1 / 45

Chapter 3

Chapter 3. Basic Monopoly Pricing and Product Strategies. Introduction. A monopolist has the power to set prices Consider how the monopolist exercises this power Focus in this section on a single-product monopolist What determines price? What different pricing strategies might be used?

mira-buckley
Download Presentation

Chapter 3

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 3 Basic Monopoly Pricing and Product Strategies Industrial Organization: Chapter 3

  2. Introduction • A monopolist has the power to set prices • Consider how the monopolist exercises this power • Focus in this section on a single-product monopolist • What determines price? • What different pricing strategies might be used? • What product design strategies might be used? • What constraints are there on the monopolist’s ability to extract consumer surplus? Industrial Organization: Chapter 3

  3. First-Degree Price Discrimination First-degree price discrimination occurs when the seller is able to extract the entire consumer surplus • suppose that you own five antique cars and you meet two collectors • each is willing to pay $10,000 for one car, $8,000 for a second car, $6,000 for a third car, $4,000 for a fourth and $2,000 for a fifth • sell the first two cars at $10,000, one to each buyer • sell the second two cars at $8,000, one to each buyer • sell the fifth car to one of the buyers at $6,000 • total revenue $42,000 • Highly profitable but requires • detailed information • ability to avoid arbitrage • Leads to the efficient choice of output: since price equals marginal revenue and MR = MC Industrial Organization: Chapter 3

  4. First-degree price discrimination (cont.) • The information requirements appear to be insurmountable • No arbitrage is less restrictive but potentially a problem • But there are pricing schemes that will achieve the same output • non-linear prices • two-part pricing as a particular example of non-linear prices Industrial Organization: Chapter 3

  5. Two-Part Pricing $ Take an example: V Jazz club: n identical consumers Demand is P = V - Q Cost is C(Q) = F + cQ c Marginal Revenue is MC MR = V - 2Q MR Marginal Cost is V MC = c Quantity Industrial Organization: Chapter 3

  6. Charging an entry fee increases profit by (V - c)2/8 per consumer Two-Part Pricing What if the seller can charge an entry fee? $ With a uniform price profit is maximized by setting marginal revenue equal to marginal cost V The maximum entry fee that each consumer will be willing to pay is consumer surplus (V+c)/2 V - 2Q = c c MC So Q = (V - c)/2 MR P = V - Q V So P = (V + c)/2 (V-c)/2 Quantity Profit to the monopolist is n(V - c)2/4 - F Consumer surplus for each consumer is (V - c)2/8 Industrial Organization: Chapter 3

  7. Two-Part Pricing Is this the best the seller can do? $ V This whole area is now profit from each consumer (V+c)/2 Lower the unit price c MC This increases consumer surplus and so increases the entry charge MR V (V-c)/2 Quantity Industrial Organization: Chapter 3

  8. Two-Part Pricing What is the best the seller can do? $ V The entry charge converts consumer surplus into profit Using two-part pricing increases the monopolist’s profit Set the unit price equal to marginal cost c MC MR This gives consumer surplus of (V - c)2/2 V V - c Quantity Set the entry charge to (V - c)2/2 Industrial Organization: Chapter 3

  9. Two-part pricing (cont.) • First-degree price discrimination through two-part pricing • increases profit by extracting all consumer surplus • leads to unit price equal to marginal cost • causes the monopolist to produce the efficient level of output • What happens if consumers are not identical? • Assume that consumers differ in types and that the monopolist can identify the types • age • location • some other distinguishing and observable characteristic • We can extend our example Industrial Organization: Chapter 3

  10. 4 4 MC MC Two-part pricing with different consumers • There is an alternative approach So the seller can charge an entry fee of $72 t o each older customer and $32 to each younger one Younger Consumers Older Consumers • Offer older customers entry plus 12 units for $120 Demand: P = 16 - Q Demand: P = 12 - Q This converts all consumer surplus into profit • and younger customers entry plus 8 units for $64 $ $ And for the younger customers consumer surplus is $32 If unit price is set at $4 older customers each buy 12 units 16 Consumer surplus for the older customers is $72 Assume that marginal cost is constant at $4 per unit And younger customers each buy 8 units 12 $72 $72 $32 $32 $48 $32 12 16 8 12 Quantity Quantity Industrial Organization: Chapter 3

