Topic Outline - Monopoly

Topic 6
6.1 Characteristics
IMPERFECT MARKET 6.2 Short-run Decision: Profit Maximization
STRUCTURE: MONOPOLY, 6.3 Short-run Decision: Minimizing Loss
MONOPOLISTIC 6.4 Long-run Profit Maximization & Misconception
& 6.5 Social Cost of Monopoly
OLIGOPOLY 6.6 Price Discrimination

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Characteristics:
Monopoly: l One seller and large number of buyers:
l Firm supply is equal to the whole market/industry supply.
l The monopolist is a firm as well as an industry in itself.
l Definition:
l Product has no close substitute :
l Unique product with no competition.
l Existence of a single seller in the market who
produces goods that have no substitutes. l Price maker :
l Monopoly can influence either the market price or quantity
l An industry with a single firm in which the entry of
supplied.
new firms is blocked. l Constraint by demand behavior of consumers.

l For example: Microsoft, Tenaga Nasional Berhad.

l Barriers to entry :
l Heavy restrictions or barriers.
l Barrier to entry is legal or natural constraints that protect a firm
from potential competitors.

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Barriers to Entry? (i) Control over raw material:

l A monopoly status can be maintained through control over
the supply of raw materials.
l Definition:
l E.g: The DeBeers Company of South Africa has created its
l legal or natural constraints that protect a firm from own barrier to entry by buying control about 80% of the
potential competitors. world’s uncut diamonds, which prevents entry and
competition.
l The existence of monopoly in the long run is depends
on the barriers to entry.
(ii) Patents or copyrights:
l A patent is an exclusive right to the production of an
l The following are some common types of barriers: innovative product.
§ Control over raw material l A copyright is an exclusive right to the author, of a book or
a composer of a music or producer of a movie.
§ Patent and copyright
l The owner of the pa ten t and t he copyright ha s a
§ Cost of establishing an efficient plant monopoly over that particular product but its valid for a
§ Government franchises
limited time period only and the monopoly will expire in
due course.

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 (iii) Cost of establishing an efficient plant:
l This is the case of natural monopoly.
l A natural monopoly exists when one firm can (iv) Government franchises:
meet the entire market demand at a lower price
as compared to two or more firms. • The government will give an exclusive rights to a
l Example; Tenaga Nasional Berhad (TNB)
firm to sell certain goods and services in certain
area.
Ø 5 small firms in the industry: Ø One large firm in the industry:
• Example; the government has given the right to
install the satellite television system to ASTRO in
Each firm can produce 100,000 produce 500,000 at lower cost
Ø
units, but produce at higher costs
Ø
($1) due to economies of scale.
Malaysia.
($5).

Ø 5 firms x 100,000 units

= 500,000.

Marginal Revenue Facing a Monopolist

Market Demand and Marginal Revenue: (1) (2) (3) (4)
QUANTITY PRICE TOTAL REVENUE MARGINAL
REVENUE
l The firm’s demand curve represents the 0 $11
industry demand curve since there is only 1 10
one producer in a monopoly. 2
3
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8
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l The demand curve for the output in 5 6
monopoly is downward sloping. 6
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5
4
l Marginal revenue (MR) curve below the 8
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3
2
demand curve. 10 1

For a monopolist, an increase in output involves not just producing

more and selling it, but also reducing the price of its output to sell it. 10
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Marginal Revenue Curve Facing by Monopolist

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Demand Curve and Elasticity of Demand: Short-run Decision: Profit Maximization
l MR = MC
The monopolist will fix a higher price if demand is inelastic
and a lower price if demand is elastic. l Profit maximizing output
l No incentive to change the output.
l When demand is elastic (Ed >1):
l a decrease in price increases total revenue l MR < MC
l the firm to decrease output as the cost would be
l When demand is unitary/ unit elastic higher than revenue
(Ed = 1):
l Total revenue is maximum
l MR > MC
l it would be better off for the firm to increase output
l When demand is inelastic (Ed < 1):
l an increase in price increases total revenue
The monopolist is a price maker because can select the price that
maximizes profit.
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Short-run Decision: Profit Maximization Supernormal Profit:

Price / cost
l In the short run, a monopolist firm can earn supernormal profit,
MC
normal profit, or subnormal profit.

l Supernormal profit:
ATC
l Profit that earned by a firm when its (TR > TC) or (P >
ATC). • TR > TC
P • P > ATC
l Normal profit: ATC
l Profit that earned by firm when its (TR = TC) or (P = ATC)

l Subnormal profit: DD=AR

l Losses that generated by firm when its (TR < TC) or (P < MR
Quantity of
ATC) 0
Q output

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Normal Profit: Subnormal Profit:

Price / cost Price / cost MC
MC ATC

ATC
ATC

• TR = TC P
P = ATC • P = ATC • TR < TC
• P < ATC

DD=AR DD=P=AR
MR MR
Quantity of Quantity of
0 output 0 output
Q Q

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 Short-run Decision: Minimizing Loss Subnormal Profit – Continue:
Price / cost
MC
l Firm suffer losses: ATC

l Price less than average total cost (P<ATC).

