Microeconomics (PGP-I)

Session 13, 14 and 15

Joysankar Bhattacharya
A Monopoly

Definition: A Monopoly Market consists of a single seller facing

many buyers.

The monopolist's profit maximization problem:

Max (Q) = TR(Q) - TC(Q)

where: TR(Q) = QP(Q) and P(Q) is the (inverse) market demand

curve.
The monopolist's profit maximization condition:

TR(Q) TC(Q)
Q = Q
MR(Q) = MC(Q)
2
A Monopoly – Profit Maximizing

• MR>MC, firm can increase Q and increase

profit

• MR<MC, firm can decrease quantity and

increase profit

• MR=MC , firm cannot increase profit.

Profit Maximizing Q: MR (Q*)  MC (Q*)

3
Marginal Revenue Curve and Demand

• To sell more units, a

monopolist has to
lower the price.
• Increase in profit is
Area III while
revenue sacrificed at a
higher price is Area I
• Change in TR equals
area III – area I

4
Marginal Revenue Curve and Demand

• Area III = price x change in quantity = P(ΔQ)

• Area I = – quantity x change in price = – Q (ΔP)
• Change in monopolist’s Total Revenue:
ΔTR = Area III – Area I
= P(ΔQ) + Q (ΔP)

TR PQ  QP P

MR    PQ
Q Q Q
5
Marginal Revenue

Marginal revenue has two parts:

• P: increase in revenue due to higher volume-
the marginal units
ΔP
• Q( ): decrease in revenue due to reduced
ΔQ
price of the inframarginal units.
• The marginal revenue is less than the price
that the monopolist can charge to sell that
quantity for any Q>0
6
Average Revenue

Since TR PxQ
AR   P
Q Q
The price a monopolist can charge to sell
quantity Q is determined by the market
demand curve ; the monopolists’ average
revenue curve is the market demand curve.
AR(Q)  P(Q)

7
Marginal Revenue and Average Revenue

• Conclusions if Q > 0:
• MR < P
• MR < AR
• MR lies below the demand curve.

8
Marginal Revenue and Average Revenue
• Given the demand curve, what are the average and
marginal revenue curves?
P  a  bQ AR  a  bQ
P P
MR(Q)  P  Q  b
Q Q

MR  a  bQ  Q(b)
 a  2bQ
Vertical intercept is a
a
Horizontal intercept is Q 
2b
9
Marginal Revenue
Price Price
Competitive Firm Monopolist

Demand facing firm Demand facing firm

P0 P0
P1 C

A B A B

q q+1 Firm output Q0 Q0+1 Firm output

10
Marginal Revenue Curve and Demand
Price
The MR curve lies below the demand curve.

P(Q0)

MR(Q0) P(Q), the (inverse) demand curve

MR(Q), the marginal revenue curve

Q0 Quantity
11
A Monopoly – Profit Maximizing

• As Q increases TC
increases, TR
increases first and
then decreases.
• Profit
Maximization is at
MR = MC

12
Shutdown Condition

In the short run, the monopolist shuts down

if the most profitable price does not
cover AVC. In the long run, the monopolist
shuts down if the most profitable price
does not cover AC.

13
Positive Profits for Monopolist

This profit is positive. Why? Because the monopolist

takes into account the price-reducing effect of
increased output so that the monopolist has less
incentive to increase output than the perfect
competitor.

Profit can remain positive in the long run. Why?

Because we are assuming that there is no possible
entry in this industry, so profits are not competed
away.

14
Equilibrium

A monopolist does not have a supply curve

(i.e., an optimal output for any exogenously-
given price) because price is endogenously-
determined : the monopolist picks a preferred
point on the demand curve.

One could also think of the monopolist choosing

output to maximize profits subject to the
constraint that price be determined by the
demand curve.
15
Inverse Elasticity Pricing Rule

We can rewrite the MR curve as follows:

P
MR = P + Q ( )
Q

P Q
= P{1 + (Q )( P ) }

1
= P (1 – )


Q P
where:  is the price elasticity of demand, – ( P )( Q )
16
Inverse Elasticity Pricing Rule

Using this formula:

• When demand is elastic ( > 1), MR > 0

• When demand is inelastic ( < 1), MR < 0

• When demand is unit elastic ( = 1), MR= 0

17
Elasticity Region of the Linear Demand Curve

Price

a
Elastic region ( > 1), MR > 0

Unit elastic (=-1), MR=0

Inelastic region ( < 1), MR<0

a/2b a/b
Quantity
18
Marginal Cost and Price Elasticity Demand

• Profit maximizing condition is MR = MC with

P* and Q* MR (Q*)  MC (Q*)
 1 

MC (Q*)  P * 1  
  
 Q,P 

• Rearranging and setting MR(Q*) = MC(Q*)

P * MC * 1

P*  Q, P

19
Market Power

Definition: An agent has Market Power if s/he

can affect, through his/her own actions, the price
that prevails in the market. Sometimes this is
thought of as the degree to which a firm can
raise price above marginal cost.

20
Cartel

Definition: A cartel is a group of firms

that collusively determine the price and
output in a market. In other words, a
cartel acts as a single monopoly firm that
maximizes total industry profit.

21
The Welfare Economies of Monopoly

Since the monopoly equilibrium output does not, in

general, correspond to the perfectly competitive
equilibrium it entails a dead-weight loss.

