MicroEconomics 5e by besanko braeutigam chapter 12

Chapter 12

Capturing Surplus


Chapter Twelve Overview
1.Introduction: Airline Tickets
3.Price Discrimination
• First Degree
• Second Degree
• Third Degree
5.Tie-in Sales
• Requirements Tie-ins
• Package Tie-ins (Bundling)

Chapter Twelve


Uniform Price Vs. Price Discrimination
Definition: A monopolist charges a uniform price if it
sets the same price for every unit of output sold.
While the monopolist captures profits due to an
optimal uniform pricing policy, it does not receive
the consumer surplus or dead-weight loss associated
with this policy.
The monopolist can overcome this by charging more
than one price for its product.
Definition: A monopolist price discriminates if it
charges more than one price for the same good or
service.
Chapter Twelve

Forms of Price Discrimination
Definition: A policy of first degree (or perfect) price
discrimination prices each unit sold at the consumer's
maximum willingness to pay. This willingness to pay is directly
observable by the monopolist.
Definition: A policy of second degree price discrimination
allows the monopolist to offer consumers a quantity discount.
Definition: A policy of third degree price discrimination offers a
different price for each segment of the market (or each
consumer group) when membership in a segment can be
observed.
Chapter Twelve


“Willingness to Pay” Curve
Definition: The consumer's maximum
willingness to pay is called the consumer's reservation
price.
Think of the demand curve as a "willingness to pay" curve. If
the monopolist can observe the willingness to pay of each
customer (based on, for example, residence, education,
"look", etc), then the monopolist can observe demand
perfectly and can "perfectly" price discriminate.

Chapter Twelve


Forms of Price Discrimination

Definition: A policy of first degree (or perfect) price
discrimination prices each unit sold at the
consumer's maximum willingness to pay. This
willingness to pay is directly observable by the
monopolist.

Chapter Twelve


Uniform Price Vs. Price Discrimination
Uniform Price Monopoly 1st Degree P.D. Monopoly

Price

CS: E+F
0
PS: G+H+K+L
E+F+G+H+J+K+L+N
TS: E+F+G+H+K+L E+F+G+H+J+K+L+N
DWL: J+N
0

PU E F
G

P1

K

H

MC

J
N
L

MR

D
Quantity
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Is it Reasonable?
Buying a Car
The monopolist will continue selling units until the
reservation price exactly equals marginal cost.
Therefore, a perfectly price discriminating
monopolist will produce and sell the efficient
quantity of output.
Note: Only if the monopolist can prevent resale
can the monopolist capture the entire surplus.

Chapter Twelve


Pricing Surplus – Monopoly
MC = 2
P = 20 - Q

What is producer surplus if uniform pricing is followed?
MR = P + (∆P/∆Q)Q = 20 - Q - Q = 20 - 2Q
MR = MC => 20 - 2Q = 2 =>
Q* = 9
P* = 11
PS= Revenue-TVC = PQ-2Q = 11(9)-2(9) = 81

Chapter Twelve


Pricing Surplus – Monopoly

What will producer surplus be if the
monopolist perfectly price discriminates?
P = MC => 20 - Q = 2 =>Q* = 18
Revenue - TVC = [18(20-2)(1/2) + 18(2)]18(2) = 162
This is a gain in captured surplus of 81!

Chapter Twelve


First Degree Price Discrimination
Price

What is the marginal revenue curve for a
perfectly price discriminating monopolist?

20

When the monopolist sells an additional unit,

it does not have to reduce the price on the
other units it is selling. Therefore, MR = P.
(i.e., the marginal revenue curve equals the
demand curve.)

11

MC

2
9

18

D
20

Quantity

MR (uniform pricing)

Chapter Twelve


Second Degree Price Discrimination
Definition: A policy of second degree price
discrimination allows the monopolist to
charge a different price to different
consumers. While different consumers pay
different prices, the reservation price of any

one consumer cannot be directly observed.

Chapter Twelve


Two Part Tariff
Definition: A monopolist charges a two part
tariff if it charges a per unit fee, r, plus a lump
sum fee (paid whether or not a positive number
of units is consumed), F.
This, effectively, charges demanders of a low
quantity a different average price than
demanders of a high quantity.
Example: hook-up charge plus usage fee for a
telephone, club membership, or the like.

Chapter Twelve


Two Part Tariff
P
10
0

Example:
All customers are identical and
have demand

4050

• P = 100 - Q
• MC = AC = 10

10
90 100
Chapter Twelve

Q


Two Part Tariff
What is the optimal two-part tariff?
Two steps:
(1) maximize the benefits to the consumers by
charging r = MC = 10.
(2) capture this benefit by setting F =
consumer benefits = 4050.

Chapter Twelve


Two Part Tariff
Any higher usage charge would result in a deadweight loss that could not be captured by the
monopolist. Any lower usage charge would
result in selling at less than marginal cost.
In essence, the monopolist maximizes the size of
the "pie", then sets the lump sum fee so as to
capture the entire "pie" for itself.
The total surplus captured is the same as in the
case of perfect price discrimination.

Chapter Twelve


Block Tariff

Definition: If a consumer pays
one price for one block of
output and another price for
another block of output, the
consumer faces a block tariff

Chapter Twelve


Block Tariff
Example
• P = 100 - Q
• MC = AC = 10
Let Q1 be the largest quantity for which the first
block rate applies so that p1(Q1) = 100 - Q1.
Let Q2 be the largest quantity purchased (so that
the second block rate will apply between Q1 and
Q2) so that p2(Q2) = 100 - Q2

Chapter Twelve


Block Tariff
Example

Then:
π = p1(Q1)Q1 + p2(Q2)(Q2-Q1) - TC(Q2)
= (100 - Q1)Q1 + (100 - Q2)(Q2-Q1) - 10Q2
and we must choose Q1 and Q2 to maximize
this profit…
MR1 = (100 - Q1) - Q1 - (100 - Q2) = 0
MR2 = (100 - Q2) - Q2
+ Twelve
Q1 = MC = 10
Chapter


Key Equations
These are two equations in two
unknowns that can be solved to obtain:
• Q1* = 30
• Q2* = 60
• P1* = 70
• P2* = 40 (a quantity discount)

Chapter Twelve


Block Pricing
P

Quantity
Discrimination
100
70

Single Price
Monopoly
100

Demand

Demand

450

55

450

40
2700

1012.5

2025

450

10
0

P

30

60

100 Q

0
Chapter Twelve

1012.5

45 MR

MC
100

Q


Block Pricing

If the monopolist could set a
different block price for each
customer, it would capture the
same amount of surplus as a
perfectly
price
discriminating
monopolist.

Chapter Twelve

Utility Pricing
D - small

D - large

MC

Chapter Twelve

Q


Utility Pricing
D - small

D - large

Additional CS

P1

Additional PS

P2
MC

Q1s

Q1L

Q2L

Chapter Twelve

Q


Third Degree Price Discrimination
Definition: A policy of third degree price
discrimination offers a different price for each
segment of the market (or each consumer
group) when membership in a segment can be
observed.
Example: Movie ticket sales to older people or
students at discount
•

Suppose that marginal costs for the two
markets are the same. How does a monopolist
maximize profit with this type of price
discrimination?
Chapter Twelve