Perfect Competition, Price discrimination and Olygopoly (Main Concepts)

Consider first the LONG RUN competitive equilibrium:

o P = AC -> substitute P* into Q, in order to find the quantity

 min

produced in the long run;

Profits are zero

 E

N = Q*/Q for finding the number of active firm, each of which

 produces at the efficient scale of production.

Find the SHORT RUN competitive equilibrium:

o Determine the supply curve S(P):

 1. QUANTITY RULE: P = MC

2. SHUT DOWN RULE: Profits > 0 ? P > AC min ?

In case there are sunk costs, you have to take

 the average avoidable costs AAC,

into account and

equate it to MC -> AAC min

 After having found the supply curve multiply it for the number of active

firms and D = S,

 The price will be above P* > AC min, hence firms will register positive

profits

 Therefore, we expect many firms to enter the market, so the price will be

drawn down to AC min again.

Why do we talk about aggregate surplus?

The aggregate surplus measures the efficiency of an economy. In other words, a

market is economically efficient if it maximizes the social surplus. The latter equals

the sum of the CS consumer surplus and the PS producer surplus.

Aggregate Surplus = total Willingness To Pay - total avoidable costs of

o production

How do we measure them?

o The total WTP equals the area under the market demand curve up to the

 quantity consumed. This is true if the quantity of goods are consumed by

the costumers who face the highest willingness to pay (which is true

whenever all consumers face the same price)

Total avoidable cost equal the area under the supply curve up to the

 quantity of goods produced by those firms with the lowest avoidable

costs.

Consumer surplus = WTP - total

expenditure

Producer surplus = profits - sunk Revenues - total avoidable

costs costs

Being economically efficient means also that any alternative outcome that makes

someone better off it must make somebody else worse off. A particular output of

this kind is the Pareto Optimal, which is an economic output at which is

impossible to make anyone better off without making someone else worse off.

Deadweight loss: is the reduction of the aggregate surplus below its maximum

value. Perfectly competitive markets maximize the aggregate surplus,

o the price taker firms

because set their price equal to the marginal cost for

maximizing their profits. Therefore, there is no deadweight loss.

Price discrimination

Why do firms price discriminate?

Price discrimination is a economic technique to increase profits by seeking to satisfy

the needs of a larger range of customers. In fact, a monopolist could increase its

profits by: Charging more the units for those costumers that are willing to pay

o more for the output,

Reducing the charge over those units, for which costumers do not

o have such a high willingness to pay.

Naturally, in order to compute price discrimination market power is needed and also

an ability to distinguish costumers' WTP.

This process is called prefect price discrimination, when the firm is able to

determine the different levels of consumers' WTP and consequently charge different

prices for each unit it sells.

However, sometimes firms aren't able to determine such a perfect pricing for each

WTP. But, if they are clever they can use different techniques of price discrimination

based on : Observable characteristic : when a firm can distinguish, even if

o imperfectly , consumers with a high versus low WTP

Self selection: when firms offer a menu of alternatives, designed

o so that the different costumers will make their own decision based on their

perceived needs.

Quantity depended: or volume sensitive pricing plan: is the price

o that a costumer pays of each extra unit, that depend on how many units the

consumer has bought.

Perfect price discrimination MR = D = MC

Since a perfectly discriminating monopolist collects an amount equal to the

consumer WTP for each unit, its marginal revenues coincides with the demand

curve, so perfect price discrimination is similar to the perfect competition:

MR = D = MC

Production = consumption

With perfect price competition the producer produce the exact amount that the

consumer consumes. Moreover, the seller produces exactly the same quantity as

the buyer consumes exactly the same quantity, as it would occur in a perfectly

competitive market. profit maximizing quantity,

Therefore, in order to find the the quantity rule

becomes: D = MC -> Q*

No deadweight loss

o Consumer surplus is transferred completely to the producer

o Consumer buys exactly the same quantity as in perfect price

o competition.

Two part tariff

The two part tariff is the simplest and most comfortable price discrimination,

because the consumer has to pay a fixed price - equal to the consumer surplus -

and a price per unit for each extra unit bought - equal to the marginal cost.

It is much simpler than the perfect price discrimination: rather than charging a

different price for each diverse WTP, the monopolist can name just two charges for

each consumer, a fixed and a per unit price.

The largest fixed fee that the monopolist can charge is equal to the

o consumer surplus.

The price per unit equals MC, because it induces the consumers to

o buy at the exact same amount of output as in perfectly competitive markets.

