Chapter 6: Pure Monopoly

6.1. What is a Pure Monopoly?

A pure monopoly exists when a single firm is the sole
producer of a product for which there are no close
substitutes.
 Monopoly is a market structure in which there is a single
seller of goods and services which has no close substitutes in
the market
 A monopoly is a market that has only one seller, but many
buyers.
 Monopsony is the opposite of monopoly: a market
with many sellers but only one buyer
 In a monopolised market structure, the industry is a single-
firm industry.
◦ Examples: Hydro electric company, Ethiopian airlines, etc

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6.2 Characteristics of Pure monopoly
1. Single supplier – the firm and the
industry are synonymous.
2. No close substitutes – the product is
unique and unlike any others.
3. Price maker – the firm has considerable
control over price since it controls the
total quantity supplied.
4. Blocked entry – barriers to entry exist
because there is no immediate
competition.

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6.3. Sources or causes of
monopoly power
 Barriers to entry are factors that prohibit firms
from entering an industry.
The barriers to entry are the sources of
monopoly power. They include:
1. Size of the market.....natural monopoly
2. Economies of scale
3. Legal barriers to entry: Copy rights, patent
rights, government franchise and licensing
4. Ownership or control of essential resources
5. Exclusive knowledge of production process
6. Pricing policies of existing firms…limit
pricing
7. Mergers, takeovers and acquisitions
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6.4. Monopoly Demand, Revenue and
Cost Curves
In pure competition, a firm faces a
perfectly elastic demand since it is a price
taker.
The market supply and demand curves
determine price, which determines the
firm’s demand curve.
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.
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 Pure Competition Pure Monopoly
Price Price
Ep>1

Firm’s demand Ep=1

P same as Market
Demand

0<Ep<1

0 0
Quantity Quantity

Demand ……cont’d
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Demand ……cont’d
Mathematically down ward sloping demand curve is
represented by equation of the form
Y=a-bX and
Thus, P=a-bQ
a- is the y(p) axis intercept
-b –is slope of demand curve
= D(Y)/d(X) = d(Q)/ d(P)

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Total Revenue
Total revenue is the total sale received from selling a
specific amount.
Mathematically

TR=PQ
TR=(a-bQ)Q
TR=aQ-bQ2, which is quadratic equation and
its graph is downward concave parabola
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Continued……
◦ TR=maximum when its slope MR=0

TR

TR

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Average Revenue
AR measures the revenue received from the
sale of one unit on average

AR= = = P

Thus, for pure monopoly P=AR

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Marginal Revenue
MR measures the revenue received from
the sale of one additional unit

MR= = =
= a-2bQ = MR
MR is the slope of TR function
MR is the first order derivative of the TR
function w.r.t. Q
MR is less than price (the demand
curve)
P=a-bQ and MR=a-2bQ
P>MR 11/13/2024 10
DD, AR, MR, TR and ep

P
Ep>1
Ep=1
P1
Ep<1 DD  P=AR

Q1 Q

TR MR

TR

Q1 Q
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DD, AR, MR, TR and ep

P Q TR AR MR
$6 0 0 - -
$5 1 5 5 5
$4 2 8 4 3
$3 3 9 3 1
$2 4 8 2 -1
$1 5 5 1 -3

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The relationship among AR, P, MR
& Price elasticity of demand
 Given TR=P*Q,
TR P Q P

Q P
MR   P' Q  Q' P  Q  P  P(1  )
Q Q P Q
 Note that: is the reciprocal of the price
elasticity of demand(ep)
Q P

MR=p(1-1/𝑒𝑝)
 Therefore ,
P Q

 Then, MR =AR (1-1/𝑒𝑝)

 Since P= AR,

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The general relationship between AR and
MR can be summarized as follows
When
◦ ep= 1, MR = 0 AR > 0 therefore, AR >
MR
◦ ep < 1 >0 MR < 0, AR > 0 therefore, AR >
MR
◦ ep > 1 < ∞ MR >0, AR > 0 but AR >
MR
◦ ep = 0, MR < 0, AR = 0 therefore, AR >
MR
◦ ep = ∞, MR > 0, AR > 0 and AR =
MR

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Graphically,

AR, e =∞
A
MR
e >1

e =1

e <1

AR e =0

Q
MR

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Cost Curves under monopoly
In the short run, cost condition faced by a
monopoly firm are, for all practical
purposes, identical to those faced by a
firm under perfect competitions
A monopoly firm is faced with usual U-
shaped AC and MC curves

11/13/2024 16
The Monopolist is a Price
Maker/searcher
A pure monopolist can influence
market supply through its output
decisions. Subsequently, it can
also influence the product price.
By increasing market supply can
decrease price or;
By decreasing market supply
can increase price.
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 Monopoly Price-Setting Strategies

