# Lecture 20: Price Discrimination, Monopoly Rents and Social Surplus

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1 Lecture 20: Price Discrimination, Monopoly Rents and Social Surplus Monopoly p 1 A monopoly price increase leads to an increase in monopoly profits whenever p 2

2 Example: Monopoly Profit Maximization (The monopoly must produce whole units and charge everyone the same price.) Chairs Total Marginal Price Quantity Revenue Revenue (P, WTP) (Q) (TR=PxQ) (MR) How many chair would the firm want to sell if the cost (MC) of each additional unit is \$15? Note: continued from previous lecture MR = MR = Q M *: MR > MC 0 MR < MC 20 At what price? Would chair #6 increase social surplus? #7? Monopoly>Profit Maximization p 3 Monopoly earns profits (MR MC) on every unit up to 5 tons but she would lose profits on units between 5 tons and 10 tons. So she will sell 5 tons. Monopoly and Social Surplus (Tons of Sugar: The monopoly can produce parts of a ton. It must charge everyone the same price.) 1, MR MC P, WTP DWL But society would have benefited from the next 5 tons, because WTP > MC. Demand Curve The next 5 tons, not produced, represent unexploited gains of trade (DWL). Monopoly>Profit Maximization p 4

3 In our example, \$ 1,000 The cost of each ton of sugar (MC) is \$ the monopolist wants to P sell 5 tons, because 600 MR MC for each of MR the first 5 tons. 400 Profits DWL She sets the price at 200 \$600 (on the demand MC curve, NOT on the MR 0 or MC curve). Why? Monopoly profits are 5( ) = \$2000. Deadweight loss = \$1000. Why? In this example, we have so far assumed that the monopolist cannot price-discriminate [sell to different consumers at different prices]. What if she could? Demand Curve Q Monopoly>Profit Maximization p 5 Price Discrimination Example: A lobster shop in Maine Visitors must take a road along a hillside, down to the lobster shop near the beach. The lobster-seller can see each car coming down the hillside long before it gets to his shop. If the car is expensive, he writes a high price on the chalk-board in his shop, but if the car is junk,?. Monopoly>Price Discrimination p 6

4 Perfect Price-Discrimination Suppose De Beers (a former diamond monopoly) had an instrument that could measure every customer s WTP for diamonds. Then De Beers could set a special price for each customer, equal to the customer s WTP. How much consumer surplus will the customers get? If the firm wanted to sell an additional diamond, it could charge the new customer his own WTP, without having to lower prices charged to other customers. Monopoly>Price Discrimination>Perfect p 7 If a consumer doesn t agree to be measured by the instrument, De Beers would say bye, bye. We show: If De Beers follows such policies, the firm will maximize profits by producing the same quantity that would be produced in a perfectly-competitive equilibrium. Why? Monopoly>Price Discrimination>Perfect p 8

5 With perfect price discrimination, what portion of the total social surplus? p 9 Perfect Price-Discrimination Suppose that a perfectly P discriminating firm facing demand D produces q 1 units. If the firm sells one more unit, revenue increases by p. p Because the firm can charge different prices to different buyers, it doesn t have to reduce prices to other buyers. Therefore, MR is always the same as p and WTP. So profits on that unit are P MC. The firm will continue to increase sales as long as p >MC, Price-Discriminating Firm Social Surplus = Producer 1 p Surplus q 1 1 q q Q M = q* and will stop only when p = MC. Social surplus is maximized, but the monopoly gets all of the surplus as producer surplus, and consumers get none. Monopoly>Price Discrimination>Perfect p 10 D MC

6 Price discrimination is difficult when goods can be resold with low transaction costs. In the case of De Beers, people with low WTP could buy diamonds and resell them to those with high WTP. Price discrimination is more effective in the case of services. Example: Monopoly>Price Discrimination>Perfect p 11 Other forms of Price Discrimination Firms cannot perfectly identify an individual s WTP, but they can test people and put them in groups with different average WTP. Age-based discounts on movies, airline tickets [often called 3 rd -degree price discrimination] Monopoly>Price Discrimination>Other Forms p 12

7 Should Price Discrimination be legal? Example: Medication for AIDS. Price discrimination allows AIDS medication to be more expensive in rich countries than in poor ones. Price discrimination increases social surplus, because pharmaceutical companies will produce more medicines, and consumers in poor countries will be able to buy them. But with price discrimination, pharmaceutical companies can make huge profits in rich countries at the expense of rich-country consumers. Monopoly>Price Discrimination>Legal? p 13 Suppose price-discrimination were outlawed. Pharmaceutical companies might charge close to the rich-country price everywhere, and medicines could become less available in poor countries. Monopoly>Price Discrimination>Legal? p 14