  11. Second-Degree Price Discrimination • What if the seller cannot distinguish between buyers? • perhaps they differ in income (unobservable) • Then the type of price discrimination just discussed is impossible • High-income buyer will pretend to be a low-income buyer • to avoid the high entry price • to pay the smaller total charge • Confirm from the diagram Industrial Organization: Chapter 3

  12. 4 4 MC MC The example again High-Demand Consumers Low-Demand Consumers Could the seller prevent this by limiting the number of units that can be bought? Demand: P = 16 - Q Demand: P = 12 - Q NO! If a high-demand consumer pays the lower fee and gets the lower quantity he gets $32 of consumer surplus If a high-demand consumer pays the lower fee and buys 12 units he gets $40 of consumer surplus $ $ 16 12 $32 8 $32 $32 $8 $16 $32 $32 8 12 16 8 12 Quantity Quantity Industrial Organization: Chapter 3

  13. Second-Degree Price Discrimination • The seller has to compromise • A pricing scheme must be designed that makes buyers • reveal their true types • self-select the quantity/price package designed for them • This is the essence of second-degree price discrimination • It is “like” first-degree price discrimination • The seller knows that there are buyers of different types • But • the seller is not able to identify the different types • A two-part tariff is ineffective • allows deception by buyers • Use quantity discounting Industrial Organization: Chapter 3

  14. 4 4 MC MC The example again High-Demand Low-Demand So any other package offered to high-demand consumers must offer at least $32 consumer surplus So will the high- demand consumers: because the ($64, 8) package gives them $32 consumer surplus This is the incentive compatibility constraint The low-demand consumers will be willing to buy this ($64, 8) package Low demand consumers will not buy the ($88, 12) package since they are willing to pay only $72 for 12 drinks These packages exhibit quantity discounting: high- demand pay $7.33 per unit and low-demand pay $8 So they can be offered a package of ($88, 12) (since $120 - 32 = 88) and they will buy this High demand consumers are willing to pay up to $120 for entry plus 12 drinks if no other package is available $ Profit from each high- demand consumer is $40 ($88 - 12 x $4) $ Offer the low-demand consumers a package of entry plus 8 drinks for $64 And profit from each low-demand consumer is $32 ($64 - 8x$4) 16 12 $32 8 $32 $32 $40 $32 $64 $8 $24 $16 $32 $32 $8 8 12 16 8 12 Quantity Quantity Industrial Organization: Chapter 3

  15. 4 4 MC MC The example again The monopolist does better by reducing the number of units offered to low-demand consumers since this allows him to increase the charge to high-demand consumers Can the club- owner do even better than this? A high-demand consumer will pay up to $87.50 for entry and 7 drinks High-Demand Low-Demand So buying the ($59.50, 7) package gives him $28 consumer surplus Suppose each low-demand consumer is offered 7 drinks So entry plus 12 drinks can be sold for $92 ($120 - 28 = $92) Each consumer will pay up to $59.50 for entry and 7 drinks $ $ Profit from each ($92, 12) package is $44: an increase of $4 per consumer 16 Yes! Reduce the number of units offered to each low-demand consumer Profit from each ($59.50, 7) package is $31.50: a reduction of $0.50 per consumer 12 $28 $87.50 $31.50 $44 $92 $59.50 $28 $48 $28 7 12 16 8 12 7 Quantity Quantity Industrial Organization: Chapter 3

  16. Second-degree price discrimination (cont.) • Will the monopolist always want to supply both types of consumer? • There are cases where it is better to supply only high-demand • high-class restaurants • golf and country clubs • Take our example again • suppose that there are Nl low-income consumers • and Nh high-income consumers Industrial Organization: Chapter 3

  17. Second-degree price discrimination (cont.) • Suppose both types of consumer are served • two packages are offered ($57.50, 7) aimed at low-demand and ($92, 12) aimed at high-demand • profit is $31.50xNl + $44xNh • Now suppose only high-demand consumers are served • then a ($120, 12) package can be offered • profit is $72xNh • Is it profitable to serve both types? • Only if $31.50xNl + $44xNh > $72xNh 31.50Nl > 28Nh Nh 31.50 This requires that < = 1.125 Nl 28 There should not be “too high” a proportion of high-demand consumers Industrial Organization: Chapter 3

