Deadweight Loss of Monopoly

Monopoly (part 2) Deadweight Loss of Monopoly Market Failure: non-optimal allocation of goods & services with economic inefficiencies (price is not marginal cost) A monopoly sets p > MC causing consumers to buy less than the competitive level of the good. So society suffers a deadweight loss. In the Figure, the monopolist s maximizing q and p are 6 and $18. The competitive values would be 8 and $16. The deadweight loss of monopoly is C E. Potential surplus that is wasted because less than the competitive output is produced. 1

Causes of Monopoly 1. Cost Based Monopolies Two cost structures facilitate the creation of a monopoly: A firm may have substantially lower costs than potential rivals: cost advantage. A firm may produce any given output at a lower cost than two or more firms: natural monopoly. Cost Advantage A low-cost firm is a monopoly if it sells at a price so low that other potential competitors with higher costs would lose money. No other firm enters the market. The sources of cost advantage over potential rivals are diverse: superior technology or better way of organizing production, control of an essential facility, control of a scarce resource Natural Monopoly One firm can produce the total output of the market at lower cost than two or more firms could: C(Q) < C(q 1 ) + + C(q n ), where Q = q 1 + q 2 + + q n is the sum of the output of any n firms where n 2 firms. Economies of scale explain this outcome: a natural monopoly has the same strictly declining average cost curve When just one firm is the cheapest way to produce any given output level, governments often grant monopoly rights to public utilities of water, gas, electric power, or mail delivery. 2

Causes of Monopoly 2. Government Creation of Monopoly Governments grant a license, monopoly rights, or patents Barriers to Entry Governments create monopolies either by making it difficult for new firms to obtain a license to operate or by explicitly granting a monopoly right to one firm, thereby excluding other firms. By auctioning a monopoly to a private firm, a government can capture the future value of monopoly earnings. However, for political or other reasons, governments frequently do not capture all future profits. Patents A patent is an exclusive right granted to the inventor of a new and useful product, process, substance, or design for a specified length of time. The length of a patent varies across countries, although it is now 20 years in the United States. Networks & Behavioral Economics Network Externalities A good has a network externality if one person s demand depends on the consumption of a good by others. If a good has a positive network externality, its value to a consumer grows as the number of units sold increases. A telephone and fax are classical examples. For a network to succeed, it has to achieve a critical mass of users enough adopters that others want to join. A customer can get a direct benefit from a larger network, or an indirect benefit from complementary goods that are offered when a product has a critical mass of users (apps for a smart phone). Network Externalities & Behavioral Economics Bandwagon effect: A person places greater value on a good as more and more other people possess it Snob effect: A person places greater value on a good as fewer and fewer other people possess it 3

Networks & Behavioral Economics Network Externalities & Monopoly Because of the need for a critical mass of customers in a market with a positive network externality, we sometimes see only one large firm surviving. The Windows operating system largely dominates the market not because it is technically superior to Apple s operating system or Linux but because it has a critical mass of users. But having obtained a monopoly, a firm does not necessarily keep it. Managerial Implication: Introductory Pricing Managers should consider initially selling a new product at a low introductory price to obtain a critical mass. By doing so, the manager maximizes long-run but not short-run profit. Advertising Advertising and Net Profit A successful advertising campaign shifts the monopolist market demand curve outward and makes it less elastic. In the Figure, D 2 is to the right and less elastic than D 1. 4

Advertising Deciding Whether to Advertise Do it only if firm expects net profit (gross profit minus the cost of advertising) to increase. In the Figure, gross profit is B. How Much to Advertise Do it until its marginal benefit (gross profit or marginal revenue) equals its marginal cost Advertising and calculus Using Calculus: π (Q,A) = R (Q,A) C (Q) - A Profit is revenue minus cost. Advertising, A, is a fixed cost and affects revenue, R(Q, A) = p(q, A)Q. The monopoly maximizes its profit by choosing Q and A. First Order Condition: π (Q,A) / Q = 0 R(Q,A) / Q C (Q) / Q = 0 The monopoly should set its output so that MR = MC First Order Condition: π (Q,A) / A = 0 R(Q,A) / A 1 = 0 The monopoly should advertise to the point where its marginal revenue or marginal benefit from the last unit of advertising, R/ A, equals the marginal cost of the last unit of advertising, $1. 5

