1

Course outline I
Introduction
Game theory
Price setting
monopoly
oligopoly
Quantity setting
monopoly
oligopoly
Process innovation
Homogeneous
goods
2
Monopoly (quantity setting)
Inverse demand function
Revenues, costs, profits
Profit maximizing quantity
Basic model
Price discrimination
Several factories
Double marginalization
Welfare analysis
Executive summary
3
Decision problem
X
H
4
Inverse demand function
X
p
X
) ( X p
p
) ( p X
demand
function
inverse demand
function
5
Revenue, costs and profit
Revenue:
Costs:
Profit:
( ) X X p X R = ) (
( ) ( ) ( ) X C X R X = H
( ) X C
6
Marginal revenue with respect to
quantity
goes up by p (the price of the last unit),
but goes down by dp/dX X (the quantity increase diminishes
the price and this price decrease is applied to all units)
When a firm increases the quantity by one unit, revenue
X
dX
X dp
X p MR
dX
dR
X
) (
) ( + = =
|
|
.
|

\
|
=
|
|
.
|

\
|
+ =
|
.
|

\
|
+ =
p X p X
X
p p
dX
X dp
X p
X
X p MR
, ,
1
1
1
1
) (
) (
1 ) (
c c
Amoroso-Robinson
relation:
7
Marginal revenue = price?

1. i.e. horizontal demand curve, perfect
competition

2. X=0 sale of first unit
first degree price discrimination
0
) (
=
dX
X dp
X
dX
X dp
X p
dX
dR ) (
) ( + =
8
Linear demand curve in a
monopoly
Demand:

Revenue:

Marginal revenue:


bX a X p = ) (
2
) ( bX aX X R =
bX a MR 2 =
9
Exercise (Depicting the linear
demand curve )
Slope of demand curve: ....
Slope of marginal revenue curve: ....
The ............................ has the same
vertical intercept, ..., as the demand curve.
Economically,
the vertical intercept is .................,
the horizontal intercept is ................. .
bX a X p = ) (
10
Depicting demand and marginal
revenue
a
a/b
a/(2b)
MR
) ( X p
X
p
b
1
2b
1
11
First order condition
Notation:
X
X
MC MC
MR MR
=
=
:
:
( )
( )
( ) ( )
0
!
= + =
H
dX
X dC
dX
X dp
X X p
dX
X d
X
MR
X
MC
12
First order condition, alternative
formulations
|
|
.
|

\
|
= =
p X
p MR MC
,
!
1
1
c
MC MC p
p X
p X
p X
1
1
1
1
,
,
,
!

=
c
c
c
p X
p
MC p
,
!
1
c
=

(price-cost margin)
13
Depicting the Cournot monopoly
Cournot
point
M
X
M
p
MR
) ( X p
MC
X
p
14
Exercise (Quantity)
Consider a monopolist facing the inverse demand
function p(X)=24-X. Assume that the average and
marginal costs are given by AC=2.
Find the profit-maximizing quantity!

11 X : S.
M
=
15
Profit in a monopoly
M
X
M
p
MR
) ( X p
MC
X
p
M
X
M
p
X
p
AC
Marginal point of view: Average point of view:
MC
MR
) ( X p
16
Exercise (monopoly)
Consider a monopoly facing the inverse demand
function p(X)=40-X
2
. Assume that the cost function
is given by C(X)=13X+19.
Find the profit-maximizing price and calculate the
profit.

35 : S. = H
M
17
Price discrimination
First degree price discrimination:
Second degree price discrimination:
Third degree price discrimination:
Every consumer pays a different price which is equal to his
or her willingness to pay.
Prices differ according to the quantity demanded and sold
(quantity rebate).
Consumer groups (students, children, ...) are treated
differently.
18
Monopolistic price
discrimination (two markets)
p
2

p
1

x
2
x
1

p
*
1
x
*
2
x
( )
1 1
p x ( )
2 2
p x
MC
2
MR
1
MR
total output
19
Inverse elasticities rule for third
degree price discrimination
Supplying a good X to two markets results in the inverse demand
functions p
1
(x
1
) and p
2
(x
2
).
( ) ( )
( )
( )
( )
( )
2 1
2 2
2 2 2
1 1
1 1 1 2 1
, x x C
x R
x x p
x R
x x p x x + + = H

Profit function:
First order conditions:
( )
( ) ( ) 0
!
,
2 1 1 1
1
2 1
= + =
H
x x MC x MR
x
x x
c
c
( )
( ) ( ) 0
!
,
2 1 2 2
2
2 1
= + =
H
x x MC x MR
x
x x
c
c
Equating the marginal revenues (using the Amoroso-Robinson relation) leads to:
( )
( )
( )
( )
|
|
.
|

\
|
=
|
|
.
|

\
|

2 2
2 2
!
1 1
1 1
1
1
1
1
x
x p
x
x p
c c
) ( ) ( ) ( ) (
2 2 1 1 2 2 1 1
x p x p x x > < c c
=

20
Exercise (two markets or one)
A monopoly sells in two markets:
p
1
(x
1
)=100-x
1
and p
2
(x
2
)=80-x
2
.

a) Calculate the profit-maximizing quantities and the profit
at these quantities, if the cost function is given by C(X)=X
2
.
b) Calculate the profit-maximizing quantities and the profit
at these quantities, if the cost function is given by
C(X)=10X.
c) What happens if price discrimination between the two
markets is not possible anymore? Consider C(X)=10X.
Hint: Differentiate between quantities below and above 20.
3200 c) , 3250 b) , 1400 a) : S. = H = H = H
M M M
21
Solution III (one market)
20
100
90
10
100 50
50
80
MR
MC
X
p
) ( X p
80
22
One market, two factories
Profit function:

