ECON-121

Industrial Organization and Public Policy

Celeste Saravia

Monopoly
Monopoly

Page 2
 Monopoly: Overview
• Definition: A firm is a monopoly if it is the only supplier of a product in a market. A
monopolist’s demand curve slopes down because firm demand equals industry
demand.
• Five cases:
1. Base Case: One price, perishable good, non-IRS Costs
2. Natural Monopoly
3. Price Discrimination
4. Bundling
5. Durable Goods

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Base Case Monopoly

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 Monopoly
Base case: Revenue

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 Monopoly
Base Case: Profit Maximization

• Monopolist’s Profit Maximization Problem:

𝑚𝑚𝑚𝑚𝑚𝑚𝜋𝜋 = 𝑃𝑃 𝑄𝑄 𝑄𝑄 − 𝐶𝐶(𝑄𝑄)
𝑄𝑄
• Choosing P or Q makes no difference because we are selecting a single point on the
demand curve. This will not be true when we consider oligopoly problems.
• F.O.C. are:
𝑑𝑑𝜋𝜋 𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑
= 𝑃𝑃 𝑄𝑄 + 𝑄𝑄 − =0
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑
⟹ 𝑃𝑃 𝑄𝑄 + 𝑄𝑄 =
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑
⟹ 𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀
• (𝑃𝑃∗ , 𝑄𝑄 ∗ ) is profit-maximizing choice.

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 Monopoly
Base Case: Linear Demand

• What does Marginal Revenue look like? Denote the inverse demand curve by P(Q). We
consider simple linear demand curves here:
𝑄𝑄 = 𝑎𝑎 − 𝑏𝑏𝑏𝑏

𝑎𝑎 1
𝑃𝑃 = − 𝑄𝑄
𝑏𝑏 𝑏𝑏
= 𝐴𝐴 − 𝐵𝐵𝐵𝐵
• Total revenue is:
𝑃𝑃𝑃𝑃 = 𝐴𝐴 − 𝐵𝐵𝐵𝐵 𝑄𝑄
= 𝐴𝐴𝐴𝐴 − 𝐵𝐵𝑄𝑄2
• Differentiate to get marginal revenue:
𝑑𝑑𝑑𝑑
𝑀𝑀𝑀𝑀 = = 𝐴𝐴 − 2𝐵𝐵𝐵𝐵
𝑑𝑑𝑑𝑑

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 Monopoly
Base Case: Linear Demand

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 Monopoly
Base Case: Profit Maximization

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 Monopoly: Let’s Practice

• Let demand be given by Q = 100 - 5p. Let total costs be C(Q) = 20 + 2Q.
1. What is the optimal price and quantity for the monopolist?
• Let demand be given by Q = 100 – 10p. Let total costs be C(Q) = 20 + 2Q.
1. What is the optimal price and quantity for the monopolist?

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 Elasticities
• Economists frequently use elasticities instead of slopes
(derivatives) to express the relationship between two variables.
• The elasticity of demand asks “How sensitive is quantity to
changes in price?”
– It is calculated as the percentage change in quantity
demanded in response to a percent change in price.
𝑄𝑄𝑄−𝑄𝑄𝑄 𝑑𝑑𝑑𝑑
%∆𝑄𝑄 𝑄𝑄𝑄
∗100 𝑄𝑄
∗100 𝑑𝑑𝑑𝑑 𝑃𝑃
– 𝐸𝐸𝑃𝑃𝐷𝐷 = = 𝑃𝑃1−𝑃𝑃2 = 𝑑𝑑𝑑𝑑 = * = 𝜀𝜀𝑑𝑑
%∆𝑃𝑃 ∗100 ∗100 𝑑𝑑𝑑𝑑 𝑄𝑄
𝑃𝑃2 𝑃𝑃

– How much does quantity “stretch” or change for a given price

change?
• If big, then it is elastic (think of a loose rubber band).
• If it is small, it is inelastic.

