Pricing Decision Under Monopoly

Monopoly is a market structure in which single seller sells a completely

differentiated product. Monopolist’s product has no substitute; therefore the
seller possesses full discretion with regard to pricing decisions. Since there is only
one firm in monopoly, the firm itself is the industry.

Characteristics of a Monopoly:
A monopoly can be recognized by certain characteristics that set it aside from the
other market structure.

1. Profit maximization: A monopoly maximizes profits. Due to the lack of

competition a firm can charge a set price above what would be charged in a
competitive market, thereby maximizing its revenue.

2. Price maker: The monopoly decides the price of the good or product being
sold. The price is set by determining the quantity in order to demand the price
desired by the firm (maximizes revenue) tm will sell a reduced quantity in an
elastic market.

3. High barriers to entry: Other sellers are unable to enter the market of the
monopoly.

4. Single seller: In a monopoly one seller produces all of the output for a good
or service. The entire market is served by a single firm. For practical purposes the
firm is the same as the industry.

5. Price discrimination: In a monopoly the firm can change the price and
quantity of the good or service. In an elastic market the firm will sell a high
quantity of the good if the price is less. If the price is high, the firm will sell a
reduced quantity in an elastic market.
 Short Run Equilibrium and Long Run Equilibrium Under
Monopoly

Short Run Equilibrium:

Short period refers to that period in which the monopolist has to work with a
given existing plant. In other words, the monopolist cannot change the fixed
factors like, plant, machinery etc. in the short period. Monopolist can increase his
output by changing the variable factors. In this period, the monopolist can enjoy
super- normal profits, normal profits and sustain losses .These three possibilities
are described as follows:

Super Normal Profits:

If the price determined by the monopolist is more than AC, he will get super
normal profits. The monopolist will produce up to the level where MC=MR. This
limit will indicate equilibrium output. . In Figure 3 output is measured on X-axis
and price on Y-axis. SAC and SMC are the short run average cost and marginal cost
curves while AR or MR are the average revenue or marginal revenue curves
respectively.
The monopolist is in equilibrium at point E because at point E both the conditions
of equilibrium are fulfilled i.e., MR = MC and MC intersects the MR curve from
below. At this level of equilibrium the monopolist will produce OQ level of output
and sells it at CQ price which is more than average cost DQ by CD per unit.
Therefore, in this case total profits of the monopolist will be equal to shaded area
ABDC.

Normal Profits:
A monopolist in the short run would enjoy normal profits when average revenue
is just equal to average cost. We know that average cost of production is inclusive
of normal profits. This situation can be illustrated with the help of fig 4.

In Fig. 4 the firm is in equilibrium at point E. Here marginal cost is equal to

marginal revenue. The firm is producing OM level of output. At OM level of
output average cost curve touches the average revenue curve at.
Minimum Losses:
In the short run, the monopolist may have to incur losses. This situation occurs if
in the short run price falls below the variable cost. In other words, if price falls
due to depression and fall in demand, the monopolist will continue to produce as
long as price covers the average variable cost. Once the price falls Below the
average variable cost, monopolist will stop production. Thus, a monopolist in the
short run equilibrium has to bear the minimum loss equal to fixed costs.
Therefore, equilibrium price will be equal to average variable cost. This situation
can also be explained with the help of Fig. 5.

In Fig. 5 monopolist is in equilibrium at point E. At point E marginal cost is equal

to marginal revenue and he produces OM level of output. At OM level of output,
equilibrium price fixed by the monopolist is OP . At OP1 price, AVC touches the AR
curve at point A. It signifies that the firm will cover only average variable cost
from the prevailing price. At OP price, firm will bear loss of fixed cost i.e., A per
unit. The firm will bear the total loss equal to the shaded area PP AN. Now if the
price falls below OP , the monopolist will stop production. It is so because if he
continues production, he will have to bear the loss of variable costs along with
fixed costs.
 Long Run Equilibrium
The monopolist creates barriers of entry for the new firms into the industry. The
entry into the industry is blocked by having control over the raw materials needed
for the production of goods or he may hold full rights to the production of a
certain good (patent) or the market of the good may be limited. If new firms try to
enter in the field, it lowers the price of the good to such on extent that it becomes
unprofitable for new firms to continue production etc.

