Microeconomics
Claudia Vogel
EUV
Winter Term 2009/2010
Claudia Vogel (EUV)
Microeconomics
Winter Term 2009/2010
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Winter Term 2009/2010
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Market Power: Monopoly and Monopsony
Lecture Outline
Part III Market Structure and Competitive Strategy
10 Market Power: Monopoly and Monopsony
Monopoly
The Social Costs of Monopoly Power
Monopsony
Summary
11 Pricing with Market Power
Capturing Consumer Surplus
Price Discrimination
Summary
Claudia Vogel (EUV)
Microeconomics
Market Power: Monopoly and Monopsony
Market Power: Monopoly and Monopsony
monopoly:
Market with only one seller
monopsony:
Market with only one buyer
market power:
Ability of a seller or buyer to aect the price of a good.
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Microeconomics
Market Power: Monopoly and Monopsony
Winter Term 2009/2010
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Monopoly
Monopoly
marginal revenue:
Change in revenue resulting from a from a one-unit
increase in output.
To see the relationship among total, average, and marginal revenue, consider a
rm facing the following demand curve:
P =6−Q
Total
Marginal
Average
Price (P)
Quantity (Q)
Revenue (R)
Revenue (MR)
Revenue (AR)
$6
0
0
5
1
5
$5
$5
4
2
8
3
4
3
3
9
1
3
2
4
8
-1
2
1
5
5
-3
1
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Market Power: Monopoly and Monopsony
Monopoly
Average Revenue and Marginal Revenue
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Microeconomics
Market Power: Monopoly and Monopsony
Winter Term 2009/2010
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Monopoly
The Monopolist's Output Decision 1/2
Prot is maximized when marginal revenue equals marginal cost.
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Market Power: Monopoly and Monopsony
Monopoly
The Monopolist's Output Decision 2/2
We can also see algebraically that
Q∗
maximizes prot. Prot
between revenue and cost, both of which depend on
Q:
π
is the dierence
π (Q ) = R (Q ) − C (Q )
As
Q
is increased from zero, prot will increase until it reaches a maximum and
then begin to decrease. Thus a prot-maximizing Q is such that the incremental
prot resulting from a small increase in Q is just zero (i.e.,
4π/4Q = 0).
Then
4R
4C
4π
=
−
=0
4Q
4Q
4Q
But
4R /4Q
is marginal revenue and
4C /4Q
is marginal cost. Thus the
prot-maximizing condition is that:
MR = MC
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Market Power: Monopoly and Monopsony
Winter Term 2009/2010
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Monopoly
Example of Prot Maximization
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Microeconomics
Market Power: Monopoly and Monopsony
Monopoly
Shifts in Demand
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Market Power: Monopoly and Monopsony
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Monopoly
The Eect of a Tax
Suppose a specic tax of t dollars per unit is levied, so that the monopolist must
remit t dollars for the government for every unit it sells. If MC was the rm's
original marginal cost, its optimal production decision is now given by
MR = MC + t
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Microeconomics
Winter Term 2009/2010
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Market Power: Monopoly and Monopsony
The Social Costs of Monopoly Power
Sources of Monopoly Power
When only few rms account for most of the sales in a market, we say that the
market is highly concentrated.
barrier to entry:
Condition that impedes entry by new competitors.
The elasticity of market demand limits the potential monopoly power of individual
producers.
Even if only two or three rms are in the market, each rm will be unable to
protably raise price very much if the rivalry among them is aggressive, with each
rm trying to capture as much of the market as it can.
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Microeconomics
Market Power: Monopoly and Monopsony
Winter Term 2009/2010
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The Social Costs of Monopoly Power
Deadweight Loss from Monopoly Power
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Microeconomics
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Market Power: Monopoly and Monopsony
The Social Costs of Monopoly Power
Price Regulation
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The Social Costs of Monopoly Power
Natural Monopoly
natural monopoly:
Firm that can produce the entire output of the market
at a cost lower than what it would be if there were several rms.
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Market Power: Monopoly and Monopsony
Monopsony
Monopsony
oligopsony:
Market with only a few buyers.
monopsony power:
marginal value:
Buyer's ability to aect the price of a good.
Additional benet derived from purchasing one more unit of
a good.
marginal expenditure:
average expenditure:
Claudia Vogel (EUV)
Additional cost of buying one more unit of a good.
Price per unit of a good.
