Transcript Lecture17

Lecture # 17
Monopoly: Applications
Lecturer: Martin Paredes
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Natural Monopoly
Multi-plant Monopoly
Cartels
Price Discrimination
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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.
 In other words, it is a market in which
production is cheaper when there is only one
firm.
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 Suppose an industry with a decreasing average
cost at all points.
 If AC is always decreasing, then AC > MC.
 Therefore, setting P = MC will not be
profitable.
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€
Example: Natural Monopoly
Demand
Quantity
5
€
Example: Natural Monopoly
AC
Demand
Quantity
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Example: Natural Monopoly
€
2.50
AC
Demand
8000
Quantity
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Example: Natural Monopoly
€
4.80
2.50
AC
Demand
4000
8000
Quantity
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 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.
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Note:
 The definition of whether an industry is a
natural monopoly depends on the size of the
market.
 See the following example where AC first
falls and then raises.
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Price
Example: Natural Monopoly with Rising Average Cost
AC
Quantity
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Price
Example: Natural Monopoly with Rising Average Cost
If demand is given by D1, then the
industry is a natural monopoly.
AC
D1
Quantity
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Price
Example: Natural Monopoly with Rising Average Cost
If demand is given by D2, the industry
is no longer a natural monopoly.
AC
D1
D2
Quantity
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 Suppose a monopolist has two plants, but each
plant has different marginal costs:
 Plant 1: MC1(Q)
 Plant 2: MC2(Q)
 How should the monopolist allocate
production across the two plants?
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 When the marginal costs of the two plants are
not equal, the firm can increase profits by
reallocating production…
 Away from the plant with higher marginal
cost.
 Towards the plant with lower marginal cost.
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
Example:
 Suppose:
MC1 = 4Q
MC2 = 2Q
 Suppose the monopolist produces 100 units.
 Will it choose to split the production equally
between both plants?
 MC1 = 4*50 = 200
 MC2 = 2*50 = 100
 Reducing production in plant 1 units and increasing
it in plant 2 raises profits
 Produce more than 50 units in plant 2.
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Example: Multi-Plant Monopolist
€
MC1
200
•
100
•
50
MC2
Quantity
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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.
 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
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
Back to example:
 Given:
MC1 = 4Q
MC2 = 2Q
 For a marginal cost of €200:
 Plant 1 can produce 50 units
 Plant 2 can produce 100 units.
 So the total production for a cost of €200 is 150 units

In fact:
MCT = 4 Q
3
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Example: Multi-Plant Monopolist
€
MC1
200
MC2
•
50
Quantity
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Example: Multi-Plant Monopolist
€
MC1
200
•
•
50
100
MC2
Quantity
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Example: Multi-Plant Monopolist
€
MC1
200
MC2
•
•
•
50
100
150
Quantity
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Example: Multi-Plant Monopolist
€
MC1
MC2
MCT
200
•
•
•
50
100
150
Quantity
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 The profit maximization condition that
determines optimal total output is now:
MR = MCT
 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.
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Price
Example: Multi-Plant Monopolist Maximization
MC1
MC2
MCT
Quantity
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Price
Example: Multi-Plant Monopolist Maximization
MC1
MC2
MCT
Demand
Quantity
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Price
Example: Multi-Plant Monopolist Maximization
MC1
MC2
MCT
Demand
MR
Quantity
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Price
Example: Multi-Plant Monopolist Maximization
MC1
MC2
MCT
P*
•
Demand
Q*T
MR
Quantity
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Example: Multi-Plant Monopolist Maximization
Price
MC1
MC2
MCT
P*
• •
•
Demand
Q*1 Q*2
Q*T
MR
Quantity
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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.
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 The problem of the optimal allocation of output
across cartel members is identical to the
monopolist's problem of allocating output
across individual plants.
 If all firms have the same marginal cost
curve, production will be equally divided.
