lecture # 17 monopoly: applications lecturer: martin paredes
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Lecture # 17Lecture # 17
Monopoly: ApplicationsMonopoly: Applications
Lecturer: Martin ParedesLecturer: Martin Paredes
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1. Natural Monopoly2. Multi-plant Monopoly3. Cartels4. Price Discrimination
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Definition: A market is a natural monopoly if, over the relevant range of production, the total cost of production incurred by a single firm is lower than the combined total cost of two or more firms, producing the same output level.
In other words, it is a market in which production is cheaper when there is only one firm.
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Suppose an industry with a decreasing average cost at all points.
If AC is always decreasing, then AC > MC.
Therefore, setting P = MC will not be profitable.
5Quantity
€
Demand
Example: Natural Monopoly
6Quantity
Demand
AC
Example: Natural Monopoly
€
7Quantity
Demand
AC
Example: Natural Monopoly
€
8000
2.50
8Quantity
Demand
AC
Example: Natural Monopoly
4000
€
8000
2.50
4.80
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In a natural monopoly, the appropriate benchmark to calculate deadweight loss cannot be P=MC, because the firm will incur losses.
For a natural monopoly, the appropriate benchmark is P=AC.
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Note: The definition of whether an industry is a
natural monopoly depends on the size of the market.
See the following example where AC first falls and then raises.
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Example: Natural Monopoly with Rising Average Cost
Quantity
Price
AC
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Example: Natural Monopoly with Rising Average Cost
Quantity
Price
D1
AC
If demand is given by D1, then the industry is a natural monopoly.
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Example: Natural Monopoly with Rising Average Cost
Quantity
Price
D1
AC
If demand is given by D2, the industry is no longer a natural monopoly.
D2
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Suppose a monopolist has two plants, but each plant has different marginal costs:
Plant 1: MC1(Q)
Plant 2: MC2(Q)
How should the monopolist allocate production across the two plants?
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When the marginal costs of the two plants are not equal, the firm can increase profits by reallocating production…
Away from the plant with higher marginal cost.
Towards the plant with lower marginal cost.
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Example: Suppose: MC1 = 4Q
MC2 = 2Q Suppose the monopolist produces 100 units. Will it choose to split the production equally
between both plants? MC1 = 4*50 = 200
MC2 = 2*50 = 100 Reducing production in plant 1 units and
increasing it in plant 2 raises profits Produce more than 50 units in plant 2.
17Quantity
€
MC1 MC2
50
•
•
100
200
Example: Multi-Plant Monopolist
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Definition: The Multi-Plant Marginal Cost Curve traces out the set of points generated when the marginal cost curves of the individual plants are horizontally summed.
In other words, it shows the total output that can be produced at every level of marginal cost.
The monopolist’s production decision will be based on its multi-plant Marginal Cost
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Back to example: Given: MC1 = 4Q
MC2 = 2Q For a marginal cost of €200:
Plant 1 can produce 50 units Plant 2 can produce 100 units.
So the total production for a cost of €200 is 150 units
In fact: MCT = 4 Q 3
20Quantity
€
MC1 MC2
50
•200
Example: Multi-Plant Monopolist
21Quantity
€
MC1 MC2
50 100
•200
Example: Multi-Plant Monopolist
•
22Quantity
€
MC1 MC2
50 100 150
•200
Example: Multi-Plant Monopolist
• •
23Quantity
€
MC1 MC2
50 100 150
•200
Example: Multi-Plant Monopolist
• •
MCT
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The profit maximization condition that determines optimal total output is now:
MR = MCT
The marginal cost of a change in output for the monopolist is the change after all optimal adjustment has occurred in the distribution of production across plants.
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Example: Multi-Plant Monopolist Maximization
Quantity
MCT
MC1 MC2
Price
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Example: Multi-Plant Monopolist Maximization
Quantity
Price
MCT
Demand
MC1 MC2
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Example: Multi-Plant Monopolist Maximization
Quantity
Price
MCT
Demand
MR
MC1 MC2
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Example: Multi-Plant Monopolist Maximization
Quantity
Price
MCT
Demand
MR Q*T
P*
MC1 MC2
•
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Example: Multi-Plant Monopolist Maximization
Quantity
Price
MCT
Demand
MRQ*1 Q*2 Q*T
P*
MC1 MC2
•••
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Definition: A cartel is a group of firms that collusively determine the price and output in a market. In other words, a cartel acts as a single monopoly firm that maximizes total industry profit.
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The problem of the optimal allocation of output across cartel members is identical to the monopolist's problem of allocating output across individual plants.
If all firms have the same marginal cost curve, production will be equally divided.
If not, firms will higher marginal cost will produce less.
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Definitions: A monopolist charges a uniform price if
it sets the same price for every unit of output sold.
