1. Industrial Organization: Chapter 31 Chapter 3 Basic Monopoly Pricing and Product Strategies

2. Industrial Organization: Chapter 32 Introduction A monopolist has the power to set prices Consider how the monopolist exercises this power –Focus in this section on a single-product monopolist –What determines price? –What different pricing strategies might be used? –What product design strategies might be used? –What constraints are there on the monopolist’s ability to extract consumer surplus?

3. Industrial Organization: Chapter 33 First-Degree Price Discrimination First-degree price discrimination occurs when the seller is able to extract the entire consumer surplus –suppose that you own five antique cars and you meet two collectors –each is willing to pay $10,000 for one car, $8,000 for a second car, $6,000 for a third car, $4,000 for a fourth and $2,000 for a fifth –sell the first two cars at $10,000, one to each buyer –sell the second two cars at $8,000, one to each buyer –sell the fifth car to one of the buyers at $6,000 –total revenue $42,000 Highly profitable but requires –detailed information –ability to avoid arbitrage Leads to the efficient choice of output: since price equals marginal revenue and MR = MC

4. Industrial Organization: Chapter 34 First-degree price discrimination (cont.) The information requirements appear to be insurmountable No arbitrage is less restrictive but potentially a problem But there are pricing schemes that will achieve the same output –non-linear prices –two-part pricing as a particular example of non-linear prices

5. Industrial Organization: Chapter 35 Two-Part Pricing Take an example: Demand is P = V - Q $ Quantity V V Cost is C(Q) = F + cQ Marginal Revenue is MR = V - 2Q Marginal Cost is MC = c MR MC c n identical consumers Jazz club:

6. Industrial Organization: Chapter 36 Two-Part Pricing $ Quantity V V MR MC c With a uniform price profit is maximized by setting marginal revenue equal to marginal cost With a uniform price profit is maximized by setting marginal revenue equal to marginal cost V - 2Q = c So Q = (V - c)/2 (V-c)/2 P = V - Q So P = (V + c)/2 (V+c)/2 Profit to the monopolist is n(V - c) 2 /4 - F Profit to the monopolist is n(V - c) 2 /4 - F Consumer surplus for each consumer is (V - c) 2 /8 Consumer surplus for each consumer is (V - c) 2 /8 What if the seller can charge an entry fee? What if the seller can charge an entry fee? The maximum entry fee that each consumer will be willing to pay is consumer surplus The maximum entry fee that each consumer will be willing to pay is consumer surplus Charging an entry fee increases profit by (V - c) 2 /8 per consumer

7. Industrial Organization: Chapter 37 Two-Part Pricing $ Quantity V V MR MC c (V-c)/2 (V+c)/2 Is this the best the seller can do? Is this the best the seller can do? Lower the unit price This increases consumer surplus and so increases the entry charge This increases consumer surplus and so increases the entry charge This whole area is now profit from each consumer

8. Industrial Organization: Chapter 38 Two-Part Pricing $ Quantity V V MR MC c What is the best the seller can do? What is the best the seller can do? Set the unit price equal to marginal cost Set the unit price equal to marginal cost This gives consumer surplus of (V - c) 2 /2 This gives consumer surplus of (V - c) 2 /2 The entry charge converts consumer surplus into profit V - c Set the entry charge to (V - c) 2 /2 Set the entry charge to (V - c) 2 /2 Using two-part pricing increases the monopolist’s profit Using two-part pricing increases the monopolist’s profit

9. Industrial Organization: Chapter 39 Two-part pricing (cont.) First-degree price discrimination through two-part pricing –increases profit by extracting all consumer surplus –leads to unit price equal to marginal cost –causes the monopolist to produce the efficient level of output What happens if consumers are not identical? Assume that consumers differ in types and that the monopolist can identify the types –age –location –some other distinguishing and observable characteristic We can extend our example

