Price Determination under Monopoly

Monopoly market is one in which there is only one seller of the product having no close substitutes. The cross elasticity of demand of a monopolised product is either zero or negative. There being only one firm, producing that product, there is no difference between the firm and industry in case of monopoly. Monopoly is a price maker not the price taker.

In the words of Koutsoyiannis, “Monopoly is a market situation in which there is a single seller, there are no close substitutes for commodity it produced there are barriers to entry of other firms”

Features of Monopoly

(i) One seller of the product: In case of monopoly there is only one seller of product. He may be sole proprietor or a partnership firm or a joint stock company or a state enterprise. There is no difference between firm and industry. The firm is a price maker and not price taker.

(ii)No close substitute: The commodity which the monopolist produces, has no close substitutes. Lack of substitutes means no other firm in the market is producing same type of commodity.

(iii) Restriction on the entry of the new firm: There are powerful restrictions to the entry of new firms in the industry, under the Monopoly. Monopolist faces no competition.

Revenue and cost curves under Monopoly

A monopoly firm face a downward sloping demand curve, unlike a competitive firm; a monopolist can reduce the price and sell more. In a monopoly situation, there is no difference between firm and industry.

Accordingly, under monopoly firm’s demand or average revenue curve (AR) and marginal revenue (MR) curves are separate from each other. Both are downward sloping from left to right. A monopolist will be in equilibrium when two conditions are fulfilled.

(i) MC = MR and

(ii) MC curve cuts MR curve from below.

Study of price and equilibrium determination under monopoly is conducted in two time periods.

(i) Short Period and

(ii) Long Period

Price Determination under Short Period or Short Run Equilibrium:

In the short run, a monopolist has to work with a given existing plant. He can expand or contract output by varying the amount of variable factors. He cannot adjust the size of plant in the short run.

A monopolist in equilibrium may face three situations in the short run

(1) Excess Profit

(2) Normal Profit

(3) Minimum Losses

The process of price determination under monopoly has been explained as follows:

Super Normal Profit

If the price (AR) fixed by monopolist in equilibrium is more than the average cost (AC) than he will earn excess profits.

The revenue and cost conditions faced by monopolist firm are presented in the Fig. AR and MR are the average and marginal revenue curves of the firm respectively. SAC and SMC are the short run average cost and marginal cost curves of the firm, respectively.

To maximise profits, the monopolist firm chooses a price and output combination for which SMC = MR, and SMC curve cuts MR from below.

As shown in the fig., E is the equilibrium where monopolist SMC curve cuts MR curve from below.

A perpendicular parallel to y-axis is drawn at point E connecting the x-axis at Q and the demand curve at A.

OQ is the equilibrium output. AQ is the equilibrium price, because the price is determined by demand curve or average revenue curve. The average cost is BQ, because line AQ cuts SAC curve at point B.

Thus the monopolist’s per unit excess profit is AB, which is the difference between the price (AQ) and the corresponding average cost of production (BQ) The ABPP1 represent total monopolist’s profit. The total profit of the monopolist will be maximum only at OQ level of output.

Normal Profit

In the short period it is possible that monopolist may earn normal profit. This happens only when the average cost curve of the monopolist is tangent to its average revenue curve.

The monopolist is the equilibrium at OQ level of output, because at this level of output his marginal cost curve (SMC) cuts MR curve at point E. Also at same level of output (OQ) the monopolist SAC curve touches his AR curve at point A.

Thus AQ or OP is the monopolist price (which is determined by AR curves) is also equal to the cost per unit (AQ). The monopolist will earn only normal profit and the normal profit is included in the average cost of production.

Loss Minimization in the Short Period

In the short run, the monopolist may incur losses also. The monopolist may continue his production so long as price of his product is high enough to cover his average variable cost. If the price falls below average variable cost, the monopolist prefers to stop production.

Accordingly, a monopolist in equilibrium, in the short run, may bear minimum losses equivalent to fixed costs. The situation of minimum losses has been illustrated in the fig.  

The monopolist is in equilibrium at point E, where SMC = MR and SMC curve cuts MR curve below. OQ is the equilibrium level of output. The price of equilibrium output OQ is fixed at BQ or OP. At this price, average variable cost (AVC) curve AR curve at point B.

It means firm will set at only average variable cost from the prevailing price. The firm will bear the loss of fixed cost equivalent to AB per unit. The firm will bear total loss equivalent to ABPP1. If its price falls below (BQ) the monopolist will prefer to stop the production. The point B is also known as ‘shut-down point’.

From the above analysis of short run price and output equilibrium it may be content that profit maximisation or loss minimization or attainment of normal profit will be accomplished only at that level of output at which marginal cost is equal to marginal revenue and marginal cost cuts MR curve from below.

Price Determination under long – Run

In the long run the monopolist has the time to expand his size of the plant, or to use his existing plant at any level which will maximise his profit. It may be noted that there is always a tendency for the monopolist firm to secure excess profits, even in the long run, since entry into the industry is prohibited.

With entry blocked, however, it is not necessary for the monopolist to reach an optimal scale, what is certain is that the monopolist will not stay in business, if he makes losses in the long run.

However, the size of his plant and the degree of utilisation of any given plant size depends entirely on the market demand. After these adjustments are completed, the monopoly will have a long run equilibrium determined by the equality of long run marginal cost and marginal revenue as shown in fig. 

E is the equilibrium point of the monopolist firm. Corresponding to this equilibrium point, OQ is the equilibrium level of output. The monopoly will fix price AQ in the long run. Average cost is BQ. Profit per unit is AB. Total profit is equal to ABPP1.

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By Hassham

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