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 Monopoly
Base case: Revenue

Given a price drop from p1

to p2 revenue increases if

Gains > Losses

(𝑞𝑞2 − 𝑞𝑞1) 𝑝𝑝2> (𝑝𝑝1 − 𝑝𝑝2)𝑞𝑞1
𝑞𝑞2−𝑞𝑞1 𝑝𝑝
∗ 2>1
𝑝𝑝1−𝑝𝑝2 𝑞𝑞1

𝑞𝑞2−𝑞𝑞1 𝑝𝑝2
∗ <-1
𝑝𝑝2−𝑝𝑝1 𝑞𝑞1

𝑑𝑑𝑑𝑑 𝑝𝑝
𝑒𝑒 = ∗ <-1
𝑑𝑑𝑑𝑑 𝑞𝑞

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 Monopoly
Base case: Revenue

negative

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 Elasticity of a Linear Demand Curve Changes at Each Point

a ε(0,a)=(-1/b)(a/0)
negative infinity
p(q)=a-bq
q=a/b-p/b
dQ/dP=-1/b
elasticity=(-1/b)(p/q)
Price

ε(a/2b,a/2) =(-1/b)((a/2)/(a/2b))=-1

a/2

D
ε(a/b,0)=(-1/b)(0/a/b))=0
a/2b Quantity a/b

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 Monopoly Base Case
• Marginal Revenue may be written:

𝑑𝑑𝑑𝑑 𝑑𝑑[𝑃𝑃 𝑄𝑄 𝑄𝑄] 𝑑𝑑𝑑𝑑

𝑀𝑀𝑀𝑀 = = = 𝑃𝑃 + 𝑄𝑄
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑

𝑄𝑄𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑 𝑃𝑃𝑃𝑃 1

𝑀𝑀𝑀𝑀 = 𝑃𝑃 + = 𝑃𝑃 + = 𝑃𝑃(1 + )
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑 𝑃𝑃 𝜀𝜀𝑑𝑑

• Inverse Elasticity Rule for Monopolist:

• Price Cost Margin, Markup, or Lerner Index is:

𝑃𝑃 − 𝑀𝑀𝑀𝑀
𝐿𝐿 =
𝑃𝑃
• The monopolist chooses output such that the markup equals the inverse of the
elasticity of demand:

𝑃𝑃 𝑄𝑄 −𝑀𝑀𝑀𝑀(𝑄𝑄) 𝑃𝑃 𝑄𝑄 −𝑀𝑀𝑀𝑀(𝑄𝑄) 𝑑𝑑[𝑃𝑃 𝑄𝑄 𝑄𝑄] 𝑑𝑑𝑑𝑑

L= = , 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑀𝑀𝑀𝑀(𝑄𝑄) = = 𝑃𝑃 + 𝑄𝑄
𝑃𝑃(𝑄𝑄) 𝑃𝑃(𝑄𝑄) 𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑
𝑑𝑑𝑑𝑑 𝑄𝑄
𝑃𝑃−(𝑃𝑃+𝑄𝑄 𝑑𝑑𝑑𝑑 ) −𝑄𝑄 𝑑𝑑𝑑𝑑(𝑄𝑄) 1
L= 𝑃𝑃(𝑄𝑄)
= 𝑃𝑃 𝑑𝑑𝑑𝑑 =
−𝜀𝜀𝑑𝑑
>0

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 Monopoly Base Case
• Monopolist produces such that: L=
𝑃𝑃−𝑀𝑀𝑀𝑀
𝑃𝑃
=
1
−𝜀𝜀𝑑𝑑
>0

– The extent of the monopolist’s markup will depend on the elasticity of demand.
– If demand is very elastic ( -∞), monopolist will price close to marginal cost.
– A monopolist will never produce along the inelastic portion of the demand curve.
• If demand is inelastic, then a 1% increase in price will lead to a less than 1% decrease in
quantity.
• If the monopolist charges a higher price, it will sell fewer units. But since demand is
inelastic, the percentage loss in units sold is less than the percentage increase in price,
therefore, total sales revenue actually will increase.
• The monopolist will keep increasing price until demand becomes elastic.

– What does this tell us about where a monopolist will operate on a linear demand
curve?

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 Monopoly: Let’s Practice
• Let demand be given by Q = 100 - 5p. Let total costs be C(Q) = 20 + 2Q.
1. What is the optimal price and quantity for the monopolist?
2. What is the elasticity of demand at the point at which the monopolist produces?

• Now suppose Q=100-10p and total cost is still C(Q) = 20 + 2Q.

1. What is the optimal price and quantity for the monopolist?
2. What is the elasticity of demand at the point at which the monopolist produces?

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 Monopoly
Base Case: What is the cost of monopoly?

What is the reason that there is DWL?