A monopolist price discriminates if it charges more than one price for its output
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Motivation: When the monopolist charges a uniform
price, it maximises profits, but does not receive the consumer surplus or dead-weight loss associated with this policy.
The monopolist can overcome this by charging more than one price for its product.
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Requirements: Ability to sort/identify consumers No possibility of resale or arbitrage. Need market power.
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Example: Prices for UA Flight 815
Ticket Price Number of Passengers
Average Advance Purchase
$2000 18 12 days
$1000-$1999 15 14 days
$800-$999 23 32 days
$600-$799 49 46 days
$400-$599 23 65 days
$200-$399 23 35 days
$1-$199 34 26 days
$0 19 -
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Based on the classification by A.C. Pigou: First degree price discrimination
Also called “personalized pricing”. Second degree price discrimination
Also called “menu pricing”. Third degree price discrimination
Also call “group pricing”.
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Definition: A policy of first degree (or perfect) price discrimination attempts to price each unit sold at the consumer's maximum willingness to pay.
The consumer's maximum willingness to pay is also called the consumer's reservation price.
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Recall that the demand curve can be interpreted as the consumers’ willingness to pay for one unit of the good.
In other words, the demand curve represents the reservation prices of every consumer in the market.
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If the monopolist can observe the reservation price of every consumer, then the monopolist can observe demand perfectly and can "perfectly" price discriminate.
The monopolist will continue selling units until the reservation price exactly equals marginal cost.
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Example: Monopoly
D
Quantity
Price
MC
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Example: Uniform Pricing
D
MC
Quantity
Price
MRQm
Pm : Consumer Surplus
: Producer Surplus
: Deadweight Loss
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Example: First Degree Price Discrimination
D
Quantity
Price
MC
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Example: First Degree Price Discrimination
D
Quantity
Price
MC
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Example: First Degree Price Discrimination
D
Quantity
Price
MC
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Example: First Degree Price Discrimination
D
Quantity
Price
MC
: Producer Surplus
Q*
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Notes: A perfectly price discriminating
monopolist will produce and sell the efficient quantity of output.
When the monopolist sells an additional unit, it does not have to reduce the price on the other units it is selling.
Therefore, MR = P. (i.e., the marginal revenue curve equals the demand curve.)
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Definition: A policy of second degree price discrimination allows the monopolist to charge a different price to different consumers, even though the reservation price of any one consumer cannot be directly observed.
The monopolist usually design a menu of options and let the consumer select its preferred package
It involves quantity discounting.
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Examples of second degree price discrimination include:
Two-part tariff Block pricing
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Definition: A monopolist charges a two part tariff if it charges:
A per unit fee, r, plus A lump sum fee F.
The lump-sum fee is paid whether or not a positive number of units is consumed.
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With two-part tariffs, consumers that demand a high quantity are charge a smaller price per unit than consumers that demand a low quantity.
Examples include Telephone landlines Club membership
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Definition: A monopolist charges a block tariff if the consumer pays one price for one block of output and another price for second block of output
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Definition: A policy of third degree price discrimination offers a different price to each consumer group (or segment of the market) when membership to a group can be observed.
Examples include movie ticket sales to older people or students at a discount.
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Suppose: A monopolist faces two markets, each
with a different demand curve Marginal cost for the two markets is the
same.
How does a monopolist maximize profit with this type of price discrimination?
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The monopolist will set the marginal revenue in each market equal to marginal cost.
In other words, the monopolist maximizes total profits by maximizing profits from each group individually.
At the optimum: MR1 = MC = MR2
If not, the monopolist could raise revenues by switching sales from the low MR group to the high MR group.
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Example: Third Degree Price Discrimination
P PMarket 1 Market 2
D1D2
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Example: Third Degree Price Discrimination
P PMarket 1 Market 2
D1D2
MR1 MR2
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Example: Third Degree Price Discrimination
P PMarket 1 Market 2
D1D2
MR1 MR2
MC MC
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Example: Third Degree Price Discrimination
P PMarket 1 Market 2
D1D2
MR1 MR2
P1
P2
Q1 Q2
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1. Price discrimination generally allows a monopolist (or any firm with market power) to capture more surplus than a uniform pricing policy.
2. First degree (or perfect) price discrimination allows the monopoly to produce efficiently and capture all the resulting surplus.
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3. Second degree price discrimination may or may not allow as much surplus to be created and captured as perfect price discrimination, depending on the precise form of the discrimination.
4. Third degree price discrimination generally does not create or allow as much capture of surplus.
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5. In order to capture surplus from any form of price discrimination, a firm must have some market power, have some information on the differential willingness to pay of customers and must be able to prevent resale (arbitrage) among customers.
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