(A) Monopoly

Benchmark Examples: Natural resources: Land, minerals, etc. Markets with high entry costs: Airlines (city pairs), grocery at the corner (small town)

Plan 1. Solution of the Basic Monopoly Problem 2. 3rd degree price discrimination (a) Basics (b) Schmalensee Model

3. 1st degree price discrimination 4. 2nd degree price discrimination 5. Illustration of additional ways to price discriminate: Intertemporal Pricing: Lazaers model

Monopoly Problem and Solution

max = max [P (Q) Q C (Q)] where: Prot Q Output P Price, P (Q) inverse demand function 0 C (Q) Total Cost, M C = C (Q) R(Q) Revenue function max = max [R(Q) C (Q)]

Graphical Illustration of Monopoly problem I

MC

Graphical Illustration II (Solution)

MC P
m

D MR Q Q
m

Optimal Monopoly Solution

One way of expressing the solution using calculus is R C = =0 Q Q Q Rewrite as MR = M C Intuition: Benet of an add. unit = Cost of an add. unit Another way: explicit solution

P C = P +Q =0 Q Q Q | {z } MR " # Q P C =0 = P 1+ P Q Q

Intuition: Benets are decomposed into a price and quantity eect

 Denition: Elasticity of Demand: P Q Q e= = 4P Q P

P 4Q

Interpretation: Proportional change in quantity divided by a proportional change in price (which % change in quantity results from a 1 % change in price) We say that demand is elastic if e < 1; inelastic if 1 e 0. 1 = MC P 1+ e

and

 Why Q as a choice variable? Can also have P the choice variable, it makes no dierence Note: Later (Cournot, Bertrand), it makes a difference

P the choice variable: Q C Q =0 = Q+P P Q {z P} | {z P } | 1/e

dP dQ

1 = P + 1 MC = 0 e as before.

MR MC Q P = P +1 M C = 0 P Q | {z }

Comments on the Monopoly Solution

1. e < 0 implies P > MC Note: distinct from perfect competition

2. Optimum at an elastic point, e < 1: Why? Since MC > 0 and because: 1 P + 1 = MC e Now RHS is positive, implies that LHS must be positive.

3. Lerner Index: Measure of degree of monopoly power P MC 1 = P e under perfect competition: e = . 4. Second order condition satised if M R intersects M C from above MR < M C
0 0

Price Discrimination
Assumption: No arbitrage between consumers (no resale) First Degree: Perfect Price Discrimination The seller knows the consumers types

Second Degree: The seller knows the distribution of consumer types only Example: Telephone calling plans Idea: Menu of prices Third Degree: The seller knows sub-groups Example: Skiing in Austria: price of local skiers versus non-locals Idea: distinct prices for distinct consumer groups

Third Degree Price Discrimination

2.1

Basic Model

Assumptions:

1. Two separate markets: P1(Q1), P2(Q2), Q = Q1 + Q2

2. Cost C (Q)

Objective Function
Q1,Q2

max = max [P1(Q1) Q1 + P2(Q2) Q2 C (Q)]

 How to solve? First order condition P1 C Q = P1 + Q1 =0 Q1 Q1 Q Q1

Q Now, since Q1 = 1, this yields:

P1 1 + Similarly,

"

1 = MC e1

P2 C Q = P2 + Q2 =0 Q2 Q2 Q Q2
Q Now, since Q2 = 1, this yields:

P2 1 +

"

1 = MC e2

 Implication

Charge a higher price, P2 > P1, for the more inelastic demand, e2 > e1 Why? Because
1 1+e P2 1 = 1 P1 1+e
2

 Illustration

P P

P2 P1 D1 D2 MC MC Q Q1 MR1 Q2 MR2

2.2

Schmalensee Model

Idea: encompass single price monopoly and price discriminating monopolist Assumptions 1. N independent markets with demand qi(pi) in market i Total demand Q=
N X

qi(pi)

i=1

Why independent? because qi depends on pi only. 2. Constant marginal cost c

 Objective Function max = =

i=1 N X i=1 N X

i(pi) (pi c)qi(pi)

Two extreme cases: (i) No price discrimination: p such that

N X

i(p) = 0

i=1

(ii) Third degree price discrimination:

0 pi such that i(p i ) = 0 for all i = 1, . . . , N.

 Robinson (i) Strong Markets: p i >p (ii) Weak Markets: p i < p . ((iii) Intermediate Markets: p = p i
0 Notice: pi > p if and only if i(p) > 0

Why? because constant marginal cost and because qi depends on pi only.

Pi

 Welfare W =

i=1

"Z N X
Pi

qi(v)dv + i(pi)

Idea: Look at an Articial Problem max

i=1 N X

i(pi)

s.t.

i=1

N X

i(p) (pi p) t

Interpretation (i) No price discrimination: t = 0 (ii) Third degree price discrimination: t is large

 First order condition

0

i (pi) = i(p)

with [0, 1]

Solution pi (t) smooth function with the property pi (0) = p, and as t increases pi (t) p i Property
i=1 N X

i(pi (t)) = 0 for all t

Why? From rst order condition, since

N X

i=1

i(pi (t)) = = 0

i |=1 {z

N X

i(p) equals 0
}

 Further, the property

i=1 N X

i(pi (t)) = 0

holds for all t. Can take the derivative with respect to t :

N 00 X 0 0 i(pi (t)) = i pi (t) t i=1 i=1 = 0
0

N X

Now, what is i? i i = pi
0

= (pi c) qi + qi Hence, we get

i=1 N X

i pi (t) =

00

i=1

= 0

N h X

2qi + (pi c) qi pi (t) (1)

00 i

Results
1. Output Eect: Q = Q t
N X

qi(pi (t))

i=1 N 0 0 X qipi = i=1 N 1X

2 i=1

(pi c) qi pi (t)

00 0

follows from equation (1) above Interpretation 00 0 Output eect depends on qi and pi (Implicit assumption:

qi(p) > 0 and qi(p i ) > 0 for all i.

