SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

CHAPTER –ONE
PRICE AND OUTPUT DETERMINATION UNDER MONOPOLY
1.1Definition and Causes of monopoly
DEFINITION:-Monopoly is a market structure in which one firm makes up the entire market whose
product is unique or no close substitute. It is a polar opposite to perfect competition. In other words,
it is a market structure in which the firm faces no competitive pressure from other firms. Hence, pure
monopolist is a price maker/setter and the consumers’ option in this market is “Take it or Leave it
price”.
BASIC ASSUMPTIONS OF PURE MONOPOLY
1. There is only one seller and many buyers in the market.
2. The product of the monopolist is unique. This implies the product doesn’t have any close-sub-
stitute.
3. Because of the above mentioned assumptions a monopolist firm is a price maker. This price is
also known as take it or leave it price.
4. Entry to and exit from the market is difficult. This is because fixed cost/initial investment is
large but the additional cost/marginal cost of producing a unit of output is small for the mono-
polist. That is, to say that once a huge investment is made to acquire the best technology with
many plants and high capacity, the marginal cost of producing an additional unit of output is
negligible. Such situation is referred to natural monopoly. Example, EEPCO, the Tekeze pro-
ject and Gelgel-Gibye hydroelectric power generation.

What Causes monopoly?

Several factors lead to the rise of monopoly power. These factors are related to barrier to entry and
exit. These include the following:
1. Control over the raw materials:-we know that the geographical distribution of natural and min-
eral resources is very uneven and the known deposits of some minerals are concentrated into very
small regions. In such situation, there is a great incentive for producers to form a monopoly, in order
to control the market by manipulating the supply of their product.
2. The Minimum Efficiency Scale [MES]
This refers to the level of output that minimizes the average total cost [ATC] relative to the size of
the demand [DD]. It is very large in monopolist in comparison to perfect competition market. Graph-
ically it can be seen easily as follows.

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SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

Where Qc= the level of output of competitive that minimizes cost

Qm= the level of output of monopolist that minimizes cost
Since the minimum level of output, as is seen in the above figure, of the monopolist [Qm] is greater
than the competitive market [Qc].There is no room for the new comers in the case of monopoly. That
is the room is blocked. This output [Qm] may be more than sufficient to supply the entire market.
This leads to natural monopoly. For example telephone companies and sewage disposal system.
3. Patent or copy right: This refers to the exclusive knowledge of low- cost of production or tech-
nique or exclusive right to produce. The firm may possess a patent right which prevents others to
produce the same product or use a particular production process. In this case the producer or mono-
polist will try to stop this technique from being copied by having
– patent right
-Trade mark
-Brand name
4. Franchise:-The government may grant a firm exclusive right to produce or provide a particular
product or service within its jurisdiction .Such a right is known as Franchise. In this special case the
firm becomes a sole producer or service provider in that specific region and will have monopoly
power.
To sum up, due to the above mentioned factors, an industry may have one dominant firm purely by
historical incidence. If one firm is the first to entre in some market, it may have enough cost advant-
age to be able to discourage other firms [new comers] from entering the industry. For example, sup-
pose that there are very large ‘tooling up’ costs to enter an industry, then the incumbent[already ex-
ist] firm ,made under certain condition ,will be able to convince potential entrants that it will cut
price drastically if they attempt to enter to the industry. By preventing entry in this manner a firm
can eventually dominate a market and becomes a monopoly.

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1.2 DEMAND AND MARGINAL REVENUE CURVES UNDER MONOPOLY

The demand curve of monopolist product is downward slopping [implying negatively
slopped].since a monopolist constitutes a one-firm market; the market demand curve is the monopol-
ist demand curve. Unlike the case of perfectly competitive firms demand curve, the monopolist de-
mand curve is different from its average and marginal revenues. When demand is negatively
slopped, marginal revenue is negatively slopped as well. Furthermore, in pure monopoly market,
marginal revenue is less than price at all relevant points of output. The difference between marginal
revenue and price depends up on the price elasticity of demand.
Graphically

FIGURE 1.2: MR Under pure monopolist firm the slope of the marginal revenue is twice steeper
than that of the slope of the demand curve.
Mathematically, given for simplicity a linear demand function of the monopolist by Q=a -bP where
Q= output level of the monopolist, P=price level of the monopolist and b>0.
First let’s derive the inverse demand function
P=a/b -Q/b -1/b isthe slope of the inverse demand function...................................[1]
TR=P.Q
TR= [a/b -Q/b].Q substituting p= a/b -Q/b in total revenue
TR= a/b.Q –Q2/b now differentiating the total revenue with respect to Quantity we obtain MR
MR= a/b -2Q/b ............................................................................................................. [2]
From equation [2] we can conclude that the slope of the Marginal revenue is twice steeper than the
slope of the demand curve under pure monopoly.
Always a monopolist will set its price in a region where demand is elastic .that is, |ed|>1.
From the profit maximization
∏=TR- TC
Where TC=F (Q)
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TR=P.Q Deriving the marginal revenue from the total revenue

