St.

Mary’s University College Department of Management

Chapter One:
Pure Monopoly

1.1. Definition
Monopoly is a market structure in which there is a single seller, there is no close substitute for
the commodity it produces and there are substantial entry barrier.
Monopoly is a Greek word Derived from “Mono”, which means “One” and “Poly”, which
means “Seller”. Therefore, monopoly means one seller. The monopoly firm produces a unique
product, i.e. a product which does not have any close substitutable at all in the market.

Unlike a perfectly competitive firm, a pure monopoly firm is a Price Maker. That is, the firm
has the power to change the price of its commodity.

In this type of market structure there are substantial entry barrier. That is no firm can enter
into this market.

1.2 Source of Monopoly

I. Ownership of strategic raw material:- or exclusive ownership of production

techniques.

Example: Suppose input X is required to produce output Y. If one firm has exclusive
control over input X, then this firm can easily establish a monopoly over product Y
simply by refusing to sell X to any potential competitors.

II. Legal Barriers – includes patents, franchise and government licenses:-

A public Franchise a right granter to a firm by government that permits the firm to provide
a particular good or service and exclude all others from doing the same (thus eliminating
potential competitors by law).

Patents are granted to inventors of a product or process for a certain specific period of time.
For example in Ethiopia, patents are given for a period of 15 years. During this period, the
patent holder is shielded from competitors; no one else can legally produce and sell the
patented produce or process. The rationales behind patent right is to encourage innovation
in an economy.

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St. Mary’s University College Department of Management

Entry into some industries and occupations requires a government granted license. For
example, radio and television stations cannot operate without a license from the Federal
Communication Authority.

III. Natural Monopoly: - the size of the market may be such as not to support more
than one plant of optimal size. The technology may exhibit substantial economies
of scale, which require only a single plant if they are to be fully reaped. An
example of natural monopoly includes communications, electricity, transport,
water, etc usually; government undertakes the production of the commodity or the
service so as the avoided exploitation of the consumer.
IV. Limit- pricing policy:- is a pricing policy aiming at the prevention of new entry.
Such a pricing policy may be combined with other policies such as heavy
advertising which render entry unattractive.

1.3 Demand and Revenue

Since there is a single firm in the industry, the firms demand curve is the industry
demand curve. The demand curve of a monopolist is downward sloping, implying that
the firm has the power to change the price of its commodity. A downward – sloping
demand curve posits an inverse relationship between price and quantity demanded.
More is sold at lower price than at higher price, cetris paribus. Unlike the perfectly
competitive firm, the monopolist can raise its price and still sell its product (though not
as much)
P

D’
D Q

MR

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St. Mary’s University College Department of Management

Q = a-b*P----------- demand Equation

a. The slope of the demand curve is:

dQ =-b
dp

b. The price elasticity of demand is

Ed = dQ * P
dp Q

Ed = -b * P
Q
a. At point D the elasticity approaches infinity

Ed = -b - P
Q ∞

b. At point D’ the elasticity is zero

Ed = -b * P
Q 0

c. At the mid point C the price elasticity is unity

Ed = -b * P
Q -1

c. Total Revenue of the monopolist

TR= P.Q

Take the inverse demand equation i.e.

Q = a – b*P

Q – a = - b*P

b*P = a – Q

P = a - 1*Q
b b

Lets suppose a = c and 1 = d , thus

b b
P = c-d*Q ------- Demand Curve

TR = P.Q

TR = (c- d*Q)Q

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St. Mary’s University College Department of Management

TR = c*Q – d*Q2 -------- Total Revenue Equation

d. The Average Revenue (AR) is the price

AR = TR
Q

AR = c*Q-d*Q2
Q
AR = c – d*Q

AR = P

Thus, the demand curve is also the AR curve

e. The Marginal Revenue

MR = dTR
dQ Where TR = CQ – dQ2

MR = C – 2dQ

That is, the MR is a straight line with the same intercept as the demand curve, but twice as
steep.

f. Relationship between MR and P

TR = PQ

MR = dTR
dQ
MR = d (P*Q)…………… Apply the Product Rule
dQ
MR = P * dQ + Q* dP
dQ dQ

MR = P + Q. dP
dQ
MR = P - Q. dP Since dP <0
dQ dQ
MR + Q*dP = P
dQ
Hence, P > MR by an amount equal to (Q* dP )
dQ

g. The Relationship between MR and Price Elasticity (Ed) is

TR = P*Q

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St. Mary’s University College Department of Management

MR = dTR
dQ

MR = P * dQ + Q * dP
dQ dQ

MR = P + Q *dP
dQ

MR = P  1 + Q * dP 
P dQ

Remember: Ed = dQ . P
dP Q

1 = dP . P
Ed dQ Q

MR = P [ 1 + 1 ]
(Ed)

MR = p [ 1- 1 ] , where e = Ed
e

When e > 1: MR > 0

e < 1 : MR < 0
e = 1: MR = 0

Therefore, it can be concluded that the monopolist always operates on the elastic portion of the
demand curve, where MR > 0

1.4 Costs
In the traditional theory of monopoly the shapes of cost curves are the same as in the theory of
pure competition. The AVC, MC, and ATC are U-shaped, while AFC is a rectangular
hyperbola.
One point that should be stressed is that the MC curve is not the supply curve of the
monopolist, as in the case of pure competition. In monopoly there is no unique relationship
between price and quantity supplied. To put the same thing differently, a monopolist has no
supply curve at all.

