Lecture 14

Monopoly behaviour
 Natural Monopoly
 An industry where a firm can supply
the whole market at a lower average
total cost than if there were more
than one firm operating
 Typically, due to significant fixed
costs
E.g. Railroads, phones, water supply
 Natural Monopoly
 Two necessary conditions:
1. Economies of scale: AC must decrease
for a significant range of output levels
(if AC is rising for large outputs, it is no
longer a natural monopoly)
2. Low demand: Consumers have a “low”
willingness to pay for “large”
quantities; the industry cannot
accommodate more than one firm
 Natural Monopoly
£/output unit
ATC(Q)

p(Q)

p(Q*)

MC(Q)
Q* Q
MR(Q)
Inefficiency of a Natural Monopolist
 Like any profit-maximizing
monopolist, the natural monopolist
causes a DWL
 Inefficiency of a Natural Monopoly
£/output unit
ATC(Q)
Profit-max: MR(Q) = MC(Q)
p(Q) Efficiency: p = MC(Q)

p(Q*)

MC(Q)
p(Q )
e

Q* Qe Q
MR(Q)
 Inefficiency of a Natural Monopoly
£/output unit
ATC(Q)
Profit-max: MR(Q) = MC(Q)
p(Q) Efficiency: p = MC(Q)

p(Q*)

DWL
MC(Q)
p(Q )
e

Q* Qe Q
MR(Q)
 Regulating a Natural Monopoly
 Why not make a natural monopoly
produce the efficient amount of
output Qe?
 Then the DWL will be zero, right?
 Regulating a Natural Monopoly
£/output unit
At the efficient output
ATC(Q) level Qe, ATC(Qe) > p(Qe)
p(Q)

MC(Q)
ATC(Qe)
p(Qe)

Qe Q
MR(Q)
 Regulating a Natural Monopoly
£/output unit
At the efficient output
ATC(Q) level Qe, ATC(Qe) > p(Qe)
The monopolist
p(Q)
makes losses!

MC(Q)
ATC(Qe)
p(Qe) Loss
Qe Q
MR(Q)
 Regulating a Natural Monopoly
 If a natural monopoly is forced to apply
MC pricing it will exit the market
 Other regulatory schemes can induce
the natural monopolist to reduce the
DWL without exiting
– Marginal cost pricing + subsidy
– Average cost pricing
– Price cap
Price discrimination at work:
Cinema tickets
Profit Maximization vs. Surplus Capture
 The monopolist earns positive profits
using uniform pricing, but could do
better
 Some consumers may find that price
too high, some too low
 The monopolist can extract more
surplus from consumers by charging
more than one price for its product
 This is called price discrimination
 Forms of Price Discrimination
 1st degree (or perfect) price discrimination:
- The monopolist can differentiate across
consumers AND units
 2nd degree price discrimination
– The monopolist cannot tell different
consumers apart
 3rd degree price discrimination
- The consumer can differentiate across
consumers
 Perfect Price Discrimination
 A policy of 1st degree (or perfect) price
discrimination prices each unit sold at the
consumer's maximum willingness to pay
 Consumers’ WTP must be observable
 No longer a purely theoretical possibility
 Perfect Price Discrimination
 Recall that the demand curve can be
thought of as a WTP curve
 If the monopolist can observe the
consumers’ WTP, it can "perfectly" price
discriminate
 The monopolist will sell units until the WTP
equals MC
 A perfectly price discriminating monopolist
produces the efficient quantity of output!
Price (£ per ticket) Perfect Price Discrimination
Increased profit from
21
price discrimination
18
16
Consumer
14 Surplus
12
Monopoly
profit
DWL
3 MC (=AC)
MR D
0 2 4 6 8 10 15 20
Tickets per showing
Price (£ per ticket) Perfect Price Discrimination
21

18
16 No DWL! Now profits
with perfect discrimination
14
12
Increase
in Output
9

6
MC (=AC)
3 MR D
0 2 4 6 8 10 15 20
Tickets per showing
 3rd Degree Price Discrimination
 A policy of 3rd degree price discrimination
offers a different price for each segment of
the market (or each consumer group)
when membership can be observed
 Very common practice
- Multinational firms set prices differently
across countries
- Concessions to seniors and students
 3rd degree Price Discrimination
 Two markets, 1 and 2
 y1 is the quantity supplied to market 1.
Market 1’s inverse demand function is
p1(y1)
 y2 is the quantity supplied to market 2.
Market 2’s inverse demand function is
p2(y2)
 3rd degree Price Discrimination
 For supply levels y1 and y2 the firm’s
profit is
 ( y 1 , y 2 )  p 1 ( y 1 ) y 1  p 2 ( y 2 ) y 2  c ( y 1  y 2 ).

 What values of y1 and y2 maximize

profit?
 3rd degree Price Discrimination
 ( y 1 , y 2 )  p 1 ( y 1 ) y 1  p 2 ( y 2 ) y 2  c ( y 1  y 2 ).

