Monopoly

Dushyant Kumar
BITS Pilani, Hyderabad Campus
Introduction

I Price maker vs price taker..

I In case of competitive market, a small increase in price results
in drastic drop (to zero) in demand.. here demand decreases
but not that drastically..
I Originally monopoly used to mean exclusive sell by a firm or
small group of firms..
I Price maker but limited by demand obviously..

maxp,y py − c(y )
D(p) ≥ y .
Introduction

I The monopolist will want to fix y = D(P), hence-

max p × D(p) − c(D(p)).

p

I Many a times its more convenient to use inverse demand

function p(y ) rather than the demand function D(p)-

maxy p(y ) × y − c(y ).

I FOC: p(y ) + p 0 (y )y = c 0 (y )
I SOC: 2p 0 (y ) + p 00 (y )y − c 00 (y ) ≤ 0
I FOC here is again standard marginal revenue equals marginal
cost condition, here marginal revenue has two components..
Elasticity of Demand

I From the FOC:

 
0 dp y
r (y ) = p(y ) 1 + = c 0 (y )
dy p
or,  
1
p(y ) 1 + = c 0 (y )

I Here the elasticity of demand is going to be negative, so for
this optimality condition to hold, we must have || > 1.
I So monopoly will always be producing in the elastic range of
the demand function.. intuition?
The Monopoly Profit Maximization Problem
Monopoly’s Optimisation

I Suppose p(y ) = a − by , c(y ) = cy .

I FOC: MR = a − 2by = c = MC
I SO, y ∗ = a−c
2b and p ∗ = a+c
2 ..
I What happens to the monopoly price as the cost increases?
Does the monopoly always pass-on entire cost increase to the
customer?
I From the FOC, we have:
dp 1
= 00 (y ) .
dc 2 + y pp0 (y )

I In the linear demand case above, p 00 (y ) = 0..

Monopoly Pricing

I So, in the linear demand case, only half of the cost increase is
passed on to the consumer.. (not because of benevolence
though!)
I In the case of constant elasticity demand function (Ap −b ),
price is increased by more than the increase!
Welfare

I We have seen earlier that the competitive markets are efficient

and maximises the social welfare.. what about monopoly?
I Continue with the quasilinear utility function: u(x) + y
I Social welfare: W (x) = u(x) − c(x).
I For socially optimal: u 0 (xo ) = c 0 (xo ) = p(xo ).
I For monopoly output xm : p(xm ) + p 0 (xm )xm = c 0 (xm )..
I So, W 0 (xm ) = u 0 (xm ) − c 0 (xm ) = −p 0 (xm )xm > 0.
I Monopoly produces ‘too little’..
Price Discrimination

I Looking at the monopoly output, the monopoly would have

loved to sell and additional unit of the output if its not going
to impact the price of other (‘already sold’) units..
I So the monopoly would be more than happy to explore the
possibilities of price discrimination..
I In order to price discriminate, the monopoly should be
however able to
1. sort consumers, and
2. prevent resale..
I First-degree, Second-degree and, Third-degree
Price Discrimination

I First-degree: perfect price discrimination- sell each unit at

the maximum willingness-to-pay..
I Second-degree: nonlinear pricing- bulk discounts, premier
memberships, etc. customers self select themselves into
desired group..
I Third-degree: different group are charged differently-
students’ discount, senior citizen discounts, etc.
I To analyse these price discriminations, lets consider 2
consumers- ui (x) + y for i = 1, 2.
I For simplicity, lets assume ui (0) = 0.
Price Discrimination

I Whats the maximum amount that consumer i is ready to pay

for x?
ri (x) = ui (x).
I Lets assume
1. u2 (x) > u1 (x) for all x, and
2. u20 (x) > u10 (x) for all x.
I Consumer 2 is high demand consumer and consumer 1 is low
demand one..
First-degree Price Discrimination
I Monopoly perfectly knows each consumer’s maximum
willingness-to-pay and charge them exactly that amount..
I If the consumers are going to buy more than one unit, the
monopoly offers them the price that leave them just
indifferent between consuming and no consuming!

maxr ,x r − cx

such that u(x) = r .

