,

Microeconomics
Chapter 11
Pricing with Market Power

Federico De Andrea
[email protected]

April 24, 2024

Question 1 - Quick Review

In a monopoly, the firm aims to maximize profits by setting the

optimal condition:
(a) Price = Marginal Cost
(b) Marginal Revenue = Price
(c) Marginal Revenue = Marginal Cost
(d) Average Total Cost = Marginal Cost
Question 1 - Solution: C

In a monopoly, the firm aims to maximize profits by setting the

optimal condition:
(a) Price = Marginal Cost
(b) Marginal Revenue = Price
(c) Marginal Revenue = Marginal Cost
(d) Average Total Cost = Marginal Cost
This condition always holds, for any firm in any market, and will be
important also in price discrimination episodes.
Question 2 - Quick Review

In a monopoly, compared to a competitive market solution, we

typically observe:
(a) higher quantity, higher price
(b) higher quantity, lower price
(c) lower quantity, higher price
(d) lower quantity, lower price
Question 2 - Solution: C

In a monopoly, compared to a competitive market solution, we

typically observe:
(a) higher quantity, higher price
(b) higher quantity, lower price
(c) lower quantity, higher price
(d) lower quantity, lower price
The main goal of a monopolist able to discriminate will be to
increase its market share (quantity he sells) without affecting too
much the margin gained on each unit sold (price).
Question 3 - First degree price discrimination

In a perfect discrimination monopoly, the consumer surplus is equal

to . . . , while the producer surplus equals to . . . , so that the
deadweight loss is . . .
(a) the entire social welfare; zero; maximized
(b) half of the social welfare; half of the social welfare; positive
(c) zero; the entire social welfare; zero
(d) zero; the entire social welfare; positive
Question 3 - Solution: C
In a perfect discrimination monopoly, the consumer surplus is equal
to . . . , while the producer surplus equals to . . . , so that the
deadweight loss is . . .
(a) the entire social welfare; zero; maximized
(b) half of the social welfare; half of the social welfare; positive
(c) zero; the entire social welfare; zero
(d) zero; the entire social welfare; positive
The monopolist extracts the entire consumer surplus and
maximizes his own producer surplus.
Paradox: since he leaves no deadweight loss, first price
discrimination is as efficient as perfect competition, and then it is
socially optimal! However, while in perfect competition the
consumer surplus was maximized, in first degree price
discrimination consumers get no surplus and the producer surplus
is maximized.
Question 4 - First degree price discrimination

In the small town of Masate (Milan), there is only one physician

for 100 patients. The patients have different reservation prices and
demand curves. The physician has a cost of 20e per visit and
estimates the following market demand: Q = 100 − P .
(a) What if the optimal quantity of visits of the physician?
(b) Is there a single equilibrium price? If yes, which one? If no,
why?
(c) What is the Consumer Surplus?
(d) What is the Producer Surplus?
(e) What is the Social Welfare?
(f) What is the Deadweight Loss?
Question 4.a, b, c - Quantity, Price & Consumer Surplus

(a) The quantity sold is the same that would be traded in perfect
competition, when P = M C. Hence, Q = 100 − 20 = 80.
Question 4.a, b, c - Quantity, Price & Consumer Surplus

(a) The quantity sold is the same that would be traded in perfect
competition, when P = M C. Hence, Q = 100 − 20 = 80.

(b) Also, there’s no a single price. Any consumer will pay a

different price, equal to her own reservation price. There will
be as many prices as consumers living in the town.
Question 4.a, b, c - Quantity, Price & Consumer Surplus

(a) The quantity sold is the same that would be traded in perfect
competition, when P = M C. Hence, Q = 100 − 20 = 80.

(b) Also, there’s no a single price. Any consumer will pay a

different price, equal to her own reservation price. There will
be as many prices as consumers living in the town.

(c) Finally, we already know the consumers will get no surplus at

all in first degree price discrimination: CS = 0.
Question 4.d - Producer Surplus

(d) You must compute the difference between the maximum

reservation price (100, from the demand function) and the
minimum price that can be asked for (20, equal to the
marginal cost), multiplied by the equilibrium quantity (80),
and divided by 2:

(100 − 20) · 80 80 · 80
PS = = = 3200
2 2
Question 4.e, f - Social Welfare & DWL

(e) Social Welfare is the sum of Consumer and Producers Surplus.

