Economics 310 Price Theory Chapters 10 and 11-Monopoly and Oligopoly. Department of Economics College of Business and Economics California State University-Northridge

Economics 310Price Theory

Chapters 10 and 11-Monopoly and Oligopoly.

Department of Economics

College of Business and Economics

California State University-Northridge

Professor Kenneth Ng

Friday, April 21, 2023

Administrative Details

No Class this Thursday.Homework due Thursday, Dec 6th.

Turn in at my office (BB4262) before 3PM. If I am not there slip it under the door. Or fax to 818-677-7139.

Monopoly or Price Searcher

A Monopoly is a firm that is the sole seller of its product. Produces a product that does not have close

substitutes. If these two conditions are met then it has some

ability to influence the market price of its product. This means that when deciding how much to produce

the monopolist cannot take the market price as a given.

It must consider the interaction between producing more and getting a lower price or producing less and getting a higher price.

Why Monopolies Arise The fundamental cause of monopoly is barriers to entry. Barriers to entry have three sources:

Ownership of key resource Exclusive ownership of an important resource that cannot be readily

duplicated is a potential source of monopoly. Legal barriers by government

Patent and copyright laws are a major source of government-created monopolies.

Governments also restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets.

This is by far the most common source of a monopoly. Large economies of scale

An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms

Because of economies of scale, the minimum efficient scale of one firm’s plant is so large that only one firm can supply the market efficiently.

The Simple Monopolists Output and Price Decision.

A simple monopoly is one that charges a single unit price and allows all customers to purchase as much as they want at that price.

There are other types of pricing schemes which we will consider later. Examples.

Disneyland. Movie tickets. Price Club.

Monopoly’s, Total, Average, and Marginal Revenue

Quantity Price Total Revenue Average Revenue Marginal Revenue Q P TR=PxQ AR=TR/Q MR=TR/Q

0 $11 1 10 2 9 3 8 4 7 5 6 6 5 7 4 8 3



0 $11 $ 0 1 10 10 2 9 18 3 8 24 4 7 28 5 6 30 6 5 30 7 4 28 8 3 24



0 $11 $ 0 — 1 10 10 $10 2 9 18 9 3 8 24 8 4 7 28 7 5 6 30 6 6 5 30 5 7 4 28 4 8 3 24 3



0 $11 $ 0 — — 1 10 10 $10 $10 2 9 18 9 8 3 8 24 8 6 4 7 28 7 4 5 6 30 6 2 6 5 30 5 0 7 4 28 4 –2 8 3 24 3 –4

Monopoly’s Demand and Marginal Revenue Curves


Quantity of Water

Price

$11109876543210

-1-2-3-4

1 2 3 4 5 6 7 8


Quantity of Water

Price

$11109876543210

-1-2-3-4

Demand(average revenue)

1 2 3 4 5 6 7 8


Quantity of Water

Price

$11109876543210

-1-2-3-4

Demand(average revenue)Marginal

revenue

1 2 3 4 5 6 7 8

Price and Output Decision of a Simple Monopoly

A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost.

It then uses the demand curve to find the price that will induce consumers to buy that quantity.

Profit Maximization of a Monopoly

Quantity0

Costs andRevenue


Quantity0

Costs andRevenue

Demand

Marginal revenue


Quantity0

Costs andRevenue

Demand

Average total cost

Marginal revenue

Marginalcost


Quantity0

Costs andRevenue

Demand

Average total cost

Marginal revenue

A

Marginalcost


Quantity0

Costs andRevenue

Demand

Average total cost

Marginal revenue

Marginalcost

1. The intersection of themarginal-revenue curveand the marginal-costcurve determines theprofit-maximizingquantity...

A


QuantityQMAX0

Costs andRevenue

Demand

Average total cost

Marginal revenue

Marginalcost


A


Monopolyprice

QuantityQMAX0

Costs andRevenue

Demand

Average total cost

Marginal revenue

Marginalcost

B


A

2. ...and then the demandcurve shows the priceconsistent with this quantity.

