Chapter 26 Monopoly Behavior Key Concept: the second -degree price discrimination.

1. Chapter 26 Monopoly Behavior • Key Concept: the second-degree price discrimination. • We see how the low end is distorted and how the high end is given some surplus.

2. Chapter 26 Monopoly Behavior • We have seen two extremes, the competitive market and the monopolized market. • In reality, most industries are in between.

3. A firm which has some monopoly has more options than a firm in a perfectly competitive industry. • It can use complicated pricing and differentiate itself. • We will examine how firms enhance and exploit their market power.

4. A monopolist is inefficient (produces too little) because producing more implies the price has to be lower. • This is not the case if a monopolist can sell different units of outputs at different prices or price discriminate.

5. First-degree price discrimination (perfect price discrimination): the monopolist sells different units of outputs for different prices and these prices may differ from person to person. • Second-degree price discrimination: prices differ across the units of goods, but not across people. • Third-degree price discrimination: prices differ across people, but a given person pays the same price for all units.

6. First-degree: unit and person • Second-degree: unit • Third-degree: person

7. First-degree: every unit is sold to the consumer who values it most highly at the highest price the consumer is willing to pay for it.

8. Since the monopolist leaves no consumers’ surplus, all surplus goes to the monopolist. • Rightly because consumers are left with no surplus, when considering marginally increasing one unit, the monopolist is comparing the marginal willingness to pay to MC. • Therefore, SS is maximized.

9. Fig. 25.1

10. We have interpreted the first-degree price discrimination as selling each unit at the maximum price a monopolist could command. • We can also think of it as selling a fixed amount of the good at a “take it or leave it” price.

11. Fig. 25.2

12. Second-degree: also known as non-linear pricing since the price per unit of output is not constant, but depends on how much you buy.

13. For instance, 1 may be a business traveler and 2 may be a tourist. • A monopolist may want to charge 1 A plus cost and 2 B plus cost. • But how can we tell 1 from 2?

14. Fig. 25.2

15. The monopolist can offer different price-quantity packages so that the consumers can self select.

16. Imagine a case with consumers 1 and 2. • The MC is set to 0.

17. Fig. 25.3

18. A monopolist would want to offer x10 at price A and x20 at price A+B+C. • Can we mimic the perfect discrimination? • Who will mimic whom?

19. By self-selection, the high-end consumer would rather choose x10 at price A because this would leave him the surplus of B. • If he instead chooses x20 at price A+B+C, his surplus is 0.

20. Can we mimic the perfect discrimination? • Who will mimic whom?

21. To leave the surplus B to 2, a monopolist could try (x10, A) and (x20, A+C). • The monopolist would then earn A from 1 and A+C from 2. • Is this the best a monopolist can do?

22. Intuition suggests that distorting 1’s package a bit may be worthwhile. • Note that the low-end consumer’s package is distorted so that the high-end consumer will not choose the low-end package.

23. Fig. 25.3

24. Compared with perfect price discrimination, without high-end, low-end is offered higher quantity but still ends up with zero surplus. • Without low-end, high end gets zero surplus, now gets positive surplus and the quantity offered is the same.

25. Applying this to air travels, by offering a downgraded product, the airlines can charge the consumers who need flexible travel arrangements more for their tickets.

26. The third class rail carriage has no roof in 19th century France. • What the company is trying to do is prevent the passengers who can pay the second-class far from traveling the third class; it hits the poor, not because it wants to hurt them, but to frighten the rich.

27. Third-degree: the most common form of price discrimination. • Ex: Student discounts, senior citizens’ discounts, a higher price for the tourists.

28. Suppose there are two groups of people and there is no resale. • Then the monopolist’s profit maximization problem becomes • maxy1, y2(=p1(y1)y1+ p2(y2)y2-c(y1+y2)) • FOC becomes MR1(y1)=MC(y1+y2)=MR2(y2).

29. MR1(y1)=p1(y1)[1-1/|1|] • MR2(y2)=p2(y2)[1-1/|2|] • Hence p1>p2 if and only if |1|<|2|. • The market with lower absolute value of elasticity has a higher price. • Quite sensible since elasticity measures how sensitive the group is to prices.

30. There are some other often-observed practices used by firms with monopoly power.

31. Bundling: packages of related goods are often offered for sale together. • A software suite (office) consists of a word processor (word), a spreadsheet (excel), presentation tool (power point).

32. Bundling may be cost saving or it may be due to complementarities among the goods involved. • But there can be reasons involving consumer behavior. Consider the following example. • Assume the marginal cost of producing is zero.

33. Type of consumers word pro spreadsheet A 120 100 B 100 120 • Suppose the willingness to pay for the bundle is the sum.

34. Type of consumers word pro spreadsheet A 120 100 B 100 120 • If each item is sold separately, then revenue will be 400. • If instead bundling two goods together, the revenue will be 440. In other words, the dispersion of willingness to pay may be reduced.

35. Two-part tariffs: amusement park (entry fee + charge per ride), razor (razor + blade). • An amusement park can set one price for tickets to get into the park and another price for the rides.

36. The price that people are willing to pay to get into the park will depend on the price they have to pay for the rides. • This gives a two-part pricing scheme called a two-part tariff.

37. Consider an example where MC is constant. • People go to the park for the rides. • Optimum is to set the charge per ride to the marginal cost, then set the entry fee to extract all the consumers’ surplus.

38. Fig. 25.5

39. Hotelling model: consumers populate uniformly on a line and two firms have to choose a position. • They go to the store that is closest. • We have too little product differentiation! • Apply this to voting.

40. Fig. 25.7

41. Chapter 26 Monopoly Behavior • Key Concept: the second-degree price discrimination. • We see how the low end is distorted and how the high end is given some surplus.