Observable characteristics : division in categories MR = MC

Sometimes firm's price discrimination is imperfect. They can only divide costumers

into groups based on their observable characteristics, but knows no more than this

about their WTP and also cannot engage quantity-dependent pricing.

quantity dependent pricing

The in a common tool that helps the

monopolist to achieve price discrimination, in which the price that

the consumer pays for an additional unit depends on how much the

latter has already bought.

Why?

Because each consumer purchases at most one unit or the firm is not able to

track how much a consumer buys.

For the sake of simplicity, we assume that the marginal cost for each group is the

same . to set a different price of every

Therefore, the only thing the monopolist can do is

group of costumers. So, for each of those we have to find the profit maximizing

price and the associated profit (MR=MC).

Conceptually, it is as if the different groups are separate markets. because

Segmenting costumers for their observable characteristic, is convenient

the monopolist can analyse each demand curve , then set the appropriated price in

accordance with the relative elasticity. d

In fact, if a group is very price sensitive (- 1/E tends to infinity), it will be more

profitable to set a lower price in order to sell more outputs and vice versa for an

inelastic demand where the monopolist will be better off raising the price.

This concept can be also described by the study of the markup of the different

groups

Example: if students have a more elastic demand that adults, then -1/E > -

A

1/E Moreover, the drawn formula implies that the markup for students will be

S.

less than the markup of adults, so the price for students will be smaller than

the price for adults.

Exercise procedure:

Find the profit maximizing price and the profit of each

o group separately. MR =MC

Find the profit maximizing price without discrimination and

o the associated profit. Therefore, create the market demand joining together

all groups. Compare the total profits with and without discrimination.

o The profit with discrimination will be always higher and the others, because the

monopolist can extract more surplus from customers by segmenting.

Self selection

When firms cannot distinguish costumers into groups based on observable

characteristics, they can offer a menu of alternatives, leaving the costumer

freely choose what fits best to her.

Another price discrimination based on quantity- dependent pricing and self selection

is the menu of alternative of different two part tariffs.

Suppose that the monopolists faces two kind of costumers: high-demand and low-

demand. The high-demand costumers have a higher willingness to pay of 50 cent

more than the low demand.

If the monopolist is able to distinguish the two groups, it will set a fixed fee

equal to each consumer surplus. It could get the entire aggregate surplus as

profit by offering to each consumer a 10-cent-per-min price (P=MC).

Instead when the monopolist cannot apply this technique, the best it can do is to

ensure that the fixed fee is at least as large as the low-demand consumer surplus,

then raise the per-unit price slightly above the marginal cost for increasing profits

from the high-demand costumers. This increment implies a small reduction in the

fixed fee.

Implications:

Slightly raising the Per-unit price larger than MC -> reduction in the

o Fixed Fee -> reduction in the total profit for the low-demand costumers,

causing a deadweight loss of 50 cents (those that the H are willing to pay).

This loss is covered by the additional profits of the per-unit price for

o high-demand costumers -> larger area -> larger profits .

Its profits depend on the number of High and Low demand

o costumers .

Nevertheless, it is possible to show that is it always profitable for the monopolist to

raise the per-min price above MC is it plans to sell to both kinds of costumers.

This techniques allows to extract more surplus from the high-demand costumers,

who are always willing to pay more.

Moreover, raising the price above MC, eliminates almost the deadweight loss on

sales to low-demand consumers.

Generally, the less are the low-end costumers the smaller will be the cost

relative to the net benefit, making worthwhile to raise the per-unit price.

MIXED Bundling

Bundling is the practise of selling several products together as a package, to

maximize profits.

BUNDLING is the practise of selling several units as a package while also

MIXED

offering those products for individual sale.

-> it is the most profitable pricing policy

Bundling eliminates the variation of the consumer evaluation , allowing the

monopolist to extract all of the aggregate surplus as profits.

Describe the advantages and the disadvantages of price discrimination for the

monopolist and the consumers.

A monopolist could increase its profit by eliminating deadweight loss and extracting

more consumer surplus. This is possible thanks price discrimination, an economic

technique that helps the monopolist to charge higher prices for those costumers

who have an higher willingness to pay than the actual price, and reducing the price

fro those who are more price sensitive.

Price discrimination can be advantageous also for costumers, if they fall into the

price category of the monopolist, otherwise some of them may be worse off,

because the price doesn't reflect their exact WTP. However, there are different

kinds of price discrimination, in accordance with the monopolist's a