terry college of business - econ...

Terry College of Business - ECON 7950

Lecture 6: Monopoly

Primary reference: McAfee, Competitive Solutions, Ch. 11

Monopoly

I One firm in a market.I Monopoly occurs when two conditions are satisfied.

I There exists a product or a set of products with no closesubstitutes.

I There are high barriers to entry.

I Monopoly typically occurs in one of three situations.I Control of a scarce resource with no close substitutes

(example: the DeBeers diamond company).I Government regulation (example: utilities, patented

pharmaceuticals).I Markets that yield profits that are too small for more than one

firm.I Is the merged entity XM/Sirius a “monopolist?”I Not really. The FTC and DoJ ruled that XM/Sirius competed

so much against terrestrial radio (a close substitute), thattheir “monopoly” of satellite radio would not result insignificant, lasting price increases.

Monopoly Pricing

I A monopolist has complete market power, in that itscustomers have no alternatives.

I This is like having all of the red cards in the Card Game. Ifsomeone with a black card wants to make money, they mustdo business with the person holding the red cards.

I A monopolist has no strategic rivals. Unless its set ofcustomers is very small, it doesn’t really have strategicinterdependence with anyone.

I In a bilateral monopoly (1 buyer, 1 seller), such as the hold-upproblem example, each monopolist interacts strategically withthe other monopolist.

I In essence, a monopolist with a large number of customers isable to make take-it-or-leave-it offers to all customerssimultaneously.

I This is kind of what Nintendo did in the late 1980s, right?

DeBeers

I The first diamond discovery in 1867 led to a diamond rush inthe 1870s. Prices fluctuated wildly in the 1870s and 1880s asthe market, which included lots of small claimants, wasflooded from time to time.

I Cecil Rhodes patiently bought up claims and eventually set hissights on the Kimberley mine, the largest.

I Rhodes outwitted Barry Barnatto to gain majority control ofthe Kimberley mine, forcing Barnatto to merge with him.

I DeBeers consolidated mines formed in 1888 in South Africa.At the time, DeBeers controlled 95% of the world’s uncutdiamonds.

I DeBeers’ share of the world’s uncut diamonds fluctuatedbetween 60-95% throughout the 20th century.

DeBeers: A Diamond is Forever

I Cecil Rhodes decided to base the supply of diamonds onnumber of weddings in diamond buying nations, mostimportantly the US.

I The N.W. Ayer agency coined the slogan “a diamond isforever” in 1947. This conjures romance and reinforcesDeBeers goal of not having recycled diamonds on the market.

I After conquering the US, DeBeers looked elsewhere andgenerally succeeded. In 1967, only 6% of Japanese bridesreceived diamonds upon engagement. By 1982, the numberwas 65%.

DeBeers: The Central Selling Organization

I DeBeers routed all uncut diamond sales through one office inLondon, the CSO.

I Ten times a year, the CSO conducted “sights” for about 150buyers.

I Buyers could request an amount of stones and a quality grade.

I The buyers traveled to London to inspect the stones.

I DeBeers made a take-it-or-leave-it offer for a particular packetof stones. No cherry picking, no haggling over price.

I Buyers refusing the offer were not invited back.

I Now this is a lot like the Card Game.

Monopoly: The Basic Single-Price Model

I The monopolist chooses an optimal P∗ that is a mark up overunit cost,

P∗ − C

P∗ =1

ϵ,

where ϵ is the elasticity of demand at price P∗

Monopoly: The Basic Single-Price Model - Inefficiencies

I The single-price monopoly outcome is a good one for themonopolist, but is still inefficient.

I They could sell some units for a price between C and P∗, andearn additional profit...but how might they do this?

Early Adopter Pricing - The iPhone

I In the summer of 2007, Apple introduced the iPhone at aprice of $600.

I Ten weeks later, they dropped the price to $400.

I In principle, this partly solves the problem of inefficiency witha single price. The monopolist gets to charge consumers witha high willingness to pay what they will pay, and chargeconsumers with a low willingness to pay what they will pay.


I There’s a problem, though...


I Consumers who paid $600 were livid!

I Why? They knew they could have waited a short period oftime and paid less.

I Apple eventually offered $100 vouchers for iTunes toconsumers who paid $600 for the iPhone.

I Presumably, some consumers willing to pay $600 did wait,probably expecting it to take longer before Apple dropped theprice. Who would wait?


I Suppose customers get services over four periods. A customerwho gets $150 worth of services per period is just willing topay $600 in the first period for the iPhone...assuming that theprice will never be lower. A company might even promise tonever change the price...but

I What if the company changes its mind a period later, after ithas already picked off the early adopters? It will lower price.

I If this same customer anticipates the price dropping to $400in the second period, he will strictly prefer to wait until thesecond period, as he would get 3 × $150 = $450 worth ofservices and pay only $400, yielding an extra surplus of $50over what he gets by buying in the first period.

I This lowers first-period demand. Because the good is durable(it delivers services over multiple periods), the monopolist hasa commitment problem...because it will be a greedyprice-cutter in the future, it competes against a price cutter(itself) in the present.

