MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 12: Product Pricing with Monopoly Power

Copyright 2012John Wiley & Sons, Inc. 2 Price Discrimination Definition – the practice of charging different prices for the same product when there is no cost difference to the producer in supplying the product Why would a firm want to price discriminate? To increase profit To increase total surplus (consumer surplus plus producer surplus)

Copyright 2012John Wiley & Sons, Inc. 3 Types of Price Discrimination First-degree (perfect) price discrimination – a policy in which each unit of output is sold for the maximum price a consumer will pay Second-degree price discrimination (block pricing) – the use of a schedule of prices such that the price per unit declines with the quantity purchased by a particular consumer Third-degree price discrimination (market segmentation) – a situation in which each consumer faces a single price and can purchase as much as desired at that price, but the price differs among categories of consumers

First-Degree (Perfect) Price Discrimination The price schedule is tailored to each consumer: all units are priced at the maximum price each consumer will pay. MR curve coincides with the demand curve. The profit-maximizing output level is efficient. The monopolist makes the maximum profit given the demand curve The monopolist captures all of the consumer surplus as profit. Implementation: monopolist needs to determine what consumer is willing to pay. Copyright 2012John Wiley & Sons, Inc. 4

Figure Price Discrimination Can Increase Profit Copyright 2012John Wiley & Sons, Inc. 5

Second-Degree Price Discrimination (Block Pricing ) Consumers are charged a different price for different quantities, with the schedule of prices set to extract the entire consumer surplus. Price per unit declines with the quantity purchased by a particular consumer The same price schedule confronts all consumers. Monopolist captures the consumer surplus as profit. Copyright 2012John Wiley & Sons, Inc. 6

Figure Second-Degree Price Discrimination: Block Pricing Copyright 2012John Wiley & Sons, Inc. 7

Copyright 2012John Wiley & Sons, Inc. 8 Third-Degree Price Discrimination (Market Segmentation) The price differs among categories of consumers. Examples: Faculty discounts at the college bookstore Telephone companies charging different monthly rates for business customers than for residential customers Movie theaters charging different prices for a matinee showing than for an evening showing

Copyright 2012John Wiley & Sons, Inc. 9 Three Necessary Conditions for Price Discrimination 1. The product seller must possess some degree of monopoly power; that is, a downward- sloping demand curve. 2. The seller must have some means of approximating the maximum amount buyers are willing to pay for each unit of output. 3. The seller must be able to prevent resale or arbitrage of the product among the market segments.

MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11 th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College Chapter 15: Using Noncompetitive Market Models

Figure The Size of the Deadweight Loss of Monopoly Copyright 2012John Wiley & Sons, Inc. 11

Why Are the Estimates of the Deadweight Loss Not Large? Estimates of the deadweight loss of monopoly in relation to GNP are not large. Reasons: Deadweight loss is compared to the size of the whole economy (GNP), not to the size of the monopoly There are few, if any, pure monopolies in the U.S. We cannot measure the restriction in output in any industry, only actual output. Copyright 2012John Wiley & Sons, Inc. 12

Other Possible Deadweight Losses of Monopoly 2 undesirable consequences of monopoly: Restriction of output Redistribution of income in favor of the owner of the monopoly Other effects: In the absence of competition with other firms, the monopolist is under less pressure to minimize (production) cost. A monopoly may incur other costs (in addition to production costs) to ensure continuation of its monopoly power. Copyright 2012John Wiley & Sons, Inc. 13

Do Monopolies Suppress Inventions? Worthwhile invention: one that allows a firm to produce a higher-quality product at an unchanged cost or to produce the same-quality product at a lower cost. Different industry structures: Competitive conditions: initial firm can gain until other firms copy it A worthwhile invention can be profitable for a monopolist. Conclusion: monopoly power does not necessarily suppress inventions Copyright 2012John Wiley & Sons, Inc. 14

Figure 15.2 – Monopoly and Inventions Copyright 2012John Wiley & Sons, Inc. 15

Natural Monopoly Natural monopoly – the case in which the average cost of a single enterprise declines over the entire range of market demand Economies of scale extend to very high output levels. Dilemma: Efficiency in production results from one supplier Lack of competition may lead to less output and higher prices Alternatives for public policy makers: Do nothing and let the monopoly produce unregulated Regulate the monopoly Governmental ownership and operation of the facility Allow the government to accept competitive bids from potential firms for the right to operate the facility Copyright 2012John Wiley & Sons, Inc. 16

Figure Natural Monopoly Copyright 2012John Wiley & Sons, Inc. 17

Regulation of Natural Monopoly: Theory Public utilities – public agencies charged with regulating natural monopolies Two pricing approaches: Average-cost pricing: AC=demand curve Marginal-cost pricing: MC=demand curve Average-cost pricing is more practical Output is greater and price is lower than if the monopoly were unregulated Monopoly’s owners receive no profit Copyright 2012John Wiley & Sons, Inc. 18

Figure Regulation of Natural Monopoly Copyright 2012John Wiley & Sons, Inc. 19

Regulation of Natural Monopoly: Practice Practice: reliance on the rate of return on invested capital (accounting profit) earned by a monopoly because complete knowledge of cost and demand conditions is unattainable Issues: The monopolist’s incentive to minimize cost is diminished. Regulated rates reduces the incentive to engage in research and development activities designed to develop new services or new products. Conclusion: Regulation is not ideal Alternatives are likewise unattractive Copyright 2012John Wiley & Sons, Inc. 20

Regulating Natural Monopoly through Public Ownership Example: United States Postal Service (USPS) Objective: P=AC, not profit maximization Profit is constrained to equal zero Incentive to innovate and/or to encourage cost-minimization is attenuated Copyright 2012John Wiley & Sons, Inc. 21

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