The profit-maximization conditions are

   c ( y1  y 2 )  ( y1  y 2 )
 p1 ( y1 )y1   
 y1  y1  ( y1  y 2 )  y1
0
   c ( y1  y 2 )  ( y1  y 2 )
 p 2 ( y 2 ) y 2   
 y2  y2  ( y1  y 2 )  y2
0
 3rd degree Price Discrimination
 ( y1  y 2 )  ( y1  y 2 )
 1 and 1
 y1  y2
So the FOCs are
  c ( y1  y 2 )
p1 ( y1 ) y1  
 y1  ( y1  y 2 )
and
  c ( y1  y 2 )
p 2 ( y 2 ) y 2   .
 y2  ( y1  y 2 )
 3rd degree Price Discrimination
   c ( y1  y 2 )
p1 ( y1 ) y1   p 2 ( y 2 ) y 2  
 y1  y2  ( y1  y 2 )



MR1(y1) = MR2(y2) implies
that the production plan
maximizes revenue
Otherwise, e.g. MR1(y1) > MR2(y2), moving
the production of one unit from one market
to the other would increase total revenue
 3rd degree Price Discrimination
   c ( y1  y 2 )
p1 ( y1 ) y1   p 2 ( y 2 ) y 2  
 y1  y2  ( y1  y 2 )





The MR common to both markets
must equal MC for profit to be
maximized
 Example: 3rd Degree Price Discrimination
 Suppose MC = 20 for any quantity sold in
any market, and suppose segments’
demands are p1 = 100 - y1 and p2 = 80 – 2y2
 At the profit maximising quantities, marginal
revenues equate marginal cost:
MR1 = 100 – 2y1 = MC = 20
MR2 = 80 – 4y2 = MC = 20
 The monopolist sells y1* = 40 in market 1 at
P1* = 60
 And quantity y2* = 15 in market 2 at P2* = 50
 3rd Degree Price Discrimination

P Market 1 P Market 2

100
Demand 1
80
A Demand 2
60 B
50

20 MC
MR2
0 40 MR1 100 Y 0 Y
20 40
 3rd degree Price Discrimination
 In which market does the monopolist
obtain the highest mark-up?
 Recall that
 1
MR1 ( y1 )  p1 ( y1 ) 1  
 1 
and
 1
MR 2 ( y 2 )  p 2 ( y 2 ) 1   .
 2
 But MR 1 ( y*1 )  MR 2 ( y*2 )  MC ( y*1  y*2 )
 3rd degree Price Discrimination
*  1 *  1
Because p1 ( y1 ) 1    p 2 ( y 2 ) 1   .
 1   2

p1 ( y*1 )  p 2 ( y*2 ) if and only if

1 1
1  1  1   2 .
1 2
The monopolist obtains the higher mark up
(has more market power) in the market
where demand is less own-price elastic
 3rd Degree Price Discrimination and the
Elasticity of Demand
P P
Market 1 Market 2
100

80
ε*1= -3/2
60 ε*2= -5/3
50

20 MC
MR1 MR2
100 y 0 Q
0 40 20 40
Higher mark up in market 1 because demand is less
elastic than in market 2 at the profit maximising outputs
 2nd Degree Price Discrimination
 A policy of 2nd degree price discrimination
offers a different price for different
quantities of the same good when the
reservation price of consumers cannot be
directly observed
 The monopolist knows that there are
different types of consumers but cannot
tell them apart
 Customer Self-Selection
 The monopolist wants buyers to self-select
– Offers a menu of options
– Options do not depend on the identity of
the consumer
– Designed to appeal to different customers
E.g. light vs heavy phone users' options
 Non-linear pricing such as quantity
discounts expands output, but not to
competitive level
E.g. utilities (water, electricity, phone, etc.)
Non-linear pricing: Two-Part Tariffs
 A two-part tariff is composed by:
1. A lump-sum fee p1, e.g. cover
charge in bars or clubs
2. Unit price p2
 To buy y units, the consumer must
thus pay
p 1 + p 2y
 Two-Part Tariffs
 Two questions:
1. Does the monopolist prefer a two-
part tariff or uniform pricing?
2. If the former, how should the
monopolist design its two-part
tariff?
 Two-Part Tariffs
p 1 + p 2y
Q: What is the largest that p1 can be?
A: The surplus the buyer gains from
participating in the market
Thus, the monopolist sets p = CS(y)
1

Now, what should p2 be?

 Two-Part Tariffs
£/output unit Should the monopolist
set p2 above MC?
p(y)

p 2  p ( y)
MC(y)

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 above MC?
p(y)
p1 = CS(y’)
p 2  p ( y) CS
MC(y)

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 above MC?
p(y)
p1 = CS(y’)
p 2  p ( y) CS PS is profit from sales
MC(y)
PS

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 above MC?
p(y)
p1 = CS(y’)
p 2  p ( y) CS PS is profit from sales
MC(y)
PS
Total profit

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 = MC?
p(y)

MC(y)
p 2  p ( y)

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS(y’’)
CS MC(y)
p 2  p ( y)

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS(y’’)
CS
PS is profit from sales
MC(y)
p 2  p ( y) PS

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS(y’’)
CS
PS is profit from sales
MC(y)
p 2  p ( y) PS
Total profit

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS(y’’)
CS
PS is profit from sales
MC(y)
p 2  p ( y) PS

y y
 Two-Part Tariffs
£/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS(y’’)
CS
PS is profit from sales
MC(y)
p 2  p ( y) PS

y y
Additional profit from setting p2 = MC
 Two-Part Tariffs
 Q: What if there are two types of
consumers (e.g. High vs Low demand)
the monopolist cannot tell apart?
 A: The monopolist must decide
whether to serve both types or just the
one with highest WTP
 Serving high types only
£/output unit Total profit:
+

p1 =
MC(y)
CSH
p2 = pH (y’)
pL(y) pH(y)
y’ y
 Serving both types
£/output unit Total profit:
+ +

p1
=
CSL MC(y)
p2 = P(Y)
P(y)
pL(y) pH(y)
Y y