14: Firm Behavior in Monopolistic markets

Question 1

When does a firm have a monopoly in the production of a good x?

Answer 1

A firm has a monopoly in the production of a good x if it is the only supplier of this good.

Question 2

What is different in this chapter than in all the other chapters? Which assumption changes?

Answer 2

In this case, we cannot sustain our previous assumption that the firm is so small that it just takes the market price as given (“price-taker”).

==> Instead, the monopolist can decide which price he wants to set.

Question 3

What relation between the quantity it sells and the price it charges is there for the monopolist?

Answer 3

The more goods the monopolists wants to sell, the lower must be the price.

Question 4

Which price strategies can the monopolist use?

Answer 4

• Optimal supply without price discrimination
• Optimal supply with perfect (first-degree) price discrimination
• Optimal supply with second-degree price discrimination
• Optimal supply with third-degree price discrimination
• Bundling of complementary goods

Question 5

What does the decision of the pricing strategy depend on?

Answer 5

Which of these pricing strategies are available to the monopolist depends on his information, the type of good he is selling, and the market structure.

Question 6

How is the elasticity of market demand for a monopolist? Why?

Answer 6

A monopolist can only sustain his monopoly for a particular good if the consumers cannot easily replace it by a different good.
==> Thus, the elasticity of market demand must be sufficiently low.

This effect becomes clearer if we have a look at the different reasons for the existence of a monopoly.

Question 7

Which reson for the existence HAS to be fulfilled for a monopoly?

Answer 7

The consumer must actually differentiate the particular monopoly good against other goods (if it is not “special” in any way compared to other goods, it cannot be a monopoly)

Question 8

In order to sustain a monopoly, the monopolist usually must obtain one of 5 advantages.
Which are these?

Answer 8

1. Exclusive control over an indispensable resource
2. Technological leadership
3. Market entry is regulated by the government (patents) and the monopolist is already present in the market.
4. Decreasing average costs (natural monopoly)
5. Network externalities (like facebook: it only works because a lot of people are already there. If you start a new social network and only a few people join, it is useless)

Question 9

Why do we need the marginal revenue?

Answer 9

If we want to find the optimal production and the optimal price of the monopolist, we are going to need another important concept: the marginal revenue

Question 10

How is the marginal revenue defined?

Answer 10

The marginal revenue (MR) is the amount of money the firm receives if it sells an additional unit of the good.

The effect of an additional unit of production x on the revenue R

Question 11

How do you calculate the revenue?

Answer 11

The revenue itself R is equal to the price of one unit p(x), multiplied by the number of units that are sold x. Thus, R = p(x)

Question 12

What is the difference to revenue under perfect competition?

Answer 12

In a monopoly the price at which a good can be sold by a firm now depends on the quantity. Thus, we write p(x) instead of only p.

Question 13

How do you calculate the marginal revenue?

Answer 13

We obtain the marginal revenue by differentiating R with respect to x.

p’(x) x + p(x).

Question 14

Which comparison does a monopolist make to maximize her profit?

Answer 14

A monopolist that wants to maximize her profit compares the marginal revenue (“by how much does the next unit of production increase my revenue”) to the marginal costs (“by how much does the next unit of production increase my costs”).

If the marginal revenue exceeds the marginal costs, the monopolist should increase the production.

Question 15

When should the monopolist increase production and when should they reduce it?

Answer 15

Marginal revenue > marginal costs –> an increase in production increases the profit

Marginal revenue < marginal costs –> an increase in production reduces the profit

Question 16

When did the monopolist maximize their profits?

Answer 16

If the marginal revenue is exactly equal to the marginal costs.

Question 17

How does the marginal revenue for a monopolist look like?

What do the components of the equation stand for?

Answer 17

The marginal revenue is

MR = p’(x) x + p(x)

The first component stands for the price effect, the second for the quantity effect.

Question 18

Which two effects has an increase in the production x on the revenue?

Answer 18

1. The firm sells higher quantity:
   The quantity effect determines how this increase in the sold quantity increases the revenue. As this next unit is sold for the price, the quantity effect is equal to p(x).
2. The price that the monopolist can charge decreases (as the demand function is usually downward-sloping).
   The price effect shows us how this affects the firm’s revenue:
   The effect of the quantity on the price itself is p’(x). However, this decrease in the price affects all units that the monopolist sells. Thus, the total price effect is p’(x) x.

