EC2204- Business Economics6-Price and Output Determination:

Monopoly

EC2204- Business Economics6-Price and Output Determination:

Monopoly

Learning Outcomes

Upon completing this section, the student should be able to:

Describe the conditions that lead to a monopoly market. Describe and illustrate long-monopoly equilibrium. Differentiate between prefect competition and monopoly. Appreciate the relationship between elasticity and

monopoly Describe the conditions for the existence of price

discrimination. Distinguish between the various forms of price

discrimination. Calculate profit maximizing levels of output and price in

monopoly.

What is a Monopoly?

The term monopoly derived from the Greek monos, alone or one.

Monopoly is a type of market structure in which there is only one producer or seller.

A single producer controls the entire output of a particular commodity.

The firm and the industry are one and the same – ESB are the sole provider of electrical power in Ireland

Why might Monopolies arise?

1. State monopoly: A government may create a statutory or legal monopoly giving a certain body the sole right to supply a particular good or provide a certain service. The Act which creates the monopoly places a legal restriction on competition. In Ireland, the government has granted monopolistic powers to ESB, Telecom Eireann etc, Mobile Phone Licence to Esat Digifone.

2. Control of critical resources: A particular firm may have exclusive access to the only source of supply of the raw materials necessary for the production of a certain commodity. Mining firms would be examples of this type of monopoly.

3. Capital intensive monopoly: Certain industries require such a large investment of capital in plant and equipment that any form of competition from potential rivals is completely discouraged e.g. aircraft manufacturing, ship-building, steel firms etc.

4. Legal restriction: A firm which develops or invents a new product or process can use the law of patents, franchise, copyright etc. to obtain the sole right of manufacture of the product or use of the process. Pfizer – Viagra

5. Trade Agreements: All the firms within a certain industry, may by agreement, adopt completely uniform policies on price and output. This type of agreement effectively creates a monopoly. (OPEC on Oil production).

Assumptions governing a Assumptions governing a MonopolyMonopoly

• Price Setter: There is only one firm in the entire industry and it has complete control over price.

• Barriers to Entry: No other firm can enter the industry even if it wants to i.e. there is no freedom of entry to the industry- cost being the main barrier to entry.

• Profit Maximiser: The monopolist aims to maximise profit.

• In a monopoly situation the equilibrium of the individual firm is the equilibrium of the industry because the entire industry is made up of just one firm.

• A monopolist can selects either the price or the output but not both

MonopolyMonopoly – Long-Run Equilibrium

Price/cost

Q - Output

D = AR

MR

MC

q(mon)

P(mon)AC

Super normal

Profits

AC not minimised

MR = MCMR = MC

AR > ACAR > AC

P <>ACP <>ACDead weight loss to society

MonopolyMonopoly versus Perfect Competition

Price/cost

Q - Output

D = AR

MR

Lr-MC

q(mon)

P(mon)

Lr-AC

Super normal

Profits

AC not minimised

MonopolistMonopolist

Higher prices and lower Higher prices and lower outputsoutputs

Supernormal profits in Supernormal profits in the L-Rthe L-R

AC not minimised AC not minimised

q(pc)

P(pc)P = D = AR = MR

MonopolyMonopoly versus Perfect Competition

When monopoly and perfect competition are compared under the same conditions, we find that the monopolist, when in equilibrium, produces a lower and sells it a higher price than the perfectly competitive firm.

the perfectly competitive firm produces q(pc) at a price p(pc), the individual firm is a price taker.

The monopolist produces q(mon) at p(mon).q(mon) at p(mon). Thus the monopolist produces at higher prices and a lower output.

The monopolist earns supernormal profits earned in the long-run and in monopoly Average Costs are not Average Costs are not minimisedminimised.

Comparing monopoly and perfect competition (video) is unrealistic because perfect competition in its pure form rarely exists.

Price Elasticity and Price Elasticity and MonopolyMonopoly

Marginal revenue is a function of price elasticity,

)1

1(pE

PMR

•A profit maximising monopolist produces a quantity where MR = MC, so by substitution

)1

1(pE

PMC

In monopoly P will be greater than MC. For example if Ep = -2,

)2

11(

PMC MC = 0.5P, so P = 2MC.

Note: a monopolist will never operate in the area of the demand curve where demand is price inelastic

Price Discrimination

It is the practice of charging different people different prices for the same goods or services.

When price discrimination is engaged in for the purpose of reducing competition, as, for instance, through tying the lower prices to the purchase of other goods or services, it constitutes a violation of Antitrust Acts.