I FOC: u 0 (x ∗ ) = c..
I The monopoly make a take-it-or-leave-it offer: pay r ∗ and
consume x ∗ ..
I The monopolist ‘appropriate’ entire social surplus..
I But notice its efficient! output at efficient level, social surplus
maximised..
Second-degree Price Discrimination

I The firm charges different price depending on the

characteristics of the purchase, like bulk discounts, bundling
etc.
I So the firm knows that the consumers differ in their ‘types’,
but does know the type of a particular customer..
I For example lets say that an airline knows that some of the
customer are business travelers who are ready to pay more..
I Solution: device a pricing scheme and let consumers
self-select themselves.. business class vs economy class..
Second-degree Price Discrimination

I Consider an example. Suppose there are 2 travelers: a

business traveler (b) and a tourist (t).
I The airline has 2 seats: one first class (F) and one economy
(E).
I Utilities: Ub (F ) = 1000, Ub (E ) = 400 and,
Ut (F ) = 500, Ut (E ) = 300.
I Ideally the airline will like to charge 1000 from the business
travelers and book him for the first class and, charge 300 from
the tourist and book him for the economy class.
I But at these prices, the business traveler will prefer to travel
by the economy class (net utility of 0 vs. 100)..
Second-degree Price Discrimination

I Let PF and PE denote the prices of the first class and

economy class respectively..
I The airline has to keep following constraints in mind:

1000 − PF ≥ 0 (1)

300 − PE ≥ 0 (2)
1000 − PF ≥ 400 − PE (3)
300 − PE ≥ 500 − PF (4)
I Using all these inequalities, we have PE = 300, PF = 900.
Second-degree Price Discrimination

I In general, the monopoly firm announces a (nonlinear) price

schedule with the intention that group 1 (economy class) pick
x1 and pays total r1 and, group 2 (business class) pick x2 and
pays total r2 ..
I The monopoly has to ensure that
1. both type are wiling to participate- participation constraint or
individual rationality constraints..

u1 (x1 ) − r1 ≥ 0
and,
u2 (x2 ) − r2 ≥ 0.
Second-degree Price Discrimination

2. one type doesn’t want to consume the ‘bundle’ intended for

the other type:

u1 (x1 ) − r1 ≥ u1 (x2 ) − r2

and,
u2 (x2 ) − r2 ≥ u2 (x1 ) − r1
these are known as self-selection constraints or incentive
compatibility constraints..

I Rearranging the inequalities above:

r1 ≤ u1 (x1 ) (5)

r1 ≤ u1 (x1 ) − u1 (x2 ) + r2 (6)

Second-degree Price Discrimination

r2 ≤ u2 (x2 ) (7)
r2 ≤ u2 (x2 ) − u2 (x1 ) + r1 (8)

I We have to check which of these equations are going to bind..

using our starting restriction on the utility functions:
u2 (x) > u1 (x) and u20 (x) > u10 (x)
I Lets suppose equation 3 binds i.e. r2 = u2 (x2 ). Using this in
equation 4, we have u2 (x1 ) ≤ r1 .
or, u1 (x1 ) < u2 (x1 ) ≤ r1 .
Second-degree Price Discrimination

this contradicts equation 1, so equation 3 is not going to

bind.. equation 4 is going to bind, we have

r2 = u2 (x2 ) − u2 (x1 ) + r1 .

I Next consider equation 1 and 2. Suppose equation 2 binds i.e.

r1 = u1 (x1 ) − u1 (x2 ) + r2 .
substituting the value of r2 from above,

u2 (x2 ) − u2 (x1 ) = u1 (x2 ) − u1 (x1 ).

or, Z x2 Z x2
u10 (t)dt = u20 (t)dt
x1 x1
Second-degree Price Discrimination

I But this clearly violates u10 (x) < u20 (x). So here equation 1
binds i.e.
r1 = u1 (x1 ).
I So for the ‘low type’ customer, the participation constraint is
going to bind.
I The monopoly is going to extract all the surplus from the low
type customer and leave him with just ‘zero’ utility.. He will
be just indifferent between consuming and not consuming..
I For the ‘high type’, the participation constraint is not going to
bind, he will be enjoying strictly positive utility..
Second-degree Price Discrimination

I Now using this the monopoly’s profit function becomes:

π = (r1 − cx1 ) + (r2 − cx2 )

or,

π = (u1 (x1 ) − cx1 ) + (u2 (x2 ) − u2 (x1 ) + u1 (x1 ) − cx2 )