8 Regulating Monopolies Some monopolies are regulated by government agencies. Utilities: electricity, gas, water, etc. Local telephone service. Long-distance telephone service (in the past). Regulators often apply price ceilings. When used in competitive markets, price ceilings tend to reduce output and social surplus, and induce nonprice rationing. What effect does a price ceiling have on a monopolized market? Monopoly>Regulation p 15 Monopolies and Price Ceilings When a nondiscriminating monopoly faces demand D and marginal cost MC, the competitive price is p*. But the monopoly will set the price to p M and restrict the quantity to q M. But if a price ceiling p c is enacted at the competitive level p*, then MR becomes p c, and the monopoly will increase output to q* (the competitive output level). P p M p C p* CS MR Monopoly>Price Ceilings p 16 D Price Ceiling PS q M MR MC q* Q Social surplus is maximized, the monopoly gets some producer surplus, consumers get consumer surplus. Difficulty: to set an efficient price ceiling, the regulator needs to know both D and MC.

9 Price-Discriminating Monopolists and Price Ceilings When monopolies cannot price-discriminate, price ceilings at the competitive level: improve efficiency, and redistribute the social surplus. Price-discriminating monopolists are already reasonably efficient, so price ceilings at the competitive level do not raise efficiency very much, BUT they do change the distribution of surplus in favor of the consumer. Monopoly>Price Ceilings p 17 Monopoly Rent Seeking Rent-Seeking>Theft p 18

10 Rent Seeking and Social Surplus Example: The Bicycle Thief [Ladri di biciclette] Film: 1948 Dir: Vittorio de Sica What happens to social surplus if someone steals your bicycle? You lose an amount of surplus equal to your WTP for the bicycle. The thief gains surplus equal to his WTP. Net gain in total surplus? Rent-Seeking>Theft p 19 Theft (stealing) is a form of rent seeking! Why? What are the social costs of the bicycle-theft activity? Static costs Thief s time and effort. Owner s effort and expense in order to avoid theft (e.g. the cost of locks). Dynamic costs (over time) The thief will have less incentive to work if he can steal. The owner will have less incentive to work if the goods he buys are often stolen. Rent-Seeking>Theft p 20

11 The rent-seeking costs of a bicycle theft are likely to be higher than the gain in surplus created by a thief who values the bicycle more than the owner does. Besides, if the thief really values the bicycle more than the owner, he could buy it, right? Or maybe not. Why not? Rent-Seeking>Theft p 21 A thief breaks your car window and steals \$100 from the car s glove compartment. p 22

12 Monopoly Rent-Seeking Nondiscriminating monopolies create artificial scarcities and inefficiency by restricting output. But perfectly discriminating monopolists do not create artificial scarcities. However all monopolies tend to waste resources to protect their monopoly status. Rent-seeking costs may include: legal expenses, political campaign contributions and bribery, and setting prices below costs. Monopoly>Rent Seeking p 23 The costly attempt to obtain or maintain monopoly status is a form of rent-seeking. Examples: local mafias NCR De Beers When monopoly status is conferred as a legally enforceable intellectual property right (patents and copyrights), rent-seeking behavior may be discouraged... but certainly not eliminated. Monopoly>Rent Seeking p 24

13 Monopoly: Rent-Seeking Losses After restricting production, the monopoly can raise its price and obtain monopoly rents. But this strategy can work only if the monopoly can prevent potential competitors from entering the market at a lower price. To maintain its monopoly position, the monopolist must pay rent-seeking costs, Price P M P* Q* Potential competitors are also likely to pay rent-seeking costs, which reduce social surplus more. which reduce its own Price-discriminating monopolists surplus and social surplus. have exactly the same problem. CS PS Monopoly Rents Rent-Seeking Costs Q M Lost CS Lost PS MC D, WTP Restricted Production Monopoly>Restricting Production p 25 Q Patents and copyrights create legally owned monopolies. Yet, costly disputes over intellectual property rights are common. Example: Apple vs. Samsung mobile phones* Apple and Samsung sued each other for patent infringement in the US, Korea, Japan, Germany and 6 other countries, with more than 50 lawsuits worldwide. On August 24, 2012, a US jury awarded Apple more than \$1 billion in damages to be paid by Samsung. In the Korean lawsuit, the verdict was mixed. It seems likely that Apple and Samsung spent hundreds of millions of dollars on lawyers and expert witnesses. These lawsuits are costly rent-seeking activities with little or no social value. *see Wikipedia, Apple Inc. v. Samsung Electronics Co., Ltd. US Verdict Monopoly>Rent Seeking p 26

14 Example: Awards of mobile-phone radio spectrum create legally owned monopolies. In some countries (e.g. US, UK and Germany), spectrum for the use of mobile phones was allocated by auction. In other countries (e.g. France, Spain, Italy), spectrum was allocated by what economists call beauty contests. Auctions force companies to pay for the spectrum they want, but beauty contests encourage rent seeking. Applicant firms spent \$\$\$ on beauty contests, but the money spent created no social surplus. Monopoly>Rent Seeking p 27 What types of firms are most likely to engage in costly rent-seeking? p 28

15 End of File End of File p 29

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