COMPARISON OF MONOPOLY PRICING AND COMPETITIVE PRICING
Monopoly pricing has important implication for consumer welfare. Indeed, setting high prices may suggest a loss of total surplus. The monopoly price is compared to the competitive equilibrium to examine this possibility.
Using the condition for competitive price requires setting price equal to the firms demand curve (MC=P). The equilibrium price and quantity from this pricing behavior is represented by Pc and Qc, respectively on Figure 9.C. The monopoly prices and quantity are respectively, Pm and Qm. This suggests that monopoly pricing is associated with such a firm selling fewer products than the competitive equilibrium dictates and at higher prices. Furthermore the total surplus loss is represented by the shaded area V. In sum, monopoly pricing does not promote an efficient market for consumers. It should be noted however, that forcing the natural monopolist to satisfy the competitive pricing condition leads to the firm facing negative profits because marginal cost is always less than average cost for a natural monopoly. Hence, setting price equal to marginal cost results in a price that is less than average costs. This suggest that any pricing regulation of such a firm should consider incorporating the constraint that sets a firm’s price equal to average cost.
Figure 9.C
$
Pm
V
AC
Pc MC
MR Demand
qm qc q
E. PRICE DISCRIMINATION
Rather than engage in monopoly pricing such a firm may choose to generate greater profits by practicing price discrimination. This pricing behavior is defined as charging different consumers different prices for the same commodity without cost justification. The classic example of this is Standard Oil’s pricing its product at below competitive prices in regions where rivals existed during the turn of the century.
A graphical depiction of price discrimination is shown in Figure 9.D. This graph presents the demand curves for two consumer groups (D1 and D2) along with the corresponding marginal revenues (MR1 and MR2). Since only one firm supplies this product there is only one marginal cost curve, which is depicted by MC. To determine the price for each consumer group the monopolist initially determines the profit maximizing output level by setting the joint marginal revenue curve equal to marginal cost. The joint marginal revenue curve is the horizontal sum of the two groups marginal revenue curves. The marginal cost corresponding to the profit maximizing output level is depicted by MCm. This is the marginal cost faced by the price discriminating monopolist when selling the profit maximizing amount of goods. Thus far, then, the procedure for setting discriminatory prices does not differ from setting the standard monopoly price. However, at this juncture, instead of setting price off of the joint demand curve, (Remember the monopoly demand curve is the horizontal sum of consumers’ demand curves), prices are determined by separately equating the profit maximizing level of marginal cost with each consumer group’s marginal revenue curve. On Figure 9.D this gives the respective price and output levels of P1 and Q1 for consumer group one, and P2 and Q2 for consumer group two. The outcome from such pricing suggest that all else equal (for the same output level) a price discriminating monopolist will set a higher price for consumers who face a less elastic demand curve. This makes perfect sense, because this consumer group is less sensitive to price changes. For example restaurants typically charge lower prices to senior citizens for the same product served to other consumers primarily because seniors are thought to be highly price sensitive given that they receive a fixed income. Mathematical support of this notion is provided by the following:
Since price discrimination occurs when MR1=MCm=MR2 and as proved earlier the value of marginal revenue is as follows
MRk=Pk(1-(1/| k|)),
where k indexes consumer groups and represents the own price demand elasticity, then the following holds:
P1(1-(1/|1|)) = P2(1-(1/|2|)) or P1/P2= (1-(1/|2|))/(1-(1/|1|))
This equation suggests that the price ratio is less than one if the demand elasticity for consumer group 1 is less than that of consumer group two. In other words P1 is less than P2 if the demand curve for consumer group two is more elastic than that for consumer group one.
The type of price discrimination that we have just examined is termed 3rd degree price discrimination because prices are only set for two consumer groups. A second category of price discrimination is depicted if prices were set for some number of consumer groups greater than two but not such that each consumer faced a different price. This example is presented in Figure 9.E. Note that the monopolist is able to further increase producer surplus at the expense of consumers. Indeed the remaining consumer surplus depicted in Figure 9.E is the sum of the triangles A, B and C. A practical example of second degree price discrimination is the setting of different utility prices throughout the day.
Figure 9.D
$
P2 MC
P1
MCm
D1 D2 D1 + D2
MR1 MR2 MR1+ MR2
q
Figure 9.E
$
A
P2 MC
B
P1
Pe C
Demand
q2 q1 qe
q
Lastly, another category of price discrimination is first degree price discrimination. This type of discrimination occurs when a seller charges each consumer their reservation price. Hence, the seller receives all of the producer surplus. This is depicted by Figure 9.F. A practical example of this is the approach used to sell autos or appliances, in which sales people allow for haggling over prices. It should be noted, however, that engaging in this practice generates extra cost for the firm since products that are not sold using such methods do not require the employment of large sales forces.
Figure 9.F
$
Additional MC
Producer
Surplus
Pe
Demand
qe q
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