When there is no threat of the entry of new firms into the industry, the monopoly
firm makes long run adjustments in the scale of plant. In case, the demand for the
product is limited, the monopolist can afford to produce output at sub optimum
scale. If the market size is large and permits to expand output, then the
monopolist would build an optimum scale of plant and would produce goods at
the minimum cost per unit. However, the monopolist would not stay in the
business, if he makes losses in the long period. The long run equilibrium of a
monopoly firm is now explained with the help of the following diagram.
In the long run, all the factors of production including the size of the plant are
variable. A monopoly firm will maximize profit at that level of output for which
long run marginal cost (MC) is equal to marginal revenue (MR) and the LMC curve
intersects the MR curve from below. In the figure (16.6), the monopoly firm is in
equilibrium at point E where LMC = MR and LMC cuts MR curve from below. QP is
the equilibrium price and OQ is the equilibrium output.

At OQ level of output, the cost per unit is QH (LAC), whereas the price per unit of
the good is QP. HP represents the per unit super normal profit. The total super
normal profit is equal to KPHN. It may here be noted that at the equilibrium
output OQ, the plant is not being fully utilized. The long run average cost (LAC) is
not minimum at this level of output OQ. The firm will build an optimum scale of
plant only if the demand for the product increases.

Price Discrimination
Monopolist has the chance to set discriminating price of its product because there
is no substitute of monopolistic product. Price discrimination refers to the sale of
identical product at different price. This may occur in the same market or
different markets. Depending on the strength of the discrimination, price
discrimination is classified as,

1. Third Degree Price Discrimination

2. Second Degree Price Discrimination

3. Perfect price discrimination or First Degree Price Discrimination

1st Degree Price Discrimination

If the monopoly can charge different price for every different unit, the form of
price discrimination is the strongest form which is called first degree price
discrimination or perfect price discrimination .In this extreme case the seller
exploits the entire amount of consumer surplus , thus the consumer is left with
zero surplus.

The above diagram displays the situation of perfect price discrimination .Had the
consumer got the chance of consuming Q0 amount of the product at a single
price P0, consumer surplus would have been AP0E.But the entire consumer
surplus goes under the seller’s possession having the opportunity of charging
different price for every different unit. This pricing policy is also known as take –
it-or-leave –it policy as the seller is able to put the buyers under the pressure of a
unique price for a distinct unit.

Under perfect price discrimination consumer surplus turns out zero.

Nevertheless several authors argue that there is no efficiency loss because full
amount of consumer surplus is transfers to the producers, thus there is no
welfare loss in net sense.

2nd Degree Price Discrimination

This type of price discrimination occurs in the same market. Identical product is
sold at two or three different prices. Same customer purchase several units at a
higher price and subsequent units at a lower price. This short of price
discrimination causes a reduction in consumer surplus .The diagram illustrates
the two part pricing.OQ1 output is sold at OP1 price per unit and the next Q1Q2
amount of output is sold at OP2 price. If the seller sells entire OQ2 output at a
single price P2 then the amount of consumer surplus would be AP2F .but in the
event of discriminating price, consumer surplus from the first OQ1 amount of
output is AP1E and from the subsequent of Q1Q2 output it is EGF. Total consumer
surplus under discrimination turns out AP1E plus EGF which is clearly smaller then
the consumer surplus AP2F in the absence of discrimination. Reduction in
consumer surplus is equal to P1P2GE.

3rd Degree Price Discrimination

This type of price discrimination , is based around the idea that the firm sets
prices that will accomodate the consumer. The firms know broad demographics
about the particular types of consumers they will supply, and charge prices such
that everyone will be able to consume the product. In order for this form of
discrimination to work the firm must be able to predict the elasticity of demand in
various consumers. This type of discrimination can be seen in the movie theater
business. Student and senior discounts are given because these groups of
consumers have more elastic price elasticity of demand. It is because of this
discrimination that the firm is able to extract the consumer surplus of those who
might not otherwise pay the standard rate. Third degree price discrimination
relies on the firm being able to separate the segments. If separation of segments
is not possible then the product can be transferred.
The example below shows the total market for public transport journeys before
9.00am. The total market demand (Dm) is the sum of the demand of two
segments, adults (Da) and students (Ds) . For adults the price of a bus ticket is
only a small part of their income and this means that their demand (Da) is more
inelastic than that of students for whom a bus ticket is a larger part of their
income, (see the determinants of elasticity).

