Business Economics

Lecture 2: Monopoly

Anastasios Dosis

ESSEC Business School and THEMA

February 3, 2017

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What is a Monopoly?

Definition
A monopoly is a market in which there is only one supplier of a good for which
there are no close substitutes.

Examples: Electricity, Telecommunications, Water, Certain pharmaceutical

products etc

Unlike perfect competition, a monopolist is a price maker; it can charge any

price it wants.

A monopoly is perceived as a bad thing for society

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 Part I: Uniform Price Monopoly

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Monopoly Uniform Pricing

Consider a market for a certain product

The inverse demand is given by p(Q), where as usual p 0 (Q) < 0

What is the revenue of the monopolist?

The revenue is given by:

R = p(Q)Q

The marginal revenue is:

MR = p 0 (Q)Q + p(Q)

Recall that for the perfectly competitive firm the marginal revenue is equal to
the price which is not affected by the production of the perfectly competitive
firm.

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Marginal Revenue

(a) Competitive Firm (b) Monopoly

Price, p, $ per unit

Price, p, $ per unit

Demand curve
p1 p1
C
p2
Demand curve
A B
A B

q q + 1 Quantity, q, Units peryear Q Q+1

Quantity, Q, Units peryear

Figure: Marginal Revenue for the perfectly competitive firm and for a monopolistic fim

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Marginal Revenue Formula

Let us re-write the marginal revenue as:

 p 0 (Q)Q 
MR = p 0 (Q)Q + p(Q) = p(Q) 1 +
p(Q)
p 0 (Q)Q
What is p(Q) ?

This is equal to 1 , where  is the price elasticity of demand.

Hence
 1
MR = p 1 +

Recall that  0

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Remarks on the Marginal Revenue Formula

The marginal revenue is closer to the price the more elastic the demand

When the demand is unit elastic,  = 1, the marginal revenue is zero

The marginal revenue is negative where the demand curve is inelastic,

1 <  0.

Note first that the monopolist would never operate in the area in which
1  0

In this area MR 0

This means that by reducing output the monopolist can not only save cost
but also increase his revenue

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Profit Maximisation

The usual formula for profit maximisation is

MR = MC

or
 1
p 1+ = MC

Because, in general,  > this means that p > MC

Therefore, obtain the following result:

Result
A monopolist (charging a uniform price) will set the price above marginal cost.

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Welfare Effects

Recall that in a perfectly competitive market p = MC

When p = MC , the Fundamental Theorem holds

When p > MC there is some loss in welfare, i.e., total surplus. This is called
the deadweight loss (DL) or allocative inefficiency.

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Example 1

Derive the marginal revenue curve when the monopolist faces the linear
inverse demand function p = 24 Q

Draw the demand curve and the marginal revenue curve in the same graph.
Show in which parts the demand curve is inelastic, unit elastic and elastic.

If the marginal cost of production is constant and equal to MC = 10 what is

the optimal quantity produced by the monopolist?

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Example 1

The marginal curve is MR = p 0 (Q)Q + p(Q) = Q + 24 Q = 24 2Q

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Example 1
p, $ per unit
24 Perfectly elastic

Elastic, < 1
MR= 2
p= 1
Q= 1
Q= 1
= 1
12

Inelastic, 1 < < 0

Demand (p= 24 Q)
Perfectly
inelastic
0 12 24
MR = 24 2Q Q, Units per day

Figure: Demand and Marginal Revenue Curves

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Example 1

If the marginal cost of production is MC = 10 then the monopolist will

produce such that
MR = MC

24 2Q = 10

QM = 7

The market price will be equal to P M = 17

This is much higher than the efficient price P = 10 (the price equal to the
marginal cost)

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Example 1
p, $ per unit
24

17

10

Demand (p= 24 Q)

0 7 24
MR = 24 2Q Q, Units per day

Figure: Monopoly Quantity and Price

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Market Power
When the market price is higher than the marginal cost of producing the
product, we say that there exists market power.

