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Perfect competition and Perfect competition and monopoly marketmonopoly market

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II. Monopoly

1. Definition1. One seller - many buyers2. One product (no good substitutes)3. Barriers to entry4. Price maker

� Monopolist controls supply-side of market � Controls price, but must consider consumer demand� Profits maximized at output level where marginal

revenue equals marginal cost

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2. Total, Marginal, and Average Revenue

� Average revenue (AR), price received per unit sold, is market demand curve

� Marginal revenue (MR), change in revenue from unit change in output

P = -aQ + b→MR = -2aQ + b

� When demand is downward sloping, AR is greater than MR� To increase sales price must fall

� As before, profits maximized at output level where MR = MC

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2. Average and Marginal Revenue

Output1 2 3 4 5 6 70

1

2

3

$ perunit ofoutput

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5

6

7

Average Revenue (Demand)

MarginalRevenue

3

5

3. Monopolist’s Output Decision

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4. Monopoly pricing

�Monopoly:

� →

� Price is larger than MC by amount that depends inversely on elasticity of demand

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- No 1:1 relationship between price and quantity

- → No functional relationship between price and quantity

- → No supply curve in monopoly

5. Supply curve of a monopolist

6. Market power (Monopoly power)

- Found in 1934 by Abba Lerner

(0 ≤ L ≤ 1)

- In perfect competition: P = MC → L = 0- The higher value of L is, the stronger market power a firm

can gain- Ed is elasticity of demand for a firm, not market

DEP

MCPL

1−=−=

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6. Monopoly Power

� Monopoly power does not guarantee profit� Firm may have more monopoly power but lower

profits due to high average costs

� Pricing for any firm with monopoly power: � If Ed large, markup is small� If Ed small, markup is large

� Firm’s demand elasticity determined by:� Elasticity of market demand� Number of firms in market (with one firm, demand

curve is market demand curve)� Interaction among firms

Elasticity of Demand and Price

Markup

P*

MR

D

$/Q

Quantity

MC

Q*

P*-MC

More elasticdemand, less

markup.

D

MR

$/Q

Quantity

MC

Q*

P*P*-MC

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7. Price Discrimination

� Price discrimination� Business practice� Sell the same good at different prices to

different customers

� Increase profit

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7. Price discrimination

7.1. First degree price discrimination (Perfect price discrimination)

- Offer a price level which exactly coincides with the level the buyers are willing to pay

- → CS = 0

CS

PE

P

Q

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7. Price discrimination

7.2. Second degree price discrimination

- Supplier divides his goods into blocks and sets different price for each block.

- The more quantity bought, the cheaper price is- Applied in “increasing returns to scale” only- Brings benefit to both supplier and consumer

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MONOPOLY

7. Price discrimination7.3. Third degree price discrimination

- Supplier sets different price for different group of customers according to their demand on goods

- MC = MRA = MRB = MRT

Third-Degree Price Discrimination

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Third-Degree Price Discrimination� Determining relative prices� Equating MR1 and MR2 gives following relationship that

must hold for prices� Higher price charged to consumer with lower demand

elasticity� →

� Example

7.3. Third degree price discrimination

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MONOPOLY

7. Price discrimination7.4. Intertemporal price

discrimination

Supplier sets different price for different period in using products

- MC is parallel with horizontal axis

MONOPOLY

7. Price discrimination7.5. Peak-load pricing

- Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be higher.

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MONOPOLY

7. Price discrimination7.6. Two-component discrimination

- Price includes 2 components:- Fee for using right

- Free for usage

7.7. Binding discrimination

- Purchase of A must go together with purchase of B

Price Discrimination

� Lessons from price discrimination1. Rational strategy

� Increase profit� Charges each customer a price closer to his

or her willingness to pay

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Price Discrimination

� Lessons from price discrimination2. Requires the ability to separate customers according

to their willingness to pay� Arbitrage – buy a good in one market, sell it in

other market at a higher price3. Can raise economic welfare� Can eliminate the inefficiency of monopoly pricing

� More consumers get the good� Higher producer surplus (higher profit)

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A monopolist has total cost function:TC=0,5Q2 + 10Q + 100

Selling his product in 2 markets with equivalent demand curves:Market 1: P = 80 – QMarket 2: P = 60 – Q

a. Draw graph, show D, MR, MC of this firm

b. Calculate optimal quantity of the firm. How can this firm distribute quantity between 2 markets in order to optimize his profit if heimplements third degree price discrimination?

c. Calculate price and total revenue in each market in firm’s third degree price discrimination strategy

d. Calculate total profit of the firm in third degree price discrimination strategy

e. Suppose that different price in different market is illegal. Find firm’s common price for the 2 markets. At that time, compare profit thefirm gain with profit in question d .