In fig. 3 the firm we once again decides on their output by equating MC with MR.
However there is not just one price. By drawing a horizontal line through the
MC=MR point until it intersects with the MR curves for adults and students and
then reading the price off the respective demand curves Da and Dr the price in
each segment is determined, Pa and Pr. Not surprisingly the price in the adult
market is higher.

Figure 5

This discrimination allows the firm to appropriate more, but not all, of the
consumer surplus, fig. 6.

Figure-6
 Firms can often segment the market by charging different amounts for providing
the product or service at different times, e.g. Weekend rail fares. The firm can
also change the basic product in some way, for example offering faster check-in
for flights, slightly more legroom and complimentary drinks. These firms can also
segment markets by location, selling in different places at different prices, car
sales are an example of this. Car prices tend to be different in different countries
and these differences in prices cannot always be explained away.

Examples of 3rd degree price discriminators: Wall street journal (student pricing),
movie theaters (student & senior discounts), hotels (senior discounts).

Peak Load Pricing

Peak Load Pricing is a pricing strategy that implies price will be set at the highest
level during times when demand is at a peak. The pricing strategy is an attempt to
shift demand, or at least consumption of the good or service, to accomodate
supply. The idea is that pricing higher when demand is at its peak will balance out
the supply and demand so that there is no shortage on either end of the
spectrum. If a good is priced at a high cost and many demand it, a capacity will be
balanced. This is a type of price discrimination; a firm discriminates between high-
traffic, high usage or high demand times and low usage time periods. The
consumer that purchases during high usage times has to pay a higher price than
that of the consumer that can delay his purchase or demand. Graphically,
Marginal Cost is constant until the quantity being produced is the maximum that
the firm can produce. At this quantity, Marginal Cost becomes vertical. Since firms
optimize profits when MC=MR, shifts in MR and MC effect the price. As demand
shifts outward, Marginal Revenue increases. As a result, the point where MR=MC
increases and higher prices result.

Two-part tariff
A two-part tariff is a price discrimination technique in which the price of a product or
service is composed of two parts - a lump-sum fee as well as a per-unit charge. In
general, price discrimination techniques only occur in partially or fully monopolistic
market . It is designed to enable the firm to capture more consumer surplus than it
otherwise would in a non-discriminating pricing environment. Two-part tariffs may
also exist in competitive markets when consumers are uncertain about their ultimate
demand. Health club consumers, for example, may be uncertain about their level of
future commitment to an exercise regimen. Depending on the homogeneity of
demand, the lump-sum fee charged varies, but the rational firm will set the per unit
charge above or equal to the marginal cost of production, and below or equal to the
price the firm would charge in a perfect monopoly . Under competition the per-unit
price is set below marginal cost. An important element to remember concerning two-
part tariffs is that it is still price discrimination, of which an important feature is that
the product or service offered by the firm must be identical to all consumers, hence,
price charged may vary, but not due to different costs borne by the firm , as this
would imply a differentiated product. Thus, while credit cards which charge an annual
fee plus a per- transaction fee is a good example of a two-part tariff, a fixed fee
charged by a car rental company in addition to a per- kilo fuel fee is not so good,
because the fixed fee may reflect fixed costs such as registration and insurance which
the firm must recoup in this manner. This can make the identification of two-part
tariffs difficult.

A natural monopoly
A natural monopoly is a specific type of monopoly that can arise when there are
very high fixed costs or other barriers to entry in getting started in a certain
business or delivering a product or service. This creates a situation where it is
more efficient for one business to deliver a product than multiple businesses. In
these situations, there are often government regulations to prevent high prices
and corruption. This efficiency results in lower average costs for us.

Can you think of an industry that would be difficult to enter because it would
require huge start-up costs? One example may be the gas utility company that
you pay to heat your home and water. Can you imagine all the land, facilities,
machinery, and technology you would have to purchase, as well as all the
pipelines you would have to lay, to start in this business? These extremely high
capital costs are often referred to as barriers to entry. Barriers to entry, such as
high start-up costs, specialized technology, or difficult licensing and regulation
requirements in an industry limit the number of possible entrants into the
industry. It is simply too expensive and risky to get started.
 MONOPOLISTIC COMPETITION

MONOPOLISTIC COMPETITION: Monopolistic competition is a market structure in

which large number of sellers sell differentiated products. This market has the
elements of both perfect competition and monopoly.

