Chapter 5 Price and Output Determination under pure monopoly

Market Structure

5. Pure Monopoly Market Structure

Pure monopoly market structure is one of the imperfect market structures which include
Monopolistic competition and Oligopoly market structures. In this chapter we start with
the discussion of pure monopoly market structure.

Definition, Pure monopoly is a market structure where there is only one firm that
produces and sells a particular commodity or service and where there large buyers. Since
the monopoly is the only seller in the market, the industry is a single firm industry and it
has no direct competitors.

The monopoly market has the following characteristics:

 Pure monopoly is a market supplied by single firm. The industry or the market is
dominated by a monopoly firm who provide product that has no alternative. Under this
market there is no distinction between the firm and the industry. (Usually the term
“industry” refers to group of firms supplied similar products, but here there is only one
firm in a given industry – thus, the firm and the industry are the same).

 Existence of Barriers to Entry – one of the basic features of monopoly market is

restriction or barriers to entry into the market by new firms. The monopoly market is
characterized existence of significant barriers to entry. There are technical, legal and
other factors that systematically make entry into the market very difficult for new firms.
This is one of the most important factors that insure an existing monopoly firm to remain
dominant in a given market for long. Even if there a single supplier to at the beginning, if
there is free entry (there is no barrier), new firms could join the market and the profile of
the market would change over time.

Monopoly practices prevail and sustained when there are barriers or restrictions against
new/ potential investors who want to join the market.

 Imperfect mobility of resources or factors of production.

 information is imperfect and is costly ( there is no free information)

 Government regulation - monopoly firm is usually under government watch over /

regulation. This is to protect monopoly firm from abusing or misuse of its market power.

 A monopoly firm faces a downward sloping demand curve for its product.

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 A monopoly firm enjoys a considerable market power and thus can influence the
market outcome in favour of its own gain.

 The monopoly firm is not a price – taker as a perfectively competitive firm. Monopoly
firm is a price maker. It doesn’t simply accept the price set by the market. The monopoly
firm could affect price through its decision.

Sources of monopoly – The emergence and survival of monopoly is attributed to the

factors which prevent the entry of other firms into the industry. The existence of barriers
to entry is therefore the sources and perpetuator of monopoly power. Without systematic
barriers a monopoly control of a market doesn’t last long. 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 created by law.

ii) Exclusive control over Technological secrets (Control of Key Industrial Secret). A
firm that knows certain key industrial secret can effectively dominate the market. Those
who have no access to this secret can’t join the market.

iii) Monopoly 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. E.g. Bauxite, graphite, diamond, etc…..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.

iv) Economies of Scale / Efficiency: a primary and technical reason for growth of
monopolies is economies of scale, the most efficient plant (probably large size firm,
which can produce at minimum cost, could eliminate the produce at minimum cost, could
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.

v) Licensing and Patent Rights: another source of monopoly is the patent right if a firm
for a product or for a production process. Patent rights are granted by the government to a
firm to produce commodity of specified quality and character or to use a specified rights
to produce the specified commodity or to use the specified technique of production, such
monopolies are called to patent monopolies.

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5.1 Demand and Marginal Revenue curves under monopoly

In perfectly competitive market, firms face a horizontal, straight line demand curve which
same as MR curve of firm.

 Both the MR and demand curve of a monopoly firm are downward sloping. However,
the demand and MR curves are not the same for a monopoly firm.

 The downward sloping demand curve of a monopoly firm implies that a monopoly firm
faces less elastic demand to price change, in other words, the price elasticity of demand
for the product of a monopoly firm is less elastic than for the product of a competitive
firm (which is perfectly elastic).

 Under monopoly there is no distinction/difference between the firm and the industry.
The monopoly industry is a single firm industry and; thus, the industry demand curve and
individual firm’s demand curve are the same.

The monopoly firm has the option to choose between price to be charged or output to be
sold. Once it chooses price, the demand for its output is fixed, similarly, if the firm
decides to sell a certain quantity of output, then its price is fixed.