In this case, Social Welfare coincides with Producer Surplus:

W = CS + P S = 0 + 3200 = 3200
Question 4.e, f - Social Welfare & DWL

(e) Social Welfare is the sum of Consumer and Producers Surplus.

In this case, Social Welfare coincides with Producer Surplus:

W = CS + P S = 0 + 3200 = 3200

(f) Finally, as we already know, there’s no deadweight loss when

the monopolist can perfectly discriminate: DW L = 0.
Question 5 - Third degree price discrimination

In a third degree price discrimination, the monopolist:

(a) discriminates based on observable characteristics of the
consumers
(b) discriminates based on non-observable characteristics of the
consumers
(c) discriminates based on quantity purchased
(d) discriminates based on preferences of the consumer
Question 5 - Solution: A

In a third degree price discrimination, the monopolist:

(a) discriminates based on observable characteristics of the
consumers
(b) discriminates based on non-observable characteristics of the
consumers
(c) discriminates based on quantity purchased
(d) discriminates based on preferences of the consumer
Examples can be discounts for students, people older than 65,
military or other particular categories which are easily recognized.
Question 6 - Third degree price discrimination

In a third degree price discrimination, the optimal condition for the

monopolist is:
(a) M C1 = M C2 = P
(b) P = M R1 e M R2 = M C2
(c) M R1 = M C1 e M R2 = P
(d) M R1 = M R2
Question 6 - Solution: D

In a third degree price discrimination, the optimal condition for the

monopolist is:
(a) M C1 = M C2 = P
(b) P = M R1 e M R2 = M C2
(c) M R1 = M C1 e M R2 = P
(d) M R1 = M R2
The full optimal condition would be M R1 = M C = M R2 :
marginal costs is the same for both the markets and the
monopolist behaves as if he is a monopolist on two different
markets by imposing the usual rule that equates marginal revenues
and marginal costs.
The marginal revenues over different markets must all be equal to
marginal costs, and then must be equal to each other.
Question 7 - Third degree price discrimination

Suppose JK Rowling is releasing a new Harry Potter book with

Bloomsbury Publishing. You need to decide how many copies are
to be printed in the US market and the European market,
according to the following demand, marginal revenue and marginal
cost functions:
PU = 36 − 4QU and M RU = 36 − 8QU
PE = 24 − 4QE and M RE = 24 − 8QE
MC = 4
If you were the main editor of Bloomsbury, which would price,
output, profits and deadweight loss be if you could discriminate
between the US and European market?
Question 7 - US Market
Let’s focus on one market per time.
In the United States, Bloomsbury follows the usual rule
M RU = M C, that is, 36 − 8QU = 4 to find that the optimal
quantity is QU = 4 millions of copies.
Question 7 - US Market
Let’s focus on one market per time.
In the United States, Bloomsbury follows the usual rule
M RU = M C, that is, 36 − 8QU = 4 to find that the optimal
quantity is QU = 4 millions of copies.
The price is PU = 36 − 4 · 4 → PU = $20 .
Question 7 - US Market
Let’s focus on one market per time.
In the United States, Bloomsbury follows the usual rule
M RU = M C, that is, 36 − 8QU = 4 to find that the optimal
quantity is QU = 4 millions of copies.
The price is PU = 36 − 4 · 4 → PU = $20 .
Profits on this market are πU = PU · QU − 4 · QU = 20 · 4 − 4 · 4
→ πU = $64 millions.
Question 7 - US Market
Let’s focus on one market per time.
In the United States, Bloomsbury follows the usual rule
M RU = M C, that is, 36 − 8QU = 4 to find that the optimal
quantity is QU = 4 millions of copies.
The price is PU = 36 − 4 · 4 → PU = $20 .
Profits on this market are πU = PU · QU − 4 · QU = 20 · 4 − 4 · 4
→ πU = $64 millions.
In case of perfect competition, in the US, price would have been
36−PUC
PUC = M C = 4 and quantity QC U = 4 = 36−4
4 = 8.
Hence, deadweight loss can be computed as:

(QC C
U − QU )(PU − PU ) (8 − 4)(20 − 4)
DW LU = = = 32
2 2
Question 7 - European Market

In Europe, let’s follow the same procedure:

M RE = M C → 24 − 8QE = 4 → QE = 2.5 millions of copies.
Question 7 - European Market

