Chapter 10 Monopoly (Part V) © 2004 Thomson Learning/South-Western

2 APPLICATION 10.6: Bundling of Satellite TV Offerings – Charging $15 per each package would yield $60 from these customers. – A bundling scheme that charges $20 per package, if purchased individually, or $23 if both are bought, would yield $86. – Thus, revenue can be increased by the proper choice of pricing bundles of services.

3 APPLICATION 10.6: Bundling of Satellite TV Offerings Bundling by Direct TV, Inc. – Bundling prices are shown in Table 1, where the incremental costs help to demonstrate the bundling price scheme. – Notice adding sports costs $10 extra, but the full movie package adds $43 ($15 for Showtime and $28 for HBO/STARZ). – Both packages together ($51) offers a minor savings over buying the separate packages.

4 TABLE 1: Sample Direct TV Program Options

5 Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma By marginal cost pricing the deadweight loss from monopolies is minimized. However, this would require a natural monopoly to operate at a loss. – A unregulated monopoly would produce Q A at price P A in Figure 10.6, yielding a profit of P A ABC.

6 Price P A C A B MC MR AC D Quantity per week Q A Q R 0 FIGURE 10.6: Price Regulation for a Natural Monopoly

7 Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma – Marginal cost pricing of P R which results in Q R demanded would generate an a loss equal to the area GFEP R because P R < AC. Either marginal cost pricing must be abandoned or the government must subsidize the monopoly.

8 Price P A G P R C H J A B MC MR AC F E D Quantity per week Q A Q R 0 FIGURE 10.6: Price Regulation for a Natural Monopoly

9 Two-Tier Pricing Systems Under this system the monopoly is permitted to charge some users a high price and charge “marginal” users a low price. The regulatory commission might allow the monopoly to charge P A and sell Q A to one class of buyers. Other users would pay P R and would demand Q R - Q A.

10 Two-Tier Pricing Systems At total output of Q R average costs are 0G. Under this system, monopoly profits (area P A AHG) balance the losses (area HFEJ). Here the “marginal user” pays marginal cost and is subsidized by the “intramarginal” user.

11 APPLICATION 10.7: Can Anyone Understand Telephone Pricing? In January 1, 1984 AT& T formally divested itself of its seven local Bell Operating Companies as the result of a 1974 Department of Justice antitrust suit. The goal of the restructuring was to improve the performance and competitiveness of the U.S. telephone industry.

12 APPLICATION 10.7: Can Anyone Understand Telephone Pricing? Subsidization of Local Phone Service – Prior to the breakup, regulators forced AT&T to subsidize local residential phone services. – They covered these losses by charging above- average costs on long distance calls. – Residential services cost an average of $28 per month but the typical charge was $11.

13 APPLICATION 10.7: Can Anyone Understand Telephone Pricing? After the breakup regulators had to choose between implementing huge increases in residential telephone rates or continuing subsidies. – The politically expedient choice was to force AT&T and other to continue to subsidize local residential rates.

14 APPLICATION 10.7: Can Anyone Understand Telephone Pricing? The Telecommunications Act of 1996 – The government used this act to increase entry into the local phone market to try to reduce the monopoly power of local providers. – This was attempted by specifying specific conditions under which these local companies could offer long distance service. – To obtain this right, local companies had to sell services to potential entrants into their market.

15 Rate of Return Regulation Regulators may permit a monopoly to charge a price above average cost that will earn a “fair” rate of return on investment. If the allowed rate exceeds that an owner might earn under competitive circumstances, the firm has an incentive to use relatively more capital input than needed to minimize costs.