Chapter Twenty-Five

Monopoly Behavior
 How Should a Monopoly Price?
 So far a monopoly has been thought
of as a firm which has to sell its
product at the same price to every
customer. This is uniform pricing.
 Can price-discrimination earn a
monopoly higher profits?
 Types of Price Discrimination
 1st-degree: Each output unit is sold
at a different price. Prices may differ
across buyers.
 2nd-degree: The price paid by a
buyer can vary with the quantity
demanded by the buyer. But all
customers face the same price
schedule. E.g., bulk-buying
discounts.
 Types of Price Discrimination
 3rd-degree: Price paid by buyers in a
given group is the same for all units
purchased. But price may differ
across buyer groups.
E.g., senior citizen and student
discounts vs. no discounts for
middle-aged persons.
First-degree Price Discrimination
 Each output unit is sold at a different
price. Price may differ across buyers.
 It requires that the monopolist can
discover the buyer with the highest
valuation of its product, the buyer with
the next highest valuation, and so on.
 First-degree Price Discrimination
$/output unit
Sell the yth unit for $ p( y).
p( y)

MC(y)

p(y)
y y
 First-degree Price Discrimination
$/output unit
Sell the yth unit for $p( y). Later on
p( y)
sell the y th unit for $ p( y).
p( y)
MC(y)

p(y)
y y y
 First-degree Price Discrimination
$/output unit
Sell the yth unit for $p( y). Later on
p( y)
sell the y th unit for $ p( y). Finally
sell the y th unit for marginal
p( y)
cost, $ p( y).
MC(y)
p( y)

p(y)
y y y
y
 First-degree Price Discrimination
$/output unit The gains to the monopolist
on these trades are:
p( y)  MC( y), p( y)  MC( y)
p( y)
and zero.
p( y)
MC(y)
p( y)

p(y)
y y y
y
The consumers’ gains are zero.
 First-degree Price Discrimination
$/output unit So the sum of the gains to
the monopolist on all
trades is the maximum
possible total gains-to-trade.

PS MC(y)

p(y)
y
y
 First-degree Price Discrimination
$/output unit The monopolist gets
the maximum possible
gains from trade.

PS MC(y)

p(y)
y
y
First-degree price discrimination
is Pareto-efficient.
First-degree Price Discrimination
 First-degree price discrimination
gives a monopolist all of the possible
gains-to-trade, leaves the buyers
with zero surplus, and supplies the
efficient amount of output.
Third-degree Price Discrimination
 Price paid by buyers in a given group
is the same for all units purchased.
But price may differ across buyer
groups.
Third-degree Price Discrimination
 A monopolist manipulates market
price by altering the quantity of
product supplied to that market.
 So the question “What discriminatory
prices will the monopolist set, one for
each group?” is really the question
“How many units of product will the
monopolist supply to each group?”
Third-degree Price Discrimination
 Two markets, 1 and 2.
 y1 is the quantity supplied to market 1.
Market 1’s inverse demand function is
p1(y1).
 y2 is the quantity supplied to market 2.
Market 2’s inverse demand function is
p2(y2).
Third-degree Price Discrimination
 For given supply levels y1 and y2 the
firm’s profit is
( y1 , y2 ) p1 ( y1 )y1  p 2 ( y2 )y2  c( y1  y2 ).

 What values of y1 and y2 maximize

profit?
 Third-degree Price Discrimination
( y1 , y2 ) p1 ( y1 )y1  p 2 ( y2 )y2  c( y1  y2 ).

The profit-maximization conditions are

   c( y1  y2 )  ( y1  y2 )
 p1 ( y1 )y1   
 y1  y1  ( y1  y2 )  y1
0
 Third-degree Price Discrimination
( y1 , y2 ) p1 ( y1 )y1  p 2 ( y2 )y2  c( y1  y2 ).

The profit-maximization conditions are

   c( y1  y2 )  ( y1  y2 )
 p1 ( y1 )y1   
 y1  y1  ( y1  y2 )  y1
0
   c( y1  y2 )  ( y1  y2 )
 p2 ( y2 )y2   
 y2  y2  ( y1  y2 )  y2
0
Third-degree Price Discrimination
 ( y1  y2 )  ( y1  y2 )
1 and 1 so
 y1  y2
the profit-maximization conditions are
  c( y1  y2 )
p1 ( y1 )y1  
 y1  ( y1  y2 )
  c( y1  y2 )
and p2 ( y2 )y2   .
 y2  ( y1  y2 )
 Third-degree Price Discrimination
   c( y1  y2 )
p1 ( y1 )y1   p2 ( y2 )y2  
 y1  y2  ( y1  y2 )
 Third-degree Price Discrimination
   c( y1  y2 )
p1 ( y1 )y1   p2 ( y2 )y2  
 y1  y2  ( y1  y2 )