MR=TR
Q
MR=P +QP
Q
Factoring out P we obtain
MR = P[1 +Q/p. P/Q]; but we do know that Q/p. P/Q=1/e
MR= P [1 +1/e] by definition we know that elasticity of demandis always negative.
MR= P [1 -1/|e|]...........................................................................................................[1]
A monopolist maximizes profit at a point where MR=MC, substituting for MR from Equation [1] the
equilibrium condition can be written as follows
P [1 -1/|e|] = MC...........................................................................................................[2]
Solving for P from the above equation we get
P = MC
1 -1/|e| .....................................................................................................................[3]
1
1 -1/|e|
This is the mark-up pricing where the amount of mark up depends on the elasticity of demand. Since
the monopolist will always operate where demand is elastic we are assuming |e|>1 and thus the mark
up is greater than one (1).

1.3 COSTS AND SUPPLY CURVES UNDER MONOPOLY

In the traditional theory of monopoly the shape of cost curves, TC, AVC, ATC are the same as in the
theory of pure competition. The short run cost curves –ATC, AVC and MC are very wide U –
shaped [implying high capacity]. However; unique supply curve can’t be derived for monopolist, it
is because a monopolist set price [P] based on elasticity of demand. Monopoly supply depends on
the shape and location of the demand curve and does not have clear and exact meaning that compet-
itive supply has. It is meaningless to ask in general what price a monopolist will charge for a given
output since the answer is not unique. In other words, the output that competitor produces depends
only on cost condition and price. The same statement can not be true to a monopolist because a
monopolist chooses his price simultaneously with the choice of output level. The competitor can
only choose output. One point to be stressed here is that the MC curve is not the supply curve of
the monopolist, as is the case in pure competition. Under monopoly there is no unique relationship
between price and the quantity supplied.

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SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

Given the MC, the same quantity may be offered at different prices depending up on the price elasti-
city of demand. Graphically this is shown in the figure below [figure 1.3 A]. The quantity Q will be
sold at price P1 if demand is D1.while the same quantity Q will be sold at price P2 if demand is
D2.Thus there is no unique relationship between price and quantity.
Similarly, given the MC of the monopolist, various quantities may be supplied at any one price, de-
pending on the market demand and the corresponding MR curve. In figure 1.3 B, given the costs of
the monopolist, he would supply OQ1, if the market demand is D1, while at the same price, P, he
would supply only OQ2 if the market demand is D2.

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SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

1.4 SHORT-RUN EQUILIBRIUM UNDER MONOPOLY

Identical to the perfect competition, monopolist maximizes profit at a point where MR=MC and MC
is rising or cuts the marginal revenue curve from below. Here we can use two approaches to determ-
ine the short run equilibrium in monopolist market.
A.The Total Revenue-Total Cost approach
The monopolist, just like as the perfect competitor, attains maximum profit by producing and selling
at the rate of output for which the positive difference between total revenue and total cost is greatest
[or minimizes loss when the negative difference is least].To illustrate the total revenue-total cost ap-
proach see the following hypothetical revenue and cost data

Quantity[Q] Price[P] TR MR TC ATC MC profit

5 2.00 10.00 - 12.25 2.45 - -2.25
13 1.10 14.30 0.54 15.00 1.15 0.34 -0.70
23 0.85 19.55 0.52 18.25 0.80 0.33 +1.30
38 0.69 26.22 0.46 22.00 0.55 0.25 +4.22
50 0.615 30.75 0.35 26.25 0.53 0.35 +4.50
60 0.55 33.00 0.23 31.00 0.52 0.48 +2.00
68 0.50 34.00 0.125 36.25 0.53 0.66 -2.25
75 0.45 33.75 0.04 32.00 0.56 0.42 -8.25
81 0.40 32.40 -0.225 48.25 0.60 1.04 -15.88
86 0.35 30.10 -0.46 55.00 0.64 1.35 -24.90

TABLE 1.1
∏=TR-TC
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 SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

∏=P.Q-Q.ATC
∏=Q [P-ATC] but from the table above we Q=50, P=0.615 and ATC=0.53
∏=50[0.615-0.53]
∏=$4.50
Graphically it is shown as follows:

B. Marginal Revenue-Marginal Cost approach

Here we use the interaction of MR, MC and ATC curves to determine the profit maximizing output
and price levels. When MR>MC, since the additional revenue generated due to producing an addi-
tional unit of output is greater than the additional cost incurred, it is advisable for the firm to expand
production. When MR<MC, in this case the additional cost incurred is greater than the additional
revenue, being a profit maximizing firm it is advisable to reduce output up to certain level. There-
fore, the short run equilibrium is attained where MR=MC, where MC is rising. From the above table
we can illustrate it both graphically and mathematically.

