# UC Berkeley Haas School of Business Economic Analysis for Business Decisions (EWMBA 201A) Fall 2013

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1 UC Berkeley Haas School of Business Economic Analysis for Business Decisions (EWMBA 201A) Fall 2013 Monopolistic markets and pricing with market power (PR and ) Module 4 Sep. 20, 2014

2 Monopoly In contrast to perfect competition, a monopoly is a market that has only one seller but many buyers. A monopsony is exactly the opposite is a market that has many sellers but only one buyer. Monopoly and monopsony are forms of market power an ability to effect the market price. Our goal is to understand how market power works and how it effects producers and consumers.

3 The theory of monopoly is, on the face of it, simple and straightforward, but behind it lie some deep and interesting questions. [1] How the monopoly came to be a monopoly, and why it stays that way? [2] If the monopoly makes profit, why does not the industry attract entrants? Standard stories, if given at all, get very fuzzy at this point. Hands start to wave, hems give away to haws, and on to the next subject...

4 Perhaps most importantly, the monopolist is the market so it completely controls the amount of output offered for sale(or the price per unit). When the monopolist decides how much to produce, the price per unit that it receives follows directly from the market demand. When the monopolist determines a price, the quantity it will sell at that price follows from the market demand. The standard theory is that the monopoly set a quantity of output 0 to maximize its profits (but we can also think of the monopoly choosing a price ).

5 Average revenue and marginal revenue The monopolist s average revenue the price it receives per unit sold is the market demand curve. To see the relationship among total, average, and marginal revenue, consider a monopolist facing a linear demand curve ( ) = where 0 Then, ( ) = ( ) = 2 = = 2

6 Dollars per unit Average and marginal costs A Average revenue (demand) Marginal revenue A/2 A Output

7 The monopolist s output decision problem The monopolist s profit ( ) is the difference between revenue and cost both of which depend on. ( ) = ( ) ( ) As increases, will increase until it reaches a maximum and then start to decrease. Hence, the profit-maximizing quantity of output is such that the marginal (incremental) profit resulting from a small increase in equals zero.

8 Algebraically, = =0 or equivalently, = That is, we have the slogan that marginal revenues equals marginal costs.

9 An example Suppose the cost of production is given by ( ) =50+ 2 (a fixed costs of \$50 and a variable costs of and variable costs of 2 ) the demand is given by Note well that ( ) =40 = ( ) =50 + = =2 ( ) = ( ) =40 2 =40 2

10 Setting marginal revenue equal to marginal cost = gives 40 2 =2 or =10(reaching the maximum profit of\$150). Alternatively, ( ) = ( ) ( ) = ( ) ( ) = (40 ) 50 2 = = and setting equal zero gives 40 4 =0,or =10. Next we will give a geometrical procedure for doing this.

11 Price The monopolist s decision problem 40 MC MR 20 D=AR 40 Output

12 Price MC MR D=AR Output

13 Price The monopolist s profit MC Profit AC 15 MR D=AR Output

14 Price 40 Loss from producing too much/little (or selling at too little/high price) 30 MC MR D=AR Output

15 Price 40 Loss from monopoly power A+B Deadweight loss C loss consumer surplus 30 MC C A B MR D=AR Output

16 The rule of thumb for pricing But a lot is wrong with the story just told managers have only limited information of the average and marginal revenue curves facing their firms. To this end, so we need a rule of thumb that can be applied in the realworld. Note that selling an extra unit must result in a small drop in price which reduces the revenue from all units sold! We therefore rewrite the marginal revenue as follows = + = + = + 1 Ã!Ã!

17 Recall that the price elasticity of demand the percentage change (decrease) in quantity demanded of a good resulting from a 1-percent increase initsprice isgivenby = = When we set marginal revenues to marginal costs we get = + 1 = Rearranging, = 1+(1 )

18 Monopoly power? For a competitive firm, price equals marginal costs; for a firm with monopoly power, price exceeds marginal costs. The Lerner Index of Monopoly Power (1934) given mathematically by = = 1 uses the markup ratio of price minus marginal costs to price to measure the monopoly power.! Firms prices are sometimes below its optimal price so its monopoly power will not be noted by the Lerner Index.