Price discrimination also occurs when it costs more to supply one customer than it does another, and yet the supplier charges both the same price.

Conditions for Price Discrimination

There must be some degree of market power Separate markets must be identified. Consumers should be largely ignorant of any PD. There should be a different price elasticity for the

same good among consumers. No opportunities for arbitrage - The buyer cannot

re-sell.

This usually entails using one or more means of preventing any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricing information.

Price discrimination is thus very common in services, where resale is not possible; an example is student discounts at cinema.

The degree of PD must be so small that consumers are not affected by it.

Ways to Separate CustomersWays to Separate Customers Geography: when the prices in the Rural and

Urban differ. Income: when Economic Associations charges

more to professors than students. Gender: when jeans for women are priced higher

than similar jeans for men Age: when kids get in at lower prices for movies Time: when prices differ by day (Reel Cinema have

reduces prices on Mondays) or season (Hotel rates are cheaper in Winter)

Race: as when shampoos targeted for African-American hair are priced differently that other shampoos, though technically the same.

Language: as when products printed in Spanish are priced differently than those in English

Ability to Haggle: when those how ask for a lower price get it

First Degree First Degree Price Price DiscriminationDiscrimination

This type of price discrimination is primarily theoretical because it requires the seller of a good or service to know the absolute maximum price that every consumer is willing to pay.

It is true that consumers have different price

elasticities, but the seller is not concerned with such.

The seller is concerned with the maximum willingness to pay (WTP) of each customer.

By knowing the maximum WTP, the seller is able to absorb the entire market surplus, thus taking all consumer surplus and transforming it into revenues.

First Degree First Degree Price Price DiscriminationDiscrimination

Price

Q

D

MC

Reservation price= MC

p1

Consumer Surplus

Aim: Minimise or eak out CS

Second Degree Second Degree Price Price DiscriminationDiscrimination

Price varies according to quantity sold.

Larger quantities are available at a lower unit price.

This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts. Examples, bulk buying, air travel – 1st class, business class and economy, multipacks of crisps, mars bars etc.,

Two-part pricing is also an example of second degree PD. There is one price for the privilege of buying items and a price per item. Examples: Golf club fees and green fees, cover charges in clubs and pubs, telephone – standing charge rental plus fee-per-unit, ESB – standing charge and fee-per-unit.

Second Degree Second Degree Price Price DiscriminationDiscrimination

Price

Q

D

MC

Economy Price

Reduced Price

5 7 units

Standard Price

1

The Price depends on the quantity The Price depends on the quantity you buyyou buy

2-Part Pricing2-Part PricingFind optimal cover charge if P=4.50-Q and Find optimal cover charge if P=4.50-Q and

MC = 0.50?MC = 0.50?

Price = 4.50

Q

D

MC

MC = €0.50

4 Pints

0.50 = 4.50-Q0.50 = 4.50-Q

Q = 4 (pints)Q = 4 (pints)

At P = €0.50 you buy 4 At P = €0.50 you buy 4 pintspints

Max cover charge = CSMax cover charge = CS

CS = ½ (4*4) = €8CS = ½ (4*4) = €8

Optimal Cover charge = Optimal Cover charge = €8€8

Consumer Surplus

Third Degree Third Degree Price Price DiscriminationDiscrimination

The monopolist sells output to different people for different prices.

Every unit of output sold to a person is the same price. - students, pensioners, and female concessions.

Third degree PDThird degree PD is based on the fact that there are different classes of consumer with different price elasticity of demand, and it is possible to divide consumers into different classes and charge the different classes different prices.

The supplier(s) of a market where this type of discrimination is exhibited are capable of differentiating between consumer classes. Examples of this differentiation are student or senior "discounts".

A student or a senior consumer will have a different willingness to pay than an average consumer, where the WTP is presumably lower because of budget constraints.

The supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand

The supplier is once again capable of capturing more market surplus than would be possible without price discrimination.

Third Degree Third Degree Price Price DiscriminationDiscrimination

Many cinemas, amusement parks, tourist attractions, and other places have different admission prices per market segment: typical groupings are Youth, Student, Adult, and Senior.

Each of these groups typically have a much different demand curve.

Children, people living on student wages, and people living on retirement generally have much less disposable income.

Women's haircuts are often more expensive than men's haircuts which in past times could be accounted for as women generally had longer hairstyles whereas men generally had shorter hairstyles.

Nowadays men's and women's styles are more varied but the price discrimination continues.

