Introduction
What we see in the case of monopoly power is that the theory really addresses the issue of market power. That is, whether or not there is only one large monopoly firm offering a product that people want or a few dominant firms, the fact that firms have the power to set price above MC is what is important.
As we go through life as consumers, we constantly face prices for what we choose to buy and for what we choose not to buy. In most cases we do not argue or haggle over the price when we make the decision to buy or not. In most cases we simply decide, and if we decide to part with our hard-earned cash, we buy at the price listed. Of course there are a few cases where we can debate price, automobiles and houses being examples. But normally when we buy a coffee or go to the dentist office, we simply "pay the price". This being the case, the producer or seller of the product we buy has some power over the price charged. In the case of non-perfect competition, this is certainly the case. Thus the door is opened for Price Discrimination (PD) – the arbitrary setting of prices with a goal to get increased revenues and sales when the firm knows, or feels, that its markets have segments (or differing willingness to pay among potential buyer groups.) As consumers, this is important for us as we have no choice other than to face prices every day. We have seen that there are three main types of Price Discrimination (PD). Third Degree – the seller divides up the market and prices differently to each market segment; Second Degree –the seller divides up the price schedule and allows the customer base to self- elect from the schedule; First Degree – seller knows the demand curve (willingness to pay) exactly, and prices down the curve with the goal to capture the entire potential consumer surplus. We have seen that for each Degree-type of PD, there are variations in strategy.
In the pure competitive model, prices are flexible, supply and demand are equal, consumers maximize their satisfaction and firms maximize their profits while minimizing their costs. Firms also know about and are using the best available technology to produce their product. When firms use the best available technology to produce their products, they are on the lowest possible cost curves, and this is called Production Efficiency. Yet in the real world of business and firms, competition involves the continuously differentiating of potentially homogeneous products in order to capture brand-customer loyalty and market share. There are many ways of doing this of which the marketing (positioning) and sales effort are the most important. Thus, for just about every product we can think of, the models of Monopoly, the Dominant Firm, and Monopolistic Competition become an appropriate deviation from the purely competitive model. Now let's get to the homework.
(1) Using the monopoly diagram with an upward sloping MC curve (normal U shaped), show the area of deadweight loss with monopoly pricing. Show the reduction in welfare to the Producers and Consumer surplus with monopoly pricing. How does this compare wit the competitive result? Now take the monopoly with a horizontal (constant AC) supply curve and show the area of deadweight loss with monopoly pricing. How large is the producer surplus? What is the elasticity rule that applies to monopoly pricing? What is it about this rule that makes sense from a strategic standpoint? Using the formula for MR where MR = P ( 1 – 1/e ) derive the elasticity rule. (2) If you had to argue that the diamond business in South Africa was a natural monopoly, what reasons would you give? Why would you think that the South African government is keen on keeping the diamond monopoly intact? (3) Explain why it is that high-powered regulation encourages cost cutting by the regulated firms while low-powered regulation does not. What is meant by high and low-powered regulation of monopolies or dominant firms? (4) What is regulatory capture? What is Rent-seeking? Why do you think that regulatory capture is so prevalent in representative democracies where market power exists among large firms? (5) Explain what we mean is when we say that the existence of monopoly prevents: inefficient use of resources (factors of production – K and L), and loss of consumer welfare. What about dynamic efficiency? Would a monopoly or dominant firm always prevent dynamic efficiency?
(6) Let's say a firm is a monopolist. Now this firm spends more on advertising to increase the demand for its product. Show on a graph with a horizontal AC curve what happens before and after the new expenditure on advertising. Show what has to happen in the graph to make sure that the firm maximizes its profits after the ad expenditure. (7) Would you classify a great popular artist like Michael Jackson as a monopolist with respect to what he produces? If so, would that be an adequate explanation of why Mr. Jackson was able to price his products way above his MC curve. How do you think Michael Jackson was able to achieve dominance in his field of music expression? Would you say that Michael Jackson's product was perceived as unique? What type of demand curve do you think he faced from those who were his fans? Do you think that the "elasticity rule" played a part in his getting rich? (Remember problem (1) above.) Thinking in terms of your answer to (7) so far, what would Michael Jackson and the Microsoft have in common? Nothing at all? Something? (8) Let's say that you want to make a lot of money as a rock star. In fact, you believe that you have a special talent for a specific type of beat music? How would you use your time in order to become a personal monopoly with respect to your type of music? (Remember the earlier graph that stressed the three factors that will determine how much a wage, salary, or payment you can commend from providing your product. Now, let's say you are successful in your rock star adventure. Do you think it is likely that your agents will ensure that concert ticket prices are above marginal cost? Would you be taking advantage of the elasticity rule in your line of work? Graph a hypothetical demand and supply (horizontal MC curve) relation for your music business and show just how the elasticity rule relationship might work out.
