Introductory Microeconomics
(ES10001)
Topic 5: Perfect Competition &
Monopoly
1
1. Introduction

MR = MC rule requires knowledge of market
structure

One of the major influences on MR, and thus on its
supply decision, is the degree of competitiveness
the firm faces in the market.

That is, the number of actual and potential
competitors
2
1. Introduction

This makes sense! If firm is the only player in
the market, then we would expect it to behave
differently than if it were one of (very) many

In what follows we will examine the causes
and effects of market structure
3
2. Taxonomy of Competition

Microeconomics has tended to categorise the degree
of competition a particular firm faces into three very
precise and distinct categories:

A lot;

A bit;

None!
4
Figure 1: Taxonomy of Competition
Perfect
Competition
More Competition
Monopoly
Imperfect
Competition
Less Competition
Monopolistic
Competition
Oligopoly
Collusive (i.e. Cartel)
Non-Collusive
5
3. Perfect Competition

Market structure where competitive forces are at
their greatest

Definition: A Perfectly Competitive (PC) market is
one in which both buyers and sellers believe that
their own buying or selling decisions have no effect
on the market price

Sometimes referred to as an ‘atomistic’ market
6
3. Perfect Competition

Formal Characteristics
1. (Very) Large number of buyers and sellers;
2. Homogenous product;
3. Free entry and exit (in long-run);
4. Perfect knowledge.

Implication: All firms face same, perfectly elastic,
demand curve
7
Figure 2: Perfectly Elastic Demand
p
S0
E0
d0
p0
D0
0
Q0
Industry
Q
q
Representative Firm
8
3. Perfect Competition

Why would firm not raise or lower price above or
below p0?

If p > p0, then it would sell nothing because
consumers have perfect knowledge and good is
homogenous

Conversely, no point in setting p < p0 since it can sell
as much as it wishes at p0
9
3. Perfect Competition

Firm’s demand curve is also its AR and MR curve

Recall:

AR = TR / q

MR = ΔTR / Δq

Since demand is perfectly elastic, AR = MR = p
10
Figure 3: Demand = AR = MR
p
5
0
E0
E1
d
1
2
q
11
Figure 3: Demand = AR = MR
p
E0
5
E1
d
TR1=5
AR1=5/1=5
0
1
2
q
12
Figure 3: Demand = AR = MR
p
5
E0
E1
d
TR2 =2*5=10
AR2=5/1=5
MR2 = TR2–TR1= 5
0
1
2
q
13
Figure 3: Demand = AR = MR
p
5
0
E0
E1
d = AR = MR
1
2
q
14
3. Perfect Competition

Consider short-run profit maximising rule

First, we know that to maximise profit we need to set
SMR = SMC

But ...
15
Figure 4: Optimal Output
p
SMC
p0
0
E0
E1
q0
q1
d = AR = MR
q
16
3. Perfect Competition

Consider short-run profit maximising rule

First, we know that to maximise profit we need to set
SMR = SMC

But, SMC must also be rising …

… otherwise, profit (loss) is minimised (maximised)
17
Figure 4: Optimal Output
p
SMC
π min
p0
0
E0
π max
E1
q0
q1
d = AR = MR
q
18
3. Perfect Competition

Thus, short-run profit maximising rule
(1) MR = SMC
(2) SMC is rising

But, it could always be in firm’s interest to produce
nothing!

Is there a ‘shut-down’ price?
19
Figure 5: Demand = AR = MR
p
π >0
SMC
Eo
p0
AR =MR
SAC
PROFIT
SAVC
SAC0
0
q0
q
20
Figure 6: Demand = AR = MR
p
π =0
SMC
SAC
SAVC
p1
0
E1
AR = MR
q1
q
21
Figure 7: Demand = AR = MR
p
- TFC < π < 0
SMC
SAC
E2
SAVC
SAC2
p2
0
LOSS < - TFC
MR
q2
q
22
3. Perfect Competition
Proof:
π(q) = TR – (TVC + TFC)
= (TR – TVC) – TFC
Thus:
p > AVC => p*q > AVC*q
=>
TR > TVC => (TR – TVC) > 0
Thus:
π(q) > π (0) = -TFC
23
Figure 8: Demand = AR = MR
p
π = - TFC < 0
SMC
SAC
E3
SAVC
SAC3
p3
0
LOSS
= TFC
AR = MR
q3
q
24
Figure 9: Demand = AR = MR
p
π < - TFC < 0
SMC
SAC
SAVC
SAC4
LOSS > TFC
p4
AR = MR
E4
0
q4
q
25
3. Perfect Competition

