# Microeconomics. Claudia Vogel EUV. Winter Term 2009/2010. Market Power: Monopoly and Monopsony

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1 Microeconomics Claudia Vogel EUV Winter Term 2009/2010 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Lecture Outline Part III Market Structure and Competitive Strategy 10 The Social Costs of Power Summary 11 Pricing with Market Power Capturing Consumer Surplus Price Discrimination Summary Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

2 monopoly: Market with only one seller monopsony: Market with only one buyer market power: Ability of a seller or buyer to aect the price of a good. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 marginal revenue: Change in revenue resulting from a from a one-unit increase in output. To see the relationship among total, average, and marginal revenue, consider a rm facing the following demand curve: P = 6 Q Total Marginal Average Price (P) Quantity (Q) Revenue (R) Revenue (MR) Revenue (AR) \$ \$5 \$ Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

3 Average Revenue and Marginal Revenue Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 The Monopolist's Output Decision 1/2 Prot is maximized when marginal revenue equals marginal cost. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

4 The Monopolist's Output Decision 2/2 We can also see algebraically that Q maximizes prot. Prot π is the dierence between revenue and cost, both of which depend on Q: π (Q) = R (Q) C (Q) As Q is increased from zero, prot will increase until it reaches a maximum and then begin to decrease. Thus a prot-maximizing Q is such that the incremental prot resulting from a small increase in Q is just zero (i.e., π/ Q = 0). Then π Q = R Q C Q = 0 But R/ Q is marginal revenue and C/ Q is marginal cost. Thus the prot-maximizing condition is that: MR = MC Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Example of Prot Maximization Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

5 Shifts in Demand Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 The Eect of a Tax Suppose a specic tax of t dollars per unit is levied, so that the monopolist must remit t dollars for the government for every unit it sells. If MC was the rm's original marginal cost, its optimal production decision is now given by MR = MC + t Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

6 The Social Costs of Power Sources of Power When only few rms account for most of the sales in a market, we say that the market is highly concentrated. barrier to entry: Condition that impedes entry by new competitors. The elasticity of market demand limits the potential monopoly power of individual producers. Even if only two or three rms are in the market, each rm will be unable to protably raise price very much if the rivalry among them is aggressive, with each rm trying to capture as much of the market as it can. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 The Social Costs of Power Deadweight Loss from Power Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

7 The Social Costs of Power Price Regulation Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 The Social Costs of Power Natural natural monopoly: Firm that can produce the entire output of the market at a cost lower than what it would be if there were several rms. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

8 oligopsony: Market with only a few buyers. monopsony power: Buyer's ability to aect the price of a good. marginal value: Additional benet derived from purchasing one more unit of a good. marginal expenditure: Additional cost of buying one more unit of a good. average expenditure: Price per unit of a good. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Competitive Buyer Compared to Competitive Seller Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

9 Monopsonist Buyer Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 and Compared Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

11 Summary Summary Market power is the ability of sellers or buyers to aect the price of a good. Market power comes in two forms. When sellers charge a price that is above marginal cost, we say that they have monopoly power, which we measure by the extent to which price exceeds marginal cost. When buyers can obtain a price below their marginal value of the good, we say they have monopsony power, which we measure by the extent to which marginal value exceeds price. Market power can impose costs on society. Because monopoly and monopsony power both cause production to fall below the competitive level, there is a deadweight loss of consumer and producer surplus. There can be additional costs from rent seeking. Sometimes, scale economies make pure monopoly desirable. But the government will still want to regulate price to maximize social welfare. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Lecture Outline Pricing with Market Power Part III Market Structure and Competitive Strategy 10 The Social Costs of Power Summary 11 Pricing with Market Power Capturing Consumer Surplus Price Discrimination Summary Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

12 Pricing with Market Power Capturing Consumer Surplus Capturing Consumer Surplus If a rm can charge only one price for all its customers, that price will be P and the quantity produced will be Q. Ideally, the rm would like to charge a higher price to consumers willing to pay more than P, thereby capturing some of the consumer surplus under region A of the demand curve. The rm would also like to sell to consumers willing to pay prices lower than P, but only doing so does not entail lowering the prive to other consumers. In that way, the rm could also capture some of the surplus under region B of the demand curve. price discrimination: Practice of charging dierent prices to dierent consumers for similar goods. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Pricing with Market Power Price Discrimination First-Degree Price Discrimination reservation price: Maximum price that a customer is willing to pay for a good. rst-degree price discrimination: Practice of charging each customer her reservation price. variable prot: Sum of prots on each incremental unit produced by a rm; i.e. prot ignoring xed costs. Perfect Price Discrimination The additional prot from producing and selling an incremental unit is now the dierence between demand and marginal cost. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

