Pure Monopoly
• What is a Pure Monopoly?
• A pure monopoly is a market structure where
a single firm is the sole producer of a product
for which there is no close substitute
• Can you give examples?
• Do you think that in Ethiopia local telephone
company, Hydro electric company, etc. are
pure monopoly firms?
• What is a Pure Monopoly?
• A pure monopoly is a market structure where
a single firm is the sole producer of a product
for which there is no close substitute
• Can you give examples?
• Do you think that in Ethiopia local telephone
company, Hydro electric company, etc. are
pure monopoly firms?
Characteristics of a Pure Monopoly
• What are characteristics of Pure Monopoly
market?
• Single supplier – the firm is an industry
• No close substitutes – the product is unique
• Blocked entry – barriers to entry exist and there
is no immediate competitor.
• Price maker – the firm has considerable control
over price since it controls the total quantity
supplied.
Barriers to Entry and Sources of Monopoly
• What are the barriers to entry?
• Barriers are factors that prohibit firms from
entering an industry. They include:
• Economies of scale
• Legal barriers to entry
- Copy rights and patent rights
- Government franchise and licensing
• Ownership or control of essential resources
• Exclusive knowledge of production process
Economies of Scale
• If as a firm expands average total cost falls, then
economies of scale exist.
• Where a single firm, achieves a low average total
costs, given market demand a natural monopoly
created.
• A natural monopoly exists because economies of
scale are large and the firm can achieve minimum
efficient scale.
• New firms face very large start up costs and it is hard
to compete with a monopolist that is already well
established
• The large firm decrease price to abolish new entrants
Legal Barriers to Entry
• It is a government-created barriers
• A copy right is the exclusive right of an
individual / group to publish, sell , or allow
others to use literary, musical or artistic work
• A patent is the exclusive right of an inventor to
use, or to allow another to use, her or his
invention.
• What is the difference between patent right and
copy right?
• Give some examples of patent and copy rights?
• Gov’t franchise and Licensing limits the
production of a product by other producers
except the permitted producer
• What is government franchise and licensing
is?
• It is a permission of government for a
producer to produce a good or service and
promise to prohibit new entrants
• Give some example of franchised products by
government or private
Ownership or Control of Essential Resources
• A firm that owns or controls an essential
resource can prohibit the entry or rival firms.
• Private property right serves as an obstacle to
potential rivals
Exclusive knowledge of techniques of
production
• When only a single firm knows how the out
put is produced then only the firm supply it
• Because others do not know how to produce
Pure Monopoly Demand Curve
• In perfect competition a firm is price taker
and faces a perfectly elastic demand curve
• The price is set by the intersection market
supply and demand curves
• In pure monopoly, the firm’s demand curve is
the market demand curve.
• The pure monopolist is the industry; therefore,
the demand curve is downward-sloping.
• Mathematically downward sloping dd curve is
represented by equation of the form P a bQ
• Where
a - is the y axis intercept
b- slope of demand curve which is
calculated as
dP
b
dQ
Total Revenue
• Total revenue is the total sale received from
selling a specific amount.
• Mathematically
TR PQ
TR (a bQ )Q
2
TR aQ bQ
• which is quadratic equation and its graph is
down ward concave parabola
Average Revenue
• AR measures the revenue received from the sale of
one unit on average
TR PQ a bQ Q
AR a bQ P
Q Q Q
• Thus, for pure monopoly P=AR
Marginal Revenue
• MR measures the revenue received from the sale of
one additional unit 2
dTR d (aQ bQ )
MR a 2bQ MR
dQ Q
• Thus, MR is less than price
DD, AR, MR, TR and Ep
MR
DD, TR, AR, and MR
• The Monopolist is a Price Maker
• A pure monopolist influence the market supply
through its output decisions.
• Subsequently, it can also influence the product
price.