Thus, short-run profit maximising rule
MR = SMC
SMC is rising
p > SAVC

Supply curve of the firm is that part of its SMC curve
above minimum SAVC
26
Figure 8: Demand = AR = MR
p
π = - TFC < 0
SMC
SAC
E3
SAVC
SAC3
p3
0
LOSS
= TFC
AR = MR
q3
q
27
Figure 8:
p
SMC
SAVC
p3
0
AR = MR
q
28
Figure 8:
p
SR Supply
Min AVC
0
q
29
3. Perfect Competition

Note, short-run ‘shutdown’ price = p3 = SAVC(q3)

π(p3) = p3*q3 – SAC(q3)*q3
= [SAVC(q3) – SAC(q3)]*q3
= -AFC(q3)*q3
= -TFC
30
3. Perfect Competition

Thus, short-run supply curve of firm is that part of
its SMC above minimum AVC

Similarly, long-run supply curve is that part of
LMC above minimum LAC

i.e. long-run ‘shutdown’ option is to leave the
industry
31
Figure 10: Long-Run Shut-Down
p
LMC
p0
0
LAC
AR = MR
q0
q
32
3. Perfect Competition

Compare SR and LR supply curves

SR supply curve of firm is that part of its SMC
above minimum AVC; similarly, long-run supply
curve is that part of LMC above minimum LAC

i.e. LR ‘shutdown’ option is to leave the industry

Note that SR supply curve lays below LR supply
curve (recall ‘Envelope’) and is steeper
33
Figure 11: Long-Run & Short-Run Supply
p
SSR
Min LAC
SLR
p1
p0
Min AVC
0
q
34
3. Perfect Competition

SSR lays below SLR because LAC is envelope of
SAC’s and SAVC’s lay below SAC since SAC
includes AFC

SSR is steeper than SLR because it will always be less
costly for firm to increase output when it can alter
all inputs (i.e. K an L) appropriately (i.e. when it is
in LR)

Now, consider MR = MC condition
35
3. Perfect Competition

TR0 = p0q0
TR1 = p1q1

Thus:

ΔTR =TR1 - TR0 = p1q1 - p0q0
= p1q1 - p0q0 + (p1q0 - p1q0)
= p1q1 - p1q0 + p1q0 - p0q0
= p1(q1 - q0) + (p1 - p0)q0
36
3. Perfect Competition

ΔTR = p1(q1 - q0) + (p1 - p0)q0
= p1Δq + Δpq0

Thus:
DTR
Dp
º MR = p1 +
× q0
Dq
Dq

Consider ‘small’ changes in (p, q) such that p1 ≈ p0,
q1 ≈ q0 , and so (p0, p1) ≈ p and (q0, q1) ≈ q
37
3. Perfect Competition

Thus:
Dp
Dp
MR = p1 +
× q0 = p +
×q
Dq
Dq
Þ
æ
Dp q ö
MR = p ç 1+
× ÷
Dq p ø
è

Dq p
× >0
Now, recall: E = Dp q
38
3. Perfect Competition

Thus:
æ Dp q ö
æ
1ö
MR = p ç 1+
× ÷ = p ç 1- ÷
è Dq p ø
è Eø

Under perfect competition, E => ∞ such that MR
=> p

Also, since MR = MC in equilibrium, then:
æ
1ö
MC = p ç 1- ÷
è Eø
39
3. Perfect Competition

Thus:
æ
1ö
p
MC = p ç 1- ÷ = p E
è Eø
Þ
p
p - MC =
E
Þ
p - MC 1
=
p
E
40
3. Perfect Competition

Lerner (1934) ‘Index of Monopoly Power’
p - MC 1
=
p
E

Note that under perfect competition, E => ∞ such
that p => MC

Firms can only ‘mark-up’ p over MC iff E < ∞
41
Figure 12: Elasticity of Demand and
Slope of (Inverse) Demand Curve
p
Dq p
E=× >0
Dp q
E0
dc
Dp
Dqa
Dqb
0
da
db
q
42
3. Perfect Competition