First order conditions:
( ) ( )( ) ( ) ( )
2 2 1 1 2 1 2 1 2 1
, , x C x C x x x x p x x + = H
( )
( ) ( ) 0 ,
,
!
1 1 2 1
1
2 1
= =
c
H c
x MC x x MR
x
x x
( )
( ) ( ) 0 ,
,
!
2 2 2 1
2
2 1
= =
c
H c
x MC x x MR
x
x x
=


( ) ( )
2 2
!
1 1
x MC x MC =
23
One market, two factories II
1
x
p
2
x
1
MC
*
1
x
*
2
x
2
MC
factory 1 factory 2
total output
24
Double marginalization - idea
Retailer, not producer sells to consumers.
Assumptions:
Zero costs for retailing.
Producer decides on a quantity and charges a price
p
pro
to the retailer.
p
pro
is the retailers marginal cost.
The retailers MR=MC condition defines the
producers demand function.
25
Double marginalization - linear case
p(x)=a-bX
MC
pro
=AC
pro
=c
Second stage: First order condition for the retailer:

First stage: First order condition for the producer:



pro pro
MR bX a c MC = = = 4
!
MR bX a p MC
pro
= = = 2
!
b
c a
X
4

=

2
*
c a
p
pro
+
=
4
3
*
c a
p
+
=
26
Double marginalization - depicting
the solution
p
X
( ) X p MR
pro
=
b
a
b
a
2
4
3
*
c a
p
+
=
c
2
*
c a
pro
p
+
=
b
c a
4

pro
MR
a
retailer
producer
Producer decides
on quantity and
announces p
pro
*
to retailer.
Retailer decides
on quantity (fore-
seen by producer).
27
Double marginalization - exercise
p(X)=110-X
c=10

a) Calculate the price the consumers have to pay!
b) What price would they pay if the producer sold
directly to the consumers?
60 b)
85 a) : S.
=
=
M
M
p
p
28
Welfare Analysis
Evaluation of economic policy measures
Welfare = consumer surplus (CS)
+ producer surplus (PS)
+ taxes - subsidies
CS = willingness to pay - price
PS = revenue - variable costs
= profit + fixed costs

29
CS, PS - graphically
0
p
supply (=MC)
demand
X
PS
CS
Welfare is
maximized at
the equilibrium.
30
MC p =
The deadweight loss of a monopoly
Without price discrimination a monopoly
realizes a deadweight loss.
M
X
M
p
MR
) ( X p
MC
X
p
-
X
-
p
MC MR=
Perfect
competition
31
Exercise (deadweight loss)
Consider a monopoly where the demand is
given by p(X)=-2X+12. Suppose that the
marginal costs are given by MC=2X.
Calculate the deadweight loss
without price discrimination,
with perfect price discrimination.


0
2 : S.
=
=
wpd
wopd
DL
DL
32
Exercise (price cap in a monopoly)
How does a price cap influence the
demand and the marginal revenue curves?
X
p
) ( X p
MR
MC
M
X
cap
p
M
p
33
Right or wrong? Why?
) ( X p
MR
MC
cap
p
M
p
M
X
X
p
34
Price cap and welfare
) ( X p
MR
MC
cap M cap
p p
,
=
X
p
cap M
X
, M
X
M
p
additional welfare
35
Taxes on profits
MR
X
p
M
X
M
p
) 1 )( ( t X H
) (X H
) ( X p
) (X C
MC
) (X R
36
Taxes on profits and welfare
Quantity / price unchanged
CS is constant
PS decrease; in the same extent net public
revenues increase
deadweight loss is zero
37
Additional deadweight loss due
to quantity tax
consumers surplus: A+B+CA
producers surplus: T+E+F E+B
T
additional
deadweight loss
A
E
F
B
C
) ( X p
MR
MC
X
p
X
T
X
p
T
p
t MC+
net public revenue: 0 T
38
Exercise (quantity taxes)
A monopolist is facing a demand curve given by p(X)=a-X.
The monopolys unit production cost is given by c>0.
Now, suppose that the government imposes a specific tax
of t dollars per unit sold.
a) Show that this tax would raise the price paid by
consumers by less than t.
b) Would your answer change if the market inverse demand
curve is given by p(X)=-ln(X)+5.
c) If the demand curve is given by p(X)=X
-1/2
, what is the
influence on price?
Industrial Organization ; Oz Shy
2 c) , 1 b) ,
2
1
a) : S.
39
c
t c+
p
X
) ( X p
MR
) ( t c p
M
+
) (c p
M
Illustrating the solutions
a) b)
MR
c
t c+
p
X
) ( X p
) ( t c p
M
+
) (c p
M
40
Lerner index of monopoly power
First order condition:


Lerner index:

|
|
.
|

\
|
= + = =
p X
p
dX
dp
X X p X MR X MC
,
!

1
1 ) ( ) ( ) (
p X
p X
p
p p
p
MC p
,
,
!

1
1
1
=
|
|
.
|

\
|

=

c
41
Monopoly profits
and monopoly power
Cournot
point
M
X
M
p
MR
) ( X p
MC
X
p
AC
0 = H =
M M
AC p
42
Executive summary
A profit-maximizing monopolist always sets the
quantity in the elastic region of the demand curve.
Monopolistic power: price will be set above the
marginal cost by a profit maximizer.
If the demand curve is tangent to the average cost
curve, the profit-maximizing price is set above
marginal cost and equal to average cost.
monopolistic power and zero profits
Monopolistic quantities without price
discrimination (!) lead to a welfare loss.
A quantity tax leads to a welfare loss, a tax on
profits does not.