MR1(y1) = MR2(y2) says that the allocation
y1, y2 maximizes the revenue from selling
y1 + y2 output units.
E.g., if MR1(y1) > MR2(y2) then an output unit
should be moved from market 2 to market 1
to increase total revenue.
 Third-degree Price Discrimination
   c( y1  y2 )
p1 ( y1 )y1   p2 ( y2 )y2  
 y1  y2  ( y1  y2 )



The marginal revenue common to both
markets equals the marginal production
cost if profit is to be maximized.
 Third-degree Price Discrimination
Market 1 Market 2

p1(y1)
p2(y2)
p1(y1*)
p2(y2*)

MC MC

y1* y1 y2* y2
MR1(y1) MR2(y2)
MR1(y1*) = MR2(y2*) = MC
 Third-degree Price Discrimination
Market 1 Market 2

p1(y1)
p2(y2)
p1(y1*)
p2(y2*)

MC MC

y1* y1 y2* y2
MR1(y1) MR2(y2)
MR1(y1*) = MR2(y2*) = MC and p1(y1*)  p2(y2*).
Third-degree Price Discrimination
 In which market will the monopolist
cause the higher price?
Third-degree Price Discrimination
 In which market will the monopolist
cause the higher price?
 Recall that
 1
MR1 ( y1 ) p1 ( y1 )  1  
 1 
and
 1
MR 2 ( y2 ) p 2 ( y2 )  1   .
 2
Third-degree Price Discrimination
 In which market will the monopolist
cause the higher price?
 Recall that
 1
MR1 ( y1 ) p1 ( y1 )  1  
 1 
and
 1
MR 2 ( y2 ) p 2 ( y2 )  1   .
 2
 * * * *
But, MR (
1 1y )  MR (
2 2y )  MC( y1  y 2)
Third-degree Price Discrimination
*  1 *  1
So p1 ( y1 )  1   p 2 ( y2 )  1   .
 1   2
Third-degree Price Discrimination
*  1 *  1
So p1 ( y1 )  1   p 2 ( y2 )  1   .
 1   2

* *
Therefore, p1 ( y1 )  p 2 ( y2 ) if and only if
1 1
1  1
1 2
Third-degree Price Discrimination
*  1 *  1
So p1 ( y1 )  1   p 2 ( y2 )  1   .
 1   2

* *
Therefore, p1 ( y1 )  p 2 ( y2 ) if and only if
1 1
1  1  1   2 .
1 2
Third-degree Price Discrimination
*  1 *  1
So p1 ( y1 )  1   p 2 ( y2 )  1   .
 1   2

* *
Therefore, p1 ( y1 )  p 2 ( y2 ) if and only if
1 1
1  1  1   2 .
1 2
The monopolist sets the higher price in
the market where demand is least
own-price elastic.
 Two-Part Tariffs
 A two-part tariff is a lump-sum fee,
p1, plus a price p2 for each unit of
product purchased.
 Thus the cost of buying x units of
product is
p1 + p2x.
 Two-Part Tariffs
 Should a monopolist prefer a two-
part tariff to uniform pricing, or to
any of the price-discrimination
schemes discussed so far?
 If so, how should the monopolist
design its two-part tariff?
 Two-Part Tariffs
 p 1 + p 2x
 Q: What is the largest that p1 can be?
 Two-Part Tariffs
 p1 + p2x
 Q: What is the largest that p1 can be?
 A: p1 is the “market entrance fee” so
the largest it can be is the surplus the
buyer gains from entering the market.
 Set p1 = CS and now ask what should
be p2?
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 above MC?
p(y)

p2 p( y)
MC(y)

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 above MC?
p(y)
p1 = CS.
p2 p( y) CS
MC(y)

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 above MC?
p(y)
p1 = CS.
p2 p( y) CS PS is profit from sales.
MC(y)
PS

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 above MC?
p(y)
p1 = CS.
p2 p( y) CS PS is profit from sales.
MC(y)
PS
Total profit

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 = MC?
p(y)

MC(y)
p2 p( y)

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS.
CS MC(y)
p2 p( y)

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS.
CS
PS is profit from sales.
MC(y)
p2 p( y)
PS

