Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)
1. A discriminating monopolist sells in two markets. Assume that no arbitrage is possible.
The demand curve in market 1 is given by p1 = 100 0.5q1 and the demand curve in
market 2 is given by p2 = 100 q2 . The monopolists aggregate production is q = q1 + q2

()

and his cost function is given by TC q = q 2 :

(a) Formulate the monopolys profit function in terms of . q1 and q2 ;
(b) Calculate the monopolys profit maximising quantity sold in market 1 and market 2;
(c) Calculate the profit level of the discriminating monopoly;
(d) Suppose now that a new management assumed control of the firm and decide to decompose the
monopoly plant into two plants, where plant 1 sells in market 1 only and plant 2 sells in market 2
only. Calculate the profit maximising level of output sold in each plant;
(e) Calculate the sum of profits in the two plants;
(f) How does this plant decomposition impact upon profit? Why?

(a) Formulate the monopolys profit function in terms of q1 and q2 ;

) (

q1 ,q2 = 100 0.5q1 q1 + 100 q2 q2 q1 + q2

q1 ,q2 = 100q1 0.5q12 + 100q2 q22 q12 q22 2q1q2

q1 ,q2 = 100 q1 + q2 1.5q12 2q22 2q1q2

(b) Calculate the monopolys profit maximising quantity sold in market 1 and market 2;
The two first-order conditions are:

q1 ,q2
q1

q1 ,q2
q2

) = 100 3q 2q
1

) = 100 2q 4q
1

=0
=0

Thus:

100 2q1 4q2 = 0

200 6q1 4q2 = 0

100 4q1 = 0

q1 = 25
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Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

And:

( )

( )

100 3 25 2q2 = 0 = 100 2 25 4q2

25 2q2 = 0 = 50 4q2

q2 = 12.5

(c) Calculate the profit level of the discriminating monopoly;

( 25,12.5 ) = 100 ( 25 + 12.5) 1.5 ( 25 ) 2 (12.5 ) 2 25 12.5

2

= 100 ( 37.5) 1.5 ( 625 ) 2 (156.25 ) 625

= 3750 937.5 312.5 625

= 1875
(d) Suppose now that a new management assumed control of the firm and decide to
decompose the monopoly plant into two plants, where plant 1 sells in market 1 only and
plant 2 sells in market 2 only. Calculate the profit maximising level of output sold in each
plant;
Each plant operates as a separate entity such that:

( ) (
)
( q ) = (100 q ) q q

1 q1 = 100 0.5q1 q1 q12 = 100q1 1.5q12

2

2
2

= 100q2 2q12

Thus:

q1 ,q2
q1

q1 ,q2
q2

) = 100 3q = 0
1

) = 100 4q

=0

q1 = 100 3
q2 = 25
(e) Calculate the sum of profits in the two plants;

Industrial Organisation (ES30044)

( )

( )

1 q = 100q 1.5 q

( )

( )

2 q2 = 100q2 2 q2

( )

( )

Seminar Three: Monopoly (ii)

100
100
= 100
1.5
= 1666.67

3
3

( ) ( )

= 100 25 2 25 = 1250

( )

q = 1 q1 + 2 q2 = 1666.67 + 1250 = 2916.67

(f) How does this plant decomposition impact upon profit? Why?

( )

= q = 2916.67 1875 = 1041.67 > 0

The decomposition increases the monopolys profit since the technology exhibits decreasing
returns to scale.
2. Consider the market for iPhones. Apple holds the patent for iPhones. On the demand side,
there are n H high-income consumers who are willing to pay a maximum price of V H for
an iPhone, and n L low-income consumers who are willing to pay a maximum price of V L
for an iPhone. Assume that V H > V L > 0 and that each consumer buys only one iPhone.
Suppose that Apple cannot price discriminate and is therefore constrained to set a uniform
market price:
(a) Draw the aggregate-demand curve facing Apple;
(b) Find the profit-maximising price set by Apple, considering all possible parameter values of
n H , n L ,V H ,V L . Assume that production is costless.