19 Sources of market power The more inelastic its demand curve, the more monopoly power the firm has. These factors determine a firm s demand elasticity: [1] The elasticity of market demand. [2] The number of firms in the market. [3] The interaction among firms.

20 Maintaining monopoly = Differentiated / branded goods. = Barriers to entry (e.g., patents). = Customer lock-in. = Predatory pricing.

21 Summary In a competitive market there are many firms selling an identical product. When one of these firms raises its price above the market price it loses all its customers. In a monopolized market, there is only one firm selling a given product. When a monopolist raises its price it loses some, but not all, its customers.! In reality, most industries are somewhere in between these two extremes.

22 If a firm has some degree of monopoly power then it has more strategies than a firm in a perfectly competitive market. The problem faced by firms with some monopoly power is how to enhance and exploit their market power most effectively. Their objective capturing more consumer surplus and converting it into additional profits for the firm. This goal can be can be achieved using price discrimination, that is charging different prices for different consumers.

23 The deficiencies of simple pricing [1] If the firm can charge only one price for all it consumers, to maximize profit, it would pick the price and corresponding output where its marginal cost ( ) and marginal revenue ( ) curves intersect. [2] But although simple pricing or uniform pricing is quite prevalent, it is neither the only nor the most desirable form of pricing. If the firm could sell different units of output at different prices, then we have another story.

24 Price A B MC MR D=AR Output

25 What simple pricing loses?! 1. It leaves potential profit in the hands of consumers in the form of their consumer surplus (the surplus under region of the demand curve). 2. It leaves money on the table (deadweight loss) due to the drivingdown-the-price effect (the surplus under region of the demand curve).

26 Two observations: 1. Under simple pricing, the firm cannot charge a price for the +1 unit that is different than the price it charges for the other units. And the fact that it would, have to lower the price on all units in order to induce someone to buy the +1unit, makes selling that unit unprofitable.

27 2. The firm would like to charge a higher price to consumers willing to pay more than.thefirm would also like to sell to consumers willing to pay prices lower than, but only if doing so does not entail lowering thepricefortheotherconsumers.! This is the basis for price discrimination charging different prices to different consumers.

28 Price discrimination Economists typically consider three degrees of prices discrimination: 1 st The firm sells different units of output for different prices and these prices may differ from consumer to consumer. 2 nd The firm sells different units of output for different prices but every consumer who buys the same amount of the good pays the same price. 3 rd The firm sells output for different consumers at different prices, but every unit of output sold to a given consumer sells for the same price. Next, we look at each of these types of prices discrimination to see what economics can say about how prices discrimination works!

29 First-degree (or perfect) price discrimination = A firm that is able to perfectly price discriminate will sell each unit of output at the highest price it will command, that is, at each consumer s reservation price. = Since the firm can capture all the welfare generated from selling any number of units, it will want to produce to the point at which demand intersects marginal cost.

30 Price First degree price discrimination MC D=AR Output

31 Producing units and capturing all of welfare is the very best the firm could ever do (the Holy Grail of pricing). Perfect price discrimination is an idealized concept but it is interesting theoretical because it achieves Pareto efficiency. Clearly, firms typically cannot know the reservation price of every consumer, but sometimes reservation prices can be roughly identified. There are very few real-life examples. Perhaps to closest example would be tuition rates in Ivy League colleges, based on ability to pay.

32 Second-degree price discrimination Under second-degree price discrimination the price per unit of output is notconstantbutdependsonhowmuchyoubuy(non-linearpricing). One form of second-degree price discrimination is via quantity discounts liter bottle of Coke is less than twice as expensive as the half-liter bottle. Typically, each price-quantity package is targeted toward different consumers, giving consumers an incentive to self-select. In practice, firms often encourage this self-selection not by adjusting quantity of the good, but rather by adjusting the quality of the good.