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS.
CS
PS is profit from sales.
MC(y)
p2 p( y)
PS Total profit

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS.
CS
PS is profit from sales.
MC(y)
p2 p( y)
PS

y y
 Two-Part Tariffs
$/output unit Should the monopolist
set p2 = MC?
p(y)
p1 = CS.
CS
PS is profit from sales.
MC(y)
p2 p( y)
PS

y y
Additional profit from setting p2 = MC.
 Two-Part Tariffs
 The monopolist maximizes its profit
when using a two-part tariff by
setting its per unit price p2 at
marginal cost and setting its lump-
sum fee p1 equal to Consumers’
Surplus.
 Two-Part Tariffs
 A profit-maximizing two-part tariff
gives an efficient market outcome in
which the monopolist obtains as
profit the total of all gains-to-trade.
 Differentiating Products
 In many markets the commodities
traded are very close, but not
perfect, substitutes.
 E.g., the markets for T-shirts,
watches, cars, and cookies.
 Each individual supplier thus has
some slight “monopoly power.”
 What does an equilibrium look like
for such a market?
 Differentiating Products
 Free entry  zero profits for each
seller.
 Differentiating Products
 Free entry  zero profits for each
seller.
 Profit-maximization  MR = MC for
each seller.
 Differentiating Products
 Free entry  zero profits for each
seller.
 Profit-maximization  MR = MC for
each seller.
 Less than perfect substitution
between commodities  slight
downward slope for the demand
curve for each commodity.
Price Differentiating Products

Slight downward slope

Demand

Quantity
Supplied
Price Differentiating Products

Demand

Quantity
Supplied
Marginal
Revenue
Price Differentiating Products

Marginal
Cost

Demand

Quantity
Supplied
Marginal
Revenue
Price Differentiating Products
Profit-maximization
MR = MC
Marginal
Cost

p(y*)

Demand

Quantity
y* Supplied
Marginal
Revenue
Price Differentiating Products
Zero profit
Price = Av. Cost Profit-maximization
MR = MC
Marginal
Cost

p(y*) Average
Cost
Demand

Quantity
y* Supplied
Marginal
Revenue
 Differentiating Products
 Such markets are monopolistically
competitive.
 Are these markets efficient?
 No, because for each commodity the
equilibrium price p(y*) > MC(y*).
 Price Differentiating Products
Zero profit
Price = Av. Cost Profit-maximization
MR = MC
Marginal
Cost

p(y*) Average
Cost
Demand
MC(y*)
Quantity
y* Supplied
Marginal
Revenue
 Price Differentiating Products
Zero profit
Price = Av. Cost Profit-maximization
MR = MC
Marginal
Cost

p(y*) Average
Cost
Demand
MC(y*)
Quantity
y* ye Supplied
Marginal
Revenue
 Differentiating Products
 Each seller supplies less than the
efficient quantity of its product.
 Also, each seller supplies less than
the quantity that minimizes its
average cost and so, in this sense,
each supplier has “excess capacity.”
 Price Differentiating Products
Zero profit
Price = Av. Cost Profit-maximization
MR = MC
Marginal
Cost

p(y*) Average
Cost
Demand
MC(y*) Excess
capacity
Quantity
y* ye Supplied
Marginal
Revenue
Differentiating Products by Location
 Think a region in which consumers
are uniformly located along a line.
 Each consumer prefers to travel a
shorter distance to a seller.
 There are n ≥ 1 sellers.
 Where would we expect these sellers
to choose their locations?
Differentiating Products by Location

0 1
x
 If n = 1 (monopoly) then the seller
maximizes its profit at x = ??
Differentiating Products by Location
½
0 1
x
 If n = 1 (monopoly) then the seller
maximizes its profit at x = ½ and
minimizes the consumers’ travel
cost.
Differentiating Products by Location
½
0 1
x
 If n = 2 (duopoly) then the
equilibrium locations of the sellers, A
and B, are xA = ?? and xB = ??
Differentiating Products by Location
A ½ B
0 1
x
 If n = 2 (duopoly) then the
equilibrium locations of the sellers, A
and B, are xA = ?? and xB = ??
 How about xA = 0 and xB = 1; i.e. the
sellers separate themselves as much
as is possible?
Differentiating Products by Location
A ½ B
0 1
x

 If xA = 0 and xB = 1 then A sells to all

consumers in [0,½) and B sells to all
consumers in (½,1].
 Given B’s location at xB = 1, can A
increase its profit?
Differentiating Products by Location
A ½ B
0 x’ 1
x