In Europe, let’s follow the same procedure:

M RE = M C → 24 − 8QE = 4 → QE = 2.5 millions of copies.
The price is PE = 24 − 4 · 2.5 → PE = $14 .
Question 7 - European Market

In Europe, let’s follow the same procedure:

M RE = M C → 24 − 8QE = 4 → QE = 2.5 millions of copies.
The price is PE = 24 − 4 · 2.5 → PE = $14 .
Profits in Europe are πE = PE · QE − 4 · QE = 14 · 2.5 − 4 · 2.5
→ πE = $25 millions.
Question 7 - European Market

In Europe, let’s follow the same procedure:

M RE = M C → 24 − 8QE = 4 → QE = 2.5 millions of copies.
The price is PE = 24 − 4 · 2.5 → PE = $14 .
Profits in Europe are πE = PE · QE − 4 · QE = 14 · 2.5 − 4 · 2.5
→ πE = $25 millions.
In case of perfect competition, in Europe, price would have been
24−PEC
PEC = M C = $4 and quantity QC E = 4 = 24−4
4 = 5.
Hence, deadweight loss can be computed as:

(QC C
E − QE )(PE − PE ) (5 − 2.5)(14 − 4)
DW LE = = = 12.5
2 2
Question 7 - Results

So, to sum up, the US market faces a higher price

(PU = 20 > 14 = PE ) and higher quantity (QU = 4 > 2.5 = QE ).
Question 7 - Results

So, to sum up, the US market faces a higher price

(PU = 20 > 14 = PE ) and higher quantity (QU = 4 > 2.5 = QE ).

Total profits are Π = πU + πE = 64 + 25 → Π = $89 millions.

Question 7 - Results

So, to sum up, the US market faces a higher price

(PU = 20 > 14 = PE ) and higher quantity (QU = 4 > 2.5 = QE ).

Total profits are Π = πU + πE = 64 + 25 → Π = $89 millions.

Total deadweight loss is

DW L = DW LU + DW LE = 32 + 12.5 = 44.5
Question 8 - Third degree price discrimination

In a third degree price discrimination, a monopolist can

discriminate comparing the markets for youngers, which are more
sensitive to price change, and adults, which are less sensitive to
price change. Then:
(a) the price will be the same on both markets
(b) the price will be higher on the markets for youngers
(c) the price will be higher on the markets for adults
(d) we cannot say anything without the cost function
Question 8 - Solution: C
In a third degree price discrimination, a monopolist can
discriminate comparing the markets for youngers, which are more
sensitive to price change, and adults, which are less sensitive to
price change. Then:
(a) the price will be the same on both markets
(b) the price will be higher on the markets for youngers
(c) the price will be higher on the markets for adults
(d) we cannot say anything without the cost function
The price is always higher in the market whose demand
elasticity is more rigid: consumers are less sensitive to price
change, so the monopolist can raise it with no fear consumers will
fly away. In the previous exercise, for example, the US demand was
more rigid to price than the European demand, so Bloomsbury
could raise the price more in the US rather than in Europe.
Question 9 - Two-part tariff

Suppose SAA offers the students the possibility to get the access
to swimming pool for which the demand curve is estimated to be
P = 40 − 2Q.
SAA faces a marginal cost M C = 2 and makes students pay an
annual subscription and, additionally, a price for the single entry.

Compute the two-part tariff that SAA would implement to

maximize profits.
Question 9 - Two-part tariff

Demand: P = 40 − 2Q.
Marginal cost M C = 2
Question 9 - Two-part tariff

Demand: P = 40 − 2Q.
Marginal cost M C = 2

The maximization rule tells us to set P = M C and then to ask a

subscription price equal to the consumer surplus.
Question 9 - Two-part tariff

Demand: P = 40 − 2Q.
Marginal cost M C = 2

The maximization rule tells us to set P = M C and then to ask a

subscription price equal to the consumer surplus.
Since P = M C = 2 , demand becomes
2 = 40 − 2Q → 2Q = 40 − 2 → Q = 19.
Question 9 - Two-part tariff