10. Industrial Organization: Chapter 310 Two-part pricing with different consumers Older Consumers Younger Consumers Demand: P = 16 - Q Demand: P = 12 - Q $ Quantity $ 16 12 4MC4 Assume that marginal cost is constant at $4 per unit Assume that marginal cost is constant at $4 per unit If unit price is set at $4 older customers each buy 12 units If unit price is set at $4 older customers each buy 12 units 12 And younger customers each buy 8 units And younger customers each buy 8 units 8 Consumer surplus for the older customers is $72 Consumer surplus for the older customers is $72 $72 And for the younger customers consumer surplus is $32 And for the younger customers consumer surplus is $32 $32 So the seller can charge an entry fee of $72 t o each older customer and $32 to each younger one This converts all consumer surplus into profit $72 $32 There is an alternative approach Offer older customers entry plus 12 units for $120 and younger customers entry plus 8 units for $64 $48$32

11. Industrial Organization: Chapter 311 Second-Degree Price Discrimination What if the seller cannot distinguish between buyers? –perhaps they differ in income (unobservable) Then the type of price discrimination just discussed is impossible High-income buyer will pretend to be a low-income buyer –to avoid the high entry price –to pay the smaller total charge Confirm from the diagram

12. Industrial Organization: Chapter 312 The example again High-Demand Consumers Low-Demand Consumers Demand: P = 16 - Q Demand: P = 12 - Q $ Quantity 16 12 4MC4 128 8 $32 8 $16 $32 $8 $ If a high-demand consumer pays the lower fee and buys 12 units he gets $40 of consumer surplus If a high-demand consumer pays the lower fee and buys 12 units he gets $40 of consumer surplus Could the seller prevent this by limiting the number of units that can be bought? Could the seller prevent this by limiting the number of units that can be bought? NO! If a high-demand consumer pays the lower fee and gets the lower quantity he gets $32 of consumer surplus NO! If a high-demand consumer pays the lower fee and gets the lower quantity he gets $32 of consumer surplus

13. Industrial Organization: Chapter 313 Second-Degree Price Discrimination The seller has to compromise A pricing scheme must be designed that makes buyers –reveal their true types –self-select the quantity/price package designed for them This is the essence of second-degree price discrimination It is “like” first-degree price discrimination –The seller knows that there are buyers of different types But –the seller is not able to identify the different types A two-part tariff is ineffective –allows deception by buyers Use quantity discounting

14. Industrial Organization: Chapter 314 The example again High-DemandLow-Demand $ Quantity 16 12 4MC4 128 8 $32 8 $16 $32 $ Offer the low-demand consumers a package of entry plus 8 drinks for $64 Offer the low-demand consumers a package of entry plus 8 drinks for $64 $32 The low-demand consumers will be willing to buy this ($64, 8) package The low-demand consumers will be willing to buy this ($64, 8) package So will the high- demand consumers: because the ($64, 8) package gives them $32 consumer surplus So will the high- demand consumers: because the ($64, 8) package gives them $32 consumer surplus $64 $32 $8 So any other package offered to high-demand consumers must offer at least $32 consumer surplus So any other package offered to high-demand consumers must offer at least $32 consumer surplus This is the incentive compatibility constraint High demand consumers are willing to pay up to $120 for entry plus 12 drinks if no other package is available High demand consumers are willing to pay up to $120 for entry plus 12 drinks if no other package is available So they can be offered a package of ($88, 12) (since $120 - 32 = 88) and they will buy this So they can be offered a package of ($88, 12) (since $120 - 32 = 88) and they will buy this $24 Low demand consumers will not buy the ($88, 12) package since they are willing to pay only $72 for 12 drinks Low demand consumers will not buy the ($88, 12) package since they are willing to pay only $72 for 12 drinks $8 Profit from each high- demand consumer is $40 ($88 - 12 x $4) Profit from each high- demand consumer is $40 ($88 - 12 x $4) $40 And profit from each low-demand consumer is $32 ($64 - 8x$4) And profit from each low-demand consumer is $32 ($64 - 8x$4) $32 These packages exhibit quantity discounting: high- demand pay $7.33 per unit and low-demand pay $8

