Advanced Microeconomic

Theory
Chapter 7: Monopoly
 Outline
• Barriers to Entry
• Profit Maximization under Monopoly
• Welfare Loss of Monopoly
• Multiplant Monopolist
• Price Discrimination
• Advertising in Monopoly
• Regulation of Natural Monopolies
• Monopsony

Advanced Microeconomic Theory 2

Barriers to Entry

Advanced Microeconomic Theory 3

 Barriers to Entry
• Entry barriers: elements that make the entry
of potential competitors either impossible or
very costly.
• Three main categories:
1) Legal: the incumbent firm in an industry has the
legal right to charge monopoly prices during the
life of the patent
– Example: newly discovered drugs

Advanced Microeconomic Theory 4

 Barriers to Entry
2) Structural: the incumbent firm has a cost or
demand advantage relative to potential entrants.
– superior technology
– a loyal group of customers
 positive network externalities (Facebook, eBay)

3) Strategic: the incumbent monopolist has a

reputation of fighting off newcomers, ultimately
driving them off the market.
– price wars
Advanced Microeconomic Theory 5
Profit Maximization under
Monopoly

Advanced Microeconomic Theory 6

 Profit Maximization
• Consider a demand function 𝑥𝑥(𝑝𝑝), which is
continuous and strictly decreasing in 𝑝𝑝, i.e.,
𝑥𝑥′ 𝑝𝑝 < 0.
• We assume that there is price 𝑝𝑝̅ < ∞ such
that 𝑥𝑥 𝑝𝑝 = 0 for all 𝑝𝑝 > 𝑝𝑝.̅
• Also, consider a general cost function 𝑐𝑐(𝑞𝑞),
which is increasing and convex in 𝑞𝑞.

Advanced Microeconomic Theory 7

 Profit Maximization
• 𝑝𝑝̅ is a “choke price”
• No consumers buy
p

x( p )=0 for all p >p

positive amounts of the p
good for 𝑝𝑝 > 𝑝𝑝.̅
x '( p ) < 0

x(p)

Advanced Microeconomic Theory 8

 Profit Maximization
• Monopolist’s decision problem is
max 𝑝𝑝𝑝𝑝 𝑝𝑝 − 𝑐𝑐(𝑥𝑥(𝑝𝑝))
𝑝𝑝

• Alternatively, using 𝑥𝑥 𝑝𝑝 = 𝑞𝑞, and taking the

inverse demand function 𝑝𝑝 𝑞𝑞 = 𝑥𝑥 −1 (𝑞𝑞), we
can rewrite the monopolist’s problem as
max 𝑝𝑝 𝑞𝑞 𝑞𝑞 − 𝑐𝑐(𝑞𝑞)
𝑞𝑞≥0

Advanced Microeconomic Theory 9

 Profit Maximization
• Differentiating with respect to 𝑞𝑞,
𝑝𝑝 𝑞𝑞𝑚𝑚 + 𝑝𝑝′ 𝑞𝑞𝑚𝑚 𝑞𝑞𝑚𝑚 − 𝑐𝑐 ′ 𝑞𝑞𝑚𝑚 ≤ 0
• Rearranging,
𝑝𝑝(𝑞𝑞𝑚𝑚 ) + 𝑝𝑝′ 𝑞𝑞𝑚𝑚 𝑞𝑞𝑚𝑚 ≤ 𝑐𝑐𝑐(𝑞𝑞𝑚𝑚 )
𝑑𝑑 𝑝𝑝 𝑞𝑞 𝑞𝑞 𝑀𝑀𝑀𝑀
𝑀𝑀𝑀𝑀=
𝑑𝑑𝑑𝑑
𝑚𝑚
with equality if 𝑞𝑞 > 0.
• Recall that total revenue is 𝑇𝑇𝑅𝑅 𝑞𝑞 = 𝑝𝑝 𝑞𝑞 𝑞𝑞

