TYBA

Subject- Economics

Paper- (RJAUECO501) Micro Economics

Internal II August 2024 Examination

Study Material

 Monopoly is a form of market where there is only one seller or one firm facing no
immediate competition. In other words, monopoly is the sole producer of a
commodity that has no close substitute.

 In pure or absolute monopoly, a monopolist controls the entire supply of a

commodity for which there is no substitute at all. The usual monopolies are
those where the seller has a very substantial share of the market, and the
commodity sold does not have close substitutes. Monopoly price is generally
higher than competitive price.

 Features of monopoly
1. Single seller
There are no competitors. He is the sole seller.
2. No close substitutes
The commodity sold by the monopolist has no close substitute. The demand is
less elastic due to the absence of close substitutes.
3. No entry
An entry in the monopoly market is completely restricted. Limiting price policy
may not attract the new firms in the market.
4. Downward sloping demand curve
A monopolist can increase his sales by lowering the price. If he increase price,
sales will decrease, therefore the demand curve is downward sloping.
5. Can control price and quantity but not both simultaneously
If he controls the price then the quantity sold depends on the market i.e. demand.
6. Relatively inelastic demand curve
The demand is less elastic due to the absence of close substitutes which makes
the cross elasticity of demand almost zero.
7. No distinction between firm and industry
A monopolist being the sole seller constitutes the firm as well as the industry.
Therefore, there is no need for a separate discussion of equilibrium of industry.
 Sources of monopoly
1. Economies of scale and scope of natural monopoly
In the long run the existence of economies of scale implies that the firm has a
downward sloping average cost curve. The larger the output of the firm, the
lower the per unit cost of production. This makes it difficult for new firms to
compete with the existing low cost producer. Also in such situations the least
costly way of serving the market is to have a single producer serve the
market. Such a firm is called the natural monopoly.
Public utilities like water, electricity, local transportation are examples of this
type of a monopoly. Most of the times government itself becomes a single
supplier or allows a single private firm to operate with price regulation by
the government.

2. Control over critical inputs

If in an industry, an input is critical in the production process, and one firm
controls the supply of the input, then that firm can become a monopoly.
Other firms cannot enter the industry because they do not have access to the
critical input.

3. Technology
Technology developed by the business firms or nations give them a
monopoly right over such a good or service.

4. Intellectual Property Rights

To encourage innovation most of the countries give an inventor sole control
over the use of invention for a certain number of years. These are called
patents. Legal protection granted by the government in the form of patent
rights, trade marks, copy rights, license etc. gives monopoly power to the
persons and firms who have introduced such commodities or production
processes.
5. Cartel formation
If a product is produced by few producers , the market is an oligopoly one. It
is possible for these few producers to come together and form a cartel to
establish a monopoly.

6. Price policy
A firm may follow a limiting price policy that is a price which does not attract
the new firms.

 Profit maximization
 Economic profit= Total revenue-Explicit cost-Implicit cost (or entrepreneur’s
opportunity cost) Profit is the residual income over and above his normal
profit. The normal profit is the minimum income which the entrepreneur
must get in order to stay in a business or industry.
The firm aiming at maximizing profit is said to be in equilibrium when it has
no tendency either to increase or decrease its output.

 Marginal revenue is the rate of change in total revenue, that is the slope of the
total revenue curve, and marginal cost is the rate of change in total cost, that is
the slope of the total cost curve. According to marginal revenue and marginal
cost analysis the firm will be maximising its profit at the output where MC=MR.
Thus the condition for the equilibrium of the firm is that the marginal cost
should be equal to marginal revenue.

 If MC<MR, the firm’s profit is increasing and its total profit can be increased by
expanding its output. If MC>MR the level of total profit is being reduced and its
total profit can be increased by cutting down its production. If MC= MR, profits
are maximized.

 Monopolist inspite of his monopoly power is not guaranteed excess profit in the
short run.

In the short run equilibrium a monopoly firm may operate with different amounts of
profit and loss.

1. AR>SAC where TR>TC is excess profit.

2. AR=SAC where TR=TC= Normal profit
3. AR<SAC where TR<TC it is loss.
4. AR=SAVC where TR=TVC =Operates at shut down point
5. AR<SAVC then TR<TVC= firm closes down

 Price Discrimination
Price discrimination refers to the act of selling the same article, produced under
single control at different prices to different buyers. Price discrimination exists
where the same product is sold at different prices to different buyers. The cost of
production is either the same, or it differs but not as much as the differences in
the prices charged.

