Industrial Economics

Monopoly: Uniform Pricing and Group Pricing

Peter Wagner, Ph.D.
Department of Economics
University of York

1
Monopoly pricing
Without competition, monopolist can use pricing schemes that go beyond charging a
uniform price for each customer
Pricing schemes requires a lot of market power
monopoly, near-monopoly or cartel of oligopolists
barriers to entry
Monopoly pricing is difficult in contestable markets.

2
Principle of monopoly pricing: set price based on information about tastes
1. Limited information about consumer tastes: uniform price
2. Partial Information about consumer tastes:
Observable characteristics: prices based on available information (group pricing)
Known but unobservable characteristics: price menu that induces consumers to
self-select (menu pricing)
3. Perfect information about consumer tastes: individualized prices

3
4
Outline
1. Uniform Pricing
2. Group pricing
3. Menu pricing
4. Bundling

5
 1. Uniform pricing
When every consumer pays the same price.

6
Uniform price
Uniform price = fixed price for one unit of a product
Opposite of price discrimination: each consumer is given the same price
The natural outcome in perfectly competitive markets
Might arise in a monopoly when monopolist knows too little about consumers to
profitably use more complicated schemes

7
1.1 Uniform pricing in a monopoly

8
The monopolist is a "price-maker": it takes as given the inverse demand
The objective of a monopolist is therefore to maximise
To solve for the optimal level of output,solve the f.o.c.

The optimal supply decision of the monopolist, , thus solves

9
Monopolist undersupplies the market:
Comparison with competitive equilibrium
at competitive output we have
at monopoly output we have
Demand is decreasing, , so

Therefore .
monopolist under-supplies the market: !!
10
11
1.2 Uniform pricing in a near-monopoly

12
Consider a market with one large "dominant firm" and a "competitive fringe"
consisting of many small firms
Assumptions:
Dominant firm influences price, and takes as given market demand
Firms in competitive fringe are price takers
No entry of new firms
Fringe shuts down at ant price below some threshold

13
Example
Suppose dominant firm has cost
Competitive fringe has quadratic cost
Demand is

Supply solves :

14
Benchmark: Perfect competition
Market clearing:
Market output:
Benchmark: Monopoly
Revenue ,
Monopoly quantity solves:
Monopoly price:

15
16
Dominant firm and competitive fringe
Consider now an equilibrium between the dominant firm and the competitive fringe
A pair is an equilibrium in the dominant firm model, if demand meets total
supply, i.e.,
"Residual demand": demand by consumers - supply of fringe at given price

17
Residual demand and inverse residual demand

Margnial revenue

18
Suppose equilibrium has :
Profit maximisation:
Price:
Market supply:
Indeed, for , this is the only equilibrium.
We have
Competitive fringe puts pressure on dominant firm.

19
Competitive fringe with entry of new firms
Suppose now "fringe" firms can enter the market freely
If average cost of fringe firms is increasing, firms enter when , increase supply
Supply function of fringe therefore becomes inelastic (horizontal) at
Result: dominant firm cannot keep the price above without losing dominance
Equilibrium price is equal to competitive price despite there being a single supplier
"Contestable market": market served by single firm, but low cost of entry (and exit)

20
21
 2. Group Pricing
Making prices dependent on observable consumer characteristics

22
Group pricing (or "Differential Pricing") is a pricing scheme that involves offering
consumers prices based on observable characteristics:
Geographical areas (e.g., countries, regions, etc)
Verifiable attributes (e.g., age, nationality, etc.)
Time of purchase (e.g., weekends, mornings, etc.)
etc.

23
Case Study: Textbooks (Cabolis et al., 2006)
Differences in book prices, US vs. elsewhere
No difference for general audience books
Textbooks substantially more expensive in the US
Why?
Not a cost factor
Difference in price due to difference in demand elasticities
Teachers in the U.S. require a single comprehensive textbook per course
that's not thetradition in European universities
Publishers prevent arbitrage by offering “International Editions" to customers abroad,
which cannot be sold in the US
.
24
2.1 Optimal Group Pricing

25
Suppose now there are different markets
Market has inverse demand with elasticity
Cost of production the same for all markets
By the inverse elasticity rule (or Lerner rule, see slides on Market Power):

Lesson: If cost of production constant across regions, mark-up and price are higher in
the market with less elastic demand.
26
2.2 Social Benefits and Costs of Group Pricing

27
Group pricing, arbitrage and welfare
Sometimes group pricing is not possible or desirable
Arbitrage (e.g., re-import of drugs, cars)
Legal restrictions (ban of differential pricing)
Moral or fairness reasons (e.g., price gauging)
Restricting group pricing on consumers can have ambiguous welfare effects:
"Price averaging" can create gains for high and loss for low value customers
Low-value customers may be excluded

28
Case: "Differential pricing" in the pharmaceutical industry
Differential pricing occurs often pharmaceuticals
Example: Some drugs are sold for $5 in India but for $1000 in the United States
Tension: innovation and access
With uniform pricing parts of the market may be excluded from access
Potentially better access with differential pricing
Should we prevent or legalise arbitrage? Ex: drug re-import illegal in the US...

