Monopoly vs. competition? Imagine 100 identical widget-manufacturing plants. (Widgets: a homogeneous good with no close subs.) Consider two possible configurations for the industry: 1. Competition. Each of the plants is owned by a different person. Each plant/firm is a price taker. Each plant/firm chooses output to max. profit, given the market-determined price.

2. Monopoly. One (very wealthy!) person buys all 100 plants, making them a single firm. The owner (facing market demand) recognizes that he/she has market power. Output levels (in all 100 plants) chosen to max. profit for the firm. How will price and output compare for the two cases? What about welfare measures (consumer and producer surplus)?

Competitive equilibrium is determined by the supply Competition Start with the competitive supply curve. (Remember, this is the horizontal sum of plant-level MCs.) ($/widget) (widgets/day) Supply Demand Introduce demand. Qc pc Competitive equilibrium is determined by the supply and demand intersection.

Now let’s consider monopoly ($/widget) (widgets/day) Demand When the monopolist merges all 100 plants, his/her MC is the “old” competitive supply. MC MR Add MR. pm Qc pc Monopoly quantity is determined by MR = MC . . . Qm . . . and monopoly price is the demand price at Qm. For comparison, let’s bring back the competitive equil. Monopolization leads to higher price and lower output.

What about the welfare effects of monopolization? ($/widget) (widgets/day) Demand Qc pc Comp. Supply = Monopoly MC MR Qm pm “Erase” MR -- to give us a little more room.

What about the welfare effects of monopolization? pc ($/widget) (widgets/day) Demand Qc Comp. Supply = Monopoly MC Qm pm C.S. P.S. T.S. Comp. Mnply. change A+B+C D+E +D+E A B+D A+B+D -(B+C) +B-E -(C+E) A B C D E ( +B-E > 0; P.S. increases with monopoly.) C + E is the “deadweight loss” of monopoly. Add some labels.

Monopoly vs. competition? Easy to see why monopoly is “bad” for consumers: . . . . . . fewer widgets consumed at a higher price! But now we also understand the sense in which monopoly is “bad” for society: . . . . . . it results in a lower total surplus than competition.

($/widget) (widgets/day) Demand Comp. Supply = Monopoly MC Qc is the efficient output -- it maximizes total surplus. (A lesson from chpt. 7.) Monopoly output, Qm, is less than this. Qm Qc To make the example a little less abstract, let’s throw in some hypothetical numbers. Suppose Qc = 100 wdgts/day and Qm = 70 wdgts/day.

Let’s consider one of those widgets between Qm and Qc . . . Comp. Supply = Monopoly MC ($/widget) . . . the 82nd, let’s say. 82 For the 82nd widget/day, the demand price (or marginal value) . . . Demand . . . is greater than the marginal cost. 70 100 (widgets/day) So production and consumption of the 82nd widget/day can add to total surplus. Because the monopoly doesn’t supply the 82nd widget/day, some potential surplus is lost.

While p > MC, MR = MC (the profit max. condition). Note that, at Qm, p > MC. ($/widget) (widgets/day) Demand Monopoly MC MR Doesn’t this mean that the monopoly can make profit bigger by producing more? pm MC(Qm) Qm No! Producing (and selling) more would require cutting price. So MR < p. While p > MC, MR = MC (the profit max. condition).

So monopoly is a source of market failure . . . . . . like externalities and public goods. Public policy toward monopoly Antitrust law: Collection of federal statutes aimed at curbing monopoly’s “bad” effects. Enforcement: U.S. Department of Justice (DOJ), Antitrust Division.

Under antitrust law: DOJ can file suit in federal court to . . . . . . prohibit firms from engaging in certain anti-competitive business practices. . . . prohibit some proposed mergers -- to prevent firms from getting too big (too “monopoly-like”). . . . break up companies that are already too big (too “monopoly-like”).

Public policy toward natural monopolies (public utilities, for example): “Rate-of-return regulation” -- prices set by a government authority with objective of achieving a “fair” profit. Government ownership (like the electric power utility in Ames)

Up to now, our analysis has focused on “uniform-price monopolist” . . . . . . charges the same price to all customers. Result: “too little” output, from society’s point of view. Price discrimination: selling the same good at different prices to different customers . . . . . . (when those price differences aren’t “justified” by cost differences). Examples: Senior-citizen discounts, student discounts at ISU-sponsored events, discount coupons at Hy-Vee.

Simple example: Widget monopolist has two groups of customers N customers with “high” willingness-to-pay (WTP) = $5 M customers with “low” WTP = $3. Marginal cost of a widget = $2 (constant; doesn’t vary with output). Fixed cost = $0.

The widget monopolist’s demand curve. At prices above $5: No demand. ($/widget) (widgets/day) When price falls to $5, the demand of the “high” WTP guys “kicks in.” N 5 N + M 3 2 MC When price falls to $3, demand of “low” WTP guys is added.

Monopolist’s profit-maximizing pricing strategy? If required to charge a uniform price . . . . . . there are only two possibilities to consider: Price = $5 or $3. If p = $5, only “high” WTP customers will buy. Profit = (5 - 2) x N = 3N.

With p = $5, Profit = (5 – 2) x N = 3N ($/widget) (widgets/day) N 5 N + M 3 2 MC

If p = $3, “high” and “low” WTP customers will buy. Profit = (3 – 2) x (N + M) = N + M ($/widget) (widgets/day) N 5 N + M 3 2 MC

If there are sufficiently many “low” WTP customers, the profit-maximizing price is $3. (For example, if N = M = 100, p = $5 is best. But if N = 100 and M = 300, p = $3 is best.) Now suppose the monopolist can price discriminate (charge different prices to the two groups). Best strategy in this case?

For each group, charge a price = WTP. (“Take them for all they’re worth!”) p = $5 to “high” WTP customers. p = $3 to “low” WTP customers. Profit = (5 - 2) x N + (3 - 2) x M = 3N + M . . . . . . greater than 3N . . . . . . and greater than N + M. Price discrimination is more profitable than uniform pricing for any values of N and M.

Results for this very simple example illustrate some general principles of price discrimination: 1. Compared to uniform pricing, price discrimination (usually) leads to greater output. Example: N = M = 100. With uniform pricing, p = $5. Sell to only “high” WTP customers. Output = 100. With price discrimination, sell to both “high” and “low” WTP customers. Output = 200.

Remember: Inefficiency of (uniform price) monopoly is caused by “too little” output. Price discrimination can improve efficiency. (Increase total surplus.) 2. Compared to uniform pricing, price discrimination allows the monopolist to make more profit . . . . . . and the extra profit comes out of consumer surplus!

Example: N = 100, M = 300. With uniform pricing, p = $3. Profit = $400. Both “high” and “low” WTP customers buy . . . . . . and “high” WTP customers get C.S. = $200. With price discrimination. Profit = $600. Monopolist has “captured” all of C.S.!! Question: Why do we usually think of price discrimination (senior citizen discounts, discount coupons, etc.) as a “bargain”?

Final observations about price discrimination: To use price discrimination to its advantage, a monopolist must . . . 1. . . . have two or more groups of customers with different WTP. 2. . . . be able to prevent resale between groups.

Airline tickets and price discrimination. Two groups of customers with different WTP? Business travelers Vacation travelers “high” WTP “low” WTP Strategy: “high” prices to business travelers, “low” prices to vacation travelers. Prevent resale between groups? Identify customer groups (so you know what price to charge)?