(9) Often you find discount coupons for groceries in the newspaper. People can choose to cut out these coupons and take them to the market for the discount on specific products. If this is PD, (Price Discrimination) what Degree of PD is it and what is the logic behind the coupon strategy? Do you think that the company offering the discount coupons has the people who do not use the coupons in mind with this strategy? What strategy might the store or the producer use when it prices its products for those who do not choose to use the coupons? (10) Assume that in the market for branded cigarettes from one producer there are distinct customer groups whose intensity of demand differs between the groups. That is, there are different demand elasticities for different types of cigarettes produced by this one company. (Low filter, high filer, no filers, long, short, sweet, sours, etc.) However, the company charges one single price for any given package of cigarettes. Is this PD? If so, what kind is it? (11) Assume that in the market for branded cigarettes from one producer there are distinct customer groups whose intensity of demand differs between the groups. That is there are different demand elasticities for different types of cigarettes produced by this one company. (Low filter, high filer, no filers, long, short, sweet, sours, etc.) The company charges many different prices for any given package of cigarettes. Is this PD? If so, what kind is it? If this is PD, what strategic rule of pricing should the cigarette company use? (12) Assume that a community has a constant- average cost monopolist that provides monthly pest control to residential homes. It wants to maximize profits. Illustrate what it would normally do to accomplish this. What does this mean for community welfare in the normal case? Now, the pest control company decides to enact two-tier pricing. It charges an up-front "service charge" fee each year for the monthly service calls. Illustrate with a graph what options are open to the company. What is the maximum fee it could reasonably expect to charge? Is it possible that a two-tier pricing strategy could lead to economic efficiency (with respect to overall welfare) in the community's pest control market?
(13) You can fly on Air France from San Francisco to Paris in economy for as low as $600.00. You can fly in the same plane on the same route, in the same time, in business class for, say, $8000.00. What kind of PD is this? What human need is Air France trying to profit from? Illustrate with two demand curves and horizontal MC curves (markets for economy and business class flights) how the pricing of these two classes might work.
(14) Determine what Degree of PD may be involved in each of the following cases: • A healthcare provider that is a monopolist prices its healthcare productsand doctor visits according to the income level of the buyer (higher income – higher price). • A government imposes a progressive income tax (this is slightly a trick question) • Air France has 25 different prices for seats on its San Francisco – Paris route. • Century Movie Theaters has discounts for Seniors and Students • Let's say that ATT Cellular charges no up-front fee for new users of the iPhone 5® version, but a large fee for existing customers who want to upgrade from the 4g or the 4gs version.
(15) The hair shampoo industry has the following characteristics: individual products do essentially the same thing, they wash and/or condition hair. However, the different shampoo products are highly differentiated by texture, smell, soapiness, container shape, and alleged benefits (volumizing, color retention, ease of use, etc.) Entry into the hair shampoo industry is easy with many firms coming and going. Each firm behaves independently from the others. (a) What type of industry is this? Explain your answer (b) Illustrate the short-run equilibrium position for a representative firm that is earning short-run economic profit. (c) What would have to happen in this industry if the firm in (b) now suffers short-run economic losses? (d) What will happen to the number of firms in this industry in the long-run? Illustrate the long-run position of a representative firm in the hair shampoo business. (e) Is the long-run equilibrium in this industry efficient – is there allocative efficiency? (f) Can you argue that the consumer is better off in this long-run equilibrium? (g) In the long run, should there be more or less firms in this industry? Why? (16) You go to a Frozen Yoghurt shop. The shop offers 16 flavors of yoghurt, 3 different fat contents in each flavor, and 27 toppings to choose from. What is it about the scene described here that would indicate that Monopolistic Competition is a fact of business life today?
