ECON 308 Week 7 1 Spring 2011 March 08 2011 Monopoly Pricing Ch 7 1 The Demand facing the individual Firm The degree of competition facing the firm is reflected by the elasticity of demand The more close substitutes D 1 D4 the more elastic the demand facing the firm and the less the market power of the firm P P P D1 P D2 Q Q Oligopoly Monopoly D3 Q Monopolistic Comp D4 Q Perfect Competition Firms in the MOST competitive market D4 are called price takers and have no market power 1 All firms that are not in perfectly competitive markets face a downward sloping demand curve We can then use the monopoly model Price Searcher to represent the pricing behavior and production decision of all other firms 2 If demand is downward sloping marginal revenue is less then Price Demand Price Qty 10 1 9 2 8 3 7 4 6 5 Total Revenue Marginal Revenue 10 18 24 28 30 10 8 6 4 2 The marginal revenue addition to revenue from selling one more unit is less than price because to sell more you must lower the price to all buyers 3 The degree of competition facing the firm is reflected by the elasticity of demand With fewer competitors the demand is more inelastic steeper with more competitors it is more elastic flatter 4 The Monopoly model downward sloping demand curve Price Searcher Price Marginal Cost Demand Pm MC Marginal Revenue Qm Qty Time 5 The profit maximizing output is where MR MC just like for the price taker firm A The Price is above MR and therefore the price is above marginal cost MC B The monopolist will always set price in range where MR 0 and therefore demand is elastic 6 Measure of Monopoly Power The ratio of price to marginal cost is a measure of the market power of the firm The Lerner index Price Marginal Cost Price The index varies between zero zero market power and one The higher the index value the greater the ratio on P to MC and the greater the market power of the firm A For a straight line demand curve Total Revenue TR is always maximized at the midpoint of the curve At this point Marginal Revenue MR 0 It is at this point that Price Elasticity of demand is unitary Price Ed 1 Ed 1 Ed 1 Ed 1 Ed 1 Marginal Revenue DEMAND Quantity Time Period On the upper half of the demand curve demand is elastic therefore MR 0 and a decrease in price increases Total Revenue On the lower half of the demand curve demand is inelastic MR 0 and an increase in price will increase Total Revenue 2 As there are more similar products or substitutes the demand becomes more elastic and the marginal revenue becomes closer to price Price Marginal Cost MC Marginal Revenue Qty Time Period Price DEMAND MC Marginal Revenue Qty Time Period Price MC DEMAND Marginal Revenue Qty Time Period DEMAND Price MC Marginal Revenue Qty Time Period 4 3 In the infinitely elastic case Marginal Revenue equals price as the firm can sell its entire possible output at the market price and has no reason to lower price Price DEMAND MR P eq Qty Time Period 8 Monopoly Profits MC Price Pm Demand ATC Profit AC Marginal Revenue Qm Qty Time 9 Monopoly profits only occur if TR Pm x Qm is greater than TC AC x Qm There is nothing in being a monopoly that guarantees profits A The existence of profits will stimulate resource owners to produce similar products B As more close substitutes enter the market the demand facing the monopoly will decline and become more elastic This means competition will bring lower prices and lower profits There are no profits in the long run UNLESS the firm can limit competition 5 C Monopoly after competition from similar products MC Price ATC Pm Demand MR Qty Time Qm 10 Efficiency Dead Weight Loss from reduced output Price Marginal Cost Pm D MC MR Qm Qc Qty Time The monopolist produces at Qm so the units from Qm to Qc are not produced Since these units have a marginal cost of production that is less than the marginal value to buyers there is a potential efficiency loss of the shaded area MV MC 5 Sources of Monopoly power Barriers to entry A Absolute Cost Advantage Unique access to production technique or an essential imput B Natural Monopoly Economies of Scale C Product differentiation D Regulatory Barriers Patents copyrights franchise license 6 1 Monopoly Pricing Price Discrimination Multiple Price Policies Since many firms use multi part pricing the efficiency loss is most often overstated If firms can charge different prices for different units sold they may be able to increase output to the social optimum of Qc 1 First Degree Two part Tariff Charging different customers different prices i e moving down the demand curve a Auction b College scholarships c IBM punch cards d Polariod cameras film e Ink Jet Printer cartridges f Swiffer pads g Gillette razors 2 Second Degree Block Pricing Quantity Forcing Offering a schedule of prices to all buyers which successively lowers the price for additional units purchased Moving down each buyers individual demand a Tires Buy 3 get 4th free b Product prices medium16 oz 1 09 068125 oz large 22 oz 1 19 6 oz 0167 oz extra large 32 oz 1 29 10 oz 01 oz gulp 44 oz 1 49 12 oz 0167 oz 3 Third Degree Charging different prices to different groups according to different elasticity of Demand a Grocery coupons b Prescription drugs in different countries c Doctors medical Services d Newly Released unique products e Movies f Mail order catalogues new customer elastic g Freeway adjacent restaurant Ala Carte cheaper than combination h brand name mixers on sale at holiday times i Mattresses We will match any advertised competitor s price 4 Requires certain necessary conditions a Ability to identify and separate buyers by elasticity of demand b Collect different prices from the different buyers c Prevent Resale 5 Efficiency of Price Discrimination Multiple Price Policies Since many firms use multi part pricing the efficiency loss is most often overstated If firms can charge different prices for different units sold they may be able to increase output to the social optimum of Qc 7