BUSINESS ECONOMICS

Session 11: Market Structure Analysis II: Monopoly and Discriminating Monopoly
2. 2.1 Post Work Learning Objectives In understanding the profit maximizing behaviour of firms in Monopoly and Monopolistic markets, the session objectives are as follows: (i) to understand the effect of demand and supply changes on the pricing behaviour of a Monopolist. to analyse the price discrimination policies of a Monopolist. to understand the implications of Competitors actions on pricing in Monopolistic markets.

(ii) (iii)

2.2 2.2.1

Summary Monopoly Pricing: Effect of changes in Demand and Supply Shifts / changes in demand and supply curves have varying effects on the profits of firms operating under Competitive and noncompetitive market structures. In a Monopoly market, a business firm can earn and retain economic profits due to high entry barriers. As the demand curve is

downward sloping, the Monopolist can determine either the Price or Quantity. As such, a Monopolist can Underproduce and charge higher price.

The profit margins of a Monopolist are influenced by the cost structure. For a given demand curve, lower the cost structure, the higher are the profit margins. In case of an increase in fixed costs (lumpsum tax, prices of fixed inputs etc.), the SRAC (Short Run Average Cost) curve shifts upward thereby reducing the profit margins. However, in case of an increase in the Variable Costs (sales tax, prices of variable inputs, etc.), the supply curve or MC curve shifts upwards, thereby resulting in the rise in price.

Can a Monopolist shift the burden of rise in costs on to the Consumers? This depends on the relative elasticities of the demand and supply curves. When the supply elasticity is greater than the demand elasticity, the firm bears lesser burden of the rise in costs as compared to the consumer. For example, for necessity goods, price elasticity of demand being low, any rise in supply costs will result in higher prices. As against this, when demand elasticity is greater than that of the supply elasticity, the firm bears higher burden of the rise in costs. For example, the price elasticity of passenger cars being high, rise in steel prices did not result in the rise in the prices of cars. To a large extent, this rise in input costs has been absorbed by the car manufacturers.

Changes in demand conditions can also influence the profits of a Monopolist. By advertising and other promotional measures, a Assuming unchanging

Monopolist can shift the demand curve.

supply conditions, shifts in demand curves leads to higher economic profits as the prices rise.

2.2.2

Monopoly: Price Discrimination The profits of a Monopoly firm can be increase if price discrimination is practiced, i.e. different prices are changed in various markets for the same product. The essence of price discrimination is to price the product corresponding to its price elasticity of demand. The

business firm distributes the supply between the market depending on the relative price elasticities in these markets. High prices are charged in markets characterized by low price elasticity of demand and low prices are changed in markets characterized by high price elasticity. In the example, Coffee Board supplies to two markets characterized by different demand curves. In the international market, the demand curve is perfectly elastic while the domestic market is characterized by a downward sloping demand curve. The determination of profit maximizing output. (Q*) is based on the equation of Combined

Marginal Revenue (CMR) and MC. The distribution of this output (Q*) between the two markets is based on determining the profit maximizing price in these two markets. In both markets prices

changed correspond to MR =MC. Thus, in domestic market Prices are higher compared to international market as the price elasticity is low compared to the international market.

2.2.3

Pricing in Monopolistic Markets In Monopolistic Markets firms are subjected to competition. Since the products are differentiated, substitution between products (or competition) is imperfect. As such, firms create niche markets which enables the firm to earn monopoly profits.

The characteristic feature of Monopolistic Competition is that each firm differentiates its product from those of the rival firms. This differentiation takes many firms, such as Quality differentials, packaging, after sales service, credit term, advertisement etc. Inspite of product differential consumers view the products as reasonably close substitutes.

The firms demand curve in this market structure would, therefore, be downward sloping but relatively elastic. Exogenous changes in demand factors would enable firms to increase Price and/or its market share. Similarly, changes in cost factors will influence the

AC and MC curves thereby influencing the profit margins. Short run monopoly profits attract competition. Since the rival firms offer close substitutes, the market share and profits of innovating firm diminish. As such the long run demand curve shifts downward until the time when all operating firms earn only normal profits. 2.3 Readings Handout 6: Monopoly & Price Discrimination Text Book: Chapter 10

2.4 1.

Learning Activity What conditions are necessary before price discrimination is both possible and profitable? Why does price discrimination result in higher profits?

2.

Case Study Pricing Practices in the Denver, Colorado, Newspaper Market pp. 513-514