 First Degree Price Discrimination

 First degree price discrimination takes place, where, each customer can be
charged a different price for a good or service. It is usually possible in the case of
services which cannot be transferred from one person to another. For example-
Doctor services

 Second Degree Price Discrimination

It is usually practised on quantity and quality. For example- 5 litre can of cooking
oil may be priced at Rs. 2000 but one litre bottle will be priced at Rs. 500.
Similarly, two different packs of ice cream may be charged on the basis of quality
ice cream reflected in the brand name.
It is also possible to charge different prices if the market is divided into segments
and each segment is charged a separate price.

 Third Degree Price Discrimination

It takes place when different prices are charged in different markets which are
located geographically at a distance so that transfer of goods by consumer from
one market to the other is not worthwhile in an economic sense. Different
market differing in price elasticities enable monopolist to charge different prices.

 Conditions for discrimination

1. Non transferability of Goods

A monopolist can charge different prices for the same good provided the
consumers are not in a position to transfer the goods from one to other.

2. Geographical distance
If the markets are situated at sufficiently long distances then the transfer of
goods may be economical.

3. Political barriers
Political boundaries prevent the movement of people from one market to the
other.

4. Tariff Barriers
If the home market is protected through tariffs , a monopolist may charge a
higher price in the protected home market and a lower one in the competitive
foreign market.

5. Ignorance
When the consumers are ignorant of the price difference, they will not mind
paying a higher price than what the others pay.
 6. Negligible price difference
Attitude of indifference on the part of consumers enables the monopolist to
discriminate the price.

7. Price quality link

When consumers, due to irrationality or for any other reason consider higher
price as an indicator of better quality, then it is possible for a monopolist to
charge higher price to such consumers.

8. Location
Goods sold in rich localities may be charged higher prices than the same
goods sold in the poor localities.

9. Government’s sanction
The government due to welfare, social and political reasons may charge
different prices for the same goods and services.

 A discriminating monopolist will be in equilibrium when Different markets differ

in price elasticities.
Total output is distributed in all the markets in such a way that marginal revenue
in all the markets is equal.
Marginal revenue in all the markets- which is equal- must also be equal to
marginal cost at the equilibrium output.

 A Game is any situation in which Players (Participants) make strategic

decisions-i.e. decisions that take into account each other actions and responses.
A complete set of rules describe a game. A play is an instance of the game. A
player has to make a decision, called a moveor an action. This is not the same as
strategy. A strategy is a plan that tells the player what move to choose in every
possible position.
 Outcomes or Payoffs: Strategic decisions result in payoffs to the players;
outcomes that generate rewards or benefits. For the price setting firms, the
payoffs are profits, for the bidders at the auction, the winner’s payoff is her
consumer surplus- i.e. the value she places on the artwork less the amount she
must pay. While playing games there are many possible outcomes, each
producing payoffs to the player. The payoffs may be monetary or they may
express satisfaction. (When someone wins the game) (Awards, trophies
recognition)

 Optimal strategy: A key objective of game theory is to determine the optimal

strategy for each player. A strategy is a rule or plan of action for plying the game
e.g. A firm will keep the price of the product high till the competitors do the same
 but if a competitor lowers the price, the firm will also lower its price than the
competitor. Optimal strategy for a player is the one that maximizes the expected
pay offs.

 Rational Behavior : Rational behaviour is assumed for all the players. That is
players have preferences, beliefs about the world and try to optimize their
individual payoffs. Moreover, players are aware that other players are trying to
optimize their payoffs.

 Zero Sum game: A zero sum game is one in which the gain of one player comes
at the expense and is exactly equal to the loss of the other player. In other words,
the gais of one player equal the losses of the other, that total gains plus total
losses sum to zero. Chess and football are zero‐sum games.

 Non Zero sum game: A non zero sum game is one in which the gain or losses of
one firm do not come at the expense of or provide equal benefit to the other
firm.An example of this is when advertising leads to higher profits or market
shares for both firms. This is a case of positive sum game. If increased advertising
raises costs more than revenues and the profits of both firms decline there is a
negative sum game.