  18. Second-degree price discrimination (cont.) • Characteristics of second-degree price discrimination • extract all consumer surplus from the lowest-demand group • leave some consumer surplus for other groups • the incentive compatibility constraint • offer less than the socially efficient quantity to all groups other than the highest-demand group • offer quantity-discounting • Second-degree price discrimination converts consumer surplus into profit less effectively than first-degree • Some consumer surplus is left “on the table” in order to induce high-demand groups to buy large quantities Industrial Organization: Chapter 3

  19. Third-Degree Price Discrimination • Consumers differ by some observable characteristic(s) • A uniform price is charged to all consumers in a particular group • Different uniform prices are charged to different groups • “kids are free” • subscriptions to professional journals e.g. American Economic Review • airlines • the number of different economy fares charged can be very large indeed! • early-bird specials; first-runs of movies Industrial Organization: Chapter 3

  20. Third-degree price discrimination (cont.) • Often arises when firms sell differentiated products • hard-back versus paper back books • first-class versus economy airfare • Price discrimination exists in these cases when: • “two varieties of a commodity are sold by the same seller to two buyers at different net prices, the net price being the price paid by the buyer corrected for the cost associated with the product differentiation.” (Phlips) • The seller needs an easily observable characteristic that signals willingness to pay • The seller must be able to prevent arbitrage • e.g. require a Saturday night stay for a cheap flight Industrial Organization: Chapter 3

  21. Third-degree price discrimination (cont.) • The pricing rule is very simple: • consumers with low elasticity of demand should be charged a high price • consumers with high elasticity of demand should be charged a low price • Illustrate with a simple example • monopolist has constant marginal costs of c per unit • two types of consumers, with the type being identifiable • all consumers of a particular type have identical demands • two pricing rules must hold • marginal revenue must be equal on the last unit sold to each type of consumer • marginal revenue must equal marginal cost in each market Industrial Organization: Chapter 3

  22. c c MC MC An example Type 1 Demand: P = A1 - BQ1 Type 2 Demand: P = A2 - BQ2 Since A1 > A2 Type 1 consumers are charged a higher price than Type 2 consumers MR1 = A1 - 2BQ1 MR2 = A2 - 2BQ2 MC = c MC = c  Q1 = (A1 - c)/2B  Q2 = (A2 - c)/2B  P1 = (A1 + c)/2  P2 = (A2 + c)/2 $ $ A1 A2 (A1+c)/2 (A2+c)/2 MR2 MR1 (A1-c)/2B A1/B (A2-c)/2B A2/B Quantity Quantity Industrial Organization: Chapter 3

  23. Third-degree price discrimination (cont.) • What happens if marginal costs are not constant? • The same principles apply • marginal revenue equalized across consumer types • marginal revenue equal to marginal cost where marginal cost is measured at aggregate output • Consider an example Industrial Organization: Chapter 3

  24. The example • Two markets • Market 1: P = 20 - Q1 • Market 2: P = 16 - 2Q2 Now calculate aggregate marginal revenue MR1 = 20 - 2Q1 MR2 = 16 - 4Q2 Note that this applies only for prices less than $16 Invert these to give Q as a function of MR: Q1 = 10 - MR/2 MC = 2Q Q2 = 4 - MR/4 The consumers with less elastic demand are charged higher prices MC = MR  2Q = 56/3 - 4Q/3 So aggregate marginal revenue is  Q = 5.6 Q = Q1 + Q2 = 14 - 3MR/4  MR = $11.20 Invert this to give marginal revenue:  Q1 = 4.4 and Q2 = 1.2 MR = 56/3 - 4Q/3 for MR < $16  P1 = $15.60 and P2 = $13.60 MR = 20 - 2Q for MR > $16 Industrial Organization: Chapter 3

  25. Third-degree price discrimination (cont.) • A general rule characterizes third-degree price discrimination • Recall the formula for marginal revenue in market i: • MRi = Pi(1 - 1/i) where i is the price elasticity of demand • Recall also that when serving two markets profit maximization requires that MR is equalized in each market • so MR1 = MR2 •  P1(1 - 1/ 1) = P2(1 - 1/ 2) Prices are always higher in markets where demand is inelastic P1 (1 - 1/ 2)  = P2 (1 - 1/ 1) Industrial Organization: Chapter 3