A monopolist faces a tradeoff between price

and the quantity sold
There are two price-setting possibilities:
◦Single price(uniform price )
 A single-price monopoly is a firm that
must sell each unit of its output for the
same price to all its customers.
◦Price discrimination
 A price-discriminating monopoly is a
firm that is able to sell different units of a
good or service for different prices.
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6.5. Short Run equilibrium
(Output and Price Determination)
In perfect competition market profit maximizing price
is set by the DD & SS forces of the market and the
firm determine only the profit maximizing quantity, Q
In pure monopoly market both profit maximizing P
and Q are set by the firm…two decision
variables
There are two approaches:
◦ TR-TC approach and
◦ MR-MC approach
11/13/2024 19
[Link] Revenue -Total Cost
approach
 P & Q are set by comparing TR and TC
 At equilibrium point:
I. The (+) gap b/n TR and TC is
maximum where TR > TC
II. The (-) gap b/n TR and TC is
minimum, where TR<TC

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 TC
a’
 a Lines aa’
TR
and bb’ are
TC
parallel and
their slopes
are equal
b’
b  Thus slope
TR
of TR (MR)
and slope of
Q* TC (MC) are
Q equal at the
π
tangency
points
Q
Q*
π
11/13/2024 21
6.5.2. Marginal Revenue- Marginal Cost Approach

It is derived from total approach

Profit maximizing Q is set where
MR=MC and MC is increasing
(slope of MC > slope of MR)
 MR curve–downward sloping
(slope negative)
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Graphically,
P,
MC
MC

Pe

e
DD P=a-bQ
Q
Qe
MR

11/13/2024 23
 SR Equilibrium ….continued

A monopolist produces a level of output where MR

= MC. This determines the profit maximizing
output.
Price is determined by the market demand curve.

◦ A vertical line is drawn from Qe to the

demand curve.
◦ Pe is the profit-maximizing price.

11/13/2024 24
Exercise
Price MC
ATC
P=10
Q: Find Profit
AC=8
for the
firm whose
e graph

DD

20 MR Quantity of output
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Short run equilibrium profit: the three
possibilities
Case A: Positive profit

P MC
P > AC at
equilibrium

P B AC
Monopoli
AC st Profit A

M e
C
DD
MR
Q
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Case B: negative profit( Loss)

P MC AC
A Mon B
o pol
C is t Lo P < AC at
ss
equilibrium
P A

MC
e
DD
MR
Q

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Case C: zero economic profit (Normal Profit)

P MC
P = AC at
AC equilibriu
m
P= AC

MC

DD
MR
Q

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Mathematically

An Equation reach its maximum where its

slope is Zero and
Slope of the first equation slope is less than
zero
or
First order derivation is = 0 (necessary)
Second order derivation < 0 (sufficient)
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π = TR – TC
F.O.C

d d dTR dTC
0    0
dQ dQ dQ dQ
MR  MC 0
Continued… MR MC
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 S.O.C

2 2 2
d π d π d (TR  TC)

d (MR
2
0 2
 2
0
dQ dQ dQ

d ( MR  MC ) dMR dMC
0 
dQ dQ dQ
slope...of ( MR )  slope...of ( MC )
Continued…
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Numerical example #1

Assume a pure monopoly firm with

Demand, p=40-Q, TFC=50, and TVC=Q2
Required:

a) the profit maximizing unit of output and price

b) the maximum profit
 Answer
a) Q=10, P=30
b) π= 150

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Numerical example #2
Suppose the monopolist faces the marke
144
Q 
demand function givenPby2

The AVC of the firm is given as AVC = Q ½

an
the firm has a fixed cost of $ 5
Required:

a) determine equilibrium P&Q

b) determine the maximum profit

 Answer: a)_____________ b) __________________
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Numerical Example #3

Given: TC and DD as:

and
Required:
a) determine equilibrium P&Q
b) determine the maximum profit
 Answer: a Qe= 6.7 b) Pe=13.3

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 6.7. Supply Curve under Monopoly
 For a perfect competitive firm
◦ its supply curve is the segment of MC curve above
the minimum of AVC and
◦ there is one to one correspondence b/n P&Q
 For pure monopoly firm
 There is no unique supply curve due to
the fact that,
I. The same Q can be sold at different P
II. Different Q can be sold at the same P based
on the elasticity of the DD curve
 A monopolistic market has no supply curve
There is no one-to-one relationship between
price and the quantity produced.
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 Supply Curve …
cont’d
The reason is that the monopolist's output
decision depends not only on marginal cost,
but also on the shape of the demand curve.
Shifts in demand can lead to changes
in price with no change in output,
changes in output with no change in
price, or changes in both.
Shifts in demand usually cause
changes in both price and quantity
Note: A competitive industry supplies a
specific quantity at every price and no such
relationship exists for a monopolist
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 Graphically,
P, MR, MC
P, MR, MC