ATC • TR < TC
l The monopolist will continue to produce rather than shut
AVC • P < ATC
down in the short run if price exceeds average variable P
• P > AVC
cost (P>AVC).

l The monopolist will shut down in the short run if price AVC
exceeds average variable cost (P>AVC).
DD=P=AR
MR
Quantity of
0 output
Q

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Price / cost
Subnormal Profit – Shut down: ATC Long Run Profit Maximization
MC
ATC AVC l Long-run is the time period in which the firm can
adjust its input used in the production.
l A monopolist firm in the long-run is also in
• TR < TC
AVC
equilibrium at a point where MR = MC.
P • P < ATC
• P < AVC
l A monopolist that earns economic profit in the
short-run may find that profit can be increased in
the long run by adjusting the scale of the firm.
DD=P=AR
l A monopoly that suffers a loss in the short run
MR
may be able to eliminate that loss in the long run
0
Quantity of
output
by adjusting to a more efficient size.
Q

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Misconception: Social Cost of Monopoly:

True Wrong l Deadweight loss

Monopolist CAN earn Monopolist ALWAYS earn l The result of not producing at price equal
positive economic profit in positive economic profit in
the long run. the long run.
to marginal cost (P ≠ MC) like in perfect
competitive market structure.
Monopolist seek to maximize Monopolist seek to maximize
PROFIT. PRICE.
l Price discrimination
Monopolist has BOTH good Monopolist ALWAYS bad to l behavior that transfer income or surplus
and bad to the the market/society. from consumers to the monopolist.
market/society.

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 Deadweight Loss: Try this!!

Perfect Monopoly Changes

Competitive
A
Consumer
B C Surplus

D
E Producer
Surplus

Total
Surplus

Deadweight Loss????
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Price Discrimination Price Discrimination (cont.)

Definition: Conditions:
l Monopoly Power:
l Charging different prices to ü The sellers must be a monopolist or at least must
posses some ability to control output and price (price
different buyers for the same maker).
good or different prices for the l No resale:
üAbility to prevent those who pay the lower price
same good on different units from reselling the product to those who pay the
sold. higher price.
l Market Segregation:
ü Identify and separate different buyers based on
different elasticity of demand.
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Question
Topic Outline –
The following graph shows LR equilibrium for ARWIN BHD. Monopolistic Competition

6.7 Characteristics
6.8 Short-run Decision: Profit Maximization
6.9 Short-run Decision: Minimizing Loss
6.10 Long-run Equilibrium
6.11 Monopolistic versus Perfect Competition
a) Identify the profit maximizing price and output.
b) Calculate the profit earned by the firm and
identify the type of profit.

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Characteristic (Cont.)
Characteristic (Cont.)
l Many seller
§ There are many firms competing for the same
l Price maker
group of customers. ¡ Control over price ‘Price makers’
§ Product examples include computer games, ¡ Downward sloping demand curve
restaurants, cookies, furniture, etc.
l Product differentiation
l Free entry and exit
¡ The firms produce goods which are differentiated.
§ Firms can enter or exit the market without
restriction.
¡ Each seller will use various methods to
differentiate their products from other sellers. § The number of firms in the market adjusts
until economic profits are zero.
¡ Differentiation of the product may be through the
packaging, design, labeling, advertising and § In the long run, firms earn zero economic
brand names. profit or normal profit.

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Characteristic (Cont.) Short-run Decision:

Profit Maximization
l Non-price competition
l When MR = MC;
l They create a sense of brand l The profit-maximizing quantity occurs
awareness among customers. while the price is found up on the
l Types of non-price competition are demand curve at that quantity .
advertisements, promotions, l The firm in monopolistic competition
discounts, free gifts and so on. makes its output and price decision
just like a monopoly firm does.

Economic Profit / Supernormal

Normal Profit / Zero Economic Profit
Profit
Price / cost Price / cost
MC MC

ATC ATC

• TR > TC • TR = TC
• P > ATC P = ATC • P = ATC
P
ATC

DD=AR DD=AR

MR MR
Quantity of Quantity of
0 Q output 0 Q output

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 Economic Loss / Subnormal
Profit
SHORT-RUN DECISION: MINIMIZING
Price / cost LOSS
MC

ATC l There is not guaranteed an economic profit

in the market.
ATC
• TR < TC l When P < ATC
P
• P < ATC l Firm must decide whether to produce at a
loss or choose to shut down.
l Keep production:
DD=AR
l As long as price exceeds AVC (P>AVC).
MR
Quantity of l Shut down:
0 Q output
l If the price cannot cover the AVC (P<AVC).