15. Industrial Organization: Chapter 315 The example again High-DemandLow-Demand $ Quantity 16 12 4MC4 12 $ Can the club- owner do even better than this? Can the club- owner do even better than this? 8 Yes! Reduce the number of units offered to each low-demand consumer Yes! Reduce the number of units offered to each low-demand consumer Suppose each low-demand consumer is offered 7 drinks 7 Each consumer will pay up to $59.50 for entry and 7 drinks $59.50 Profit from each ($59.50, 7) package is $31.50: a reduction of $0.50 per consumer $31.50 A high-demand consumer will pay up to $87.50 for entry and 7 drinks 7 $87.50 $28 So buying the ($59.50, 7) package gives him $28 consumer surplus So entry plus 12 drinks can be sold for $92 ($120 - 28 = $92) $92 $28 Profit from each ($92, 12) package is $44: an increase of $4 per consumer $44 $48 The monopolist does better by reducing the number of units offered to low-demand consumers since this allows him to increase the charge to high-demand consumers

16. Industrial Organization: Chapter 316 Second-degree price discrimination (cont.) Will the monopolist always want to supply both types of consumer? There are cases where it is better to supply only high- demand –high-class restaurants –golf and country clubs Take our example again –suppose that there are N l low-income consumers –and N h high-income consumers

17. Industrial Organization: Chapter 317 Second-degree price discrimination (cont.) Suppose both types of consumer are served –two packages are offered ($57.50, 7) aimed at low-demand and ($92, 12) aimed at high-demand –profit is $31.50xN l + $44xN h Now suppose only high-demand consumers are served –then a ($120, 12) package can be offered –profit is $72xN h Is it profitable to serve both types? –Only if $31.50xN l + $44xN h > $72xN h  31.50N l > 28N h This requires that N h N l < 31.50 28 = 1.125 There should not be “too high” a proportion of high-demand consumers

18. Industrial Organization: Chapter 318 Second-degree price discrimination (cont.) Characteristics of second-degree price discrimination –extract all consumer surplus from the lowest-demand group –leave some consumer surplus for other groups the incentive compatibility constraint –offer less than the socially efficient quantity to all groups other than the highest-demand group –offer quantity-discounting Second-degree price discrimination converts consumer surplus into profit less effectively than first-degree Some consumer surplus is left “on the table” in order to induce high-demand groups to buy large quantities

19. Industrial Organization: Chapter 319 Third-Degree Price Discrimination Consumers differ by some observable characteristic(s) A uniform price is charged to all consumers in a particular group Different uniform prices are charged to different groups –“kids are free” –subscriptions to professional journals e.g. American Economic Review –airlines the number of different economy fares charged can be very large indeed! –early-bird specials; first-runs of movies

20. Industrial Organization: Chapter 320 Third-degree price discrimination (cont.) Often arises when firms sell differentiated products –hard-back versus paper back books –first-class versus economy airfare Price discrimination exists in these cases when: –“two varieties of a commodity are sold by the same seller to two buyers at different net prices, the net price being the price paid by the buyer corrected for the cost associated with the product differentiation.” (Phlips) The seller needs an easily observable characteristic that signals willingness to pay The seller must be able to prevent arbitrage –e.g. require a Saturday night stay for a cheap flight

21. Industrial Organization: Chapter 321 Third-degree price discrimination (cont.) The pricing rule is very simple: –consumers with low elasticity of demand should be charged a high price –consumers with high elasticity of demand should be charged a low price Illustrate with a simple example –monopolist has constant marginal costs of c per unit –two types of consumers, with the type being identifiable –all consumers of a particular type have identical demands –two pricing rules must hold marginal revenue must be equal on the last unit sold to each type of consumer marginal revenue must equal marginal cost in each market

22. Industrial Organization: Chapter 322 An example Type 1 Demand: P = A 1 - BQ 1 Type 2 Demand: P = A 2 - BQ 2 $ Quantity A1A1 A 1 /B A2A2 A 2 /B cMCc $ MR 1 MR 2 MR 1 = A 1 - 2BQ 1 MC = c  Q 1 = (A 1 - c)/2B (A 1 -c)/2B  P 1 = (A 1 + c)/2 (A 1 +c)/2 MR 2 = A 2 - 2BQ 2 MC = c  Q 2 = (A 2 - c)/2B  P 2 = (A 2 + c)/2 (A 2 -c)/2B (A 2 +c)/2 Since A 1 > A 2 Type 1 consumers are charged a higher price than Type 2 consumers

