Tutorial Chapter 11

Pricing with Market Power

Federico De Andrea

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

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 ob-
serve:

(a) higher quantity, higher price

(b) higher quantity, lower price

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 (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

In this case, the monopolist is able to extract the entire consumer surplus
and to maximize its own producer surplus.
The paradox is that he leaves no deadweight loss: this implies that first
price discrimination is as efficient as perfect competition, and then it is so-
cially 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.

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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?

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

(b) No, 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) We already know the consumers will get no surplus at all in first degree
price discrimination: CS = 0.

(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, and divided by 2:

(100 − 20) · 80 80 · 80
PS = = = 3200
2 2
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 (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) 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 con-

sumers

(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.

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Question 6 - Third degree price discrimination
In a third degree price discrimination, the optimal condition for the monop-
olist 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 Blooms-
bury Publishing. You need to decide how many copies (in millions) 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
M C = 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?

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 SOLUTION
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 PUC =
36−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 = = → DW LU = 32
2 2

• 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 PEC =
24−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 = = → DW LE = 12.5
2 2

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 • 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 →
DW L = 44.5

Question 8 - Third degree price discrimination

In a third degree price discrimination, a monopolist can discriminate com-
paring 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.

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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 suffers
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.
SOLUTION
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

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).

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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?

Let’s start from Prime Video: if price is 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.
Now consider 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.

(b) What would be the profit in case of pure bundling?

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 at maximum 60.
If P = 50, everyone can buy the bundle: profits are 100 · 50 = 5000.
If P = 60, only generalists decide to buy the bundle: profits become
20 · 60 = 1200.

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 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)

(c) What would be the profit in case of mixed bundling?

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.

(d) What is the best strategy for Amazon?

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
= − ϵϵA
P

PQ
(b) A
= − ϵϵPA

(c) A
PQ
= − ϵϵPA
PQ
(d) A
= − ϵϵPA

Can you interpret this equation? What does it mean?

Equation at point (a) states that the proportion of advertising expendi-

ture A with respect to total revenue P Q must be proportional to the sensitiv-
ity of demand to advertising but inversely related to price demand sensitivity.

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 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.
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.

(b) The discriminating monopolist generates more inefficiency, compared

to a standard monopolist, because it gains a larger portion of the con-
sumer surplus.
SOLUTION : IT DEPENDS. We have seen that a 1st de-
gree price discrimination can vanish any inefficiency and dead-
weight loss, but a 3rd degree price discrimination can raise the
size of the deadweight loss and create larger inefficiency.

(c) 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

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