P, MR, MC
Cost

0.61 AATC
Profit
0.525 ..........................B
.

DD
O 50 MR Quantity

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SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

Figure 1.5
Numerical Example -1
Given the market demand of monopolist by Q=50-0.5Pand the cost function TC=50+40Q where
Q=output of the monopolist and P=price of the monopolist.
Then determine
A] The profit maximizing level of output and price
B] The short run profit level
Solution
A] step-1. TR=P.Q from the demand function solve for P.
Then P=100-2Q→inverse demand curve

TR=P.Qsubstitute the inverse demand in to the equation above

TR= [100-2Q] Q
TR=100Q-2Q2................................................................................[1]
Step-2.Derive the marginal Revenue from equation [1]
MR=TR
Q
MR =100 - 4Q............................................................................................[2]
Step -3derive the marginal cost from the cost function
MC=TC
Q
MC=$40---------------------------------------------------------------------------[3]
Step-4equate equation 2 and 3 and then solve for Q
MR=MC
100-4Q=40
Q=15 units
Step-5substitute Q=15 in the inverse demand
P=100-2[15]
P=$70
B] ∏=TR-TCOR∏=Q [P-ATC]
∏=70[15]-[50+40[15]] ∏=15[70-43.33333]
∏=1050-650 ∏=$400.00
∏=$400.00

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1.5Two common misconceptions about monopoly

i. Monopoly always makes profit.
There is no guarantee that a monopoly profits in the short run .In fact, whether a monopoly
makes profit or loss n the short run depends on its revenue and cost conditions. It is quite
likely thatits SAClies aboveits AR as shown in thegraph below.

SMC
P1 P SAC
P2 m

AR=D
MR
O Q output
Fig 1.6
At the profit maximizing output (OQ), SAC exceedAR by PM. The monopoly firm therefore,
makes use losses to the extent of PM x OQ=P2mPP1
ii. A monopoly can charge an arbitrary price.
Another common misconception about monopoly is that a monopoly firm , by virtue of be-
ing a single seller of a commodity, can charge any price or an exorbitantly high price for its
product.
Where will the monopoly firm fix its price?
To answer this question , a convenient starting point is point M on the AR curve in fig. 1.7.
Let thefirm set its price at MN. At this price, e=1 and MR=0. It means that for profit to be max-

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imum, MC must be equal to zero ( MC=0) . It follows that if AR<MN,MR will be

negative .and then firm’s MC must be less than 0 for its profit to be maximum. This is an
impossibly, unless the government subsidizes the monopoly to the extent of its loss. It may
thus be concluded that no price less than MN will maximize monopoly’s profit . Soany price-
less than MN is ruled out. In fact, the point on the demand curve where e=1is the lower limit of
price of a profit maximising monopoly.
Can a monopoly firm set any price between points P and M ? The answer is ‘NO’.
The range of demand curve between points P and M no doubt marks the profitable range of
prices. But any pricein this range will not maximise monopoly’s profit. Given the cost curves, thereis
only oneprice (PQ) that maximises profits. Therefore , a monopoly firm cannot, by using its
monopoly power , charge any price. It will charge that maximisesits profit.

How to find profit- maximizing price? If the monopoly firm is aware of its MC and price
elasticity (e) of demand for its product , it can easily find out its profit -maximizing price.
Suppose firm’s MC=4 and elasticity of demand curve e=-2. Given these variables , the profit
maximizing price can be found as follows.
We know that profit is maximum where
MC=MR
We also know that

MR=P

Since MC=4=MR

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4=P

1.6 LONG -RUN EQUILIBRIUM UNDER MONOPOLY

In a pure monopoly, entrance into the market by potential competitors is not possible. Thus whether
or not a monopolist earns a pure profit in short run; no other producer can enter the market in the
hope of sharing whatever pure profit exists.Therefore, pure economic profit is not eliminated in the
long run, as it is in the case of perfect competition.
In the long run monopolist will have time to expand its plant to produce any level of output which
will maximize profit. Long run equilibrium adjustment in a single-plant monopolist must take one
of the two possible courses. First, if the monopolist incurs short run loss and if there is no plant size
that will result in pure profit [or at least NO loss]; the monopolist goes out of the business. Second,
if the firm earns a short run profit with its original plant, it must determine a plant of different size
[and thus a different price and output] will earn a larger profit.
The first situation requires no comment. The second calls for the introduction of a new concept, long
run marginal cost [LMC].Long run marginal cost is the change in total cost associated with a change
in output when factors, including the scale of the plant, can vary.
Since entry is blocked, it is not necessary for a monopolist to operate at its optimal capacity, that is,
installing additional plant size to produce at the minimum point of long run average cost [LAC]
where there is no excess profit.
Consider the following table and see how a monopolist will derive the long run marginal cost
[LMC].For simplicity let’s assume the monopolist has only two plants and consumers [people] have
the same elasticity of demand.
Derivation of long run marginal costs
SAC1 SAC2 TC1 TC2 SMC1 SMC2 Long run LMC MR
Output total cost
1 15 20 15 20 - - 15 - -
2 12 13 24 26 9 13 24 9 10
3 11 10 33 30 9 4 30 6 5
4 12 8.5 48 34 15 4 34 4 4
TABLE1.2

