1 Monopoly, Price Discrimination & Regulation Hall and Lieberman, 3 rd edition, Thomson South-Western, Chapter 9

2 MC = ATC MR Demand Figure 1a Can the monopolist do better than charge a single price? ProfitPMPM ATC Π/Q QMQM

3 MC = ATC MR Demand Figure 1b Can the monopolist do better? ProfitPMPM ATC Π/Q Can the monopolist extract consumer surplus? Can the monopolist expand output profitably beyond the single price monopolist level? QMQM

4 Price Discrimination  Two types of monopoly 1. Single-price monopoly Firm that is limited to charging same price for each unit of output sold 2. Price discrimination monopoly Different prices are charged to different customers based on their willingness to pay for the good not based on prejudice, stereotypes, or ill-will toward any person or group

5 Requirements for Price Discrimination  Demand curve m ust be a downward-sloping demand curve for the firm’s output  Firm must be able to identify consumers willing to pay more  Firm must be able to prevent low-price customers from reselling to high-price customers Arbitrage

6 Price Discrimination and Consumers  Why does monopoly like price discriminate? always benefits owners of a firm, increasing its profit but harms some consumers  since price discrimination raises price for some consumer above price they would pay under a single-price policy Additional profit for the firm is equal to monetary loss of consumers

7 Figure 2a: Without price Discrimination -- price is $120 for all consumers 30 E ATC 80 $120 D MR MC (a) Number of Round-trip Tickets Dollars per Ticket Profits from standard monopoly profit maximization

8 Figure 2b: Price Discrimination -- price is $160 for some consumers, which harms consumers 30 Dollars per Ticket 120 D MR MC 10 $160 Additional profit from price discrimination – charge a higher price for business traveler Number of Round-trip Tickets (b)

9 Price Discrimination That Benefits Consumers  Price discrimination benefits monopoly at the same time it benefits a group of consumers  When price discrimination lowers price for some consumers below what they would pay under a single-price policy, it benefits consumers as well as firm Figure 2c

10 Figure 2c: Price Discrimination -- Benefits consumers Number of Round-trip Tickets Dollars per Ticket $120 D MR MC F G H Additional profit from price discrimination – charge discounted rate to students (c)

11 Perfect Price Discrimination  Perfect price discrimination Firm charges each customer the most the customer would be willing to pay for each unit he or she buys By assuming that firms could somehow find out maximum price customers would be willing to pay for each unit of output it sells It could increase profits even further, but at expense of consumers

12 MC = ATC MR Demand Figure 3b Perfect price discrimination: the monopolist charges each customer their reservation price Profit: gap between reservation price and ATC PMPM ATC QMQM Q PD Monopolist will produce at the efficient level

13 Most monopolists cannot perfectly price discriminate  Discriminate by customer groups Regional markets Consumer groups (senior discounts, volume users) Time of sale (on- vs. off-season; early bird specials; day vs. night use, weekend vs. weekday)

14 MC = ATC MR Demand Figure 4 Can the monopolist do better than charge a single price? P1P1 P3P3 QMQM P2P2 Charge P 1 for group 1 Charge P 2 for group 2 Charge P 3 for group 3 Additional Π

15 Application: Airline Ticket Price  Lower price to students and non-business travelers  Higher price to business travelers  Price discrimination is satisfied Downward sloping demand curve Airline Companies are able to identify wiliness to pay  Saturday overnight stay  Purchase time  Round-trip or one-way Can prevent resale of tickets by checking ID

16 Price Discrimination and Elasticity  The types of consumers can be distinguished on the basis of their sensitivity to price Price elasticity of demand  High price is offered to consumers with low price elasticity of demand  Low price is offered to consumers with high price elasticity of demand  For businessmen and students, who have an relatively elastic demand for air ticket?

17 MC MR Demand Figure 5 How Can We Deal With DWL? Producer surplus Consumer surplus Dead Weight Loss: DWL PMPM PCPC

18 Anti-trust Law - Reduce DWL  Break the monopoly into several competing firms Guitar-lesson market would function very well under competitive conditions, But breaking up a monopoly would not make sense when the market would perform even worse with more competition  Monopolies that arise from patents and copyrights  Monopoly power that arises from network externalities  Monopoly arises as a natural monopoly

19 The Special Case of Natural Monopoly  If breaking up a natural monopoly is not advisable, what can government do to bring us closer to economic efficiency? 1. Public ownership and operation  Public takeover of private business is rare  Often works badly in practice Few incentives to lower costs or offer higher quality products Ends up serving political interests 2. Regulation

20 MC MR Demand Figure 6a Price Regulation: Government sets P R Mimics Competitive Equilibrium Monopolistic equilibrium PMPM = P C PRPR

21 MC MR Demand Figure 6b: Price Regulation: Government can make solution more efficient as long as P C < P R < P M Competitive Equilibrium Monopolistic equilibrium PMPM PC PC PRPR

22 Regulation of Natural Monopoly  Regulators aim to achieve economic efficiency by telling the firm what price it can charge  Easy? Unfortunately, no. There is the matter of information  Regulators must be able to trace out firm’s MC curve as well as market demand curve  Monopolists may exaggerate the cost and still earn profits  Monopolists may offer low quality good or services

23 Regulation of Natural Monopoly  Even with perfect information about monopolist’s cost and demand curves, regulators have a serious problem Look again at Figure 7a—notice that MC curve lies everywhere below LRATC curve  Firm will suffer a loss  In long-run, it will go out of business

24 Figure 7a: Regulating A Natural Monopoly Unregulated Profit B $15 $29 A C MC $60 LRATC 50,000 DMR 85, ,000 Number of Households Served Dollars Unregulated monopoly F E Losses with efficient output

25 How To Regulate the Monopoly with MC<LRATC anywhere ? 1. Subsidize the firm for the loss part And set prices to MC Figure 7b 2. In practice, however, regulators determine a price that gives owners a “fair rate of return” for funds they’ve put into the monopoly

26 Figure 7b: Regulating A Natural Monopoly Unregulated Profit B $15 $29 A C MC $60 LRATC 50,000 DMR 85, ,000 Number of Households Served Dollars Unregulated monopoly F Efficient production (requires subsidy) "Fair rate of return" production Losses with efficient output

27 Regulation of Natural Monopoly -- Average Cost Pricing  Average cost pricing Most common solution  Not constrained to the case of loss P = cost per unit  where LRATC curve crosses demand curve The natural monopoly makes zero economic profit  provides a fair rate of return, and keeps the monopoly in business

28 Figure 7c: Regulating A Natural Monopoly B $15 $29 A C MC $60 LRATC 50,000 DMR 85, ,000 Number of Households Served Dollars Unregulated monopoly "Fair rate of return" production F

29 Regulation of Natural Monopoly -- Average Cost Pricing  Average cost pricing is not a perfect solution Does not quite make the market efficient Provides little or no incentive for the natural monopoly to economize on capital

30 Summary  Perfect Price discrimination Price are set along demand curve Can generate as efficient solution as perfectly competitive market  Price discrimination generating higher profits, may harm or benefit consumers  Price are discriminated to groups of consumers Related with price elasticity of demand  Regulations on natural monopoly to reduce DWL To generate as close as possible efficient quantity Average cost pricing strategy