(26) Monopoly Behavior

o How firms can enhance and exploit their market power

Price Discrimination

o Selling different units of output at different prices is called price discrimination. There
are three kinds of price discrimination:
o First-degree price discrimination means that the monopolist sells different units
of output for different prices and these prices may differ from person to person.
o Second-degree price discrimination means that the monopolist sells different
units of output for different prices, but every individual who buys the same
amount of the good pays the same price. Bulk discount.
o Third-degree price discrimination occurs when the monopolist sells output to
different people for different prices, but every unit of output sold to a given
person sells for the same price. Student discount.

First-Degree Price Discrimination

o A producer who can perfectly price discriminate will sell each unit of the good at the
highest price it will command, that is, at each consumer’s reservation price. Yielding
maximum profit and no consumer surplus.
o The outcome will be Pareto efficient, since there will be no way to make both the
consumers and the producer better off: the producer’s profit can’t be increased, since it is
already the maximal possible profit, and the consumers’ surplus can’t be increased
without reducing the profit of the producer.
o Can be seen as selling the good for a fixed price:

o The monopolist would offer to sell x 01 units of the good to person 1 at a price equal to the
area under person 1’s demand curve and offer to sell x 02 units of the good to person 2 at a
price equal to the area under person 2’s demand curve B.
 o Each person would end up with zero consumer’s surplus, and the entire surplus of A+B
would end up in the hands of the monopolist.

Second Degree Price Discrimination

o Non-linear pricing means the price per unit depends on how much you by buy,
commonly used by public utilities.
o Problem with First Degree price discrimination is the seller has no effective way to tell
apart person A and B. To get around this they use price-quantity packages to induce the
consumer to select the package meant for them.

o A monopolist would like to offer x 01 at price A and to offer x 02 at price A + B + C.

o This would capture all the surplus for the monopolist and generate the most profit.
o The high-demand consumer wants quantity x 01 and to pay price A; this creates a surplus
= B, which is better than the zero surplus if he chose x 02.
o One thing the monopolist can do is to offer x 02 at a price of A+C to yield more profit. The
high-demand consumer finds it optimal to choose x 02 and receive a gross surplus of A +
B + C and a net surplus of B same as if he chose x 01.
o By reducing x 01, the monopolist makes area A smaller (by the dark triangle) but makes
area C bigger (by the triangle plus the light trapezoid area). The net result is that the
monopolist’s profits increase.
o Ultimately, monopolist will reduce the amount offered to person 1 to the point where the
profit lost on person 1 due to a further reduction in output = the profit gained on person
2. The marginal benefits = costs of quantity reduction.
o Person 1 chooses x m1 and is charged A; person 2 chooses x 02 and is charged A + C
+ D. Person 1 ends up with a zero surplus and person 2 ends up with a surplus of
B — just what he would get if he chose to consume x m1 .
o The monopolist achieves this in real life by adjusting quality and not quantity to not
cannibalize sales on the high end.
o Without the low-end consumers, the high-end consumers would have zero surplus.
Third Degree Price Discrimination

o Let us use p1 ( y 1) and p2 ( y 2 )to denote the inverse demand curves of groups 1 and 2,
respectively, and let c ( y 1 + y 2 ) be the cost of producing output. Profit-maximization:
max p 1( y 1) y 1+ p 2( y 2) y 2−c ( y 1+ y 2)
o
y 1, y 2
o The optimal solution must have:
 MR1(y1) = MC(y1 + y2)
 MR2(y2) = MC(y1 + y2)
o Since marginal cost is the same in each market a good should bring the same
increase in revenue whether it is sold in market 1 or in market 2.
o The market with the higher price must have the lower elasticity of demand. An
elastic demand is a price-sensitive demand.
o A firm that price discriminates will therefore set a low price for the price-sensitive
group and a high price for the group that is relatively price insensitive.

o
o Allowing price discrimination will unambiguously increase total output, since the
monopolist will find it in its interest to sell to both markets if it can charge a
different price in each one.

Bundling

o Firms often choose to sell goods in bundles: packages of related goods offered for sale
together as is often a cost-saver or as complements.
o Let us assume that the marginal cost is negligible so that you only want to maximize
revenue. When you sell an item to several different people, the price is determined by the
purchaser who has the lowest willingness to pay. The more diverse the valuations of the
individuals, the lower the price you have to charge to sell a given number of items.
 o Bundling the word two goods reduces the dispersion of willingness to pay—
allowing the monopolist to set a higher price for the bundle of goods.

Two-Part Tariffs

o Consider a camera and film, the price of film influences the demand for a camera.
o Since the monopolist gets to charge people their consumers’ surplus, setting price equal
to marginal cost and the entry fee to the resulting consumer’s surplus is the profit-
maximizing policy.
o There is one price for admission, but then the attractions inside are free. It appears that
the marginal cost of the rides is less than the transactions cost of collecting a separate
payment for them.