Some nightclubs feature a "ladies' night" in which women are offered discount or free drinks, or are absolved from payment of cover charges.

This differs from conventional price discrimination in that the primary motive is not, usually, to increase revenue at the expense of consumer surplus.

Rather, establishments benefit by maintaining an equitable gender balance; if the clientele of an establishment is primarily male.

3rd Degree PD Domestic and Export Demand for Irish Butter

MC

Domestic price

Exportprice

Domestic market

Export market

Domestic + Exportmarket

•Different price elasticities of demand exist for Irish butter.

•Higher prices are available in the domestic market as few substitutes are available.

•However, on the export mark lower prices are obtained as we have to compete with our trading partners on the export market.

•The composite demand curve shows the combined domestic plus export market.

Other Forms of Price DiscriminationOther Forms of Price Discrimination Inter-temporal PricingInter-temporal Pricing: If at peak rush hour, the toll is

higher than at the off-peak, we are using different prices at different time periods. The peak toll can encourage shifting travel patterns to off-peak times or discourage some commuting altogether. Inter-temporal pricing appears more frequently than one thinks. Example- night rate electricity is cheaper, peak versus off-peak phone charges.

Bundling:Bundling: McDonalds sells Extra Value Meals, as a bundle of [burger, fries, and a soft drink] for less than it sells them separately. Selling both bundles and items separately is mixed bundling.

If Eugene would pay €3 for a burger and €1 for a soft drink, and if Kate would pay €2 for a burger and €2 for a soft drink, a bundle of €4 for both a burger and soda will work for both customers as a bundle. But if the price of a burger individually were €2.5 and a soft drink €1.50, then Eugene would buy only a burger and Kate only a soft drink. Not everyone is alike, so mixed bundles succeeds with more customers.

Other Forms of Price DiscriminationOther Forms of Price Discrimination Skimming:Skimming: Price declines over time. Those who wish to get it

first pays the highest price, others are willing to wait. Examples: Hardcover & Paperback Books, New electrical, computer products, and PDAs, the new Iphone.

Prestige Pricing:Prestige Pricing: Some products distinguish themselves by being noticeably expensive. Mercedes, Audi, or BMW, Cartier jewelry. The price is itself a way to distinguish the product from others Prestige Pricing is the practice of charging a high price to enhance its perceived value. However, the firms typically have to spend a great deal in promotional activities to convince customers that the product is prestigious.

Control of monopolies and the Promotion of Competition

Most monopolies which existed in Ireland in the past arose as a result of the establishment of semi-state bodies in those industries in which the Irish Government felt that such a monopoly was appropriate and in the public interest.

In many cases this involved the exploitation of natural resources or the provision of services which the private sector was reluctant to provide.

However in recent years the Irish Government, in accordance with EU policy, has undertaken major market deregulation and liberalisation, and now many semi-state companies which previously operated as monopolies have been exposed to competition.

This has come about either through privatisation (e.g. Eircom, Aer Lingus, Irish Life) or through the granting of licences to competitors (e.g. TV3).

Sample QuestionsSample Questions Q1. Show that the MR curve is twice as steep as a linear

demand curve?

Solution: Let P = a - bQ, We know that TR = P * Q So TR = a - bQ * Q TR = aQ – bQ2

SoSo if P = a – bQ, then MR = a - if P = a – bQ, then MR = a - 22bQbQ

0Q

TRMR

Sample QuestionsSample Questions Q2: Suppose the demand curve is estimated to be: P = 140 - 3Q, MC = 4

+ 2Q. Find (a) the monopoly price(a) the monopoly price and (b) the profit maximising the profit maximising level of outputlevel of output? ?

Solution: The slope of the MR is twice as steep as the linear demand curve P

= 140 - 3Q, so MR = 140 – 6Q, A monopolist produces where MR = MC. Therefore 140 – 6Q = 4 + 2Q, so 136 = 8Q.

(a) Therefore the monopoly profit maximising level of output is Q Therefore the monopoly profit maximising level of output is Q =17.=17.

To find the monopoly price, substitute Q = 17 into the demand curve.

We find that P = 140-3(17) = 89.

(b) Therefore the monopoly price at profit maximising level of output (b) Therefore the monopoly price at profit maximising level of output is P = 89.is P = 89.

Sample QuestionsSample Questions Q3: If P = 100 - Q, and MC = 20. Find (a) the profit (a) the profit

maximising level of outputmaximising level of output and (b) and (b) the monopoly pricethe monopoly price?

