ECON1010

Introductory Microeconomics

LECTURE 9
Imperfect Competition (cont)

Price Discrimination,
Oligopoly (thinking strategically)

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Last lecture feedback

Q1. If a monopoly produces output such that MR is more

than MC at that output level, then to maximise profit it
should:
a. keep producing exactly the same level of output.
b. charge a higher price for the output produced.
c. increase output and decrease price.
d. decrease output and increase price.
e. increase price and increase output.

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Last lecture feedback

Q2. If a monopolist’s marginal cost is more than marginal

revenue, for a particular output level, it will:
a. raise price and increase output

b. reduce price and increase output.

c. reduce price and decrease output

d. raise price and decrease output.

e. shut down.

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Plan of Lecture 9

1. Price Discrimination
- how, why and where used
- various types

2. Thinking Strategically – game theory

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From last week in Lecture 8.

Imperfect competition is when a firm has at

least some ability to dictate the selling price
(demand is downward sloping).

This is the same as saying a firm has some

market power (pricing power).

Imperfectly competitive markets include

monopoly, monopolistic, and oligopoly firms.

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How can a firm further increase profits?
If demand is downward sloping, maximise profit
for an output quantity where MR = MC.

Firm sells all output produced at the same price.

But, some buyers would pay a higher price,

and other buyers would only buy if the price
was lower.

To use this fact, firms in imperfectly competitive

markets price discriminate to increase profits.

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Price Discrimination - What is it?

Occurs when the same item is sold at

different prices to different groups of people,
depending on customers’ willingness to pay.
Example: supply of electricity to users in Qld.
Different groups of users:
- household
- commercial
- industrial
- railways 7

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Price Discrimination - when can firms use it?

Example: Electricity generating firms

1. Must have some degree of pricing power.

2. Different groups of customers.

3. Difficult to buy electricity at home then

resell it to someone else down the street
(ie: arbitrage is not possible).

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Price Discrimination
When can firms use it?
Example: Does Qantas fill the requirements to
be able to price discriminate?
1.

2.

3.
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Different Types of Price Discrimination

1. First Degree (perfectly) Discrimination

2. Second Degree Discrimination
3. Third Degree Discrimination
4. Peak Load Pricing.

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Different Forms of Price Discrimination
1. First Degree (perfectly) Discrimination
▪ The firm must know the maximum amount
each and every customer will pay for their
product or service
▪ Each customer can be charged a different
price for the same product and the product
will be sold to them.
▪ The full consumer surplus is extracted from
each customer, so firm maximises profit.
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 First Degree (perfect) Discrimination
(in practice, doesn’t exist, as no seller
Price knows every buyer’s reservation price)
($/unit)

Quantity
0 1 2 3........ (units)

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First Degree Discrimination
Examples:
1. Car Sales person
(based on appearance, knowledge etc. they
can try to figure out what car to sell you)
2. Doctor/Accountant/Lawyers
(charge different customers different amounts
based on what they think they can pay)
3. Funeral Director (and selling coffins)

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Different Forms of Price Discrimination
2. Second Degree Discrimination
▪ a firm takes part of the consumer surplus (but
not all).
▪ different prices are charged for different
“blocks” of quantities consumed.
▪ results in larger revenues and profits
compared to charging a single lower price for
larger quantities.
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Second Degree Discrimination
Examples:
1. Utility company charges (gas, water,
electricity.... “block” type pricing for usage).

2. Mobile phone plans for call charges

Note: Economies of scale can allow firms to

reduce their selling prices to be able to
supply more (and profit).
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 Second Degree Discrimination
Example: Electricity company charges:
Price
P1 units for the first 500 kWh
($/kWh)
P2 units for 501 kWh to 1000 kWh
P3 units over each kWh over 1000 kWh
P1

P2

P3

Quantity
0 500 1000 1500 (kWh)

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Different Forms of Price Discrimination

3. Third Degree Discrimination

▪ Different market segments charged different

prices because of differences in price
elasticity of demand.

▪ Economic models can be used to show how a

firm should operate to maximize profits.

