Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

Economics 3130: Intermediate Microeconomic Theory

Topic 4: Perfect Competition and Monopoly
Monopoly Taxation and Two-Part Tariffs
Outline: 1. Introduction
2. Monopoly Taxation
3. Two-Part Tariffs

1. Introduction
We now consider two further extensions to the standard model of monopoly.

2. Monopoly Taxation
We consider how a monopoly faced with, firstly, a linear demand schedule and then a
constant elasticity demand schedule, reacts to the imposition of a unit sales tax.

Linear Demand
Let the monopoly face a demand function given by p = α − β q and have a unit production
cost of c > 0. Suppose the government imposes a specific tax of $t per unit on each unit of
output sold to consumers. We show that this tax imposition raises the price paid by
consumers by less than t.
Total revenue is given by:

(
TR = pq = α − β q q )
⇒
TR = α q − β q 2

Marginal revenue is thus:

∂TR
MR ≡ = α − 2β q
∂q

Equating marginal revenue to the tax inclusive unit cost implies:

MR = α − 2β q = c + t
⇒
α −c−t
qt =
2β

Thus:

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

pt = α − β qt
⇒
⎛α − c−t⎞
pt = α − β ⎜
⎝ 2β ⎟⎠
⇒
α +c+t
pt =
2

such that:

∂p t 1
= <1
∂t 2

Hence, as illustrated in Figure 1, an increase in t raises the monopoly price by less than t:

pt
p

c+t MCt
AR
c MC

MR
0 q1 q0 q

Figure 1

Constant Elasticity Demand

Assume now that market demand curve is given by p = q −θ . This is the case of a constant-
elasticity demand curve. To be sure:

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

−θ
dp q p
= −θ q −θ −1 = −θ = −θ
dq q q
⇒
dp q
⋅ = −θ
dq p
⇒
dq p 1
Ε≡− ⋅ =
dp q θ

Recall:

TR = p ( q ) q
⇒
dTR dp
MR ≡ = q+ p
dq dq
⇒
⎛ dp q ⎞ ⎛ 1⎞ ⎛ 1⎞
MR = p ⎜ 1+ ⋅ ⎟ = p ⎜ 1− ⎟ = p ⎜ 1− 1 ⎟
⎝ dq p ⎠ ⎝ E⎠ ⎝ θ⎠

⇒
MR = p (1− θ )

Monopoly equilibrium implies:

( )
MR = p 1− θ = c + t = MC
⇒
c+t
p=
1− θ

Thus:

∂p 1
=
∂t 1− θ

Thus, price will increase by more (resp. less) than the increase in the tax if θ < 1 (resp.
θ > 1 ).

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

pt
p
c+t MCt
c MC
AR
MR
0 q1 q0 q

Figure 2

III. Linear Two-Part Tariffs

We investigate the potential benefit to the monopolist of setting a two-part tariff. Assume for
illustration that a monopoly faces demand from two individuals for its output. Let the
demand function of individual 1 be given by q1d = 24 − p1 and the demand function of
individual 2 be given by q2d = 24 − 2 p2 . Assume that the monopoly has a unit production cost
of c = 6. We
A linear two-part tariff is a scheme under which demanders pay a fixed fee for the
right to consume the good and a uniform price for each unit consumed. The prototype case,
first studied by Oi (1971) is an amusement park (Disneyland?) that sets a basic entry fee
coupled with a stated marginal price for each amusement used.1 Mathematically, such a
scheme can be represented by a tariff under which a demander must pay T ( q ) to purchase q
units of the good where:

T ( q ) = a + pq

1
Interestingly, Disneyland once used a two-part tariff but abandoned it because the costs of administering the
payment scheme for individuals rises became too high. Like other amusement arks, Disney moved to a single-
admissions price policy (which still provided them with ample opportunities for price discrimination, especially
with the multiple parks at Disney World).

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

Thus, a is the fixed fee and p is the marginal price to be paid. The monopolist’s goal is to
chose a and p to maximise profits, given the demand for this product. Note that the average
price paid by any demander is given by:

T (q) a
p= = +p
q q

Thus, the tariff is inversely related to q and is thus only feasible when those who pay low
prices (i.e. those for whom q is large) are unable to resell the good to those who must pay
high average prices (i.e. those for who q is small).
One approach for establishing the parameters of the linear tariff would be for the firm
to set the marginal price, p, equal to MC and then to set the fixed fee, a, so as to extract the
maximum consumer surplus from a given set of buyers [Oi (1971)]. One might imagine
buyers being arrayed according to their willingness to pay. The choice of p = MC would then
maximise consumer surplus for this group, and a could be set equal to the surplus enjoyed by
the least eager buyer. This buyer would then be indifferent about buying the good, but all the
other (i.e. more eager) buyers would experience net gains from the purchase.
This feasible tariff might not, however, be the most profitable. Consider the effects on
profits of a small increase in p above MC. This would result in no net change in the profits
earned from the least willing buyer. Quantity demanded would drop slightly at the margin
where p = MC, and some of what had previously been consumer surplus (and therefore part
of the fixed fee, a) would be converted into variable profits because now p > MC. For all
other demanders, profits would be increased by the price rise. Although each will pay a bit
less in fixed charges, profits per unit purchased will rise to a greater extent.2 IN some cases it
is possible to make an explicit calculation of the optimal two-part tariff but, in general,
optimal schedules will depend on a variety of contingencies.
In terms of the example, an Oi Tariff requires the monopolist to set p1 = p2 = 6 = MC
such that q1 = 18 and q2 = 12 . With this marginal price, demander 2 (i.e. the less eager of the
two) obtains consumer surplus of CS2 = 0.5 (12 − 6 ) = 36 , which is the maximal entry fee
that might be charged without causing demander 2 to leave the market - see Figure 3.
Consequently, the two-part tariff in this case would be:

