Session 2: Monopoly: Price Discrimination

and Durable Goods

Definition: A firm is a monopoly if it is the

only supplier of a product in a market.
A monopolists demand curve slopes down
because firm demand equals industry demand.

Four cases:
1. Base Case (One price, perishable good,
non-IRS Costs).
2. Natural Monopoly
3. Price Discrimination
4. Durable Goods

P
Z

P0

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P1

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Q0

Q1

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1. Base Case
Demand Curve Facing Monopolist (MC =
0). Decreasing price from P0 to P1 reduces
revenue on the inframarginal unit, but increases revenue on the extra marginal unit.

Which revenue effect is larger?

Revenue = P Q
Is the % decrease in P greater or less than
the % increase in Q?

It depends on the price elasticity of demand:

P dQ
d =
Q dP
Moving toward the point where d = 1
(|d| = 1) increases total revenue.

What does Marginal Revenue look like?

Denote the inverse demand curve by P(Q).
We consider simple linear demand curves
here:
Q = a bP
P =

a 1
Q
b
b

A BQ
Total revenue is:
T R = P Q = (A BQ)Q
= AQ BQ2
Differentiate to get marginal revenue:
dR
MR =
= A 2BQ
dQ
Same intercept and twice the slope of the
(linear) demand curve.
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MR

Note that Marginal Revenue may be written:

dR
d[P (Q)Q]
dP
MR =
=
= P+
Q
dQ
dQ
dQ
=P+

dP P Q

= P
dQ P

1+

1
d

Monopolists Profit Maximization Problem:

max (Q) = p(Q)Q C(Q)
Q

(Choosing P or Q makes no difference because we are selecting a single point on the

demand curve. This will not be true when
we consider oligopoly problems.)
F.O.C. is:
d
dP
dC
= P (Q) + Q

=0
dQ
dQ dQ
dP
dC
=
P (Q) + Q
dQ
dQ
MR = MC

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Q
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(P , Q)

MR

is profit-maximizing choice.
What is the Monopolists Supply curve?

Inverse Elasticity Rule for Monopolist:

1+

1
d

= MC

Markup is P M C and Lerner Index is:

P MC
L=
P
Rewrite inverse elasticity rule as:
P MC
1
=
>0
P
|d|
Dead Weight Loss exists because P > M C.
Flatter demand implies higher |d| holding
P and Q fixed, a lower monopoly markup
and lower DWL.

Monopolists induce inefficient rent-seeking

behavior and monopoly profit is (partly) a
transfer from consumers.
But: there are benefits to monopoly: Incentives to innovate (new products, more
efficient production).

2. Natural Monopoly

Definition: Declining average cost over all

meaningful quantities. The most efficient
outcome is for a single firm to produce all
output.

Note: IRS is sufficient but not necessary

for a natural monopoly.

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Pd

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Qd
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Monopoly will maximize profits at (P , Q).

(Pd, Qd) are welfare maximizing, but a firm
would make a loss in this case.

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What is the first best regulation for a natural monopoly?

1. Pay a subsidy to the firm to cover losses,

2. or have firms bid based on price,
3. or, even better, have firms bid based on
a two-part price (Demsetz auction).

Additional details of natural monopoly are

left for topics on regulation.

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3. Price Discrimination:
1. We distinguish between three types of
price discrimination:

First degree (i.e., perfect price discrimination)

Second degree (i.e., non-linear pricing

such as quantity discounts)

Third degree (i.e., market segmentation)

2. Price discrimination always increases

profits (producer surplus), but its effects
on consumer surplus are ambiguous.

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Price Discrimination by the Monopolist:

Market 1

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Price Discrimination by the Monopolist:

Market 2

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Monopolists Profit Maximization Problem:

max T R1 (Q1 ) + T R2 (Q2 ) T C(Q1 + Q2 ).
Q1 ,Q2

FOCs are
M Ri (Qi ) = M C(Q1 + Q2 ),

i = 1, 2

M R1 = M R2 = M C

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MR

Price Discrimination by the Monopolist:

Implications for Consumer Surplus in both
Markets:

This is an empirical issue essentially. Theory tells us how to think about the problem,
but does not answer the welfare question
(other than to say that P.C. would do better).

Implications for firm profits? They should

go up with price discrimination. Remember we could always choose optimal p1 and
p2, such that p1 = p2 so the option of price
discrimination must do at least as well.

