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Chapter 25
Monopoly Behavior
25.1 Price Discrimination
Price discrimination: selling different units of
output at different prices.
 First-degree price discrimination

 Different
units of output for different prices.
 Price schedules differ from person to person.
 Prices differ across quantities as well as consumers.
25.1 Price Discrimination

Second-degree price discrimination
 Different
units of output for different prices.
 Same price for the same quantity.
 Prices differ across quantities, but not across
consumers.

Third-degree price discrimination
 Different
prices for different consumers.
 Same price for the same consumer.
 Prices differ across consumers, but not across
quantities.
25.2 First-degree Price Discrimination
Discrete good willingness to pay
 Reservation
r
prices
r
r1=v(1)-v(0)
r
r2=v(2)-v(1)
r3=v(3)-v(2)
 Gross
Consumer’s
surplus
r1+ r2+ r3=v(3)-v(0)

1
2
3
1
2
3
Y
25.2 First-degree Price Discrimination

Price of the 1st unit: r1



Price of the



2nd
willingness to pay
unit: r2
ΔCS: zero
ΔPS: r2-MC
Price of the 3rd unit: r3



ΔCS: zero
ΔPS: r1-MC
r1
r2
r3
ΔCS: zero
ΔPS: r3-MC
Can charge v(3) for the
first three units


ΔCS: zero
ΔPS: v(3)-3*MC
MC
1
2
3
Y
25.2 First-degree Price Discrimination
willingness to pay
willingness to pay
r1
r2
r3
r1
r2
r3
MC
1

2
3
To consumer 1


Sell 6 units
Charge v1(6)
Y
1

2
3
To consumer 2


Sell 4 units
Charge v2(4)
Y
25.2 First-degree Price Discrimination
Each unit of the good is sold at the reservation
price.
 No consumer’s surplus generated.
 The output is Pareto efficient.

25.2 First-degree Price Discrimination
willingness to pay
Continuous
demand
 Quantity sold: y
 Price charged:
A+B
 ΔCS: zero
 ΔPS: A

A
MC
B
D
y
Y
25.2 First-degree Price Discrimination
willingness to pay
willingness to pay
A1
A2
MC
B2
B1
y1

To consumer 1


Sell y1 units
Charge A1+B1
Y
y2

To consumer 2


Sell y2 units
Charge A2+B2
Y
25.3 Second-degree Price
Discrimination
Two consumers: high demand and low demand.
 The firm cannot identify the consumers.
 Zero marginal cost assumed for simplicity.
 Screening: price-quantity packages that give
the consumers an incentive to choose the right
package meant for them.

 Two
contracts: (yH, pH), (yL, pL).
 The high demand selects (yH, pH).
 The low demand selects (yL, pL).
25.3 Second-degree Price
Discrimination willingness to pay
Full information
case
 Low demand

 yL=y1, pL=A

B
High demand
 yH=y2,
A
pH=A+B+C
C
y1
y2
Y
25.3 Second-degree Price
Discrimination willingness to pay
Self-selection
 High demand
will choose (yL,
pL) and get B.
 yH=y2, pH=A+C

B
A
C
y1
y2
Y
25.3 Second-degree Price
Discrimination willingness to pay
Adjustment
 Low demand

 yL=ym, pL=A-D

High demand
B
 yH=y2,
pH=A+C+E

A
E
New profit: E-D
C
D
ym y1
y2
Y
25.3 Second-degree Price
Discrimination willingness to pay
Optimum
 Low demand

 yL=ym, pL=A-D

High demand
B
 yH=y2,
E
pH=A+C+E
A
C
D
ym
y1
y2
Y
EXAMPLE: Price Discrimination in
Airfares
High demand and low demand: business and
non-business travelers.
 Restricted fare

 Advanced
purchase, inconvenient hours, but cheap.
 Designed for low demand.

Unrestricted fare
 Fully
flexible but expensive.
 Designed for high demand.
25.4 Third-degree Price Discrimination
Two groups of consumers.
 The firm is able to identify the consumers.
 Constant unit price for each market.
 The good cannot be resold.
 Firm’s problem

max p1 ( y1 ) y1  p2 ( y2 ) y2  c( y1  y2 )
y1 , y2
25.4 Third-degree Price Discrimination

F.O.C.:
MR1(y1)=MC(y1+y2)
MR2(y2)=MC(y1+y2)

or

1 
p1 ( y1 ) 1 
  MC ( y1  y2 )
 1 ( y1 ) 

1 
p2 ( y2 ) 1 
  MC ( y1  y2 )
  2 ( y2 ) 
25.4 Third-degree Price Discrimination
|2(y2)| > |1(y1)|: p1>p2
 The market with the higher price must have the
lower elasticity of demand.

25.5 Bundling

Bundles: packages of related goods offered for sale
together.
Willingness to pay for software components
Type of consumer
Word processor
Spreadsheet
Type A consumers
120
100
100
120
Type B consumers
25.5 Bundling

Selling software separately
 Charge
$100 for each software.
 Total revenue: $400.

Bundling
 Charge
$220 for the software suite.
 Total revenue: $440.


Diversity in consumers’ willingness to pay lowers the
price one can charge.
Bundling reduces this diversity.
25.6 Two-Part Tariffs


People go to
PRICE
Disneyland for rides.
Two prices
 Admission
ticket: t
 Price of rides: p*

Given p*, CS=A
A
p*
 t=A


Total profits: A+B
Optimal price:
p*=MC
B
MC
D
x*
NUMBERS OF RIDES
25.7 Monopolistic Competition

Product differentiation
 Products
are similar, but not identical.
 Coca-Cola and Pepsi-Cola.

Monopolistic competition
 Each
firm faces a downward-sloping demand
curve for its product.
 Free entry into the industry.
 Monopolists with zero profits.
25.7 Monopolistic Competition
PRICE

Monopolistic
competition
AC
 The
demand curve and
the average cost curve
must be tangent.
MC
p*
D
MR
y*
Y