Advanced Microeconomic Theory 10

 Profit Maximization
• In addition, we assume that 𝑝𝑝 0 ≥ 𝑐𝑐 ′ (0).
– That is, the inverse demand curve originates
above the marginal cost curve.
– Hence, the consumer with the highest willingness
to pay for the good is willing to pay more than the
variable costs of producing the first unit.
• Then, we must be at an interior solution 𝑞𝑞𝑚𝑚 >
0, implying
𝑝𝑝(𝑞𝑞𝑚𝑚 ) + 𝑝𝑝′ 𝑞𝑞𝑚𝑚 𝑞𝑞𝑚𝑚 = 𝑐𝑐𝑐(𝑞𝑞𝑚𝑚 )
𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀
Advanced Microeconomic Theory 11
 Profit Maximization
• Note that
𝑝𝑝 𝑞𝑞𝑚𝑚 + 𝑝𝑝′ 𝑞𝑞𝑚𝑚 𝑞𝑞𝑚𝑚 = 𝑐𝑐𝑐(𝑞𝑞𝑚𝑚 )
−
• Then, 𝑝𝑝 𝑞𝑞𝑚𝑚 > 𝑐𝑐𝑐(𝑞𝑞𝑚𝑚 ), i.e.,
monopoly price > 𝑀𝑀𝑀𝑀
• Moreover, we know that in competitive
equilibrium 𝑝𝑝 𝑞𝑞∗ = 𝑐𝑐𝑐(𝑞𝑞∗ ).
• Then, 𝑝𝑝𝑚𝑚 > 𝑝𝑝∗ and 𝑞𝑞𝑚𝑚 < 𝑞𝑞∗ .

Advanced Microeconomic Theory 12

Profit Maximization

Advanced Microeconomic Theory 13

 Profit Maximization
• Marginal revenue in monopoly
𝑀𝑀𝑀𝑀 = 𝑝𝑝 𝑞𝑞𝑚𝑚 + 𝑝𝑝′ 𝑞𝑞𝑚𝑚 𝑞𝑞𝑚𝑚
MR describes two effects:
– A direct (positive) effect: an additional unit can be
sold at 𝑝𝑝 𝑞𝑞 𝑚𝑚 , thus increasing revenue by 𝑝𝑝 𝑞𝑞 𝑚𝑚 .
– An indirect (negative) effect: selling an additional
unit can only be done by reducing the market
price of all units (the new and all previous units),
ultimately reducing revenue by 𝑝𝑝′ 𝑞𝑞 𝑚𝑚 𝑞𝑞 𝑚𝑚 .
 Inframarginal units – initial units before the marginal
increase in output.
Advanced Microeconomic Theory 14
 Profit Maximization
• Is the above FOC also sufficient?
– Let’s take the FOC 𝑝𝑝 𝑞𝑞 𝑚𝑚 + 𝑝𝑝′ 𝑞𝑞 𝑚𝑚 𝑞𝑞 𝑚𝑚 − 𝑐𝑐 ′ 𝑞𝑞 𝑚𝑚 ,
and differentiate it wrt 𝑞𝑞,
𝑝𝑝′ 𝑞𝑞 + 𝑝𝑝′ 𝑞𝑞 + 𝑝𝑝′′ 𝑞𝑞 𝑞𝑞 − 𝑐𝑐𝑐𝑐(𝑞𝑞) ≤ 0
𝑑𝑑𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑𝐶𝐶
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑

𝑑𝑑𝑑𝑑𝑅𝑅 𝑑𝑑𝑑𝑑𝑑𝑑
– That is, ≤ .
𝑑𝑑𝑑𝑑 𝑑𝑑𝑑𝑑
– Since MR curve is decreasing and MC curve is
weakly increasing, the second-order condition is
satisfied for all 𝑞𝑞.
Advanced Microeconomic Theory 15
 Profit Maximization
p

MC(q)

pm

x(p)
MR(q)

qm q

Advanced Microeconomic Theory 16

 Profit Maximization
• What would happen if MC curve was
decreasing in 𝑞𝑞 (e.g., concave technology
given the presence of increasing returns to
scale)?
– Then, the slopes of MR and MC curves are both
decreasing.
– At the optimum, MR curve must be steeper MC
curve.

Advanced Microeconomic Theory 17

 Profit Maximization
p

pm

MC(q)
x(p)
MR(q)