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 Monopoly: Let’s Practice

• Let demand be given by Q = 100 - 5p. Let total costs be C(Q) = 20 + 2Q.
1. What is the optimal price and quantity for the monopolist?
2. What is the elasticity of demand at the point at which the monopolist produces?
3. What is the dead weight loss resulting from this market outcome?

• Let demand be given by Q = 100 - 10p. Let total costs be C(Q) = 20 + 2Q.
1. What is the optimal price and quantity for the monopolist?
2. What is the elasticity of demand at the point at which the monopolist produces?
3. What is the dead weight loss resulting from this market outcome?

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 Monopoly
Base Case: Summary

• To Reiterate: The Pricing Rule of A Monopolist Is:

1
𝑀𝑀𝑀𝑀 = 𝑃𝑃 1 + = 𝑀𝑀𝑀𝑀
−𝜀𝜀𝑑𝑑
Or equivalently:
𝑃𝑃 − 𝑀𝑀𝑀𝑀 1
=
𝑃𝑃 −𝜀𝜀𝑑𝑑

• Flatter demand implies higher 𝜀𝜀𝑑𝑑 holding P and Q fixed, a lower monopoly markup and
lower DWL.

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 Monopoly
Base Case: Summary

• Costs of monopoly:
– Monopoly profit is a transfer from consumers.
– Monopoly leads to DWL
– Monopolies can engage in rent seeking (a competitive activity that consumes
resources):
• Persuasive advertising needed to convince consumers that alternative brands are inferior
• Resources needed to preempt potential entrants from entering the industry/excessive
production or investment in capital for the purpose of making entry unprofitable for
potential competitors.
• Lobbying costs needed to convince the legislators that a particular monopoly is not harmful
(provided that these costs divert resources from productive activities).
• Excessive R&D resulting from a patent race.
• But: there are benefits to monopoly:
– The possibility of earning monopoly profits incentives firms to invest in R&D,
become more efficient, create new products.

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 Monopoly: Let’s Practice

• Let demand be given by Q = 100 - 5p. Let total costs be C(Q) = 20 + 2Q.
1. What is the optimal price and quantity for the monopolist?
2. What is the elasticity of demand at the point at which the monopolist produces?
3. What is the dead weight loss resulting from this market outcome?
4. At what fixed cost would the firm choose to close down?
• Let demand be given by Q = 100 - 10p. Let total costs be C(Q) = 20 + 2Q.
1. What is the optimal price and quantity for the monopolist?
2. What is the elasticity of demand at the point at which the monopolist produces?
3. What is the dead weight loss resulting from this market outcome?
4. At what fixed cost would the firm choose to close down?
• You are working for a firm that is a monopoly. It is producing using technology that
exhibits obvious decreasing returns to scale. After working with them for a while, a co-
worker makes a mistake and accidentally increases the price per unit from $10 to $11
for a week. You notice that the quantity sold drops by 5%. Management asks you to
think about whether any strategic implications can be drawn from this episode. What do
you write in your memo in response?

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Natural Monopoly

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 Natural Monopoly
• A firm is a natural monopoly if it can produce the market quantity Q, at lower cost than
two or more firms.
• To argue for a natural monopoly, have to establish subadditivity of cost function:
𝐶𝐶 𝑄𝑄 < 𝐶𝐶 𝑞𝑞1 + 𝐶𝐶 𝑞𝑞2 + ⋯ + 𝐶𝐶 𝑞𝑞𝑞𝑞 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑄𝑄 = ∑𝐾𝐾
𝑖𝑖=1 𝑞𝑞𝑞𝑞
• Claim: if AC is declining everywhere, subadditivity is satisfied.
• However, the reverse is not always true, i.e. economies of scale is sufficient but not
necessary for natural monopoly.
• It is often argued that electrical, gas, telephone and other utilities are natural
monopolies. Why?

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Natural Monopoly

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 Natural Monopoly
• Monopoly will maximize profits at (𝑃𝑃𝑀𝑀 , 𝑄𝑄𝑀𝑀 ).
• (𝑃𝑃𝑠𝑠 ; 𝑄𝑄𝑠𝑠 ) are perfectly competitive and, hence, welfare maximizing (not counting fixed
costs), but a firm would make a loss in this case.
• How to regulate a natural monopoly?
1. Pay a subsidy to the firm to cover losses,
2. or have firms bid based on price: “franchise bidding”
3. or, even better, have firms bid based on both a fee to operate, but also the price
they will charge consumers.