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The problem of the monopolist is which of the two plants to use in order to maximize long run
profit?
If the monopolist wants to produce only one unit of output, then the best choice in the long run
would be to use plant one. This is because of the TC1<TC2,15<20.if the monopolist wants to produce
two units of output ,it should again choose plant one, TC1<TC2, 24<26.The long run marginal cost of
the second unit is $9[i.e. the difference between TC of using plant1 to produce output 1&2]
If he wants to produce three units of output, he should rather choose plant two. Because TC2<TC1
OR 30<33.Therefore the long run marginal cost of producing three units of output is the difference
between the total cost of producing three units of output optimal using plant two and total cost of
producing two unit of optimal using plant one.[i.e.30-24=6].if the monopolist wants to produce the
fourth unit of output ,s/he will choose plant two. Hence long run marginal cost is 4.
There fore, the long run equilibrium for monopolist is given by MR=LMC. From the above table
equilibrium MR=LMC=SMC2=4
How do we get the selling price of output in monopolistic market? This is possible if we are given
elasticity of demand.

Numerical-Example-2
Given that at the long run equilibrium output the elasticity of demand is -1.666666. Then determine
the equilibrium price level in the above table A) P4, B) long run equilibrium profit and C) P1, P2,P3
Solution
A) MR= P [1 -1/|e|] But in the table above we are given marginal revenue is 4 in the long run
equilibrium.
4= P [1 -1/|e|]
4=P [1 -1/1.66666]
4=0.4P
P=$10 is the Equilibrium price
C) MR4 =TR4 –TR3
Q4– Q3
B) LR∏= Q [P – ATC]
LR∏=4[10 – 8.5] MR4 =P4 .Q4 – P3 .Q3
LR∏=$6 4=10[4] -3P3
P3 =$12
MR2 =P2.Q2 –P1. Q1 MR3=TR3 –TR2

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10=15.5[2] – P1Q3 – Q2
P1 = $21 5=12[3] -2P2
P2 =$15.5

Diagrammatical representation of long run equilibrium of monopolist is

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Suppose in the initial period the firm builds production plant represented by SAC1and SMC1.Equal-
ity of the short run marginal cost and marginal revenue leads to the sale of OQsrunits of output at the
price level of OA. At this rate of output, cost per unit is OD=QsrC; short run monopoly profit is rep-
resented by the area of the rectangle ABCD.
Since a pure economic profit is can be obtained, the firm would not consider going out of business.
However, it would search for a more profitable long run organization and profit maximization is at-
tained when long run marginal cost (LMC) equals marginal revenue (MR) .in the above graph, the
associated rate of output is OQlr and price is OE.
By reference to LAC, the plant capable of producing OQlr unit of output per period at the least unit
cost is the one represented by SAC2 and SMC2. Unit cost is accordingly OH, and long run maximum
profit is given by the area of the rectangle EFGH. This profit is visually greater than the profit ob-
tainable from the original plant.
From the above analysis one can propose that; a monopolist maximizes profit in the long run by pro-
ducing and marketing that rate of output for which long run marginal cost equals marginal revenue.
The optimal plant is the one whose short run average total cost curve is tangent to the long run aver-
age cost curve at the point of corresponding to the long run equilibrium output level.

1.7 PRICE DISCRIMINATION

So far we have considered monopolist that charge the same price to all consumers. Now let’s con-
sider what would happen if our monopolist suddenly gained the ability to price discriminate-to
charge different prices to different individuals or group of individuals. If a monopolist can identify
group of customers who have different elasticity of demand, separate them in some way, and limit
their ability to resell its product between groups, it can charge each group a different price. Specific-
ally, it could charge consumers with less elastic demand [price insensitive group] a higher price and
individuals with more elastic demand [price sensitive group] a lower price level. By doing so, it will
increase total revenue and there by its profit.
In other words, a firm that price discriminates will therefore, set a lower price for price sensitive
group and a higher price for the group that is relatively price insensitive.
For example:-
1. Movie theatres give discount to senior citizens and children →movie theatres charge senior cit-
izens and children at lower price because they have a more elastic demand for movies [price sensit-
ive].

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SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

2. Entrance fee for NATIONAL MUSEUM OF ETHIOPIA is quite different for students, senior cit-
izens and foreigner
Economists usually consider three types of price discrimination.
1. First-degree [perfect] price discrimination:-in this case the monopolist sells different unit of
output for different prices and these prices differ from person to person. In first degree price discrim-
ination pricing depends upon who you are. Under perfect price discrimination, the seller leaves no
consumer surplus to any buyer.
2. Second-degree [non-linear] price discrimination:-this refers to the case when a monopolist sells
different unit of output for different price but, every individual who buys the same amount will pay
the same price. That is, price differs across amount of output, not across people.
3. Third-degree price discrimination: - It occurs when a monopolist divides his buyers in to two or
more than two sub markets or groups depending on the price elasticity of demand and charges a dif-
ferent price in each sub segment. But every unit of output sold to a given group of people [e.g stu-
dents, house holds] is sold at the same price.