qm q

Advanced Microeconomic Theory 18

 Profit Maximization: Lerner Index
• Can we re-write the FOC in a more intuitive
way? Yes.
′ 𝜕𝜕𝜕𝜕
– Just take 𝑀𝑀𝑀𝑀 = 𝑝𝑝 𝑞𝑞 + 𝑝𝑝 𝑞𝑞 𝑞𝑞 = 𝑝𝑝 + 𝑞𝑞 and
𝜕𝜕𝑞𝑞
𝑝𝑝
multiply by ,
𝑝𝑝
𝑝𝑝 𝜕𝜕𝜕𝜕 𝑞𝑞 1
𝑀𝑀𝑀𝑀 = 𝑝𝑝 + 𝑝𝑝 = 𝑝𝑝 + 𝑝𝑝
𝑝𝑝 𝜕𝜕𝜕𝜕
� 𝑝𝑝 𝜀𝜀𝑑𝑑
1/𝜀𝜀𝑑𝑑
– In equilibrium, 𝑀𝑀𝑀𝑀(𝑞𝑞) = 𝑀𝑀𝑀𝑀(𝑞𝑞). Hence, we can
replace MR with MC in the above expression.
Advanced Microeconomic Theory 19
 Profit Maximization: Lerner Index
• Rearranging yields
𝑝𝑝 − 𝑀𝑀𝑀𝑀(𝑞𝑞) 1
=−
𝑝𝑝 𝜀𝜀𝑑𝑑
• This is the Lerner index of market power
– The price mark-up over marginal cost that a
monopolist can charge is a function of the elasticity of
demand.
• Note:
𝑝𝑝−𝑀𝑀𝑀𝑀(𝑞𝑞)
– If 𝜀𝜀𝑑𝑑 → ∞, then →0 ⟹ 𝑝𝑝 = 𝑀𝑀𝑀𝑀(𝑞𝑞)
𝑝𝑝
𝑝𝑝−𝑀𝑀𝑀𝑀(𝑞𝑞)
– If 𝜀𝜀𝑑𝑑 → 0, then →∞ ⟹ substantial mark-up
𝑝𝑝
Advanced Microeconomic Theory 20
 Profit Maximization: Lerner Index
• The Lerner index can also be written as
𝑀𝑀𝑀𝑀(𝑞𝑞)
𝑝𝑝 = 1
1+
𝜀𝜀𝑑𝑑

which is referred to as the Inverse Elasticity Pricing

Rule (IEPR).
• Example (Perloff, 2012):
– Prilosec OTC: 𝜀𝜀𝑑𝑑 = −1.2. Then price should be 𝑝𝑝 =
𝑀𝑀𝑀𝑀(𝑞𝑞)
1 = 6𝑀𝑀𝑀𝑀
1+
−1.2
– Designed jeans: 𝜀𝜀𝑑𝑑 = −2. Then price should be 𝑝𝑝 =
𝑀𝑀𝑀𝑀(𝑞𝑞)
1 = 2𝑀𝑀𝑀𝑀
1+ Advanced Microeconomic Theory 21
−2
 Profit Maximization: Lerner Index
• Example 1 (linear demand):
– Market inverse demand function is
𝑝𝑝 𝑞𝑞 = 𝑎𝑎 − 𝑏𝑏𝑏𝑏
where 𝑏𝑏 > 0
– Monopolist’s cost function is 𝑐𝑐 𝑞𝑞 = 𝑐𝑐𝑐𝑐
– We usually assume that 𝑎𝑎 > 𝑐𝑐 ≥ 0
 To guarantee 𝑝𝑝 0 > 𝑐𝑐𝑐(0)
 That is, 𝑝𝑝 0 = 𝑎𝑎 − 𝑏𝑏𝑏 = 𝑎𝑎 and 𝑐𝑐 ′ 𝑞𝑞 = 𝑐𝑐, thus
implying 𝑐𝑐 ′ 0 = 𝑐𝑐

Advanced Microeconomic Theory 22

 Profit Maximization: Lerner Index
• Example 1 (continued):
– Monopolist’s objective function
𝜋𝜋 𝑞𝑞 = 𝑎𝑎 − 𝑏𝑏𝑏𝑏 𝑞𝑞 − 𝑐𝑐𝑐𝑐
– FOC: 𝑎𝑎 − 2𝑏𝑏𝑏𝑏 − 𝑐𝑐 = 0
– SOC: −2𝑏𝑏 < 0 (concave)
 Note that as long as 𝑏𝑏 > 0, i.e., negatively sloped
demand function, profits will be concave in output.
 Otherwise (i.e., Giffen good, with positively sloped
demand function) profits will be convex in output.
Advanced Microeconomic Theory 23
 Profit Maximization: Lerner Index
• Example 1 (continued):
– Solving for the optimal 𝑞𝑞𝑚𝑚 in the FOC, we find
monopoly output
𝑚𝑚
𝑎𝑎 − 𝑐𝑐
𝑞𝑞 =
2𝑏𝑏
𝑚𝑚 𝑎𝑎−𝑐𝑐
– Inserting 𝑞𝑞 = in the demand function, we
2𝑏𝑏
obtain monopoly price
𝑚𝑚
𝑎𝑎 − 𝑐𝑐 𝑎𝑎 + 𝑐𝑐
𝑝𝑝 = 𝑎𝑎 − 𝑏𝑏 =
2𝑏𝑏 2
– Hence, monopoly profits are
2
𝑎𝑎 − 𝑐𝑐
𝜋𝜋 𝑚𝑚 = 𝑝𝑝𝑚𝑚 𝑞𝑞𝑚𝑚 − 𝑐𝑐𝑞𝑞𝑚𝑚 =
4𝑏𝑏
Advanced Microeconomic Theory 24
 Profit Maximization: Lerner Index
• Example 1 (continued):