• By increasing market supply can decrease p or
• By decreasing market supply can increase p
• Consider the following graph
Output and price determination
Short-run Equilibrium
(Output and Price Determination)
• In perfect competition profit maximizing price
is set by the market DD & SS forces
• The firm determine only the π maximizing Q
• In pure monopoly market the firm set both π
maximizing P and Q
• There are two approaches
a) Total approach
b) Marginal approach
a) Total approach
• P & Q are set by comparing TR and TC
• Equilibrium is where the positive difference b/n
TR and TC is maximum (at Q*)
Then the profit maximizing p is set at Q* on the
b) Marginal Approach
• It is derived from the total approach
• Profit maximizing Q is set where
MR=MC and
MC is increasing
• π is the area b/n MR
and MC and
mathematically
given by
Q*
( MR MC ) dQ
0
• Profit maximizing Q is where MR = MC, and MC
rising
• Equilibrium P is determined by inserting Q* in the
market demand curve
• A vertical line is drawn from Q* to the demand curve
to get price.
• Perfect competition firm charges price that is equal to
MC
• Pure monopoly firm charges P which is greater than
MC
• In the short-run the monopolist can get
– Positive profit
– Zero profit or
– Negative profit
• Positive profit getting firm
P
MC
AC
P*
AC
DD
MC
Q* Q
• Zero profit getting firm
P
MC
AC
P*=AC
DD
MC
Q* Q
• Negative profit getting firm
P
MC
AC AC
P*
DD
MC
Q* Q
Mathematically
• An Equation reach its maximum where its
slope is Zero and
• Slope of the slope is less than zero or
• First order derivation is = 0 (necessary)
• Second order derivation < 0 (sufficient)
• Example
• For a Pure monopoly firm given Demand P=40-Q
and Total Cost
• TC=120+40Q-21Q2+(2/3)Q3
a) Find the profit maximizing unit of output
b) Find the profit maximizing price
c) Find the maximum profit
Solution
a) TR TC
PQ TC
2 3
40 Q Q 120 40Q 21Q Q
2
3
2 3
120 20Q Q
2
3
d
F .O.C 40Q 2Q 2 0
dQ
Q (40 2Q) 0
Q 0 or Q 20
d 2 d
S .O.C
dQ 2
dQ
40Q 2Q 2
0
40 4Q 0
at Q 0 40 4(0) 0 which is wrong
at Q 20 40 4(20) 0 which is correct
b) P 40 Q
P 40 20
P 20
Mark-up pricing
• Price is set where MR=MC
• But managers know MC and do not know MR
before P is set
• So the easy and practical way of setting P is mark
up pricing using the formula that derived from
MR=MC
• The formula is
• Mark up is the amount added on MC to get P
• P-MC=mark up
• From where this formula come?
• The mark up pricing is derived from the equilibrium
formula MR=MC
TR PQ where P f (Q ) due to demand
dTR d ( PQ) dQ dP dP
MR P Q P Q
dQ dQ dQ dQ dQ
• Factoring out P
dP Q dP Q 1
MR P 1 where
dQ P dQ P d
1
MR P 1
d
• Solving for P we get
MR
P
1
1
d
Finally MR MC at equilibrium
MC
P which is mark up pricing formula
1
1
d
Example
• Assume a monopolist’s TC=10+1.5Q and
Estimated εd=-4
• Find profit maximizing P (answer=2)
• What is the mark up (answer 0.5)
Long – run Equilibrium
of Pure Monopoly
• In perfect competition LR there is free entry and exit –
thus, normal profit in the LR
• In pure monopoly barrier to entry exist thus, in the LR
the firm can get (+) profit, (-) profit or (0) profit
• If the monopolist makes positive profit in the short run
(SRAC<P) it expands its firm in the long
• If the monopolist incur loss in the short run (SRAC>P)
• It see for profitable plant size by decreasing its plant
size
• If there is no plant size that will result in super normal
profit in the long run given the market size, the
monopolist must exit from the market
Monopoly Power
• Pure monopoly is rare
• Several firms compete with one another in any
mkt.
