Lecture 4 - Monopoly Behavior - PDF

Lecture 4 Monopoly behavior 5ECON010C-n Intermediate Microeconomics Pricing with Market Power LECTURE OUTLINE 1. Capturing Consumer Surplus 2. Price Discrimination 3. Intertemporal Price Discrimination 4. Peak-Load Pricing 5. The Two-Part Tariff Cop...

Lecture 4 Monopoly behavior 5ECON010C-n Intermediate Microeconomics Pricing with Market Power LECTURE OUTLINE 1. Capturing Consumer Surplus 2. Price Discrimination 3. Intertemporal Price Discrimination 4. Peak-Load Pricing 5. The Two-Part Tariff Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved Capturing Consumer Surplus FIGURE 11.1 CAPTURING CONSUMER SURPLUS If a firm can charge only one price for all its customers, that price will be P* and the quantity produced will be Q*. Ideally, the firm 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 firm would also like to sell to consumers willing to pay prices lower than P*, but only if doing so does not entail lowering the price to other consumers. In that way, the firm could also capture some of the surplus under region B of the demand curve.  Capturing Consumer Surplus FIGURE 11.1 Suppose, a firm is selling at price P* and supplying Q* But there are consumers who are ready to pay more – segment A of the demand curve Also, there are consumers who are not buying, because the price is too high for them – segment B of the demand curve 5ECON010C-n Intermediate Microeconomics  Capturing consumer surplus To capture consumer surplus under segment A, the firm should increase the price But in that case the firm will lose all the consumer surplus below that new price level The same applies to lowering the price to capture the surplus under segment B – the firm will be forgoing the profit from high-end consumers 5ECON010C-n Intermediate Microeconomics Capturing consumer surplus The monopolist resolves this problem by charging different prices for different consumer groups This kind of strategy is called price discrimination There are three major types of price discrimination First-degree Second-degree Third-degree 5ECON010C-n Intermediate Microeconomics First-degree price discrimination FIGURE 11.2 There is a maximum price each consumer is ready to pay for the product – reservation price If the monopolist knows reservation price of each consumer, it can charge different price to each consumer This is called perfect price discrimination 5ECON010C-n Intermediate Microeconomics First-degree price discrimination FIGURE 11.3 However, monopoly cannot know reservation prices of each and every consumer So, it divides consumers into classes according to their ability to pay (for ex. low, middle and high) It will keep lowering price until 𝑷 = 𝑴𝑪 5ECON010C-n Intermediate Microeconomics  Second-degree price discrimination FIGURE 11.4 In some cases, consumer’s readiness to pay depends on the quantity consumed The example is water supply: consumers ready to pay high prices for first 100 liters of water Next 100 liters is less urgent and has lower marginal utility – so, consumers are ready to pay for them lower price 5ECON010C-n Intermediate Microeconomics Second-degree price discrimination Here monopolist can charge different prices for different quantities of the good The monopoly captures consumer surplus by decreasing the price when consumption surpasses some threshold This is called second-degree price discrimination 5ECON010C-n Intermediate Microeconomics  Third-degree price discrimination FIGURE 11.6 Sometimes different groups of consumers have different demand curves If monopoly can estimate those demand curves, it will