Demand: P = 40 − 2Q.
Marginal cost M C = 2

The maximization rule tells us to set P = M C and then to ask a

subscription price equal to the consumer surplus.
Since P = M C = 2 , demand becomes
2 = 40 − 2Q → 2Q = 40 − 2 → Q = 19.
Consumer surplus can be computed as CS = (40−2)·19
2 , where 40 is
the reservation price of consumers (you can always find it from the
demand function by setting Q = 0).
Question 9 - Two-part tariff

Demand: P = 40 − 2Q.
Marginal cost M C = 2

The maximization rule tells us to set P = M C and then to ask a

subscription price equal to the consumer surplus.
Since P = M C = 2 , demand becomes
2 = 40 − 2Q → 2Q = 40 − 2 → Q = 19.
Consumer surplus can be computed as CS = (40−2)·19
2 , where 40 is
the reservation price of consumers (you can always find it from the
demand function by setting Q = 0).
Then CS = 361 , which is the subscription price.
Question 10 - Bundling

The monopolist does not gain anything from bundling if:

(a) there are more goods than consumers
(b) demands are negatively correlated
(c) demands are positively correlated
(d) it’s not possible to do a mixed bundling
Question 10 - Solution: C

The monopolist does not gain anything from bundling if:

(a) there are more goods than consumers
(b) demands are negatively correlated
(c) demands are positively correlated
(d) it’s not possible to do a mixed bundling
When demands are positively correlated, the costumer
willingnesses to pay are symmetric, that is, they both prefer the
same good and profits would be the same by selling the goods
separately (so bundling doesn’t give any gain).
Question 11 - Bundling
Suppose that Amazon is unsure whether to sell Prime Video and
Prime Music bundled together or separated. There are three types
of consumers: cinema fans (more interested in Prime Video),
musicians (interested in Prime Music) and generalists (interested in
both). The annual reservation prices (that is, the willingness to
pay) are as follows:
Type of user Number of users Prime Video Prime Music
Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

(a) What would be the profit in case of separate selling?

(b) What would be the profit in case of pure bundling?
(c) What would be the profit in case of mixed bundling?
(d) What is the best strategy for Amazon?
Question 11 - Separate selling

Type of user Number of users Prime Video Prime Music

Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

Prime Video: if PV = 50, then only cinema fans would buy it and
profits would be 40 · 50 = 2000, while if price decreases to 30 both
cinema fans and generalists would buy it, with profits equal to
30 · (40 + 20) = 1800. Since profits are higher in the first case,
Prime Video will be sold at PV = 50.
Question 11 - Separate selling

Type of user Number of users Prime Video Prime Music

Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

Prime Video: if PV = 50, then only cinema fans would buy it and
profits would be 40 · 50 = 2000, while if price decreases to 30 both
cinema fans and generalists would buy it, with profits equal to
30 · (40 + 20) = 1800. Since profits are higher in the first case,
Prime Video will be sold at PV = 50.
Prime Music: with a similar argument, we can find that in
equilibrium PM = 50 as well, with profits equal to 2000 and Prime
Music sold only to the musicians. Total profits would be then 4000.
Question 11 - Pure Bundling

Type of user Number of users Prime Video Prime Music

Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

Musicians and cinema fans would pay at maximum 50 for the

bundle (the sum of their two reservation prices for Prime Video
and Music), while generalists would reach even 60.
Question 11 - Pure Bundling

Type of user Number of users Prime Video Prime Music

Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

Musicians and cinema fans would pay at maximum 50 for the

bundle (the sum of their two reservation prices for Prime Video
and Music), while generalists would reach even 60.
If P = 50, everyone buy the bundle: profits are 100 · 50 = 5000.
Question 11 - Pure Bundling

Type of user Number of users Prime Video Prime Music

Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

Musicians and cinema fans would pay at maximum 50 for the

bundle (the sum of their two reservation prices for Prime Video
and Music), while generalists would reach even 60.
If P = 50, everyone buy the bundle: profits are 100 · 50 = 5000.
If P = 60, only generalists buy it: profits are 20 · 60 = 1200.
Question 11 - Pure Bundling

Type of user Number of users Prime Video Prime Music

Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

Musicians and cinema fans would pay at maximum 50 for the

bundle (the sum of their two reservation prices for Prime Video
and Music), while generalists would reach even 60.
If P = 50, everyone buy the bundle: profits are 100 · 50 = 5000.
If P = 60, only generalists buy it: profits are 20 · 60 = 1200.
The optimal strategy is to sell the bundle to everyone at P = 50:
in this case, profits would be even higher than separate selling
(5000 > 4000).
Question 11 - Mixed Bundling
Type of user Number of users Prime Video Prime Music
Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