Advanced Microeconomic Theory 25

 Profit Maximization: Lerner Index
• Example 1 (continued):
– Non-constant p
marginal cost
c’(q)

a
– The cost function is
convex in output pm
𝑐𝑐(𝑞𝑞) = 𝑐𝑐𝑞𝑞2
– Marginal cost is p(q)=a-bq
MR=a-2bq
𝑐𝑐′(𝑞𝑞) = 2𝑐𝑐𝑐𝑐
a
qm 1 ⋅ a
q

2 b b
Advanced Microeconomic Theory 26
 Profit Maximization: Lerner Index
• Example 2 (Constant elasticity demand):
– The demand function is
𝑞𝑞(𝑝𝑝) = 𝐴𝐴𝑝𝑝−𝑏𝑏
– We can show that 𝜀𝜀 𝑞𝑞 = −𝑏𝑏 for all 𝑞𝑞, i.e.,
𝜕𝜕𝜕𝜕(𝑝𝑝) 𝑝𝑝 −𝑏𝑏−1
𝑝𝑝
𝜀𝜀 𝑞𝑞 = = −𝑏𝑏 𝐴𝐴𝑝𝑝
𝜕𝜕𝑝𝑝 𝑞𝑞 𝐴𝐴𝑝𝑝−𝑏𝑏
𝜕𝜕𝜕𝜕(𝑝𝑝)
𝜕𝜕𝜕𝜕 𝑝𝑝
𝑞𝑞
𝑝𝑝−𝑏𝑏 𝑝𝑝
= −𝑏𝑏 −𝑏𝑏
= −𝑏𝑏
𝑝𝑝 𝑝𝑝
Advanced Microeconomic Theory 27
 Profit Maximization: Lerner Index
• Example 2 (continued):
– We can now plug 𝜀𝜀 𝑞𝑞 = −𝑏𝑏 into the Lerner
index,
𝑚𝑚
𝑐𝑐 𝑐𝑐 𝑏𝑏𝑏𝑏
𝑝𝑝 = = =
1 1 𝑏𝑏 − 1
1+ 1−
𝜀𝜀 𝑞𝑞 𝑏𝑏
– That is, price is a constant mark-up over marginal
cost.

Advanced Microeconomic Theory 28

Welfare Loss of Monopoly

Advanced Microeconomic Theory 29

 Welfare Loss of Monopoly
• Welfare comparison for perfect competition and
monopoly.
p

q*

A
∫ [ p(s) − c '(s)] ds
q m
c’(q)

p(q m ) pm B C
p* E
D

p(q)
MR=p(q)+p’(q)q

qm q* q

Advanced Microeconomic Theory 30

 Welfare Loss of Monopoly
• Consumer surplus
– Perfect competition: A+B+C
– Monopoly: A
• Producer surplus:
– Perfect competition: D+E
– Monopoly: B+D
• Deadweight loss of monopoly: C+E
𝑞𝑞 ∗
𝐷𝐷𝐷𝐷𝐷𝐷 = � 𝑝𝑝 𝑠𝑠 − 𝑐𝑐𝑐(𝑠𝑠) 𝑑𝑑𝑑𝑑
𝑞𝑞 𝑚𝑚
• DWL decreases as demand and/or supply become
more elastic.
Advanced Microeconomic Theory 31
 Welfare Loss of Monopoly
• Infinitely elastic demand
𝑝𝑝′ 𝑞𝑞 = 0
• The inverse demand curve p

becomes totally flat. c’(q)

