ECON 0100 Lecture Notes - Lecture 7: Price Discrimination, Natural Monopoly, Arbitrage
Market Structures
There are 4 possible market structures:
Perfect Competition
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Oligopoly
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Monopoly
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Monopolistic Competition
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They differ in 2 primary dimensions:
Number of Sellers
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Product Differentiation
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What is Monopoly?
A monopolist is a firm that is the:
Sole producer of good/service
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No close substitutes
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Monopoly
An industry controlled by a monopolist
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Due to anti-trust laws, it is hard to find many modern examples of perfect monopolies.
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History
There are 3 primary anti-trust laws:
Sherman Act (1890)
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Clayton Act (1914)
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FTC Act (1914)
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Anti-trust laws regulate businesses by preventing activities that are "anti-competitive".
Some examples:
Prevent mergers of businesses that would significantly reduce competition
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Prevent raising prices artificially by restricting quantity supplied
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Some classical examples of monopolies:
De Beers in 1880's controlled almost all of the world's diamonds
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Standard Oil Co. Inc. ended in 1911 as a result of anti-trust laws
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Why do Monopolies Exist?
Monopolies can exist when there are ________________.
Control of resources or input
i.e. De Beers with diamonds
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Increasing returns to scale
Leads to larger firms producing at lower costs
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Natural monopolies are an example
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Technological Superiority
Firms with technological advantages can sometimes establish monopoly.
Typically only for a short term.
®
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Created by the Government
Patents, copyrights
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To incentivize innovation
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Network Externality
Value of a good increases as more consumers use it
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i.e. Facebook
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Recall, perfectly competitive firms are PRICE TAKERS. This means perfectly competitive
firms took the market price as given. No matter how much or little a single PC firm sells, it
doesn't affect the market price. Why was this?
Many sellers --> firm behavior doesn't affect the market supply.
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Products not differentiated --> if Pfirm > Pmarket, nobody will buy from it
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The monopolist is NOT a price taker! Because monopolists are the only firm in their
industry and because monopolists sell goods that do not have close substitutes, their actions
directly affect the price in the market.
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Marginal Revenue for Monopolists
Monopolists face downward sloping demand. By restricting Q below the competitive level.
Monopolist can charge a higher price.
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The single-price monopolist's marginal revenue curve.
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One price to all consumers. To INCREASE quantity, monopolist must DECREASE price.
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Price
Quantity
TR = P*Q
MR
20
0
18
1
16
2
14
3
12
4
10
5
8
6
Low Quantity, quantity effect dominates. High Quantity, price effect dominates.
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Visualization of Price & Quantity Effects
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Demand & Marginal Revenue for a Monopolist
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Profit Maximization for a Monopoly
Let us consider an example, where there are NO FIXED COSTS and marginal costs are
constant.
This makes the graphs easier.
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This implies that MC = ATC & is a horizontal line.
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Monopoly Compared to Perfect Competition
Monopolist can have positive economic profit in the long run due to barriers to entry.
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There is no supply curve for a monopoly.
In Perfect Competition _____, but in Monopoly _____.
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QPC ___ QMonopoly
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PPC ___ PMonopoly
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In Perfect Competition, Profit ___ 0 in the long run.
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In Monopoly, Profit ___ 0 in the long run.
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Welfare Analysis for Monopoly and PC
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Monopoly Compared to Perfect Competition
Main Takeaway:
By restricting Quantity, monopolist ________ CS & ________ PS.
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_______ CS is greater than ______ PS, thus Total Surplus ________ in monopoly.
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Monopolies create DWL, because some mutually beneficial trades don't occur.
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For this reason, governments prevent monopolies.
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Natural Monopolies
Natural monopolies occur when there are increasing return to scale over the entire relevant
level of output.
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Seen in industries with high fixed costs.
Examples of Natural Monopolies:
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Natural monopolies also prefer to set the price above MC leading to DWL. However, it is not
always clear that breaking up a natural monopoly is a good idea. Doing so would result in
higher ATC for all firms in industry than a monopolist would incur.
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Methods to Reduce DWL in a Natural Monopoly
Public Ownership
Pro: Set prices based on maximizing efficiency, not profit.
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Con: Less incentives to keep costs down and more vulnerable to influence from political
interests.
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Regulations
Government can grant monopoly rights with price regulations.
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Restrict monopoly to charging P = ATC.
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Price Discrimination
Up until now, we have focused on single-price monopolists. These are monopolists that must
charge all consumers the same price.
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Some firms, however, engage in a practice called price discrimination. This is where a firm
charges different consumers different prices for a same good.
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Examples of Price Discrimination
Health Insurance
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Car Insurance
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Student Discount
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Why Price Discriminate?
Remember, with our single-price monopolist, in order to sell more of a good, our monopolist
had to lower its price on all units.
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Price discrimination, instead, allows firms to charge consumers with a high willingness to
pay a high price and consumers with low willingness to pay a low price.
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This increases the firm's total revenue!
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Perfect Price Discrimination
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What is needed for price discrimination to be possible:
Identify different consumers with different price sensitivities
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Prevent resale (no arbitrage condition)
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There are 2 effects when price DECREASES
Quantity Effect
Monopolist sells an additional
unit, TR INCREASES by Pnew
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Price Effect
Lower price for all units sold, TR
DECREASES by ΔP * Qold
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Demand: P = 20 - 2Q
To find MR: Take derivative
MR =
What should the monopolist produce?
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What price does the monopolist charge?
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As #of Prices INCREASES,
profit INCREASES, CS
DECREASES, & DWL
DECREASES.
Firm charges each consumer
their willingness to pay.
No DWL
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Firm extracts all surplus
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Not really possible in
practice, but firms may try
to do price discrimination.
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Lecture 7
Monday,*June*11,*2018
18:40
Document Summary
A monopolist is a firm that is the: Due to anti-trust laws, it is hard to find many modern examples of perfect monopolies. Anti-trust laws regulate businesses by preventing activities that are anti-competitive. Prevent mergers of businesses that would significantly reduce competition. Prevent raising prices artificially by restricting quantity supplied. De beers in 1880"s controlled almost all of the world"s diamonds. Standard oil co. inc. ended in 1911 as a result of anti-trust laws. Control of resources or input i. e. de beers with diamonds. Leads to larger firms producing at lower costs. Firms with technological advantages can sometimes establish monopoly. Value of a good increases as more consumers use it i. e. facebook. This means perfectly competitive firms took the market price as given. No matter how much or little a single pc firm sells, it doesn"t affect the market price. Many sellers --> firm behavior doesn"t affect the market supply.