33 The airline industry has been very successful in prices discrimination (the industry spokesperson prefer to use the term yield management ): [1] restricted and unrestricted fares [2] first-class and couch-class travel [3] Saturday night stayovers [4] advance-ticketing! In the 19 th century, the French railroads removed the roofs from secondclass carriages to create third-class carriages...

34 Price Second degree price discrimination (two different price quantity packages) MC MR D=AR Output

35 Third-degree price discrimination Third-degree price discrimination means charging different prices to different consumers on the basis of identifiable characteristics. An example of third-degree discrimination is charging different prices on the basis of observed group membership (children, seniors, students, etc). Geography-based third-degree price discrimination is quite prevalent in air travel, a round-trip SFO-JFK has a different price than JFK-SFO... Clearly, the market with the higher price must have a lower elasticity of demand.

36 An example Let 1 ( 1 ) be the demand of students and 2 ( 2 ) be the demand of non-students where 1 and 2 are the amount sold to students and non-students, respectively. Let ( ) for = be the firm s cost function. The firm s profit is its revenue from each population less its costs is given by ( )= 1 ( 1 ) ( 2 ) 2 ( )

37 The profit-maximizing quantity of output 1 (resp. 2 ) is such that the marginal (incremental) profit resulting from a small increase in 1 (resp. 2 ) equals zero, that is, and 1 = = =0 2 =0 Thus, at the profit-maximizing quantities 1 and 2 1 ( 1 )= 2( 2 )= ( )

38 To determine relative prices, we can write the marginal revenues in terms of elasticity of demand: and 1 = 1 ( ) 2 = 2 ( ) By equating 1 and 2,wemusthave 1 2 = ! This analysis generalizes to any (finite) number of populations.

39 Price Third degree price discrimination (two populations) Output

40 Price Third degree price discrimination Output

41 Price Third degree price discrimination Output

42 Two-part tariffs (The Disneyland Dilemma) A two-part tariff can help get a firm closer to the Grail than can simple pricing. It is a pricing scheme (tariff) with, as the name indicates, two parts: I An entry fee the amount that the consumer must pay before she can buy any units at all (overhead charge). II A per-unit charge the amount that the consumer must pay for each unit she chooses to purchase.! In some instances, as with some but not all amusement parks, the per-unit charge might even be set to zero (so-called Disneyland pricing).

43 = Identical consumers Suppose consumers have identical demands (are homogeneous). Under the profit-maximizing two-part tariff, the firm produces units, where ( )= ( ) sets the per-unit charge equal ( ) setsanentryfee to equal where is the number of consumers.

44 Price Two part tariff CS MC D Output

45 = Consumers are heterogeneous If consumers do not all have the same demand curves then designing the optimal two-part tariff becomes much more complicated. One strategy would be to divide customers into homogeneous subgroups (third-degree price discrimination), and then employ the optimal two-part tariff on each group.! Real-life use of two-part tariffs are hard to recognize initially club stores, tech support (some has service-call charge), land-line phones, and more.

46 Takeaways 1. If all consumers are identical, then perfect price discrimination can be achieved by a two-part tariff. When consumers are not identical, then it is typically not possible to achieve perfect discrimination. 2. When consumers are heterogeneous it is sometimes possible to divide them into different populations that are more homogeneous. If so, then the firm can engage in third-degree price discrimination. 3. When the firm cannot freely identify consumers types, it can try to induce them to reveal their types. This form of price discrimination is known as second-degree price discrimination.

47 4. Two prevalent forms of second-degree price discrimination are using quality distortions and quantity discounts. 5. Another method of price discrimination is bundling. Bundling allows the firm to take advantage of the correlations that exist between consumers preferences for different products. 6. All discriminatory pricing is, in theory, vulnerable to arbitrage the advantaged reselling to the disadvantaged. Firms seek to deter or reduce arbitrage.

48 Problem set IV PR 10 exercises 3,4 and PR 11 exercises 4, 5, 7 and 8.

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