However, some weak markets may not be served at all)

 Three cases: (i) Linear demand: qi = 0 implies Q =0 t (ii) Strong markets: (pi c) pi > 0 Sign of output eect depends on the sign of qi concave demand: positive output eect (ii) Above is reversed for weak markets
00 0 00

convex demand: negative output eect.

2. Welfare Eect
Welfare (= CS +PS)
"Z N X #

W =

i=1

Pi(t)

qi(v )dv + (pi(t) c) qi (pi(t))

Derivative with respect to t

N X 0 0 W [(pi(t) c)] qi pi = t i=1 0 (other terms involving pi cancel) N 0 0 Q X + [pi p] qi pi = [p c] | {z t} i=1 | {z }

Welfare eect

price discrimination eect

of output

Q Welfare eect of output depends on t

Price discrimination eect is negative Why? 0 0 Look at [pi p] qi pi (i) strong market: + () + (ii) weak market: () Cases: 1. Linear demand Q = 0 implies t 2. Negative output eect W Q 0 implies <0 t t

W <0 t

 Illustration Welfare eect for 2 markets (strong and weak)

Pw Ps e P
* s

b b c

P c

D1 a

e a d

D2 d

qs

qs

qs

qw

qw

qw

Illustration: Total eect

Pw Ps e P
* s

b b c

P c

D1 a

e a d

D2 d

qs

qs

qs

qw

qw

qw

h 0 0 0 0 i h 0 0 0 i W = a b c d abcd b c e + bce t 0 0 0 1 0 = (p c)(Q Q ) b c e + bce

which can be positive only if Q1 > Q0

W > 0) (Note: Q1 > Q0 is not sucient for t

First Degree Price Discrimination

Assumptions

1. ni buyers of type i = 1, 2

2. Quasi linear utility ui = Ui(xi) + yi with monopolized good xi, and numeraire good yi

3. Single crossing U2(x) > U1(x) type 2 prefers good x stronger than type 1
0 0

(Assumptions continued)

4. Identical incomes M

5. Normalize Ui(0) = 0 diminishing marginal utility Ui (x) < 0 6. Constant marginal cost of production (equals average cost): c
00

 Recall Demand under quasi linear utility (from problem set) xi(p) = Ui
0 1

(p)

yi = M F p xi(p) here F is a xed charge and p is the monopoly price

Indirect utility let ui denote the reservation utility (the utility when not buying good x) vi(p, F ) = Ui (xi (p)) + M F p xi(p)
| {z }

equals yi

Monopoly Prots

(pi ,Fi )

max =

i=1

2 X

ni (pi xi(pi) + Fi) c ni xi(pi)

|

buyers reserv. utility

{z

cost

{z

subject to the consumer reservation (participation) constraint vi(p, F ) ui for i = 1, 2

Choose (pi, Fi)2 i=1 to maximize prot subject to the IR constraint

 Solution

pi = c Fi s.t. vi(p, F ) = ui for i = 1, 2

Intuition Price equals marginal cost Participation fee equals the consumer surplus

Comments 1. Solution maximizes aggregate surplus

2. All the surplus goes to the monopolist

Second Degree Price Discrimination

Cannot see type or characteristics Knows the distribution of types, can oer options Examples: telephone calling plans, damaged goods, theater seating, etc. Consider (3rd degree) oers (c, F1) and (c, F2) Is not optimal. Why? Because type 2 would select (c, F1). Can do better? Suppose an option is (xi, Fi) (use quantity instead of price)

Monopoly Prot
2 X

(xi,Fi )

max =

i=1

[ni (Fi cxi)]

subject to

1. IR (participation) Ui (xi) + M Fi ui for i = 1, 2 where yi = M Fi IC (no mimicking) U1 (x1) + M F1 U1 (x2) + M F2 U2 (x2) + M F2 U2 (x1) + M F1

Solution
Notice IC1 and IR2 are not binding (proof omitted: reading material) Lagrangean problem FOC can be used to solve it Properties of the solution 1. Type 2 buyer gets the solution under rst degree price discrimination (No distortion at the top) 2. Type 1 buyer gets less than under rst degree price discrimination
st 1 x1 < x1

(Distortion due to IC2)

Illustration of additional ways to price discriminate:

5.1

Bundling, or quantity discounts

Examples: Microsoft Oce (Word, Excel, etc.), vacation packages, mobile phone calling plans, supermarket products, etc.

Can oer a price for the bundle and prices for each item separately

Intuition: Oer lower prices for additional units (or bundles)

5.2

Intertemporal Price discrimination: Lazaers fashion goods model (problem set)

2 Periods Monopolist discounts the future Sells a product over two periods; Consumers can buy in period one or in period two. Solution P1 > P2 High valuation consumers buy in the rst period The remaining (low) valuation consumers buy in period 2 Intuition: Fashion good

 Fashion Goods Illustration

P P

P1

D1

P2

D2=DR

Q1 DR

Q2