• Marginal revenue coincides

with inverse demand: p p(q) = p
𝑀𝑀𝑀𝑀 𝑞𝑞 = 𝑝𝑝 𝑞𝑞 + 0 � 𝑞𝑞
= 𝑝𝑝(𝑞𝑞)
• Profit-maximizing 𝑞𝑞
𝑀𝑀𝑀𝑀 𝑞𝑞 = 𝑀𝑀𝑀𝑀 𝑞𝑞 ⟹ q
qm
𝑝𝑝 𝑞𝑞 = 𝑀𝑀𝑀𝑀(𝑞𝑞)
• Hence, 𝑞𝑞 𝑚𝑚 = 𝑞𝑞 ∗ and Coincides with q* (PC market)
𝐷𝐷𝐷𝐷𝐷𝐷 = 0.
Advanced Microeconomic Theory 32
 Welfare Loss of Monopoly
• Example (Welfare losses and elasticity):
– Consider a monopolist with constant marginal and
average costs, 𝑐𝑐 ′ 𝑞𝑞 = 𝑐𝑐, who faces a market
demand with constant elasticity
𝑞𝑞 𝑝𝑝 = 𝑝𝑝𝑒𝑒
where 𝑒𝑒 is the price elasticity of demand (𝑒𝑒 < −1)
– Perfect competition: 𝑝𝑝𝑐𝑐 = 𝑐𝑐
– Monopoly: using the IEPR
𝑚𝑚
𝑐𝑐
𝑝𝑝 =
1
1+
𝑒𝑒
Advanced Microeconomic Theory 33
 Welfare Loss of Monopoly
• Example (continued):
– The consumer surplus associated with any price (𝑝𝑝0 ) can be
computed as
∞
∞ ∞
𝑝𝑝𝑒𝑒+1 𝑝𝑝0𝑒𝑒+1
𝐶𝐶𝐶𝐶 = � 𝑄𝑄 𝑃𝑃 𝑑𝑑𝑑𝑑 = � 𝑝𝑝𝑒𝑒 𝑑𝑑𝑝𝑝 = � =− >0
𝑝𝑝0 𝑝𝑝0 𝑒𝑒 + 1 𝑒𝑒 + 1
𝑝𝑝0 <0
– Under perfect competition, 𝑝𝑝𝑐𝑐 = 𝑐𝑐,
𝑐𝑐 𝑒𝑒+1
𝐶𝐶𝑆𝑆 = −
𝑒𝑒 + 1
𝑐𝑐
– Under monopoly, 𝑝𝑝𝑚𝑚 = ,
1+1/𝑒𝑒
𝑒𝑒+1
𝑐𝑐
1 + 1/𝑒𝑒
𝐶𝐶𝐶𝐶𝑚𝑚 = −
𝑒𝑒 + 1
Advanced Microeconomic Theory 34
 Welfare Loss of Monopoly
• Example (continued):
– Taking the ratio of these two surpluses
𝑒𝑒+1
𝐶𝐶𝐶𝐶𝑚𝑚 1
=
𝐶𝐶𝐶𝐶 1 + 1/𝑒𝑒

– If 𝑒𝑒 = −2, this ratio is ½

 CS under monopoly is half of that under perfectly
competitive markets

Advanced Microeconomic Theory 35

 Welfare Loss of Monopoly
• Example (continued):
𝐶𝐶𝐶𝐶𝑚𝑚 1 𝑒𝑒+1
– The ratio = decreases as demand becomes
𝐶𝐶𝐶𝐶 1+1/𝑒𝑒
more elastic (𝑒𝑒 increases in absolute value).

Advanced Microeconomic Theory 36

 Welfare Loss of Monopoly
• Example (continued):
– Monopoly profits are given by
𝑚𝑚 𝑚𝑚 𝑚𝑚 𝑚𝑚
𝑐𝑐
𝜋𝜋 = 𝑝𝑝 𝑞𝑞 − 𝑐𝑐𝑞𝑞 = − 𝑐𝑐 𝑞𝑞𝑚𝑚
1 + 1/𝑒𝑒
𝑐𝑐 𝑒𝑒
where 𝑞𝑞𝑚𝑚 (𝑝𝑝) = 𝑝𝑝𝑒𝑒 = .
1+1/𝑒𝑒
– Rearranging,
𝑒𝑒
𝑚𝑚
−𝑐𝑐/𝑒𝑒 𝑐𝑐
𝜋𝜋 =
1 + 1/𝑒𝑒 1 + 1/𝑒𝑒
𝑒𝑒+1
𝑐𝑐 1
=− �
1 + 1/𝑒𝑒 𝑒𝑒
Advanced Microeconomic Theory 37
 Welfare Loss of Monopoly
• Example (continued):
– To find the transfer from CS into monopoly profits
that consumers experience when moving from
perfect competition to a monopoly, divide
monopoly profits by the competitive CS
𝜋𝜋𝑚𝑚 𝑒𝑒+1 1 𝑒𝑒+1 𝑒𝑒 𝑒𝑒
= =
𝐶𝐶𝐶𝐶 𝑒𝑒 1+1/𝑒𝑒 1+𝑒𝑒