Now the question arises here if a monopolist discriminates price, charging different prices to differ-
ent individuals or group of individuals or setting different prices for different units of output then
how does a monopolist determine the optimal price in each market?
Assumptions [necessary condition for price discrimination]
 The monopolist is assumed to identify at least two groups of people with different elasticity
of demand.
 The consumers in each market are not able to resell in the other market.
Given
Max.P1 [Q1].Q1 +P2 [Q2].Q2 -TC [Q1+Q2]...................................................................[1]
The optimal solutions are:-
MR1=MC......in market one
MR2=MC......in market two..........................................................................................[2]

Equation two says that the marginal cost of producing an additional unit of output must equal to
marginal revenue in each market. If marginal revenue [MR] in market one exceed marginal cost
[MC], it pays to expand output in market one. But if MR in market one is less than the correspond-
ing MC, it is advisable to reduce output. The same analysis is true for market two.
Using the standard elasticity formula and the profit maximization conditions we can generalized the
relationship between price and elasticity demand.

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MR1=MC [Q1 +Q2]

MR2=MC [Q1 +Q2]
............................................................................................................................[3]
We know from the last section of our discussion that
MR=P [1- 1/|e|] where P is price, |e| is elasticity of demand and MR is marginal revenue
Then
P1 [1-1/|edq1|] = MC [Q1+Q2]
P2 [1-1/|edq2|] = MC [Q1+Q2]
............................................................................................................[4]
Equation [4] says since marginal cost is the same at equilibrium in each market, the marginal rev-
enue must always be equal.
If P1>P2, then 1-1/|edq1|<1-1/|edq2|.........................................................................[5]
This implies
1/|edq1|>1/|edq2|.......................................................................................................[6]

|edq2|>|edq1|......................................................................................................[7]
Thus, the market with the higher price must have lower elasticity of demand and the market with
the lower price must have relatively higher elasticity of demand. Stated differently, the price sensit-
ive group will have lower price and the relatively price insensitive group will have higher price.

Numerical-example-2
Suppose a profit maximizing monopolist produces its output with total cost [in dollars]function
given by TC=5Q +20 and sells its product in two market segments which are completely separated
from each other and resell is also impossible. The demand curve for the product in each segment are
given by
q1=55-p1 – The DD function in market 1
q2=70-2p2 – The DD function in market 2
Then determine
A. q1, q2, p1, and p2 that maximises profit
B. Find the elasticity of DD in the two markets
C. Calculate the total profit the monopolist will obtains from its sell in the two markets [with
price discrimination]
D. Find the output and price levels which optimize profit with out price discrimination
E. Is the monopolist better off with or with out price discrimination

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Solution
Given TC=5Q+20, TC= 5
Q

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A] For market segment1

1st Find the inverse DD function
q1=55-p1
p1=55-q1
2nd.Find TR1=p1q1
TR1= (55-q1) q1
TR1=55q1-q12
3rd.Find MR1= TR1
q1
MR1=55-2q1
4th.Equate MR1=MC
55-2q1=5
-2q1=5-55
-2q1= -50
q1=25
5th.Substitute q1=25 in the inverse DD fun.
p1=55-q1
p1=55-25
P1=$30

For market segment 2

Inverse DD function
q2=70-2P2

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B] Price elasticity of DD in market 1 price elasticity DD in market 2
q1=55-p1 q2=70-2p2
d1=| dq1| x p1 d2=|dq2 |x p2
| dp1| q1 |dp2| q2
d1=|-1| x 30 d2= |-2| x 20
25 30
d1 =1.2 d2= 1.33
The above result tells us that DD is more elastic in market 2. Therefore, the monopolist charges lower
price in market two than market 1.
C] The profit of the monopolist
= (TR1 + TR2) – TC
 = (p1q1 + p2q2) – (5Q + 20), where Q is q1+q2
 = 30 (25) + 20 (30) – (5 (25 + 30) + 20)
= 750 +600 – (5 (55) +20)
=1350 – (275 +20)
=1370 – 295
= $1055

D] Let’s add up the demand curves like this

q1=55_ p1
q2=70_2p2
Q=125_3p this is market demand with out price discrimination
TR=P.Q WHERE P= 41.666666 - 0.333333Q

TR= [41.66666-0.333333Q] .Q
TR=41.666666Q-0.333333Q2
MR=dTR
dQ

MR=41.66666_0.66666Q
MR=MC
41.66666_0.666666Q=5
Q=55 UNITS
Substitute Q=55 in the inverse demand function
P=41.66666_0.333333 [55]
P=23.333333
∏=TR_TC
∏=P.Q_TC
∏=23.3333[55] _ [5[55] +220]
∏=$988.333333
E] The monopolist will be better off with price discrimination because it earns higher profit with price dis-
crimination than with out price discrimination [$1055>$988.3333].