We measure market power by using the Lerner Index:

p MC
L=
p

The Lerner Index ranges from zero to one

The higher is L, the higher is market power

If we re-arrange the optimal pricing formula for the monopolist

 1
p 1+ = MC

p MC 1
L= =
p 

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Lerner Index

p MC 1
L= =
p 

The more elastic the demand, the lower the Lerner Index and hence the lower
the market power

More elastic demand is a consequence of better substitutes for the product

If  = , L = 0

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Example 1 (contd)

What is the Lerner Index for Example 1?

17 10
L= = 0.41
17
What is the price elasticity of demand?

1
= 0.41

 = 2.44

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Example 1 (contd)

What are the CS, Profit and DL?

Recall that the CS is the area below the demand function

Z 7 Z 7
CS = p(Q)dQ p(7) 7 = [24 Q]dQ 119 = 143.5 119 = 24.5
0 0

The profit is (p MC )Q = (17 10)7 = 49

The maximum surplus is attained when Q = 14

Z 14 Z 14
max TS = p(Q)dQ MC (Q)dQ = 238 140 = 98
0 0

The DL = 98 24.5 49 = 14.5

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Why Monopolies?

1 Cost advantage:
I A firm controls an essential facility or a scarce resource that a rival needs to
survive (e.g., )
I A firm uses a superior technology or a better and secret way of organising
production than any other firm
2 Patents:
I A firm is granted an exclusive right to sell a new product, substance, process
or design for a fixed period of time (e.g., iPhone, MacBook, Nespresso, drugs
etc.)
3 Natural Monopolies:
I A firm can produce the total output of the market at lower cost than several
firms. This is particularly prevalent when there are high fixed costs (e.g.,
water, gas, electricity, mail, etc.)

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Cost Advantage

Suppose that a firm (Firm A) has a secret technology that produces a

product at a marginal/average cost equal to c

Suppose that any other firm can produce the same product at a cost equal to
c 0 , where c 0 > c
There are two possibilities:
c 1
1
c0
<1+ 
c 1
2
c0
1+ 

In Case 1, Firm A is a monopolist because any other firm entering the market
will make losses

In Case 2, other firms will enter the market and Firm A will not be a
monopolist

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Patents

Governments grant patents to inventors that give monopoly rights

Think for instance the case of the pharmaceutical industry. An inventor of a

new drug is granted a patent to sell this new medicine for a few years

This institution has been designed to encourage innovation

Intellectual property has the characteristic of a public good; if one makes a

discovery, knowledge becomes public information

Without some form of protection, inventors would be reluctant to undertake

costly research activities

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Patents

Suppose that an inventor has made an invention of a new product which

requires K > 0 euros to be manufactured and marketed

After preliminary investigations, the inventor has estimated that the product
will cost a constant marginal average cost equal to c to be produced and the
market demand will be p(Q) = a q, where a > c

Without any form of intellectual property, anyone can copy the invention and
produce at a cost of c. Therefore, the net profit will be K and the
invention will not be realised

With a patent, the inventor becomes a monopolist. His profit will be

(ac)2 (ac)2
4 K . Therefore, if 4 > K , the invention will be realised

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Natural Monopoly

A natural monopoly is a situation in which one firm can produce a product

more efficiently (i.e., at a lower cost) than several firms

This situation arises when there are high fixed costs

Formally, suppose that there is a production technology for a product and the
cost of production is c(Q)

A natural monopoly arises when for N > 1:

c(q1 ) + c(q2 ) + ... + c(qN ) > c(q1 + q2 + ... + qN )

For instance consider a product with a cost C (Q) = F + cQ, where F is a

high fixed cost

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Regulation of Monopolies

Because monopolies entail a deadweight loss, the government may take

action to reduce this
There two main categories of regulation:
1 Facilitation of competition
2 Price regulation