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Third Degree Discrimination
Examples:

1. Airline tickets are sold as business, economy,

student, senior, or holiday class. Each group
has differing elasticities of demand.
2. Frozen vegetables vs fresh vegetables.
3. Regular/draft beer vs premium beer.
4. Branded name product vs “no name” brand.
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 Profit Maximising - Third Degree Discrimination
Price
($/unit) Business Class
PriceBusiness Demand

Qantas Demand
PriceEconomy

MRQantas
= MCQantas Economy
Class Demand

0
Qprofit max Qprofit maxQprofit max Quantity
Business Class Economy Class (units)

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 Different Forms of Price Discrimination
4. Peak Load Pricing.
▪ Suppliers face peak (maximum) demands at
particular times (hourly, daily, weekly, yearly).
▪ Pricing based on efficiency measures and
reflects costs of supply (ie: marginal cost).
▪ Typically MC will be higher for suppliers in
peak period times (because of capacity
restraints for production). Prices are higher in
peak periods.
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 Peak Load Pricing.
Example: Electricity Generators Pricing
a. Early in morning (2am to 5am), low demand
for electricity. Operate base load coal fired
generators.
b. Demand slowly increases (5am to 8am).
Other efficient generators come online.
c. Office and businesses demand increases.
d. Excess demand by mid afternoon forces less
efficient gas fired generators to come online.

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 Rising MC of Electricity Supply

Price
($/kWh) MCSupplier

Pmidday
Demand
Demand midday
early morning

Pmorning

Qprofit max Qprofit max Quantity

(kWh)

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 Rising MC of Electricity Supply

Price MCSupplier rising

($/kW)

Other, less efficient least efficient generators

generators used come online to meet
as demand rises. very high demand.

Coal fired
base load

2am Time
2pm

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Price Discrimination - Why use it?

A firm’s profit will be larger by using price

discriminating compared to charging all buyers
the same price.
Firms can aim to extract as much expenditure
from consumers as possible by understanding
how much they are willing to pay.
Theoretically, a firm aims to exert market power
to capture as much consumer surplus as
possible and convert it into producer surplus.

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Price Discrimination - comments

▪ is not necessarily a bad thing.

▪ results in an increase in the level of output

compared to if a single price is charged.

▪ in increasing output toward the perfectly

competitive output level, price discrimination
can be thought of as a “good thing” in terms of
enhancing economic efficiency.

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 Part 2:
Thinking strategically – game theory
Monopoly

Price
($/unit) Oligopoly

Monopolistic

Perfectly Competitive

Quantity
0
(units)

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Oligopoly Market.
A market structure where a small number of
interdependent firms compete (game theory).
Key Features include:
i) Firms are large, possess a larger market
share (say 80%), and dominate production.
ii) Large initial capital investment needed to
start operations (barriers to entry high).
iii) Price is set above marginal cost for the
profit maximising condition.
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Oligopoly Market Structure.
Features.
iv) Typically there are only a few substitutes
available.
v) Products are slightly differentiated.
vi) Able to make significant economic profits.

Examples:
Car manufacturers, beer makers, major retail
stores, steel production, Australian banks
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 Why an Oligopoly Market can exit.
Existence primarily from barriers to entry.
i) large capital investment needed to enter.
ii) economies of scale exits (which pushes
ATC down as output increases so others are
unable to compete).
iii) government imposed restrictions on firms
from entering through patents, licensing
agreements, tariffs and quotas on foreign
competition.
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Strategic Interdependence of Oligopoly Firms
Definition:
The actions of one firm can have major impacts
on actions of other firms in the same market.
Example:
If Holden managers decide to cut the price of
their family sedan, will Ford and Toyota do the
same? Holden will base their decision, in part,
on their competitors’ likely reactions and
strategies.
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Market Equilibrium in Oligopoly Markets
For perfect competition, monopolistic, and
monopoly markets, profit is maximised when
MR = MC.
For Oligopoly markets, there is no simple
profit maximising rule!
Generally, equilibrium is said to exist when a
firm is doing the best it can, given what other
firms are doing, and when it has no reason to
change price or inputs.
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Market Equilibrium in Oligopoly Markets

Interactions (and firm interdependence) is

analysed using game theory. “Business is all
about the game!”

Game theory characteristics

1. Players
2. Strategies (possible actions players can
choose)
3. Payoffs (outcomes from strategies)
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Example of Game Theory Analysis
Consider two rival concrete firms, Boral and
Pioneer. The firms realize if they undercut each
another in price, by dropping the delivery
charge, they stand to gain more market share
over the other and increase profits.
The profit payoff matrix each player believes
will result, from the possible actions of the
firms, is shown on the next slide. What is the
equilibrium outcome?
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 Profit Payoff Matrix (in ‘1000s of dollars)

Boral
Cut Delivery Keep Delivery
Charge Charge
Cut Delivery 30, 30 40, 25
Charge
Pioneer
Keep Delivery 25, 40 35, 35
Charge