Managerial Solution Managerial Problem Drug firms have patents that expire after 20 years and Congress expects drug prices to fall once generic drugs enter the market. However, evidence shows, prices went up after the expiration. Why can a firm with a patent-based monopoly charge a high price? Why might a brand-name pharmaceutical's price rise after its patent expires? Solution When generic drugs enter the market after the patent expires, the demand curve facing the brand-name firm shifts to the left, and rotates to become less elastic at the original price. Price sensitive consumers switch to the generic, but loyal customers prefer the brand-name drug (familiar and secure product for them). Elderly and patients with generous insurance plans fit this group. More on monopoly pricing: Introduction Managerial Problem Heinz dominates the ketchup market in the U.S., Canada, and U.K. When Heinz goes on sale, switchers purchase Heinz rather than the low-price generic ketchup. How can Heinz s managers design a pattern of sales that maximizes Heinz s profit? Under what conditions does it pay for Heinz to have a policy of periodic sales? Solution Approach We need to examine how monopolies and other noncompetitive firms set prices. These firms can earn a higher profit setting different prices for the same good or service depending on consumer s willingness to pay (non-uniform pricing). 6

What is Price Discrimination Price Discrimination and Equal Costs Price discrimination is based on charging different prices even for units of a good that cost the same to produce. Different Prices and Different Costs Newsstand prices and subscription prices for magazines differ in large part because of the higher cost of selling at a newsstand rather than mailing magazines directly to consumers. This is not price discrimination. Price Discrimination If a magazine standard subscription rate is higher than a college student subscription rate, it is price discrimination because the two subscriptions are identical in every respect except the price. Price Discrimination Why Price Discrimination Pays For almost any good or service, some consumers are willing to pay more than others. Price discrimination increases profit above the uniform pricing level through two channels. Channel 1: Higher Prices for Some Price discrimination can extract additional consumer surplus from consumers who place a high value on the good. Channel 2: Attract New Customers Price discrimination can simultaneously sell to new customers who would not be willing to pay the profit-maximizing uniform price. 7

Conditions for Price Discrimination 1 st Condition, A Firm Must Have Market Power A monopoly, an oligopoly, or a monopolistically competitive firm might be able to price discriminate. A perfectly competitive firm cannot. 2 nd Condition, A Firm Must Identify Groups with Different Price Sensitivity If consumers have different demands, a firm must identify how they differ. Disneyland knows tourists and local residents differ in their willingness to pay and use driver licenses to identify them. 3 rd Condition, A Firm Must Prevent Resale If resale is easy, price discrimination doesn t work because of only lowprice sales. The biggest obstacle to price discrimination is a firm s inability to prevent resale. Types of Price Discrimination Type 1, Perfect Price Discrimination The firm sells each unit at the maximum amount any customer is willing to pay. Price differs across consumers, and may differ too for a given consumer. Type 2, Group Price Discrimination The firm charges each group of customers a different price, but it does not charge different prices within the group. Type 3, Nonlinear Price Discrimination The firm charges a different price for large purchases than for small quantities so that the price paid varies according to the quantity purchased. 8

Perfect Price Discrimination How a Firm Perfectly Price Discriminates A firm with market power that can prevent resale and has full information about its customers willingness to pay price discriminates by selling each unit at its reservation price the maximum amount any consumer would pay for it. The maximum price for any unit of output is given by the height of the demand curve at that output level. Perfectly Price Discrimination: Price = MR A perfectly price-discriminating firm s marginal revenue is the same as its price. So, the firm s marginal revenue curve is the same as its demand curve Efficiency of Perfect Price Discrimination Perfect price discrimination is efficient: It maximizes the sum of consumer surplus and producer surplus. All the surplus goes to the firm, consumer surplus is zero. In the Figure, at the competitive market equilibrium, e c, consumer surplus is A + B + C and producer surplus is D + E. At the perfect price discrimination eqm, Qd=Qc, no deadweight loss occurs, all surplus goes to the monopoly. 9

Difficulties with Perfect Price Discrimination Individual Price Discrimination Perfect price discrimination is rarely fully achieved in practice. Firms can still increase profits with imperfect individual price discrimination: charge individual-specific prices to different consumers, which may or may not be the consumers reservation prices. Transaction Costs and Price Discrimination It is often too difficult or costly to gather information about each customer s reservation price for each unit of the product (high transaction costs). However, recent advances in computer technologies have lowered these transaction costs. Hotels, car and truck rental companies, cruise lines, airlines, and other firms are increasingly using individual price discrimination. Group Price Discrimination Conditions for Group Price Discrimination Group price discrimination: potential customers are divided into two or more groups with different prices for each group (single price within a group). Consumer groups may differ by age, location, or in other ways. A firm must have market power be able to identify groups with different reservation prices prevent resale. 10