Industry Supply

SR industry supply curve (when factor prices are
given) is the horizontal summation of each firm’s
SMC curve above minimum AVC

Similarly, LR industry supply curve (when factor
prices are given) is horizontal summation of each
firm’s LMC curve above minimum LAC
43
Figure 13: SR Industry Supply
p
p
Ssra = SMC
Q0 = 2q0
p
Q1 = 2q1
a
Q2 = 2q2
Ssrb = SMC b
SSR = å SMC
p2
p1
p0
0
q0
q1
q2
Firm A
qa 0
q0
q1 q2
Firm B
qb 0
Q0
Q1
Industry
Q2 Q
44
3. Perfect Competition

Consider effect of an exogenous increase in
industry demand for the good

Increase in demand will increase each existing
firm’s profit

Existing firms increase SR supply by moving up
their SMC curves
45
Figure 14a: SR Industry Supply
p
p
S
SMC
SR
0
SAC
e0
E0
p0
d0
D0
0
Q0
Industry
Q
q0
Representative Firm
q
46
Figure 14b: SR Industry Supply
p
p
S
SMC
SR
0
SAC
e1
E1
e0
E0
p0
d1
d0
D1
D0
0
Q0 Q1
Industry
Q
q0
q1
Representative Firm
q
47
3. Perfect Competition

But, the existence of super-normal profits will
attract other firms into the industry

This will shift out industry (SR) supply curve and
lead to a fall in the (perfectly elastic) demand
facing individuals firms

Industry supply is higher because of entry of new
firms; each firm produces same amount in new
equilibrium (E2) as original firms produced in
48
original equilibrium (E0)
Figure 14c: SR Industry Supply
p
p
S
SR
0
SMC
S1SR
SAC
e1
E1
E0
p0
e2 = e0
E2
d1
d0
D1
D0
0
Q0 Q1 Q2
Industry
Q
q0
q1
Representative Firm
q
49
3. Perfect Competition

LR supply curve of industry is horizontal /
perfectly elastic

LR supply price of industry is equal to minimum
LAC of constituent firms

Thus, demand only determines quantity; price is
supply (i.e. cost) determined)
50
Figure 15: LR Industry Supply
p
P
LMC
LAC
p*
e*
E*
SLR
D
0
q*
Representative Firm
q 0
Q*
Industry
Q
51
3. Perfect Competition

LR supply curve of industry is upward sloping in
two situations:
1. Factor prices increase with usage
2. Heterogeneous firms

Consider each in turn
52
3. Perfect Competition

Consider first the SR response of a representative
firm and the industry to an increase in demand

If factor prices increase with usage, then increase in
demand induces each firm to increase output along
its SMC curve

But, increase in industry supply of output increases
demand for / price of the variable input
53
3. Perfect Competition

Increase in price of variable input shifts up
vertically each firm’s SMC curve

The expansion of output by each firm can thus be
interpreted as a combination of a ‘movement
along’ and a ‘shift of’ its SMC curve

Similarly, the expansion of output by the industry combination of a ‘movement along’ / ‘shift of’ the
aggregation of constituent firms’ SMC curves
54
Figure 16: SR Industry Supply
Factor prices increase with usage
p
p
∑SSR
D1
SSR
∑SMC1
E1
e1
p1
SMC0
D0
SMC1
p0
0
∑SMC0
E0
e0
q0
q1
Representative Firm
q
Q0
Q1
Industry
Q
55
3. Perfect Competition

In LR, free entry / exit implies each firm produces
at minimum LAC

If firms are equally efficient, then firms have same
minimum LAC and industry supply is perfectly
elastic

Intuitively, whatever happens to demand, SR
supply, and thus price, competitive forces ensure a
normal-profit LR equilibrium such that LR supply
56
is perfectly elastic at minimum LAC
3. Perfect Competition

But this presumes factor prices are fixed

What if factor prices increase with their usage?

