1. Market Failure: Monopoly
Econ 201 Lecture 7.1
Market Failure:
Monopoly

2. Price Discrimination
Because they have market power, monopolists could practice price discrimination.
Price discrimination
separate customers into groups based on willingness to pay,
then charging each group a different price set at their different maximum willingness-to-pay.

3. First-Degree Price Discrimination
Under first-degree price discrimination, each customer is charged the highest price they are willing and able to pay.
Example: Dutch auction
The monopolist can capture the entire consumer surplus.
Apple: IPod releases
Initial high price
Price lowered 6 months later

4. Measuring consumer surplus with the demand curve2
Measuring consumer surplus with the demand curve
(a) Price = $80
(b) Price = $70
$100 80 70 50
Price of
Albums
$100 80 70 50
Price of
Albums
Demand
Demand
John’s consumer
surplus ($30)
John’s consumer
surplus ($20)
Paul’s consumer
surplus ($10)
Total consumer
surplus ($40) 4 3 1 2
Quantity of Albums 4 3 1 2
Quantity of Albums
In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel (b), the price of the good is $70, and the consumer surplus is $40.

5. Welfare with and without price discrimination9
Welfare with and without price discrimination
(a) Monopolist with Single Price
(b) Monopolist with Perfect Price Discrimination
Price
Price
Consumer
surplus
Demand
Marginal
revenue
Profit
Demand
Deadweight
loss
Monopoly
price
Profit
Quantity
sold
Marginal cost
Marginal cost
Quantity
sold
Quantity
Quantity
Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus.

6. Price Discrimination Lessons from perfect price discrimination
Rational strategy
Increase profit
Charges each customer a price closer to his or her willingness to pay
Sell more than is possible with a single price

7. Price Discrimination Lessons from price discrimination
Requires the ability to separate customers according to their willingness to pay
Certain market forces can prevent firms from price discriminating
Arbitrage – buy a good in one market, sell it in other market at a higher price
Can raise economic welfare
Can eliminate the inefficiency of monopoly pricing
More consumers get the good
Higher producer surplus (higher profit)

8. Price Discrimination The analytics of price discrimination
Perfect price discrimination
Charge each customer a different price
Exactly his or her willingness to pay
Monopolist - gets the entire surplus (Profit)
No deadweight loss
Without price discrimination
Single price > MC
Consumer surplus
Producer surplus (Profit)
Deadweight loss

9. Second-Degree Price Discrimination
Second-degree price discrimination occurs when firms sell their product at a discount when consumers buy large quantities.
Example: Electricity prices?
Costco/Sam’s Club – “Big Box Stores”
&k=second-degree+price+discrimination

10. Third-Degree Price Discrimination
Under third-degree price discrimination, a firm charges different prices in different markets for their product.
The most common form of price discrimination
Examples include:
Children's discounts
Senior citizen’s discounts
Airfares
Different geographic markets (Madison Park, U District)

11. More Complex Monopoly Pricing Schemes
Classic categorization of monopolies
3 levels of price discrimination
First degree (Perfect Price Discrimination)
Extract almost all of the Consumer Surplus
Able to get a different price for each unit sold
Moves consumer along the Demand Curve
Second degree
Provide quantity discounts; but have to buy in blocks, with each larger block having a lower price than the last
Third degree
Different prices for same good in different markets
In all cases, it is necessary to prevent resale and new entrants

12. Third Degree Price Discrimination
Choose Qs based
MR = MC for market demand
Set price for each segment
Equating MC(market) to MR for each segment
Setting price for Qs (segment)
Zone pricing
Gas stations?
Grocery stores?
Senior citizen discounts?

13. Third Degree Price Discrimination
Setting separate prices in each market

14. Other Monopolist Pricing Strategies
Perfect Price Discrimination: 1st degree
Block Pricing: 2nd degree
Zone Pricing: 3rd degree
Tie-in Sales
Predatory Pricing
Dumping
All aimed at extracting Consumer Surplus

15. To Be Able to Do Price Discrimination
To be a successful price discriminator, a seller must satisfy three conditions:
(1) to have market control and be a price maker,
(2) to identify two or more groups that are willing to pay different prices, and
(3) to keep the buyers in one group from reselling the good to another group.

16. A Word from the FTC on Discriminatory Pricing
A seller charging competing buyers different prices for the same "commodity" or discriminating in the provision of "allowances" -- compensation for advertising and other services -- may be violating the Robinson-Patman Act. This kind of price discrimination may hurt competition by giving favored customers an edge in the market that has nothing to do with the superior efficiency of those customers. However, price discriminations generally are lawful, particularly if they reflect the different costs of dealing with different buyers or result from a seller’s attempts to meet a competitor’s prices or services.