Microeconomics
Market Power: Monopoly and Monopsony
Winter Term 2009/2010
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Monopsony
Competitive Buyer Compared to Competitive Seller
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Microeconomics
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Market Power: Monopoly and Monopsony
Monopsony
Monopsonist Buyer
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Market Power: Monopoly and Monopsony
Winter Term 2009/2010
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Monopsony
Monopsony and Monopoly Compared
Claudia Vogel (EUV)
Microeconomics
Market Power: Monopoly and Monopsony
Monopsony
Sources of Monopsony Power
Elasticity of Market Supply
If only one buyer is in the market - a pure monopsonist - its monopsony power is
completely determined by the elasticity of market supply. If supply is highly
elastic, monopsony power is small and there is little gain in being the only buyer.
Number of Buyers
When the number of buyers is very large, no single buyer can have much inuence
over price. Thus each buyer faces an extremely elastic supply curve, so that the
market is almost completely competitive.
Interaction Among Buyers
If few buyers in a market compete aggressively, they will bid up the price close to
their marginal value of the product, and will thus have little monopsony power.
On the other hand, if those buyers compete less aggressively, or even collude,
prices will not be bid up very much, and the buyers' degree of monopsony power
might be nearly as high as if there were only one buyer.
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Microeconomics
Market Power: Monopoly and Monopsony
Winter Term 2009/2010
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Monopsony
The Social Costs of Monopsony Power
Claudia Vogel (EUV)
Microeconomics
Market Power: Monopoly and Monopsony
Summary
Summary
Market power is the ability of sellers or buyers to aect the price of a good.
Market power comes in two forms. When sellers charge a price that is above
marginal cost, we say that they have monopoly power, which we measure by
the extent to which price exceeds marginal cost. When buyers can obtain a
price below their marginal value of the good, we say they have monopsony
power, which we measure by the extent to which marginal value exceeds price.
Market power can impose costs on society. Because monopoly and
monopsony power both cause production to fall below the competitive level,
there is a deadweight loss of consumer and producer surplus. There can be
additional costs from rent seeking.
Sometimes, scale economies make pure monopoly desirable. But the
government will still want to regulate price to maximize social welfare.
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Microeconomics
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Winter Term 2009/2010
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Pricing with Market Power
Lecture Outline
Part III Market Structure and Competitive Strategy
10 Market Power: Monopoly and Monopsony
Monopoly
The Social Costs of Monopoly Power
Monopsony
Summary
11 Pricing with Market Power
Capturing Consumer Surplus
Price Discrimination
Summary
Claudia Vogel (EUV)
Microeconomics
Pricing with Market Power
Capturing Consumer Surplus
Capturing Consumer Surplus
If a rm can charge only one price for all
its customers, that price will be P ∗ and
the quantity produced will be Q ∗ . Ideally,
the rm 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 rm would also like to sell to consumers
willing to pay prices lower than P ∗ , but only
doing so does not entail lowering the prive to
other consumers.
In that way, the rm could also capture some
of the surplus under region B of the demand
curve.
price discrimination:
Practice of charging dierent prices to dierent
consumers for similar goods.
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Microeconomics
Pricing with Market Power
Winter Term 2009/2010
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Price Discrimination
First-Degree Price Discrimination
reservation price:
Maximum price
that a customer is willing to pay for
a good.
rst-degree price discrimination:
Practice of charging each customer
her reservation price.
variable prot:
Sum of prots on
each incremental unit produced by a
rm; i.e. prot ignoring xed costs.
Perfect Price Discrimination
The additional prot from producing and selling an incremental unit is now the
dierence between demand and marginal cost.
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Microeconomics
Winter Term 2009/2010
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Pricing with Market Power
Price Discrimination
Second-Degree Price Discrimination
second-degree price
discrimination: Practice of
charging dierent prices per unit for
dierent quantities of the same
good or service.
block pricing:
Practice of charging
dierent prices for dierent
quantities or blocks of a good.
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Microeconomics
Pricing with Market Power
Winter Term 2009/2010
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Price Discrimination
Third-Degree Price Discrimination 1/2
third-degree price discrimination:
Practice of dividing consumers into two
or more groups with separate demand curves and charging dierent prices to
each group.
Creating Consumer Groups
π = P1 Q1 + P2 Q2 − (QT )
4π
4P1 Q1
4C
=
−
=0
4Q 1
4Q 1
4Q1
MR1 = MC
MR2 = MC
MR1 = MR2 = MC
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Microeconomics
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Pricing with Market Power
Price Discrimination
Third-Degree Price Discrimination 2/2
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Microeconomics
Pricing with Market Power
Winter Term 2009/2010
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Summary
Summary
Firms with market power are in enviable position because they have the
potential to earn large prots. Realizing that potential, however, may depend
critically on pricing strategy. Even if the rm sets a single price, it needs an
estimate of the elasticity of demand for its output. More complicated
strategies, which can involve setting several dierent prices, require even
more information about demand.