P2 MC
P1=P2
MC
P1

DD
DD 2
DD
1
Q 1 Q
Q1=Q2 Q1 Q2
DD MR
2 MR 2
MR MR 1
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2 1
In this panel, the same quantity Q* is sold at different
prices depending on the market demand. If the
market demand is D1 and the MR curve is MR1,
equilibrium occurs when MR1 cuts MC curve and the
equilibrium price and quantity are P1 and Q*. If the
market demand for the monopolist product decreases
to D, the monopolist can still sell the same quantity
Q* by lowering the price. So, there is no unique (or
one to one correspondence) between P&Q, as the
same Q* is matched with two different price, P&P1

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In this panel, initially equilibrium is E1(where

MR1=MC) and equilibrium P&Q1. when the demand

for monopolist product decreases to D the new

equilibrium becomes E2 where the new MR=MC At

the new equilibrium, price is the same, but the

monopolist sell only Q amount of output i.e. the

monopolist sells lower quantity at the original price

when the dd decrease

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[Link] – run Equilibrium under
Monopoly
In perfect competition, there is free entry
and exit of firms– thus, normal profit in the
LR
In monopoly, there are
barriers to entry and thus, in
the LR the firm can get:
◦ (+) profit
◦ (0)profit
It can also build a plant which is:
◦ Less than optimal plant(small)
◦ Optimal plant
◦ Greater than optimal plant(large)
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Long – run Equilibrium…… cont’d
Monopoly firm in the LR:
May not build optimum plant (which
operates at minimum LAC)
May not use the existing plant at full
capacity (production at the minimum
point on the SRAC)
No loss in the LR
The size of the plant depends on the
market size

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Sub-optimal Plant size in the LR
P, MR, MC, AC

P SRMC
LAC
LMC
SRAC

DD

MR

Qe Q Opt Q

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 Optimal Plant size in the LR
P, MR, MC, AC
LMC
SRMC LAC

SRAC

DD
e
MR

Qe Q

• Note: any of these could exist and there are

no external forces to push the firm to optimal
plant as such.
11/13/2024 43
LR Equilibrium …..cont’d
At what output level the monopolist
maximizes its profit?
A monopolist maximizes its long run
profit where
LMC = MR ,
slope of LMC > the slope of MR at the
point of intersection, and
SAC curve is tangent to the LAC at the
point corresponding to long run
equilibrium output.

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6.9 Price Discrimination
Price discrimination is the business practice
of selling the same good at different prices to
different or same consumers
It is selling same or slightly differentiated
products at different prices
The price differences are not justified by
differences in costs.
The characteristic used in price
discrimination
is willingness to pay (WTP)
 A firm can increase profit by charging
a higher price to buyers with higher
WTP.
11/13/2024 45
Examples of price discrimination
 Firms use common variables for price
discrimination ( discriminating variables) such
as:
◦ Age, sex, location of consumer, quantity
bought, income, time of purchase etc.
 Examples of price discrimination in reality:
◦ Movie tickets: Discounts for seniors, students,
and people who can attend during weekday
afternoons.
 Example: Olyad Cinema: different P at 8:00, 10:00
and 12:00
◦ Transportation fee: for students, for children,
◦ Night club entrance fee: for female
◦ Price of Books: hard/soft cover, EEE, low price
edition 11/13/2024 46
◦ Unit price of pipe water consumed
6.9.1. Goal and types of Price
Discrimination
What do you think is the aim of applying
PD?
The major goal of price discrimination is to
raise profit of the firm
There are three types/ degrees/ of
price discrimination
1. Degree I
2. Degree II
3. Degree II

11/13/2024 47
First degree (Perfect) price discrimination
The firm charges each consumer the
maximum price that they willing to pay for
each unit of output
Reservation price= willingness to pay
= maximum price the consumer is
willing to pay = actual price
Reservation price varies with the amount
bought due to the law of diminishing MU
Seller negotiate with each buyer on each
unit bought
 Seller charges the maximum price on the
demand curve
11/13/2024 48

e.g. A doctor who charges poor and rich

Degree I ….Continued
Consumers are willing to pay less and less
as the amount bought increase due to
LDMU
This is shown by down ward sloping DD
p.
curve
7
Price for different consumer
6 and different unit is different
5

4
3

1 2 3 4 5 Q
11/13/2024 49
Effects
The producer captures the whole
consumer surplus
It is more or less ideal and less common