17. Tie-In Sales A tie-in sale:
consumer can only obtain the desired good (tying good) if he agrees also to purchase a different good (tied good) from the producer.
What it accomplishes:
(1) the tie-in can be a substitute for a lump sum payment tailored to extract the consumer’s surplus in the tying good market;
(2) the tie-in serves to price discriminate among types of consumers having different demand elasticities;

18. Optimal Pricing Strategy for a Tie-in Sale
Lower the price in the more demand elastic market
Raise price above MC in the more inelastic market
Cellular industry
Price < Cost for SmartPhone
2-year contract at P > MC for service
Can’t unlock phone – barrier to entry/exit

19. IBM Example So optimal pricing strategy Boeing
Underprice computers in order to sell at a single price to both high and low demand customers
Price cards at > MC in order to extract CS
Boeing
Airplane market was more competitive
WTP correlated with miles
Tied-in on-board navigational systems

20. Other Examples Automobile warranties
Cars bought/sold in a competitive marketplace
Warranty maintenance must be performed at dealer’s or authorized shop (costs > MC?)
Soda (other goods) at Gas stations
Gas bought/sold in a more competitive market
Soda prices > MC

21. Predatory Pricing Predatory pricing
firm sells a product at very low price attempting to drive competitors out of the market,
or create a barrier to entry for potential new competitors.
If the other firms cannot sustain equal or lower prices without losing money, they go out of business.
The predatory pricer then has fewer competitors or even a monopoly, allowing it to raise prices above what the market would otherwise bear.

22. Predatory Pricing
In many countries, including the United States, predatory pricing is considered anti- competitive and is illegal under antitrust laws.
Usually difficult to prove that a drop in prices is due to predatory pricing rather than normal competition
Predatory pricing claims are difficult to prove due to high legal hurdles designed to protect legitimate price competition.

23. The Standard Oil Case Rockefeller’s Standard Oil Monopoly (1911)
The efficiencies of economies of scale and vertical integration caused the prices of refined petroleum to fall from over 30 cents a gallon in 1869 to 10 cents by 1874 and to 5.9 cents by During the same period, Rockefeller reduced his average costs from 3 cents to 0.29 cents per gallon.
Contrary to popular mythology, Standard Oil’s market share declined from 88 percent in 1890 to 64 percent by Because of intense competition the company's oil production as a percentage of total market supply had declined to a mere 11 percent in 1911, down from 3 percent in 1898.
McGee shows that rather than practicing predatory pricing. Std Oil was able to build its monopoly through the purchase of other refineries.
McGee, John S. "Predatory Price Cutting: The Standard Oil (N.J.) Case."J. Law and Econ. 1 (October 1958):

24. Another Explanation
McGee, John, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics Vol 1 (April 1958)
Buy out other gas stations at a price higher than the competitive value, based on possible future monopolistic value

25. Dumping "dumping" can refer to any kind of predatory pricing.
Term is now generally used only in the context of international trade law, where dumping is defined as the act of a manufacturer in one country exporting a product to another country at a price which is either below the price it charges in its home market or is below its costs of production.
The term has a negative connotation, but advocates of free markets see "dumping" as beneficial for consumers and believe that protectionism to prevent it would have net negative consequences.
Advocates for workers and laborers however, believe that safeguarding businesses against predatory practices, such as dumping, help alleviate some of the harsher consequences of free trade between economies at different stages of development

26. What’s the Downside to Monopolies?
Economically inefficient
Deadweight loss
Higher price and lower quantity demanded/supplied
Transfer losses
From CS to PS
Economists have no opinion
Pareto efficient
No/less incentive for innovation

27. Factors Working Against Persistence
Monopoly rents attract entry of other firms
First mover advantage
monopolies tend to become less efficient and innovative over time,
complacent giants", do not have to be efficient or innovative to compete in the marketplace
One of the arguments advanced by AT&T for deregulating the Telecomm industry in 1996
Availability in the longer term of substitutes in other markets. For example, a canal monopoly, while worth a great deal in the late eighteenth century United Kingdom, was worth much less in the late nineteenth century because of the introduction of railways as a substitute.
However, loss of efficiency can raise a potential competitor's value enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives.

28. Does a Single Supplier Always Mean There is a Monopoly?
The theory of contestable markets argues that in some circumstances (private) monopolies are forced to behave as if there were competition because of the risk of losing their monopoly to new entrants.
This is likely to happen where a market's barriers to entry are low.
Single supplier does not necessarily mean there is a monopoly
Firm may behave as though its in a competitive market

29. Natural Monopolies Natural Monopolies (monopolies of scale)
When monopolies are not broken through the open market, often a government will step in,
regulate the monopoly, turn it into a publicly owned monopoly,
forcibly break it up (see Antitrust law). Public utilities,
Natural monopolies are less susceptible to efficient breakup,
strongly regulated or publicly owned.
AT&T and Standard Oil are debatable examples of the breakup of a private monopoly. When AT&T was broken up into the "Baby Bell" components, MCI, Sprint, and other companies were able to compete effectively in the long distance phone market and began to take phone traffic from the less efficient AT&T.