A pricing strategy aims to enlarge the customer base thatthe rm can sell to
and capture as much consumer surplus as possible. There are a number of
ways to do this, and they usually involve setting more than a single price.
Ideally, the rm would like to price discriminate perfectly - i.e., to charge
each customer his or her reservation price. In practice, this is almost always
impossible. On the other hand, various forms of imperfect price
discrimination are often used to increase prots.
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Microeconomics
Winter Term 2009/2010
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Exerxises 9
Problem 1
1
Why might a rm have monopoly power even if it is not the only producer in
the market?
2
What are some of the dierent types of barriers to entry that give rise to
monopoly power? Give an example.
3
What factors determine the amount of monopoly power an individual rm is
likely to have? Explain briey.
4
Why is there a social cost to monopoly power? If the gains to producers from
monopoly power could be redistributed to consumers, would the social cost of
monopoly power be eliminated?
5
Why will a monopolist's output increase if the government forces it to lower
its price? If the government wants to set a price ceiling that maximizes the
monopolist's output, what price should it set?
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Microeconomics
Winter Term 2009/2010
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Exerxises 9
Problem 2
1
How should a monopsonist decide how much of a product to buy? Will it buy
more or less than a competitive buyer?
2
What are some sources of monopsony power? what determines the amount
of monopsony power an individual rm is likely to have?
3
Why is there a social cost to monopsony power? If the gains to buyers from
monopsony power could be redistributed to sellers, would the social cost of
monopsony power be eliminated?
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Microeconomics
Winter Term 2009/2010
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Exerxises 9
Problem 3
The following table shows the demand curve facing a monopolist who produces at
a constant marginal cost of $10:
Price
Quantity
18
0
1
Calculate the rm's marginal revenue curve.
16
4
2
14
8
What are the rm's prot maximizing output and
12
12
10
16
8
20
6
24
4
28
were forced to produce and price at the competitive
2
32
equilibrium? Who would gain and lose as a result?
0
36
price? What is its prot?
3
What would the equilibrium price and quantity be in
a competitive industry?
4
What would the social gain be if this monopolist
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Microeconomics
Winter Term 2009/2010
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Exerxises 9
Problem 4
1
Suppose a rm can practice perfect, rst-degree price discrimination. What is
the lowest price it wioll charge, and what will its total output be?
2
Electric utilities often practice second-degree price discrimination. why might
this improve consumer welfare?
3
Give some examples of third-degree price discrimination. Can third-degree
price discrimination be eective if the dierent groups of consumers have
dierent levels of demand but the same price elasticity?
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Microeconomics
Winter Term 2009/2010
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Exerxises 9
Problem 5
Price discrimination requires the ability to sort customers and the ability to
prevent arbitrage. Explain how the following can function as price discrimination
schemes and discuss both sorting and arbitrage:
1
Requiring airline travelers to spend at least one Staurday night away from
home to qualify for a low fare.
2
Oering temporary price cuts on bathroom tissue.
3
Charging high-income patients more than low-income patients for plastic
surgery
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Microeconomics
Winter Term 2009/2010
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Exerxises 9
Problem 6
Elizabeth Airlines (EA) ies only one route: Chicago-Honolulu. The demand for each ight is
Q = 500 − P . EA's cost of running each ight is $30000 plus $100 per passenger.
1
What is the prot-maximizing price that EA will charge? How many people will be on each
ight? What is EA's prot for each ight?
2
EA learns that the xed costs per ight are in fact $41000 instead of $30000. Will the
airline stay in business for long? Illustrate your answer using a graph of the demand curve
that EA faces, EA's average cost curve when xed costs are $30000, and EA's average cost
curve when xed costs are $41000.
3
EA nds out that two dierent types of people y to Honolulu. Type A consists of business
people with demand of QA = 260 − 0.4P . Type B consists of students whose total demand
is QB = 240 − 0.6P . Because the students are easy to spot, EA decides to charge the
dierent prices. Graph each of these demand curves and their horizontal sum. What price
does EA charge the students? What price does EA charge other customers? How many of
each are on each ight?
4
What would EA'S prot be for each ight? Would the airline stay in business? Calculate
the consumer surplus for each group. What is the total consumer surplus?
5
Before EA started price discriminating, how much consumer surplus was the Type A
demand getting from air travel to Honolulu? Type B? Why did total consumer surplus
decline with price discrimination, even though total quantity sold remained unchanged?
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Microeconomics
Winter Term 2009/2010
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