charge different prices for each group This is called third-degree price discrimination 5ECON010C-n Intermediate Microeconomics Third-degree price discrimination The rule is that the marginal revenue for each group needs to be equal to marginal cost: 𝑴𝑹𝟏 = 𝑴𝑹𝟐 = 𝑴𝑪𝑻 This way the monopolist is able to capture maximum surplus from each group and maximize profits 5ECON010C-n Intermediate Microeconomics  Third-degree price discrimination Proof of: 𝑴𝑹𝟏 = 𝑴𝑹𝟐 = 𝑴𝑪𝑻 Profits function of the monopoly with two distinct consumer groups is: 𝝅 = 𝑷𝟏 𝑸𝟏 + 𝑷𝟐 𝑸𝟐 − 𝑪(𝑸𝑻 ) We optimize for both groups: 𝜕𝜋 𝜕(𝑃1 𝑄1 ) 𝐶 𝑄𝑇 𝜕𝜋 𝜕(𝑃2 𝑄2 ) 𝐶 𝑄𝑇 = − = 0; = − =0 𝜕𝑄1 𝜕𝑄1 𝜕𝑄1 𝜕𝑄2 𝜕𝑄2 𝜕𝑄2 𝑴𝑹𝟏 = 𝑴𝑪 𝑴𝑹𝟐 = 𝑴𝑪 𝑴𝑹𝟏 = 𝑴𝑹𝟐 = 𝑴𝑪 5ECON010C-n Intermediate Microeconomics Third-degree price discrimination Marginal revenue can be expressed as: 𝟏 𝑴𝑹 = 𝑷 𝟏 + 𝑬𝑷 So, we have: 1 1 𝑴𝑹𝟏 = 𝑃1 1+ 𝑴𝑹𝟐 = 𝑃2 1+ 𝐸1 𝐸2 1 1 𝑃1 1+ = 𝑃2 1 + 𝐸1 𝐸2 1 𝑃1 1+ 𝐸2 = 𝑃2 1 1+ 𝐸1 5ECON010C-n Intermediate Microeconomics Third-degree price discrimination Example: If the elasticity of demand E1 = -2, E2=-4, then we have: 1 𝑃1 1+ 𝐸2 = 𝑃2 1 1+ 𝐸1 1 1+ 𝑃1 −4 = 1 = 1.5 𝑃2 1+−2 In other words, the price charged to the first group should be 1.5 times higher 5ECON010C-n Intermediate Microeconomics  Intertemporal price discrimination FIGURE 11.7 Demand for some goods can change over time or be seasonal The monopoly can change its prices according to the changes in demand This is called intertemporal price discrimination 5ECON010C-n Intermediate Microeconomics Peak-load pricing FIGURE 11.8 Demand for some goods can sharply increase during certain periods Marginal cost in such peaks times increases due to pressure from high demand Thus, for the monopoly it’s profitable to charge higher prices in peak times 5ECON010C-n Intermediate Microeconomics  Two-part pricing FIGURE 11.9 Some services (usually these are services) can be charged for in two parts: the entry price and usage price Classical example is mobile operator, who charges both a subscription fee and per- minute fee In case of one consumer group, the entry fee is charged to capture the entire consumer surplus which constitutes the total profit of the firm 5ECON010C-n Intermediate Microeconomics  Two-part pricing FIGURE 11.10 When there are two groups of consumers, the monopoly will set price higher than MC If it sets 𝑃 = 𝑀𝐶, it loses potential profit Entry fee is equal to consumer surplus of the group with lower demand Otherwise, the firm loses the lower- demand group altogether 5ECON010C-n Intermediate Microeconomics Two-part pricing Here the profit is: 𝝅 = 𝟐𝑻∗ + (𝑷∗ − 𝑴𝑪)(𝑸𝟏 + 𝑸𝟐 ) We take 2𝑇 ∗ , as the firm is charging both consumer groups the same entry fee It sells 𝑄1 to higher-demand group and 𝑄2 to lower-demand group 5ECON010C-n Intermediate Microeconomics  Two-part pricing FIGURE 11.11 If the firm faces many different consumers (or consumer groups), the profit becomes: 𝝅 = 𝝅𝒂 + 𝝅𝒔 = 𝒏 𝑻 𝑻 + 𝑷 − 𝑴𝑪 𝑸 𝒏 Here 𝜋𝑎 is profits from charging entry fee and 𝜋𝑠 is profit from usage fee Assuming the firms chose certain price, total profits 𝜋 are maximized at certain level of 𝑇 ∗ 5ECON010C-n Intermediate Microeconomics  Reading Mandatory reading Pindyck & Rubinfeld (2018). “Microeconomics”, 9th edition. Chapter 11 Optional reading https://www.cambridge.org/core/journals/business-ethics- quarterly/article/big-data-and-personalized- pricing/5F48CDDFC1D50507C078C737D749EDF0 Big Data Might Lead to Higher Prices, https://www.bloomberg.com/opinion/articles/2018-03-09/big-data- might-tell-retailers-which-consumers-to-charge-more (1,000 words) 5ECON010C-n Intermediate Microeconomics