Suppose that we compare a monopolist to a

competitive market, where the supply curve of the
competitors is equal to the marginal cost curve of the
monopolist

22
The Welfare Economies of Monopoly

CS with competition: A+B+C ; CS with monopoly: A

PS with competition: D+E ; PS with monopoly: B+D

A MC
PM
B
PC C DWL = C+E
E
D

Demand
MR
QM QC
23
Capturing Consumer Surplus
If a firm can charge only one price for
all its customers, that price will be P*
and the quantity produced will be Q*.
Ideally, the firm would like to charge
a higher price to consumers willing
to pay more than P*, thereby
capturing some of the consumer
surplus under region A of the demand
curve.
The firm would also like to sell to
consumers willing to pay prices
lower than P*, but only if doing so
does not entail lowering the price to
other consumers.
In that way, the firm could also
capture some of the surplus under
region B of the demand curve.
● Price Discrimination Practice of charging different
prices to different consumers for similar goods.
Price Discrimination

First-Degree Price Discrimination

Firms usually don’t know the

reservation price of every
consumer, but sometimes
reservation prices can be
roughly identified.
Here, six different prices are
charged. The firm earns
higher profits, but some
consumers may also benefit.
With a single price P*4, there
are fewer consumers.
Price Discrimination

Second-Degree Price Discrimination

● Second-degree Price Discrimination Practice of charging different
prices per unit for different quantities of the same good or service.

● Block Pricing Practice of charging different prices for different

quantities or “blocks” of a good.
Different prices are charged for
different quantities, or
“blocks,” of the same good.
Here, there are three blocks,
with corresponding prices P1,
P2, and P3.
There are also economies of
scale, and average and
marginal costs are declining.
Second-degree price
discrimination can also make
consumers better off by this
expansion of output
Price Discrimination

Third-Degree Price Discrimination

● Practice of dividing consumers into two or more groups with
separate demand curves and charging different prices to each group.

Creating Consumer Groups

If third-degree price discrimination is feasible, how should the firm
decide what price to charge each group of consumers?

1. We know that however much is produced, total output should be

divided between the groups of customers so that marginal
revenues for each group are equal.

2. We know that total output must be such that the marginal revenue
for each group of consumers is equal to the marginal cost of
production.
Price Discrimination

Third-Degree Price Discrimination

(11.1)

Determining Relative Prices

(11.2)
Price Discrimination

Third-Degree Price Discrimination

Consumers are divided into two

groups, with separate demand
curves for each group. The
optimal prices and quantities are
such that the marginal revenue
from each group is the same and
equal to marginal cost.
Here group 1, with demand
curve D1, is charged P1,
and group 2, with the more
elastic demand curve D2, is
charged the lower price P2.
Marginal cost depends on the
total quantity produced QT.
Note that Q1 and Q2 are chosen
so that MR1 = MR2 = MC.
The Economics of Coupons and Rebates

Coupons provide a means of price

discrimination.

Studies show that only about 20 to

30 percent of all consumers
regularly bother to clip, save, and
use coupons.

Rebate programs work the same way.

Only those consumers with relatively price-sensitive

demands bother to request rebates.

Again, the program is a means of price discrimination.

Airline Fares

Travelers are often amazed at the variety of fares available for round-
trip flights

These fares provide a profitable form of price discrimination. The

gains from discriminating are large because different types of
customers, with very different elasticities of demand, purchase these
different types of tickets.
Elasticities of Demand for Air Travel

FARE CATEGORY

Elasticity Business Economy Discounted

Price −0.3 −0.4 −0.9

Income 1.2 1.2 1.8
Intertemporal Price Discrimination
and Peak-load Pricing

● Intertemporal Price Discrimination Practice

of separating consumers with different demand
functions into different groups by charging
different prices at different points in time.

● Peak-load Pricing Practice of charging higher

prices during peak periods when capacity
constraints cause marginal costs to be high.
Intertemporal Price Discrimination
and Peak-load Pricing
Intertemporal Price Discrimination

Consumers are divided into

groups by changing the price
over time.

Initially, the price is high.

The firm captures surplus
from consumers who have a
high demand for the good
and who are unwilling to
wait to buy it.

Later the price is reduced to

appeal to the mass market.
Intertemporal Price Discrimination
and Peak-load Pricing

Peak-Load Pricing

Demands for some goods and

services increase sharply
during particular times of
the day or year.

Charging a higher price P1

during the peak periods is
more profitable for the firm
than charging a single price at
all times.

It is also more efficient

because marginal cost is
higher during peak periods.
How to Price a Best-Selling Novel

Publishing both hardbound and paperback editions of

a book allows publishers to price discriminate.

Some consumers want to buy a new bestseller as

soon as it is released, even if the price is $25.
Other consumers, however, will wait a year until
the book is available in paperback for $10.

Devoted fans of the Harry Potter series dressed in

costume and lined up for hours !!!

The key is to divide consumers into two groups, so that those who are willing to pay a
high price do so and only those unwilling to pay a high price wait and buy the
paperback.

It is clear, however, that those consumers willing to wait for the paperback edition
have demands that are far more elastic than those of bibliophiles.

It is not surprising, then, that paperback editions sell for so much less than hardbacks.