NUMERICAL-EXERCISE-2
Suppose a profit maximizing monopolist produces its output with total cost [in dollars]function given by
TC=20Q +1200 and sells its product in two market segments which are completely separated from each
other and resell is also impossible. The demand curve for the product in each segment are given by
q1=100- p1 – The DD function in market 1
q2=100- 2p2 – The DD function in market 2

Then determine
A. q1, q2, p1, and p2 that maximises profit
B. Find the elasticity of DD in the two markets
C. Calculate the total profit the monopolist will obtains from its sell in the two markets[with price
discrimination]
D. Find the output and price levels which optimize profit with out price discrimination
E.Is the monopolist better off with or with out price discrimination

1.8.MULTI- PLANT MONOPOLIST IN SHORT RUN

So far we have assumed that a monopolist owns and produces an output by means of only one plant. This
is not all the case. It is possible for the monopolist to install more than one production plant and hence cost
conditions may differ from one plant to another. The cost curves associated to each plant are different. The
problem faced by monopolist is the allocation of production between plant1 and 2. The monopolist
maximises profit by equating MR equal to MC. However, there is one MR and three MC curves when we
assume the monopolist have two plants. That is, MC1 for plant1, MC2 for plant 2, and MC common mar-
ginal cost (multi-plant MC). The monopolist maximises profit by producing output level where each
plant’s MC is equal to MR.
 Consider the following table to examine how a monopolist with two plants having different
cost of production first determines total output and then decides how much to be produced using each plant.

Q P MR MC1 MC2 MC
1 5.00 - 1.92 1 2.04 3 1.92
2 4.50 4.00 2.00 2 2.14 5 2.00
3 4.10 3.30 2.08 4 2.248 2.04
4 3.80 2.90 2.16 6 2.34 10 2.08
5 3.55 2.55 2.247 2.44 2.14
6 3.35 2.35 2.32 9 2.54 2.16
7 3.20 1.30 2.40 2.64 2.24
8 3.08 2.24 2.48 2.74 2.24
9 2.98 1.18 2.56 2.84 2.32
10 2.89 2.08 2.64 2.94 2.34

 The total output level that maximises the profit of the monopolist is 8, MR=MC. The monopolist will
produce 5 units using plant 1 while 3 units using plant 2. This, is because profit is maximized when
MR=MC1=MC2=MC.
Mathematical example: Given, Q=200 - 2P, TC1=10q1 and TC2=0.25q22, find q1, q2, Q and profit of the
firm.
Solution:
1st find the inverse fun
Q=200 – 2P 7th Apply simultaneous equ. for
Q – 200= -2P MR=MC1 and MR=MC2
P= 100 – 0.5Q, where Q is q1 +q2 100-q1-q2=10
nd
2 TR=PQ -(100-q1-q2=0.5q2)
= (100 – 0.5Q) Q 10- 0.5q2=0
2
= 100Q – 0.5Q 10=0.5q2
3 MR= TR1
rd
q2= 10/0.5=20
q1
=100 –Q 8th MR=MC1=100-q1-q2-10
4th MC1= TC1 = 100- q1-20-10
q1 q1=100-30
= 10 q1= 70
MC2=TC2 9thThe profit of the monopolist q2
Π=TR-TC
=0.5q2 =(TR)-(TC1+TC2)
th
5 Equate MR=MC1 =(100Q-0.5Q2)-(10q1+0.25q22)
100 – Q=10 =(100(90)-0.5(90)2)-(10(70)+0.25(20)2)
100 – q1 – q2 –10=0 =(9000-4050)-(700+100)
6th Equate MR=MC2 = 4950 - 800
100 – Q=0.5q2 = $4150
100-q1-q2=0.5q2

1.9Bilateral Monopoly
Bilateral monopoly is a market consisting of a single seller ( monopolist) and a single buyer
(monopsonist). For example, if a single firm produced all the copper in a country and if only one
firm used this metal, the copper market would be a bilateral monopoly market. The equilibrium in
such a market cannot be determined by the traditional tools of demand and supply. Economic analysis can
only define the range within which the price eventually be settled.
To illustrate a situation of bilateral monopoly assume that all Railway equipment is produced by a
single firm and is bought by a single buyer, Ert-Ale Rail , both firms are assumed to aim at profit
maximization. The equilibrium of the producer is defined by the intersection of his marginal revenue
and marginal cost curves (point e 1 in the figure below) . he would maximize his profit if he were
to produce X1 quantity of equipment and sell it at price p1.
However , the producer cannot attain the above profit maximizing position , because he does not
sell in a market with many buyers , each of whom would be unable to affect the price by his pur -
chases. The producer -monopolist is selling to a single buyer who can obviously affect the market
price by his purchasing decisions.
The buyer is aware of his power , and, being a profit maximize , he would like to impose his own
price terms to the producer. What are the monopsonist’s price terms? Clearly the MC curve of the pro-
ducer represents the supply curve to the buyer: the upward slope of this curve shows that as the
monopsonist increase his purchases the price he will have to pay rises. The MC(=S) curve is de -
termined by conditions outside the control of the buyer, and it shows the quantity that the monopolist-
seller is willing to supply at various prices. The increase in the expenditure of the buyer ( his mar -
ginal outlay or marginal expenditure ) caused by the increase in his purchases is shown by the curve
ME in the fig. below. In other words, curve ME is the marginal cost of equipment for the monopsonist-
buyer. The equipment is an input for the buyer. Thus in order to maximize his profit he would like to
purchase additional units of X until his Marginal outlay is equal to his price, as determined by the
demand curve DD. The equilibrium of the monopsonist is sown by point ‘e’ in the fig. below : he
would like to purchase X2 units of equipment at a price P2 , determined by a point on the supply
curve MC(=S).However, the monopsonist does not buy from a lot of small firms which would be
price takers( that is, who would accept the price imposed by the buyer ) , but from the monopolist, who
wants to charge p1 , there is indeterminacy in the market . The two firms will sooner or later start
negotiations and will eventually reach at an agreement about price , which will be settled some
where in the range between p1 and p2 ,(p2≤p≤p1) , depending on :
 Bargaining power and skill of the participant firms.
 Government intervention

