Econ 201Lecture 7.1

Market Failure:Monopoly

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Because they have market power, monopolists could practice price discrimination. ◦ Price discrimination

separate customers into groups based on willingness to pay,

then charging each group a different price set at their different maximum willingness-to-pay.

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Price Discrimination

Under first-degree price discrimination, each customer is charged the highest price they are willing and able to pay.◦ Example: Dutch auction◦ The monopolist can capture the entire consumer

surplus.◦ Apple: IPod releases

Initial high price Price lowered 6 months later

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First-Degree Price Discrimination

$100

8070

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Price ofAlbums

Measuring consumer surplus with the demand curve

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4

In panel (a), the price of the good is $80, and the consumer surplus is $20. In panel (b), the price of the good is $70, and the consumer surplus is $40.

0 431 2Quantity of Albums

John’s consumersurplus ($20)

Demand

(a) Price = $80

$100

8070

50

Price ofAlbums

0 431 2Quantity of Albums

John’s consumersurplus ($30)

(b) Price = $70

Paul’s consumersurplus ($10)

Total consumersurplus ($40)

Demand

Welfare with and without price discrimination

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5

Price

Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus, and lowers consumer surplus.

Quantity0

(a) Monopolist with Single Price

Price

Quantity0

(b) Monopolist with Perfect Price Discrimination

Profit

Consumersurplus

Deadweightloss

Monopolyprice

Quantitysold

Marginalrevenue

Demand

Marginal cost

Quantitysold

Profit

Demand

Marginal cost

Price Discrimination Lessons from perfect price discrimination

1. Rational strategy Increase profit Charges each customer a price closer to his or her

willingness to pay Sell more than is possible with a single price

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Price Discrimination Lessons from price discrimination

2. Requires the ability to separate customers according to their willingness to pay

Certain market forces can prevent firms from price discriminating Arbitrage – buy a good in one market, sell it in other market

at a higher price3. Can raise economic welfare Can eliminate the inefficiency of monopoly pricing

More consumers get the good Higher producer surplus (higher profit)

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Price Discrimination The analytics of price discrimination Perfect price discrimination

Charge each customer a different price Exactly his or her willingness to pay

Monopolist - gets the entire surplus (Profit) No deadweight loss

Without price discrimination Single price > MC Consumer surplus Producer surplus (Profit) Deadweight loss

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Second-degree price discrimination occurs when firms sell their product at a discount when consumers buy large quantities.◦ Example: Electricity prices?◦ Costco/Sam’s Club – “Big Box Stores”

http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=second-degree+price+discrimination

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Second-Degree Price Discrimination

Under third-degree price discrimination, a firm charges different prices in different markets for their product.◦ The most common form of price discrimination ◦ Examples include:

Children's discounts Senior citizen’s discounts Airfares Different geographic markets (Madison Park, U District)

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Third-Degree Price Discrimination

Classic categorization of monopolies◦ 3 levels of price discrimination

First degree (Perfect Price Discrimination) Extract almost all of the Consumer Surplus

Able to get a different price for each unit sold Moves consumer along the Demand Curve

Second degree Provide quantity discounts; but have to buy in blocks, with

each larger block having a lower price than the last Third degree

Different prices for same good in different markets In all cases, it is necessary to prevent

resale and new entrants

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More Complex Monopoly Pricing Schemes

Choose Qs based ◦ MR = MC for market demand

Set price for each segment◦ Equating MC(market) to MR for each segment◦ Setting price for Qs (segment)

Zone pricing◦ Gas stations?◦ Grocery stores?◦ Senior citizen discounts?

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Third Degree Price Discrimination

Setting separate prices in each market http://www.nowsell.com/marketing-guide/price-discrimination.html

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Third Degree Price Discrimination

Perfect Price Discrimination: 1st degree Block Pricing: 2nd degree Zone Pricing: 3rd degree Tie-in Sales Predatory Pricing Dumping All aimed at extracting Consumer Surplus

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Other Monopolist Pricing Strategies

To be a successful price discriminator, a seller must satisfy three conditions: ◦ (1) to have market control and be a price maker, ◦ (2) to identify two or more groups that are willing

to pay different prices, and ◦ (3) to keep the buyers in one group from reselling

the good to another group.

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To Be Able to Do Price Discrimination

A seller charging competing buyers different prices for the same "commodity" or discriminating in the provision of "allowances" -- compensation for advertising and other services -- may be violating the Robinson-Patman Act. This kind of price discrimination may hurt competition by giving favored customers an edge in the market that has nothing to do with the superior efficiency of those customers. However, price discriminations generally are lawful, particularly if they reflect the different costs of dealing with different buyers or result from a seller’s attempts to meet a competitor’s prices or services.

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A Word from the FTC on Discriminatory Pricing

A tie-in sale:◦ consumer can only obtain the desired good

(tying good) if he agrees also to purchase a different good (tied good) from the producer.