In this case, Amazon can set the prices for single selling at
PV = PM = 50, so that cinema fans will buy only Prime Video
and musicians will buy only Prime Music, and the price for the
bundle at P = 60, so that generalists will buy it (and cinema fans
and musicians will have no incentive to buy the entire bundle).
Question 11 - Mixed Bundling
Type of user Number of users Prime Video Prime Music
Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

In this case, Amazon can set the prices for single selling at
PV = PM = 50, so that cinema fans will buy only Prime Video
and musicians will buy only Prime Music, and the price for the
bundle at P = 60, so that generalists will buy it (and cinema fans
and musicians will have no incentive to buy the entire bundle).

So, profits would become: (40 · 50) + (40 · 50) + (20 · 60) = 5200.
Question 11 - Mixed Bundling
Type of user Number of users Prime Video Prime Music
Cinema Fans 40 50e 0e
Musicians 40 0e 50e
Generalists 20 30e 30e

In this case, Amazon can set the prices for single selling at
PV = PM = 50, so that cinema fans will buy only Prime Video
and musicians will buy only Prime Music, and the price for the
bundle at P = 60, so that generalists will buy it (and cinema fans
and musicians will have no incentive to buy the entire bundle).

So, profits would become: (40 · 50) + (40 · 50) + (20 · 60) = 5200.

It comes out that:

Profits with mixed bundling = 5200
Profits with pure bundling = 5000
Profits with separate selling: 4000
Question 12 - Advertising

The optimal quantity of advertising should respect the following

condition:
(a) A
PQ = − ϵϵPA
PQ
(b) A = − ϵϵPA
(c) A
PQ = − ϵϵPA
PQ
(d) A = − ϵϵPA

Can you interpret the solution? What does it mean?

Question 12 - Solution: A

The optimal quantity of advertising should respect the following

condition:
(a) A
PQ
= − ϵϵA
P
PQ
(b) A = − ϵϵPA
(c) A
PQ = − ϵϵPA
PQ
(d) A = − ϵϵPA
Question 12 - Explanation

A ϵA
=−
PQ ϵP
The solution states that the proportion of advertising expenditure
A with respect to total revenue P Q must be proportional to the
sensitivity of demand to advertising but inversely related to price
demand sensitivity.
Indeed, when demand is very sensitive to advertising (elasticity ϵA
is high), then it does make a lot of sense to invest and spend in
advertising, since you’re attracting a lot of new consumers.
However, this expenditure may be useless when consumers are also
very sensitive to price (price elasticity ϵP is high as well): higher
advertising expenditure forces the firm to raise prices and this can,
in turn, make consumers fly away. Then, it would be better not to
invest in advertising but to keep prices lower.
Question 13 - TRUE OR FALSE

(a) A monopolist who does not discriminate can sell to those

consumers that are not reached by the monopolist who
discriminates.
(b) The discriminating monopolist generates more inefficiency,
compared to a standard monopolist, because it gains a larger
portion of the consumer surplus.
(c) With price discrimination, a consumer with high elastic
demand will pay a lower price than a consumer with a rigid
demand.
Question 13.a - TRUE OR FALSE

A monopolist who does not discriminate can sell to those

consumers that are not reached by the monopolist who
discriminates.

SOLUTION: FALSE, the opposite is true. The monopolist

decides to discriminate precisely because it intends to reach
extract consumer surplus from those consumers he previously
could not sell to.
Question 13.b - TRUE OR FALSE

The discriminating monopolist generates more inefficiency,

compared to a standard monopolist, because it gains a larger
portion of the consumer surplus.

SOLUTION: IT DEPENDS. We have seen that a 1st degree

price discrimination can vanish any inefficiency and
deadweight loss, but a 3rd degree price discrimination can
raise the size of the deadweight loss and create larger
inefficiency.
Question 13.c - TRUE OR FALSE

With price discrimination, a consumer with high elastic demand

will pay a lower price than a consumer with a rigid demand.

SOLUTION: TRUE, this is exactly what happens in a 3rd

degree discrimination. The monopolist will raise the price to
those who are not sensitive to it, that is, whose demand is
rigid and elasticity is lower.