Solution: Find the where MR = MC TR = PQ = (100 – Q)Q = 100Q – Q2.

(b) Qmonopoly = 40.

(a) Therefore the monopoly profit maximising level of output is Q Therefore the monopoly profit maximising level of output is Q =40.=40.

To find the monopoly price, substitute Q = 40 into the demand curve.

Pmonopoly P = 100 –Q, so = 100 - 40 = 60 .

(b) Therefore the monopoly price at profit maximising level of (b) Therefore the monopoly price at profit maximising level of output is P = 60.output is P = 60.

Sample QuestionsSample QuestionsQ4: A monopolist has the following Total Cost function: TC =

10 + 5Q, the price elasticity of demand has been estimated to be -2 [Ep = -2].

Estimate the monopoly pricethe monopoly price? Solution:

So p =

If demand is more price elastic i.e. Ep = -2 then

Then p =

5Q

TCMC )

2

11(5

P)

11(

pEPMC

unit/10€5.0

5

)4

11(5

P

unit/67.6€75.0

5

Sample QuestionsSample QuestionsQ5: The demand for Nike sportswear can be expressed as follows:

Log Q = -1.5 Log P + 1.3 Log Y where Q = quantity demanded of Nike sportswear, P = Price and Y = income. If the marginal cost of a Nike sweatshirt is €20, the optimal monopoly price of the sweatshirt is:

€20. €17. €60. None of the above.

Solution Solution

So 20 = P(0.333333)

Then p = 60

)1

1(pE

PMC )5.1

11(20

P

Recall: The above are double log functions: the powers, or the number before the logs are the elasticities, -1.5 = price elasticity of demand and 1.3 = income elasticity of demand.

Sample QuestionsSample QuestionsQ6: The demand for Nike sportswear can be expressed as

follows: Log Q = -1.5 Log P + 1.3 Log Y where Q = quantity demanded of Nike sportswear, P = Price and Y = income. From the expression Nike sportswear can be considered as an:

1. A normal good that is price inelastic.2. An inferior good that is price elastic.3. A normal good that is price elastic.4. None of the above.

Solution: It’s a normal good as it has a positive income elasticity (+1.3), its price elastic as its EP = -1.5

Recall: The above are double log functions: the powers, or the number before the logs are the elasticities, -1.5 = price elasticity of demand and 1.3 = income elasticity of demand.

Sample QuestionsSample QuestionsQ7: : If Ep = - 3 and MC = 100. Calculate the monopoly

price? If the elasticity increases to Ep = -5 , how does this change affect the price?

Solution Solution

)1

1(pE

PMC

Note: When the optimal monopoly price falls to €125, the more price elastic is the demand. The more price elastic is the demand the closer the price is to its MC.

)3

11(100

P

unit/150€6667.0

100 Monopoly Price = €150/unitthen

If Ep increases to – 5 then )5

11(100

P = €125/unit

Sample QuestionsSample Questions

Q8: Liverpool FC practices third degree price discrimination as it charges €60 per ticket for Students with an ID card for entry to its Premiership matches and €80 for non-students. Liverpool FC has estimated that the price elasticity of demand for non-student groups is –2.

Calculate the price elasticity of demand for students. Describe second-degree price discrimination. Support your answer

with a typical example.(Students) Other Groups

MR = P (1 + 1/Ep) = MR = P (1 + 1/Ep)

60 (1 + 1/ Ep) = 80 (1 + 1 / -2)

60 (1 + 1/ Ep) = 40

(1 + 1/ Ep) = 40/60 = 0.6667

1/ Ep = 0.667 – 1 = -0.3333

Ep = -3 = 1/-0.33333 =

Note: Ped for students = -3, students are more price sensitive for Liverpool match tickets

Sample QuestionsSample Questions

Q9: If the TC = 100Q – 3Q2 + 2Q3, the marginal cost (MC) at an output of Q = 5 is:

Solution

1. 100.2. 90.3. 220.4. None of the above.

0

Q

TCMC

MC = 100 – 6Q + 6Q2 :

Substitute 5 instead of Q so MC = 100 – 6(5) + 6(5)2 = 220

Recall our Learning Outcomes

You should now be able to:

Describe the conditions that lead to a monopoly market. Describe and illustrate long-monopoly equilibrium. Differentiate between prefect competition and monopoly. Appreciate the relationship between elasticity and

monopoly Describe the conditions for the existence of price

discrimination. Distinguish between the various forms of price

discrimination. Calculate profit maximizing levels of output and price in

monopoly.