Lecture 17 Monopoly Applications Lecturer Martin Paredes 1

Lecture # 17 Monopoly: Applications Lecturer: Martin Paredes

1. 2. 3. 4. Natural Monopoly Multi-plant Monopoly Cartels Price Discrimination 2

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. l In other words, it is a market in which production is cheaper when there is only one firm. 3

l Suppose an industry with a decreasing average cost at all points. l If AC is always decreasing, then AC > MC. l Therefore, setting P = MC will not be profitable. 4

€ Example: Natural Monopoly Demand Quantity 5

€ Example: Natural Monopoly AC Demand Quantity 6

Example: Natural Monopoly € 2. 50 AC Demand 8000 Quantity 7

Example: Natural Monopoly € 4. 80 2. 50 AC Demand 4000 8000 Quantity 8

l l 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. 9

Note: l The definition of whether an industry is a natural monopoly depends on the size of the market. l See the following example where AC first falls and then raises. 10

Price Example: Natural Monopoly with Rising Average Cost AC Quantity 11

Price Example: Natural Monopoly with Rising Average Cost If demand is given by D 1, then the industry is a natural monopoly. AC D 1 Quantity 12

Price Example: Natural Monopoly with Rising Average Cost If demand is given by D 2, the industry is no longer a natural monopoly. AC D 1 D 2 Quantity 13

l l Suppose a monopolist has two plants, but each plant has different marginal costs: l Plant 1: MC 1(Q) l Plant 2: MC 2(Q) How should the monopolist allocate production across the two plants? 14

l When the marginal costs of the two plants are not equal, the firm can increase profits by reallocating production… l Away from the plant with higher marginal cost. l Towards the plant with lower marginal cost. 15

l Example: l Suppose: MC 1 = 4 Q MC 2 = 2 Q l Suppose the monopolist produces 100 units. l Will it choose to split the production equally between both plants? l MC 1 = 4*50 = 200 l MC 2 = 2*50 = 100 l Reducing production in plant 1 units and increasing it in plant 2 raises profits Þ Produce more than 50 units in plant 2. 16

Example: Multi-Plant Monopolist € MC 1 200 • 100 • 50 MC 2 Quantity 17

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. l l 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 18

l Back to example: l Given: MC 1 = 4 Q MC 2 = 2 Q l For a marginal cost of € 200: l Plant 1 can produce 50 units l Plant 2 can produce 100 units. l So the total production for a cost of € 200 is 150 units l In fact: MCT = 4 Q 3 19

Example: Multi-Plant Monopolist € MC 1 200 MC 2 • 50 Quantity 20

Example: Multi-Plant Monopolist € MC 1 200 • 50 MC 2 • 100 Quantity 21

Example: Multi-Plant Monopolist € MC 1 200 • 50 MC 2 • • 100 150 Quantity 22

Example: Multi-Plant Monopolist € MC 1 MC 2 MCT 200 • 50 • • 100 150 Quantity 23

l The profit maximization condition that determines optimal total output is now: MR = MCT l 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. 24

Price Example: Multi-Plant Monopolist Maximization MC 1 MC 2 MCT Quantity 25

Price Example: Multi-Plant Monopolist Maximization MC 1 MC 2 MCT Demand Quantity 26

Price Example: Multi-Plant Monopolist Maximization MC 1 MC 2 MCT Demand MR Quantity 27

Price Example: Multi-Plant Monopolist Maximization MC 1 MC 2 MCT P* • Demand Q*T MR Quantity 28

Example: Multi-Plant Monopolist Maximization Price MC 1 MC 2 MCT P* • • • Demand Q*1 Q*2 Q*T MR Quantity 29

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. 30

l The problem of the optimal allocation of output across cartel members is identical to the monopolist's problem of allocating output across individual plants. l If all firms have the same marginal cost curve, production will be equally divided. l If not, firms will higher marginal cost will produce less. 31

Definitions: l A monopolist charges a uniform price if it sets the same price for every unit of output sold. l A monopolist price discriminates if it charges more than one price for its output 32

Motivation: l 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. l The monopolist can overcome this by charging more than one price for its product. 33

Requirements: l Ability to sort/identify consumers l No possibility of resale or arbitrage. l Need market power. 34

Example: Prices for UA Flight 815 35

l Based on the classification by A. C. Pigou: l First degree price discrimination l Also called “personalized pricing”. l Second degree price discrimination l Also called “menu pricing”. l Third degree price discrimination l Also call “group pricing”. 36

Definition: A policy of first degree (or perfect) price discrimination attempts to price each unit sold at the consumer's maximum willingness to pay. l The consumer's maximum willingness to pay is also called the consumer's reservation price. 37

l Recall that the demand curve can be interpreted as the consumers’ willingness to pay for one unit of the good. l In other words, the demand curve represents the reservation prices of every consumer in the market. 38

l l 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. 39

Price Example: Monopoly MC D Quantity 40

Price Example: Uniform Pricing MC Pm : Consumer Surplus : Producer Surplus : Deadweight Loss D Qm MR Quantity 41

Price Example: First Degree Price Discrimination MC D Quantity 42

Price Example: First Degree Price Discrimination MC D Quantity 43

Price Example: First Degree Price Discrimination MC D Quantity 44

Price Example: First Degree Price Discrimination MC : Producer Surplus D Q* Quantity 45

Notes: l A perfectly price discriminating monopolist will produce and sell the efficient quantity of output. l When the monopolist sells an additional unit, it does not have to reduce the price on the other units it is selling. l Therefore, MR = P. (i. e. , the marginal revenue curve equals the demand curve. ) 46

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. l l The monopolist usually design a menu of options and let the consumer select its preferred package It involves quantity discounting. 47

l Examples of second degree price discrimination include: l Two-part tariff l Block pricing 48

Definition: A monopolist charges a two part tariff if it charges: l A per unit fee, r, plus l A lump sum fee F. l The lump-sum fee is paid whether or not a positive number of units is consumed. 49

With two-part tariffs, consumers that demand a high quantity are charge a smaller price per unit than consumers that demand a low quantity. l Examples include l Telephone landlines l Club membership l 50

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 51

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. l Examples include movie ticket sales to older people or students at a discount. 52

l l Suppose: l A monopolist faces two markets, each with a different demand curve l Marginal cost for the two markets is the same. How does a monopolist maximize profit with this type of price discrimination? 53

The monopolist will set the marginal revenue in each market equal to marginal cost. l In other words, the monopolist maximizes total profits by maximizing profits from each group individually. l At the optimum: MR 1 = MC = MR 2 l If not, the monopolist could raise revenues by switching sales from the low MR group to the high MR group. l 54

Example: Third Degree Price Discrimination P P Market 1 Market 2 D 1 Q Q 55

Example: Third Degree Price Discrimination P P Market 1 Market 2 D 1 MR 1 Q Q MR 2 56

Example: Third Degree Price Discrimination P P Market 1 Market 2 MC MC D 2 D 1 MR 1 Q Q MR 2 57

Example: Third Degree Price Discrimination P P Market 1 Market 2 P 1 P 2 D 1 Q 1 MR 1 Q Q 2 Q MR 2 58

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. 59

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. 60

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. 61