In this case, then LR expansion of output by the
industry will increase the price of all factors such
that each constituent firm’s LAC and LMC will
shift-up
57
3. Perfect Competition

Thus, LR industry response to increase in demand
when factor prices increase with their usage is a
combination of:
(i) a ‘movement along’ a perfectly elastic LR supply curve
(i.e. one determined by minimum LAC of equally
efficient constituent firms, but where factor prices are
held constant);
(ii) a ‘shift-up’ of such a curve (i.e. where factor
prices are allowed to increase)
58
Figure 17: LR Industry Supply
p
Factor prices increase with usage
S LR
E1
*
1
p
*
0
p
S1LR
E0
S0LR
D1
D0
0
*
0
Q
*
1
Q
Q
59
3. Perfect Competition

Consider also ‘heterogeneous firms’

i.e. inter-firm differences in efficiency

The earlier firms enter into an industry, the lower
their cost curves; subsequent firms are increasingly
less efficient
60
3. Perfect Competition

At any particular LR equilibrium price, p*, the least
efficient (i.e. ‘marginal’) firm is that firm which
can make just normal profit at p*

The more efficient (i.e. ‘intra-marginal’) firms
make positive profits at p* and, thus, produce in the
region of DRS
61
Figure 18: LR Industry Supply
p
Heterogeneous Firms
p
p
LMC2
LMC1
LAC1
p*
SLR
LAC2
e1
E*
e2
LAC1
D
0
q1
q
(Intra-Marginal) Firm 1
0
q2
(Marginal) Firm 2
q
Q*
0
Q
Industry
62
4. Monopoly

Consider now the other extreme market
environment

Monopoly; single seller

The monopolist is the industry; no distinction
between firm and industry; less need to distinguish
SR and LR since entry / exit is less of an issue

Consider monopolist's AR and MR curves
63
4. Monopoly

As with PC firm, demand curve is also the AR
curve

But since AR curve is downward sloping, MR curve
lays below AR curve

Intuitively, to sell more Q, monopolist has to cut p
on all units of Q
64
Figure 19a: AR and MR
p
p1
TR1 = p1
TR2 = 2p2
A
MR2 = 2p2 - p1
= p2 - (p1-p2) < p2
B
p2
C
MR2
D = AR
MR
0
1
2
Q
65
Figure 19b: AR and MR
p
p1
TR1 = p1
TR2 = 2p2
A
MR2 = 2p2 - p1
= p2 - (p1-p2) < p2
B
p2
p2
C
MR2
D = AR
MR
0
1
2
Q
66
Figure 19c: AR and MR
p
TR1 = p1
TR2 = 2p2
A
p1
(p1-p2)
MR2 = 2p2 - p1
= p2 - (p1-p2) < p2
B
p2
p2
C
MR2
D = AR
MR
0
1
2
Q
67
4. Monopoly

We will assume that the monopolist, like PC firms
and industries, faces increasing and then decreasing
returns to both factors and scale; i.e. ‘U-Shaped’
SAC / LAC

N.B. Monopoly that faces IRS always is termed a
‘Natural Monopoly’

Monopolist's profit can be supernormal (most
likely), normal or negative
68
Figure 20a: Monopolist LR Equilibrium
p
π>0
LMC
p0
LAC
Profit
LAC0
D = AR
MR
0
Q0
Q
69
Figure 20b: Monopolist LR Equilibrium
p
π<0
LMC
LAC
LAC0
p0
Loss
MR
0
Q0
D = AR
Q
70
Figure 20c: Monopolist LR Equilibrium
p
π=0
LMC
LAC
p0 = LAC0
MR
0
Q0
D = AR
Q
71
4. Monopoly

Consider efficiency

Allocative Efficiency (AE)
p = MC

Productive Efficiency (PE)
IRS are exhausted such that LAC is minimised
72
4. Monopoly

(Non-Discriminating) monopolist is never AE and
(extremely) unlikely to be PE

PE would require MR curve to cross MC at
minimum AC

It can happen, but infinitely small chance!
73
Figure 21: Monopolist LR Equilibrium
p
Productive efficiency is possible, but very unlikely!
LMC
pmes
LAC
LACmes
D = AR
MR
0
Qmes
Q
74
4. Monopoly

Allocative Efficiency requires marginal (social)
benefit (MSB) to equal marginal (social) cost
(MSC)

Define: MSC = MPC + MEC
MSB = MPB + MEB

i.e. marginal social benefit (cost) equals marginal
private benefit (cost) plus marginal external benefit
(costs)
75
4. Monopoly

Private benefits (costs) are those enjoyed (incurred)
by agent producing or consuming) the good

External benefits (costs) are the non-price effects
on the production or consumption of other
members of society

