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.

Chapter 26 Monopoly Behavior A monopoly can use complicated pricing and marketing strategies to enhance its market power. 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.

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.

First-degree: unit and person Second-degree: unit Third-degree: person

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.

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.

Fig. 25.1

Fig. 25.2

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

Can we mimic the perfect discrimination? Who will mimic who? Note that the low-end consumer’s package is distorted so that the high-end consumer will not choose the low-end package.

Fig. 25.3

Compared to 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.

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.

Third-degree: the most common form of price discrimination (student discounts, senior citizens’ discounts).

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).

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.

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

Bundling: packages of related goods are often offered for sale together: software suite (word processor, spreadsheet, presentation tool), cosmetic products, etc.

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.

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

Two-part tariffs: amusement park (entry fee + charge per ride), razor (razor + blade). Consider an example where MC is constant. Optimum is to set the charge per ride to the marginal cost, then set the entry fee to extract all the consumers’ surplus.

Fig. 25.5

Hotelling model: consumers populate uniformly on a line and two firms have to choose a position. They go to the store that is closest.

Fig. 25.7

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.