– If 𝑒𝑒 = −2, this ratio is ¼

 One-fourth of the consumer surplus under perfectly
competitive markets is transferred to monopoly profits
Advanced Microeconomic Theory 38
 Welfare Loss of Monopoly
• More social costs of monopoly:
– Excessive R&D expenditure (patent race)
– Persuasive (not informative) advertising
– Lobbying costs (different from bribes)
– Resources to avoid entry of potential firms in the
industry

Advanced Microeconomic Theory 39

Comparative Statics

Advanced Microeconomic Theory 40

 Comparative Statics
• We want to understand how 𝑞𝑞𝑚𝑚 varies as a
function of the monopolist’s marginal cost
p

c2' (q )

c1' (q )
p2m
p1m

p(q)
MR

q2m q1m
Advanced Microeconomic Theory 41
 Comparative Statics
• Formally, we know that at the optimum, 𝑞𝑞 𝑚𝑚 (𝑐𝑐), the
monopolist maximizes its profits
𝜕𝜕𝜕𝜕 𝑞𝑞 𝑚𝑚 𝑐𝑐 , 𝑐𝑐
𝑚𝑚
=0
𝜕𝜕𝑞𝑞
• Differentiating wrt 𝑐𝑐, and using the chain rule,
𝜕𝜕 2 𝜋𝜋 𝑞𝑞 𝑚𝑚 𝑐𝑐 , 𝑐𝑐 𝑑𝑑𝑞𝑞 𝑚𝑚 𝑐𝑐 𝜕𝜕 2 𝜋𝜋 𝑞𝑞 𝑚𝑚 𝑐𝑐 , 𝑐𝑐
2
+ =0
𝜕𝜕𝑞𝑞 𝑑𝑑𝑑𝑑 𝜕𝜕𝑞𝑞𝜕𝜕𝑐𝑐
𝑑𝑑𝑞𝑞𝑚𝑚 𝑐𝑐
• Solving for , we have
𝑑𝑑𝑑𝑑
𝜕𝜕 2 𝜋𝜋 𝑞𝑞 𝑚𝑚 𝑐𝑐 , 𝑐𝑐
𝑑𝑑𝑞𝑞 𝑚𝑚 𝑐𝑐 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕
=− 2
𝑑𝑑𝑑𝑑 𝜕𝜕 𝜋𝜋 𝑞𝑞 𝑚𝑚 𝑐𝑐 , 𝑐𝑐
𝜕𝜕𝑞𝑞 2
Advanced Microeconomic Theory 42
 Comparative Statics
• Example:
– Assume linear demand curve 𝑝𝑝 𝑞𝑞 = 𝑎𝑎 − 𝑏𝑏𝑏𝑏
– Then, the cross-derivative is
𝜕𝜕 𝑎𝑎 − 𝑏𝑏𝑏𝑏 𝑞𝑞 − 𝑐𝑐𝑐𝑐
𝜕𝜕 2 𝜋𝜋 𝑞𝑞𝑚𝑚 𝑐𝑐 , 𝑐𝑐 𝜕𝜕
𝜕𝜕𝑞𝑞
=
𝜕𝜕𝑞𝑞𝜕𝜕𝑐𝑐 𝜕𝜕𝜕𝜕
𝜕𝜕 𝑎𝑎 − 2𝑏𝑏𝑏𝑏 − 𝑐𝑐
= = −1
𝜕𝜕𝜕𝜕
and
𝜕𝜕 2 𝜋𝜋 𝑞𝑞𝑚𝑚 𝑐𝑐 , 𝑐𝑐
𝑑𝑑𝑞𝑞𝑚𝑚 𝑐𝑐 𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕 −1
=− 2 𝑚𝑚 =− <0
𝑑𝑑𝑑𝑑 𝜕𝜕 𝜋𝜋 𝑞𝑞 𝑐𝑐 , 𝑐𝑐 −2𝑏𝑏
𝜕𝜕𝑞𝑞2
Advanced Microeconomic Theory 43
 Comparative Statics
• Example (continued):
– That is, an increase in marginal cost, 𝑐𝑐, decreases
monopoly output, 𝑞𝑞 𝑚𝑚 .
– Similarly for any other demand.
– Even if we don’t know the accurate demand
function, but know the sign of
𝜕𝜕 2 𝜋𝜋 𝑞𝑞 𝑚𝑚 𝑐𝑐 , 𝑐𝑐
𝜕𝜕𝜕𝜕𝜕𝜕𝜕𝜕

