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Price Discrimination

Where a monopoly exists, the price of a product is likely to be higher than in a


competitive market and the quantity sold less, generating monopoly profits for the seller.
These profits can be increased further if the market can be segmented with different
prices charged to different segments (referred to as price discrimination), charging higher
prices to those segments willing and able to pay more and charging less to those whose
demand is price elastic. The price discriminator might need to create rate fences that will
prevent members of a higher price segment from purchasing at the prices available to
members of a lower price segment. This behaviour is rational on the part of the
monopolist, but is often seen by competition authorities as an abuse of a monopoly
position, whether or not the monopoly itself is sanctioned. Examples of this exist in the
transport industry (a plane or train journey to a particular destination at a particular time
is a practical monopoly) where Business Class customers who can afford to pay may be
charged prices many times higher than Economy Class customers for essentially the same
service. Microsoft and the Video industry generally also price very similar products at
widely varying prices depending on the market they are selling to.

Monopoly Companies
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A monopoly is a single producer of a product which does not have close substitute. A
monopoly is characterized by barriers to entry. Sources of a monopoly include:

• Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers


diamond monopoly).
• Exclusive Right Given by Government - patents, copyrights, franchises
(pharmaceutical companies, research, authors).
• Falling Average Total Cost - making one company more efficient than others (also
known as a natural monopoly), arising from economies of scale over the relevant
range of output.
• Public Utilities - electricity, cable television. and water provision.

Pricing and Production Decisions

A monopoly is a large enough business to influence its own price, such that it is the price
setter rather than taker, unlike a perfectly competitive market where each firm faces a
perfectly elastic demand curve. A monopoly faces a downward-sloping demand curve and
the market demand is the company’s demand. Monopolists are still constrained by the
negative relationship between price and quantity demanded.
Revenue for a Monopoly

A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower
its price. There are two effects on total revenue (profit x quantity):

1. Output effect - gains more revenue because it sells more.


2. Price effect - gains less revenue because it gets less from each unit sold because of
the lower price.

Marginal revenue (MR) can even turn negative if price falls enough to reduce total
revenue, even though the company sells more. What determines value of MR? It depends
on whether the fall in price is larger than the increase in quantity. In other words, it
depends on the elasticity of demand. Note that MR = P [1-1/abs. E].

When E > 1, MR > 0 because output effect > price effect


When E < 1, MR < 0 because price effect > output effect
When E = 1, MR = 0 because price effect = output effect

Therefore, the monopolist will never produce in the inelastic portion of the demand curve
since MR < 0. A straight-line demand has elasticity that varies from zero to infinity.
Assuming a linear demand curve P = a-bQ, the MR curve for a straight line will:

• be a straight line with the same intercept and;


• have twice the slope of the demand curve (i.e. it is zero at the halfway point of the
demand curve).

Profit Maximization

Recall that the objective of a business is to maximize profits. As such, a company should
produce where profit is at a maximum. In marginal terms,

1. If MC < MR, producing 1 more unit will add more to TR than to TC, so the
monopoly should increase quantity.
2. If MC > MR, producing 1 more unit will add more to TC than to TR, so the
monopoly should decrease quantity.
3. Only when MR = MC (and MC cuts MR from below) is profit maximized.

A monopolist will generally produce less than a socially efficient level of output, and
charge too high a price. Are the above normal profits of monopoly a social cost? Not
usually, since profit is still part of surplus but has been transferred from consumers to
producers. Social cost arises from inefficiently low output which leads to the dead weight
loss. However, if the monopolist uses some of its normal profits to lobby in order to
maintain a monopoly (rent seeking), then this can be a welfare cost to society.
Price Discrimination

Price discrimination is selling the same good to different customers/markets at different


prices. Examples include movie tickets, airline tickets, and discount coupons. In order to
practice price discrimination, there must be easy to separate customer into groups. These
groups are determined based on their elasticities to demand. The company must also be
able to prevent resales between groups, as well as arbitrage, which is buying where a
good is cheap and selling where it is expensive.