P,c

ME

e
P1 MC

P*
P2e1
D
X
X2 X1 x* MR

N.B- Bilateral monopoly is rare in commodity markets and quite common in labour markets

1.10.SOCIAL COST OF MONOPOLY

 Is the existence of a monopolist evil? The answer to this question is no and yes. No if the monopolist
charges different prices based on the marginal WTP, bulk discount, and elasticity of DD. That is, as we have
seen in the three types of price discrimination that a monopolist charge higher and lower price for those who
have high and low willingness to pay for its product-discrimination across person, on the basis of bulk dis-
count-discrimination across product consumed, and elasticity of DD-across group of people in first, second,
and third degree price discrimination, respectively are Pareto efficient. YES If it leads to social welfare loss or
dead weight loss.
 We have seen in chapter 5 that a remarkable outcome of perfect competitive market is resource alloca -
tion efficiency, which results to social welfare and increase in employment. This is because at competitive
equilibrium, the marginal utility of the consumed good (MU=DD) equals price (P), which in turn equals the
MC of producing the good. Hence, if MU=P (social welfare) and P=MC (allocation efficiency), then
MU=MC.
 An alternative way to understand the efficiency of competitive market is through the concept of Con-
sumers surplus. Consumers’ surplus is the difference between the consumers willing to pay for and the amount
actually paid. In other words, it is the area to the left of the perceived DD curve above the equilibrium price or
since equilibrium represents the money not spent by consumers who would have been willing to pay a price
higher than equilibrium. In short, it is the savings of the consumer for buying Qe at Pe.
 Clearly, an economy is performing well when it generates much to the consumer surplus and an effi-
cient situation is one in which the maximum amount of consumers’ surplus is squeezed out of the system.
Price price
CS CS

P E P E

MU=

MU= qty

Qe qt y Qe
Linear DD curve Non-linear DD curve
 The MC of goods represents supply. Equating the MC curve that passes through point E in the above
graphs shows producers’ surplus. Producers’ surplus is the area above the MC curve but below the equilibrium
Price (Pe). In other words, it indicates the difference between the additional cost (MC) firms are willing to in-
cur and what they actually incurred (Pe=MC). In short, it is the money that suppliers would not have received
if demand had been less than Qe.
Price

MC=SS
CS

PS
DD
DD
 Qe Quantity
2
Given Pd=25-Q and Ps=2Q+1 as demand and supply function, respectively calculate the consumers’ and pro-
ducers’ surplus.
 1st find the equilibrium Q and P
Pd=Ps
25-Q2=2Q+1
25-1=2Q+Q2
24=2Q+Q2
Q2+2Q-24=0
2nd Use the quadratic formula to get Q
-b±√b2-4ac
2a
-2±√22 - (4(1)(-2)
2(1)
-2±√4+96
2
-2±√100

-2±10
2
-2+10 and –2-10
2 2
Q=4 and Q= -6
3rd find equilibrium P
Pd=25-Q2 or Ps=2Q+1
Pd=25-(4) 2 or Ps=2(4)+1
Pd= 25-16 or Ps=8+1 Pd=Ps=9
2

4th Show the equilibrium Q and P graphically

PRICE
SS

SS

CS
DD
9
DD
QUANTITY

5th CS= -PeQe

=(25Q-Q3/3)/ -36
=25(4)-43/3-36
=100-64/3-36
=100-21.3-36
CS =42.7

6th PS=PeQe-

=9(4)-

=36-(2Q2/2+Q)
=36-(2(42/2)+4)
=36-(32/2)+4)
=36-20
PS =16
 These being the CS and PS in perfectly competitive market, the social cost of monopoly arises due to the
fact that a monopolist operates inefficiently as compared to perfect competition in the sense that Pm>Pc and
Qm<Qc. This is because a monopolist determines its Q and P by equating MR=MC unlike sellers in perfect
competition market that equate P=MC. As a result some part ofMCS and PS obtained in perfectly competitive
market are lost. To understand the social cost (DWL) of monopoly, consider the graph below.

