Managerial Economics

Profit maximization by a monopolist

Inefficiency of monopoly
Price discrimination

BM - Term I

Sumit Sarkar, XLRI Jamshedpur

 What causes monopolization?
 Declining AC due to drastic change in scale of operation - e.g.,
POSCO, Nippon Steel, Tata Steel, ArcelorMittal in steel industry
(which was a competitive industry of small smelting firms).
 Innovation leading to drastic change in technology that results in
decreasing AC
 Knott Mill of Manchester installed 30 power looms and planned to put 500
of Cartwright’s looms. Scared hand loom weavers (known as Luddites)
burnt down the factory in 1790.
 Edition’s electric lamp didn’t just replace the kerosene lamp, but helped
formation of General Electric Company in 1891.
 Multi-product technology (economies of scope and scale) –
Standard Oil in petroleum refining.
 Patent – GE acquired Edition’s patent.
 Monopolization of PC operating system industry by Microsoft
happened because of strategic incompatibility of complementary
product with rival operating systems.
Sumit Sarkar, XLRI
 Natural monopoly

 Very large number of buyers and only one seller

 Industry concentration is absolute (HHI = 1)

 Lerner Index [= (P-MC)/P] is maximum

 Monopolist determines price.

 No entry (Natural entry barrier)

Sumit Sarkar, XLRI

 Monopolist as profit maximizer
Profit = Rev. – Cost
or,  = p (x) x – c (x) – F

By first order condition of profit maximization,

x[dp(x)/dx] + p(x) – (dc(x)/dx) = 0
Or, p(x) [1 + x.dp(x) / p(x).dx] = (dc(x)/dx) (A)
Or, MR = MC
The LHS of (A) is MR and the RHS is MC

MR = p(x)[ 1+ 1/] where,  < 0

Or, MR = p(x)[( + 1) / ]
If  < -1, ( + 1) < 0 and hence, MR > 0
If  = -1 MR = 0
If 0 >  > -1, ( + 1) > 0 and hence, MR < 0

Sumit Sarkar, XLRI

 The marginal revenue (MR) schedule

 < -1
 = -1
 > -1
D : [p(x)]

x0 x

MR : p(x)[ 1+
1/] The MR cuts the x-axis at x0.
Sumit Sarkar, XLRI
At x = x0, price elasticity of demand is -1.
 Monopolist’s equilibrium
p(x)
MC

AC
p*

AC(x*)

MC(x*) E
D : [p(x)]

x* x

MR : p(x)[ 1+
Sumit Sarkar, XLRI
1/]
 Lerner Index of a Monopolist
At the profit maximizing equilibrium
MR = MC
Or, P[( + 1) / ] = MC
Or, [MC / P] = [( + 1) / ]

Learner Index = (P – MC) / P

= 1 – (MC / P)
= -1/

Less elastic the demand is, more is the LI of the monopolist.

Sumit Sarkar, XLRI

 Monopolist may supply
different quantities at same price

p
MC

p*

E2
E1 D1 D2
x
x1 x2
MR1 MR2

Sumit Sarkar, XLRI

 Monopolist may supply
same quantity at different prices

p
MC

p1

p2

E
D2
D1
x* x

MR1 MR2

Sumit Sarkar, XLRI

 Third degree price discrimination –
Market segmentation
Concept:
Sell different quantities at different prices in different markets /
segments. Price will he higher in the market(s) / segments with
low elasticity of demand.

Conditions:
• Market can be segmented (geographically, or on basis of

consumers’ income group and other characteristics (age,

gender, rural-urban divide, cultural factors etc.)
• The groups should have different demand functions (and

hence different price elasticity of demand).

Sumit Sarkar, XLRI

 Examples of third degree price discrimination

• Discounts / concessions for students / retired people in

restaurants, public transport etc.
• Discounts in “off season” / “happy hour”.
• Hardbound and paperback editions of books (yes, it’s price
discrimination and not price differential because of cost
differential).
• Student edition of certain software (e.g., Matlab, Mapel etc.)
• Unit rates for electricity billing – commercial vis-à-vis
domestic use.

Sumit Sarkar, XLRI

 Equilibrium condition of a third degree
discriminating monopolist
• Profit function
π = p1(x1).x1 + p2(x2)x2 – c(x1+x2) – F

• By first order conditions of profit maximization:

p1(x1) + x1.dp1(x1)/dx1 = dc(x1+x2)/dx1
p2(x2) + x2.dp2(x2)/dx2 = dc(x1+x2)/dx2

• Clearly, we get two equations in two variables. Solving them

we get the equilibrium sales in each market segment and the
corresponding prices.

Sumit Sarkar, XLRI

Willingness to pay
WtP

P1
P2
P3
P4
P5
P6
P7

0 x
1 2 3 4 5 6 7 8
Consumer’s surplus
WtP

P1
P2
Consumer’s
P3 surplus

P4

0 x
1 2 3 4 5 6 7 8
 Inefficiency of monopoly
p(x)
MC

p*
C
MC =p c c

MC(x*) E D

x* xc x

MR
Sumit Sarkar, XLRI
Reading
• Besanko & Braeutigam. Ch. 11 (Sec. 11.1-11.3)
Ch. 12 (Sec 12.1-12.4)

Sumit Sarkar, XLRI