Price Discrimination can increase the profit of monopolies, since they can charge a higher
price to those with less elastic demand, and a lower price to those with more elastic
demand. In this manner, a business does not have to lower prices to all buyers in order to
sell more goods.

Price Discrimination
When you were young, did you ever order from the children's menu in a restaurant?
When a family with small children goes to a restaurant, they are often given a children's
menu in addition to the regular menu. If they order two similar items, one from each
menu, they will find that the item ordered from the children's menu will be a bit smaller,
but its price will be much smaller. In fact, it would often be worthwhile for the entire
family to order from the children's menu, but they cannot. Restaurants usually only allow
children to order from it.1

Why do restaurants use children's menus? Economists doubt that restaurant owners have
a special love for children; they suspect that the owners find offering children's menus to
be profitable. It can be profitable if adults who come to restaurants with children are, on
the average, more sensitive to prices on menus than adults who come to restaurants
without children. Children often do not appreciate restaurant food and service, and often
waste a large part of their food. Parents know this and do not want to pay a lot for their
child's meal. If restaurants treat children like adults, the restaurants may lose customers as
families switch to fast-food restaurants. If this explanation is correct, then restaurants
price discriminate.2

A seller price discriminates when it charges different prices to different buyers. The ideal
form of price discrimination, from the seller's point of view, is to charge each buyer the
maximum that the buyer is willing to pay. If the seller in our monopoly example could do
this, it could charge the first buyer $7.01, the second buyer $6.51, etc. In this case the
marginal revenue curve becomes identical with the demand curve. The seller will sell the
economically efficient amount, it would capture the entire consumers' surplus, and it
would substantially increase profits.
The Simple Analytics of Monopoly-Repeated
Marginal Benefit Marginal Benefit
Output Marginal Cost
to Buyers to Sellers
1 $5.00 $7.01 $7.01
2 5.00 6.51 6.01
3 5.00 6.01 5.01
4 5.00 5.51 4.01
5 5.00 5.01 3.01
6 5.00 4.51 2.01

Every seller would price discriminate if there were not two major obstacles standing in
the way. First, the seller must be able to distinguish between those buyers who are willing
to pay a high price from those who are not. Second, there must be substantial difficulty
for a low-price buyer to resell to those willing to buy at a high price.3

Because price discrimination is potentially profitable, businesses have found many ways
to do it. Theaters often charge younger customers less than adults. Doctors sometimes
charge the rich or insured patient more for services than they charge the poor or
uninsured. Grocery stores have a lower price for people who bother to check the
newspaper and clip coupons. Some companies, such as firms selling alcoholic beverages,
produce similar products but try to promote one as a prestige brand with a much higher
price. Electric utilities usually charge lower rates to people who use a lot of electricity
(and thus probably have electric stoves and water heaters) than they do to those who use
only a little electricity (and who probably have gas stoves and water heaters). Banks offer
special interest rates on Certificates of Deposit (CDs) that will not be obtained when one
lets a CD roll over. People who are more sensitive to interest rates will take the time and
effort to personally renew each maturing CD.

To the extent that businesses find ways to price discriminate, they eliminate the triangle
of welfare loss and approach the economically efficient amount of production. Thus, the
mere existence of monopoly does not prove there is economic inefficiency.

Next we look at antitrust policy, one government policy towards monopoly.

Antitrust Policy
Governments have a number of policies that affect monopoly and market power. Two that
are intended to reduce monopoly are regulation and antitrust policy. However, there are
also policies that purposely increase monopoly. Patent and copyright laws, for example,
protect monopoly. The belief that it is socially useful to encourage people to develop new
processes and products has led to laws that provide monopoly rewards for those who do
so. Patent laws are a case in which there is some recognition that the analysis of
efficiency is static but the economy is dynamic.
Competition may mean price takers in a static model, but in a dynamic model it can be
striving for positions of temporary monopoly. Joseph Schumpeter argued that this
competition for positions of temporary monopoly was the most important type of
competition in a market economy. He argued that it provides a "gale of creative
destruction." Entrepreneurs would find new products and ways of producing things that
would make obsolete the old products and ways of production. In turn their positions
would sooner or later be destroyed by new entrepreneurs. For Schumpeter, the essence of
market economies was change.