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St. Mary’s University College Department of Management

1.5 Equilibrium of the Monopolist

A. Short-run Equilibrium

The monopolist maximizes his short-run profit if the following two conditions are fulfilled

1. MR = MC
2. The slope of MR (dMR ) is less than the slope of the MC ( dMC) , i.e
dQ dQ

dMR < dMC

dQ dQ

Fig 1. Short – run equilibrium of monopolist

In the above fig 1, the equilibrium of the monopolist is defined by point E, at which the
MC intersects the MR curve from below. Thus, price P* will be charged and an amount of
Q* output will be produced and supplied. The monopolist will realize excess profit of an
amount equal to the shaded area.

Mathematical Derivation of Equilibrium of the monopolist

Given the demand function,
P = f (Q)
and given the cost function
C = f(Q)

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St. Mary’s University College Department of Management

The monopolist aimed at the maximization of its profit

 = TR - TC
a) The first order condition for maximum profit  is
FOC: d = 0
dQ

d (TR – TC ) = 0
dQ

dTR dTC
dQ - dQ = 0

MR - MC = 0

MR = MC

b) The Second order condition for maximum profit it is

d2 < 0
dQ2
d2( TR – TC) < 0
dQ2
d2TR - d2TC <0
dQ2 dQ2

dMR - dTC <0

dQ dQ

dMR < dTC

dQ dQ
The slope of The Slope of
MR < MC

c) Long-run Equilibrium

Long-run equilibrium of a monopolist is the same as short-run equilibrium where MR is

equal to MC, provided that the MC cuts the MR from below. In the long – run the
monopolist has the time to expand its plant, or to use its existing plan at any level which
will maximize his profit. What is certain is that the monopolist will not stay in business if

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St. Mary’s University College Department of Management

it makes losses in the long-run; it will most probably continue to earn supernormal profits
even in the long-run, given that entry is blocked.

1.6 Price Discrimination

Price discrimination exists when the same product is sold at different price for different
buyers, for the reason not associated with cost. The cost of production is either the same, or
it may be different but not as much as the difference in the charged price.

1.6.1 Preconditions necessary for Price discrimination

Pre-condition which must be fulfilled for the implementation of price discrimination are
the following:
1. The market must be divided into sub-markets depending on the price elasticity of
demand. That is those markets characterized by higher price elasticity of demand must
be charged lower price and vice-versa.
2. There must be effective separation of the market so that no reselling can takes place
from a low price market to high price market. There must be no sort of "arbitrage",
which means buying less and selling high.

The rational behind price discrimination is to obtain an increase in total revenue and hence
profit.

1.6.2 Types of Price Discrimination

There are three types of price discrimination:

A. 3rd Degree Price discrimination: exists when the same product is sold for two different
categories of buyers at two different prices, where everyone in the same category faces the
same price.

The ultimate objective of price discrimination is to increase total revenue and hence profit.
The increase in total revenue will be achieved by taking away part of the consumer surplus.
Consumer surplus is the difference between the maximum willingness and ability to pay
and the price actually paid.

Suppose a given consumer faces the following dd curve.

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St. Mary’s University College Department of Management

If the monopolist sell all OX amount at P, he would receive total revenue of OXAP But.
lets assume that the monopolist sell OX, amount of output at P for one category of buyer
and the remaining X1X amount of output at P1 for the other category of buyer. Thus, the
monopolist total revenue will be.
OX1CP1 + X1XAB = OPAX + PBC P1
The monopolist takes away part of the consumer surplus, an area equal to PBCP 1, by
practicing 3rd degree price discrimination.

B. 2nd Degree Price Discrimination: exists when the monopolist negotiates at more than
two prices.

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St. Mary’s University College Department of Management

For example, the monopolist sell X1X amount at P, X2X1 at P1, X3X2 amount at P2 and OX3
amount at P3 and hence the monopolist receives still larger part of consumers surplus.

C. 1st Degree price Discrimination: exists when the monopolist negotiates with each and
every single buyer and charges them the maximum price they bear. The consumer will not
have any consumer surplus. This type of price-discrimination also known as perfect price
discrimination or take it or leave it price discrimination.

The equilibrium condition for a monopolist where it sells its product at two different
market is given by:
MR1 = MR2 = MC
If, however, there are N markets the equilibrium condition will be given by:
MR1 = MR2 = …=MRN =MC
The numerical example on price discrimination will be discussed during class room
discussion.

1.7 Multiplan Monopolist

So far we have assumed that there is only one plant where the monopolist produce its output ,
but sells at different markets. Since the monopolist operates only in a single plant, there exists
only one cost structure, hence the equilibrium condition is given by:

MR1 = MR2 = MC

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St. Mary’s University College Department of Management

However, let's assume that the monopolist operates with two different plants and sells its
output for only a single market. Let's also assume that the monopolist knows its cost structure
with certainly and the objective of the firms is profit maximization.

The equilibrium condition for a multiplant monopolist will be

MR = MC1 = MC2 = … = MC
The mathematical derivation of a multi plant monopolist, which operates only in two different
plant, and numerical example will be discussed during the normal class discussion.

1.8 Social Cost of Monopoly

From the society point of view, monopoly is inefficient in allocating factors of production as
compared to perfect competition. The monopolist produces less amount of output and charges
higher price as compared to perfect competitive firm.
The extent of monopolist inefficiency is measured by the concept of consumer's and producer's
surplus
Consider the following diagram:

Welfare of society = C.S + P.S

In perfect competition
= (A+B+C) +(D+E)

= A+B+C+D+E

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St. Mary’s University College Department of Management

Welfare of society = C.S + P.S

In Monopoly
= (A) + ( B + D )

= A+B+D

Change in Welfare of = Welfare of Society - Welfare of Society

Society in Monopoly in Perfect Competition
= ( A+B+D) - (A+B+C+D+E )
=-( C+E)

Thus, welfare has declined by the area C and E. Note that the area B is not lost, rather
transferred from CS to PS

The area C + E is known as Dead Weigh Loss. It's a loss neither gained by the producer
nor by the consumer. It is a loss to society.

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