 Under monopoly, P> MR always; the price charged by a monopoly firm is greater than
its MR. this can easily proved as follows:

 [1] P=a−bQ – price function( given) , where ‘a’ and ‘b’ are any constant number

[2] R ¿ QP=Q(a−bQ )=aQ−b Q 2 - total revenue of a monopoly firm

dR
[3] MR= =a – 2bQ
dQ

Now compare [1] and [3]

Equation [3] can be written as; MR ¿ a−bQ−bQ=(a−bQ) – bQ

[4] Thus, MR=P−bQ

Equation [4] shows that; P=MR +bQ ,

⤇ a monopoly price is higher than its MR by bQ amount (end of the proof).

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 Price

Fig.5.1: Demand and MR curves of a monopoly firm

MR D = AR
Quantity

AR curve for a firm is the same as its demand curve, since a monopoly firm faces a down
ward sloping demand curve, its AR also slopes down ward to the right. What is much
more important in the analysis of the equilibrium of a monopoly firm is the relationship
between AR and MR.

There is a specific relationship between AR and MR, i.e. the slope of MR is twice that of
AR or demand curve. That is, given the linear demand function, marginal revenue curve
is twice as steep as the average revenue curve. This can be proved us follows. Let us
assume the monopoly firms faced with price function or overage revenue function as;

P=a – bQ - Price function (or an inverse demand function).

From this the total revenue (R) and the marginal revenue (MR) are derived as follows;
R=P × Q=Q( a−bQ); Hence, R=aQ – b Q2
dR d ( aQ−b Q )
2
MR= = =a – 2 bQ
dQ dQ

Note that: the slope of price function equals b, where as the slope of MR function equals
2b. It means that the slope of the MR function is twice that of the AR function.

5.2 Short-run Equilibrium under Monopoly

The monopoly firm, like a competitive firm, reaches its equilibrium when it maximizes
total profit. We can employ the two approaches we have discussed in chapter 5; the total
and marginal approaches.

Marginal condition for equilibrium of the firm:- using the marginal revenue and
marginal cost condition, profit is maximum the following conditions are satisfied
simultaneously:

 The first order condition (F.O.C): i.e. MC=MR , and,

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 The second order condition (S.O.C): i.e. the slope of MC >the slope of MR ,

These conditions are identical to equilibrium conditions of a perfectly competitive firm.

The difference here is MR not equal to price as in case under perfect market.

Similar to what we have discussed under perfect market; a monopoly firm could also
reach at short run equilibrium with positive, negative or zero profit.

Graphically,
Price At point E, MC = MR the; equilibrium
SMC condition is satisfied. Equilibrium output is
Qe, corresponding to this AC is at point B
Pe C SAC and price at point C; since P > AC profit
A B is positive & equal to shaded area of
ABCPe
E
MR D=AR
0 Qe Output
Fig. 5.2: Short run Equilibrium of a monopoly firm, marginal approach

In the above figure, the monopoly firm choose price and output combination for which
MR = MC. The equilibrium condition is satisfied at point E where MR = MC.
Point E determines the profit maximizing output for a firm is Qe and price, Pe.
A Monopoly is assumed to make profit in the short run using its monopoly power.
However depending on its revenue and Average cost conditions, it may not make profit
or even incur a loss.

Equilibrium of a monopoly firm with zero profit (when P = SAC) is shown below –
Price
SAC Equilibrium condition is satisfied at point
SMC E; where MR = MC. But, corresponding
to this AC = P at point C. Thus, the
Pe C monopoly firm is at equilibrium with zero
profit.
E
DD = AR
MR
0 Qe Output
5.3: Short run Equilibrium of a monopoly firm with zero profit

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Equilibrium of a monopoly firm with negative profit ( P < SAC) -

In the following figure, per unit cost or SAC (OA) of the firm exceeds the per unit price
(Pe) that is SAC > P and TC > TR; the monopoly firm incur loss, earn negative profit.