23. Industrial Organization: Chapter 323 Third-degree price discrimination (cont.) What happens if marginal costs are not constant? The same principles apply –marginal revenue equalized across consumer types –marginal revenue equal to marginal cost where marginal cost is measured at aggregate output Consider an example

24. Industrial Organization: Chapter 324 The example Two markets –Market 1: P = 20 - Q 1 –Market 2: P = 16 - 2Q 2 MR 1 = 20 - 2Q 1 MR 2 = 16 - 4Q 2 Now calculate aggregate marginal revenue Now calculate aggregate marginal revenue Invert these to give Q as a function of MR: Q 1 = 10 - MR/2 Q 2 = 4 - MR/4 Note that this applies only for prices less than $16 Note that this applies only for prices less than $16 So aggregate marginal revenue is Q = Q 1 + Q 2 = 14 - 3MR/4 Invert this to give marginal revenue: MR = 56/3 - 4Q/3 for MR < $16 MR = 20 - 2Q for MR > $16 MC = 2Q MC = MR  2Q = 56/3 - 4Q/3  Q = 5.6  MR = $11.20  Q 1 = 4.4 and Q 2 = 1.2  P 1 = $15.60 and P 2 = $13.60 The consumers with less elastic demand are charged higher prices The consumers with less elastic demand are charged higher prices

25. Industrial Organization: Chapter 325 Third-degree price discrimination (cont.) A general rule characterizes third-degree price discrimination Recall the formula for marginal revenue in market i: –MR i = P i (1 - 1/  i ) where  i is the price elasticity of demand Recall also that when serving two markets profit maximization requires that MR is equalized in each market –so MR 1 = MR 2 –  P 1 (1 - 1/  1 ) = P 2 (1 - 1/  2 )  P1P1 P2P2 = (1 - 1/  2 ) (1 - 1/  1 ) Prices are always higher in markets where demand is inelastic Prices are always higher in markets where demand is inelastic

26. Industrial Organization: Chapter 326 Price Discrimination and Welfare Does price discrimination reduce welfare? First- and second- degree: “not necessarily” –because output is at or near to the efficient level Third-degree is less clear –monopolist restricts output in the markets supplied –but markets may be served that would otherwise be left unsupplied A necessary condition for third-degree price discrimination not to reduce welfare is that it leads to an increase in output

27. Industrial Organization: Chapter 327 Public Policy Uneven –Robinson-Patman makes price discrimination illegal if it is intended to create a monopoly –One defense is if discriminatory prices are intended to “meet the competition” Enforcement has been spotty –weak in recent years –but note the pharmaceutical case –private actions are possible: see http://lawmall.com International restrictions also exist –anti-dumping regulations –these are currently pursued very actively

28. Industrial Organization: Chapter 328 Monopoly and Product Quality Firms can, and do, produce goods of different qualities Quality then is an important strategic variable The choice of product quality by a monopolist is determined by its ability to generate profit Focus for the moment on a monopolist producing a single good –what quality should it have? –determined by consumer attitudes to quality prefer high to low quality willing to pay more for high quality but this requires that the consumer recognizes quality also some are willing to pay more than others for quality

29. Industrial Organization: Chapter 329 Demand and Quality We might think of individual demand as being of the form –Q i = 1 if P i < R i (Z) and = 0 otherwise for each consumer i –Each consumer buys exactly one unit so long as price is less than her reservation price –the reservation price is affected by product quality Z Assume that consumers vary in their reservation prices Then aggregate demand is of the form P = P(Q, Z) An increase in product quality increases demand

30. Industrial Organization: Chapter 330 Demand and quality (cont.) Begin with a particular demand curve for a good of quality Z 1 Begin with a particular demand curve for a good of quality Z 1 Price Quantity P(Q, Z 1 ) P1P1 Q1Q1 If the price is P 1 and the product quality is Z 1 then all consumers with reservation prices greater than P 1 will buy the good If the price is P 1 and the product quality is Z 1 then all consumers with reservation prices greater than P 1 will buy the good R 1 (Z 1 ) These are the inframarginal consumers These are the inframarginal consumers This is the marginal consumer This is the marginal consumer Suppose that an increase in quality increases the willingness to pay of inframarginal consumers more than that of the marginal consumer Suppose that an increase in quality increases the willingness to pay of inframarginal consumers more than that of the marginal consumer Then an increase in product quality from Z 1 to Z 2 rotates the demand curve around the quantity axis as follows Then an increase in product quality from Z1 Z1 to Z2 Z2 rotates the demand curve around the quantity axis as follows R 1 (Z 2 ) P2P2 Quantity Q 1 can now be sold for the higher price P 2 Quantity Q1 Q1 can now be sold for the higher price P2P2 P(Q, Z 2 )