The Monopolist’s Profit


Quantity0

Costs andRevenue


Quantity0

Costs andRevenue

Demand

Marginal revenue


Quantity0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

Average total cost


Monopolyprice

QuantityQMAX0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

Average total cost


Monopolyprice

Averagetotal cost

QuantityQMAX0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

Average total cost


Monopolyprice

Averagetotal cost

QuantityQMAX0

Costs andRevenue

Demand

Marginal cost

Marginal revenue

B

C

E

D

Monopolyprofit

Average total cost

The Welfare Cost of Monopoly

A monopoly leads to an inefficient allocation of resources and a failure to maximize total economic well-being. Another way of stating this is that monopolies are usually

considered bad. The monopolist produces less than the socially efficient quantity

of output. Because a monopoly charges a price above marginal cost,

consumers who value the good at more than its marginal cost but less than the monopolist’s price won’t buy it.

Monopoly pricing prevents some mutually beneficial trades from taking place.

Quantity0

Price

Demand(value to buyers)

Efficientquantity

Marginal cost

Value to buyersis greater thancost to seller.

Value to buyersis less than

cost to seller.

Cost tomonopolist

Value tobuyers

Value to buyersCost to

monopolist

The Deadweight Loss

Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost. This wedge causes the quantity sold to fall short of the

social optimum.

The Deadweight Loss

Quantity0

Price

The Deadweight Loss

Quantity0

DemandMarginalrevenue

Price

The Deadweight Loss

Quantity0


Marginal costPrice

The Deadweight Loss

Quantity0

Monopolyprice

Monopolyquantity


Marginal costPrice

The Deadweight Loss

Quantity0 Efficientquantity

Monopolyprice

Monopolyquantity


Marginal costPrice

The Deadweight Loss

Quantity0 Efficientquantity

Monopolyprice

Monopolyquantity

Deadweightloss


Marginal costPrice

What’s Wrong with Monopoly-Another Look at the Deadweight Loss.

Another way of thinking about why monopolies are usually considered bad is to realize that monopolies distort the a market economy’s normally efficient allocation of productive resources. In a market economy, productive resources will only be used to

produce a good if the value of the good to consumers is greater than the cost of production.

Firm’s will only produce a good if it can earn a profit by doing so. Simple monopolists restrict their production to maximize profits.

The simple monopolist, when they set MC=MR to determine the profit maximizing output level, produce fewer units of the good than a competitive firm so they can increase the price.

At the output level where MC=MR, price exceeds marginal cost, consumers are willing to pay more for extra output than it costs to produce it.

From societies point of view, output is too low as some mutually beneficial transactions are missed.

Let’s look at a graphical illustration of the deadweight loss or distortion of resource allocation from monopoly.

Price

P**

P*

D

A

EMC ( =AC)

MR

B

Quantity per weekQ*Q**0

Allocation and Distributional Effects of Monopoly

In the figure, the monopolist is assumed to produce under conditions of constant marginal cost.

Further, it is assumed that if the good where produced by a perfectly competitive industry, the long-run cost curve would be the same as the monopolist’s.

In this situation, a perfectly competitive industry would produce Q* where demand equals long-run supply.

A monopolist produces at Q** where marginal revenue equals marginal cost and charges P**.

The restriction in output (Q* - Q**) is a measure of the harm done by a monopoly.

Price

P**

P*

D

A

EMC ( =AC)

MR

B


Allocational and Distributional Effects of Monopoly

The competitive output level (Q* ) is produced at price P*.

The total value to consumers of Q* units of the good is the area DEQ*0 Consumers’ pay P*EQ*0.Consumer surplus, or the amount consumers would benefit from trade in a competitive market is DEP*.

A monopolist would produce Q** at price P**.

Total value to the consumer is reduced by the area BEQ*Q**.However, the area AEQ*Q** is money freed for consumers to spend elsewhere.The loss of consumer surplus is BAP*P**. This is money that was captured by consumers as a gain from trade but is now accruing to the monopolist as profits. The social loss to monopoly is ABE. This area represents the unrealized potential gain from trade that is not captured by either consumers or monopolist.

Price

P**

P*

D

A

E

Transfer from Consumers to firm

Value oftransferredinputs

MC ( =AC)

MR

B



Monopoly profits equal the area P**BAP*.