  26. Price Discrimination and Welfare • Does price discrimination reduce welfare? • First- and second- degree: “not necessarily” • because output is at or near to the efficient level • Third-degree is less clear • monopolist restricts output in the markets supplied • but markets may be served that would otherwise be left unsupplied • A necessary condition for third-degree price discrimination not to reduce welfare is that it leads to an increase in output Industrial Organization: Chapter 3

  27. Public Policy • Uneven • Robinson-Patman makes price discrimination illegal if it is intended to create a monopoly • One defense is if discriminatory prices are intended to “meet the competition” • Enforcement has been spotty • weak in recent years • but note the pharmaceutical case • private actions are possible: see http://lawmall.com • International restrictions also exist • anti-dumping regulations • these are currently pursued very actively Industrial Organization: Chapter 3

  28. Monopoly and Product Quality • Firms can, and do, produce goods of different qualities • Quality then is an important strategic variable • The choice of product quality by a monopolist is determined by its ability to generate profit • Focus for the moment on a monopolist producing a single good • what quality should it have? • determined by consumer attitudes to quality • prefer high to low quality • willing to pay more for high quality • but this requires that the consumer recognizes quality • also some are willing to pay more than others for quality Industrial Organization: Chapter 3

  29. Demand and Quality • We might think of individual demand as being of the form • Qi = 1 if Pi< Ri(Z) and = 0 otherwise for each consumer i • Each consumer buys exactly one unit so long as price is less than her reservation price • the reservation price is affected by product quality Z • Assume that consumers vary in their reservation prices • Then aggregate demand is of the form P = P(Q, Z) • An increase in product quality increases demand Industrial Organization: Chapter 3

  30. Demand and quality (cont.) Begin with a particular demand curve for a good of quality Z1 Price Suppose that an increase in quality increases the willingness to pay of inframarginal consumers more than that of the marginal consumer Then an increase in product quality from Z1 to Z2 rotates the demand curve around the quantity axis as follows R1(Z2) P(Q, Z2) If the price is P1 and the product quality is Z1 then all consumers with reservation prices greater than P1 will buy the good P2 R1(Z1) Quantity Q1 can now be sold for the higher price P2 This is the marginal consumer These are the inframarginal consumers P1 P(Q, Z1) Q1 Quantity Industrial Organization: Chapter 3

  31. Demand and quality (cont.) Suppose instead that an increase in quality increases the willingness to pay of marginal consumers more than that of the inframarginal consumers Price Then an increase in product quality from Z1 to Z2 rotates the demand curve around the price axis as follows R1(Z1) Once again quantity Q1 can now be sold for a higher price P2 P2 P1 P(Q, Z2) P(Q, Z1) Q1 Quantity Industrial Organization: Chapter 3

  32. Demand and quality (cont.) • The monopolist must choose both • price (or quantity) • quality • Two profit-maximizing rules • marginal revenue equals marginal cost on the last unit sold for a given quality • marginal revenue from increased quality equals marginal cost of increased quality for a given quantity • This can be illustrated with a simple example: P = Z( - Q) where Z is an index of quality Industrial Organization: Chapter 3

  33. Demand and quality: an example P = Z(q - Q) Assume that marginal cost of output is zero: MC(Q) = 0 Cost of quality is D(Z) = aZ2 This means that quality is costly and becomes increasingly costly Marginal cost of quality = dD(Z)/d(Z) = 2aZ The firm’s profit is: p(Q, Z) =P.Q - D(Z) = Z(q - Q)Q - aZ2 The firm chooses Q and Z to maximize profit. Take the choice of quantity first: this is easiest. Zq - 2ZQ Marginal revenue = MR = MR = MC  Zq - 2ZQ = 0  Q* = q/2  P* = Zq/2 Industrial Organization: Chapter 3

  34. The example continued Total revenue = P*Q* = (Zq/2)x(q/2) = Zq2/4 So marginal revenue from increased quality is MR(Z) = q2/4 Marginal cost of quality is MC(Z) = 2aZ Equating MR(Z) = MC(Z) then gives Z* = q2/8a Does the monopolist produce too high or too low quality? Is it possible that quality is too high? Only in particular constrained circumstances. Industrial Organization: Chapter 3