Despite Schumpeter's argument, most economists have argued that the government
should take measures to attack the efficiency loss of monopoly. Antitrust policy is one
way to do this. Antitrust policy attempts to make companies act in a competitive manner
by breaking up companies that are monopolies, prohibiting mergers that would increase
market power, and finding and fining companies that collude to establish higher prices.

The antitrust laws in the United States are stricter and more comprehensive than those of
other industrialized nations. Many other industrialized nations, perhaps because they
focus on the possibility of foreign competition, have minimal antitrust law. In the United
States, the original antitrust law was the Sherman Act of 1890, with important extensions
added in 1914. Two government agencies have authority to enforce antitrust laws, the
Antitrust Division of the Justice Department and the Federal Trade Commission. In
addition, the laws allow companies, organizations, or persons who are adversely affected
by actions that violate the antitrust acts to sue for damages.

The economic case for antitrust policy is based on efficiency. Monopoly can lead to an
inefficient use of resources when compared to the competitive result. Furthermore, there
are clear cases in which businesses have tried to act as monopolists, charging high prices
with restricted outputs. Nonetheless, there are unanswered questions about how great the
net benefits of antitrust enforcement are. There are conditions under which monopoly
may be more efficient than competition. When an industry has increasing returns to scale,
two small firms will require more resources to produce a given amount of output than one
large firm. Trying to keep two such firms in existence by, for example, preventing merger
will keep the economy inside its production-possibilities frontier, making the economy
production inefficient.

Further, the argument that competition is more efficient than monopoly relies on static
equilibrium analysis that assumes fixed production functions, demand curves, and supply
curves for resources. Some economists, following Schumpeter, argue that the competition
that matters in a market economy is the struggle to find ways to change these constraints
and to gain temporary monopoly power.

It is possible that antitrust laws can be used to attack behavior that is economically
efficient and socially desirable. For example, suppose that a company is extremely well-
managed and excels at producing quality products at low prices. Such a company will be
profitable and will grow to dominate its industry. Its dominance and large profits would
appear to indicate that it was a monopoly and could trigger antitrust action. In fact, there
are actual cases similar to this. The Alcoa case of 1945 seems to be one.

Alcoa was found innocent of monopolistic practices by the district court, but an appeals
court reversed this decision and found it guilty. Justice Learned Hand explained in the
decision:

"It was not inevitable that it [Alcoa] should always anticipate increases in the demand for
ingot and be prepared to supply them. Nothing compelled it to keep doubling and
redoubling its capacity before others entered the field. It insists that it never excluded
competitors; but we can think of no more effective exclusion than progressively to
embrace each new opportunity as it opened, and to face every newcomer with new
capacity already geared into a great organization, having the advantage of experience,
trade connections and the elite of personnel."

Hand's decision-makes clear that Alcoa maintained its position with managerial
excellence. There was no evidence that it restricted output to keep prices high, the sins of
monopoly which lead to economic inefficiency. On the contrary, it kept prices low and
expanded output. Hand's reasoning, subsequently reaffirmed in other cases, is difficult to
justify economically.

There are clearly cases in which antitrust laws move the economy closer to a competitive
state. There also seems to have been times when antitrust actions were misguided, when
antitrust actions did not result in lower prices and higher quantities for consumers.
Unfortunately, economists have traditionally been so sure that antitrust laws were
beneficial that they have not sought to measure whether the net benefit of those laws was
in fact positive. We really do not know how much good, if any, that antitrust actions
accomplish.

Next we look at a second governmental policy, regulation.