power results in higher prices
and lower quantities produced, we would expect it to make consumers worse off and the firm
better off. But suppose we value the welfare of consumers the same as that of producers. In
aggregate, does monopoly power make consumers and producers better off or worse off? To
answer this question, suppose an industry operating under perfectly competitive situation is
suddenly monopolized. We can answer the questions by comparing the consumer and producer
surplus that results when a competitive industry produces a good with the surplus that results
when a monopolist supplies the entire market. Referring to the following figure, suppose DD
represents the market demand curve, MR represents the corresponding marginal revenue.

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Figure: 2.9 Here, we use consumers’ and producers’ surplus as a measure of welfare of each.
Consumer surplus is the area between the demand curve and equilibrium price and producer
surplus is the area between the equilibrium price and marginal cost curve.

-A perfect competitor’s equilibrium occurs when MC equal price or marginal revenue at Ec and
the equilibrium price and quantity are PC &QC respectively. Here the consumer’s surplus is the
area above the dropped line Pc Ec and below the demand curve i.e. area of ∆ Pc F Ec. On the
other hand the producer surplus is the area below the dropped line PcEc and above the MC
curve.

-A monopolist equilibrium occurs when MC = MR i.e. at Em and the equilibrium price and
quantity become Pm and Qm respectively. Hence, in monopoly lower quantity is sold at higher
price. The new consumers’ welfare is the area above the dropped line PmD and below the
demand curve (i.e. area of ∆ PmFD) where as the producers surplus becomes the area below the
dropped line PmD and above MC curve to the left of Qm (i.e. the area GPm DEm)

-Thus monopoly power reduces the consumers’ surplus by the amount which equals area A+B.
But increases the producers’ surplus by the area A-C. The net welfare effect (loss) is obtained by
deducting the welfare loss of consumers from the welfare gain of producers i.e.,

Net welfare = Welfare gain by producers – Welfare loss by consumers

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