This would be consumer surplus under perfect competition.It does not necessarily represent a loss of social welfare.

This area represents the redistributional effects of monopoly that may or may not be desirable.

The monopolist is richer and the consumer is poorer.The redistribution of the social surplus is why monopolists are considered bad for consumers.

Price

P**

P*

D

A

E

Transferfromconsumersto firm

Deadweightloss

Value oftransferredinputs

MC ( =AC)

MR

B



A Numerical Illustration of Deadweight Loss

Consider the following table. Assume that cassette tapes have a $3 marginal cost and that this

would be the price under perfect competition. As shown in the Table, this would result in consumer surplus

equal to $21.

Effects of Monopolization on the Market for Cassette Tapes

Demand Conditions Consumer Surplus

Price

Quantity (Tapes per Week)

Total Revenue

Marginal Revenue

Average and Marginal Cost

Under Perfect Compe- tition

Under Monopoly

Monopoly Profits

$9 1 $9 $9 $3 $6 $3 $3 8 2 16 7 3 5 2 3 7 3 21 5 3 4 1 3 6 4 24 3 3 3 0 3 5 5 25 1 3 2 -- -- 4 6 24 -1 3 1 -- -- 3 7 21 -3 3 0 -- -- 2 8 16 -5 3 -- -- -- 1 9 9 -7 3 -- -- -- 0 10 0 -9 3 -- -- -- Totals $21 $6 $12 Competitive Equilibrium: (P = MC) Monopoly equilibrium: (MR = MC)

If the industry were a monopoly the firm would produce where marginal revenue equals marginal cost, an output of 4 units.

As shown in the Table, this would result in $12 of monopoly profits and $6 of consumer surplus which totals $18.

The deadweight loss is the difference between the $21 and the $18 or $3.

Price Discrimination A monopolist using a simple pricing scheme restricts

himself to charging a single price and letting all customers buy as much of the at that price as they wish.

Is a monopolist using a simple pricing scheme maximizing profits?

More sophisticated pricing schemes. Price discrimination occurs if identical units of output

are sold at different prices.

Price

P**

P*

D

A

E MC ( =AC)

MR

B

Quantity per week

Q*Q**0

Targets for Price Discrimination

Profit from a Simple Pricing Scheme

ConsumerSurplus

DeadweightLoss

The potential theoretical profit for a monopolist is the sum of all three colored areas.

Using a simple pricing scheme the monopolist will be able to capture only the green area.

Using a simple pricing scheme the monopolist is missing out on potential profit equal to the purple and pea green areas.

Under certain conditions, the monopolist could capture more of the potential theoretical profit by price discriminating.

Perfect Price Discrimination

Perfect price discrimination is selling each unit of output for the highest price obtainable. The firm would sell the first unit at slightly below

0D , the next for slightly less, and so on until the firm reaches Q*, where a lower price would result in less profit.

All consumer surplus (area P*DE) would be monopoly profit.

Consider a numeric example.

Effects of Perfect Price Discrimination on the Market for Cassette Tapes.

Demand Conditions Consumer Surplus

Price

Quantity (Tapes per Week)

Total Revenue

Marginal Revenue

Average and Marginal Cost

Under Perfect Compe- tition

Perfect Price Discrimination

Consumer Surplus

$9 1 $9 $9 $3 $6 $6 $0 8 2 16 7 3 5 5 0 7 3 21 5 3 4 4 0 6 4 24 3 3 3 3 0 5 5 25 1 3 2 2 0 4 6 24 -1 3 1 1 0 3 7 21 -3 3 0 0 2 8 16 -5 3 -- -- -- 1 9 9 -7 3 -- -- -- 0 10 0 -9 3 -- -- -- Totals $21 $21 $0

Competitive Equilibrium: (P = MC) Simple Monopoly equilibrium: (MR = MC)

Under perfect price discrimination, the monopolist charges each consumer a price equal to their marginal value.

The perfectly price discriminating monopolist is able to earn to capture all of the potential gain from trade as profit.

It is impossible for a monopolist to extract any more money from consumers under a system of voluntary exchange.