Group Price Discrimination: A Graphic Approach If a firm can prevent resale between countries and has a common MC, then it can maximize profit by acting like a traditional monopoly in each country separately. Firm acts as a traditional monopoly in each country. U.S. market: MR A =1, Q A =5.8, p A =$29. U.K. market: MR B =1, Q B =2, p B =$39. Group Price Discrimination: A Formal Approach Profit: (Q A, Q B ) = π A (Q A ) + π B (Q B ) = [R A (Q A ) mq A ] + [R B (Q B ) mq B ] Total profit is the sum of the profits in each market. In each country, profit is revenue minus cost (both depend on the Q sold in each country). To maximize profit: differentiate the monopoly s profit function with respect to each quantity, holding the other quantity fixed, and set derivatives equal to zero. Market 1: (Q A, Q B ) / Q A = 0 (Q A, Q B ) / Q A = dr A (Q A )/dq A m = 0 The monopoly sets MR = MC in this market, so MR A = dr A (Q A )/dq A = m Market 2: (Q A, Q B ) / Q B = 0 (Q A, Q B ) / Q B = dr B (Q B )/dq B m = 0 The monopoly sets MR = MC in this market, so MR B = dr B (Q B )/dq B = m 11

Group Price Discrimination: A Formal Approach Two Group Price Discrimination and Elasticities We know MR A = m = MR B We also know from Chapter 9 that MR = p (1 + 1/ε) So, MR A = p A (1 + 1/ε A ) = m = p B (1 + 1/ε B ) = MR B Implication: p B / p A = (1 + 1/ε A ) / (1 + 1/ε B ) The ratio of prices depend on the elasticity values in these two markets. Group Price Discrimination Identifying Groups: Divide Buyers Based on Observable Characteristics The firm believes observable characteristics are associated with unusually high or low reservation prices or demand elasticities. Movie theaters price discriminate using the age of customers. Higher prices for adults than for children. Identifying Groups: Divide Buyers Based on Their Actions Allow consumers to self-select the group to which they belong depending on their opportunity cost of time. Customers may be identified by their willingness to spend time to buy a good at a lower price (buy at the store; low opportunity cost) or to order goods and services in advance of delivery (phone or online shopping; high opportunity cost). 12

Group Price Discrimination Effects on Total Surplus: Group Price Discrimination vs. Perfect Competition Consumer surplus is greater and more output is produced with perfect competition than with group price discrimination. Group price discrimination transfers some of the competitive consumer surplus to the firm as additional profit and causes deadweight loss due to reduced output. Effects on Total Surplus: Group Price Discrimination vs. Single-Price Monopoly From theory alone, we cannot tell whether total surplus is higher if the monopoly uses group price discrimination or if it sets a single price. The closer the firm comes to perfect price discrimination using group price discrimination (many groups rather than just two), the more output it produces, and the less production inefficiency the greater the total surplus. Nonlinear Price Discrimination Characteristics and Conditions Many firms, with market power and no resale, are unable to determine high reservation prices. However, such firms know a typical customer s demand curve is downward sloping. Such a firm can price discriminate by letting the price each customer pays vary with the number of units the customer buys (nonlinear price discrimination). 13

Nonlinear Price Discrimination: Block Pricing A firm charges one price per unit for the first block purchased and a different price per unit for subsequent blocks. Used by gas, electric, water, and other utilities. In panel a of the Figure, the firm charges a price of $70 on any quantity between 1 and 20 1 st block and $50 for the 2 nd block. In panel b, the firm can set only a single price of $60. With block pricing, consumer surplus is lower, total surplus is higher and deadweight loss is lower. The firm and society are better off but consumers lose. The more block prices that a firm can set, the closer the firm gets to perfect price discrimination. Two-Part Pricing: Characteristics and Conditions Two-part pricing: a firm charges each consumer a lumpsum access fee for the right to buy as many units of the good as the consumer wants at a per-unit price. A consumer s overall expenditure for amount q consists of two parts: an access fee, A, and a per-unit price, p. Therefore, expenditure is E = A + pq. To do it, a firm must have market power, know how individual demand curves vary across its customers, and prevent resale. 14

Two Part Pricing with Identical Consumers With identical customers, a firm can set a two-part price that is efficient (p = MC) and all total surplus goes to the firm (CS = 0). In panel a, the monopoly charges a per-unit fee price, p, equal to the marginal cost of 10, and an access fee, A = 2,450 = CS. The firm s total profit is 2,450 times the number of identical customers. If the firm were to charge a price above its marginal cost of 10, it would sell fewer units and make a smaller profit. For instance, p = 20 in panel b. Two-Part Pricing with Different Consumers Two-part pricing is more complex if consumers have different demand curves. Having two different demands implies consumers have different consumer surpluses. Two-part pricing would require the monopolist to charge different access fees Need to ensure self-selection: everyone buys at the two-part price set for him/her 15

Two-Part Pricing with Different Consumers: an example In the Figure, the monopoly faces two consumers. Valerie s demand curve is D 1, and Neal s demand curve is D 2. If the monopoly can charge different prices, it sets price for both customers at p = MC = 10 and access fee of 2,450 to Valerie and 4,050 to Neal. π = 6,500 Two-Part Pricing with Different Consumers: an example If the monopoly cannot charge its customers different access fees, it sets its per-unit price at p = 20, where Valerie purchases 60 and Neal buys 80 units. It charges both the same access fee of 1,800 = A 1, which is Valerie s CS. π = 5,000 16