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Monopoly: Price Discrimination

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 Price Discrimination
First Degree

First-Degree Price Discrimination

• Monopolist knows the WTP of each customer, and charges a different price from each.
• The key idea is all the consumer surplus is extracted.
• The best way to think of this is that it is done with a lump sum fee and quantity
restriction, or an access fee and P = MC

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Price Discrimination
First Degree

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Price Discrimination
First Degree

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 Price Discrimination
First Degree

• Claim: This type of price discrimination leads to an efficient

outcome.
• What’s the MR curve of a monopolist who can charge the area
under the demand curve?
• Implementation problem: how does the monopolist know its
demand curve?

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 Price Discrimination
Third Degree

• This is “market segmentation”.

• Two segments:
– 𝑚𝑚𝑚𝑚𝑚𝑚𝑞𝑞𝑞,𝑞𝑞𝑞 𝜋𝜋 𝑞𝑞1 , 𝑞𝑞2 = 𝑇𝑇𝑅𝑅1 𝑞𝑞1 + 𝑇𝑇𝑅𝑅2 𝑞𝑞2 − 𝑇𝑇𝑇𝑇 𝑞𝑞1 + 𝑞𝑞2
– 𝑀𝑀𝑅𝑅1 𝑞𝑞1𝑚𝑚 = 𝑀𝑀𝑀𝑀 𝑞𝑞1𝑚𝑚 + 𝑞𝑞2𝑚𝑚
– 𝑀𝑀𝑅𝑅2 𝑞𝑞2𝑚𝑚 = 𝑀𝑀𝑀𝑀 𝑞𝑞1𝑚𝑚 + 𝑞𝑞2𝑚𝑚
• Equate marginal revenues across two markets!
• Marginal revenues might be the same, but not the resulting
prices!

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Price Discrimination
Third Degree

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 Price Discrimination
Third Degree

• Claim:𝑝𝑝1𝑚𝑚1+
1
−∥𝜀𝜀1 ∥
=𝑝𝑝2𝑚𝑚1+
1
−∥𝜀𝜀2 ∥
• Price in market with less elastic demand is higher (Ramsey
pricing principle)
• Examples: Cinema pricing; Book Pricing
• In general, welfare consequences are ambiguous.

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 Price Discrimination
Second Degree

Second-Degree Price Discrimination

• This is the case where you can’t effectively segment the market.
• Instead you get people to choose between different pricing plans
(“tariffs”).
– Cell phone plans are a good example.
– Quantity discounts (ever wonder how Starbucks sets prices
across sizes?)
• In some cases, a much harder problem to analyze.
• We will do a simple version to build intuition, then a more
rigorous treatment to show generality of intuition.

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 Price Discrimination
Second Degree: Easy version (also assuming MC = 0)

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 Price Discrimination
Second Degree: Easy version (also assuming MC = 0)

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 Price Discrimination; Rigorously...
Second Degree

• Two type example:

– Consumer i’s surplus from drinking q ounces of coffee and paying t is given
by:
– 𝑞𝑞𝜃𝜃𝑖𝑖 − 𝑡𝑡 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑖𝑖 = 1; 2;
– With (ℷ, 1 − ℷ) percent of each type in population
– 𝜃𝜃1 < 𝜃𝜃2 , 𝑖𝑖. 𝑒𝑒. 𝜃𝜃2 people get higher marginal utility from each ounce of coffee
(“H” types).
– Costs are given by C(𝑞𝑞𝑖𝑖 )

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 Price Discrimination
Second Degree

• Monopolist offers two sizes of coffee: 𝑞𝑞1 , 𝑡𝑡1 , 𝑞𝑞2 , 𝑡𝑡2 and corresponding pricing.
• Maximization problem:

max ℷ 𝑡𝑡1 − 𝐶𝐶 𝑞𝑞1 + (1 − ℷ)(𝑡𝑡2 − 𝐶𝐶 𝑞𝑞2 )

𝑞𝑞1 ,𝑡𝑡1 , 𝑞𝑞2 ,𝑡𝑡2

• such that people (a) buy and (b) buy the bundle they are supposed to

𝜃𝜃1 𝑞𝑞1 − 𝑡𝑡1 ≥ 0 (𝐼𝐼𝐼𝐼 − 𝐿𝐿)