Price
Equilibrium condition is satisfied at point E.
SMC where: MR=MC , and equilibrium output is Qe.
SAC Corresponding to the level of equilibrium
AC output, price is less than SAC, Pe ¿ SAC .

Thus, the monopoly firm is at its short run

P B equilibrium with negative profit (π < 0 ).
E
AR = DD
0 Qe MR Output
Fig. 5.4: Short run Equilibrium of a monopoly firm incurring loss

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5.3 Long run Equilibrium of a Monopoly Firm

Previously, you have learned a competitive industry is in a long run equilibrium when all
firm reach to the same level of efficiency (i.e. producing up to the minimum level of
LAC) where ; SMC = LMC = MR = SAC = LAC = P=AR ; which implied zero profit. A
monopoly firm doesn’t necessarily earn zero profit at its long run equilibrium. In fact it
earns positive profit in the long run. Depending on the market size, cost and revenue
conditions –a monopoly firm could be at long run equilibrium;

 With Optimum Plant Size and Utilization – this happens when the firm operates at
its minimum LAC with: (LMC = SMC) = (LAC = SAC) at equilibrium. This is condition for
an optimum plant size and utilization where production took place at minimum possible
cost per unit. But profit could still be positive.
 With Suboptimal Plant Size. The monopoly firm could be at its long run equilibrium
with a suboptimal plant size (at the falling region of the LAC curve or region of
economies of scale). Under this condition we have: (SMC= LMC) < (LAC= SAC) at
equilibrium – marginal costs are below average costs. This indicates under utilization of
capacity and is inefficiency in resource uses.

 With Over-Optimal Plant Size, that is, where it is at its long run equilibrium at the
rising portion of LAC curve (in the region of diseconomies of scale). Here (SMC =
LMC) > (LAC = SAC) - marginal costs are higher than average costs at equilibrium. This
indicates over utilization of capacity or over expansion of plant size by monopoly firm.

There are no adequate competitive factors that necessarily push a monopoly firm to its
optimum efficiency in the long run. One of the basic characteristics of a monopoly
market is barrier to entry for a new firm. Thus, the long run equilibrium of the monopoly
firm depends on to the extent the existing firm decides to expend its capacity. As such,
the long run position solely depend on the choice of the existing monopoly firm; it may
optimally expands its capacity or sub optimally expands (below optimal) or over expands
(beyond optimal size).

Numerical Example

The demand and cost functions of a firm is given below

Q = 100 – 0.2P (Or P = 500 – 5Q)
C=50+20 Q+Q 2 - Total cost function

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Find the profit maximizing price and output, assuming

a) A firm is monopoly
b) A firm operate in perfectly competition market
c) compare the difference

Soln a. If the firm is a monopoly to maximize profit: F.O.C is MR=MC ;

Q = 100 – 0.2P & P = 500 – 5Q

R=QP=Q(500 – 5 Q) & R=500Q – 5Q 2 ; MR=500−10Q and MC=20+ 2Q

500 - 10Q = 20 + 2Q; ⤇ 480 = 12Q; thus; Q = 40 units & P = 300 birr

R = P ×Q=300 × 40=12,000 birr & C=50+20 × 40+ 402 = 2450 birr; thus;

π=12,000 – 2,450=9550 birr

Soln b. if the firm is operate in competitive market –

Equilibrium condition, MR = MC; and we know that in perfect market MR = P.
Mc=20+ 2Q and MR=P=500−5 Q
20+2 Q=500−5 Q ⤇ 7Q = 480 ⤇ Q = 68. 57units
P=500 – 5∗68.57=500 – 342.86=157 .14 Birr

Equilibrium price and output a competitive firm: Q = 68. 57units and P = 157 .14 Birr

Profit = TR – TC = 68.57* 157.14 – (50 + 20*68.57 + 68.572)

= 10,775.29 – 6121.84 = 4653.45 birr

C) Soln: compare the monopoly and competitive out comes - in terms of output, price
and profit in the two markets.