◦ What it accomplishes:◦ (1) the tie-in can be a substitute for a lump sum

payment tailored to extract the consumer’s surplus in the tying good market;

◦ (2) the tie-in serves to price discriminate among types of consumers having different demand elasticities;

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Tie-In Sales

Lower the price in the more demand elastic market

Raise price above MC in the more inelastic market

Cellular industry◦ Price < Cost for SmartPhone

2-year contract at P > MC for service Can’t unlock phone – barrier to entry/exit

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Optimal Pricing Strategyfor a Tie-in Sale

So optimal pricing strategy◦ Underprice computers in order to sell at a single

price to both high and low demand customers◦ Price cards at > MC in order to extract CS

Boeing ◦ Airplane market was more competitive◦ WTP correlated with miles◦ Tied-in on-board navigational systems

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IBM Example

Automobile warranties◦ Cars bought/sold in a competitive marketplace◦ Warranty maintenance must be performed at

dealer’s or authorized shop (costs > MC?) Soda (other goods) at Gas stations

◦ Gas bought/sold in a more competitive market◦ Soda prices > MC

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Other Examples

Predatory pricing ◦ firm sells a product at very low price attempting

to drive competitors out of the market, or create a barrier to entry for potential new

competitors. If the other firms cannot sustain equal or lower prices

without losing money, they go out of business. ◦ The predatory pricer then has fewer

competitors or even a monopoly, allowing it to raise prices above what the market would otherwise bear.

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Predatory Pricing

In many countries, including the United States, predatory pricing is considered anti-competitive and is illegal under antitrust laws.

Usually difficult to prove that a drop in prices is due to predatory pricing rather than normal competition

Predatory pricing claims are difficult to prove due to high legal hurdles designed to protect legitimate price competition.

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Predatory Pricing

Rockefeller’s Standard Oil Monopoly (1911) The efficiencies of economies of scale and vertical integration

caused the prices of refined petroleum to fall from over 30 cents a gallon in 1869 to 10 cents by 1874 and to 5.9 cents by 1897. During the same period, Rockefeller reduced his average costs from 3 cents to 0.29 cents per gallon.

Contrary to popular mythology, Standard Oil’s market share declined from 88 percent in 1890 to 64 percent by 1911. Because of intense competition the company's oil production as a percentage of total market supply had declined to a mere 11 percent in 1911, down from 3 percent in 1898.

McGee shows that rather than practicing predatory pricing. Std Oil was able to build its monopoly through the purchase of other refineries.

McGee, John S. "Predatory Price Cutting: The Standard Oil (N.J.) Case."J. Law and Econ. 1 (October 1958): 137-69.

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The Standard Oil Case

McGee, John, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics Vol 1 (April 1958)

Buy out other gas stations at a price higher than the competitive value, based on possible future monopolistic value

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Another Explanation

"dumping" can refer to any kind of predatory pricing. Term is now generally used only in the context of

international trade law, where dumping is defined as the act of a manufacturer in one country exporting a product to another country at a price which is either below the price it charges in its home market or is below its costs of production.

The term has a negative connotation, but advocates of free markets see "dumping" as beneficial for consumers and believe that protectionism to prevent it would have net negative consequences.

Advocates for workers and laborers however, believe that safeguarding businesses against predatory practices, such as dumping, help alleviate some of the harsher consequences of free trade between economies at different stages of development

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Dumping

Economically inefficient◦ Deadweight loss

Higher price and lower quantity demanded/supplied◦ Transfer losses

From CS to PS Economists have no opinion

Pareto efficient◦ No/less incentive for innovation

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What’s the Downside to Monopolies?

Monopoly rents attract entry of other firms◦ First mover advantage

monopolies tend to become less efficient and innovative over time, ◦ complacent giants", do not have to be efficient or innovative to

compete in the marketplace One of the arguments advanced by AT&T for deregulating the

Telecomm industry in 1996 Availability in the longer term of substitutes in other markets. For

example, a canal monopoly, while worth a great deal in the late eighteenth century United Kingdom, was worth much less in the late nineteenth century because of the introduction of railways as a substitute.

However, loss of efficiency can raise a potential competitor's value enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives.

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Factors Working Against Persistence

The theory of contestable markets argues that in some circumstances (private) monopolies are forced to behave as if there were competition because of the risk of losing their monopoly to new entrants.

This is likely to happen where a market's barriers to entry are low.

Single supplier does not necessarily mean there is a monopoly◦ Firm may behave as though its in a competitive

market

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Does a Single Supplier Always Mean There is a Monopoly?

Natural Monopolies (monopolies of scale)◦ When monopolies are not broken through the

open market, often a government will step in, regulate the monopoly, turn it into a publicly owned

monopoly, forcibly break it up (see Antitrust law). Public utilities, Natural monopolies are less susceptible to efficient

breakup, strongly regulated or publicly owned. AT&T and Standard Oil are debatable examples of the

breakup of a private monopoly. When AT&T was broken up into the "Baby Bell" components, MCI, Sprint, and other companies were able to compete effectively in the long distance phone market and began to take phone traffic from the less efficient AT&T.

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Natural Monopolies