Question

Q1

a. Using a market model (ONLY), clearly show the perfectly competitive market outcome (price & quantity) and compare that with the monopoly outcome (price & quantity). Clearly identify the deadweight loss that results from the monopoly. What is allocative efficiency? On your model, clearly show why monopoly firms are NOT allocatively efficient.

b. Clearly describe perfect price discrimination. Using a market model, show how a perfectly price discriminating monopolist is more efficient than a monopolist who does not price discriminate. Why might consumers not like perfect price discrimination?

Answer 1

Perfect Competition

Few of the characteristics of perfect completion can be described as below :

1. Products produced by a perfectly competitive firm are completely identical to the products produced by other firms, which means they are perfect substitutes to each other.

2. There are large number of buyers and sellers in the market

3. Each firm is a price taker – which means must takes the price set by market

o Refer to the Figure 1(a) which shows the equilibrium in the market or the industry under which individual firms operates. Here the market demand curve D and supply curve S intersect at equilibrium point E. Equilibrium Price is Pc and Equilibrium quantity id Qm.

o Refer to figure 1(b) shows the graph for one individual firm. Since they are price takers they set price equal to Pc and their demand curve D is horizontal, which is perfectly elastic. If they raise the price even by a small proportion than Pc, all the demand would be shifted to its competitive firm. The demand here is also the marginal revenue and it is also equal to the average revenue. Given the U shaped Marginal cost curve and the average total cost curve, a profit maximizing firm produces till that level of out where marginal revenue is equal to the marginal cost, i.e. MR = MC , thus here the profit maximizing level of quantity is Qc with profit maximizing price being Pc. If the firm tries to produce any amount higher that Qc, the marginal cost will exceed the marginal revenue. If it produces any amount less than Qc, it losses potential profits.

Total Revenue (TR) is given by the box “EPcOQc”

Total cost (TC) is given by the boc “FPAOQc”

Profits = Shaded region “EPcPAF”    {TR – TC = EPcOQc - FPAOQc}

Monopoly

Few of the characteristics of Monopoly can be described as below :

1. A monopoly firm produces a unique good with no close substitutes

2. Unlike perfect completion, it’s a price maker and not a price taker

3. There exist high barriers to entry of new firms

o Refer to figure 2, under monopoly we have the firm faces a downward sloping demand curve, which means the monopolist can sell more goods at lower price and less goods at higher price.

o Here we assume the monopolist cannot price discriminate, which means it cannot charge different prices to different customers.

o Here the marginal revenue is less than the demand and the MR curve fall below the demand curve.

o However the MC and ATC curves are generic U shaped curves

o The profit maximizing conditions here are : (1) MR = MC (2) MC cuts MR from below.

o Here equilibrium quantity is given by QM and equilibrium price on the demand curve s given by Pc.

o An allocative efficient outcome is one where the marginal benefit to the society is equal to the marginal cost. Under perfect competition the demand and MR curve were same so the profit maximizing levels of quantity was higher like the point C where Price is equal to MC. This is a socially optimal level of outcome. However, under monopoly the MR and Demand curve are different so the price charged here is greater than the marginal cost (Pc>MC) leading to an in efficient outcome. Here consumers are worse off as they have to pay a higher price for more quantity as compared to under perfect competition.

o Since at a higher quantity more than Qm, people are willing to pay more than the marginal cost as we move above the MC curve from point B. However, the monopoly pricing strategy, the additional benefit to the society is lost as Deadweight Loss given by the Triangle ABC.

Perfect Price Discrimination

Price discrimination refers to when a firm with monopoly/market power charges different prices to consumers for identical products. Some important conditions for price discrimination to occur are:

1. A firm must have market power

2. The firms must be able to segregate the market between consumers who have different willingness to pay and have different price elasticity’s of demand

3. The buyers of that particular god are not able to resell the good to other buyers who would other-wise had to pay higher prices

Perfect Price discrimination or 1st Degree Price Discrimination: This price discrimination by the individual consumer. If a firm is able some-how determine exactly what each consumer is willing and able to pay for good, then the firm charges each consumer exactly according to his/her willingness to pay. In the way firm can extract the entire consumer surplus. Here the firm charges different prices to each consumer which is based on his/her demand.

As given in figure 3, as single price monopolists charges a price Pm and sells quantity Qm, The maximum profits that he earns is given by the are “PmPFA”.

Under price discrimination, the demand curve represents the willingness to pay of individual consumers. Some are willing to pay prices as high as P1 and someone willing to P2 and many other below P2 and between P1 and P2. As we work over down the demand curve we see that the monopolist keeps on charging lower prices to additional consumers. This way the marginal revue becomes the price at which the additional units are sold. At the end MR becomes equal to demand just like in case of perfect competition. So here the monopolist produces till P = MC, which is a socially allocative outcome which is Qp on the X-axis. Thus the lowest price which a perfectly discriminating monopolist charges is where P = MC. It’s the price paid by the last consumer.

Here economic profits as measured by the minim point of ATC curve is the whole triangle “P1PpCq” which are now larger much larger than the single price monopolist. Also there is a greater quantity sold as compared to before.

For a single price monopolist the consumer surplus by the area below demand curve and price Pm = Triangle P1PmA. However, with a perfectly price discriminating monopolist there is no consumer surplus.