Bundling and Types of Bundling Firms with market power often pursue a pricing strategy called bundling: selling multiple goods or services for a single price. Most goods are bundles of many separate parts. However, firms sometimes bundle even when there are no production advantages and transaction costs are small. Bundling allows firms to increase their profit by charging different prices to different consumers based on the consumers willingness to pay. Types of bundling: pure bundling: only a package deal is offered (a cable company sells a bundle of Internet, phone, and television for a single price, no service separately) mixed bundling: goods are available as a package or separately. Pure Bundling Whether it pays to sell a bundle or sell the programs separately depends on how reservation prices for the components vary across customers. Pure bundling increases profits if reservation prices are negatively correlated and it reduces profits it they are positively correlated. We assume the marginal cost of producing an extra copy of either type of software is essentially zero; fixed cost is negligible so that the firm s revenue equals its profit; the firm must charge all customers the same price it cannot price discriminate. 17

Profitable Pure Bundling: Reservation Prices Negatively Correlated In the table, the reservation prices are negatively correlated If the firm sells the two products separately, it maximizes its profit by charging $90 for the WP and selling it to both consumers, and selling the SS program for $50 to both consumers. The firm s total profit from selling the programs separately is $280 (= $180 + $100). If the firm sells the two products in a bundle, it maximizes its profit by charging 160, selling to both customers, and earning $320. Pure bundling is more profitable. Pure bundling is more profitable because the firm captures more of the consumers potential consumer surplus their reservation prices. 18

Non-Profitable Pure Bundling: Reservation Prices Positive Correlated In the Table, the reservation prices are positively correlated: a higher reservation price for one product is associated with a higher reservation price for the other product. If the programs are sold separately, the firm charges $90 for the WP, sells to both consumers, and earns $180. However, it makes more charging $90 for the SS program and selling it only to Carol. The firm s total profit if it prices separately is $270 (= $180 + $90). If the firm uses pure bundling, it maximizes its profit by charging $130 for the bundle, selling to both customers, and making $260. Because the firm earns more selling the programs separately, $270, than when it bundles them, $260, pure bundling is not profitable in this example. As long as reservation prices are positively correlated, pure bundling cannot increase the profit. 19

Mixed Bundling Under mixed bundling, consumers are allowed to buy the pure bundle or to buy any of the bundle s components separately. Aaron, a writer, places high value on the WP program but has relatively little use for a SS. Dorothy, an accountant, has the opposite pattern of preferences. Brigitte and Charles have intermediate reservation prices that are negatively correlated. Separate prices: the firm maximizes its profit by charging $90 for each product and selling each to 3 customers. It earns $540 total. Pure bundling: the firm can charge $150 for the bundle, sell to all four consumers, and earns $600 total. Mixed bundling: the firm can charge $200 for the bundle to two consumers and $120 for each product separately to the other two consumers. It earns $640 total. 20

Requirement Tie-In Sales Requirement tie in sales is another form of bundling: requires customers who buy one product from a firm to make all concurrent and subsequent purchases of a related product from that firm. This requirement allows the firm to identify heavier users and charge them more per unit. Example If a printer manufacturer can require that consumers buy their ink cartridges only from the manufacturer, then that firm can capture most of the consumers surplus. Heavy users of the printer, who presumably have a less elastic demand for it, pay the firm more than light users because of the high cost of the ink cartridges. Printer firms such as Hewlett-Packard (HP) write their warranties to strongly encourage consumers to use only their cartridges and not to refill them. Peak-load pricing Charging higher prices during peak demand than in other periods In the Figure has a maximum capacity of Q rooms MC = m up to Q, then it goes to infinity During the low season, D L is the demand. The hotel maximises profits where MR L = m. The hotel has excess capacity During the high season, D H is the demand. The hotel maximises profits where MR H = MC in the vertical section. At p H, the hotel has no excess capacity 21

Managerial Solution Managerial Problem How can Heinz s managers design a pattern of sales that maximizes Heinz s profit? Under what conditions does it pay for Heinz to have a policy of periodic sales? Solution By putting Heinz on sale periodically, Heinz s managers can price discriminate. Every n days, the typical consumer buys either Heinz or generic ketchup. Switchers are price sensitive, always know when Heinz is on sale and buy it. Loyal customers do not distort their shopping patterns solely to buy Heinz on sale. If there are more switchers than loyal customers, then having sales is more profitable than selling at a uniform price to only loyal customers. Take home assignments Chapter 9 Exercise 3.2 Exercise 3.4 Exercise 4.2 Exercise 5.3 Chapter 10 Exercise 3.4 Exercise 4.3 Exercise 4.4 Exercise 5.4 Hand in by Friday 13/10/2017, h. 11.00 22