𝜃𝜃2 𝑞𝑞2 − 𝑡𝑡2 ≥ 0 (𝐼𝐼𝐼𝐼 − 𝐻𝐻)

𝜃𝜃1 𝑞𝑞1 − 𝑡𝑡1 ≥ 𝜃𝜃1 𝑞𝑞2 − 𝑡𝑡2 (𝐼𝐼𝐼𝐼 − 𝐿𝐿)

𝜃𝜃2 𝑞𝑞2 − 𝑡𝑡2 ≥ 𝜃𝜃2 𝑞𝑞𝟏𝟏 − 𝑡𝑡1 (𝐼𝐼𝐼𝐼 − 𝐻𝐻)

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 Price Discrimination
Second Degree

• Let’s get rid of some of these constraints:

• Claim: IR-L and IC-H automatically imply IR-H.
• Proof :
𝜃𝜃2 𝑞𝑞2 − 𝑡𝑡2 ≥ 𝜃𝜃2 𝑞𝑞1 − 𝑡𝑡1 𝐼𝐼𝐼𝐼 − 𝐻𝐻
> 𝜃𝜃1 𝑞𝑞1 − 𝑡𝑡1 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝜃𝜃2 > 𝜃𝜃1
>0 (𝐼𝐼𝐼𝐼 − 𝐿𝐿)

• Claim: IR-L binds at an optimum.

• Proof : Suppose not. If monopolist increases 𝑡𝑡1 and 𝑡𝑡2 by ε, he still satisfies IR-L. IC-L
and IC-H are unchanged (ε cancels from both sides), and IR-H continues to hold. But
then monopolist increases profit (price increased by ε, so we can’t be at an optimum.
Contradiction.

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 Price Discrimination
Second Degree

• Claim: IC-H binds.

• Proof : Suppose not. Increase 𝑡𝑡2 by ε such that IC-H still holds. IR-L not affected, so IR-
H still holds. IC-L not affected. So once again monopolist increased profits!
Contradiction.
• Claim: IC-L is satisfied automatically given other constraints. Assume for now and
verify at optimum.

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 Price Discrimination
Second Degree

• “Simplified” Maximization problem:

max { ℷ 𝑡𝑡1 − 𝐶𝐶 𝑞𝑞1 + (1 − ℷ)(𝑡𝑡2 − 𝐶𝐶 𝑞𝑞2 )}

𝑞𝑞1 ,𝑡𝑡1 , 𝑞𝑞2 ,𝑡𝑡2

𝑠𝑠. 𝑡𝑡. 𝑡𝑡1 = 𝜃𝜃1 𝑞𝑞1

𝑡𝑡2 − 𝑡𝑡1 = 𝜃𝜃2 𝑞𝑞2 − 𝜃𝜃2 𝑞𝑞1

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 Price Discrimination
Second Degree

• So we can write the problem as:

max ℷ(𝜃𝜃1 𝑞𝑞1 − 𝐶𝐶 𝑞𝑞1 )

(𝑞𝑞1 ,𝑞𝑞2 )

+(1 − ℷ)(𝜃𝜃2 𝑞𝑞2 + 𝜃𝜃1 − 𝜃𝜃2 𝑞𝑞1 − 𝐶𝐶 𝑞𝑞2 )

• Giving FOC’s:

𝜃𝜃1 − 1 − ℷ 𝜃𝜃2 = ℷ𝐶𝐶 ′ (𝑞𝑞1 )

𝜃𝜃2 = 𝐶𝐶 ′ (𝑞𝑞2 )

• For H-types, ”large” coffee size is socially optimal: The high types marginal value of
consuming coffee is equal to the marginal cost of producing coffee, which means it is
efficient.

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 Price Discrimination
Second Degree

• For L-types, suboptimal:

– FOC: 𝜃𝜃1 − 1 − ℷ 𝜃𝜃2 = ℷ𝐶𝐶 ′ (𝑞𝑞1 )
– Remember that, by assumption: 𝜃𝜃1 < 𝜃𝜃2
– This assumption implies: 𝜃𝜃1 − 1 − ℷ 𝜃𝜃2 < 𝜃𝜃1 − 1 − ℷ 𝜃𝜃1 = ℷ𝜃𝜃1
– This implies that ℷ𝐶𝐶 ′ (𝑞𝑞1 ) <ℷ𝜃𝜃1 FOC states: 𝜃𝜃1 − 1 − ℷ 𝜃𝜃2 = ℷ𝐶𝐶 ′ 𝑞𝑞1
– The low types marginal value of coffee is GREATER than the marginal cost of the
small coffee: 𝜃𝜃1 > 𝐶𝐶 ′ 𝑞𝑞1
• That is, small coffee size is too small. Moreover, L-types enjoy zero surplus:
𝜃𝜃1 𝑞𝑞1 − 𝑡𝑡1 = 0 and are just indifferent between buying coffee and not.
• Last step:
– Verify IC-L: since IR-L binds, 𝜃𝜃1 𝑞𝑞2 ≤ 𝑡𝑡2 Subtract IR-L (which binds) from both sides:
𝜃𝜃1 𝑞𝑞2 − 𝜃𝜃1 𝑞𝑞1 ≤ 𝑡𝑡2 − 𝑡𝑡1 .
– H-types enjoy surplus:
𝜃𝜃2 𝑞𝑞2 − 𝑡𝑡2 ≥ 0
– Proof: Use IC-h and IR-L

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 Price Discrimination
Third Degree Price Discrimination Practice

• In market 1, let demand be given by q1 = 100 -5p. In market 2, let demand be

given by q2 = 500-10p. Let Q = q1 + q2. Let total costs be C(Q) = 20 + 2Q.
– What is the price in each market if the monopolist can charge different
prices in each market?
– If a monopolist is forced to charge the same price in both markets what
price will that be?
– As a consumer in market 1, which of the above do you prefer?
– Is a monopolist always better off if they can engage in Type 3 price
discrimination (as opposed to charging the same unit price in all market
segments)?
– Provide a formal argument for this proposition.

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 Price Discrimination
Second Degree Price Discrimination Practice

• Let there be two types of consumer.

– Type A has utility given by 12q-p.
– Type B has utility given by 5q-p, where q is a numerical index of quality and
p is the price of a unit.
• There are three times as many Type B's as there are Type A’s.
• The total number of consumers is 400.
• Cost assumptions:
– The marginal cost of serving each individual consumer's purchase is 4q.
– This means the total variable cost of serving a consumer is equal to 2q2.
– The firm must also incur a fixed cost of production equal to F.
• Given that the rm cannot distinguish a Type A from a Type B, would the firm
want to operate if F = 1000?

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Bundling

Page 47
 Price Discrimination
Bundling

• Good A and B are sold in fixed proportions, in a “package”

• Examples:
– Movie distributors force theaters to acquire “bad” movies if they want to show good
ones
– Photocopier manufacturers offer several goods: the copier, maintenance, and a
package of both together
• Why is this a profitable strategy?

Page 48
 Price Discrimination
Bundling: Example 1

• Two products: A and B

• Two types of consumers: 1 and 2
• Unit demand
• No complementarity between products: 𝑊𝑊𝑊𝑊𝑃𝑃𝐴𝐴𝐴𝐴 = 𝑊𝑊𝑊𝑊𝑃𝑃𝐴𝐴 + 𝑊𝑊𝑊𝑊𝑃𝑃𝐵𝐵
• Assume MC = 0
• If sell separately, 𝑝𝑝𝐴𝐴 = 9000, 𝑝𝑝𝐵𝐵 = 2000. 𝜋𝜋𝐴𝐴 +𝜋𝜋𝐵𝐵 = 2 9000 + 2 2000 = 22000
– Review: How do we think about marginal revenue from going from selling 1 to 2 units of an A?
• If sell 𝐴𝐴𝐴𝐴, 𝑝𝑝𝐴𝐴𝐴𝐴 = 12000, 𝜋𝜋𝐴𝐴𝐴𝐴 = 24000

Page 49
 Price Discrimination
Bundling: Example 2

• How do we price:
– If sell separately, 𝑝𝑝𝐴𝐴 = 9000, 𝑝𝑝𝐵𝐵 = 2000. Why not 𝑝𝑝𝐵𝐵 = 500?
– 𝜋𝜋𝐴𝐴 + 𝜋𝜋𝐵𝐵 = 2 9000 + 2000 = 20000
– If sell 𝐴𝐴𝐴𝐴, 𝑝𝑝𝐴𝐴𝐴𝐴 = 9500. 𝜋𝜋𝐴𝐴𝐴𝐴 = 19000.
• What’s different between Example 1 and Example 2?
– In the first example, type 1 has higher demand for B, type 2 has higher demand for
A.
– In the second example, type 2 has higher demand for both goods
– Intuition: bundling works when there is heterogeneity in preferences across goods.

