Econ 201
Lecture 5.4
Summer 2009
Market Failure:
Monopoly & Price Discrimination
More Complex Monopoly
Pricing Schemes
• 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
Price Discrimination
• Because they have market power,
monopolists could practice price
discrimination.
– Price discrimination is the practice of
separating customers into groups based
on willingness to pay, then charging each
group a different price.
First-Degree 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.
Second-Degree Price
Discrimination
• Second-degree price discrimination
occurs when firms sell their product
at a discount when consumers buy large
quantities.
– Example: Electricity prices?
• http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp&k=seco
nd-degree+price+discrimination
Third-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
Third Degree Price Discrimination
• 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?
Third Degree Price Discrimination
• Setting separate prices in each market
•
http://www.nowsell.com/marketing-guide/price-discrimination.html
Other Monopolist Pricing Strategies
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•
•
•
•
•
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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
To Be Able to Do Price
Discrimination
• 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.
A Word from the FTC on
Discriminatory Pricing
• 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.
Tie-In Sales
• 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;
Optimal Pricing Strategy
for a Tie-in Sale
• Lower the price in the more demand
elastic market
• Raise price above MC in the more
inelastic market
IBM Example
• 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
Other Examples
• 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
Predatory Pricing
• 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.
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.
The Standard Oil Case
•
•
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.
•
Another Explanation
• 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
Dumping
• "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
What’s the Downside to
Monopolies?
• 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
Factors Working
Against Persistence
• 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.
Does a Single Supplier Always
Mean There is a Monopoly?
• 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
Natural Monopolies
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.