(a) Draw the aggregate-demand curve facing Apple;

Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

VH

VL
Demand
nH

nH + nL

Figure 1

Figure 1 illustrates an aggregate demand composed of the two groups of consumers, where
each group shares a common valuation for the product:
(b) Find the profit-maximising price set by Apple, considering all possible parameter values
of (n H , n L , V H , V L ). Assume that production is costless.
The monopoly has two options: (i) setting a high price, p = V H ; or (ii) setting a low price,
p = V L . Figure 1 reveals that the profit levels (i.e. revenue, since production is costless) are
given by:

p =V H

= n HV H

And:

p =V L

= (n H + n L )V H

Comparing the two profit levels yields the monopolys profit maximizing price. Hence:

H
V
m
p =
V L

If

nH + nL
VH >
H
n
Otherwise

L
V

Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

Thus, the monopoly sets a high price if either there are relatively many (few) high (low)
valuation consumers (i.e. nH is large or nL is small) and / or high (low) valuation consumers
are willing to pay a relatively high (low) price (VH is high or VL is small).
3. A monopoly faces a demand function given by p = q and has a unit production cost
of c > 0. Suppose the government imposes a specific tax of $t per unit on each unit of
output sold to consumers:
(a) Show that this tax imposition would raise the price paid by consumers by less than t;
(b) How would your answer to (a) change if the market demand curve was given by p = q

(a) Show that this tax imposition would raise the price paid by consumers by less than t;
Total revenue is given by:

TR = pq = q q

TR = q q 2
Marginal revenue is thus:

MR

TR
= 2 q
q

Equating marginal revenue to the tax inclusive unit cost implies:

MR = 2 q = c + t

ct
qt =
2
Thus:

pt = qt

ct
pt =
2

pt =

+c+t
2

such that:

p t 1
= <1
t 2
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Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

Hence, as illustrated in Figure 2, an increase in t raises the monopoly price by less than t:

pt
p

c+t

MCt

MC
MR
0

q1

q0

AR

Figure 2

(b) How would your answer to (a) change if the market demand curve was given by p = q ?
This is the case of a constant-elasticity demand curve. To be sure:

dp
q
= q 1 =
dq
q

dp q
q
= q 1 =
dq p
q

dq p
1

=
dp q

p
q

p q
=
q p

Recall:

Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

()

TR = p q q

MR

dTR dp
=
q+ p
dq
dq

dp q
1
1
MR = p 1+
= p 1+ = p 1 1
dq p
E

MR = p 1

Monopoly equilibrium implies:

MR = p 1 = c + t = MC

p=

c+t
1

Thus:

p
1
=
t 1
Thus, price will increase by more (resp. less) than the increase in the tax if < 1 (resp.
> 1 ).

Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

pt
p
c+t
c

MCt
MC
AR
MR

q1 q0

Figure 3

4. A monopoly faces demand from two individuals for its output. The demand function of
individual 1 is given by q1d = 24 p1 and the demand function of individual 2 is given by

q2d = 24 2 p2 . Assume that the monopoly has a unit production cost of c = 6. Investigate
the potential benefit to the monopolist of setting a two-part tariff [Hint: See Oi (1971)].
A linear two-part tariff is a scheme under which demanders pay a fixed fee for the right to
consume the good and a uniform price for each unit consumed. The prototype case, first
studied by Oi (1971) is an amusement park (Disneyland?) that sets a basic entry fee coupled
with a stated marginal price for each amusement used.1 Mathematically, such a scheme can
be represented by a tariff under which a demander must pay T ( q ) to purchase q units of the
good where:

T ( q ) = a + pq

Interestingly, Disneyland once used a two-part tariff but abandoned it because the costs of administering the
payment scheme for individuals rises became too high. Like other amusement arks, Disney moved to a singleadmissions price policy (which still provided them with ample opportunities for price discrimination, especially
with the multiple parks at Disney World).

Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

Thus, a is the fixed fee and p is the marginal price to be paid. The monopolists goal is to
chose a and p to maximise profits, given the demand for this product. Note that the average
price paid by any demander is given by:

p=

T (q) a
= +p
q
q

Thus, the tariff is inversely related to q and is thus only feasible when those who pay low
prices (i.e. those for whom q is large) are unable to resell the good to those who must pay
high average prices (i.e. those for who q is small).
One approach for establishing the parameters of the linear tariff would be for the firm
to set the marginal price, p, equal to MC and then to set the fixed fee, a, so as to extract the
maximum consumer surplus from a given set of buyers [Oi (1971)]. One might imagine
buyers being arrayed according to their willingness to pay. The choice of p = MC would then
maximise consumer surplus for this group, and a could be set equal to the surplus enjoyed by
the least eager buyer. This buyer would then be indifferent about buying the good, but all the
other (i.e. more eager) buyers would experience net gains from the purchase.
This feasible tariff might not, however, be the most profitable. Consider the effects on
profits of a small increase in p above MC. This would result in no net change in the profits
earned from the least willing buyer. Quantity demanded would drop slightly at the margin
where p = MC, and some of what had previously been consumer surplus (and therefore part
of the fixed fee, a) would be converted into variable profits because now p > MC. For all
other demanders, profits would be increased by the price rise. Although each will pay a bit
less in fixed charges, profits per unit purchased will rise to a greater extent.2 IN some cases it
is possible to make an explicit calculation of the optimal two-part tariff but, in general,
optimal schedules will depend on a variety of contingencies.
In terms of the example, an Oi Tariff requires the monopolist to set p1 = p2 = 6 = MC
such that q1 = 18 and q2 = 12 . With this marginal price, demander 2 (i.e. the less eager of the
two) obtains consumer surplus of CS2 = 0.5 (12 6 ) = 36 , which is the maximal entry fee
that might be charged without causing demander 2 to leave the market - see Figure 4.
Consequently, the two-part tariff in this case would be:
T ( qi ) = 36 + 6qi