T ( qi ) = 36 + 6qi

If the monopolist opted for this pricing scheme, then its profits would be:
π = TR − TC = T ( q1 ) + T ( q2 ) − AC ( q1 + q2 )
⇒
π = ⎡⎣ 36 + 6 (18 ) ⎤⎦ + ⎡⎣ 36 + 6 (12 ) ⎤⎦ − 6 (18 + 12 )
⇒
π = 72

2
This follows because qi ( MC ) > q1 ( MC ) where qi ( MC ) is the quantity demanded when p = MC for all
except the least willing purchaser (i.e. purchaser 1). Hence, the gain in profits from an increase in p above MC
[i.e. Δpqi ( MC ) ] exceeds the loss in profits from a smaller fixed fee [i.e. Δpq1 ( MC ) ].

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

p1 p2

q1 = 24 - p1 q2 = 24 - 2p2
24

12
CS1= 162

CS2 = 36
6 MC

0 18 24 q1 0 12 24 q2

Figure 3

Note that this is a lower profit than the monopolist could obtain from third-degree price
discrimination. In that case, p1 = 15, q1 = 9, p2 = 9, q2 = 6, π = 99 . Moreover, it is less,
than the profit it could obtain setting a single price. In that case, the monopolist would cease
serving market 2 since it can maximise profits by setting p = 15 such that
q1 = 9, q2 = 0, π = 81 - see Figure 4:

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

p1 p2

q1= 24 - p1 q2 = 24 - 2p2
24

15
12
9

6 MC

MR1 AR1 MR2 AR2

0 9 12 24 q1 0 6 12 24 q2

Figure 4: Second-Degree Price Discrimination

The optimal two-part tariff in this situation can be computed by noting that that total profits
with such a tariff are:

π = 2a + ( p − MC ) ( q1 + q2 )

where the entry fee, a, must equal the consumer surplus of the least eager demander (i.e.
demander 2). Thus:

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

π = 2a + ( p − MC ) ( q1 + q2 )
⇒
π = 2 ⎡⎣ 0.5 (12 − p ) q2 ⎤⎦ + ( p − 6 ) ( q1 + q2 )
⇒
π = 2 ⎡⎣ 0.5 (12 − p ) ( 24 − 2 p ) ⎤⎦ + ( p − 6 ) ⎡⎣( 24 − p ) + ( 24 − 2 p ) ⎤⎦
⇒
π = (12 − p ) ( 24 − 2 p ) + ( p − 6 ) ( 48 − 3p )
⇒
π = 288 − 24 p − 24 p + 2 p 2 + 48 p − 3p 2 − 288 + 18 p
⇒
π = 18 p − p 2

Thus:

dπ
= 18 − 2 p∗ = 0
dp
⇒
p∗ = 9

Thus, maximum profits from a two-part tariff are obtained when p∗ = 9 and
( ) ( )( )
a = CS2 = 0.5 12 − p∗ q2∗ = 0.5 12 − p∗ 24 − 2 p∗ = 0.5 (12 − 9 ) ( 24 − 18 ) = 9 . The optimal
tariff is thus:

T ( q ) = 9 + 9q

With this tariff, q1 = 15, q2 = 6 and π = 2a + ( p − MC ) ( q1 + q2 ) = 2 ( 9 ) + ( 9 − 6 ) (15 + 6 ) = 81 .

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Economics 3130: Intermediate Microeconomic Theory Topic 4: Perfect Competition & Monopoly

p1 p2

q1= 24 - p1 q2 = 24 - 2p2
24

12
9 9

6 MC

MR1 AR1 MR2 AR2

0 12 15 24 q1 0 6 12 24 q2

Figure 5: Optimal Two-Part Tariff

The monopolist might opt for this pricing scheme if it were under political pressure to have a
uniform pricing policy that did not price demander 2 ‘out of the market’. The two-part tariff
permits a degree of differential pricing [i.e. p1 = ( 9 15 ) + 9 = 9.60 , p2 = ( 9 6 ) + 9 = 10.5 ] but
appears ‘fair’ because all buyers face the same schedule.

Reference

Oi, W. Y. (1971). ‘A Disneyland Dilemma: Two-Part Tariffs for a Mickey Mouse Monopoly.’ The
Quarterly Journal of Economics, 85(1), pp. 77-96.