Page 50
 Price Discrimination
Bundling: Example 3

• If sell separately, 𝑝𝑝𝐴𝐴 = 3000, 𝑝𝑝𝐵𝐵 = 3000. 𝜋𝜋𝐴𝐴 + 𝜋𝜋𝐵𝐵 = 3000 × 4 = 12000.
• If sell AB, 𝑝𝑝𝐴𝐴𝐴𝐴 = 4000. 𝜋𝜋𝐴𝐴𝐴𝐴 = 12000.
• If sell A and B and AB, 𝑝𝑝𝐴𝐴 = 4000, 𝑝𝑝𝐵𝐵 = 4000, 𝑝𝑝𝐴𝐴𝐴𝐴 = 6000, 𝜋𝜋𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = 14000.
• What’s different?
– In this example, consumer type 2 has a fairly low valuation for the 2 products
separately but a much higher valuation for the 2 together.
– In contrast, consumers 1 and 3 only value one of the two products.
– Firm can extract all surplus from all consumers through mixed bundling (offering
both the bundle and its components).

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Durable Goods Monopolist

Page 52
 Durable Goods Monopolist
• Durable goods are bought in one period and then used for multiple periods (cars and
houses).
• When a monopolist sells a durable product, it charges a single price, pS, which
transfers the product to the consumer for an indefinite period of time.
• When the monopolist rents a product, it charges the consumer a specific price, pR, to
use the product for one period.
• Basic setup:
– Suppose consumers live for 2 periods, t=1 and 2 (i.e., no population change
between the two periods).
– Monopoly sells a durable product that last for two periods.
– The aggregate inverse demand curve, at time t=1, is p=100-Q.
– In the absence of period 1 sales, the aggregate demand curve at time t=2 is
identical to the aggregate demand curve at time t=1.
– MC=0

Page 53
 Durable Goods Monopolist: Rent
• When the monopolist rents the product, it faces the same demand curve in both
periods.
• For a single period, the problem is : MaxQ Q (100-Q) Q*=50 and pR*=50.
• The monopolist’s total profits for renting in both periods: 50*50+50*50=5,000

100
P1

D1

MR(q1) q1

Page 54
 Durable Goods Monopolist: Sell
• The monopolist knows that consumers who purchase the durable good at t=1, will not
repurchase in period t=2.
• At t=2, the monopolist will face demand that is lower than in period 1 by exactly the
amount it sold at t=1 the monopolist will have to sell at a lower price in period 2.
• Consumers need to decide whether to buy in period 1 or wait until period 2. If they own
the product in both periods, they get consumer surplus in both periods.

100
P1
P2

100-q1
D1

D2

MR(q1) q1
q2

Page 55
 Durable Goods Monopolist: Sell
• 2-Period Game:
– Monopoly Payoff: Total revenue generated in periods 1 and 2.
– Monopoly Strategies: Set prices p1 and p2, where p2 is a function of the quantity
sold in period 1 p2(q1).
– Buyer Strategy: Buy or not buy in period 1 and 2 as a function of the price in each
period.
• We look for a subgame perfect equilibrium to solve this game (remember an
understanding of game theory is needed in this class)
• This means we solve the game backwards!

Page 56
 Durable Goods Monopolist: Sell
• Period 2 Game:
• Monopolist Problem: Maxq2 q2*(100-q1-q2), where we are taking q1 as fixed because it
was picked in the first period.
– MR2(q2)=100-q1-2q2 =0q2* =50-q1/2
– Profits2(q1)=p2q2=(50-q1/2)2

