Industrial Organization

Week 1. Lecture 3. Monopoly

Mikhail Drugov

New Economic School - Egor Gaidar Foundation

Summer School

27 June 2017

Industrial Organization, Week 1, Lecture 3 1 / 15

Monopoly: Plan

I Monopoly maximization problem (lecture 3)

I Multiproduct monopoly (lecture 3)
I Price discrimination (lecture 4)
I Bundling and tying (lecture 5)
I Durable goods (lecture 5)

Industrial Organization, Week 1, Lecture 3 2 / 15

Monopoly

I A sole supplier of a good for which there is no close substitute

I Full (maximum) market power
I Sources of monopolistic power
I Merger
I Technological advantage
I technology, know-how
I access to critical resource
I State-created monopoly
I patents, legislation
I Natural monopoly
I e¢ cient size of a …rm is too large, only one …rm survives on
the market

Industrial Organization, Week 1, Lecture 3 3 / 15

Monopoly: maximization problem

I The problem of the monopoly is

max pD (p ) C (D (p ))
p

or equivalently
max qP (q ) C (q )
q

I First-order condition at q = q m or p = p m

P (q ) + qP 0 (q ) = C 0 (q ) or D (p ) + pD 0 (p ) = C 0 (D (p ))D 0 (p )

I Second-order condition:

2P 0 (q m ) + q m P 00 (q m ) C 00 (q m ) < 0

I Su¢ cient conditions: P 00 0 and C 00 0

Industrial Organization, Week 1, Lecture 3 4 / 15

Monopoly: pricing rule
I Rewrite the FOC as
P (q m ) C 0 (q m ) q m P 0 (q m )
=
P (q m ) P (q m )
I That is, Lerner Index = 1ε , where ε is the demand elasticity
P (q m ) D 0 (p m )p m
with respect to the price: ε = P 0 (q m )q m = D (p m )
I Lower elasticity leads to a higher mark-up
I On which part of the demand curve does monopoly operate?
I Rewrite the FOC
1
MR (q m ) = P (q m ) + q m P 0 (q m ) = 1 P (q m )
ε
I Thus, MR (q m ) > 0 if and only if demand elasticity ε > 1
I Exercise: solve the monopoly problem in case of constant
marginal cost and (a) linear demand, (b) isoelastic demand
q = p ε . Check also the second-order condition
Industrial Organization, Week 1, Lecture 3 5 / 15
Monopoly: e¢ ciency
I Monopolistic pricing is not socially optimal: P > C 0
) Dead-weight loss

I The government can subsidize monopoly to restore e¢ ciency

I Exercise: derive e¢ ciency restoring per unit subsidy s
Industrial Organization, Week 1, Lecture 3 6 / 15
Monopoly: e¤ect of higher marginal cost

I What happens if marginal costs increase?

I Take C20 (q ) > C10 (q ) for any q > 0
I If the monopoly chooses p1m and p2m , respectively, this means

p1m q1m C1 (q1m ) p2m q2m C1 (q2m ) and

p2m q2m C2 (q2m ) p1m q1m C2 (q1m )

I Summing up:

[C2 (q1m ) C2 (q2m )] [C1 (q1m ) C1 (q2m )] 0

Z qm
1
, C20 (x ) C10 (x ) dx 0
q 2m

I Since C20 (x ) > C10 (x ) for all x, then q1m q2m

I Exercise: prove this di¤erently for constant marginal cost
Industrial Organization, Week 1, Lecture 3 7 / 15
Monopoly: multiple products
I Monopolist produces several goods and has monopolistic
power in all the markets
I Demands (p = (p , ..pn ) is the vector of all the prices)
1

qi = D i ( p )
I Cost of production
C (q1 , ..., qn )
I Monopolist solves
n
max
p 1 ,p 2 ,...,p n
∑ pi D i ( p ) C (D1 (p ), ..., Dn (p ))
i =1
I FOCs for each j:
n n
∂Di ∂C ∂Di
D j + ∑ pi =∑
i =1 ∂pj i =1 ∂Di ∂pj
I Several cases: (in)dependent demands, (in)dependent costs
Industrial Organization, Week 1, Lecture 3 8 / 15
Monopoly: multiple products
Independent demands, independent costs

I C (D1 (p ), D2 (p ), ..., Dn (p )) = ∑ni=1 Ci (Di (p ))

I Di (p ) does not depend on p i
I FOC from the previous slide
n n
∂Di ∂C ∂Di
D j + ∑ pi =∑
i =1 ∂pj i =1 ∂D i ∂pj

∂D (p ) ∂C (D 1 (p ),...,D n (p )) ∂C i (D i (p ))
I Since ∂pi j = 0 for i 6= j and = ,
∂(D i (p )) ∂(D i (p ))
this condition becomes

Dj + pj Dj0 = Cj0 Dj0

I Of course!