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4. Monopolists Selling Durable Goods

Definition of a Durable Good: goods that

are bought only once in a long time and can
be used for a long time. Examples: cars,
houses, land.

Since the typical analysis uses perishable or

flow goods, we can use static models to understand pricing decisions.

With durable goods, we need to take the

future into account, and we need dynamic
models to understand pricing decisions.

Note that durability is a relative concept:

there are many different degrees of durability. Definition by U.S. Census: 3 years.
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Coase Conjecture.
Consider the example of a monopolist who
owns all the land in the world and wants to
sell it at the largest discounted profit.

In year 1, the monopolist sets a monopoly

price and sells half the land. (Think of a
linear demand curve with marginal cost at
zero.)

In year 2, the monopolist will want to do

the same with the remaining land, but unless the population is growing very quickly,
demand for land will be lower. Thus, the
monopoly land price in year 2 will be lower.

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Coase conjecture: if consumers do not discount time too heavily and if consumers
expect price to fall in future periods, current demand facing the monopolist will fall,
implying that the monopoly will charge a
lower price (compared to a perishable good).
(Price is driven down in the blink of an
eye.)

Crucial assumptions:

1. durable good
2. demand does not grow quickly over time
3. consumers anticipate price cuts

As we will see, the assumption of a downward sloping demand (with a continuum of

consumers) is also a crucial assumption.
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Model I: Continuum of consumers, downward sloping demand.

Assumptions:
Consumers live for 2 periods
Product lasts for 2 periods

The aggregate one-period demand for the

services of the good is p = 100 - q.

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Define a game:

1. Set of players: seller and buyers

2. Set of actions/strategies for each player:

seller chooses price in period 1, and

price in period 2 (as a function of q1)
buyers choose whether to buy in each
period as a function of price

3. Pay-off function (producer and consumer surplus)

Use backward induction to solve:

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In period 2, demand is
p2 = 100 q1 q2.
because people who bought in period 1 do
not need to buy again.

Set MR = MC (assume) = 0, just like always. Then

M R = 100 q1 2q2 = 0.
Implying
q2 = 50q1/2, p2 = 50q1/2, 2 = (50q1/2)2

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If the monopolist sells to the q1 buyers with

the highest valuations in period 1, then the
marginal buyer must be indifferent between
purchasing the good in period 1, or waiting
until period 2.
Thus,
value in period 1 - price in period 1 =
value in period 2 - price in period 2
2(100 q1) p1 = (100 q1) (50 q1/2)
Now it is straightforward to solve for p1 as
a function of q1:
p1 = 150

3q1
.
2

More intuition: the first period price should

include the second-period price because purchasing in the first period gives two periods
of the flow of the service.
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Now we can write the firms profit maximization problem as a function of q1 only:

3q1
q1 2
max(1 + 2) = (150
)q1 + (50 ) .
q1
2
2
Take F.O.C. and solve. . .
We find q1 = 40, q2 = 30, p2 = 30, p1 =
90. This implies that total profits for both
periods (no discounting) are 4, 500.

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An alternative strategy set: RENT.

Define selling vs. renting. (See Shy: Selling means charging a single price for an
indefinite period. . . Renting means charging a price for using the product for a limited time period.)

How does the firm maximize discounting

profits if it rents out the good?

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Recall that the aggregate one-period demand for the services of the good is p =
100 - q.

Therefore, solve the static model twice (a

repeated game). F.O.C. (MR = MC) imply

pt = 50, qt = 50,
t = 2, 500, 1 + 2 = 5, 000.
The firm does better by renting out the
product.

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Two outstanding issues:

1. Does the firm have any other choice variables?
Choosing a lower relative level of durability is
one way of solving the problem of consumers
expectations. The usual example is lightbulbs.
Renting (we just did that)
Planned obsolescence (new car models, new
fashions... as long as costs are not too high)
Capacity constraints (numbered prints)
Buy-back provisions (not useful if consumers
can damage good, or easily resell)
Announcements/advertising future prices

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2. How does the analysis work when demand is discrete?

Shys example with two types of consumers:

Two types of consumers

Consumers are different enough in
their willingness to pay for the good
Two periods for consumption
Shy shows: selling may be more profitable
than renting.

The Coase conjecture is false.

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