Assume (for now!) that MEC = MEB = 0 such that
allocative efficiency requires MPC = MPB
76
4. Monopoly

Now:
MPC = LMC of monopolist
MPB = price consumers willing to pay for good

Thus, the MPB can be derived from the
monopolist's Demand = AR curve

Recall, the (inverse) demand curve sets out
consumer's reservation price vis. the maximum
price the consumer is willing to pay
77
Figure 22: D = MPB
p
p1
A
B
p2
C
p3
D = MPB
0
Q1
Q2
Q3
Q
78
4. Monopoly

It is apparent that the monopolist produces less
output than the socially optimal (allocatively
efficient) level

Monopolist maximises profit by setting MR = MC

Allocative efficiency is achieved when p = MC

Since p > MR, it must be the case that monopolist
output is less than socially optimal
79
Figure 23: Monopolist LR Equilibrium
p
DWL = ABC
Privately Optimal
LMC = MPC
Socially Optimal
p0
A
B
LAC0
LAC
D = AR = MPB
C
MR
0
Q0
Q1
Q
80
4. Monopoly

Consider the (‘overnight’) monopolisation of a PC
industry

The constituent firms of the industry become
manufacturing plants for the monopolist

Assume that the SLR = ∑LMC of the PC industry
becomes the monopolist’s LMC curve (N.B.
heterogeneous firms thus SLR is upward sloping)
81
4. Monopoly

Define social welfare (SW) as sum of consumer
surplus (CS) and producer surplus (PS)
SW = PS + CS

NB: No concern with equity! 1+ 99 = 100 = 99 + 1

Define CS as excess of what consumers are willing
to pay over what they actually pay; PS as excess of
what producers actually receive over what they are
willing to receive
82
Figure 22a: Monopoly and PC
p
A
SLR
CS
pc C
Perfect Competition
B
CS = ABC
PS = BCD
SW = ABD
PS
D
0
D = AR
Qc
Q
83
Figure 22a: Monopoly and DWL
p
A
LMC
G
pm
E
Monopoly
pc C
B
CS = AEG
PS = GEFD
SW = AEFD
DWL = EBF
F
D
0
MR
Qm
Qc
D = AR
Q
84
Figure 22a: Monopoly and DWL
p
A
LMC
G
pm
E
Monopoly
pc C
H
B
ΔCS = -GEHC - EBH
ΔPS = +GEHC - BHF
ΔSW = -EBH - BHF
F
D
0
MR
Qm
Qc
D = AR
Q
85
4. Monopoly

But this is a static analysis - i.e. the instantaneous
effects of monopolisation; what happens to cost
over time, i.e. dynamic effects?

Two scenarios:
(i) Liebenstein ‘X-Inefficency’ (pessimistic)
(ii) Schumpeter ‘R&D’ (optimistic)

Balance of argument - empirical issue
86
Figure 22a: Monopoly and DWL
p
A
Liebenstein
B
pm
LMC
E
pc C
B
Schumpeter
F
D
0
MR
Qm
Qc
D = AR
Q
87
4. Monopoly

To summarise; monopolies would appear to be
harmful to society in sense that they lead to DWL
(i.e. consumers lose more than producers gain)

Perhaps some benefits over time (R&D), but that is
an empirical issue

There is an argument, however, that if we are to
have monopolies, then we should make them as
powerful as possible!
88
4. Monopoly

Price Discrimination (PD)

Selling different units of the same good at different
prices

Two basic approaches to PD:
Charging different prices to different consumers for same
units of the good;
Charging same consumers different prices for different
units of the good
89
4. Monopoly

Three main types of PD:
1. First-Degree (Perfect);
2. Second-Degree;
3. Third-Degree

Consider each in turn
90
4. Monopoly

First-Degree (Perfect) Price Discrimination

Monopolist charges each consumer maximum
price willing to pay for each unit of the good; thus
demand curve is also MR curve, since only reduce
p on additional units of Q

Monopolist produces socially optimal Q (i.e. p =
MC) and is thus allocatively efficient (DWL = 0)
but completely inequitable (CS = 0)
91
Figure 23: First Degree (Perfect) Price Discrimination
p
A
p1
p2
A'
LMC
A''
Perfect PD
PS
p*
B
CS = 0
PS = ABC
SW = ABC
DWL = 0
C
0
D = MR
1
2
Q*
Q
92
4. Monopoly