29
a

30
 Prescription Drug Prices in Canada and the United States

Source: Graham and Tabler (2001) Prescription Drug Prices in Canada and the United States – Part 3 Retail
Price Distribution,The Fraser Institute.
31
Example: "Celebrex"
Pricing of anti-inflammatory drug in the United States and EU
Market have different demand:
Stronger demand in US
Suppose linear demand (for simplicity)
Suppose marginal cost constant in each market

32
Demand:
United States:
EU:
Point-Price Elasticities:
United States:
EU:
Demand in EU is more elastic!

33
Optimal Group Pricing by Region
United States:
Inverse Demands
Marginal Revenues:
Optimal quantity and price: and
Europe:
Inverse Demands
Marginal Revenues:
Optimal quantities: and
Supply and price both lower in EU!
34
Optimal Uniform Price
Steps for finding optimal uniform price policy:
1. Derive aggregate demand: sum up demands for US and Europe
2. Invert aggregate demand
3. Calculate marginal revenue
4. Find monopoly supply solving
5. Monopoly price is

35
Sum up demands:

Invert to obtain inverse demand (exercise!):

36
Marginal Revenue:

Notice:
the marginal revenue is negative if
there is a jump at
Value on the left-hand side :
Value on the right-hand side :
Profit maximization for the monopolist (see Section 2):
37
Derive monopoly pricing policy:
Given marginal cost
Find at intersection
Find price

38
Suppose
Solve :
Corresponding price
Both markets are served!

39
Suppose
Solve :
Corresponding price
Only one market is served!

40
Suppose
There are two possible solutions:
Supply both markets
Supply only one market
How do we know which is correct?:
Calculate each case and compare!

41
Single market:
Solve for :
Corresponding price

42
Both markets:
Solve for :
Corresponding price

43
How much does the monopolist supply when ?
Compare profits
Single market:
Both markets:
Supplying both markets is more profitable

44
Graphically:
The area between marginal revenue
and marginal cost
represents changes in profits!
Supply both markets when additional
profits (green area) are larger than
losses (red area)

45
Comparison: uniform vs. group pricing

The effects of group pricing on consumer surplus:

Group pricing generates a surplus loss for consumers when cost is low ( ).
Surplus gain for high cost ( ), because with uniform price, Europe is excluded
46
2.3 The value of information in group pricing

47
We now consider a model in which we vary the amount of information the monopolist
has about customers
Question: How does "more information" affect surpluses and efficiency?
Effects are ambiguous:
lower prices / more access to low income consumers
but: higher prices for high incomes consumers

48
Model
Unit mass of consumers with unit demand
Valuation uniformly distributed over
Consumer with valuation buys if
Zero marginal cost:

49
Benchmark: Uniform price
Demand function
Inverse demand
Profit:
Marginal revenue: ("twice as steep as demand")
We have the following solution:

50
What happens when the monoplist has better information?
Suppose the monopolist has better information.
To model this, we partition into subintervals of equal length.
The number measures the amount of information the firm has about consumers
Valution in -th interval is uniformly distributed on
Firm can differentiate which group each customers belong to
Demand within each group :

51
Inverse Demand:
Marginal revenue:
Profit maximisation condition yields
But note that maximum demand within group is , so that .
Hence, for , we obtain boundary solution .
Therefore, the supply for group , and corresponding price is

52
Comparison: Uniform Pricing vs. Group Pricing with 2 Segments
Monopoly quantity and price for each group

Producer surplus:
Consumer surplus:
Dead-weight Loss:
Compared with uniform price across segments:
Consumers and firm are better off, deadweight loss is smaller.
53
54
Effects of better information...
Producer Surplus (=profits)

Consumer Surplus (=sum of utilities)

Deadweight Loss (unrealized gains-from-trade):

55
Monopoly profits are increasing in :

Deadweight loss and consumer surplus decrease for :

56
Hence, the monopolist is better off with more information, consumers worse off, but
efficiency increases.

Lesson
More information increases the monopolist's profit and
welfare, but diminishes consumer surplus (rent extraction)

57