I FOC for maximisation w.r.t x1 and x2 ,

u10 (x1 ) − c − u20 (x1 ) + u10 (x1 ) = 0

or,
u10 (x1 ) = c − (u20 (x1 ) − u10 (x1 )) > c
and,
u20 (x2 ) = c.
Second-degree Price Discrimination

I So the low type consumer’s consumption is distorted

downwards; high type continue to consume at the efficient
level!
I These results are quite general..
Third-degree Price Discrimination

I Lets suppose that the monopoly knows the demand function

of different groups and it can price-differentiate among them!
I Different from first-degree: monopoly doesn’t know
differentiations within the group..
I Example: a firm serving 2 different regions, different pricing
of Windows OS for students, senior citizen discounts by travel
agencies..
I Suppose there are two groups of consumers- 1 and 2, inverse
demand functions- pi (xi )..
I Monopolist optimisation:

max p1 (x1 )x1 + p2 (x2 )x2 − cx1 − cx2

x1 ,x2
Third-degree Price Discrimination

FOC:
p10 (x1 )x1 + p1 (x1 ) = c,
p20 (x2 )x2 + p2 (x2 ) = c
I Rewriting these using elasticity of demand:
1
p1 (x1 ) 1+ 1
= 1
p2 (x2 ) 1+ 2

I The elasticities here are negative, so we have- p1 > p2 if

|1 | < |2 |..
I The elastic demand will be served at lower price..
I Example: q1 = 5 − p1 and q2 = 5 − 2p2 .. For simplicity,
assume zero cost..
I Market equilibrium with and without price discrimination..
Third-degree Price Discrimination

I What about the welfare effects of third-degree price

discrimination? Should this be allowed?
I Lets try to workout the effects of price discrimination on the
social welfare..
I The price discrimination obviously increases the monopolist
profit. (?)
I But whats the net social effect?
I Continue with our quasilinear preference example: 2 group of
consumers, ui (xi ) + y ..
∂ui
I Consumers’ optimisation: pi (xi ) = ∂xi .
I Social welfare: W (x1 , x2 ) = u(x1 , x2 ) − c(x1 , x2 ).
Third-degree Price Discrimination

I Consider two bundles, x10 , x20 and, x10 , x20 : associated prices-
p10 , p20 and, p10 , p20 .
I Lets assume that the utility function is concave..
I Then, we have

∂u(x10 , x20 ) 0 ∂u(x10 , x20 ) 0

u(x10 , x20 ) ≤ (x1 − x10 ) + (x2 − x20 )
∂x1 ∂x2
I Rearranging terms, ∆u ≤ p10 ∆x1 + p20 ∆x2 .
I Similarly, we have ∆u ≥ p10 ∆x1 + p20 ∆x2 .
Third-degree Price Discrimination

I Since ∆W = ∆u − ∆c, we have

p10 ∆x1 + p20 ∆x2 − ∆c ≥ ∆W ≥ p10 ∆x1 + p20 ∆x2 − ∆c

I In the case of constant marginal cost: ∆c = c∆x1 + c∆x2

I So, we have

(p10 −c)∆x1 +(p20 −c)∆x2 ≥ ∆W ≥ (p10 −c)∆x1 +(p20 −c)∆x2

I This inequality gives a lower and a upper bound on the

change in social welfare due to a price change..
Third-degree Price Discrimination

I Lets suppose initially the monopoly is not allowed to price

discriminate, p10 = p20 = p 0 ..
I Let p 0 be the prices when price discrimination is allowed..
I So, above inequality becomes

(p 0 − c)(∆x1 + ∆x2 ) ≥ ∆W ≥ (p10 − c)∆x1 + (p20 − c)∆x2 .

I So from the upper bound, a necessary condition for welfare

to increase is that the total output increase.
I Lower bound gives the sufficient condition..
Third-degree Price Discrimination

I Consider the linear demand case: x1 = a1 − b1 p1 and,

x2 = a2 − b2 p2 .
I For simplicity assume marginal cost c = 0.
a1 a2
I Under price discrimination- x1 = 2 and, x2 = 2.
I If the price discrimination is not allowed, optimal aggregate
output X = a1 +a2 .
2
Third-degree Price Discrimination

I So the total output is same- hence the welfare can’t increase

under price discrimination.
I In fact, if the utility function is strictly concave, the social
welfare is going to decrease..
I One interesting positive impact of price discrimination is that
it can allow for low demand market/segment to be served!