Perfect Price Discrimination If the monopolist can perfectly price discriminate, it will produce the

same output as in a competitive market. There is no deadweight loss to a perfectly price discriminating

monopolist. A perfectly price discriminating monopolist is socially efficient. It

will produce the “right” amount of the good. If the monopolist can perfectly price discriminate, however, the wealth

re-distribution effect of monopoly will be maximized. The perfectly discriminating monopolist will capture all of the

potential gain from trade. Why don’t all monopolist’s perfectly price discriminate?

Two conditions must exist for a monopolist to be able to perfectly price discriminate.

This pricing scheme requires a way to determine what each consumer would be willing to pay.

The monopolist must be able to stop consumers from selling to each other.

It is not normally in the consumer’s best interest to provide this information.

Example of Prefect Price Discrimination--Financial Aid at Private Colleges

Prior to the 1990s the U.S. government proposed a formula to determine a student’s need, and schools would offer such aid. Because the formula differed among colleges, the net price

(family contribution) differed. The Overlap Group (23 prestigious colleges) negotiated the

differences so that each college offered the same net price. The U.S. Justice Department challenged this pricing scheme as price fixing.

Although the schools signed a consent decree, they were exempted from the antitrust laws by the Higher Education Act of 1992. Several innovative pricing schemes were put forth by schools in the 1990s. Several schools adopted sophisticated statistical models

used to offer the lowest price necessary to get a particular student to accept an offer of admission.

Schools using this approach come very close to perfect price discrimination


Price Market Demand Total RevenueMarginal Revenue

Total Willingness to

Pay10 0

9 3

Question 2: How would your answer change if the price searcher could charge different prices for

different quantitites of the good purchased?8 5

7 8

Question 3: How would you answer change if the price searcher could charge different prices to

different people based upon their willingness to pay?6 11

5 16

Question 4: What would happen if the price searcher could do both, charge different prices for different

amounts and charge different people different prices?4 213 282 361 450 50

The chart shows the market demand for a good.

Fill in the empty cells.

Numeric Example Continued.

PriceMarket

DemandTotal

RevenueMarginal Revenue

Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

If MC=0, what price would the monopolist charge and what would be the price?

Answer: P= $3, Q=$28.

How much profit would the monopolist earn?

Answer: P=$84

What is the maximum theoretical profit the monopolist could earn?

Answer: $173

What grade would you give the monopoly’s management?

Why?

The monopolist is missing out on $89 of potential profit.

Price D MR

Quantity per week

Q*0

A Graphical Look.

Depict the outcome of a monopolist using a simple pricing scheme.

Show the price and quantity chosen by the simple monopolist, consumer surplus, profits, and the deadweight loss.

Price

$3

D MR

Quantity per week

Q*280

A Graphical Look.

Profit: $84

ConsumerSurplus: $64

DeadweightLoss: $25

Consumer Surplus:

148-84=64

Deadweight Loss:

173-148=25

Another type of Price Discrimination--Quantity Discounts

Quantity discounts reduce the unit price as consumers buy more of the good.


The chart shows an individual’s demand for a good.

Fill in the empty cells.

Price

Consumer X Quantity

Demanded Total RevenueMarginal Revenue


Pay10 09 08 07 16 25 44 63 102 151 210 25


Price

Consumer X Quantity

DemandedTotal


Total Willingness to Pay

10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

If MC=0, what price would the monopolist charge and what would be the price?

Answer: P= $2, Q=$15.

How much profit would the monopolist earn?

Answer: P=$30

What is the maximum theoretical profit the monopolist could earn

Answer: $59

What grade would you give the monopoly’s management?

Why?

The monopolist is missing out on $29 of potential profit.


Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

Suppose the monopolist decided to try to increase its’ profits using price discrimination—e.g. a quantity discount.

What type of pricing schedule could it offer the consumer?

$5 for the first 4 units, $2 for additional units.

How much of the good will the person buy when faced with the quantity discount?


Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

$5 for the first 4 units, $2 for additional units.

How much of the good will the person buy when faced with the quantity discount?

The person will buy 4 units for $5 and 11 additional units for $2.

The profits of the monopoly will be $42 (20+$22).

By price discriminating, the monopolist has increased his profit by $12.

