Chapter 11 Monopoly

ch12: Monopoly 1

Monopoly

Some introductory questions

Question 1: Why is the fast food restaurant next to Beacon Hill park so

expensive?

Question 2: Why do you often get a discount when showing your student

card?

Question 3: In the Thrifty’s on Hillside Robin Hood ‘all purpose’ flour costs

the following: 1kg = $2.39; 2.5kg =$4.59; 5kg =$7.49; and 10kg = $8.79.

How come the priceper kilogram decreases so drastically?

ch12: Monopoly 2

Organization

Setup• The sources of monopoly power

• The monopolist’s problem

• Solving the monopolist’s problem– About the optimal solution: Pricing vs. elasticity

• Welfare in monopolistic markets

• Seeking more surplus Part 1: price discrimination– First-degree price discrimination

– Second-degree price discrimination

– Third-degree price discrimination

• Seeking more surplus Part 2: bundling goods

ch12: Monopoly 3

The sources of monopoly power

Monopoly Greek: monos = single + polein = to sell

• Where do monopolists come from?

– What prevents market entry from occurring?

What prevents market entry?

• Exclusive control over crucial inputs

• Economies of scale AVC decreases natural monopolies

– Information as an important source of economies of scale

• Network economies

• Patents : temporary monopoly rights (currently 20 years)

• Licensing by governments or other institutions

– Often with: airports, gas stations at highways, etc.

– Exclusive license of UVic food service

ch12: Monopoly 4

The objective of the Monopolist

The monopolist’s problem– Objective of the monopolist (by assumption): maximize profits

– Temporary assumption: single price is charged

In general:

Profits = Revenue – Costs = R(q) – C(q)

– R(q) and C(q) are functions of quantity q

– R(q) = price x quantity = pq

– C(q) given by technology (see chapter 6)

The monopolist’s problem: such that p=P(q)

– In other words:

ch12: Monopoly 5

)(max qCpqq

)()(max qCqqPq

The objective of the Monopolist

In words: monopolist chooses output level q so as to maximize

profits. She uses her knowledge about market demand P(q)

Notes

• Two ways to write down relation between p and q:

– Demand function: q=D(p) (Chapter 4)

– p=P(q) “inverse demand function” (more useful here)

– Same relationship between p and q, but different notation

• Choosing prices vs. choosing quantities: same thing!

ch12: Monopoly 6

Solving the problem of monopolist

• General problem of profit maximizing firm:

• Necessary condition: R’(q)-C’(q)=0

• So, optimum q : marginal revenue = marginal cost

• Back to the monopolist’s problem:

• Necessary condition:

• Notice MR=MC.

ch12: Monopoly 7

)()(max qCqRq

)()(max qCqqPq

0)(')( qCqPqdq

dP

Solving the monopolist problem

Example: Linear demand, CRS technology

• P(q)=a-bq, C(q)=cq

• Necessary condition: -bq+a-bq-c=0

ch12: Monopoly 8

cqqbqaq

)(max

)(2

1

2

,2

cab

cabap

sob

caq

M

M

Monopolist problem

Lerner Index (a measure of markup): • Lerner Index =

• Derivation:– F.O.C. Monopolist :

– Rearranging yields:

– Or, put differently : Lerner index = , where– is the price - elasticity of demand

• Example: if =2 then profit max. markup should be 100% or profit max. price should be twice the marginal cost.

ch12: Monopoly 9

P

MCP

)(')( qCqPqdq

dP

)()(

)(')(

qP

q

dq

dP

qP

qCqP

/1

Monopolist problemGraphically

FIGURE 12-9

The Profit-

Maximizing Price

and Quantity for

a Monopolist

ch12: Monopoly 10

Welfare in monopolist markets

• The single monopoly price is higher than the socially optimal

price (perfectly competitive outcome). The welfare cost of the

resulting low quantity is called the deadweight loss (welfare

loss) of monopoly power.

ch12: Monopoly 11

Welfare in monopolist markets

• Socially optimal allocation is at (p2,q2)

ch12: Monopoly 12

Price discrimination12.6 How can the monopolist increase profitability?

– Can the monopolist somehow get higher profits? Is there a way to capture part of the

deadweight loss and the consumer surplus?

• Method 1 price discrimination: charge different consumers a different price for

the same good.

– Only effective if arbitrage is not possible. Arbitrage: consumers can

sell to each other

• First-degree price discrimination / Perfect price discrimination

• Second-degree price discrimination. Example: quantity discounts

• Third-degree price discrimination. Example: student discounts

• Method 2 bundling: combining and selling two or more goods

ch12: Monopoly 13

First degree price discrimination

ch12: Monopoly 14

First degree price discrimination

Special Application –Two part Tariff.

• Necessary conditions:

– Individual demand curves are all known

– No arbitrage opportunity.

Method:

– Total amount (= tariff) the consumer pays for q units is

– T(q) = F + p*q

– F: fixed fee, p: per-unit charge

– Result: Charge consumer p=MC and F equal to the would-be consumer surplus when p=MC.

• Hence F is different for each consumer.

• Special case: if consumers are identical F is equal across consumers.

ch12: Monopoly 15

Third degree price discrimination

ch12: Monopoly 16

Third degree price discrimination

ch12: Monopoly 17

Second degree price discrimination

Second-degree price discrimination:• The monopolist post a schedule along which price declines with the

quantity one buys, i.e. quantity discount.

• “Price discrimination within markets”

• Examples: quantity discounts, coupons, regular price fluctuations

Two-part tariff T(q) = F + vq is again one pricing scheme that does the job

• Example: If F=3, v=2 then we have T(1)= 5, T(2)=7, T(3)=9

• Observe F>0 implies there is a quantity discount

• Examples: Buying flour at the Thrifty’s?; taxi rides; utility and phone bills; shopping at Costco; Disneyland

ch12: Monopoly 18

Method 2: Bundling

So far, we assumed the monopolist produces just 1 good– What about monopolists with multiple products?

Topic 2: Bundling products– Example: Sell Word and Excel separately or sell the bundle called

Microsoft office? Two types of consumers, A and B. A’s valuations are 120 for Word and 80 for Excel. B’s valuations are opposite: 80 for Word and 120 for Excel. MC=0.

• Microsoft can sell all programs separately for 2*80+2*80=$320

• Microsoft can also sell two times MS Office Suite for 2*200=$400

ch12: Monopoly 19