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Facilitation of Competition

Since the 1980s governments worldwide have taken measures to open up

markets to competition

Previous monopolies such as telecommunication or electricity are now

oligopolies

Because these are classic cases of natural monopolies, the usual type of
operation of the market is that there is a principal provider (e.g., Orange,
AT&T, etc.) which owns the network and the rest of the companies operate
on this network

This economises on costs

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Price Regulation

In some cases facilitation of competition is practically impossible (the case of

patents) or socially inefficient (the case of natural monopolies)

In these cases, governments around the world have proceeded to an

alternative type of regulation, this of price regulation

Assume that the regulator imposes to the monopolist a certain price and
punishes it if it charges a different price

If the regulator knows exactly the demand characteristics and marginal cost,
then it can set the equal to p = MC

This automatically would result to the firm producing the efficient level of
output and the inefficiency would disappear

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Price Regulation - Difficulties

Unfortunately, price regulation is not problem-free

First consider the case of a natural monopoly

Setting p = MC entails a fundamental problem

For instance in the example where C (Q) = F + cQ setting p = c results in a

loss for the monopolist equal to F
Because no firm can operate for a long period with losses there are two
possibilities:
1 The regulator gives to the monopolist subsidies to cover its losses. This entails
dangers because it may create clientele relationships and corruption between
the monopolist and the regulator
2 The regulator sets a price equal to AC and not MC . This regulation is called
average cost pricing, and a variant of this has been implemented in the US
and elsewhere under the name rate-of-return regulation

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Price Regulation - Difficulties

Another fundamental issue with price regulation is that the regulator usually
lacks essential information on market characteristics such as marginal,
average cost and/or demand

Without this information, the regulator is unable to compute the efficient

price and hence is unable to regulate efficiently the monopolist

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 Part II: Price Discrimination

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Uniform and Non-Uniform Pricing

Uniform (or linear) pricing: The price of a product remains the same
regardless of who buys the product or the quantity that he buys

Non-uniform (or non-linear) pricing: The price of a product depends on

who buys it or the quantity that he buys.

When a firm charges a non-uniform price, we say that this firm exercises
price discrimination

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Why Price Discrimination?

Why price discrimination is profitable?

I A firm charges a higher price to customers who are willing to pay more than
the uniform price, capturing some or all of their consumer surplus.
I A firm sells to some customers who were not willing to pay as much as the
uniform price.

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Example from Lecture 2
p, $ per unit
24

17

10

Demand (p= 24 Q)

0 7 24
MR = 24 2Q Q, Units per day

Figure: Monopoly Quantity and Price

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When is Price Discrimination Possible?
When is price discrimination possible?
I The seller must have at least some sort of short-run market power to set prices
above marginal cost
I The seller is able to identify and charge different prices to different groups of
buyers with similar characteristics
I The seller can prohibit resale of the product in a secondary market

Resale is difficult or impossible for most services and when transaction costs
are high

Some firms raise transaction costs or make resale difficult

A firm can prevent resale by vertically integrating: participating in more than

one successive stage of the production and distribution chain for a good or
service

Governments frequently aid price discrimination by preventing resale

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Forms of Price Discrimination

Third-degree price discrimination or personalised pricing:The seller can

condition the price of the product on some observable characteristic of the
buyer that is directly or indirectly related to his willingness to pay, e.g.
geographical location, income, etc.

Second-degree price discrimination or menu pricing: The seller can use

different tariff instruments such as: charge a different price based on the
amount purchased, e.g. discounts for larger amounts, provide a discount if
the buyer has or has not bought from the same seller before, e.g. selective
discounts, charge different prices for different versions of the same product,
e.g. shopping online vs. shopping in the store, bundle a product with some
other product, offer a special price after the buyer takes some costly action
e.g. rebates etc.