Price D MR

Quantity per week

Q*0

A Graphical Look.

Depict the outcome of a monopolist using the quantity discount from the previous slides.

Price

$5

D MR

Quantity per week

Q*150

A Graphical Look

Profit: $42

ConsumerSurplus: $3

DeadweightLoss: $6

4

$2

ConsumerSurplus: $8

Compare the social loss and redistribution of income from consumers to monopolist if the the monopolist price discriminates with the quantity discount compared to using a simple pricing scheme.

The social loss has been has stayed the same.

The redistribution of the gain from trade from consumer to monopolist has increased.

Is the particular quantity discount depicted the most profitable for the monopolist?

Would the monopolist be better off charging $6 for 2 units, $4 for 4 additional units, and $2 for additional units?

Depict this situation on the graph.

Price

$6

D MR

Quantity per week

Q*150

A Graphical Look-Quantity Discount.

.

Profit: $46

DeadweightLoss: $6

2

$2

ConsumerSurplus: $1

$4

ConsumerSurplus: $2

ConsumerSurplus: $4

6

Would the monopolist be better off charging $6 for 2 units, $4 for 4 additional units, and $2 for additional units?

Depict this situation on the graph.

The total gain from trade for 15 units is $53. Since the monopolist is getting $46 in revenue/profit, the consumer surplus is $7.

The total potential gain from trade is $59. Therefore there is a $6 deadweight loss.

Is there a quantity discount that would eliminate the deadweight loss? Explain.

Another Type of Price Discrimination-Two-Part Tariffs

In this pricing scheme, customers must pay an entry fee for the right to purchase a good.


Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

Suppose the monopolist used a two-part tariff—where the person paid a fee and then consumed as much of the good as they desired at a zero price.

Using the same numbers from the previous example.

Pricing scheme:

Pay $25 and consume as much of the good as you wish.

Price

$3

D MR

Q 250

A Graphical Look-Two Part Tariff.

Entry Fee or Profit: $25

ConsumerSurplus: $34

Will the consumer pay the $25 fee or would he pass on the monopolist’s offer?

The consumer would accept because if he did, he could consume 25 units of the good at zero cost he would get a gain from trade of $59.

If he subtracts the $25 fee, he will still have a net gain from trade of $34.

Is there a deadweight loss?

Is the monopolist maximizing his profits under this pricing scheme? How could he do better?

Price

$3

D MR

Q 250


ConsumerSurplus: $7

Suppose the monopolist increased his fee to $52. Would this increase his profits?

Yes. The monopolist would earn a profit of $52 and leave the consumer with a $7 consumer surplus.

As the monopolist raises the entry fee, what happens to the welfare and distributional effects of monopoly.

The wealth redistribution from consumers to firms increases.


Price

$3

D MR

Q 250


ConsumerSurplus: $2

With a $52 entry fee, is the monopolist maximizing profits?

Is there anyway for the monopolist to capture the entire $59 gain from trade?

What might be the dangers to such a scheme?


APPLICATION: Disneyland Pricing. During the 1960s Disneyland patrons had to purchase a “passport” containing a

ticket for admission to the rides. What type of pricing scheme were they using? Simple pricing scheme.

Disney then switched to a fixed fee for the day and unlimited rides at zero MC. What type of pricing scheme is this? Two-Part Tariff or sometimes referred to as an all or nothing offer.

What conditions allow Disneyland to use a more sophisticated pricing scheme? Monopoly? Resale prevention? Know demand or willingness to pay? If Disneyland were going to offer a yearly pass, what would they have to

prevent?

Item ExampleNumber of Ticketsin Passport

Price of ExtraTicket

Admission -- 1 $4.00“A” ride Shooting Gallery 2 .25“B” ride Dumbo, train 3 .50“C” ride Peter Pan’s Flight 3 .75“D” ride Autopia 2 1.00“E” ride Space Mountain 5 1.50

Price

$3

D MR

Q 250

A Graphical Look-Disneyland Pricing.


APPLICATION: The Price Club. The Price Club charges a annual

fee but only stocks items in large sizes.

Price Club claims it only “marks up” items by a small percentage.