First-Degree (Perfect) Price Discrimination

Monopolist charges each consumer maximum
price willing to pay for each unit of the good;
thus demand curve is also MR curve, since only
reduce p on additional units of Q

Monopolist produces socially optimal Q (i.e. p =
MC) and is thus allocatively efficient (DWL = 0)
but completely inequitable (CS = 0)
93
Figure 23: First Degree (Perfect) Price Discrimination
p
A
p1
p2
p3
p*
A1
LMC
A2
A3
Perfect Price Discrimination
PS
F
B
Price = ABCD; Quantity = Q*
CS = 0
PS = ABE
SW = ABE
DWL = 0
E
D = MR
D
0
C
1
2
3
Q*
Q
94
Figure 23: First Degree (Perfect) Price Discrimination
p
A
LMC
Perfect Price Discrimination
PS
B
Price = ABCD; Quantity = Q*
CS = 0
PS = ABE
SW = ABE
DWL = 0
E
0
D = MR
1
2
3
Q*
Q
95
4. Monopoly

Second-Degree Price Discrimination

Monopolist knows there are different ‘types’ of
consumers with different WTP (i.e. utility from
consuming good) but cannot identify them
individually

CSi(x) = ui(x) – p(x)

uH(x) > uL(x) – i.e. H values good x more than L
i = H, L
96
Figure 23: Second-Degree Price Discrimination
p
Consider two ‘packages’ vis:
(PH, xH)
DH
(PL, xL)
Assume production is costless
DL
B
A
0
C
xL
D
xH
x
97
Figure 23: Second-Degree Price Discrimination
p
Ideally, monopolist would
like to extract all CS. e.g.
DH
PH = A + B + C
PL = A
DL
B
A
0
C
xL
D
xH
x
98
Figure 23: Second-Degree Price Discrimination
p
Such pricing will ensure zero CS
vis:
DH
PH = A + B + C
PL = A
DL
=>
B
CSH(xH) = 0 = CSL(xL)
A
0
C
xL
D
xH
x
99
Figure 23: Second-Degree Price Discrimination
p
But H prefers (PL, xL) to (PH, xH):
PH = A + B + C
DH
PL = A
=>
DL
CSL(xH) = - (B + C + D) < 0
B
CSH(xL) = B > 0
A
0
C
xL
D
xH
x
100
Figure 23: Second-Degree Price Discrimination
p
Thus, monopolist must remove
B from (PH, xH):
PH = A + C
DH
PL = A
=>
CSH(xH) = B = CSH(xL)
DL
CSL(xL) = 0
B
CSL(xH) = - (C + D) < 0
A
0
C
xL
D
xH
x
101
Figure 23: Second-Degree Price Discrimination
p
Optimal packages? Consider cut
in xL to xLL
DH
=>
PH(xH) = A1 + A2 + B2 + C
PL(xLL) = A1
DL
0
B1
B2
A1
A2
xLL
C
xL
D
xH
x
102
Figure 23: Second-Degree Price Discrimination
p
(xLL, xH) is still incentive compatible
=>
CSH(xH) = B1 = CSH(xL)
DH
CSL(xLL) = 0
CSL(xH) = - (B2+ C + D) < 0
DL
0
B1
B2
A1
A2
xLL
C
xL
D
xH
x
103
Figure 23: Second-Degree Price Discrimination
p
Effect on profit?
=>
π(xH, xL) = (A1 + A2) + (A1 + A2 + C)
DH
π(xH, xLL) = A1 + (A1 + A2 + B2 + C)
=>
DL
0
Δπ = π(xH, xLL) - π(xH, xL) = - A2 + B2
B1
B2
A1
A2
xLL
C
xL
D
xH
x
104
Figure 23: Second-Degree Price Discrimination
p
Optimal package is found by
reducing xL until MC (i.e.  in A2)
equals MR (i.e.  in B2)
DH
PH(xH*) = A1 + A2 + B2 + C
a
DL
A1
0
PL(xL*) = A1
B1
where
b
B2
c
A2
xL*
a-b = b-c
C
D
xH*
x
105
4. Monopoly

Third-Degree Price Discrimination

Monopolist sells good at different prices to
different groups of consumers

Monopolist must be able to identify distinct
markets

Geographical, age, gender, race …
106
4. Monopoly

Assume monopolist sells identical good to two
markets (A and B)