 If xA = 0 and xB = 1 then A sells to all

consumers in [0,½) and B sells to all
consumers in (½,1].
 Given B’s location at xB = 1, can A
increase its profit? What if A moves
to x’?
Differentiating Products by Location
A ½ B
0 x’ 1
x x’/2

 If xA = 0 and xB = 1 then A sells to all

consumers in [0,½) and B sells to all
consumers in (½,1].
 Given B’s location at xB = 1, can A
increase its profit? What if A moves
to x’? Then A sells to all customers
in [0,½+½ x’) and increases its profit.
Differentiating Products by Location
A ½ B
0 x’ 1
x

 Given xA = x’, can B improve its profit

by moving from xB = 1?
Differentiating Products by Location
A ½ B
0 x’ x’’ 1
x

 Given xA = x’, can B improve its profit

by moving from xB = 1? What if B
moves to xB = x’’?
Differentiating Products by Location
A ½ B
0 x’ x’’ 1
x (1-x’’)/2

 Given xA = x’, can B improve its profit

by moving from xB = 1? What if B
moves to xB = x’’? Then B sells to all
customers in ((x’+x’’)/2,1] and
increases its profit.
 So what is the NE?
Differentiating Products by Location
½
0 A&B 1
x

 Given xA = x’, can B improve its profit

by moving from xB = 1? What if B
moves to xB = x’’? Then B sells to all
customers in ((x’+x’’)/2,1] and
increases its profit.
 So what is the NE? xA = xB = ½.
Differentiating Products by Location
½
0 A&B 1
x

 The only NE is xA = xB = ½.
 Is the NE efficient?
Differentiating Products by Location
½
0 A&B 1
x

 The only NE is xA = xB = ½.
 Is the NE efficient? No.
 What is the efficient location of A
and B?
Differentiating Products by Location
¼ ½ ¾
0 A B 1
x
 The only NE is xA = xB = ½.
 Is the NE efficient? No.
 What is the efficient location of A
and B? xA = ¼ and xB = ¾ since this
minimizes the consumers’ travel
costs.
Differentiating Products by Location
½
0 1
x
 What if n = 3; sellers A, B and C?
Differentiating Products by Location
½
0 1
x
 What if n = 3; sellers A, B and C?
 Then there is no NE at all! Why?
Differentiating Products by Location
½
0 1
x
 What if n = 3; sellers A, B and C?
 Then there is no NE at all! Why?
 The possibilities are:
– (i) All 3 sellers locate at the same point.
– (ii) 2 sellers locate at the same point.
– (iii) Every seller locates at a different
point.
Differentiating Products by Location
½
0 1
x
 (iii) Every seller locates at a different
point.
 Cannot be a NE since, as for n = 2,
the two outside sellers get higher
profits by moving closer to the
middle seller.
Differentiating Products by Location
½
A
B
0 C 1
x C gets 1/3 of the market
 (i) All 3 sellers locate at the same
point.
 Cannot be an NE since it pays one of
the sellers to move just a little bit left
or right of the other two to get all of
the market on that side, instead of
having to share those customers.
Differentiating Products by Location
½
A B C
0 1
x C gets almost 1/2 of the market
 (i) All 3 sellers locate at the same
point.
 Cannot be an NE since it pays one of
the sellers to move just a little bit left
or right of the other two to get all of
the market on that side, instead of
having to share those customers.
Differentiating Products by Location
½
A B C
0 1
x A gets about 1/4 of the market
 2 sellers locate at the same point.
 Cannot be an NE since it pays one of
the two sellers to move just a little
away from the other.
Differentiating Products by Location
½
A B C
0 1
x A gets almost 1/2 of the market
 2 sellers locate at the same point.
 Cannot be an NE since it pays one of
the two sellers to move just a little
away from the other.
Differentiating Products by Location
½
A B C
0 1
x A gets almost 1/2 of the market
 2 sellers locate at the same point.
 Cannot be an NE since it pays one of
the two sellers to move just a little
away from the other.
Differentiating Products by Location
 If n = 3 the possibilities are:
– (i) All 3 sellers locate at the same
point.
– (ii) 2 sellers locate at the same
point.
– (iii) Every seller locates at a
different point.
 There is no NE for n = 3.
Differentiating Products by Location
 If n = 3 the possibilities are:
– (i) All 3 sellers locate at the same
point.
– (ii) 2 sellers locate at the same
point.
– (iii) Every seller locates at a
different point.
 There is no NE for n = 3.
 However, this is a NE for every n ≥ 4.