Chapter 12 - MonopolyGoals:

1. The sources of monopoly power

2. The monopolist’s problem

3. Seeking more surplus

Part 1: Price Discrimination

Part 2: Bundling Goods.

Sources of Monopoly Power.

Exclusive control over crucial inputs.

Economies of scale with a downward

sloping LAC natural monopolies

Network economies

Patents temporary monopoly rights

Licensing by governments or other

institutions

The Monopolist’s Problem.

The monopolist’s problem

◦ Objective of the monopolist : maximize

profits.

◦ Temporary assumption: the monopolist

charges a single price.

◦ In general:

Max (Q) = TR(Q) – TC(Q)=P(Q)*Q - TC(Q)

MR(Q) = MC(Q).

Note that MR(Q) = ( P/ Q)*Q + P(Q) ≠ P

optimum Q* and P*

Monopolist’s Problem

The Monopolist’s Problem

Example:

◦ A monopolist faces a demand for its product

given by: P=15 – 1/2Q. Its total cost takes the

following form:

◦ Find the monopolist’s profit maximizing price

and quantity. How much economic profit the

monopolist earn?

25TC Q

Seeking more surplus: Price

Discrimination. So far, monopolist charges a single price

to the entire market.

What if the monopolist can charge

multiple prices?

◦ First-degree price discrimination

◦ Second-degree price discrimination.

◦ Third-degree price discrimination.

Degree = ability to identify consumers.

Price Discrimination.

Third Degree Price Discrimination:

◦ Low ability to distinguish consumers.

◦ Consumers are divided in groups/markets.

◦ Charge different prices across

groups/markets.

◦ For each group, it is still a single price.

Price Discrimination

Third Degree Price Discrimination.

◦ Exercise: A monopolist faces two market segments each with a well defined demand function.

◦ Demand in market 1 is P = 10 – Q1

◦ Demand in market 2 is P = 20 – Q2

Total Cost =

If the monopolist exercises his monopoly power to price discriminate in the two market, what are the prices and quantity he charges in each market? What is his profit?

If the monopolist cannot price discriminate, what is the market price and quantity? What is his profit in this case?

1

1

2

2

2

0

0

5

MR MCQ

MR MCQ

Q

25 Q

Price Discrimination

Third Degree Price Discrimination – Steps to

solve the monopolist’s problem.Max = TR – TC

where TR = TR1 + TR2 and Q= Q1 + Q2

◦ First order conditions:

◦ Solve for Q1 and Q2.

◦ Substitute into the demand function to get P1 and P2.

1

1

2

2

0

0

MR MCQ

MR MCQ

Price Discrimination.

Third Degree Price Discrimination.

Price Discrimination.

Second Degree Price Discrimination.

◦ Charge small number of different prices in

one group/market (quantity discount)

Price Discrimination

Second Degree Price Discrimination.

◦ Exercise (Hurdle Model of Price Disc.)

A monopolist has the total cost curve as: TC=

He sets two price PH and PL . To be eligible to buy at PL, buyer needs to present a coupon cut from a local newspaper (hurdle).

Suppose the demand curve is: P = 20 – Q. What are the profit maximizing values of PH and PL . What is

the resulting economic profit?

A new law prevent the monopolist to price discriminate. What is his profit under this law?

Are buyers better or worse off under this new law?

25 Q

Price Discrimination

Second Degree Price Discrimination - Hurdle Model of Price Disc.◦ The monopolist charges two prices PL and PH

associated with quantity purchased QL and QH :Max = TR – TC

where TR = PHQH + PLQL , Q= QL + QH

and PH = a + bQH ; PL = a + b(QL + QH)

◦ First order conditions:

◦ Solve for QL and QH.

◦ Substitute into the demand function to get PL and PH.

0

0

L

L

H

H

MR MCQ

MR MCQ

Price Discrimination.

First-degree price discrimination:

◦ Charge different price for each different unit

purchased.

Price Discrimination.

Practical application – Two part Tariff.

◦ Necessary conditions:

Individual demand curves are all known

No arbitrage opportunity.

◦ Method:

Total amount (= tariff) the consumer pays for q units is

T(q) = F + p*q

F: fixed fee, p: per-unit charge

Result: Charge consumer p=MC and F equal to the would-be consumer surplus when p=MC.

Hence F is different for each consumer.

Special case: if consumers are identical F is equal across consumers.

Price Discrimination

First Degree Price Discrimination – 2 part tariff.

◦ Exercise: Consider the monopolist presented in the previous exercise with demand curve given by P=120 – Q and the MC =2Q.

◦ If the monopolist is allowed and is able to first price discriminate, using the two part tariff method to identify his fixed fee and the per unit price and quantity associated with that price.

◦ What happen to the DWL?

Other pricing method: Sell in

Bundle. Example: Sell Word and Excel separately

or sell the bundle called Microsoft office. Two types of consumers, A and B. A’s valuations are 120 for Word and 80 for Excel. B’s valuations are opposite: 80 for Word and 120 for Excel. MC=0.

Microsoft can sell all programs separately for 2*80+2*80=$320

Microsoft can also sell two times MS Office Suite for 2*200=$400