This is an an example of a two-part tariff.

Price

P

D MR

0

Annual Fee or Profit: $35

2 gal.

MC

Market Separation-3rd Degree Price Discrimination

If the market can be separated into two or more categories, the monopolist may be able to charge different prices to different groups of consumers.

Market Separation

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

Price

Consumer Y Quantity

Demanded Total RevenueMarginal Revenue


Pay10 09 38 57 76 95 124 153 182 211 240 25

Consider two individuals (X and Y) whose demand schedules for the good are given above.

Fill in the empty columns for consumer y.

Market Separation

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

Suppose the market was composed of these two individuals.

What would the market demand schedule look like?

You would add up the demand of each individual at each price.

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

Market SeparationPrice

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

The market demand curve is the sum of the demand of each individual in the market.

The total willingness to pay for all consumers is the sum of the total willingness to pay of each individual in the market.

What is the maximum profit the monopolist could earn?

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

PriceMarket

DemandTotal


Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

Market Separation

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

Suppose the monopolist was restricted to using a simple pricing scheme, but could charge X and Y a different price and let them each buy as much as they wished at that price.

What price would they charge X and Y?

What would happen to the monopolist’s profit compared to charging them each the same price?

Compute.

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

PriceMarket

DemandTotal


Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

Market Separation

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

Simple pricing scheme:

Set MC=MR, produce 28 units and charge $3. Profits =$84.

Market Separation:

Set MC=MR, charge X-$2 and charge Y-$4 and produce 30 units. Profits =$90.

Market Separation increased profits by $6.

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

PriceMarket

DemandTotal


Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

Market Separation

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

How would you grade the market separation scheme just analyzed?

Could the monopolist do better?

Yes, there is $83 of unearned potential profit.

How much more could the monopolist get from each player?

$29 from X and $54 from Y.

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

PriceMarket

DemandTotal


Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

Market Separation

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

The basic underlying principle of market separation strategies is to separate potential buyers into groups based on their willingness to pay.

Then charge the groups with a high willingness to pay a high price and the groups with a low willingness to pay a low price.

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

PriceMarket

DemandTotal


Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

Market Separation

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

What are the distributional and welfare effects of market separation compared to a simple pricing scheme?

Market Separation increased the monopolist’s profit from $84 to $90-greater wealth redistribution from consumer to monopolist.

Because the number of units produced increased, production more closely approached the amount that would be produced in a competitive market so the deadweight loss to monopoly was reduced.

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

PriceMarket

DemandTotal


Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

Market Separation-3rd Degree Price Discrimination

Why don’t all firms engage in 3rd degree price discrimination or market separation pricing schemes? These schemes are possible only if certain conditions are met.

To engage in a market separation strategy, the monopolist must: Have a monopoly. Know demand or willingness to pay.

• Must have a way of separating customers into low and high willingness to pay groups.

• They can then charge the high willingness to pay customers a high price and the low willingness to pay customers a low price.

• Because an aware consumer would not be willing to voluntarily provide this information, the monopolist must use some other means of obtaining it.

Personal Characteristics-age, gender, etc. Geographic Location.

Prevent Resale.

Pricing for Multiproduct Monopolies-Bundling

If a firm has pricing power in markets for several related products, other strategies can be used. Firms can require users of one product to also buy a

related product such as coffee filters bought with coffee machines.

Firms can also create pricing bundles such as option packages on cars or computers.

Movies

20

A

B

C

D

15

Sports20158

APPLICATION: Bundling of Satellite TV Offerings

8

Theory of Program BundlingGraph shows the willingness to pay

of four consumers for two different packages of programming, movies and sports.

Two people, A and D, are willing to pay $20 per month for sports (A) or movies (D) but nothing for the other type of programming.B want sports but some movies and C wants movies with some sports.

Movies

20

A

B

C

D

15

Sports20158


8

If the monopolist charged $15 for each package, how much revenue would it generate?

Charging $15 per each package would yield $60 from these customers.D and C would buy movies.A and B would buy sports.

A bundling scheme that charges $20 per package, if purchased individually, or $23 if both are bought, would yield $86.Thus, revenue can be increased by the proper choice of pricing bundles of services.