11/13/2024 50
 Second degree price discrimination
It is sometimes called block pricing or
quantity discrimination
The seller charges different prices for
different category of quantities purchased
If the consumer buys less, price will be high
but if the consumer buy high amount there
will be a discount
For public utilities such as telephone ,
electricity, water consumption, prices
increase with quantity consumed
The goal is to discourage increased
consumption
11/13/2024 51
Graphically
• In second degree price discrimination price for
the consumers buying in the same block is equal
and price of different blocks are different
• For example consumer who buy between 10 and
20 units will pay birr 5 for each.
p
7
6
5

4
3

10 20 30 40 50 Q
11/13/2024 52
Effects
Only part of consumer
surplus is taken away
It may encourage efficient
utilization of resources for
public utilities such as
telephone , electricity, water.
For these services, higher
prices are used to discourage
further consumption
11/13/2024 53
Third Degree (multi-market) price discrimination
Sometimes called 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
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Necessary conditions for price
Discrimination ( Degree III)
 There are three necessary conditons for
this type of price discrimination to be
successful
1. There should be effective division of the
market in to sub markets
 buyers of low price market should not
resale the commodity in high price market.
 Effective division could be possible through
 Geographical variation with high
transport cost
 Exclusive use of the commodity..non
transferable
 Lack of distribution channels
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Conditions …..continued
2. The price elasticity of demand should be
different in each sub market.
◦ If the price elasticity of demand is the same in the
submarkets, it is not possible to apply price
discrimination
◦ The consumer with high price elasticity is
charged less price
◦ The consumer with high price elasticity is
charged less price
3- Lastly, the market should be imperfectly
competitive
◦ Price discrimination is the extent to which firms
extract consumer surplus and this is not possible
in perfect competition
Example : movie & theatre halls charge college
students and other people different
11/13/2024 prices 56
Decisions of the firm
 Equilibrium output to be produced
 The corresponding amount of the good or
service to be sold in each market
 Equilibrium price charged in each market
 Profit generated from each marker
 Total equilibrium profit generated due to
discrimination
 Equilibrium condition:

 The goods produced in the same plant  So MC is

the same
11/13/2024 57
 Graphical Analysis

M
C

P2
P P
P1

e1 e2 e DD
DD1 DD2
MR1 MR2 MR
q1 Q q2 Q Qe=q1+q2Q
Market I Market II Firm Level

11/13/2024 58
Price Elasticity and Price
Discrimination

Note:
• If ep1=ep2, P1 will be the same as [Link]
price discrimination
• If ep1 >Ep2, P1 should be smaller than P2, for
the equality to hold
• If ep1 < Ep2, P1 should be grater than P2, for
the equality to hold 11/13/2024 59

• Elastic demand curve has smaller price

Numerical Example #1

 Suppose a monopolist sells its product in

two markets (A and B) and total out put is
55
 Demand for market A PA=100-QA
 Demand for market B PB=80-2QB
a) How many units should be sold in each
markets?
b) In which market higher price should be
charged?
◦ Hint:
 at equilibrium MR1=MR2=MC
 High ep implies less price
11/13/2024 60
Numerical example #2
 Suppose Ethiopian Air lines (EAL) flies only one
route: from Addis Ababa to Dubai. EAL knows
that two different types of people fly to Dubai.
◦ Type A consists of rich merchants flying to
Dubai for business purposes with demand for
flight of QA = 260-0.4PA.
◦ Type B consists of poor ladies flying to Dubai
in search of jobs ( such as house maid) whose
total demand is QB = 240-0.6PB.
 Assume that EAL has a running cost of $30,000
plus $100 per passenger and it has decided to
charge different prices for the two groups of
passengers.
11/13/2024 61
Required:

a. How many tickets should EAL sell to

each group?
b. How much price should EAL charge each
group?
c. Suppose now that EAL is prohibited by
the Ethiopian government to exercise
such discrimination. How many tickets
should the EAL sell to maximize
Answer Key: its profit
and at what price? a) QA = 110 and QB
= 90
b) PA=375, PB=250
Q=200, P=300
11/13/2024 62
 ,
Numerical example #3
Given: demand and cost functions faced by a price
discriminating monopoly, answer questions that follows

Required:
[Link] sold in each market and total
equilibrium output
[Link] charged in each market
[Link] generated in each market
[Link] that price discrimination increases profit
of the firm
E. Show that the firm charges relatively high
11/13/2024 63
price in the inelastic market
 Ingeneral, monopoly firm, compared to a
competitive firm,
1. Charges higher price at equilibrium
2. Produces smaller output

11/13/2024 64