Market Failure:
Monopoly
1

Because they have market power,
monopolists could practice price
discrimination.
◦ Price discrimination
 separate customers into groups based
on willingness to pay,
 then charging each group a different price set at their
different maximum willingness-to-pay.
2

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.
◦ Apple: IPod releases
 Initial high price
 Price lowered 6 months later
3
2
(a) Price = $80
Price of
Albums
John’s consumer
surplus ($20)
$100
(b) Price = $70
Price of
Albums
John’s consumer
surplus ($30)
$100
80
70
80
70
50
50
Paul’s consumer
surplus ($10)
Total consumer
surplus ($40)
Demand
Demand
0
1
2
3
4
Quantity of Albums
0
1
2
3
4
Quantity of Albums
In panel (a), the price of the good is $80, and the consumer surplus is $20. In
panel (b), the price of the good is $70, and the consumer surplus is $40.
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(a) Monopolist with Single Price
(b) Monopolist with Perfect Price Discrimination
Price
Price
Consumer
surplus
Deadweight
loss
Monopoly
price
Profit
Profit
Marginal
revenue
0
Marginal cost
Marginal cost
Quantity
sold
Demand
Demand
Quantity
0
Quantity
sold
Quantity
Panel (a) shows a monopolist that charges the same price to all customers. Total surplus in this market equals
the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopolist that can perfectly
price discriminate. Because consumer surplus equals zero, total surplus now equals the firm’s profit.
Comparing these two panels, you can see that perfect price discrimination raises profit, raises total surplus,
and lowers consumer surplus.
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
Lessons from perfect price discrimination
1. Rational strategy
 Increase profit
 Charges each customer a price closer to his or her
willingness to pay
 Sell more than is possible with a single price
6

Lessons from price discrimination
2. Requires the ability to separate customers according
to their willingness to pay
 Certain market forces can prevent firms from price
discriminating
 Arbitrage – buy a good in one market, sell it in other market at
a higher price
3.
Can raise economic welfare
 Can eliminate the inefficiency of monopoly pricing
 More consumers get the good
 Higher producer surplus (higher profit)
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
The analytics of price discrimination
Perfect price discrimination
 Charge each customer a different price
 Exactly his or her willingness to pay
 Monopolist - gets the entire surplus (Profit)
 No deadweight loss

Without price discrimination




Single price > MC
Consumer surplus
Producer surplus (Profit)
Deadweight loss
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
Second-degree price discrimination occurs
when firms sell their product
at a discount when consumers buy large
quantities.
◦ Example: Electricity prices?
◦ Costco/Sam’s Club – “Big Box Stores”

http://www.amosweb.com/cgibin/awb_nav.pl?s=wpd&c=dsp
&k=second-degree+price+discrimination
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
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
Different geographic markets (Madison Park, U District)
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
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
11

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?
12

Setting separate prices in each market

http://www.nowsell.com/marketing-guide/price-discrimination.html
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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
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
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.
15

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.
16

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;
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


Lower the price in the more demand elastic
market
Raise price above MC in the more inelastic
market
Cellular industry
◦ Price < Cost for SmartPhone
 2-year contract at P > MC for service
 Can’t unlock phone – barrier to entry/exit
18

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
19

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
20

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.
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
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In many countries, including the United
States, predatory pricing is considered anticompetitive 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.
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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.
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

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
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"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
25

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
26

Monopoly rents attract entry of other firms

monopolies tend to become less efficient and innovative over
time,
◦ First mover advantage
◦ 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.
27

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
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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.
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