31. Industrial Organization: Chapter 331 Demand and quality (cont.) Price Quantity P(Q, Z 1 ) P1P1 Q1Q1 R 1 (Z 1 ) Suppose instead that an increase in quality increases the willingness to pay of marginal consumers more than that of the inframarginal consumers Suppose instead that an increase in quality increases the willingness to pay of marginal consumers more than that of the inframarginal consumers Then an increase in product quality from Z 1 to Z 2 rotates the demand curve around the price axis as follows Then an increase in product quality from Z1 Z1 to Z2 Z2 rotates the demand curve around the price axis as follows P(Q, Z 2 ) Once again quantity Q 1 can now be sold for a higher price P 2 Once again quantity Q1Q1 can now be sold for a higher price P2P2 P2P2

32. Industrial Organization: Chapter 332 Demand and quality (cont.) The monopolist must choose both –price (or quantity) –quality Two profit-maximizing rules –marginal revenue equals marginal cost on the last unit sold for a given quality –marginal revenue from increased quality equals marginal cost of increased quality for a given quantity This can be illustrated with a simple example: P = Z(  - Q) where Z is an index of quality

33. Industrial Organization: Chapter 333 Demand and quality: an example P = Z(  - Q) Assume that marginal cost of output is zero: MC(Q) = 0 Cost of quality is D(Z) =  Z 2 This means that quality is costly and becomes increasingly costly This means that quality is costly and becomes increasingly costly Marginal cost of quality = dD(Z)/d(Z) = 2  Z The firm’s profit is:  (Q, Z) =P.Q - D(Z)= Z(  - Q)Q -  Z 2 The firm chooses Q and Z to maximize profit. Take the choice of quantity first: this is easiest. Marginal revenue = MR = Z  - 2ZQ MR = MC  Z  - 2ZQ = 0  Q* =  /2  P* = Z  /2

34. Industrial Organization: Chapter 334 The example continued Total revenue = P*Q* =(Z  /2)x(  /2) =Z  2 /4 So marginal revenue from increased quality isMR(Z) =  2 /4 Marginal cost of quality isMC(Z) = 2  Z Equating MR(Z) = MC(Z) then givesZ* =  2 /8  Does the monopolist produce too high or too low quality? Is it possible that quality is too high? Only in particular constrained circumstances.

35. Industrial Organization: Chapter 335 The Multiplant Monopolist A monopolist rarely produces all output in one plant –how should production be allocated across plants? –this is especially important if different plants have different costs To maximize profit set MR = MC on the last unit produced But with several plants what is MC? First case: –marginal costs constant within a plant but varying across plants –each plant has a capacity constraint

36. Industrial Organization: Chapter 336 The multiplant monopolist (cont.) Price Quantity MR q1q1 MC 1 q 1 + q 2 MC 2 MC 3 Produce output Q* using plant 1 and plant 2. Plant 3 is not operated (or introduced) Produce output Q* using plant 1 and plant 2. Plant 3 is not operated (or introduced) Q* Suppose that there are three possible plants. Arrange them in order of their marginal costs Suppose that there are three possible plants. Arrange them in order of their marginal costs Plant 1 has marginal cost MC 1 and capacity q 1 Plant 1 has marginal cost MC 1 and capacity q 1 Plant 2 has marginal cost MC 2 and capacity q 2 Plant 2 has marginal cost MC 2 and capacity q 2 Plant 3 has marginal cost MC 3 and capacity q 3 Plant 3 has marginal cost MC 3 and capacity q 3 Maximize profit by equating marginal cost and marginal revenue Maximize profit by equating marginal cost and marginal revenue