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Personalised Pricing - Students Discounts

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Personalised Pricing - Senior Citizens Discounts

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Personalised Pricing - Multi-Market Price Discrimination

The most common method of multi-market price discrimination is to divide

potential customers into two or more groups and set a different price for each
group

A copyright gives Universal Studios the legal monopoly to produce and sell
the Mama Mia! DVD. Universal engages in multimarket price discrimination
by charging different prices in various countries because it believes that the
elasticities of demand differ compared to the U.S. price.

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Personalised Pricing- Multi-Market Price Discrimination

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Personalised Pricing- Multi-Market Price Discrimination

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Multi-Market Price Discrimination: Exercise

A monopoly drug producer with a constant marginal cost of m = 1 sells in

only two countries and faces a linear demand curve of Q1 = 12 2p1 in
Country 1 and Q2 = 9 p2 in Country 2. What price does the monopoly
charge in each country, how much does it sell in each, and what profit does it
earn in each with and without a ban against shipments between the
countries?

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Multi-Market Price Discrimination: Exercise

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Multi-Market Price Discrimination: Exercise

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Menu Pricing

A firm may be unable to discriminate based on observable characteristics or,

even worse, some characteristics, such as willingness to pay, are not at all
observable

In that case a firm might exercise second degree price discrimination (or
menu pricing)

With menu pricing, the firm tries to extract information about willingness to
pay indirectly

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Rebates

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Coupons

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Coupons and Rebates

Who uses coupons and rebates?

Why Bosch doesnt give a discount $100 to every customer?

Why a Burger King doesnt simply give the discount without the coupon?

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Coupons and Rebates

Coupons and rebates are extensively used in marketing

The main idea is that customers with low income have a lower willingness to
pay and more time to search for coupons or more time to mail the rebates

Firms usually give coupons and rebates to indirectly discriminate low-income

(and hence low willingness to pay) from high-income (and hence high
willingness to pay) customers

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Quantity Discounts

Most customers are willing to pay more for the first unit than for successive
units (recall that the typical customers demand curve is downward sloping)

This information is usually used by firms to price discriminate

Firms usually do block-pricing schedules: They charge one price for the
first few units (a block) of usage and a different price for subsequent blocks

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Quantity Discounts

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Quantity Discounts

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Block Pricing

(a) Quantity Discrimination (b) Single-Price Monopoly

p2, $ per unit

p1, $ per unit

90 90

A=
$200
70
E = $450
60
C=
$200
50
B= F = $900
$1,200 D=
$200 G = $450
30 m 30 m

Demand Demand

MR

0 20 40 90 0 30 90
Q, Units per day Q, Units per day

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Two-Part Tariffs

Two-part tariff is a pricing system in which the firm charges a customer a

lump-sum fee (the first tariff or price) for the right to buy as many units of
the good as the consumer wants at a specified price (the second tariff)

With identical consumers, a firm knowing its customers demand curve can
set a two-part tariff to extract all consumer surplus

Firms usually do block-pricing schedules: They charge one price for the
first few units (a block) of usage and a different price for subsequent blocks

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A Two-Part Tariff with Identical Consumers

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A Two-Part Tariff with Non-Identical Consumers

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A Two-Part Tariff with Identical Consumers

The firm charges a price above marginal cost

By raising its price, the monopoly earns more per unit from both types of
customers but lowers its customers potential consumer surplus

Thus, if the monopoly can capture each customers potential surplus by

charging different lump-sum fees, it sets its price equal to marginal cost

However, if the monopoly must charge everyone the same lump-sum fee, the
increase in profit from Customer 2 from the higher price more than offsets
the reduction in the lump-sum fee

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Bundling

Pure Bundling occurs when two or more products are sold together and
cannot be bought separately
I Microsoft-Explorer, Printer -Cartridge etc
Mixed Bundling occurs when two or more products are sold together but
can also be bought separately
I Internet-Landline-Mobile, Shampoo-Conditioner, Family packs etc

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Mixed Bundling

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Pure Bundling

Figure: In Case (a) bundling is not profitable because the firm has a higher profit by
selling the two products separately. In Case (b), bundling is profitable

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