Question 19

Which are the two optimality conditions?

Answer 19

Perfect competition:
MR = MC(x) –> p = MC(x)

monopoly:
MR(x) = MC(x) –> p(x) = MC(x)

Question 20

What is the same in both optimality conditions?

Answer 20

In both cases we know that in the end, the combination of price and quantity must be a point on the demand curve.

Thus, we can now substitute the (inverse) demand function p(x) into our optimality conditions (also for the case of perfect conditions, that is p = p(x) = MC(x))

We can now solve the relevant equation for our case for the quantity x. If we substitute this optimal quantity x into the demand function, we also obtain the price at which this good is traded.

Question 21

What can you do when determining the marginal revenue if the demand function is linear?

Answer 21

If the demand function is linear, that is, a straight line, we can use a simple rule to save a lot of time when we determine the marginal revenue:

If the (inverse) demand is linear, p(x) = A - Bx) the marginal revenue has almost the same equation: the marginal revenue has the same intersect as the demand function A, we only have to double the slope MR = A - 2Bx.

Important: We can use this little trick only with the inverse demand function p(x) = A - Bx. Thus, you need to make sure that your demand function is solved for the price (p = …) before you apply this approach.

Question 22

What is Consumer Surplus?

Answer 22

Difference between the willingness to pay and the actual price
==> area between the demand function and the price.

Question 23

What is the Producer Surplus?

Answer 23

Difference between the actual price and the willingness to sell
==> area between the price and the supply function

Question 24

What is welfare?

Answer 24

The sum of the consumer surplus and the producer surplus (and, if applicable, tax revenue) is the welfare (total surplus):

welfare = surplus = consumer surplus + producer surplus

Question 25

How do you compute consumer surplus?

Answer 25

For linear demand functions, we can use the formula of a right triangle to compute the area between the demand function and the price: CS = 1/2 times base times height.

Thus, the consumer surplus is CS = 1/2 * x * (B - p), where B is the intercept (with the price-axis) of the inverse demand function.

Question 26

What is “deadweight loss”?

Answer 26

The welfare with a monopoly is lower than in a comparable situation with perfect competition.

This reduction in welfare is called deadweight loss.

Question 27

Why is a monopolist bad for welfare?

Answer 27

Remember that with perfect competition, the firms increased their production until the price was equal to the marginal costs.

However, our monopolists finds it optimal to produce a lower amount in order to increase the price and therefore make a larger profit.

Thus, the deadweight loss occurs because there are customers in the market for which the willingness to pay exceeds the marginal costs of production, but who are not able to buy any goods.

Question 28

Which types of price discrimination are there in a monopoly?

Answer 28

First-degree price discrimination (perfect price discrimination), second-degree price discrimination and third degree price discrimination.

Question 29

What does “price discrimination” mean?

Answer 29

Sometimes the monopolist can price-discriminate between different customers.
In general, this means that the monopolist can set different prices for different customers, depending on their individual characteristics.

Question 30

What is the first-dgree price discrimination about?

Answer 30

The monopolist sells different units for different prices.
The prices can differ between buyers. Usually this means that the monopolist can directly observe the willingness to pay of each individual customer and charges exactly this price.

Question 31

What is second-degree price discrimination about?

Answer 31

The monopolist sells different amounts of the good for different prices, but each buyer pays the same price for a given amount of good.

Example: I sell apples for CHF 1 each. If you buy at least 20 apples, they are only CHF 0.9 each.
Thus, the price depends on the quantity but not on the type of buyer.

Question 32

What is the third-degree price discrimination?

Answer 32

The monopolist can differentiate between different groups of consumers according to some attributes (example: students vs. non-students).
The monopolist charges group-specific prices (example: one (low) price for students and one (high) price for everyone else).

Thus, the price depends on the type of the buyer, but ot on the quantity.

Question 33

How big is the consumer surplus in the first-degree price discrimination?