Advanced Microeconomic Theory 44

 Comparative Statics
• Example (continued):
– Marginal costs are
increasing in 𝑞𝑞
– For convex cost curve
𝑐𝑐 𝑞𝑞 = 𝑐𝑐𝑞𝑞 2 , monopoly
output is
𝑎𝑎
𝑞𝑞𝑚𝑚 𝑐𝑐 =
2(𝑏𝑏 + 𝑐𝑐)
– Here,
𝑑𝑑𝑞𝑞𝑚𝑚 𝑐𝑐 𝑎𝑎
=− 2
<0
𝑑𝑑𝑑𝑑 2 𝑏𝑏 + 𝑐𝑐
Advanced Microeconomic Theory 45
 Comparative Statics
• Example (continued):
– Constant marginal cost
– For the constant-elasticity
demand curve 𝑞𝑞 𝑝𝑝 = 𝑝𝑝𝑒𝑒 ,
𝑚𝑚 𝑐𝑐
we have 𝑝𝑝 = and
1+1/𝑒𝑒
𝑒𝑒𝑒𝑒 𝑒𝑒
𝑞𝑞𝑚𝑚 (𝑐𝑐) =
1+𝑒𝑒
– Here,
𝑑𝑑𝑞𝑞𝑚𝑚 𝑐𝑐 𝑒𝑒 𝑒𝑒𝑒𝑒 𝑒𝑒
=
𝑑𝑑𝑑𝑑 𝑐𝑐 1 + 𝑒𝑒
𝑒𝑒 𝑚𝑚
= 𝑞𝑞 < 0
𝑐𝑐 Advanced Microeconomic Theory 46
Multiplant Monopolist

Advanced Microeconomic Theory 47

 Multiplant Monopolist
• Monopolist produces output 𝑞𝑞1 , 𝑞𝑞2 , … , 𝑞𝑞𝑁𝑁 across
𝑁𝑁 plants it operates, with total costs 𝑇𝑇𝑇𝑇𝑖𝑖 (𝑞𝑞𝑖𝑖 ) at
each plant 𝑖𝑖 = {1,2, … , 𝑁𝑁}.
• Profits-maximization problem
𝑁𝑁 𝑁𝑁
max 𝑎𝑎 − 𝑏𝑏 ∑𝑖𝑖=1 𝑞𝑞𝑖𝑖 ∑𝑖𝑖=1 𝑞𝑞𝑖𝑖 − ∑𝑁𝑁
𝑖𝑖=1 𝑇𝑇𝑇𝑇𝑖𝑖 (𝑞𝑞𝑖𝑖 )
𝑞𝑞1 ,…,𝑞𝑞𝑁𝑁
• FOCs wrt production level at every plant 𝑗𝑗
𝑁𝑁
𝑎𝑎 − 2𝑏𝑏 � 𝑞𝑞𝑖𝑖 − 𝑀𝑀𝐶𝐶𝑗𝑗 𝑞𝑞𝑗𝑗 = 0
𝑖𝑖=1
⟺ 𝑀𝑀𝑀𝑀 𝑄𝑄 = 𝑀𝑀𝐶𝐶𝑗𝑗 (𝑞𝑞𝑗𝑗 )
for all 𝑗𝑗.
Advanced Microeconomic Theory 48
 Multiplant Monopolist
• Multiplant monopolist operating two plants with
marginal costs 𝑀𝑀𝑀𝑀1 and 𝑀𝑀𝑀𝑀2 .