  35. The Multiplant Monopolist • A monopolist rarely produces all output in one plant • how should production be allocated across plants? • this is especially important if different plants have different costs • To maximize profit set MR = MC on the last unit produced • But with several plants what is MC? • First case: • marginal costs constant within a plant but varying across plants • each plant has a capacity constraint Industrial Organization: Chapter 3

  36. The multiplant monopolist (cont.) Plant 3 has marginal cost MC3 and capacity q3 Price Suppose that there are three possible plants. Arrange them in order of their marginal costs Maximize profit by equating marginal cost and marginal revenue Plant 2 has marginal cost MC2 and capacity q2 MC3 Plant 1 has marginal cost MC1 and capacity q1 Produce output Q* using plant 1 and plant 2. Plant 3 is not operated (or introduced) MC2 MC1 MR q1 q1 + q2 Q* Quantity Industrial Organization: Chapter 3

  37. The multiplant monopolist (cont.) • What happens if marginal costs are not constant? • Output allocation • operate plants such that marginal cost is equal on the last unit produced in each plant • Why? • If not, then cost can be reduced by reallocating output between plants • For example: suppose MC1 = $10 and MC2 = $15 • Reducing output of plant 2 by one unit and increasing output of plant 1 by one unit reduces total costs Industrial Organization: Chapter 3

  38. An Example Suppose MC1 = aq1 and MC2 = bq2 q1 = MC/a ; q2 = MC/b $  Q =q1 + q2 = MC(a + b)/ab $ Maximize profit by setting marginal revenue equal to marginal cost  MC = Qab/ (a + b) MC2 = bq2 Allocate output to the two plants to equate marginal costs MC1 = aq1 MC1 + MC2 MR q2* q1* Quantity Q* Quantity Industrial Organization: Chapter 3

  39. Industrial Organization: Chapter 3

  40. Demand and quality (cont.) Price Z2q P(Q, Z2) When quality is Z2 price is Z2q/2 How does increased quality affect demand? MR(Z2) When quality is Z1 price is Z1q/2 Z1q P2 = Z2q/2 P1 = Z1q/2 MR(Z1) P(Q,Z1) q/2 q Quantity Q* Industrial Organization: Chapter 3

  41. Social surplus at quality Z2 is this area minus quality costs Social surplus at quality Z1 is this area minus quality costs Demand and quality (cont.) Price So an increase is quality from Z1 to Z2 increases surplus by this area minus the increase in quality costs Z2q The increase is total surplus is greater than the increase in profit. The monopolist produces too little quality An increase in quality from Z1 to Z2 increases revenue by this area Z1q P2 = Z2q/2 P1 = Z1q/2 q/2 q Quantity Q* Industrial Organization: Chapter 3

  42. Demand and quality: an alternative The increase in social surplus is this area minus the cost of increased quality The increase in total surplus is less than the increase in profit. The monopolist produces too much quality Price The increase in quality increases profit by this area minus the cost of increased quality Assume that an increase in quality from Z1 to Z2 rotates the demand function as follows Further assume that the firm is constrained to produce output Q Exporters subject to quotas tend to export high quality goods P(Q,Z2) This may arise as a result of an export quota or other restriction on output P(Q,Z1) Q Quantity Industrial Organization: Chapter 3

  43. Demand and quality Derivation of aggregate demand Order consumers by their reservation prices Aggregate individual demand horizontally Price 1 2 3 4 5 6 7 8 Quantity Industrial Organization: Chapter 3

  44. Market 1 Market 2 Aggregate $ $ $ $20 $20 MC $16 $16 $15.60 $13.60 $11.20 D1 MR1+MR2 MR1 D2 MR2 4.4 10 20 1.2 4 8 5.6 14 Quantity Quantity Quantity Industrial Organization: Chapter 3

  45. The incentive compatibility constraint • Any offer made to high demand consumers must offer them as much consumer surplus as they would get from an offer designed for low-demand consumers. • This is a common phenomenon • performance bonuses must encourage effort • insurance policies need large deductibles to deter cheating • piece rates in factories have to be accompanied by strict quality inspection • encouragement to buy in bulk must offer a price discount Industrial Organization: Chapter 3

More Related