Industrial Organization, Week 1, Lecture 3 9 / 15

Monopoly: multiple products
Independent demands, dependent costs

I FOCs take the following form

∂Dj ∂C ∂Dj
Dj + pj =
∂pj ∂Dj ∂pj
or
1 Dj C0
=
Dj εj
I The same formula as in case of a single product but the
marginal cost depend on the total output
I Example: Learning by doing
I Costs are reduced over time due to learning
I Model
I Two periods
I Demand in each period: Dt (pt )
I Cost: C1 (q1 ), C2 (q2 , q1 ), where ∂∂Cq12 < 0
I Discounting δ between periods
Industrial Organization, Week 1, Lecture 3 10 / 15
Monopoly: multiple products
Independent demands, dependent costs: Learning by doing

I Monopolist solves
max p1 D1 (p1 ) + δp2 D2 (p2 ) C1 (D1 (p1 )) δC2 (D2 (p2 ), D1 (p1 ))
p 1 ,p 2
I Monopolist’s FOCs
∂D2 (p2 ) ∂C2 (D2 (p2 ), D1 (p1 )) ∂D2 (p2 )
D 2 ( p2 ) + p2 =
∂p2 ∂(D2 (p2 )) ∂p2

∂C2 (D2 (p2 ), D1 (p1 ))

D1 (p1 ) + p1 D10 (p1 ) = C10 + δ D10 (p1 )
∂(D1 (p1 ))
0 0
< C1 D 1 ( p1 )
I Monopolistic price in the second period
I Price below the single-period myopic level (MR1 < MC1 ) in
the …rst period
I more output in the …rst period to decrease the second-period
costs
Industrial Organization, Week 1, Lecture 3 11 / 15
Monopoly: multiple products
Dependent demands, independent costs

I FOCs take the following form

n n
∂Di ∂Ci ∂Di
D j + ∑ pi =∑
i =1 ∂pj i =1 ∂Di ∂pj

I That is, a general equality of marginal revenues and marginal

costs
∂Dj n ∂Dj n
∂Di ∂D
Dj + p j + ∑ pi = Cj0 + ∑ Ci0 i
∂pj i 6 =j
∂pj ∂pj i 6 =j
∂pj
I or equivalently
pj Cj0 1 n pi Ci0 εij
pj
=
εjj ∑ pj D j
Di
εjj
i 6 =j

∂D i /∂p j
where εjj is the own elasticity of demand and εij = p j /D i is
the cross elasticity of demand
Industrial Organization, Week 1, Lecture 3 12 / 15
Monopoly: multiple products
Dependent demands, independent costs

I A reference point: n independent monopolists

I What happens if the goods are substitutes,
∂D i
∂p j > 0 , εij < 0?
I Multi-product monopoly prices are higher than those of the
collection of n independent monopolist producers
I Internalize the demand-driven externality (do not be so afraid
of demand switch)
I What happens if the goods are complements,
∂D i
∂p j < 0 , εij > 0?
I Multi-product monopoly prices are lower than those of the
collection of n independent monopolist producers
I Lower the price to increase demand for other products too

Industrial Organization, Week 1, Lecture 3 13 / 15

Monopoly: multiple products
Dependent demands, independent costs

I Goodwill e¤ect
I Low prices in the …rst period increase demand both in the …rst
and in the second period
I Model
I Two periods
I Demand: D1 (p1 ), D2 (p2 , p1 ), where ∂∂Dp12 < 0
I Cost: C1 (q1 ), C2 (q2 )
I Discounting δ between periods

Industrial Organization, Week 1, Lecture 3 14 / 15

Monopoly: multiple products
Dependent demands, independent costs: Goodwill e¤ect

I Monopolist solves
max p1 D1 (p1 ) + δp2 D2 (p2 , p1 ) C1 (D1 (p1 )) δC2 (D2 (p2 ))
p 1 ,p 2

I Monopolist’s FOCs
∂D2 (p2 ) ∂C2 (D2 (p2 )) ∂D2 (p2 , p1 )
D 2 ( p2 ) + p2 =
∂p2 ∂(D2 (p2 )) ∂p2
∂D1 (p1 ) ∂D2 (p2 , p1 ) ∂C1 (D1 (p1 )) ∂D1 (p1 )
D 1 ( p1 ) + p1 + δp2 =
∂p1 ∂p1 ∂(D1 (p1 )) ∂p1
I Monopolistic price in the second period
I Price below the single-period myopic level in the …rst period
I more output in the …rst period to increase demand in the
second period
I Similar to learning by doing, but di¤erent economic channel
Industrial Organization, Week 1, Lecture 3 15 / 15