Introduction to Economics –ECO401 VU

Lesson 20

MARKET STRUCTURES (CONTINUED)

LIMIT PRICING
If a firm is already established in the market, it got gradually the business tricks of how to run
the business. A new entrant firm in the market has to face high costs. A monopolist firm knows
about this fact very well that his costs are lower than the new entrant firm so he can take
advantage of this situation.

P
Limit Pricing

MC
M
AC E
PM* AC M
PL

D = AR

MR

O Q M* Q

In this figure,
ACE = Average cost curve for new entrant firm
ACM = Average cost curve for monopolist firm
New entrant firm should charge the same or lower price than the monopolist other wise people
will not purchase from new entrant firm. Now if monopolist wants to maximize his profits he
would produce the output where MC=MR at QM*. At this output level, monopolist will charge
the price of PM*. This is the price that monopolist should charge if he wants to maximize his
profits. But in order to ensure that the new entrant will not enter the market, he can charge the
price lower than PM*.

MONOPOLIES AND THE PUBLIC INTEREST

Disadvantages of monopolies:

i. Monopolists produce lower quantities at higher prices compared to perfectly

competitive firms. This is because monopolists do not produce where P=MC (the
point of Allocative efficiency) nor at P= AC minimum (the point of cost efficiency).
ii. Monopolists earn supernormal profits compared to perfectly competitive firms
iii. Most of the “surplus” (producer + consumer surplus) accrues to monopolists.
iv. Monopolists do not pay sufficient attention to increasing efficiency in their
production processes.

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Introduction to Economics –ECO401 VU

Equilibrium of the industry under perfect competition and monopoly: with the same MC

P MC

D = AR
MR
Q
Advantages of monopolies:
i. Natural Monopolies are beneficial and efficient for society.
ii. Supernormal or monopoly profits can be invested in R&D, development of new
innovative products and to sustain a price war when breaking into new foreign
markets.

GOVERNMENT REGULATION
The government can regulate monopolies to ensure that they set a price where the AR curve
intersects the MC curve. This will ensure allocative efficiency. It might not be possible to
ensure that productive efficiency is attained as well because it is not necessary for the AR
curve to intersect MC at the AC minimum. Also, in setting AR (or P) = MC, the economist
might make a loss in which case the government would have to provide a subsidy. If the
monopolist makes a profit then a tax is warranted. Due to difficulties with implementing
subsidies, governments sometimes regulate monopolies at the point where the AR curve
intersects the AC curve. This often takes the monopolist reasonably close to the allocative and
productive efficiency points without necessitating a tax or a subsidy.
P Subsidy to the monopolist MC

12 AC

D = AR

MR

O 400 600 725 Q

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