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Monopoly, Price Discrimination & Regulation

Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 9

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MC = ATC

MR

Demand

Figure 1a Can the monopolist do better than charge a single price?

ProfitProfitPM

ATC

Π/Q

QM

3

MC = ATC

MR

Demand

Figure 1b Can the monopolist do better?

ProfitProfitPM

ATC

Π/Q

Can the monopolist extract consumer surplus?

Can the monopolist expand output profitably beyond the single price monopolist level?

QM

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Price Discrimination Two types of monopoly

1. Single-price monopoly Firm that is limited to charging same price

for each unit of output sold

2. Price discrimination monopoly Different prices are charged to different

customers based on their willingness to pay for the good not based on prejudice, stereotypes, or

ill-will toward any person or group

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Requirements for Price Discrimination

Demand curve must be a downward-sloping demand curve for the firm’s output

Firm must be able to identify consumers willing to pay more

Firm must be able to prevent low-price customers from reselling to high-price customers Arbitrage

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Price Discrimination and Consumers

Why does monopoly like price discriminate? always benefits owners of a firm,

increasing its profit but harms some consumers

since price discrimination raises price for some consumer above price they would pay under a single-price policy

Additional profit for the firm is equal to monetary loss of consumers

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Figure 2a: Without price Discrimination-- price is $120 for all consumers

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E ATC

80

$120

DMR

MC

(a)

Number of Round-trip Tickets

Dollars per Ticket

Profits from standard monopoly profit maximization

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Figure 2b: Price Discrimination-- price is $160 for some consumers, which harms consumers

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Dollars per Ticket

120

DMR

MC

10

$160

Additional profit from price discrimination – charge a higher price for business traveler

Number of Round-trip Tickets

(b)

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Price Discrimination That Benefits Consumers

Price discrimination benefits monopoly at the same time it benefits a group of consumers

When price discrimination lowers price for some consumers below what they would pay under a single-price policy, it benefits consumers as well as firm Figure 2c

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Figure 2c: Price Discrimination-- Benefits consumers

Number of Round-trip Tickets

Dollars per Ticket

$120

DMR

MC

30

100

40

FG

H

Additional profit from price discrimination – charge discounted rate to students

(c)

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Perfect Price Discrimination Perfect price discrimination

Firm charges each customer the most the customer would be willing to pay for each unit he or she buys

By assuming that firms could somehow find out maximum price customers would be willing to pay for each unit of output it sells

It could increase profits even further, but at expense of consumers

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MC = ATC

MR

Demand

Figure 3b Perfect price discrimination: the monopolist charges each customer their reservation price

Profit: gap between reservation price and Profit: gap between reservation price and ATCATC

PM

ATC

QM QPD

Monopolist will produce Monopolist will produce at the efficient level at the efficient level

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Most monopolists cannot perfectly price discriminate

Discriminate by customer groups Regional markets Consumer groups (senior discounts,

volume users) Time of sale (on- vs. off-season; early bird

specials; day vs. night use, weekend vs. weekday)

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MC = ATC

MR

Demand

Figure 4 Can the monopolist do better than charge a single price?

P1

P3

QM

P2

Charge PCharge P1 1 for group 1 for group 1

Charge PCharge P2 2 for group 2 for group 2

Charge PCharge P3 3 for group 3for group 3

Additional Additional ΠΠ

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Application: Airline Ticket Price Lower price to students and non-business

travelers Higher price to business travelers Price discrimination is satisfied

Downward sloping demand curve Airline Companies are able to identify wiliness to pay

Saturday overnight stay Purchase time Round-trip or one-way

Can prevent resale of tickets by checking ID

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Price Discrimination and Elasticity

The types of consumers can be distinguished on the basis of their sensitivity to price Price elasticity of demand

High price is offered to consumers with low price elasticity of demand

Low price is offered to consumers with high price elasticity of demand

For businessmen and students, who have an relatively elastic demand for air ticket?

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MC

MR

Demand

Figure 5 How Can We Deal With DWL?

Producer surplus

Consumer surplus

Dead Weight Loss: DWL

PM

PC

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Anti-trust Law- Reduce DWL

Break the monopoly into several competing firms Guitar-lesson market would function very well

under competitive conditions, But breaking up a monopoly would not make sense

when the market would perform even worse with more competition

Monopolies that arise from patents and copyrights

Monopoly power that arises from network externalities

Monopoly arises as a natural monopoly

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The Special Case of Natural Monopoly

If breaking up a natural monopoly is not advisable, what can government do to bring us closer to economic efficiency?

1. Public ownership and operation Public takeover of private business is

rare Often works badly in practice

Few incentives to lower costs or offer higher quality products

Ends up serving political interests

2. Regulation

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MC

MR

Demand

Figure 6a Price Regulation: Government sets PR

Mimics Competitive Mimics Competitive EquilibriumEquilibrium

Monopolistic Monopolistic equilibriumequilibriumPM

= PCPR

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MC

MR

Demand

Figure 6b: Price Regulation: Government can make solution more efficient as long as PC < PR < PM

Competitive EquilibriumCompetitive Equilibrium

Monopolistic Monopolistic equilibriumequilibriumPM

PC

PR

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Regulation of Natural Monopoly

Regulators aim to achieve economic efficiency by telling the firm what price it can charge

Easy? Unfortunately, no. There is the matter of information

Regulators must be able to trace out firm’s MC curve as well as market demand curve

Monopolists may exaggerate the cost and still earn profits

Monopolists may offer low quality good or services

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Regulation of Natural Monopoly

Even with perfect information about monopolist’s cost and demand curves, regulators have a serious problem Look again at Figure 7a—notice that MC

curve lies everywhere below LRATC curve Firm will suffer a loss In long-run, it will go out of business

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Figure 7a: Regulating A Natural Monopoly

Unregulated Profit

B$15

$29

A

C

MC

$60

LRATC

50,000

DMR

85,000

100,000 Number of Household

s Served

Dollars

Unregulated monopoly

F

E

Losses with efficient output

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How To Regulate the Monopoly with MC<LRATC anywhere ?

1. Subsidize the firm for the loss part And set prices to MC Figure 7b

2. In practice, however, regulators determine a price that gives owners a “fair rate of return” for funds they’ve put into the monopoly

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Figure 7b: Regulating A Natural Monopoly

Unregulated Profit

B$15

$29

A

C

MC

$60

LRATC

50,000

DMR

85,000

100,000 Number of Household

s Served

Dollars

Unregulated monopoly

F

Efficient production (requires subsidy)

"Fair rate of return" production

Losses with efficient output

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Regulation of Natural Monopoly --Average Cost Pricing

Average cost pricing Most common solution

Not constrained to the case of loss P = cost per unit

where LRATC curve crosses demand curve

The natural monopoly makes zero economic profit

provides a fair rate of return, and keeps the monopoly in business

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Figure 7c: Regulating A Natural Monopoly

B$15

$29

A

C

MC

$60

LRATC

50,000

DMR

85,000

100,000 Number of Household

s Served

Dollars

Unregulated monopoly

"Fair rate of return" production

F

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Regulation of Natural Monopoly --Average Cost Pricing

Average cost pricing is not a perfect solution Does not quite make the market efficient Provides little or no incentive for the

natural monopoly to economize on capital

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Summary Perfect Price discrimination

Price are set along demand curve Can generate as efficient solution as perfectly

competitive market

Price discrimination generating higher profits, may harm or benefit consumers

Price are discriminated to groups of consumers Related with price elasticity of demand

Regulations on natural monopoly to reduce DWL To generate as close as possible efficient quantity Average cost pricing strategy