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Monopoly

We now move on to another Market Structure called monopoly. As we all understand it,
Monopoly is considered to be a market structure in which there is only one seller who faces no
competition from sellers of close substitutes and is able to remain a single seller in the market
due to strong barriers to entry.

A barrier maybe in the form of a government regulation that prevents other players from entering
the market. For example, in UAE, Etisalat was the only telecom service provider since the
government regulations prevented other players from entering the telecom industry in UAE. This
was relaxed subsequently and one more player Du is now allowed to operate in the market.
Similarly, if a firm acquires a patent for a product or service, then no other firm will have the
right to market the product up to a period of 20 years. This is enforced by the patent law in each
country. This is common in the case of some medicines marketed by Pharmaceutical companies.
In some other case, the exclusivity of the brand itself makes the firm a monopolist because no
other firm can easily imitate the brand. Branding therefore can form a very strong barrier to entry
and can lend to creating substantial monopoly power for a firm. The example of Harley
Davidson discussed in the preprogram module is a case in point.

Though theoretically a monopolist is a single seller, our focus will be on monopoly power or the
power that a monopolist has and the advantage of that power.

This power comes from the fact that a monopolist, as opposed to a firm operating under
competition, has the power to determine price. Monopoly power is therefore also referred to as
Pricing Power. In order to understand this, it is important to first understand how price is
determined under Monopoly.

As discussed in the last session, whether it is Perfect Competition or Monopoly, the condition for
equilibrium remains the same, that is:

1) MR = MC
2) MC is rising

The difference between perfect competition and monopoly in this context is that under perfect
competition price is constant and the demand curve is horizontal whereas under monopoly, price
is not constant and the firm faces a downward sloping demand curve. In other words, a
monopolist can start by setting a high price but at such a price he can sell fewer units. IN order to
sell more units, he has to lower the price. As he lowers the price, he can sell more and more
units.

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This is depicted in the figure:

Price

Demand

Quantity
Demanded

As we already know from the earlier module, the demand curve is also the Average Revenue or
AR curve. This is because Price = AR. Let us understand this more clearly,

Average Revenue = Total Revenue/Quantity

Average Revenue = Price *Quantity/Quantity

Average Revenue is therefore = Price

The relationship between price and quantity demanded is therefore the same as the relationship
between AR and quantity demanded.

We can therefore conclude that the average revenue curve and the demand curve is the same as
represented in the following graph:

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Price

AR = Price

Quantity
Demanded

Now consider the relationship between Marginal Revenue (MR) and Average Revenue ( AR) .

Under monopoly, Marginal Revenue is lesser than Average Revenue at all units. This is because
each additional unit of the product is sold at a lower price and so the addition to total revenue, or
marginal revenue, is always lesser than price.

Let us revisit the example of South west leather designs that you dealt with in the pre program
module.

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MARGINAL
OUTPUT PRICE = AR TOTAL REVENUE REVENUE
(MR)
0 40
1000 35 35000
2000 32.5 65000 30
3000 28 84000 19
4000 25 100000 16
5000 21.5 107500 7.5
6000 18.92 113520 6.02
7000 17 119000 5.48
8000 15.35 122800 3.8

As we can see in the table, the Marginal Revenue or MR is less than Average Revenue at every
level of output . For example, at 1000 units, average revenue is $ 35 and marginal revenue is
$30. At 2000 units, average revenue is $32.5 and marginal revenue is $19 and so on. This can be
represented in a diagram as follows:

Price

AR
MR

Quantity

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We can see in the graph that at all units of quantity, marginal revenue is less than average
revenue because the marginal revenue curve lies below the average revenue curve.

Now let us understand how the monopolist sets the price of its product.

To do so the condition remains the same, that is. MR = MC and MC is rising.

We will return to the same example to understand this:

PRICE TOTAL TOTAL MARGINAL MARGINAL


OUTPUT PROFIT REVENUE COST (MC)
= AR COST REVENUE
(MR)
0 40 40000
1000 35 42000 35000 -7000
2000 32.5 43500 65000 21500 30 1.5
3000 28 45500 84000 38500 19 2
4000 25 48500 100000 51500 16 3
5000 21.5 52500 107500 55000 7.5 4
6000 18.92 57500 113520 56020 6.02 5
7000 17 63750 119000 55250 5.48 6.25
8000 15.35 73750 122800 49050 3.8 10

In the table, we see that up to 6000 units, marginal revenue is more than marginal cost. For
example, at 1000 units, marginal revenue is $ 30 and marginal cost $ 1.5 . At 5000 units,
marginal revenue is $7.5 and marginal cost is $ 4 and at 6000 units marginal revenue is $ 6.02
and marginal cost is $ 5. At 7000 units marginal revenue has fallen below marginal cost . At this
level of output, marginal revenue is $5.48 and marginal cost is $ 6.25. Therefore marginal
revenue is equal to marginal cost somewhere between 6000 and 7000 units. The point of
intersection lies between 6000 and 7000 units.

The price is therefore determined at approximately 17.

This can be represented in the following diagram

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MC
Price

T
P

E
AR
MR

0 Q Quantity

In the diagram, E is the point of equilibrium where MR = MC and as you can see it is on the
rising portion of MC. The corresponding quantity Q is therefore the profit maximizing quantity.

In monopoly, since Price is not equal to MR but is greater than MR at every unit of output, price
is determined at P or T. Price is therefore greater than MR and MC.

This is the main difference between monopoly and Perfect competition.

Under Perfect Competition. Price = MC. Under Monopoly, Price is greater than marginal
revenue and marginal cost.

At Q, marginal revenue and marginal cost is QE. Price is OP or QT. The difference between
price and marginal cost is therefore QT minus QE which is equal to ET.

ET is the measure of monopoly power. Larger the ET, larger is the monopoly power. Take a
minute to understand what will bring about a larger or smaller ET? It is obviously, the slope of
the AR and MR curves. The steeper the curve, the larger the ET and the larger the monopoly
power…and what does a steeper curve indicate?...Of course it indicates a lesser price elasticity
of demand. It is therefore now clear that monopoly power is a function of elasticity of demand.

In the next module we will see how this monopoly power governed by price elasticity of demand
determines the pricing power of a monopolist.

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We can conclude by saying that, a firm need not be a single seller; it may face competition from
sellers of similar products selling different brands. Each seller is a monopolist in its own brand
and therefore has a monopoly power depending how much above MC it is able to set its price.

We will now consider the various situations, a monopolist can experience.

It is most often thought that a monopolist always earns profits…and so why should there be
different situations for a monopolist. Let us be clear about this.

Though the monopolist is a single seller, it can face a fall in demand or a shift of the demand or
AR curve to the left. It can also face a situation of rising costs. Any one of these factors or both
together can therefore be responsible for losses that a monopolist may incur. Let us now discuss
each of these situations separately.

1) The monopolist earns a profit because it can price its product higher than average cost.

This is represented in the following figure:

AC
MC
Price

T
P
R L

AR
MR

0 Q Quantity

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As we see in the graph, the firm’s average cost curve is above the price or average
revenue curve. The point of equilibrium or the point at which the firm makes maximum
profits is point E where the following two conditions are fulfilled:

MR = MC
MC is rising

At the point E, the firm sells an output equal to OQ, and don’t forget that at this level of
output production, it maximizes profits.

We can find out its profits or area of profits in this graph.

At OQ output, price or average revenue the firm earns is OP or QT.Therefore the total
revenue it earns is Price * quantity sold, that is OP *OQ which is = the area of the
rectangle OPTQ.

At OQ output, the firm’s average cost is QL or OR. Therefore, its total cost is the area of
the rectangle ORLQ.

The profits earned by the firm is equal to Total Revenue minus total cost, that is equal to
A(OPTQ) – A(ORLQ) that is equal to A(RPTL).

2) Another situation that a monopolist is likely to experience at a given market price is that
price or average revenue is equal to average cost. In such a case, the firm just earns that
amount of revenue which covers the entire cost. It is important her to note that, this cost
also includes a certain minimum profit that the owner or entrepreneur should get as an
income for the services he renders. Such a minimum profit which is a part of cost is
called normal profit. We can therefore say that in such a situation, the firm earns normal
profits.
We can represent this situation in the following graph:

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MC AC

Price

T
P

E
AR
MR

0 Q Quantity

At OQ output, price or average revenue the firm earns is OP or QT. Therefore the total
revenue it earns is Price * quantity sold, that is OP *OQ which is = the area of the
rectangle OPTQ.

At OQ output, the firm’s average cost is QT or OP. Therefore, its total cost is the area of
the rectangle OPTQ..

We thus see that total revenue is equal to total cost and the firm is making only normal
profits.

3) A third possible situation for the firm is that average cost is higher than average revenue
or price. In such a situation, the firm’s revenue falls short of its cost and therefore the
firm incurs negative profit or loss. This represented in the following graph:

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Price
AC
MC

L
R
P T

E
AR
MR

0 Q Quantity

At OQ output, price or average revenue the firm earns is OP or QT. Therefore the total
revenue it earns is Price * quantity sold, that is OP *OQ which is = the area of the
rectangle OPTQ.

At OQ output, the firm’s average cost is QL or OR. Therefore, its total cost is the area of
the rectangle ORLQ.

The profits earned by the firm is equal to Total Revenue minus total cost, that is equal to
A(OPTQ) – A(ORLQ) . Now here we notice, that total cost or A(ORLQ) is greater than
total revenue or A(OPTQ). As a result, the firm\s profit = negative A(PRLT) or a loss
equal to that area.

Now what do you recommend for such a firm incurring a loss? Should the firm continue
operations, or should it close down its business?

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Now this is a very important decision for the firm. In business, let us understand, there
are bound to be instances of losses now and then. That does not mean that the firm should
take a hasty decision and close down the business. It is foolish to do such a thing without
considering several factors. IN the first place, the firm may want to wait and see whether
the situation improves or not. What do we mean by an improvement? It means that either
the market price will rise or the cost will fall. In either case, the firm’s losses will reduce
and there may come a stage when it starts making positive profits again. Since an analysis
depends on the abilities and foresight, risk taking ability and business acumen of the
entrepreneur. Sometimes, the firm may just decide that it wants to close down its business
because it cannot bear the losses. Sometimes, it may be ready to wait and bear losses for
some time, maybe because it has a backing in terms of reserves accumulated when the
going was good or because it is confident that it has access to funds at a low interest cost.

Anyhow, during this waiting period, the firm has to still decide whether it should
continue operations or not. By that we mean whether it should continue producing and
selling the product or shut down its factory temporarily. Here, it is important to remember
the difference between Shut down and close down.
Shut down relates to a temporary shutting down of operations and does not involve the
selling off of assets. Close down refers to the permanent close down of business which
also involves the selling off of assets.

Shut down is therefore more of a short run phenomenon and close down is more of a long
run phenomenon.

Coming back to the decision this firm has to take given that it is incurring a loss and
given that the firm is prepared to wait and not close down business till things improve, it
still needs to decide whether during this waiting period it should temporarily shut down
operations or not.

For this, the firm will compare its losses in the two situations of continuing with
operations and shutting down operations. When the firm continues operations, it incurs a
certain loss equal to the difference between the total cost and total revenue, which is
A (PRLT) in this example. When it shuts down, it has to incur the fixed costs anyway
because it has not sold off its assets. Therefore, if the loss is greater than fixed cost, it
makes sense for the firm to shut down during the short run. On the other hand, if loss is
less than fixed cost, it makes sense for the firm to continue operations.

When the loss is less than the fixed cost, it means that the revenue is covering the entire
variable cost and also a part of the fixed cost. Let us not forget, that the first priority for
the firm is to cover its variable costs. In such a case, it implies that the firm’s price or
average revenue should be greater than average variable cost, only then can the total
revenue cover the entire variable costs. But of course, its average revenue will be less
than its average cost.
Let us represent this case in the following graph.

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Price

AC
MC
AVC
L
R
P T

S M

E
AR
MR

0 Q Quantity

Here we see that the average variable cost (AVC) is less than average revenue or price .
At the equilibrium quantity Q, total revenue is equal to area (OPTQ). Total cost is equal
to area ORLQ. It is clear that the total revenue does not cover the total cost. Average
variable cost is equal to MQ and total variable cost = average variable cost * output, that
is MQ*OQ, that is equal to A (OSMQ).

Fixed cost is equal to total cost minus variable cost.

Here total cost = A(ORLQ) and total variable cost = A(OSMQ), therefore, total fixed cost
= A(ORLQ) minus A(OSMQ) = A(SRLM)

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It is evident from this that the total revenue, A(OPTQ) not only covers the entire variable
cost A(OSMQ) but also a part of the fixed cost. The part of fixed cost that is covered by
the revenue is A(SPTM).

Another way of looking at this is that the loss is less than the fixed cost.
Loss is = A(PRLT) and fixed cost is A(SRLM) and therefore the loss is less than fixed
cost.

In such a case therefore, the firm can continue operations in the short run so long as the
revenue covers the entire variable cost and a part of the fixed cost or in other words its
price or Average Revenue is less than AC but greater than Average Variable Cost or
AVC. This is because if the firm decides to shut down its operations (that is, shut down
operations and not produce any output and not close down the business) then the firm
will incur a fixed cost which will be larger than the loss incurred in production. By
operating the business, at least a part of the fixed cost is covered.

The monopolist continues to operate in the short run in spite of losses ( given that price is greater
than AVC) because it is hopeful that things will improve in the long run. He hopes that he will be
able to improve market perception through branding or changing the quality or features of his
product or may be able to reduce the cost of production.

4) The last situation that a firm can encounter in the short run is that the price is not only
lesser than the average cost but also lesser than the average variable cost. Such a situation
is represented in the following graph which depicts that both the average cost curve, AC
as well as the average variable cost curve, AVC are higher than average revenue or price
and so both these curves lie above the average revenue curve.

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This is represented in the following graph:

Price AC
MC AVC

AR
MR

0 Q Quantity

This means that the revenue will not cover even the variable cost then it means that the
loss is greater than the fixed cost or the firm loses all the fixed cost and also a part of the
variable cost. In such a scenario it is better for the firm to shut down operations and wait
for things to improve. When it shuts down it has to incur only fixed cost as a loss.

In such a case, we cannot mark a point of equilibrium because a firm will never
operate at such a point..

In analyzing a situation the following steps have to be followed

a) Is MR = MC and is MC rising
b) Is Price greater than or less than AC

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c) If Price is less than AC then is price at least greater than AVC. If Price is greater than
AVC in case of a loss then the firm can continue operations in the short run. If Price
is less than AVC then the firm should shut down.

What do you think happens in the long run?

Unlike under perfect competition, under monopoly, in the long run, a monopolist can
even earn profits. A monopolist will not incur losses in the long run because by then the
monopolist will close down business.

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