13 Pricing with Market Power Price Discrimination Second-Degree Price Discrimination second-degree price discrimination: Practice of charging dierent prices per unit for dierent quantities of the same good or service. block pricing: Practice of charging dierent prices for dierent quantities or blocks of a good. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Pricing with Market Power Price Discrimination Third-Degree Price Discrimination 1/2 third-degree price discrimination: Practice of dividing consumers into two or more groups with separate demand curves and charging dierent prices to each group. Creating Consumer Groups π = P 1 Q 1 + P 2 Q 2 (QT ) π Q 1 = P 1Q 1 Q 1 MR 1 = MC C Q 1 = 0 MR 2 = MC MR 1 = MR 2 = MC Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

14 Pricing with Market Power Price Discrimination Third-Degree Price Discrimination 2/2 Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Pricing with Market Power Summary Summary Firms with market power are in enviable position because they have the potential to earn large prots. Realizing that potential, however, may depend critically on pricing strategy. Even if the rm sets a single price, it needs an estimate of the elasticity of demand for its output. More complicated strategies, which can involve setting several dierent prices, require even more information about demand. A pricing strategy aims to enlarge the customer base thatthe rm can sell to and capture as much consumer surplus as possible. There are a number of ways to do this, and they usually involve setting more than a single price. Ideally, the rm would like to price discriminate perfectly - i.e., to charge each customer his or her reservation price. In practice, this is almost always impossible. On the other hand, various forms of imperfect price discrimination are often used to increase prots. Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

15 Exerxises 9 Problem 1 1 Why might a rm have monopoly power even if it is not the only producer in the market? 2 What are some of the dierent types of barriers to entry that give rise to monopoly power? Give an example. 3 What factors determine the amount of monopoly power an individual rm is likely to have? Explain briey. 4 Why is there a social cost to monopoly power? If the gains to producers from monopoly power could be redistributed to consumers, would the social cost of monopoly power be eliminated? 5 Why will a monopolist's output increase if the government forces it to lower its price? If the government wants to set a price ceiling that maximizes the monopolist's output, what price should it set? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Problem 2 Exerxises 9 1 How should a monopsonist decide how much of a product to buy? Will it buy more or less than a competitive buyer? 2 What are some sources of monopsony power? what determines the amount of monopsony power an individual rm is likely to have? 3 Why is there a social cost to monopsony power? If the gains to buyers from monopsony power could be redistributed to sellers, would the social cost of monopsony power be eliminated? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

16 Exerxises 9 Problem 3 The following table shows the demand curve facing a monopolist who produces at a constant marginal cost of \$10: Price Quantity Calculate the rm's marginal revenue curve. 2 What are the rm's prot maximizing output and price? What is its prot? 3 What would the equilibrium price and quantity be in a competitive industry? 4 What would the social gain be if this monopolist were forced to produce and price at the competitive equilibrium? Who would gain and lose as a result? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Problem 4 Exerxises 9 1 Suppose a rm can practice perfect, rst-degree price discrimination. What is the lowest price it wioll charge, and what will its total output be? 2 Electric utilities often practice second-degree price discrimination. why might this improve consumer welfare? 3 Give some examples of third-degree price discrimination. Can third-degree price discrimination be eective if the dierent groups of consumers have dierent levels of demand but the same price elasticity? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34

17 Exerxises 9 Problem 5 Price discrimination requires the ability to sort customers and the ability to prevent arbitrage. Explain how the following can function as price discrimination schemes and discuss both sorting and arbitrage: 1 Requiring airline travelers to spend at least one Staurday night away from home to qualify for a low fare. 2 Oering temporary price cuts on bathroom tissue. 3 Charging high-income patients more than low-income patients for plastic surgery Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34 Problem 6 Exerxises 9 Elizabeth Airlines (EA) ies only one route: Chicago-Honolulu. The demand for each ight is Q = 500 P. EA's cost of running each ight is \$30000 plus \$100 per passenger. 1 What is the prot-maximizing price that EA will charge? How many people will be on each ight? What is EA's prot for each ight? 2 EA learns that the xed costs per ight are in fact \$41000 instead of \$ Will the airline stay in business for long? Illustrate your answer using a graph of the demand curve that EA faces, EA's average cost curve when xed costs are \$30000, and EA's average cost curve when xed costs are \$ EA nds out that two dierent types of people y to Honolulu. Type A consists of business people with demand of Q A = P. Type B consists of students whose total demand is Q B = P. Because the students are easy to spot, EA decides to charge the dierent prices. Graph each of these demand curves and their horizontal sum. What price does EA charge the students? What price does EA charge other customers? How many of each are on each ight? 4 What would EA'S prot be for each ight? Would the airline stay in business? Calculate the consumer surplus for each group. What is the total consumer surplus? 5 Before EA started price discriminating, how much consumer surplus was the Type A demand getting from air travel to Honolulu? Type B? Why did total consumer surplus decline with price discrimination, even though total quantity sold remained unchanged? Claudia Vogel (EUV) Microeconomics Winter Term 2009/ / 34