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Monopoly, Price Discrimination & Regulation
Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 9
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MC = ATC
MR
Demand
Figure 1a Can the monopolist do better than charge a single price?
ProfitProfitPM
ATC
Π/Q
QM
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MC = ATC
MR
Demand
Figure 1b Can the monopolist do better?
ProfitProfitPM
ATC
Π/Q
Can the monopolist extract consumer surplus?
Can the monopolist expand output profitably beyond the single price monopolist level?
QM
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Price Discrimination Two types of monopoly
1. Single-price monopoly Firm that is limited to charging same price
for each unit of output sold
2. Price discrimination monopoly Different prices are charged to different
customers based on their willingness to pay for the good not based on prejudice, stereotypes, or
ill-will toward any person or group
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Requirements for Price Discrimination
Demand curve must be a downward-sloping demand curve for the firm’s output
Firm must be able to identify consumers willing to pay more
Firm must be able to prevent low-price customers from reselling to high-price customers Arbitrage
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Price Discrimination and Consumers
Why does monopoly like price discriminate? always benefits owners of a firm,
increasing its profit but harms some consumers
since price discrimination raises price for some consumer above price they would pay under a single-price policy
Additional profit for the firm is equal to monetary loss of consumers
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Figure 2a: Without price Discrimination-- price is $120 for all consumers
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E ATC
80
$120
DMR
MC
(a)
Number of Round-trip Tickets
Dollars per Ticket
Profits from standard monopoly profit maximization
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Figure 2b: Price Discrimination-- price is $160 for some consumers, which harms consumers
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Dollars per Ticket
120
DMR
MC
10
$160
Additional profit from price discrimination – charge a higher price for business traveler
Number of Round-trip Tickets
(b)
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Price Discrimination That Benefits Consumers
Price discrimination benefits monopoly at the same time it benefits a group of consumers
When price discrimination lowers price for some consumers below what they would pay under a single-price policy, it benefits consumers as well as firm Figure 2c
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Figure 2c: Price Discrimination-- Benefits consumers
Number of Round-trip Tickets
Dollars per Ticket
$120
DMR
MC
30
100
40
FG
H
Additional profit from price discrimination – charge discounted rate to students
(c)
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Perfect Price Discrimination Perfect price discrimination
Firm charges each customer the most the customer would be willing to pay for each unit he or she buys
By assuming that firms could somehow find out maximum price customers would be willing to pay for each unit of output it sells
It could increase profits even further, but at expense of consumers
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MC = ATC
MR
Demand
Figure 3b Perfect price discrimination: the monopolist charges each customer their reservation price
Profit: gap between reservation price and Profit: gap between reservation price and ATCATC
PM
ATC
QM QPD
Monopolist will produce Monopolist will produce at the efficient level at the efficient level
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Most monopolists cannot perfectly price discriminate
Discriminate by customer groups Regional markets Consumer groups (senior discounts,
volume users) Time of sale (on- vs. off-season; early bird
specials; day vs. night use, weekend vs. weekday)
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MC = ATC
MR
Demand
Figure 4 Can the monopolist do better than charge a single price?
P1
P3
QM
P2
Charge PCharge P1 1 for group 1 for group 1
Charge PCharge P2 2 for group 2 for group 2
Charge PCharge P3 3 for group 3for group 3
Additional Additional ΠΠ
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Application: Airline Ticket Price Lower price to students and non-business
travelers Higher price to business travelers Price discrimination is satisfied
Downward sloping demand curve Airline Companies are able to identify wiliness to pay
Saturday overnight stay Purchase time Round-trip or one-way
Can prevent resale of tickets by checking ID
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Price Discrimination and Elasticity
The types of consumers can be distinguished on the basis of their sensitivity to price Price elasticity of demand
High price is offered to consumers with low price elasticity of demand
Low price is offered to consumers with high price elasticity of demand
For businessmen and students, who have an relatively elastic demand for air ticket?
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MC
MR
Demand
Figure 5 How Can We Deal With DWL?
Producer surplus
Consumer surplus
Dead Weight Loss: DWL
PM
PC
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Anti-trust Law- Reduce DWL
Break the monopoly into several competing firms Guitar-lesson market would function very well
under competitive conditions, But breaking up a monopoly would not make sense
when the market would perform even worse with more competition
Monopolies that arise from patents and copyrights
Monopoly power that arises from network externalities
Monopoly arises as a natural monopoly
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The Special Case of Natural Monopoly
If breaking up a natural monopoly is not advisable, what can government do to bring us closer to economic efficiency?
1. Public ownership and operation Public takeover of private business is
rare Often works badly in practice
Few incentives to lower costs or offer higher quality products
Ends up serving political interests
2. Regulation
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MC
MR
Demand
Figure 6a Price Regulation: Government sets PR
Mimics Competitive Mimics Competitive EquilibriumEquilibrium
Monopolistic Monopolistic equilibriumequilibriumPM
= PCPR
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MC
MR
Demand
Figure 6b: Price Regulation: Government can make solution more efficient as long as PC < PR < PM
Competitive EquilibriumCompetitive Equilibrium
Monopolistic Monopolistic equilibriumequilibriumPM
PC
PR
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Regulation of Natural Monopoly
Regulators aim to achieve economic efficiency by telling the firm what price it can charge
Easy? Unfortunately, no. There is the matter of information
Regulators must be able to trace out firm’s MC curve as well as market demand curve
Monopolists may exaggerate the cost and still earn profits
Monopolists may offer low quality good or services
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Regulation of Natural Monopoly
Even with perfect information about monopolist’s cost and demand curves, regulators have a serious problem Look again at Figure 7a—notice that MC
curve lies everywhere below LRATC curve Firm will suffer a loss In long-run, it will go out of business
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Figure 7a: Regulating A Natural Monopoly
B$15
$29
A
C
MC
$60
LRATC
50,000
DMR
85,000
100,000 Number of Household
s Served
Dollars
Unregulated monopoly
F
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How To Regulate the Monopoly with MC<LRATC anywhere ?
1. Subsidize the firm for the loss part And set prices to MC Figure 7b
2. In practice, however, regulators determine a price that gives owners a “fair rate of return” for funds they’ve put into the monopoly
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Figure 7b: Regulating A Natural Monopoly
B$15
$29
A
C
MC
$60
LRATC
50,000
DMR
85,000
100,000 Number of Household
s Served
Dollars
Unregulated monopoly
F
Efficient production (requires subsidy)
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Regulation of Natural Monopoly --Average Cost Pricing
Average cost pricing Most common solution
Not constrained to the case of loss P = cost per unit
where LRATC curve crosses demand curve
The natural monopoly makes zero economic profit
provides a fair rate of return, and keeps the monopoly in business
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Figure 7c: Regulating A Natural Monopoly
B$15
$29
A
C
MC
$60
LRATC
50,000
DMR
85,000
100,000 Number of Household
s Served
Dollars
Unregulated monopoly
"Fair rate of return" production
F
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Regulation of Natural Monopoly --Average Cost Pricing
Average cost pricing is not a perfect solution Does not quite make the market efficient Provides little or no incentive for the
natural monopoly to economize on capital
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Summary Perfect Price discrimination
Price are set along demand curve Can generate as efficient solution as perfectly
competitive market
Price discrimination generating higher profits, may harm or benefit consumers
Price are discriminated to groups of consumers Related with price elasticity of demand
Regulations on natural monopoly to reduce DWL To generate as close as possible efficient quantity Average cost pricing strategy