Price and Output Determination under Monopoly (with graph)

Price and Output Determination under Monopoly (with graph)!

The analysis of the determination of the price, output and profit under monopoly is based on the following assumptions:

1. It is a simple monopoly which has very low cross elasticity of demand with other products.

2. The monopolist is a rational being who aims at maximum gain with the minimum of costs.

3. The monopolist may produce in the market period, the short period or the long period. But his sole aim is to maximize his profits.

4. There is the presence of full competition on the demand side on the part of buyers so that none is in a position to influence the price of the product by his individual actions. Thus, the price of the product is given for the consumer.

5. The monopolist does not charge discriminating prices. He treats all consumers alike and charges uniform price for his product.

6. The monopoly price is uncontrolled. There are no restrictions on the power of the monopolist. He is free from the threat of entry of other firms into his market.

Given these assumptions, the price, output and profits under monopoly are determined by the forces of demand and supply. The monopolist has complete control over the supply of the product. He is also a price-maker who can set the price to his maximum advantage. But he cannot do both the things simultaneously.

Either he can fix the price and leave the output to be determined by the consumer demand at that price. Or, he can fix the output to be produced and leave the price to be determined by the consumer demand for his product. Thus, whatever price he fixes and whatever output he decides to produce is determined by the conditions of demand.

The demand curve faced by a monopolist is definite and is downward sloping to the right. It is his sales curve or average revenue curve. Its corresponding marginal revenue curve is also downward sloping and lies below it (see Fig. 4.16). But the manner and extent to which the monopolist will be able to influence price or output will depend upon the elasticity of demand for his product.

If the demand for his product is highly elastic, he can sell more by a small reduction in price. If, on the other hand, the demand is less elastic, the tendency will be to raise the price and profit more by selling less.

Given the demand for his product, the monopolist can select the most profitable output against this demand. His costs of production may be rising, falling or constant. Whatever the nature of the cost curves-straight line, convex or concave-monopoly equilibrium will take place at a point where the marginal cost equals marginal revenue. The monopolist maximizes his profits at the price where the difference between total revenue and total costs is the maximum. He will attain this if he regulates his output in such a way that the addition to his total revenue from selling an additional unit exactly equals the addition to his total costs by producing that unit.

In other words, the monopolist gains the maximum when he equates marginal revenue to marginal cost. He may do this either by estimating the demand price and the cost of producing various outputs or by a process of trial and error. Geometrically speaking, the point of monopoly equilibrium is one where the MC curve cuts the MR curve from below or from left, and a perpendicular from it to the AR curve determines price. It implies that price > MC = MR. In fact, monopoly price is equal to the marginal cost multiplied by –

E/(E – 1)

Since, AR = MR [E/(E – 1)], and MC = MR, therefore, monopoly price = MC [E/(E – 1)]. It is thus a function of the MC (marginal cost) and the elasticity of demand. We discuss the determination of monopoly price in the market period, the short period, and the long period.

Monopoly Price in Market Period:

The market period being a very short period, we assume that the monopolist has already produced a certain quantity of the product. Since the product has been manufactured in the past, costs are of no relevance to him. He has to sell the product at a price determined by the demand for it and which brings him maximum total revenue. Suppose D demand curve for the monopolists product. He has OM₂ quantity of the product to sell. Since costs are of no importance, he will try to sell the entire quantity at M₂P₂ price.

But this price does not bring in maximum total revenue as MR is negative. The total revenue is the maximum when MR is zero. Therefore, the monopolist will sell OM₁ quantity at M₁P₁ price. The unsold quantity M₁M₂ of the product will be destroyed if the product happens to be perishable. If the product is non-perishable, the monopolist might keep it in stock in the hope of selling it future when the market improves.

Short Period Monopoly Price:

In the short run, the monopoly firm attains equilibrium when its profits are maximized or losses are minimized. Like the competitive equilibrium, this analysis can also be discussed in terms of the total revenue-total cost approach and the marginal revenue-cost approach.

Total Revenue-Cost Approach:

In Fig. 4.17, TC is the total cost curve showing a constant rise in the total costs as output increases. TR is the total revenue curve which goes on rising to begin with, then flattens and later on slopes downward showing fall in total receipts after a given point. The monopolist will maximize his profits at that output where the difference between TR and TC is the greatest.

This will be the level at which the slopes of TR and TC curves equal. Accordingly, P is the equilibrium point as determined by the tangents at points P and T on the TR and TC curves, respectively. The monopolist will sell OM output at MP Price. His profits will be PT. Any other level of output will decrease rather than increase his profits.

Marginal Approach:

In the short-run, the monopolist can change the price as well as quantity of his product. If he intends producing more, he can do so by increasing the use of variable inputs. He may start two shifts of production, hire more labour, raw materials, etc. But he cannot change his fixed plant and equipment. On the other hand, if he wants to restrict his output, he may dispense with certain workers, work for less hours and use less of the variable factors. In any case, his price cannot be below the average variable costs.

It implies that he can continue to incur losses during the short period so long as he covers his average variable costs of production. Price as usual is determined at the point where the SMC curve cuts the MR curve from below. It is at the equilibrium point that profits are maximized or losses are minimized. In Fig. 18, SAC and SMC are the short-run average and marginal revenue curves. AVC is the average variable cost curve. D is the demand curve or the average revenue curve whose corresponding marginal revenue curve is MR.

Figure 18 (A) depicts short-run monopoly equilibrium at point E where the SMC curve cuts the MR curve from below. The monopolist sells OM output at MP price. The price MP, being above the short-run average cost ME, APBC.

Profits are earned by the monopolist per unit of output. Thus, total monopoly profits are equal to the area of CAPB.

Figure 18 (B) shows a short-run situation in which the monopolist earns only normal profits. The short-run average cost curve is tangential to the AR or price line where the firm is earning normal profits. The amount incurred to produce OM output is just equal to the amount earned from OM output.

Figure 18 (c) shows a short-run situation in which the monopolist incurs losses. As usual, the equilibrium point E is determined by the equation SMC = MR. But the monopoly price MP, as fixed by demand conditions, does not cover the short-run average costs of production MA. It just covers the average variable costs MP, represented by the tangency of the demand curve D and the AVC curve at P.

PA is, thus, the per unit loss which the monopolist incurs. Total losses are equal to BP X PA = BPAC. In this figure, P is the shut-down point for this firm. If the market demand conditions lower the price from MP downwards, the monopolist will temporarily stop production. The firm will close down.