 The Prisoners Dilemma: A classic example in game theory, called prisoners’

dilemma, illustrates the problem faced by oligopolistic firms. Oligopolistic firms
often find themselves in a prisoner’s dilemma situation. They must decide
whether to compete aggressively; attempting to capture a larger share of the
market at the competitor’s expense or to cooperate and compete more passively
coexisting with their competitors and settling for their current market share. If
the firms compete passively, setting high prices and limiting output, they will
make higher profits than if they compete aggressively.

 Dominant strategy: A dominant strategy is one that produces a higher payoff no

matter what the other players in a game choose. In other words, a player has a
dominant strategy when that strategy provides a higher payoff no matter which
choice the other player makes.

 Dominated strategy: A dominated strategy is any other strategy available to a

player who has a dominant strategy. It is one that leads to a lower pay off than an
alternative choice regardless of the other player’s choice.

 Dominant strategies are stable, but in many games, one or more players do not
have dominant strategy. Therefore we need a more general equilibrium concept.
Nash Equilibrium is a set of strategies or actions such that each player is doing
the best it can given the actions of its opponents. Because each player has no
incentive to deviate from its Nash strategies, the strategies are stable. In the
previous example Nash equilibrium is Advertise for both the firms. Given the
decision possible and so has no incentive to change its decision.

 Battle of sexes game: In case here knowing the opponents strategy will not help
you to decide your own course of action.
  In game theory, the extensive form is a way of describing a game using a game
tree. It’s simply a diagram that shows that choices are made at different points in
time (corresponding to each node). The payoffs are represented at the end of
each branch. Since the extensive form represents decisions at different moments,
it’s usually used to describe sequential games, while simultaneous games are
described using the strategic form. Since sequential games imply making
decisions at different moments for each player, information is perfect since each
player can see the decision taken by theprevious player, complete and the rules
of the game andeach player’s payoffs are common knowledge.

 Oligopoly is a market form in which there are few sell homogeneous or

differentiated products. If the commode homogeneous, it is called pure or
homogeneous oligopoly. It differentiated of heterogeneous oligopoly market, if
the product differentiated.

 Non- Collusive Oligopoly market has the features such a few large firms, entry
barriers, non-price competition, product branding and differentiation and
interdependence in decision making. Collusive Oligopoly Comes in existence
when the firms come together to reduce uncertainly in the market. There are two
types of collusion, cartels and price leadership. Rigid price is the characteristic of
collusive oligopoly.

 A reaction curve is a locus of the highest points of iso profit curves. Cournot's
equilibrium is determined by the intersection of the reaction curves. Cournot's
model with two producers. A and B, each one reacting to the other decision
finally settle down at a point, that is equilibrium point from where there is no
further change.

 Professor E.H. Chamberlin, in his book, "The Theory of Monopolistic

Competition" (1933) explains pricing and output under oligopoly. Accordingly, to
Chamberlin it rival firms are assumed to recognise their mutual interdependence
and act accordingly. Stable equilibrium can be reached where each firm charges
a monopoly price and shares equally the monopoly equilibrium output. When all
firms are in equilibrium, industry profit is maximized.

 PRICE LEADERSHIP The most common type of leadership area; (a) Price
leadership by a low-cost firm. (b) Price leadership by a large (dominant) firm. (c)
Barometric price leadership. (d) Aggressive Price Leadership

PRICE LEADERSHIP

(A) Low-cost price leadership

 Production is carried on by each producer till the point MC, MR and MC is increasing at
the point of equilibrium. The low-cost firm will be able to sell more and will emerge as a
leader. Others will have no option but to accept low-cost firm as a leader and accept the
price charged by him.

(B) PRICE LEADERSHIP BY A LARGE (DOMINANT) FIRM

In this case one large firm has a major share of total sales while group of smaller firms
supplies the reminder of the market. The large firm then might act, as a dominant firm,
setting a price that maximizes its own profits.

(C)BAROMETRIC PRICE LEADERSHIP

There may not always be a firm that dominates all others and sets for price sometimes
one firm in the industry will initiate a price change response to economic conditions,
and other firms may or may be follow the leader.

(D)AGGRESSIVE PRICE LEADERSHIP

The leadership in which one organization establishment threatens the other

organizations to follow. Dominant organization leadership following aggressive price
policies and the prices set by it.

This is the study material for Internal II August 2024 Examination. However, for
the exam students should also read all the topic notes in detail.