Perfectly Competitive markets:

many firms offering identical products,

so each firm has little influence over price
Price takers

Can we use perfectly competitive market analysis to model

the pricing strategy of these firms?
Microsoft Windows (operating system)
OPEC
DeBeers
 Microsoft has no close competitors
85-90 % market share in the PC operating system
therefore, can influence the market price of its product

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

traded internationally

De Beers had control of over 80% of the world's rough diamonds

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

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

Monopolist has market power

Ability to choose price > MC

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

The market price of Windows >> marginal cost.

Objectives:
examine the production and pricing decisions of monopolist

examine the implications of market power of monopoly

implications of monopoly for the society

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

Competitive firm
Price taker
Demand horizontal line at market price

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

Demand

Demand

0 Quantity of output 0 Quantity of output

6
 Competitive firms are price takers: individual
representative firm faces horizontal demand
curve

A monopoly firm is the sole producer in its

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

- The market demand curve provides a constraint on a monopolys

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

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

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

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

 Assumption:
Monopolists goal is to maximize profit = R- C
 1
A monopolists total, average, and marginal revenue

Quantity Price Total revenue Average revenue Marginal revenue

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

11
 Monopolists Production& Pricing Decisions
Monopolists revenue
Total revenue = price times quantity

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

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

12
 Monopolists Production& Pricing
Decisions
A monopolists marginal revenue is less than the price of its good: MR < P

For example, if the firm raises production from 3 to 4, it will increase total
revenue by 4, even though it will be able to sell each unit of output for 7
 Monopolists Production& Pricing Decisions

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

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

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

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

MR = P

14
 By contrast, when a monopoly increases production by 1 unit, it must
reduce the price for every unit it sells

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

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

The marginal-revenue curve shows how the firms revenue changes when the quantity increases
by 1 unit.
Because the price on all units sold must fall if the monopoly increases production, marginal
16
revenue is always less than the price.
 How Monopolies Make Production
& Pricing Decisions

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

17
 How does the monopoly find the profit-maximizing price for its product?

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

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

1. The intersection of the marginal-revenue

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

Demand

Marginal revenue

0 Q1 QMAX Q2 Quantity

A monopoly maximizes profit by choosing the quantity at which marginal revenue equals
marginal cost (point A). It then uses the demand curve to find the price that will induce
consumers to buy that quantity (point B). 19
How Monopolies Make Production& Pricing Decisions

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

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

20
 5
The monopolists Profit = TR TC = (P ATC) Q

Costs
and
Revenue Marginal cost

Monopoly E B
Average total cost
price

Monopoly
profit
Average Demand
total
cost D C

Marginal revenue

0 QMAX Quantity

The area of the box BCDE equals the profit of the monopoly firm. The height of the box
(BC) is price minus average total cost, which equals profit per unit sold. The width of the
box (DC) is the number of units sold. 21
Monopoly drugs versus generic drugs

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

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

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

competitive

Simplifying Assumptions:
1. MC of producing the drug is constant. (This is approximately true for
many drugs)
2. Demand curve remains unchanged

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

22
 New drug, patent laws monopoly
Produce Q where MR=MC
P>MC=MR

Generic drugs competitive market

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

Price
during
patent life

Price after Marginal cost

patent
expires

Demand
Marginal revenue

0 Monopoly Competitive Quantity

quantity quantity

When a patent gives a firm a monopoly over the sale of a drug, the firm charges the
monopoly price, which is above the marginal cost of making the drug.
When the patent on a drug runs out, new firms enter the market, making it more competitive.
As a result, the price falls from the monopoly price to marginal cost. 24
 Welfare Cost of Monopoly
Is monopoly a good way to organize a market?

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

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

26
 Welfare Cost of Monopoly
Suppose the monopoly firm were run by a benevolent planner /govt.

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

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

Produce quantity where

Marginal cost curve intersects demand curve
Charge P=MC

27
 7
The efficient level of output
Costs
and
Revenue
Marginal cost

Value Cost to
to monopolist
buyers

Value
to Demand
MC of
buyers (value to buyers)
monopolist
0 Quantity
Value to buyers is greater Efficient Value to buyers is less
than cost of producer quantity than cost of producer

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

- choose the level of output where the demand curve and MC intersect.
28
 The Welfare Cost of Monopoly
Monopolist produces less than the socially efficient quantity of
output.

Produce quantity where MC = MR

Charge P>MC

Deadweight loss to the society ?

29
 The Welfare Cost of Monopoly
Note: a monopolist charges P > MC

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

These consumers cannot buy the good.

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

Hence the output produced by monopolist is inefficient.

This is the source of inefficiency in monopoly case

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

Demand

Marginal revenue

0 Monopoly Efficient Quantity

quantity quantity

31
Take Away points:

Monopolist produces less than the socially desirable quantity

of output and

Monopolist charges P > MC

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

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

Eg. 1) Lipsey Chrystal

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

33
 Price Discrimination
2) hardcover books and paperbacks:
publisher initially releases an expensive hardcover edition and
later releases a cheaper paperback edition

3) Train tickets: charge lower price to students and senior citizens

4) Airline prices: seats are sold at different prices

34
 Price Discrimination
Perfect price discrimination
describes a situation in which the monopolist exactly knows the willingness
to pay of each customer and can charge each customer a different price.

Charge each customer a different price

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

Deadweight loss =?

Without price discrimination

Single price > MC
Deadweight loss = ?

35
 9
Welfare with and without price discrimination
(a) Monopolist with Single Price (b) Monopolist with Perfect Price Discrimination

Price Price
Consumer
surplus

Deadweight
Monopoly
loss
price
Profit
Profit
Marginal cost Marginal cost

Marginal Demand Demand

revenue

0 Quantity Quantity 0 Quantity Quantity

sold sold

36
Panel (a) shows a monopolist that charges the same price to all
customers.

Total surplus = producer surplus + consumer surplus.

There is deadweight loss

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

Consumer surplus = 0

Total surplus = producer surplus +0

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

Comparison:
perfect price discrimination raises monopolists profit,
raises total surplus,
and lowers consumer surplus.
 Price Discrimination
1. Rational strategy for monopolist

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

Note:
In reality, a monopolist may not be able to practice perfect price
discrimination
Monopolist may not have exact information regarding consumers
willingness to pay.
Hence, firms often practice price discrimination by dividing customers into
different groups
38
 Price Discrimination
2. Requires the ability to separate customers according to their willingness
to pay
Certain market forces can prevent firms from price discriminating
Arbitrage: buy a good in one market where price is low & then sell
in another market at a higher price
Eg. Often books cannot be sold outside the countries as
mentioned on cover

3. Can raise economic welfare

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

39
Is price discrimination possible in a competitive market?

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

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

because the firm can sell all it wants (subject to capacity) at the
market price.
- There is large demand @ prevailing market price

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

customer would buy from another firm.
- Homogeneous product
Problem

Consider inverse demand curve: P = 120 -0.02 Q

Cost of production = 60 Q + 25000

Find profit earned by monopolist

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