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Reading the Payoff Matrix

1. The first number in a cell represents the

variable across the rows.
2. the second number represents the variable in
the column.
Boral

Pioneer 40, 25

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 Payoff Matrix

Boral
Cut Delivery Keep Delivery
Charge Charge
Cut Delivery 30, 30 40, 25
1 4
Charge 3
Pioneer
Keep Delivery 25, 40 35, 35
2
Charge

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 Prisoner’s Dilemma Payoff Matrix
(values in the table are years in prison)
Jim
Confess Keep Quiet
Confess 5, 5 0, 20
Kelly
Keep Quiet 20, 0 1, 1

Where each firm chooses their dominant

strategy, and without any cooperation, the
equilibrium outcome leaves both worse off.

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Game Theory Analysis
Dominant Strategy = a strategy for a firm that
gives it a higher payoff no matter what strategy
the other players in a game chose. That is, no
matter what a competitor does, the firm will
always chose the same strategy.
Dominated Strategy = any other strategy
available to a player who has a dominant
strategy.

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Prisoner’s Dilemma Game Theory Analysis

1. It is a game where each player has a dominant

strategy, and when each plays their dominant
strategy, the resulting payoffs are smaller than if
each had played a dominated strategy.

2. It is an example of a Nash Equilibrium

when each player’s adopted strategy is the best that
can be chosen, given the other player’s chosen
strategies. ie: do the best you can, given what
the other players have done and will allow you to do.

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UN Copenhagen Climate Change Conference

Much of the world believed the UN Copenhagen

Climate Change Conference in 2009 would reach
an agreement on reducing global CO2 emissions.

Using the theory of Prisoner’s Dilemma,

economists at this time predicted any successful
outcomes would be extremely unlikely. Why?

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 Prisoner’s Dilemma & Imperfectly
Competitive Firms
Collusion
= an agreement between firms to charge the
same price (price fixing) to avoid competing
= formation of Cartels (oil cartel OPEC).
= illegal in Australia (ACCC watching)
eg: Amcor and Visy cardboard price fixing.
(record penalty at the time of $36 million against the
Visy Board of directors).

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Cartels explicitly agree to cooperate in price.
Aim is to earn an economic profit.
Characteristics needed for product/service:
1. Inelastic demand
2. Monopoly pricing power
3. Cartel supplies a large percentage of product
to the entire market.
4. Cartel members must maintain the agreed
high price and NOT cheat! Otherwise,
price falls.
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 Cartel Behaviour
OPEC sets the price to maximise its
profits. Smaller suppliers then sell the
Price, MR, MC extra quantity needed to meet market
($/barrel)
demand at the price dictated by OPEC.

POPEC

MC=MR Demand for OPEC oil

Market Demand oil

0 Quantity
QOPEC profit max Q
market (Barrels of oil)

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Repeated Prisoner’s Dilemma Game.
A game where the same two players play a prisoner’s
dilemma over and over many times.
Outcomes from all previous plays are observed before
the next play begins.

Tit-for-tat repeated prisoner’s dilemma game.

A strategy for playing the repeated prisoner’s dilemma
game in which a player cooperates on the first move,
then mimics the other player’s last move on
each successive moves.

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Other game theory concepts
Credible threat
– a threat to take action that is in the threatener’s
interest to carry out.
– it is one that can be believed could happen as that
player has the ability to carry through on the threat

Credible promise
– a promise to take action that is in the promiser’s
interests to keep, when the time comes to deliver.

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Games where Timing matters

So far we have considered competitive and cooperative

simultaneous games.

However, many games also include a time dimension

where one player gets to go first. These games can be
analysed using a diagram call a decision tree.

The decision tree describes the possible moves players

can make and shows the sequence of possible moves
over time. The tree also lists the payoffs that correspond
to each possible combination of moves.
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 Games where Timing matters
Example: ultimate bargaining game = “take it
or leave it” offer.
$99 for Tom
Michael $1 for Michael
accepts

A B
Tom proposed $99 for himself
Michael gets $1 Michael $0 for Tom
declines $0 for Michael

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Conclusions on Game Theory

1. Good decision-making often requires attention be

paid to strategic interactions. Game theory provides a
tool for analysing strategic interactions.
2. An important game that helps gain insights to assess
real world choices is the Prisoner’s Dilemma.
3. Game theory models can reflect real world settings.
They can take the form of being competitive,
cooperative, simultaneous, or incorporate time.

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Next Lecture

▪ Lecture 10.

Externalities, Common Resources, and property

rights.

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