The Coase Conjecture

I Ronald Coase reasoned that if firms sell durable goods andcannot commit to not lower prices later, consumers willanticipate such future cuts and be less willing to pay today.

I In a roundabout way, this is exactly what happened with theiPhone. Customers who would have waited complained andgot rebates. The story is a bit different because they actuallydidn’t wait to buy. What would have changed had Applewaited longer before dropping the price?

I The moral of the story is that a monopolist selling a durablegood does face a situation with strategic interaction...withitself. This can be overcome.

Overcoming the Durable Goods Problem

I In the 1960s, Xerox overcame this problem by primarilyleasing its fleet of plain-paper copiers.

I This effectively removes the durability factor out of pricingdecisions. Now a price is charged per period for services.

I Artists who make prints commit to a fixed number bydestroying the mold and writing the total number of printsmade on each print.

I This (partially) removes the greedy future self from the picture.

Price Discrimination

I The example we just saw illustrates (intertemporal) pricediscrimination, where different consumers are chargeddifferent prices for the same good.

I What about charging different prices in the same period?

I To do it, you need to be able to segment the market andprevent resale

You Must Be Able to Segment the Market

I Pharmaceutical prices vary by country.

I They are high in the US, lower elsewhere. In 1998 a 20mgdose of fluoxetine (Prozac, Sarafem) cost $72.16 in the US,less than half that in most European countries.

I As a result, Texans have an incentive to travel to Mexico tobuy drugs. Most Americans cannot do this, however.

You Must Be Able to Prevent Resale

I Methyl methacrylate (MM) was sold by duPont and Rohm &Haas in the 1940s, acting as a cartel.

I MM has a variety of industrial uses as a plastic.

I MM is particularly good for making dentures.

I The two firms charged $.85 per pound (as a powder) for MMfor industrial uses and charged $22.00 per pound (as a liquid)for MM to licensed dental labs.

I There were other differences, but bootleggers nonethelesssuccessfully bought the powder, reworked it and sold it to thedental labs at a discount.

I Rohm & Haas apparently debated adulterating the product soit would be unhealthy to use in dentures, and eventually justplanted a rumor that they had done so.

Types of Price Discrimination (Pigou 1920)

I First-Degree price discrimination: charge a different price toeach consumer.

I Second-Degree price discrimination: offer a menu ofdifferent combinations of price and quality or price andquantity, allowing consumers to choose.

I Third-Degree price discrimination: charge differentconsumers different prices based on an observablecharacteristic, such as age

Third-Degree Price Discrimination

I This is the simplest type of price discrimination, conceptually.

I Suppose you are selling movie theater tickets and have twogroups of customers, students and non-students. It is possibleto identify students by requiring an ID and the cost of servingthem is identical, C per customer.

I Suppose you know the demand curves for students andnon-students, and that they are different. Then your optimalpricing structure is

P∗S−CP∗S

= 1ϵS

P∗NS−CP∗NS

= 1ϵNS

I If ϵS > ϵNS , then students are charged less.

Third-Degree Price Discrimination

Elasticity and Price Discrimination

I Recall that the price elasticity of demand measures the %increase in quantity demanded resulting from a 1% decreasein price.

I With ϵ = 2, a 10% drop in price results in a 20% increase inquantity demanded.

I When demand from a group of consumers is such that ϵ ishigher, the consumers are more price sensitive.

I Optimal third-degree price discrimination calls for charginglower prices to more price sensitive customers, like students orsenior citizens at movie theaters.

I Note that to do this, you need an observable characteristicthat is correlated with price sensitivity.

First-Degree Price Discrimination

I Suppose a set of N consumers each demand one unit of agood.

I Suppose each consumer has a different reservation value forthe good, and that the monopolist knows this value.

I Let’s rank the reservation values, such thatv1 > v2 > ... > vN .

I For simplicity, suppose the good is produced without cost.

First-Degree Price Discrimination

I Demand for the good follows a stair-step pattern. For pricesbetween v1 and v2, say, total demand does not change.

First-Degree Price Discrimination: Optimal Prices

I Charge consumer 1 a price of P1 = v1, charge consumer 2 aprice of P2 = v2, ..., charge consumer N a price of PN = vN .

I The monopolist captures all of the surplus.

First-Degree Price Discrimination: Examples

I To execute first-degree price discrimination, you must knowboth the preferences and income levels of your customers, i.e.a lot of stuff.

I Service providers with repeat customers could learn suchinformation.

I Prior to reformation, the Roman Catholic Church had (withinthe Christian community) a monopoly on salvation. Thispermitted them to extract surplus from parishioners thatdepended on their wealth (Ekelund, Hebert and Tollison).

I Small-town doctors might accept cakes or other baked goodsfrom their lower-income customers as payment for services.

I Sellers with the ability to force information revelation couldalso learn such information.

I Elite colleges grant “financial aid” to students based on theirability to pay. Colleges typically require applicants to fill outthe Free Application for Federal Student Aid (FAFSA) form.Using this form, they determine what someone can pay andcharge them that for admission.

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