If the monopolist opted for this pricing scheme, then its profits would be:
= TR TC = T ( q1 ) + T ( q2 ) AC ( q1 + q2 )

= 36 + 6 (18 ) + 36 + 6 (12 ) 6 (18 + 12 )

= 72

This follows because qi ( MC ) > q1 ( MC ) where qi ( MC ) is the quantity demanded when p = MC for all
except the least willing purchaser (i.e. purchaser 1). Hence, the gain in profits from an increase in p above MC
[i.e. pqi ( MC ) ] exceeds the loss in profits from a smaller fixed fee [i.e. pq1 ( MC ) ].
2

Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

p1

p2
q1 = 24 - p1

q2 = 24 - 2p2

24

12

CS1= 162

CS2 = 36

18

24

q1 0

MC

12

24

q2

Figure 4

Note that this is a lower profit than the monopolist could obtain from third-degree price
discrimination. In that case, p1 = 15, q1 = 9, p2 = 9, q2 = 6, = 99 . Moreover, it is less,
than the profit it could obtain setting a single price. In that case, the monopolist would cease
serving market 2 since it can maximise profits by setting p = 15 such that
q1 = 9, q2 = 0, = 81 - see Figure 5:

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Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

p1

p2
q1= 24 - p1

q2 = 24 - 2p2

24

15
12
9

MC

MR1

9 12

AR1

24

MR2

q1 0

12

AR2

24

q2

Figure 5: Third-Degree Price Discrimination

The optimal two-part tariff in this situation can be computed by noting that that total profits
with such a tariff are:

= 2a + ( p MC ) ( q1 + q2 )
where the entry fee, a, must equal the consumer surplus of the least eager demander (i.e.
demander 2). Thus:

= 2a + ( p MC ) ( q1 + q2 )

= 2 0.5 (12 p ) q2 + ( p 6 ) ( q1 + q2 )

= 2 0.5 (12 p ) ( 24 2 p ) + ( p 6 ) ( 24 p ) + ( 24 2 p )

= (12 p ) ( 24 2 p ) + ( p 6 ) ( 48 3p )

= 288 24 p 24 p + 2 p 2 + 48 p 3p 2 288 + 18 p

= 18 p p 2
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Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

Thus:

d
= 18 2 p = 0
dp

p = 9
p = 9

Thus, maximum profits from a two-part tariff are obtained when

a = CS2 = 0.5 12 p q = 0.5 12 p

tariff is thus:

)( 24 2 p ) = 0.5 (12 9 )( 24 18 ) = 9 .

and

The optimal

T ( q ) = 9 + 9q
With this tariff, q1 = 15, q2 = 6 and = 2a + ( p MC ) ( q1 + q2 ) = 2 ( 9 ) + ( 9 6 ) (15 + 6 ) = 81 .

p1

p2
q1= 24 - p1

q2 = 24 - 2p2

24

12
9

MC

MR1

12 15

AR1

24

MR2

q1 0

12

AR2

24

q2

Figure 6: Optimal Two-Part Tariff

The monopolist might opt for this pricing scheme if it were under political pressure to have a
uniform pricing policy that did not price demander 2 out of the market. The two-part tariff
permits a degree of differential pricing [i.e. p1 = ( 9 15 ) + 9 = 9.60 , p2 = ( 9 6 ) + 9 = 10.5 ] but
appears fair because all buyers face the same schedule.

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Industrial Organisation (ES30044)

Seminar Three: Monopoly (ii)

Reference
Oi, W. Y. (1971). A Disneyland Dilemma: Two-Part Tariffs for a Mickey Mouse Monopoly. The Quarterly
Journal of Economics, 85(1), pp. 77-96.

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