Chapter 26 Monopoly Behavior Key Concept the seconddegree
• Chapter 26 Monopoly Behavior • Key Concept: the second-degree price discrimination. • We see how the low end is distorted and how the high end is given some surplus.
• Chapter 26 Monopoly Behavior • We have seen two extremes, the competitive market and the monopolized market. • In reality, most industries are in between.
• A firm which has some monopoly has more options than a firm in a perfectly competitive industry. • It can use complicated pricing and differentiate itself. • We will examine how firms enhance and exploit their market power.
• A monopolist is inefficient (produces too little) because producing more implies the price has to be lower. • This is not the case if a monopolist can sell different units of outputs at different prices or price discriminate.
• First-degree price discrimination (perfect price discrimination): the monopolist sells different units of outputs for different prices and these prices may differ from person to person. • Second-degree price discrimination: prices differ across the units of goods, but not across people. • Third-degree price discrimination: prices differ across people, but a given person pays the same price for all units.
• First-degree: unit and person • Second-degree: unit • Third-degree: person
• First-degree: every unit is sold to the consumer who values it most highly at the highest price the consumer is willing to pay for it.
• Since the monopolist leaves no consumers’ surplus, all surplus goes to the monopolist. • Rightly because consumers are left with no surplus, when considering marginally increasing one unit, the monopolist is comparing the marginal willingness to pay to MC. • Therefore, SS is maximized.
• We have interpreted the first-degree price discrimination as selling each unit at the maximum price a monopolist could command. • We can also think of it as selling a fixed amount of the good at a “take it or leave it” price.
• Second-degree: also known as non-linear pricing since the price per unit of output is not constant, but depends on how much you buy.
• For instance, 1 may be a business traveler and 2 may be a tourist. • A monopolist may want to charge 1 A plus cost and 2 B plus cost. • But how can we tell 1 from 2?
• The monopolist can offer different pricequantity packages so that the consumers can self select.
• Imagine a case with consumers 1 and 2. • The MC is set to 0.
• A monopolist would want to offer x 10 at price A and x 20 at price A+B+C. • Can we mimic the perfect discrimination? • Who will mimic whom?
• By self-selection, the high-end consumer would rather choose x 10 at price A because this would leave him the surplus of B. • If he instead chooses x 20 at price A+B+C, his surplus is 0.
• Can we mimic the perfect discrimination? • Who will mimic whom?
• To leave the surplus B to 2, a monopolist could try (x 10, A) and (x 20, A+C). • The monopolist would then earn A from 1 and A+C from 2. • Is this the best a monopolist can do?
• Intuition suggests that distorting 1’s package a bit may be worthwhile. • Note that the low-end consumer’s package is distorted so that the high-end consumer will not choose the low-end package.
• Compared with perfect price discrimination, without high-end, low-end is offered higher quantity but still ends up with zero surplus. • Without low-end, high end gets zero surplus, now gets positive surplus and the quantity offered is the same.
• Applying this to air travels, by offering a downgraded product, the airlines can charge the consumers who need flexible travel arrangements more for their tickets.
• The third class rail carriage has no roof in 19 th century France. • What the company is trying to do is prevent the passengers who can pay the second-class far from traveling the third class; it hits the poor, not because it wants to hurt them, but to frighten the rich.
• Third-degree: the most common form of price discrimination. • Ex: Student discounts, senior citizens’ discounts, a higher price for the tourists.
• Suppose there are two groups of people and there is no resale. • Then the monopolist’s profit maximization problem becomes • maxy , y (=p 1(y 1)y 1+ p 2(y 2)y 2 -c(y 1+y 2)) 1 2 • FOC becomes MR 1(y 1)=MC(y 1+y 2)=MR 2(y 2).
• MR 1(y 1)=p 1(y 1)[1 -1/| 1|] • MR 2(y 2)=p 2(y 2)[1 -1/| 2|] • Hence p 1>p 2 if and only if | 1|<| 2|. • The market with lower absolute value of elasticity has a higher price. • Quite sensible since elasticity measures how sensitive the group is to prices.
• There are some other often-observed practices used by firms with monopoly power.
• Bundling: packages of related goods are often offered for sale together. • A software suite (office) consists of a word processor (word), a spreadsheet (excel), presentation tool (power point).
• Bundling may be cost saving or it may be due to complementarities among the goods involved. • But there can be reasons involving consumer behavior. Consider the following example. • Assume the marginal cost of producing is zero.
• Type of consumers word pro spreadsheet A 120 100 B 100 120 • Suppose the willingness to pay for the bundle is the sum.
• Type of consumers word pro spreadsheet A 120 100 B 100 120 • If each item is sold separately, then revenue will be 400. • If instead bundling two goods together, the revenue will be 440. In other words, the dispersion of willingness to pay may be reduced.
• Two-part tariffs: amusement park (entry fee + charge per ride), razor (razor + blade). • An amusement park can set one price for tickets to get into the park and another price for the rides.
• The price that people are willing to pay to get into the park will depend on the price they have to pay for the rides. • This gives a two-part pricing scheme called a two-part tariff.
• Consider an example where MC is constant. • People go to the park for the rides. • Optimum is to set the charge per ride to the marginal cost, then set the entry fee to extract all the consumers’ surplus.
• Hotelling model: consumers populate uniformly on a line and two firms have to choose a position. • They go to the store that is closest. • We have too little product differentiation! • Apply this to voting.
• Chapter 26 Monopoly Behavior • Key Concept: the second-degree price discrimination. • We see how the low end is distorted and how the high end is given some surplus.
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