Features of Monopolistic Competition :

i. Large number of sellers : In a monopolistically competitive market, there

are a large number of sellers who individually have a small share in the
market.
ii. Product differentiation : In a monopolistic competition market, the
products of different sellers are differentiated on the basis of brands. These
brands are generally so much advertised that a consumer starts associating
the brand with particular manufacturer and a type of brand loyalty is
developed.
iii. Freedom of entry and exit : New firms are free to enter into the market
and exiting firms are free to quit it.
iv. Non-price competition : In a monopolistically competitive market, sellers
try to compete on bases other than price, as for example aggressive
advertising, product development, better distribution arrangements,
efficient after-sales service, and so on. A key base of non-price competition
is a deliberate policy of product differentiation. Sellers attempt to promote
their products not by cutting prices but by incurring high expenditure on
publicity and advertisement and other sales promoting techniques. This is
because price competition may result in price-wars which may throw a few
firms out of market.
Price-output determination under monopolistic competition :
Equilibrium of a firm :
Short Run
In a monopolistically competitive market, since the product is differentiated each
firm does not face a perfectly elastic demand for its products. Each is a price
maker and is in a position to determine the price of its own products. As such, the
firm is faced with a downward sloping demand curve for its product. Generally,
the less differentiated the product is from its competitors, the more elastic this
curve will be.

The firm depicted in figure 22 has a downward sloping but flat demand curve for
its product. The firm is assumed to have U-shaped short run cost curves.

Conditions for the equilibrium of an individual firm : The condition for price-
output determination and equilibrium of an individual firm may be stated as
follows :
 i. MC = MR
ii. MC curve must cut MR curve from below.

Figure 22 shows that MC cuts MR at E. At E, the equilibrium price is OP and the

equilibrium output is OM. Since per unit cost is SM, per unit super-normal profit
(i.e. price-cost) is QS (or PR) and the total super-normal profit is PQSR.

It is also possible that a monopolistically competitive firm may incur losses in the
short run. This is shown in fig. 23.

The figure shows that per unit cost (HN) is higher than price OT (or KN) of the
product of the firm and the loss per unit is KH (HN-KN). The total loss is GHKT.

What about long run equilibrium of the industry? If the firms in a monopolistically
competitive industry earn super-normal profit in the short run, there will be an
incentive for new firms to enter the industry. As more firms enter, profits per firm
will go on decreasing as the total demand for the product will be share among a
larger number of firms. This will be happen till all the profits are wiped away and
all the firms earn only normal profits. Thus in the long run all the firms will earn
only normal profits.
 The Long-run equilibrium of a firm in monopolistic competition
Diagram:

Figure 24 shows the long run equilibrium of a firm in a monopolistically

competitive market. The average revenue curve touches the average cost curve at
point T corresponding to quantity Q and price P. At equilibrium (i.e. MC=MR)
supernormal profits are zero, since average revenue equals average cost. All firms
are earning zero normal profits or just normal profits.

In case of losses in the short run, the loss making firms will exit from the market
and this will go on till remaining firms make normal profits only.

Excess Capacity: Excess capacity is the measure of the gap between the current
output and the level corresponding to the optimum plant. It is to be noted that an
individual firm which is in equilibrium in the long run, is in the long run is in
equilibrium position at a position where it has excess capacity. That is, it is
producing a lower quantity than its full capacity level. The firm in figure 24 could
expand its output from Q to R and reduce average costs. But it does not do so
because to do so would be to reduce average revenue to minimum more than
average costs. It implies that, firms in monopolistic competition are not of
optimum size and there exits excess capacity (QR in our example above) of
production with each firm.

MONOPOLISTIC COMPETITION AND ADVERTISING:

Advertising is commonly used by firms operating under monopolistic competition

as a way to create product differentiation and thus to acquire some degree of
market control and thus charge a higher price. Advertising is information provided
by a company about its product or operation, usually through media such as
television, radio, newspapers, magazines, and the Internet, to promote or
maintain sales, revenue, and/or profit. Advertising is frequently used by
monopolistic competition to accomplish two related goals-- product
differentiation and market control. To the extent that a firm can inform buyers
about physical differences or create the perception of such differences, then
product differentiation increases. Moreover, with product differentiation market
can be controlled. If advertising convinces buyers, that a good is different (and
better) from other comparable products, then a firm can charge a higher price.