Monopolistic Competition

o The measure of a monopoly is how unique a product is. Identical products in an industry
produce a flat demand curve. Raising the price would cause consumers to switch
products. This isn’t the case in a monopoly.
o The more successful a firm is at product differentiation the more their monopoly power it
has, the less elastic the demand curve.
o The industry structure is monopolistic if each firm has some market power in the sense
that it can set its own price, rather than passively accept the market price as does a
competitive firm. But must compete for customers in terms of both price and the kinds of
products they sell. There are also no barriers to entry.
o As more firms enter the industry for a particular kind of product:
o We would expect the demand curve to shift inward since at each price, we would
sell fewer units of output.
o We would expect that the demand curve facing a given firm would become more
elastic as more firms produced more and more similar products.
 o If firms continue to enter the industry if they expect to make a profit, equilibrium must
satisfy the following three conditions:
o 1. Each firm is selling at a price and output combination on its demand curve.
o 2. Each firm is maximizing its profits, given the demand curve facing it.
o 3. Entry has forced the profits of each firm down to zero.
o Another way to see this is to examine what would happen if the firm charged any price
other than the break-even price. At any other price, higher or lower, the firm would lose
money, while at the break-even price, the firm makes zero profits. Thus, the break-even
price is the profit-maximizing price.
o 1. Although profits are zero, the situation is still Pareto inefficient. Profits have
nothing to do with the efficiency question: when price is greater than marginal
cost, there is an efficiency argument for expanding output.
o 2. Firms will typically be operating to the left of the level of output where average
cost is minimized.
 If there were fewer firms, each could operate at a more efficient scale of
operation, which would be better for consumers.
 If there were fewer firms there would also be less product variety, and this
would tend to make consumers worse off.

A Location Model of Production Differentiation

o What is most efficient is often not the equilibrium. Product differentiation will give you
access to new markets while maintaing your current market. Why does Samsung produce
phones and aircons.

Product Differentiation

o Neither monopolist has an incentive to imitate the other, and the products are about as
different as they can get.
o It is possible to produce models of monopolistic competition where there is excessive
product differentiation. But it relies on excessive advertising to capture market power.
Summary:

1. There will typically be an incentive for a monopolist to engage in price discrimination of

some sort.
2. Perfect price discrimination involves charging each customer a different take-it-or-leave-it
price. This will result in an efficient level of output.
3. If a firm can charge different prices in two different markets, it will tend to charge the
lower price in the market with the more elastic demand.
4. If a firm can set a two-part tariff, and consumers are identical, then it will generally want to
set price equal to marginal cost and make all of its profits from the entry fee.
5. The industry structure known as monopolistic competition refers to a situation in which
there is product differentiation, so each firm has some degree of monopoly power, but there
is also free entry so that profits are driven to zero.
6. Monopolistic competition can result in too much or too little product differentiation in
general.
(28) Oligopoly

o Oligarchy: There are several competitors in the market, but not so many as to regard each
of them as having a negligible effect on price.

Choosing a Strategy:
o There are two firms producing a homogeneous good:

o When one firm decides about its choices for prices and quantities it may already
know the choices made by the other firm.
 Firm 1 choose the price price leader, firm 2 price follower.
 Firm 1 choose the quantity quantity leader, firm 2 quantity follower.
 The strategic interactions in these cases form a sequential game.

o It may be that when one firm makes its choices it doesn’t know the choices made
by the other firm.
 This is a simultaneous game. Again, there are two possibilities: the firms
could each simultaneously choose prices or each simultaneously choose
quantities.
o This classification scheme gives us four possibilities: quantity leadership, price
leadership, simultaneous quantity setting, and simultaneous price setting.
o Instead of the firms competing against each other in one form or another they may be
able to collude. In this case the two firms can jointly agree to set prices and quantities
that maximize the sum of their profits. This sort of collusion is called a cooperative
game.

Quantity Leadership:

o Suppose that firm 1 is the leader and that it chooses to produce a quantity y 1. Firm 2
responds by choosing a quantity y 2. Each firm knows that the equilibrium price in the
market depends on the total output produced. For the leader to make a sensible decision
about its own production, it must consider the follower’s profit-maximization problem.
o The follower wants to choose an output level such that marginal revenue equals marginal
cost:
∆p
o M R 2= p ( y 1+ y 2) + y =M C 2
∆ y2 2
o The important thing to observe is that the profit-maximizing choice of the follower will
depend on the choice made by the leader, so the reaction function.
o y 2=f 2 ( y 1)
o π 2 ( y 1 , y 2 )=[a−b ( y 1+ y 2) ] y 2 or π 2 ( y 1 , y 2 )=a y 2 −by 2 y 1−b y 22=π 2
o We can use this expression to draw the isoprofit lines. These are lines depicting those
combinations of y 1 and y 2 that yield a constant level of profit to firm 2.
o This is true since if we fix the output of firm 2 at some level, firm 2’s profits will increase
as firm 1’s output decreases. Firm 2 will make its maximum possible profits when it is a
monopolist; that is, when firm 1 chooses to produce zero units of output.

o
o Firm 2 reaction: