Market Power and Its Effect on Price, Profit, Efficiency and Innovation

Week 3
Market Power and Its Effect on the

Price, Profit, Efficiency, and
Innovation
Industrial Organization: Chapter 3 1

Introduction
• Market power is the ability of firm to control the price and

quantity.
• Few firms in oligopoly and a monopolist have the market
power.
• Firm with market power has the power to set prices in
order to generate the higher profit : Inefficiency (quite-life
hypothesis).
• Firms with market power may be efficient (efficient-
structure hypothesis) and generate higher quality through
innovation (Schumpeterian).

Efficiency and CR4 In Indonesian Manufacturing
2001-2010

Price-cost margin and CR4 In Indonesian
Manufacturing 2001-2010

Market Power in Monopoly
• 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?

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
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

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

Two-Part Pricing
$ What
Whatififthe
theseller
seller
With
Withaauniform
uniformprice
priceprofit
profit V can
cancharge
chargeananentry
entry
isismaximized
maximized by
bysetting
setting
marginal
Charging
revenue
an
equal fee?
fee?
marginal revenue equal
entry fee increases
totomarginal
marginalcost
cost (V+c)/2 The
profit by Themaximum
maximumentryentryfee
feethat
that
each
eachconsumer
consumerwill
willbe
bewilling
willing
(V - c)2/8 totopay
V - 2Q = c payisisconsumer
consumersurplus
surplus
per consumer c MC
So Q = (V - c)/2
MR
P=V-Q
So P = (V + c)/2 (V-c)/2 V
Quantity
Profit
Profittotothe
themonopolist
monopolist Consumer
Consumersurplus
surplusfor foreach
each
isis consumer
consumerisis
n(V
n(V--c)c)/4
2
2 - F
/4 - F (V
(V--c)c)/8
2
2
/8
Two-Part Pricing
Is $
Isthis
thisthe
thebest
best
the V
theseller
seller This whole area is
can
cando?
do? now profit from each
(V+c)/2 consumer
Lower
Lowerthe
theunit
unitprice
price
c MC
This
Thisincreases
increasesconsumer
consumer MR
surplus
surplusand
andsosoincreases
increases
the
theentry
entrycharge
charge (V-c)/2 V
Quantity

Two-Part Pricing
What $
Whatisisthe
thebest
best
the V
theseller
seller The entry charge
can
cando?
do? converts consumer
surplus into profit
Set
Setthetheunit
unitprice
priceequal
equal
totomarginal
marginalcost
cost c Using two-part MC
pricing increases
MR the
This
Thisgives
givesconsumer
consumer monopolist’s
surplus
surplusof
of(V
(V--c)c)/2
2
2
/2 V-c V
profit Quantity
Set
Setthe
theentry
entrycharge
charge
toto(V
(V--c)c)/2
2
2
/2

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

Two-part
• There ispricing with different consumers
an alternative
approach
• Offer
Older older
Consumers
So the seller can charge Younger Consumers
customers
entry plus 12
an entry feeunits
of $72 fort o each
Demand: PP==16
$120older
Demand: 16--QQ
customer and $32 Demand:
Demand:PP==12 12--QQ
$ • and to
younger
each customers
IfIfyounger
unit price one$
And for the
unit price This
And forconverts
the
16 entry plus 8
Consumerunits
isisset
Consumer setat
for
surplus
$4
surplus
at $4
$64 younger
younger Assume
Assumethat
customers
customers that
for all consumer
forthe
older
older the older
customers
older
customers
12 And
consumer
And
consumer marginal
younger
surplus
marginal
younger
surplus cost
costisis
customers
each isis$72 surplus
customers into
constant
each
eachatat
eachbuy
customers buy 12
$72
12 is
is$32
customers
$32 constant
units
units buy
buyprofit
$4
8$4
8units
per
perunit
unitsunit
$72
$72 $32
$32
4 MC 4 MC
$48 $32
12 16 8 12
Quantity Quantity
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

The example again
High-Demand Low-Demand
Consumers Consumers
Demand: PP==16
Demand:NO! 16 - QQCould the seller Demand: PP==12
prevent 12--QQ
NO!If Ifaa-high-demand
Could the seller
high-demand Demand:
prevent
$ consumer
consumerpayspays If
this
the
If
this aby
the high-demand
aby limiting
lower
lower fee
high-demand
limiting
fee the
thenumber
number
$
16 and
andgets theconsumer
getsthe lower
of
consumer
lower
of units
pays
quantity
units that
pays
quantity
that
the
he
can
the
he lower
can be
lower
be bought?
bought?
gets $32 of fee and
consumer buys
fee and buys 12
surplus
12 units he
gets $32 of consumer 12 units he
surplus
gets
gets$40
$40of ofconsumer
consumer
$32 surplus
surplus
8
$32 $32
4 $8 MC 4 MC
$32 $16 $32
8 12 16 8 12
Quantity Quantity
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
The example again
High-Demand Low-Demand
So any The
Thelow-demand
low-demandconsumers will be
So
Sowill
willthe Sohigh-
the anyother
high- otherpackage
package consumers
Low demand
Low8) demand
will be
demand consumers:
offered to willing
willing
high-demand totobuy
buy this
this ($64,
($64, 8) package
package
demand
So consumers:
theyoffered
can This
be to ishigh-demand
offeredthe a incentive
package consumers
consumers will
will not
not
$ So
because they
These
the can
($64, packages
be8)offered exhibit
a package
because
Profitoffrom consumers
High
($88,the demand
($64,
consumers
High demand
compatibility
each
12) (since
high- must
must$ - offer
8)consumers
consumers
$120 32 are
offer
=are at
constraint
88) atAnd
Offer buy the ($88,
($88,12)
buylow-demand
the the 12)
16 Profit
package
packageoffrom
($88,
quantity
gives
willing
gives each
12)
them
themdiscounting:
(since
high-
totopay$32
$32up $120 -
toto$120high-
32 =
for 88) Offer
And profit
the from
low-demand
profit from
demand least
willing
consumer
and $32
they consumer
pay
will
is upbuy $120
thissurplus
for consumers package
package since
since they
they
demand
consumer
consumer
least
demand
entryconsumer
and $32
pay
they
surplus
plus
surplus
12
consumer
$7.33
will
is
drinks buy
perif unit
this
no
surplus
and
other each a package
low-demand
consumers
each a package
low-demand of
of
$40 entry
($88 - 12plus
x 12
$4) drinks 12
if no other entry are
plusare willing
willing
88drinks totopay
pay
$40 ($88 -package
low-demand
12 x $4)is available
pay $8 consumer
entry plus
consumer isis for
drinks for $64
$64
package is available only
only$72
$72 for
for 12
12
$32 $32
$32($64
($64--8x$4)
8x$4)
drinks
drinks
8
$32
$40 $32
$32
4
$64 $8
$24 MC 4 MC
$32 $16 $32
$8
8 12 16 8 12
Quantity Quantity
The example again
A high-demand consumer will pay
High-Demand The
up to $87.50 for
Can monopolist
entry
Can theandclub-
the club- Low-Demand
7 drinks does better by
So buying theowner
($59.50,do
reducing 7) package
the
even number of Suppose
units each low-demand
owner do
gives him $28 consumer surpluseven
offered
better
So entry plusbetter
to
than
12 drinksthanlow-demand
this?
this?
can be sold
consumers
consumer is offered 7 drinks
$ for $92since
($120 -this
28 = allows
$92) him to increase
Each consumer will pay up to
$ $59.50 for entry and 7 drinks
16 Profit from eachthe charge
($92, to
12) package high-demand
is $44: an increase of $4consumers
per ProfitReduce
Yes! from eachthe($59.50,
number 7)
12 Yes! Reduce the number
consumer package
of units isoffered
$31.50: to
a reduction
each
ofofunits offered to
$0.50 per consumereach
$28 low-demand consumer
low-demand consumer
$87.50
$44$92 $31.50
$59.50
4 MC 4 MC
$28$48 $28
7 12 16 7 8 12
Quantity Quantity
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 Nl low-income consumers
– and Nh high-income consumers

• 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 $31.50xNl + $44xNh
• Now suppose only high-demand consumers are served
– then a ($120, 12) package can be offered
– profit is $72xNh
• Is it profitable to serve both types?
– Only if $31.50xNl + $44xNh > $72xNh  31.50Nl > 28Nh
Nh 31.50
This requires that < = 1.125
Nl 28
There should not be “too high” a proportion of high-demand consumers
• 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

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

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

• 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

An example
Type
Type11Demand:
Demand:PP==AA11--BQ
BQ11 Type
Type22Demand:
Demand:PP==AA22--BQ
BQ22
MR1 = A1 - 2BQ1 MR2 = A2 - 2BQ2
MC =c A >A
Since Type 1 MC = c
1 2
 Q1 = (A1 - c)/2B  Q2 = (A2 - c)/2B
consumers are charged a
$  P1 = (A1 + c)/2  P2 = (A2 + c)/2
higher price than
$
A1
Type 2 consumers
A2
(A1+c)/2
(A2+c)/2
c MC c MC
MR1 MR2
(A1-c)/2B A1/B (A2-c)/2B A2/B

Quantity Quantity
• 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

The example
• Two markets
– Market 1: P = 20 - Q1 Now
Nowcalculate
calculate
– Market 2: P = 16 - 2Q2 aggregate
aggregatemarginal
marginal
MR1 = 20 - 2Q1 revenue
revenue
MR2 = 16 - 4Q2 Note
Notethat
thatthis
thisapplies
applies
Invert these to give Q as a function
only forof
onlyfor MR:less
prices
prices lessthan
than
Q1 = 10 - MR/2 $16
$16
MC = 2Q
Q2 = 4 - MR/4 MC = MR  2Q = 56/3 - 4Q/3
The
Theconsumers
consumerswith
with
So aggregateless
marginal revenue is  Q = 5.6
lesselastic
elasticdemand
demandare
are
Q = Q1 + Q2 =charged higher
higherprices
14 - 3MR/4
charged prices  MR = $11.20
Invert this to give marginal revenue:  Q1 = 4.4 and Q2 = 1.2
MR = 56/3 - 4Q/3 for MR < $16  P1 = $15.60 and P2 = $13.60
MR = 20 - 2Q for MR > $16

• A general rule characterizes third-degree price discrimination
• Recall the formula for marginal revenue in market i:
– MRi = Pi(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 MR1 = MR2
  P1(1 - 1/ 1) = P2(1 - 1/ 2) Prices
Pricesare
arealways
always
higher
higherin inmarkets
marketswhere
where
demand
demandisisinelastic
inelastic
P1 (1 - 1/ 2)
 =
P2 (1 - 1/ 1)

AS Tuding RI Dumping Kertas
Suhendra - detikfinance
Rabu, 22/09/2010 12:41 WIB
Jakarta - AS memberikan sanksi dengan mengenakan bea masuk imbalan (countervailing duty) atas kertas berlapis asal Indonesia karena dinilai
ada unsur dumping.
Benarkah sanksi tersebut merupakan balasan AS atas upaya Indonesia menggugat negeri paman Sam itu dalam kasus diskriminasi rokok ke
WTO?
"investigasi. Tidak ada kaitannya dengan masalah rokok," kata Gusmardi lewat pesan singkatnya, Rabu (22/9/2010)
Saat ini Indonesia tengah berjuang di WTO menggugat AS dalam kasus diskriminasi rokok kretek oleh AS. Pada tanggal 14 September 2010
pihak dispute settlement body (DSB) WTO telah membetuk panel sengketa, meluluskan permintaan Indonesia.
Ditempat terpisah Menteri Perindustrian MS Hidayat masih berhati-hati menyikapi masalah tindakan AS terhadap tuduhan subsidi produk kertas
lapis Indonesia oleh AS. Ia pun optimis dampak dari tindakan itu tak akan mempengaruhi industri kertas secara keseluruhan.
Departemen Perdagangan AS juga menemukan produsen/eksportir China telah menjual jenis kertas berlapis tertentu di AS pada marjin dumping
antara 7,60% hingga 135,83%.
Pada tahun 2009, China mengimpor kertas jenis tersebut senilai US$ 280 juta, sementara Indonesia mencapai US$ 62 juta.
Departemen Perdagangan AS mulai menginvestigasi dugaan dumping dan subsidi yang tidak adil setelah adanya pengaduan dari sejumlah
perusahaan kertas dan Serikat Pekerja di AS.
Mereka menuding eksportir kertas Indonesia dan China menjual produknya ke AS pada harga yang lebih murah dari biasanya dan menerima
bantuan finansial yang tidak adil dari pemerintah sehingga menguntungkan produk tersebut.
Depdag AS mengatakan akan menginstruksikan bea dan cukai untuk mengenakan uang jaminan atau surat berharga berdasarkan tarif anti
dumping terhadap produk kertas berlapis Indonesia dan China itu.
29
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

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

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

Rabu, 10 November 2010 | 17:23 WIB
Inovasi Pertamina Bikin Hemat Rp 450 Miliar
TEMPO Interaktif, Jakarta - PT Pertamina (Persero) menciptakan sekitar 40

inovasi di bidang pengembangan teknologi dalam pengelolaan kilang.
Perusahaan minyak dan gas bumi pelat merah ini memperkirakan dapat
menghemat hingga Rp 450 miliar dari inovasi tersebut.
Inovasi juga dilakukan Pertamina dalam hal pemasaran, yaitu dengan
memanfaatkan Jetty Idle Small Craft untuk meningkatkan pelayanan kapal
sandar pelanggan dan mengurangi Bunching Tanker Loading Port Depot
Bitung. "Ini lebih ke masalah teknis. Artinya kita memperpendek waktu sandar
kapal sehingga mobilisasi dari depot atau Pelabuhan Bitung bisa meningkat,"
tutur Direktur Operasional Pertamina.
Selain itu masih banyak lagi upaya inovasi yang dilakukan Pertamina. Inovasi
tersebut, dilakukan sebagai langkah Pertamina untuk mengkaselasri
transformasi dengan mengedepankan perbaikan yang berkesinambungan dan
manajemen pengetahuan sehingga mendukung komitmen perusahaan untuk
terus meningkatkan kesempurnaan dalam operasional.
Demand and Quality
• We might think of individual demand as being of the form
– Qi = 1 if Pi < Ri(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

Demand and quality (cont.)
Begin
Beginwithwithaaparticular
particulardemand
demandcurve curve
for
foraagood
goodof ofquality
qualityZZ11
Price Then
Thenan anincrease
increaseininproduct
product
R1(Z2) Suppose that
Suppose quality
that an increase
anfrom in
ZZ1 totoinZZ2 rotates
increase
P(Q, Z2) quality from 1 2 rotates
quality
quality increases
increases
the demand the
the
curve
IfIfthe
theprice
priceisisPP11willingness
and
andthe product
thethe demand
product curvearound
quality
quality around
willingness
the to
to pay
quantity of
payaxis
of as follows
isisZZ1 then
then all
all consumers
consumers the
withquantity
with axis
reservation
reservation as follows
P2 1 inframarginal consumers
inframarginal consumers more more
prices greater
prices greaterthanthan
thanP 1 will
that of buy the
thegood
R1(Z1) than P
that ofthe
1 will themarginal
buy good
marginal
Quantity
QuantityQQ11can
consumer cannow nowbe be
These This
are
This is
theisthe
the consumer
P1 These are the sold
sold for
forthe
the higher
higher
marginal
inframarginal
marginal
inframarginal price
price PP2
consumer
consumers
consumer 2
consumers
P(Q, Z1)
Q1 Quantity

Suppose
Supposeinstead
insteadthatthatan
an
Price Then
Thenan
increase
increase increase
aninincreaseininproduct
in product
quality
quality from
increases
quality ZZ1 totoZZ2 rotates
fromthe
quality increases the1 2 rotates
willingness
willingnesstothe
to pay
thepay of
of marginal
demand
demand curve
curvearound
marginal around
consumers
the
consumers more
theprice axis
more
price axisasasfollows
follows
than
thanthat
thatof
ofthe
theinframarginal
inframarginal
R1(Z1) consumers
consumers
Once
Onceagain
againquantity
quantityQQ11
P2
P1 can
cannow
nowbe besold
soldforforaa
higher
higherprice
pricePP22
P(Q, Z2)
P(Q, Z1)
Q1 Quantity

• 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

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) = Z2
Marginal cost of quality = dD(Z)/d(Z)
This
This means
means that
thatquality
qualityisis
= 2Z costly
costlyand
andbecomes
becomes
The firm’s profit is: increasingly
increasinglycostly
costly
(Q, Z) =P.Q - D(Z) = Z( - Q)Q - Z2
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

The example continued
Total revenue = P*Q* = (Z/2)x(/2) = Z2/4
So marginal revenue from increased quality is MR(Z) = 2/4
Marginal cost of quality is MC(Z) = 2Z
Equating MR(Z) = MC(Z) then gives Z* = 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.

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

The multiplant monopolist (cont.)
Price Plant
Plant33has hasmarginal
marginal
Suppose
cost
cost MC33that
MC
Suppose andthere
and
that thereareare
Plant 2 has marginalthree
capacity
three possible
possible
q plants.
plants.
Plant 2 has marginal capacity q
3
Maximize
MCcost Maximize
MC and Arrange
profit
profit by
Arrangeby them
them
3
ininorder
order
cost MC22 and
3
of their marginal costs
Plant 1 has equating
marginal
equating marginal
capacity of
marginal
q cost
their marginal
cost costs
Plant 1 has marginal capacity q2
cost MC and and
and marginal
marginal 2 revenue
revenue
cost
MC 2 MC1 and Produce
Produceoutput
outputQ* Q*using
usingplant
1
capacity q plant
capacity q1 11and
1
andplant
plant2.2. Plant
Plant33isisnot
not
operated
operated(or(orintroduced)
introduced)
MC1
MR
q1 Q* q1 + q 2 Quantity

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 MC1 = $10 and MC2 = $15
– Reducing output of plant 2 by one unit and increasing output of
plant 1 by one unit reduces total costs

An Example
Suppose MC11==q
SupposeMC q11and MC22==q
andMC q22 qq1 ==MC/
1 MC/;;qq22==MC/
MC/
$ 
$ QQ=q
=q11++qq22==MC()/
MC()/
Maximize
Maximizeprofit
profit
Allocate
MC2 = q2  MC
 MCby = Q()
=setting marginal
Q()
Allocateoutput
output by setting marginal
totothe revenue
revenueequal
thetwotwoplants
plants equal
totoequate totomarginal
marginalcost
cost
equate
marginal
marginalcosts
costs MC1 = q1
MC1 + MC2
MR
q 2* q1* Quantity Q* Quantity

Price
Z2
P(Q, Z2) When
Whenquality
qualityisisZZ22
MR(Z2) price
priceisis
When /2
ZZquality
Z1  When Howisdoes
2/2
How
2quality ZZ1 increased
isdoes quality
1 increased quality
price
priceisis affect
affectdemand?
demand?
P2 = Z2/2 ZZ1/2
1/2
P1 = Z1/2
MR(Z1) P(Q,Z1)
/2  Quantity
Q*

Price
So
Soan anincrease
increaseisisquality
qualityfromfrom
ZZ1 totoZ
Social 2 increases
surplus
Z surplus
Social 2 increases
surplus atatquality
surplus
quality ZZ2
Z2 1
by this area minus the
2
isisthis
by
thisthis
area
areaarea
minusminus
minus quality
the
quality
increase
increasein inquality
qualitycosts
costs costs
costs
AnAnincrease
increaseininquality
quality from
from
ZZ1 totoZZ2 increasesThe increase is total
Z1  2 increases
Social
1
revenue by
surplus
surplus
this
at area
quality
is greater than
Z
P2 = Z2/2 revenue by this area
Social surplus at quality Z11
isisthis area thequality
minus increase in profit.
this area minus quality
P1 = Z1/2
The monopolist produces
costs
costs
too little quality
/2  Quantity
Q*

Demand and quality: an alternative
The
Theincrease
increaseinin
Price social
social surplus
surplus in
The
The increase
increase in Assume
Assumethat thatananincrease
increase
isisthis
this area
area
quality
quality
minus the
increases
increases
cost of
The increase
ininquality in from
quality total
from ZZ1 toto
minus
profit the
by cost
this of
area
1
profit by
increased this areasurplus
quality ZZ2is less the
rotates
rotates than
the demand
demand
increased
minus quality
the cost of 2
minus the cost of the increasefunction in profit.
function asas follows
follows
increased quality
increased quality The monopolist produces
too muchFurther Further
quality assume
assumethat that
the
thefirm
firmisisconstrained
constrained
totoproduce
produceoutput
outputQQ
P(Q,Z2)
Exporters
Exporterssubject
subjecttotoquotas
quotas P(Q,Z
This 1) arise as a result
Thismaymay arise as a result
tend to export high quality
tend to export high quality of
Q ofananexport
exportquota
quotaor or
goods
goods other Quantity
otherrestriction
restrictionononoutput
output

Demand and quality
Derivation of aggregate demand
Order consumers by their reservation prices

Aggregate individual demand horizontally
Price
1 2 3 4 5 6 7 8 Quantity

Market
Market11 Market
Market22 Aggregate
Aggregate
$ $ $
$20 $20 MC
$15.60 $16 $16

$13.60
$11.20
D1
MR1 MR1+MR2
D2
MR2
4.4 10 20 1.2 4 8 5.6 14
Quantity Quantity Quantity

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

Market Power and Its Effect on Price, Profit, Efficiency and Innovation

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Week 3

Market Power and Its Effect on the

Industrial Organization: Chapter 3 1

• Market power is the ability of firm to control the price and

Industrial Organization: Chapter 3 2

Industrial Organization: Chapter 3 3

Industrial Organization: Chapter 3 4

• A monopolist has the power to set prices

Industrial Organization: Chapter 3 5

Industrial Organization: Chapter 3 7

Industrial Organization: Chapter 3 8

Industrial Organization: Chapter 3 10

Industrial Organization: Chapter 3 11

Industrial Organization: Chapter 3 12

Industrial Organization: Chapter 3 14

Industrial Organization: Chapter 3 19

Industrial Organization: Chapter 3 21

Industrial Organization: Chapter 3 22

Industrial Organization: Chapter 3 23

Industrial Organization: Chapter 3 24

(A1-c)/2B A1/B (A2-c)/2B A2/B

Industrial Organization: Chapter 3 26

Industrial Organization: Chapter 3 27

Industrial Organization: Chapter 3 28

Industrial Organization: Chapter 3 30

Industrial Organization: Chapter 3 31

Industrial Organization: Chapter 3 32

TEMPO Interaktif, Jakarta - PT Pertamina (Persero) menciptakan sekitar 40

Industrial Organization: Chapter 3 34

Industrial Organization: Chapter 3 35

Industrial Organization: Chapter 3 36

P = Z( - Q) where Z is an index of quality

Industrial Organization: Chapter 3 37

Industrial Organization: Chapter 3 38

Is it possible that quality is too high?

Industrial Organization: Chapter 3 39

Industrial Organization: Chapter 3 40

Industrial Organization: Chapter 3 41

Industrial Organization: Chapter 3 42

q 2* q1* Quantity Q* Quantity

Industrial Organization: Chapter 3 43

Industrial Organization: Chapter 3 44

Industrial Organization: Chapter 3 45

Industrial Organization: Chapter 3 46

Order consumers by their reservation prices

Industrial Organization: Chapter 3 47

$15.60 $16 $16

Industrial Organization: Chapter 3 48

Industrial Organization: Chapter 3 49

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