• In perfect competition many sellers are there and
no monopoly power P=MC
• In pure monopoly only one seller is there
• The single seller monopolize the mkt. P>MC
• In several sellers case monopoly power is greater
than perfect competition firm but less than pure
monopoly
• Measuring monopoly power is simply
measuring the extent to which P>MC
• It is measured by learner index or ed that is
derived from mark up pricing formula
• Hence the monopoly power formula (Learner
index) is
• From where this formula derived?
• The learner index formula is derived from the
mark up pricing formula
Example
• For an imperfect market firm assume
TC=50+1.5Q and ed=-4
• Find P using mark-up pricing (Answer P=2)
• Measure monopoly power of the firm (Answer
L=0.25)
The Multi- plant Monopolist
• A firm may have branches
• Firms produce the same product in different plants which
sold in the same market
• Reasons – to minimize cost of transportation
• - to make the product accessible quickly
• Operating cost of plants may differ (different MC)
• Sold in the same market (equal MR)
• To maximize profit, the firm produces more in the plant
that has less MC
• So the firm allocates its production until MC of all plants
become equal.
• Assuming there are two plants how can the
monopolist decide the total production and
how much of that output each plant should
produce?
• Total Q produced where MR=MC
• But there are two different MC (MC1 & MC2)
• It produces each additional Q in the plant that
has less MC and this continues until MC of the
two firms become equal and also equal with
the market MC
Mathematically
TR PQ where Q q1 q2
TC TC1 TC2 where TC1 f (q1 ) and TC2 f (q2 )
TR TC
TR TC1 TC2
TR TC1 TC2
F.O.C
d dTR dTC1 dTC2 d dTR dTC1 dTC2
dq dq dq dq 0 dq dq dq dq 0
1 1 1 1
2 2 2 2
MR1 MC1 0 MR2 MC2 0
MR1 MC1 MR2 MC2
• How ever since the product (q1 and q2) are
sold in the same market MR of both are equal
MR1 MR2 MC1 MC2 MCm
q1 q2 Q
Example
• Suppose Ethiopian Electric Light and Power
Corporation (EELPC) is a multi plant
monopolist having two plants, Tekeze plant
(plant1) and Fincha plant (Plant2). The
operating costs of the two plants are given as
follows: Tekeze Plant: TC1 = 10 q12 Fincha
plant: TC2 = 20 q22 where q1 – is amount of
electric power produced in Tekeze and q2 – is
amount of electric power produced in Fincha.
• EELPC estimates the demand for electric
power by the following function
• P= 700 – 5Q where P - is price (total in
million birr) per Giga-watt-hour and
• Q – is the total amount of Giga-watt-hour sold
and Q = q1 + q2
• Note that a Giga watt of electric power,
whether it comes from Fincha or Tekeze plant
worth equal price
a) Find the total profit function
b) Find the profit maximizing q1 and q2
c) Find the profit maximizing P
d) What is the maximum profit?
Solution
e) TR TC1 TC2
PQ TC1 TC2
PQ TC1 TC2
(700 5Q)Q 10q12 20q22 where Q q1 q2
700 5(q1 q2 ) (q1 q2 ) 10q12 20q22
700q1 15q12 10q1q2 700q2 25q22
700q1 15q12 10q1q2 700q2 25q22
b)
d
700 30q1 10q2 0
dq1
d
700 50q2 10q1 0
dq2
Solving simultaneously
q1 20 and q2 10
P 700 5Q where Q q1 q2
c) P 700 5(30)
P 550
d) 700q1 15q12 10q1q2 700q2 25q22
700(20) 15(20) 2 10(20)(10) 25(10) 2
3,500
Price Discrimination
• Price discrimination is the business practice of
selling the same good at different prices to
different consumers when the price differences
are not justified by differences in costs
Necessary conditions for price discrimination
1) There should be effective separation of
markets (no resale of the good) due to
– Geographical variation with high transport cost
– Exclusive use of the commodity (like service)
– Lack of distribution channels
2) The price elasticity of demand should be
different in each sub market.
