15 The Price-Setting Firm

Question 1

Is this situation Pareto efficient?

Answer 1

No, more units could be sold, with the surplus going to either party.

If total surplus (CS+PS) reaches its maximum possible level then the situation must be Pareto efficient.

Question 2

What are the criteria for perfect competition? (4)

Answer 2

• All buyers and sellers are price-takers - fails
• All contracts are complete - fails with labour discipline model
• No transaction costs - fails with tax
• Transaction only affects buyers and sellers (no external effects) - fails with externalities (pollution and public goods)

Question 3

How are monopolies similar and different from other firms?

Answer 3

They profit-maximise.

BUT, because of market power, they have the ability to set both price and quantity. That is why they are a price-setting firm.

Question 4

Monopoly market diagram

Answer 4

Question 5

How do monopolistic markets compare to competitive ones (price and quantity)?

Answer 5

Compared to perfect competition where p = MC = demand, we see that under monopoly, higher price, smaller quantity.

Question 6

When is a monopoly… good?

Answer 6

Question 7

Welfare diagram for monopoly

Answer 7

Question 8

Equation for marginal revenue for a monopolist. Why?

Answer 8

Question 9

Marginal revenue equation explained

Answer 9

Question 10

Marginal revenue and the inverse demand curve

Answer 10

Question 11

Derive the Lerner Index equation

Answer 11

Question 12

How can firms increase their market power?

Answer 12

Innovating- allowing for products to be differentiated. Patents and copyright can play a role in preventing competition altogether.

Advertising- attract consumers away from competitors and crease brand loyalty. It can be more effective that giving out discounts.

Both tactics can shift the firm’s demand curve.

Question 13

Learner index implications (4)

Answer 13

Higher marginal cost means firms must operate at higher marginal revenue, restricting supply further at a point where the demand is elastic.

• Firms’ profit margins depend on elasticity of demand- determined by competition
• Demand is relatively inelastic if there are few close substitutes
• Firms with market power have bargaining power to set prices without losing customers
• Competition policy (limits on market power) can benefit consumers when firms collude to keep prices high

Question 14

What is 1st degree price discrimination?

Answer 14

If firms can identify individuals and prevent arbitrage then they could in principle practice perfect price discrimination by charging each individual a personalised price.

^online retailers and financial services.

Question 15

Implications of 1st degree price discrimination

Answer 15

Perfect price discrimination is perfectly Pareto efficient: everyone is charged a price exactly equal to their willingness to pay, hence no DWL.

But, there is not consumer surplus as it is transferred entirely to the producer.

Question 16

What is 2nd degree price discrimination?

Answer 16

We cannot identify people either as individual or as groups.

The incentive now is to differentiate the products available - either by bundling up larger quantities or higher quality.

• Higher WTP consumers self-sort into the more expensive variants

Question 17

What is 3rd degree price discrimination?

Answer 17

Occurs when a firm can identify different groups of consumer and sell to each of them at different prices.