L2: monopoly
Intermediate Microeconomics Lecture Notes
Lecture Overview
Instructor: Huw Edwards
Institution: Loughborough University
Course: Intermediate Microeconomics
Lecture: S2 Lecture 2
Date: Winter/Spring 2026
Recommended Readings
Perloff Chapter 12
Varian Chapter 32
Walter Oi: "A Disneyland Dilemma," Quarterly Journal of Economics, 1971, pp. 77-90
Monopoly and Consumer Surplus
Concept of Monopoly Power:
Monopoly power enables firms to capture a portion of the consumer surplus.
Graphical Representation:
MC: Marginal Cost
D: Demand Curve
MR: Marginal Revenue
Q: Quantity
P: Price
Inelastic Demand:
High consumer surplus implies that monopolists can impose a significant markup on prices.
Inefficiencies Associated with Monopoly
Production Decisions:
A classical monopolist establishes the equilibrium where MC = MR. This results in reduced quantity sold at inflated prices when compared to perfect competition.
Deadweight Loss:
Capturing consumer surplus leads to inefficiencies, affecting both consumers and firms.
Monopolists May Exploit Surplus Further:
Additional strategies can enable monopolists to increase their share of consumer surplus.
Conditions for Price Discrimination
To implement price discrimination effectively, the following conditions must be met:
The firm must operate as a price-maker.
The firm can identify different consumer segments.
Arbitrage (reselling between consumers) should not be possible.
Consumers must exhibit different levels of price sensitivity.
First Degree Price Discrimination
Definition:
Also known as Perfect Price Discrimination, it occurs when producers charge each consumer the maximum amount that they are willing to pay for each unit sold.
Implication:
This strategy extracts all available consumer surplus for the producer.
Marginal Revenue:
In this model, Marginal Revenue equals Price (MR = P), because the price for each additional unit does not require lowering the prices on prior units sold.
Efficiency:
It is considered Pareto-efficient, but it can lead to significant distributional consequences favoring producers.
Example: Disneyland Pricing
Pricing Strategy (1998 example):
Disneyland charged $38 for adults and $28 for Southern Californians, and offered free rides starting in 2003.
This pricing strategy was economically rational since long-distance visitors are less sensitive to minor pricing changes compared to local visitors.
Challenges with Preventing Resales
Service Resale Dynamics:
Resales are comparatively challenging for services, especially in scenarios with high transaction costs.
One possible approach is for firms to engage in vertical integration, thus acquiring price-sensitive customers directly.
Second Degree Price Discrimination
Definition:
Firms typically lack sufficient information on individual customers; thus, they create pricing schemes that differentiate customers without exact price discrimination.
Goal:
To enhance the consumer surplus extracted by adjusting prices based on observed behaviors and consumption levels.
Third Degree Price Discrimination
Profit Maximization Equation:
Monopolists can maximize profits through the pricing strategy: P = \frac{MC}{1 + \frac{1}{\varepsilon}}, where \varepsilon is the own-price elasticity of demand.
Market Segmentation:
Different segments of the market exhibit varying price elasticities, necessitating adjusted prices for different groups.
Examples of Segmentation:
Rail passengers may have varying sensitivities based on alternative travel modes and purpose of travel (tourists vs. commuters).
Impacts of Third Degree Price Discrimination
Price Adjustments:
Some prices may increase while others decrease, potentially leading to varied effects on total output and overall surplus within the market.
Two-Part Pricing Strategy
Structure:
Involves a fixed charge (F) plus a variable charge per unit (P). If a consumer buys x units, their total payment is given by F + Px.
Market Consideration:
For instance, in a scenario involving pay-TV dishes, if each consumer is identical and set pricing is done at marginal cost, charging an appropriate fixed fee could extract surplus effectively.
Strategies:
Setting the variable price above marginal cost while adjusting the fixed component allows for retaining consumers.
Diagram from Perloff Figure 12.5
Setup:
The firm charges a unit price P = m = 10 and applies a fee reflective of consumer surplus: Consumer 1 incurs fees equal to A1 + B1 + C1, whereas Consumer 2 pays A2 + B2 + C2.
Tie-in Sales and Bundling
Tie-in Sales Definition:
Consumers can only purchase one product if they simultaneously agree to buy another.
Bundling Dynamics:
Firms may limit the mix-and-match options for different products to improve profit margins. An example includes printers bundled with proprietary ink cartridges.
Bundling Example
Scenario Consideration:
Megasoft markets a word processor and a spreadsheet package targeting two distinct student types.
Willingness to Pay:
English students value the word processor at £100 and the spreadsheet at £51.
Maths students assign £51 to the word processor but £100 to the spreadsheet.
Bundling Strategy:
Instead of pricing each separately to £51 per package, Megasoft can nominally price both at a combined £151 but offer it as a special deal to maximize overall consumer participation.
Bundling Profit Considerations
Profit Calculation:
Analyze if the bundling strategy generates profit from variations in consumers' perceived valuation, and reflect on impact on consumer surplus and total social welfare.
Hypothetical Situations:
Consider implications of consumer valuations adjusting downwards to £49 for both products and the resultant business strategy adjustments.
Summary on Price Discrimination Approaches
Price Discrimination Context:
Strategies range from first-degree (perfect price discrimination) and second-degree to third-degree (e.g., special deals or bundled offers).
Business Implication:
These practices aim to maximize monopoly rents while presenting as beneficial to consumers.