Economic Loss / Subnormal Economic Loss / Subnormal

Profit (keep operating) Profit (Shut down)
Price / cost Price / cost
MC MC

ATC ATC

ATC • TR < TC ATC • TR < TC

AVC • P < ATC AVC AVC • P < ATC
P P
• P > AVC • P < AVC
AVC

DD=AR DD=AR

MR MR
Quantity of Quantity of
0 Q output 0 Q output

LONG-RUN EQUILIBRIUM
LONG-RUN EQUILIBRIUM
Free entry:
l If the firms are making economic profit /
supernormal profit in the short-run, they will
attract more firms to enter the market.
l Decrease the demand for existing firms, so
the demand curve will shift leftward.
l The process will continue until all profits are
eliminated and (P = ATC).
l In the long-run, a monopolistic firm will earn
normal profit.

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 LONG-RUN EQUILIBRIUM
LONG-RUN EQUILIBRIUM
Free exit:
l If the firms are making economic loss /
subnormal profit in the short-run, the existing
firms will exit from the market.
l Increase the demand for existing firms, so
the demand curve will shift rightward.
l The process will continue until all losses are
eliminated and (P = ATC).
l In the long-run, a monopolistic firm will earn
normal profit.

ECONOMIC EFFICIENCY AND ECONOMIC EFFICIENCY AND RESOURCE ALLOCATION (cont.)

RESOURCE ALLOCATION
1. Excess Capacity:
The two key differences between • A firm’s efficient scale is the quantity at which ATC is a
minimum.
Monopolistic Competition and • Perfect competitive firm produces at P = min ATC
Perfect Competition are that in (efficient scale).
• A monopolistic competitive firm has excess capacity
Monopolistic Competition, there is because the quantity (QMC) it produces is less than
quantity at which ATC is a minimum (QPC). P ≠ min
excess capacity & a markup of ATC
price. 2. Markup
§ A monopolistic competitive firm’s markup is the amount
by which P > MC.
§ In perfect competition, the firm produces at P = MC.

Monopolistic versus Perfect Competition Inefficiency of Monopolistic

Price Pmc = Price Monopolistic
Competition
a) Monopolistic b) Perfect Competition
Qmc = Quantity
Price Price
MC Monopolistic Competition
Not min
ATC ATC
min
MC ATC ATC MC
Pmc
min
ATC
Mark UP Pc
ATC (Monopolistic
Price > MC)
MC
P AR=DD
P=MC P=MR
MC

MR
D
MR
Qmc Qc Quantity
QMC Quantity QPC Quantity
(efficient scale)
Excess Capacity
(when firm in monopolistic produces output
less than efficient point)

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 Characteristic of Oligopoly
Topic Outline - Oligopoly l Few in number but large in size
l The market share of each firm is large enough
to dominate the market and its controlled by a
6.12 Characteristic few firms.
l Interdependent
6.13 Oligopoly Model l The behavior of oligopoly firms depend on the
(a) The Collusion Model behavior of other firms in the industry before
making the decision.
(b) The Kinked Demand Curve Model
l Homogeneous or differentiated product
(c) The Price-Leadership Model
l The products sold may be homogeneous or
differentiated.
l Example: Petroleum (homogenous) and
automobiles (differentiated). 50

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Characteristic of Oligopoly (cont.) Oligopoly Model

l Barriers to entry
(a) Collusion Model
l Scale economies (reduce LRATC as Q l Agreement among firms to
increases)
l Divide the market
l Patents l Fix the price
l Technology
l Name recognition l Cartel
l Group of firms that agree to collude
l Incentive to collude (join together)
l Act as monopoly
l Colluding firms usually reduce output,
l Increase economic profit
increase price, and block the entry of new
l Example: Organization of Petroleum Exporting
firms to achieve the monopoly power.
Countries (OPEC).

Kinked Demand Curve Model

Oligopoly Model (cont.)
(b) The Kinked Demand Curve Model elastic
• Demand is elastic -
• In the kinked demand curve model of oligopoly increase in price more than
P* - large drop in quantity -
(the general assumption) inelastic
customers switch to the
üeach firm believes that if it raises its price, rival’s lower priced product.
its competitors will not follow
• Demand is inelastic -
üif it lowers its price all of its competitors decreasing the price less
will follow than P* - reflect a small
increase in quantity.
• Price rigidity - behavior of an oligopoly firm
which has no incentive to either increase or
decrease the price of its products.

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 Kinked Demand Curve Model and Price Rigidity
Oligopoly Model (cont.)
§ The kinked demand (c) The Price-Leadership Model
curve creates a gap in
the MR curve, illustrates
the price rigidity of a • The dominant firm (leader) set a
firm in an oligopoly. price level .
§ Equilibrium price and • Then, the smaller firms (followers)
quantity occur at P* and
Q*, when MR = MC. follow its pricing policy due to
§ As long as MR intersect assumption that products are
with MC c urve in t he identical.
gap, price and output
will remain constant.

Comparison for Market Structure

Characteristics of Different Market Organizations

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