5.3 Equilibrium of a multi-plant monopoly

Multi-plant monopoly is a type of monopoly which produces homogeneous product in
more than one plant. The same product is produced in different firms with different cost
structure. Though the product in produced in different plants with different MC, sold in
same market with same price, and MR from sell is also the same.

The purpose of constructing multiples of plants by a monopoly is to increase total profit

by reducing costs of production. Construction of multiples of plants could help counter
act (avoid) diseconomies (rise in average cost) due to overexpansion within a single
plant, avoid cost of transportation, etc.

The multi plant monopoly has to determine:

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 Determination total output and price: – the monopoly firm first has to decide how
much out output has to produce and what price to charge so as to maximize its total
profit. The obvious condition for profit maximization is:

MR = MC, using the multi plant monopolist will determine aggregate output and price.

 The other decision need to be made is allocation of total output to be produced across
the different plants constructed. That is, the determination of how much output has to
produce at each plant.

The marginal condition for allocation production across plants is where the marginal
costs of different plants (plants: 1, 2… n) are simultaneously equal to the common MR.
this stated as:

MR = MC1 = MC2 = ….. = MC n; 1, 2,….,n denote number of plants.

MR is common for plants, because products are homogenous and at same price. The MC
differs across plants and the multi plant monopoly utilizes each plant up to the point
where the MC equal to each other and to common MR, simultaneously.

Suppose a monopolist operates in two plants (plant 1 and plant 2). The cost structure is
different for each plant. Given this assumption, the monopoly will produce output that
optimizes its profit in the two plants.

Price

MC MC1 MC2

P AC1 AC2

E MR=MC A B

MR

Q Q1 Q2
a) Total output & price b). Output in Plant1. c).Output in plant 2
Fig 5.5 Output allocation by multi-plant monopoly
Q = Q1 + Q2 is the total output. The price P is determined based on the total output.

When MR and MC are known, the monopolist can easily decide the output and price. The
profit maximizing output would be Q, now the problem is how to allocate Q between the

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two plants so that output of each plant is optimized when the following marginal rules are
satisfied.

MR = MC1= MC1

Numerical Example: the demand and cost functions of a monopoly frim operating into
plants are given below;
Q = 100 – 0.5P (P = 200 – 2Q) total demand function and Q = Q1 +Q2
C1 = Q12 + 40Q1 – cost function of plant 1 and C2 = 2Q22 - cost function of plant 2

 Then determine Q, Q1,Q2 , and Price (P) to be charged by the multi plant monopoly.
Soln – first get MR, MC1 and MC2 functions
R = Q*P = Q(200- 2Q) = 200Q +Q2
MR = 200 - 4Q = 200 – 4(Q1 +Q2) ; and MC1 = 2Q1 + 40 and MC2 = 4Q2
For plant – condition; MR = MC1

200 – 4(Q1 +Q2) = 2Q1 + 40 ⤇ 2Q1 + 4(Q1 +Q2) = 160

6Q1 + 4Q2 = 160 ---------- [1]
For plant 2 – condition MR = MC2

4Q2 = 200 – 4(Q1 +Q2) ⤇ 4Q2 + 4(Q1 +Q2) = 160

4Q1 + 8Q2 = 200 ---------- [2]
Solve [1] and [2] simultaneously;
(- 2) 6Q1 + 4Q2 = 160 -------- [1]
4Q1 + 8Q2 = 200 ---------- [2]
-8Q1 + 0 = 200 – 2*160

- 8Q1 = 200 – 320 = -120 ⤇ Q1 = -120/-8 = 15

Q1 = 15 units produced in plant1.
Use [1] or [2] to get Q2
4Q1 + 8Q2 = 200 8Q2 = 200 – 4*15 = 140
Q2 = 140/8 = 17.5 Units produced by plant 2
Total output, Q = 15 + 17.5 = 32.5units is optimum level of output
Price; P = 200 – 2(32.5) = birr 135 and Total revenue; R = 32.5* 135 = birr 4387.5

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5.4 Price Discrimination under monopoly
Price discrimination is one of pricing strategies used by firm that has monopoly power. It
refers to a situation where a firm charges different prices to different buyers for the same
product. Different prices for the same product in markets that have different price
elasticity of demand. The Product could be produced by a single firm/ plant under same
cost (MC) conditions but sold at different prices. The main purpose of price
discrimination is to increase total revenue (sales) and there increase total profit than it
would be without discrimination. Price discrimination allows the firm to take away the
consumers surplus or absorb it into its total revenue.