Answer 33

Zero

First-degree price discrimination means that the monopolist knows for whatever reason the exact willingness to pay of each individual customer.
In this case, he charges an individual price for each customer that is equal to this customer’s willingness to pay.
==> This means that the monopolist can gather the whole willingness as revenue and the consumer surplus is zero.

Question 34

What does a consumer surplus of zero mean for the quantity of the product?

Answer 34

However, this also means that the monopolist increases the quantity until the willingness to pay of the next customer is exactly equal to the marginal costs of the monopolist.

Question 35

Why is the outcome efficient in the first degree price discrimination?

Answer 35

This outcome is efficient because the production is determined by the rule “price equal marginal costs”, that is as long as the willingness to pay is above the marginal costs, a unit is produced and sold.

Question 36

What does the welfare consist of in the first degree price discrimination?

Answer 36

The whole welfare consist only of the producer surplus, while the consumer surplus is zero.

Question 37

Summarize the welfare of the first-degree price discrimination.

Answer 37

• The consumer surplus is zero
• The producer surplus is equal to welfare, and
• The market equilibrium is efficient, no deadweight loss! despite the presence of a monopoly.

Question 38

What is the monopolist trying to do in the second-degree price discrimination?

Answer 38

Our monopolist now tries to maximize her profits by offering different packages or contracts, that is, combinations of quantities and prices.

The monopolist tries to build these packages such that each type of customer decides freely to buy exactly the package that the monopolist built for him.

Question 39

What is the difficulty for the second-degree price discrimination?

Answer 39

The monopolist has to choose a price for package x that leaves a consumer surplus for group one of C such that group x is willing to buy their “own” package.

Question 40

How can you reach the profit maximum in the second-degree price discrimination?

Answer 40

A profit maximum is reached if a further reduction in the quantity in the less luxurious package reduces the revenue with the target group by more than the additional revenue that can be generated with the target group of the more luxurious package.

Question 41

How can the maximum be reached if the two groups in the second degree price discrimination have the same size?

Answer 41

The profit is maximized if the distance between the demand curve of group 2 and the x-axis has the same size as the distance between the curves of the two groups.

Question 42

Why do you not reduce the quantity of the more luxurious package in the second degree price discrimination?

Answer 42

The reduction of the quantities of the less luxurious package is necessary to make it less attractive for the “wrong” group.

This can never be necessary for the most expensive package for the group with the highest willingness to pay - no other group would want to buy this package anyway.

Question 43

What is the monopolist trying to do in the third-degree price discrimination?

Answer 43

With third-degree price discrimination, the monopolist can divide the customers into different groups.

Each group must pay a different price, but within a group each unit has the same price.

The monopolist treats these groups as seperate markets.

Question 44

Under which conditions can the third-degree price discrimination only work?

Answer 44

This can only work if the monopolist can clearly tell who belongs to which group.

Moreover it must not be possible that the good is traded from one group to another.

Question 45

When is the profit maximized in the third-degree price discrimination?

Answer 45

The profit is maximized if for each market if the marginal revenue in this market is equal to the marginal costs, where the marginal costs depend on the total amount that the firm produces.

Question 46

What role does elasticity play in the third-degree price discrimination? Why?

Answer 46

The market with the higher elasticity pays the lower price.

Intuitively, this should not surprise us: If the demand elasticity is high, an increase in the price has a strong, negative effect on the demand of customers. Thus, the firm should charge a low price in this situation.

Question 47

What is Product bundling?

Answer 47

Product bundling is another method to increase the revenue from customers.

Example of the football games of FCZ vs. Real Madrid and FCZ vs. AC Mailand.

Question 48

What is Multi-part tariffs?

Answer 48

Multi-part tariffs consist of two components
- fixed free (basic fee)
- additional fee per unit that is consumed

Question 49

How does the multi-part tariffs work?

Answer 49

First the monopolist charges a price equal to his marginal costs for each unit of the good is consumed.

However, this would leave a lot of surplus for the consumer.

If the monopolist now charges an additional basic fee that is exactly as high as the consumer surplus that was left, he can earn the whole willingness to pay as revenue, almost like with perfect price discrimination.

Question 50

Which two steps are needed for the two-part tariff?

Answer 50

• Set the price per unit equal equal to the marginal costs.
• Charge an additional fixed basic fee equal to the remaining consumer surplus.