 If not, firms will higher marginal cost will
produce less.
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Definitions:
 A monopolist charges a uniform price if it sets
the same price for every unit of output sold.
 A monopolist price discriminates if it charges
more than one price for its output
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Motivation:
 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.
 The monopolist can overcome this by charging
more than one price for its product.
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Requirements:
 Ability to sort/identify consumers
 No possibility of resale or arbitrage.
 Need market power.
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Example: Prices for UA Flight 815
Ticket Price
Number of
Passengers
 $2000
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Average
Advance
Purchase
12 days
$1000-$1999
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14 days
$800-$999
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32 days
$600-$799
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46 days
$400-$599
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65 days
$200-$399
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35 days
$1-$199
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26 days
$0
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 Based on the classification by A.C. Pigou:
 First degree price discrimination
 Also called “personalized pricing”.
 Second degree price discrimination
 Also called “menu pricing”.
 Third degree price discrimination
 Also call “group pricing”.
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Definition: A policy of first degree (or perfect)
price discrimination attempts to price each
unit sold at the consumer's maximum
willingness to pay.
 The consumer's maximum willingness to pay is
also called the consumer's reservation price.
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 Recall that the demand curve can be
interpreted as the consumers’ willingness to
pay for one unit of the good.
 In other words, the demand curve represents
the reservation prices of every consumer in
the market.
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 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.
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Price
Example: Monopoly
MC
D
Quantity
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Price
Example: Uniform Pricing
MC
Pm
: Consumer Surplus
: Producer Surplus
: Deadweight Loss
D
Qm
MR
Quantity
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Price
Example: First Degree Price Discrimination
MC
D
Quantity
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Price
Example: First Degree Price Discrimination
MC
D
Quantity
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Price
Example: First Degree Price Discrimination
MC
D
Quantity
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Price
Example: First Degree Price Discrimination
MC
: Producer Surplus
D
Q*
Quantity
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Notes:
 A perfectly price discriminating monopolist
will produce and sell the efficient quantity of
output.
 When the monopolist sells an additional unit, it
does not have to reduce the price on the other
units it is selling.
 Therefore, MR = P. (i.e., the marginal
revenue curve equals the demand curve.)
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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.
 The monopolist usually design a menu of
options and let the consumer select its
preferred package
 It involves quantity discounting.
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 Examples of second degree price discrimination
include:
 Two-part tariff
 Block pricing
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Definition: A monopolist charges a two part tariff
if it charges:
 A per unit fee, r, plus
 A lump sum fee F.
 The lump-sum fee is paid whether or not a
positive number of units is consumed.
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 With two-part tariffs, consumers that demand a
high quantity are charge a smaller price per
unit than consumers that demand a low
quantity.
 Examples include
 Telephone landlines
 Club membership
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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
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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.
 Examples include movie ticket sales to older
people or students at a discount.
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 Suppose:
 A monopolist faces two markets, each with a
different demand curve
 Marginal cost for the two markets is the
same.
 How does a monopolist maximize profit with
this type of price discrimination?
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 The monopolist will set the marginal revenue
in each market equal to marginal cost.
 In other words, the monopolist maximizes total
profits by maximizing profits from each group
individually.
 At the optimum: MR1 = MC = MR2
 If not, the monopolist could raise revenues
by switching sales from the low MR group to
the high MR group.
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Example: Third Degree Price Discrimination
P
P
Market 1
Market 2
D2
D1
Q
Q
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Example: Third Degree Price Discrimination
P
P
Market 1
Market 2
D2
D1
MR1
Q
Q
MR2
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Example: Third Degree Price Discrimination
P
P
Market 1
Market 2
MC
MC
D2
D1
MR1
Q
Q
MR2
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Example: Third Degree Price Discrimination
P
P
Market 1
Market 2
P1
P2
D2
D1
Q1
MR1
Q
Q2
Q
MR2
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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.
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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.
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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.
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