Consumers are discriminated with respect to price based on number conditions – which
includes:
i. income (purchasing power) of the consumers ii. Geographical location
iii. Age or sex of the consumers iv. Quantity the consumers purchase
v. Their association with sellers vi. Frequency of visit to the shop

Price discrimination is possible as long as there is difference in price elasticity among

markets or consumers. When elasticity’s are the same price discrimination is not
profitable - the monopolist will charge a uniform price for his product. If price elasticity
of demand varies among markets / consumers, then a higher price will be charged in
market with less elastic (inelastic) demand; and charge low price for market with high
elasticity of demand (elastic demand).
Assumptions /necessary/ condition for price discrimination
i. the market should be divided in to submarkets with different elasticity’s of price. The
price elasticity of demand must be different for different Markets.

ii. There should be effective separation of the sub-markets, so that no reselling can take
place form a low- price market to a higher price market. Thus, there shouldn’t be resell of
the product by the buyer for the discrimination to effective.
iii. The discrimination should carry out at a very reasonable cost (very insignificant).
iv. There should be imperfect competition i.e. there should be monopoly power. The firm
should face a downward sloping demand curve for its product.

Degrees of price discrimination

1. First degree price discrimination

Under this price discrimination the firm charges the highest possible price for each unit
sold to the consumer, depending on what the consumer willingness to pay. It is
discriminatory pricing that the monopoly attempts to take away the entire consumers
surplus, by selling its product at maximum price that individual buyer is able to pay.

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It is possible only when a seller is in a position to know the price each buyer is willing to
pay i.e. he knows his buyer’s demand curve for his product. This is a case which is most
unlikely or very limited application.

2. Second degree price discrimination

It is charging different prices for different quantities of purchase.

P OQ2 Units sold at price, P1

Q1Q2 Units sold at price, P2

P1 A
Q2Q3 Units sold at price, P3
P2 B * It is also referred as “block Pricing”

P3 C

0 Q1 Q2 Q3 Q
Fig 5.6 second degree price discrimination
3. Third degree price discrimination

Selling the same product with different price in different markets having demand curves
with different elasticity is called third degree price discrimination. Profit in each market
would be maximum only when his MR = MC in each market.
The monopolist, therefore, divides or allocates the total output between different markets
in such way that allocation maximizes its total profit – which is possible when:
MR = MC In all markets.
Since all output is produced under the same cost condition, the MC is same for all
markets. Thus, the firm allocates total output until MR from different market
simultaneously equalized to the common MC; if a market is segmented into two sub-
markets with different demand functions, the equilibrium condition is stated as:
MC = MR1= MR2
The process of output allocation and determination of price for different market is
illustrated in the following figure.

Market 1 market 2 total market Demand

P1
MC
P2

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 A B MC R
MR1 D2 Dm
D1 MR2
Q1 Q2 Q = Q1+Q2
Fig 5.7 third degree price discrimination

Quantities of demand per unit at price P 1 in the first market is Q1, and Q2 units in the
second market at price P2. Then total revenue of the firm is:

R = P1 *Q1 + P2* Q2

The firm’s total equilibrium output is Q = Q1 + Q2.

In market 1 at Q1 level of output, MR1 = MC at point A.
In market 2 for Q2 level of output, MR2 = MC at point B.
For total output; Q = Q1 +Q2, MC = MR1= MR2 at point R in the figure.