100
P1
P2

100-q1
D1 q2*

D2

MR(q1) q1
q2

Page 57
 Durable Goods Monopolist: Sell
• Period 1 Game: Suppose that the monopolist sells to the 𝓺𝓺𝟏𝟏 customers with the
highest demand in period 1.
• Then the marginal customer has a reservation price of 100- 𝓺𝓺𝟏𝟏 will be indifferent
between purchasing in the first period or waiting until the second period.
– This customers surplus from first period purchase:
• 2(100- 𝓺𝓺𝟏𝟏 )-p1
– This customers surplus from the second period purchase:
• (100-𝓺𝓺𝟏𝟏 )-p2 =(100- 𝓺𝓺𝟏𝟏 )-(50- 𝓺𝓺𝟏𝟏 /2) [substituting in p2 ]
• We can do some simplification:
– 2(100- 𝓺𝓺𝟏𝟏 )-p1=(100- 𝓺𝓺𝟏𝟏 )-(50- 𝓺𝓺𝟏𝟏 /2) p1 =(150-3 𝓺𝓺𝟏𝟏 /2)
• We can also get the result p1 =(150-3q1/2), by noting that the first period price should
be equal to the second period price plus the value of using the product in period 1.
– p1=(100- 𝓺𝓺𝟏𝟏 )+ p2 =(100- 𝓺𝓺𝟏𝟏 )+(50- 𝓺𝓺𝟏𝟏 /2) p1 =150-3q1/2

Page 58
 Durable Goods Monopolist: Sell
• In a SPE equilibrium, monopolist chooses q1 to maximize the following problem.
– max Π1 + Π2 = 150 − 3q1/2 q1 + 50 − q1/2 2
(𝑞𝑞1 )
100−q1
– FOC: 150 − 3q1 − = 0  100- 5q1/2=0 q1=40
2
– The Monopolist picks the following prices and quantities:
• q1=40
• 𝑞𝑞2= p2=50-q1/2=50-40/2=30
• 𝑝𝑝1=(100-q1)+p2=(100-40)+30=90
• Selling Profits= 90*40+30*30=4500
– This is lower than it made from renting the product.
• This is a general result: A monopoly selling a durable good earns lower profits than a renting
monopoly.
– The intuition is that rational consumers are able to calculate that a selling-durable-good
monopoly would lower future prices due to the fall in demand resulting from some consumers
already having purchased the product.
– This reduces the consumers willingness to pay high prices in the first period in which the
monopolist offers the product for sale.
– Because the monopolist cannot commit itself to not lower prices in the future, the monopoly
must lower its first period price.

Page 59
U.S. Antitrust: Quick Overview

Page 60
 What Is the Purpose of the Antitrust Laws?

• Purpose of Antitrust Laws: Protect and promote the

process of competition NOT to protect specific
competitors.
• Antitrust laws seek to protect consumer welfare: They
attempt to stop activity that will raise prices or diminish
the quantity or quality of products & services.

Page 61
 Key Terms and Concepts

• Market Power: Ability of a firm (or group of firms acting

together) to increase the price of products/services
above the competitive level, reduce quality or
innovation below competitive level, or exclude
competitors.
• Procompetitive: Activity that enhances a firm’s ability
to lower prices increase output (e.g., merger that
creates efficiencies or new products).
• Note that firms may obtain market (or even monopoly)
power by innovating and creating better products.

Page 62
 Antitrust Laws
• Sherman Act Section 1: Prohibits contracts, combinations, and
conspiracies that unreasonably restrain interstate commerce.
– Focus is on conspiracies (cartels) between competitors to fix
prices, divide markets etc.
– Can also apply to conduct, like exclusive contracts, where the
anticompetitive effects may outweigh procompetitive benefits.
• Sherman Act Section 2: Prohibits monopolies, attempted
monopolies, and conspiracies to monopolize a market.
– The focus is on the Unlawful Use of Market Power by a single
firm.
• Clayton Act Section 7: Prohibits mergers, acquisitions and joint
ventures that may substantially lessen competition or tend to
create a monopoly. It is forward looking.

Page 63
 U.S. Antitrust Enforcement
• Federal Enforcement Agencies: Both the Federal Trade Commission (FTC)
and the U.S. Department of Justice (DOJ) Antitrust Division enforce the federal
antitrust laws.
– In some respects, their authorities overlap, but in practice the two agencies
complement each other.
– Over the years, the agencies have developed expertise in particular industries or
markets.
– Before opening an investigation, the agencies consult with one another to avoid
duplicating efforts.
• State attorneys general can play an important role in antitrust enforcement on
matters of particular concern to local businesses or consumers. They may
bring federal antitrust suits on behalf of individuals residing within their states,
or on behalf of the state as a purchaser.
• Private parties can also bring suits to enforce the antitrust laws. In fact, most
antitrust suits are brought by businesses and individuals seeking damages for
violations of the Sherman or Clayton Act.

* https://www.ftc.gov/advice-guidance/competition-guidance/guide-antitrust-laws/enforcers
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