– The consumer with high price elasticity is charged
less price
– The consumer with high price elasticity is charged
less price
• The price elasticity should be in the elastic part
3) Lastly, the market should be imperfectly
competitive (the firm has monopoly power)
• Degrees of price Discrimination is the extent
to which firms extract consumer surplus
• There are three degrees of price discrimination
– First degree of price discrimination
– Second “ “ “ “
– Third “ ‘’ “ “
First degree (Perfect) price discrimination
• The firm charges each consumer the maximum
price he is willing to pay (Reservation price) for
each unit of output = maximum price the consumer
is willing to pay
• All consumer surplus is taken away
• Reservation price varies with the amount bought
due to the law of diminishing MU
• Seller negotiate with each buyer on each unit bought
• e.g. A doctor who charges poor and rich different
prices according to their willingness to pay
• A consumers are willing to pay less and less as
the amount bought increase due to LDMU
• This is shown by down ward sloping DD
curve.
Second degree (block) price discrimination
• Is also called quantity discrimination
• The seller charges different prices for different
quantities purchased
• If the consumer buy less, price will be high but if
the consumer buy more amount there will be
discount
• Only part of consumer surplus taken away
• On other way price may increase to encourage
efficient utilization of the resource
• e.g. telephone , electricity, water etc. bills
• In second degree price discrimination price for the
consumers buying in the same block is equal and
price of different blocks are different
• Note: all price discounts are not price discrimination
• Production of more product may reduce cost of
Third degree (multi-market) price
discrimination
• The seller group the market (potential consumers)
into different groups according to the ability to pay
and charge different prices
• The market group with high price elastic are charged
lower price and with less elastic charged higher price
• To maximize profit the seller sell more in the market
with high MR and redistribute until MR in all market
segment are equal
• If MR of one group > MR of the other, more is sold
in the group with higher MR
• The goods produced in the same plant so MC is the
• The goods sold in different market at different
prices so MR from different group is different
Example
• Suppose Ethiopian Air lines (EAL) flies only
one route: from Addis Ababa to Dubai. It
knows that two different types of people fly to
Dubai. Type 1 consists of rich merchants
flying to Dubai for business purposes with
demand for flight of p1=650-(5/2)q1. Type 2
consists of poor ladies flying to Dubai in
search of jobs whose total demand is
p2=400-(5/3)q2. Let the EAL cost function is
TC=30,000+100Q where Q=q1+q2
a) What is the profit function?
b) How many tickets should EAL sell to each group?
c) How much price should EAL charge each group?
d) What is the profit of the EAL?
Solution
e)
TR1 TR2 TC
p1q1 p2 q2 TC
5 5
650 q1 q1 400 q2 q2 30, 000 100(q1 q2 )
2 3
5 2 5 2
550q1 q1 300q2 q2 30, 000
2 3
5 2 5 2
b) 550q1 q1 300q2 q2 30, 000
2 3
d
550 5q1 0 q1 110
dq1
d 10
300 q2 0 q2 90
dq2 3
c) 5 5
p1 650 q1 p2 400 q2
2 3
5 5
p1 650 (110) p2 400 (90)
2 3
p1 375 p2 250
5 2 5 2
d) 550q1 2 q1 300q2 3 q2 30, 000
5 5
550(110) (110) 300(90) (90)2 30, 000
2
2 3
13750
Social costs of monopoly:
The dead weight loss
• Consumer surplus= willingness to pay – actual
payment
• Producer surplus=actual receipt – willingness to
receive
• Total welfare of the society = consumer surplus
+ producers surplus
• Now to see the efficiency of pure monopoly we
compare the welfare of the society in perfect
competition and in pure monopoly
• Assume there was a perfect competition firm
• In the LR P=MC
• Thus area a is consumer surplus and area b is
producer surplus in the following graph .
• Assume due to a certain reason the firm is
monopolized
• Its DD curve become market demand curve
DDm
• MR become less than DDm that is P > MC
• Both producer and consumer surpluses
decrease that decrease welfare of the society
• The monopolist
– produce less than its capacity
– Charge higher price
– Deadweight loss
