Introductory Economics

Price Determination under Monopoly

• Short-run refers to that period in which time is so short that a monopolist cannot change fixed factors like machinery, plant etc. Monopolist can increase his output in response to increase in demand by changing his variable factors.
• No doubt fixed factors will also be utilized to their maximum capacity to increase the output. Similarly, when demand decreases the monopolist will reduce his output by reducing variable factors and by slowing down the use of fixed factors.
• A monopolist will be in equilibrium when he produces that amount of output at which marginal cost is equal to marginal revenue and marginal cost curve cuts marginal revenue curve from below.
• A monopolist in equilibrium may face three situations in the short run, viz., (1) Super Normal Profit (2) Normal Profit and (3) Minimum, These are described with the help of the follow diagrams.

Super Normal Profit:

• If the price (AR) fixed by the monopolist in equilibrium is more than his average cost (AC) then he will get super normal profits. The monopolist will produce up to the extent where MC = MR and MC curve cuts MR curve from below. This limit will indicate equilibrium output.
• If the price of equilibrium output is more than average cost (AR > AC) then the monopolist will earn super-normal profits. It is shown in Fig. 3. In this figure, the monopolist is in equilibrium at point E, because at this point marginal cost is equal to marginal revenue and MC curve is cutting M R curve from below.
• The monopolist will produce OM units of output and sell it at MB price which is more than average cost AM, by BA per unit. (BM - AM = BA). Thus in this situation the total super normal profit of the monopolist will be ACPB.

Normal Profit:

• If in the short run equilibrium (MC = MR) the monopolist price (AR) is equal to its average cost (AC) i.e. AR = AC, then he will earn only normal profit.
• It is shown in Fig. 4. In this figure, the firm is in equilibrium at point E where MC = MR and MC curve is cutting MR curve from below. OM is the equilibrium output. At this output, average cost (AC) curve touches average revenue (AR) curve at point A. Thus, at point 'A' price OP (AR) is equal to the average cost (AM) of the product. Monopoly firm, therefore, earns only normal profit in equilibrium situation, as at equilibrium output its AC =AR

Minimum Loss:

• In the short run, the monopolist may incur loss also. If in the short-run price fall due to depression or fall in demand, the monopolist may continue his production so long as the low price covers his average variable cost (AVC). In case the monopolist is obliged to fix a price which is less man average variable cost, then he will prefer to stop production or shut down.
• Accordingly, a monopolist in equilibrium, in the short period, may bear minimum loss equivalent to fixed costs. In this situation equilibrium price (AR) is equal to average variable cost (AVC) and the monopolist bears the loss of fixed costs.
• The monopolist will have to bear this loss even if he chooses to discontinue production in the short period. Thus, minimum loss = AR - AVC = AFC. This situation of equilibrium is shown in fig. 4. According to this figure, the monopolist is in equilibrium at point E where M C = MR and MC curve cuts.
• MR curve from below. He produces OM output. The price of equilibrium output OM is fixed at OP (AM). At this price, average variable cost (AVC) curve touches AR curve at
• point A. It means that the firm will cover only average variable cost from the prevailing price. The firm will bear the loss of fixed costs, or AN per unit. The firm will bear total loss equivalent to NAPPI as shown in fig. It will constitute minimum loss to the firm. If the monopolist is obliged to fix a price lower than OP he would prefer to discontinue production.