Thus, the equilibrium condition is satisfied in both sub-markets and the monopoly firm
adopting the third degree method of price discrimination maximizes its profits.

Numerical Example

Suppose a monopoly firm supply identical product to a market. Latter the firm segment
(discriminates) the market into two based their demand functions;
Demand in Market 1: Q1 = 32 – 0.4P1 (P1 = 80 – 2.5Q1)
Demand in market 2: Q2 = 18 – 0.1P2 (P2 = 180 – 10Q2 )
The total cost function of the firm is given as: C = 50 + 40Q
Note that total output will be; Q = Q1 +Q2

A. determines the prices to be charged and quantity to be sold in each market so as to

maximize profit of the monopoly firm.

Soln:- equilibrium conditions : MR1 = MR2 = MC

 First get the total revenue and MR functions in both markets

R1 = Q1 * P1 = Q1( 80 – 2.5Q1) = 80Q1 – 2.5Q12
MR1 = 𝑑R1/ 𝑑Q1 = 80 – 5Q1
R2 = Q2 * P2 = Q2(180 – 10Q2) = 180Q2 – 10Q22
MR2 = 𝑑R2/ 𝑑Q2 = 180 – 20Q2
The MC is: MC = 𝑑C/𝑑Q = 40

Then solve the following simultaneously (MR1 = MR2 = MC)

MR1 = 80 – 5Q1 = 40
MR2 = 180 – 20Q2 = 40
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80 – 5Q1 = 40 ; ⤇ 5Q1 = 80 – 40 = 40 ⤇ Q1 = 40/5 = 8units
180 – 20Q2 = 40 ;⤇ 20Q2 = 180 – 40 = 140 ⤇ Q2 =140/20 = 7units

P1 = 80 – 2.5Q1 = 80 – 2.5*8 = 80 – 20 = 60 birr

P2 = 180 – 20Q2 = 180 – 10*7 = 180 – 70 = 110 birr

Hence:
In market 1; it charges price, P1 = birr 60 and sell Q1 = 8 units
In market 2: P2 = 40 birr and quantity sold is Q2 = 7 units
Total output of the firm is : Q = Q1 + Q2 = 8+7 = 15 units
Total revenue of the firm: R = P1 *Q1 + P2* Q2 = 60*8 + 110*7 = birr 1250
Total cost: C = 50 + 40Q = 50+ 40 (8+7) = 50 + 40*15 = 50 + 600 = birr 650
Total profit = R – C = 1250 – 650 = birr 600

B. If the firm makes no price discrimination, determine: output, price to be charged,

total revenue (R) and profit of the monopoly firm

Soln:- Equilibrium condition; MR = MC

First get the total demand function of the firm (add both demand functions)
Q = Q1 + Q2 = 32 – 0.4P1 +18 – 0.1P2
(Note that now prices are equal in both market or the monopoly firm charges same price
for all consumers; P1 = P1 = P – no more price difference)
Q = 32 – 0.4P + 18 – 0.1P = 32+18 – P(0.4+0.1 ) = 50 – 0.5P
Q = 50 – 0.5P - is total demand function with no price discrimination
(And P = 100 – 2Q is the price function)

R = Q * P = Q(100- 2P) = 100Q – 2Q2 total revenue function

MR = 100 – 4Q marginal revenue function with no discrimination
MC = 40

Then solve for MR = MC;

100 – 4Q = 40 ⤇ Q = 60/4 = 15units

P = 100 – 2Q = 100 – 2*15 = 100 – 30 = Birr 70
R = P*Q = 70* 15 = birr 1050
C = 50 + 40* 15 = birr 650
Profit = 1050 – 650 = birr 400

You can observe that without discrimination, both total revenue and profit of the lower
than the case with price discrimination. With price discrimination the firm’s total revenue

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is, R = birr 1250 and profit = Birr 600. However without price discrimination its total
revenue is R = birr 1050 and profit = birr 400

What are the disadvantages and advantages of monopoly relative to

perfect market?

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