Assume costs of producing and supplying good to
either market are identical

E.g. Cinema selling seats in Bath to students and
lecturers who have distinct reservations prices and
elasticities of demand from each other
107
Figure 24a: Third-Degree Price Discrimination
p
p
p
LMC
~
p
ARB
AR
MR
MRB
ARA
MRA
0
QA
QB 0
QA 0
Market A
Market B
Lecturers
Students
Q
Q = QA
Market A + B
108
4. Monopoly

Assume first that price-discrimination is illegal

The cinema will maximise profit by setting
(aggregate) MR = LMC

Thus, sells Q = QA + QB seats in total at a common
price of p = p

QA to lecturers and QB to students
109
Figure 24b: Third-Degree Price Discrimination
p
p
p
LMC
p
ARA
ARB
AR
MRB
MR
MRA
0
QA
QA 0
QB 0
QB
Market A
Market B
Lecturers
Students
Q
Q = QA + QB
Market A + B
110
4. Monopoly

Assume now that price discrimination is legal

Setting a common price implies that MRA ≠ MRB

Thus, the monopolist can increase its revenue (and
since production costs are independent of the
market supplied, its profit) by transferring Q from
the low MR market to the high MR market
111
Figure 24c: Third-Degree Price Discrimination
p
p
p
LMC
p
MRB
MRA
ARB
AR
MR
MRB
ARA
MRA
0
QA
QA 0
QB 0
QB
Market A
Market B
Lecturers
Students
Q
Q = QA + QB
Market A + B
112
4. Monopoly

As Q is withdrawn from the low MR market,
p and MR in that market rise;

And vice versa, as Q is transferred to the
high MR market, p and MR in that market
fall; profit is maximised when MRA = MRB
113
p
p
p
LMC
pA
p
pB
MRB
AR
ARB
MR
MRA
MRB
ARB
MR
MRA
0
QA Q A
Market A
QA 0
QB
QB
Market B
QB 0
Q
Q = QA + QB
Market A + B
114
4. Monopoly

Intuitively, lecturers have relatively inelastic
demand, thus it is optimal to raise the price they
face, since relatively little demand is lost

Conversely, students have relatively elastic
demand, thus it is optimal to lower the price they
face since demand increases substantially
115
4. Monopoly

Recall:
æ
1ö
MRi = pi ç 1- ÷
è Ei ø

Thus:
æ
æ
1 ö
1 ö
MRA = p A ç 1= MC = pB ç 1= MRB
÷
÷
è EA ø
è EB ø
116
4. Monopoly

Recall:
æ
1ö
MRi = pi ç1 - ÷
è Ei ø

Thus:

If MRA = MRB, but EA < EB, then pA > pB
117
4. Monopoly

For all this to work:
1.
Group making up sub-markets must have
distinct elasticities of demand;
2.
Third-degree price discrimination must be legal;
3.
There must be no arbitrage between the groups
(i.e. usually used in service industries)
118
p
p
ARb = Db
ARa = Da
A
p
B
E
G
K
pa
I
L
p
J
M
pb
C
D
0
F
H
qb
N
qb
Q
119
Area
No Price
Discrimination (1)
Price Discrimination
(2)
Change (2) – (1)
CSb
+A
+A+B+E+G
+B+E+G
Rb
+B+E+C+D+F
+C+D+F+H
-B-E+H
CSa
+K+I+L
+K
-I-L
Ra
+G+H+J+M+N
+L+M+N
-G-H-J+L
SW
+A+B+C+D+E+F+ +A+B+C+D+E+F+
G+H+I+J+K+L+M+ G+H+K+L+M+N
N
-I-J
120
Figure 23: Natural Monopoly
p
pm
LAC
LAC
MR
0
Qm
D
LMC
Q
121
Figure 23: Natural Monopoly
p
LAC
p = LMC
p <0
LAC
D
MR
0
Q*
LMC
Q
122
4. Monopoly

Finally …

Note that the monopolist does not have a supply
curve

No one-to-one mapping between price and
quantity supplied
123
Figure 23: Monopolist does not have a supply curve
p
LMC
p0
E1
E0
AR1
AR0
MR0
0
Q0
Q1
MR1
Q
124