37. Industrial Organization: Chapter 337 The multiplant monopolist (cont.) What happens if marginal costs are not constant? Output allocation –operate plants such that marginal cost is equal on the last unit produced in each plant Why? –If not, then cost can be reduced by reallocating output between plants –For example: suppose MC 1 = $10 and MC 2 = $15 –Reducing output of plant 2 by one unit and increasing output of plant 1 by one unit reduces total costs

38. Industrial Organization: Chapter 338 An Example Suppose MC 1 =  q 1 and MC 2 =  q 2 Quantity $ MC 1 =  q 1 MC 2 =  q 2 q 1 = MC/  ; q 2 = MC/  q 1 = MC/  ; q 2 = MC/   Q =q 1 + q 2 = MC(  )/   Q =q 1 + q 2 = MC(  )/   MC = Q  (  )  MC = Q ((  ) $ Quantity MC 1 + MC 2 MR Maximize profit by setting marginal revenue equal to marginal cost Maximize profit by setting marginal revenue equal to marginal cost Q* q2*q2*q1*q1* Allocate output to the two plants to equate marginal costs Allocate output to the two plants to equate marginal costs

39. Industrial Organization: Chapter 339

40. Industrial Organization: Chapter 340 Demand and quality (cont.) Price Quantity  Z1Z1 P(Q,Z 1 ) How does increased quality affect demand? How does increased quality affect demand? Z2Z2 P(Q, Z 2 ) MR(Z 1 ) MR(Z 2 )  /2 Q* P 1 = Z 1  /2 P 2 = Z 2  /2 When quality is Z 1 price is Z 1  /2 When quality is Z 1 price is Z 1  /2 When quality is Z 2 price is Z 2  /2 When quality is Z 2 price is Z 2  /2

41. Industrial Organization: Chapter 341 Demand and quality (cont.) Price Quantity  Z1Z1 Z2Z2  /2 Q* P 1 = Z 1  /2 P 2 = Z 2  /2 An increase in quality from Z 1 to Z 2 increases revenue by this area An increase in quality from Z 1 to Z 2 increases revenue by this area Social surplus at quality Z 1 is this area minus quality costs Social surplus at quality Z 1 is this area minus quality costs Social surplus at quality Z 2 is this area minus quality costs Social surplus at quality Z 2 is this area minus quality costs So an increase is quality from Z 1 to Z 2 increases surplus by this area minus the increase in quality costs So an increase is quality from Z 1 to Z 2 increases surplus by this area minus the increase in quality costs The increase is total surplus is greater than the increase in profit. The monopolist produces too little quality

42. Industrial Organization: Chapter 342 Demand and quality: an alternative Price Quantity P(Q,Z 1 ) Assume that an increase in quality from Z 1 to Z 2 rotates the demand function as follows Assume that an increase in quality from Z 1 to Z 2 rotates the demand function as follows P(Q,Z 2 ) Further assume that the firm is constrained to produce output Q Further assume that the firm is constrained to produce output Q Q The increase in quality increases profit by this area minus the cost of increased quality The increase in quality increases profit by this area minus the cost of increased quality The increase in social surplus is this area minus the cost of increased quality The increase in social surplus is this area minus the cost of increased quality The increase in total surplus is less than the increase in profit. The monopolist produces too much quality This may arise as a result of an export quota or other restriction on output This may arise as a result of an export quota or other restriction on output Exporters subject to quotas tend to export high quality goods Exporters subject to quotas tend to export high quality goods

43. Industrial Organization: Chapter 343 Demand and quality Derivation of aggregate demand Order consumers by their reservation prices Aggregate individual demand horizontally Price Quantity 12345678

44. Industrial Organization: Chapter 344 Market 1 $ Quantity $16 8 $ Quantity $20 20104 D1D1 D2D2 MR 1 MR 2 MR 1 +MR 2 Quantity $ Market 2 Aggregate $20 $16 14 MC 5.6 $11.20 4.41.2 $15.60 $13.60

45. Industrial Organization: Chapter 345 The incentive compatibility constraint Any offer made to high demand consumers must offer them as much consumer surplus as they would get from an offer designed for low-demand consumers. This is a common phenomenon –performance bonuses must encourage effort –insurance policies need large deductibles to deter cheating –piece rates in factories have to be accompanied by strict quality inspection –encouragement to buy in bulk must offer a price discount