Bundling by Direct TV, Inc. Bundling prices are shown in the table, where the incremental costs

help to demonstrate the bundling price scheme. Notice adding sports costs $10 extra, but the full movie package

adds $43 ($15 for Showtime and $28 for HBO/STARZ). Both packages together ($51) offers a minor savings over buying the

separate packages.

PackageCost

$/MonthIncremental

CostBasic 95 Channel Package 29.99 --Gold: Basic + Sports 39.99 10.00Basic + Showtime 44.99 15.00Basic + HBO/STARZ 57.99 28.00Basic + HBO/STARZ + Showtime 72.99 43.00Platinum: Basic + Sports + Movie 80.99 51.00

The Real World: Mix and Match Pricing Strategies.

We have discussed several different types of pricing schemes,

1. Simple pricing-single unit price, buy as much as you want.

2. Perfect Price Discrimination-each unit of the good bought is priced at the consumers marginal value.

3. Quantity Discounts-unit price falls as you buy more.

4. All or Nothing Offers-fixed fee for a specified amount.

5. Multi-Part Tariffs-entry fee for right to buy, then charge a single unit price.

6. 3rd Degree Price Discrimination-Market Separation-divide customers based on willingness to pay and charge high willingness to pay customers a high price and low willingness to pay customers a low price.

In the real world, monopolists mix and match, combining pricing schemes.

Combination Schemes

Price

Consumer X Quantity

DemandedTotal



10 0 0 0 09 0 0 0 08 0 0 0 07 1 7 7 76 2 12 5 135 4 20 4 234 6 24 2 313 10 30 1.5 432 15 30 0 531 21 21 -1.5 590 25 0 -5.25 59

A simple pricing scheme yields-$84.

3rd degree price discrimination plus simple pricing yields $90.

How could the monopolist get more by combining different schemes?

3rd degree price discrimination plus two-part tariff.

3rd degree price discrimination plus all-or-nothing offer.

Etc.

Price

Consumer Y Quantity

DemandedTotal



10 0 0 0 09 3 27 9 278 5 40 6.5 437 7 49 4.5 576 9 54 2.5 695 12 60 2 844 15 60 0 963 18 54 -2 1052 21 42 -4 1111 24 24 -6 1140 25 0 -24 114

PriceMarket

DemandTotal


Total Willingness

to Pay10 0 0 09 3 27 9.0 27.08 5 40 6.5 43.07 8 56 5.3 64.06 11 66 3.3 82.05 16 80 2.8 107.04 21 84 0.8 127.03 28 84 0.0 148.02 36 72 -1.5 164.01 45 45 -3.0 173.00 50 0 -9.0 173.0

Wealth Redistribution, Deadweight Loss and Monopoly- A Summary

Monopoly(a) Monopolist with Single Price

Price

0 QuantityQuantity sold

priceProfit

Deadweightloss

Demand

Marginal cost

Marginalrevenue

Consumersurplus

Quantity sold

(b) Monopolist with Perfect Price Discrimination

Price

0 Quantity

Profit

Demand

Marginal cost

Compared to a competitive market, a monopolist using simple pricing produces two few units of the good.

By restricting output and raising price, he causes a wealth redistribution from consumer to monopolist, but also produces too few units of the good creating a deadweight loss.

Wealth Redistribution, Deadweight Loss and Monopoly- A Summary

Monopoly(a) Monopolist with Single Price

Price

0 QuantityQuantity sold

priceProfit

Deadweightloss

Demand

Marginal cost

Marginalrevenue

Consumersurplus

Quantity sold

(b) Monopolist with Perfect Price Discrimination

Price

0 Quantity

Profit

Demand

Marginal cost

Monopolists who are able to successfully use more sophisticated pricing schemes, increase the wealth redistribution from monopoly while simultaneously expanding output and reducing the deadweight loss.

True, false, uncertain. Explain. Allowing monopolists to use more sophisticated pricing schemes is good for society?

Analyze.

Analyze.

Analyze.

Analyze.

Documents

Economics 310 Price Theory Chapters 10 and 11-Monopoly and Oligopoly. Department of Economics College of Business and Economics California State University-Northridge