MC
Pm A
Pc B D

C
DDm

MRm

Qm Qc Qty

 The above graph shows the change in the CS and PS for a movement from competitive (monopoly) to
monopoly (competitive) output. The CS goes down (up) by area PcEcAPm. That is, it goes down (up) by rect-
angle PcBAPm since consumers are not (now) getting all the units they were buying before at a higher
(cheaper) price; and it goes down by a triangle ABEc since they loose (get) some surplus from the lower (ex-
tra) units that are being sold.
 The PS on the other hand, goes up (down) by area PcBAPm due to the higher (lower price) on the units
he was already selling. It goes down (up) by EmBEc due to looses (profits) on the lower (extra) units it is now
selling. The area PcBAPm is just a transfer from the consumers (monopolist) to the monopolist (consumers)
and hence one side of the market is made better off while the other worse off, but the total surplus does not
change as a result of the transfer. However, the area ABEc and EmBEc represent the DWL due to monopoly
behaviour (a true increase in surplus-measure the value that the consumers and the producers place on the ex-
tra output that has been produced).
 The DWL provides a measure of how much worse off people are paying the monopolist than paying
the completive price. The DWL due to monopoly like that of the DWL due to tax increase measures the value
of the lost output by valuing each unit of lost output at a price that people are willing to pay for a unit. In other
word, as we move from competitive to monopoly output, the sum of the distance between the demand curve
and the MC curve generates (gives) the value of the lost output (Qc-Qm)due to monopoly behaviour. The total
area between the two curves is the DWL when moving from competitive to monopoly output.
Numerical Example:
 Assume there is a tendency of moving from competitive to monopoly output. If the demand and total
functions are Q=100-2P and TC=14Q+2Q2, respectively
A. Determine Pc, Qc, Pm, and Qm.
B. Show the equilibrium Q and P you obtained in A above graphically.
C. Calculate the CS and PS under competitive and monopolistfirms.
D. Calculate part of CS transferred to the monopolist due to inefficiency of monopoly.
E. Calculate the social cost (net loos or DWL) of monopoly.
 Solution:
Equilibrium Q and P in perfectly competitive market
50-14=4Q+0.5Q
36=4.5Q
QC=8units
Pc=50-0.5Q or 14+4Q
=50-0.5(8) or 14+4(8)
=50-4 or 14+32
PC=46=46birr
Equilibrium Q and P in monopoly market
TR=PQ
= (50-0.5Q) Q
=50Q-0.5Q2
MR=∂TR=50-Q
∂Q
MC=∂TC=14+4Q
∂Q
MR=MC
50-Q=14+4Q
50-14=4Q+Q
36=5Q
QM=7.2 units
Pm=50-0.5Q
=50-0.5(7.2)
=50-3.6 =46.4 birr

MC=SS
B.
Pm

Pc
MRm DDm

Qm Qc
Consumers’ and producers’ surplus in perfect competition
C. CS=1/2 (50-46) x 8
SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

1.11MEASUREMENT OF MONOPLOLY POWER

Professor A.P. Lerner has put forward a measure of monopoly power which has gained great popularity and is
most widely cited. Lerner takes perfect competition as the basis of departure for measuring monopoly power. He
regards pure or perfect competition as the state of social optimum or maximum welfare and any departure from it
would indicate the presence of some monopoly power leading to misallocation of resources or state of less than
social optimum.

Degree of monopoly power =

Where P = price at the equilibrium level of output.

MC= marginal cost at the equilibrium level of output.
The greater the divergence between price and marginal cost, the greater the degree of monopoly power possessed
by the seller.
When competition is pure or perfect, price is equal to marginal cost and therefore Lerner’s index of monopoly
power is equal to zero, indicating no monopoly power at all. Thus, under perfect competition, Lerner’s index of

monopoly power { = =0

On the other hand, when monopolized product entails no cost of production, that is, when the product is a free
good whose supply is controlled by one person, the marginal cost will be equal to zero and Lerner’s index of

monopoly power { would be equal to one or unity. Thus when MC is equal to zero = = 1.

It is thus clear that Lerner’s index of monopoly power can vary from zero to unity.Within this range, the greater
the value of the index, the greater the degree of monopoly power possessed by the seller.
Monopoly power and price elasticity of demand

Now, it has been shown that Lerner’s index of monopoly power is equal to the inverse of the price elasticity of
demand. We can prove this as follows:
Since at the equilibrium level, marginal cost is equal to marginal revenue, we can substitute in the above formula
marginal revenue for marginal cost.

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‘‘An idle mind is the devil’s workshop!! ’’, SO…
SAMARA UNIVERSITY DEPARTMENT OF ECONOMICS

Thus

Lerner’s index of monopoly power =

Since in equilibrium, MC = MR

Lerner’s index of monopoly power =

We know that MR = P(1- ) where e is absolute value of the price elasticity of demand at the equilibrium out-

put. Thus, putting P (1- ) in place of MR in in the above equation we get,

Lerner’s index of monopoly power = = = 1-1+ =

It therefore follows that Lerner’s index of monopoly power is equal to the inverse of price elasticity of demand.
Thus degree of monopoly power can be judged by merely knowing the price elasticity of demand at the equilib-
rium output. The degree of monopoly power varies inversely with the absolute value of price elasticity of demand
for the good. It is worth noting that price elasticity of demand in Lerner’s index refers to the price elasticity at the
equilibrium output.

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‘‘An idle mind is the devil’s workshop!! ’’, SO…