Output and Pricing Decisions under Monopoly

As we leave the world of perfect competition and enter the world of imperfect competition, we find the balance of power between buyers and sellers changes rather dramatically. In the competitive market, it was the buyers who were the main beneficiaries of the market structure - they received the product at lowest possible cost. The firms, meanwhile, were locked in a bitter competitive battle in which only the strongest, most efficient, least cost firms survived.  It would not be hard to think of some possible examples of competitive markets on campus.  In theory, this could be an adequate representation of the tutoring market with many potential sellers of tutoring services, the market for copies where one only needs a copy machine and a room, and the market for resume writing where one only needs a word processor and some typing skills.

If you look around campus, however, you may find what exists in practice is far different from what exists in theory.  It turns out that both on-campus and "real" world examples of perfect competition are rare, and we thus need to move beyond this simplistic model to examine the situations where firms can exert market power - where they face a downward sloping demand curve.  In this unit we will look at the most extreme case of market power, monopoly, where there is only one seller.  Oligopoly and monopolistic competition, two other forms of imperfect competition will be discussed in the next unit. 

In this unit we examine the monopolist, a situation where the buyer is at the mercy of the seller because the seller does not need to worry about other sellers because of the existence of barriers to entry.  This makes our analysis a bit easier. In fact, it is very easy because we have already seen the analysis, now we simply need to revisit it. Below you will see the table of cost and revenue which you saw in our initial foray into the analysis of business decisions.

Financials for the Firm/Industry

In the table you will see in the price column that the firm's price does influence the level of demand - as price rises, output declines. This is no perfect competitor since it faces a downward sloping demand curve. This is the type of "financials" we would expect to see for a monopolist and we could expect to see the monopolist continue to expand production until MR = MC. At that time the monopolist will need to determine, with information from the market demand, what price could be charged to attain the desired level of production. The price will be above MC and the firm will not operate at the minimum AC, two issues in the perfect competition - monopoly debate.

What does this look like if we take the graphical approach? As we saw earlier, there are a variety of ways of looking at the optimal choice. In the first graph we plot out the Total Revenue and Total Cost columns where the vertical distance between the two curves is profit. Our profit maximizing rule would be to pick the level of output where the gap was widest.

We could also look at the optimal choice problem using a graph of the marginal and average cost and revenue concepts. The advantage of this diagram is that we simply look for the output level at which MR = MC, where the two curves intersect. We can then use the level of output to determine the price to charge and then calculate the level of economic profit.

Optimal Choice

It appears from this diagram that the optimal size would be approximately 53.   This is what we would have expected based on the table.  At an output of 46 MR > MC so we should expect output to increase.  Similarly, to achieve maximum profit you would not move to an output level of 54 since MR < MC and profit would be increased by reducing output.  At that level of output, average cost would be approximately $.50.  As for the price, once the decision had been made to produce 53, then you would need to charge a price that would allow this level of production to be bought. This price is determined by picking the point where MR and MC curves intersect and then drawing a line up until you reach the demand curve.  In this example the price (AR) is between $7 and $8. You could also get the information from the table.

And that is the end of the story for our monopolist - because there are barriers to entry and no firm would enter to put downward pressure on prices and profit.  One indicator of the potential profit to a company from limiting competition would be the fees paid by Pepsi to RIU for its designation as the sole supplier on campus.  Pepsi is able to pay the fee out of the higher prices it receives due to the fact Coke is not available.  When it raises the price of Pepsi there is no place on campus to get the Coke alternative which gives Pepsi a little more leeway in its pricing decisions.

Actually, it is not quite the end of the story. There is one additional topic we need to look into - price discrimination. The concept is simple enough: there are advantages to a seller who can divide a market into sub markets. You can certainly see some examples of price discrimination, although you see far fewer today than you would have twenty+ years ago before our society was sensitized to the concept of discrimination. For those of you who go to the movies, there are children and adult prices, and there are afternoon and evening prices. And then there is the post office which charges the same price regardless of how far you are sending a letter even though the costs of sending a letter to San Francisco is greater than the cost of sending a letter to Providence.  Now let's turn to the analysis of price discrimination