Advanced Microeconomic Theory 49

 Multiplant Monopolist
• Total marginal cost is 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = 𝑀𝑀𝑀𝑀1 + 𝑀𝑀𝑀𝑀2 (i.e.,
horizontal sum)
• 𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 is determined by 𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 (i.e., point
A)
• Mapping 𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 in the demand curve, we obtain
price 𝑝𝑝𝑚𝑚 (both plants selling at the same price)
• At the MC level for which 𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 (i.e.,
point A), extend a line to the left crossing 𝑀𝑀𝑀𝑀1
and 𝑀𝑀𝑀𝑀2 .
• This will give us output levels 𝑞𝑞1 and 𝑞𝑞2 that
plants 1 and 2 produce, respectively.
Advanced Microeconomic Theory 50
 Multiplant Monopolist
• Example 1 (symmetric plants):
– Consider a monopolist operating 𝑁𝑁 plants, where
all plants have the same cost function 𝑇𝑇𝑇𝑇𝑖𝑖 𝑞𝑞𝑖𝑖 =
𝐹𝐹 + 𝑐𝑐𝑞𝑞𝑖𝑖2 . Hence, all plants produce the same
output level 𝑞𝑞1 = 𝑞𝑞2 = ⋯ = 𝑞𝑞𝑁𝑁 = 𝑞𝑞 and
𝑄𝑄 = 𝑁𝑁𝑁𝑁𝑗𝑗 . The linear demand function is given by
𝑝𝑝 = 𝑎𝑎 − 𝑏𝑏𝑏𝑏.
– FOCs:
𝑎𝑎 − 2𝑏𝑏 ∑𝑁𝑁 𝑗𝑗=1 𝑞𝑞𝑗𝑗 = 2𝑐𝑐𝑞𝑞𝑗𝑗 or 𝑎𝑎 − 2𝑏𝑏𝑁𝑁𝑁𝑁𝑗𝑗 = 2𝑐𝑐𝑞𝑞𝑗𝑗
𝑎𝑎
𝑞𝑞𝑗𝑗 =
2(𝑏𝑏𝑏𝑏 + 𝑐𝑐)
Advanced Microeconomic Theory 51
 Multiplant Monopolist
• Example 1 (continued):
– Total output produced by the monopolist is
𝑁𝑁𝑎𝑎
𝑄𝑄 = 𝑁𝑁𝑁𝑁𝑗𝑗 =
2(𝑏𝑏𝑏𝑏 + 𝑐𝑐)
and market price is
𝑁𝑁𝑁𝑁 𝑎𝑎(𝑏𝑏𝑏𝑏 + 2𝑐𝑐)
𝑝𝑝 = 𝑎𝑎 − 𝑏𝑏𝑏𝑏 = 𝑎𝑎 − 𝑏𝑏 =
2 𝑏𝑏𝑏𝑏 + 𝑐𝑐 2 𝑏𝑏𝑏𝑏 + 𝑐𝑐
– Hence, the profits of every plant 𝑗𝑗 are
2
𝑎𝑎(𝑏𝑏𝑏𝑏 + 2𝑐𝑐) 𝑎𝑎 𝑎𝑎 𝑎𝑎2
𝜋𝜋𝑗𝑗 = − 𝑐𝑐 = − 𝐹𝐹
2 𝑏𝑏𝑏𝑏 + 𝑐𝑐 2(𝑏𝑏𝑏𝑏 + 𝑐𝑐) 2(𝑏𝑏𝑏𝑏 + 𝑐𝑐) 4 𝑏𝑏𝑏𝑏 + 𝑐𝑐
– Total profits become
𝑁𝑁𝑎𝑎2
𝜋𝜋𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = − 𝑁𝑁𝑁𝑁
4 𝑏𝑏𝑏𝑏 + 𝑐𝑐

Advanced Microeconomic Theory 52

 Multiplant Monopolist
• Example 1 (continued):
– The optimal number of plants 𝑁𝑁 ∗ is determined by
𝑑𝑑𝜋𝜋𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑎𝑎2 𝑐𝑐
= 2
− 𝐹𝐹 = 0
𝑑𝑑𝑑𝑑 4 (𝑏𝑏𝑏𝑏 + 𝑐𝑐)
and solving for 𝑁𝑁
1 𝑎𝑎 𝑐𝑐
𝑁𝑁 ∗ = − 𝑐𝑐
𝑏𝑏 2 𝐹𝐹
– 𝑁𝑁 ∗ is decreasing in the fixed costs 𝐹𝐹
– 𝑁𝑁 ∗ is decreasing in 𝑐𝑐 as long as 𝑎𝑎 < 4 𝑐𝑐𝑐𝑐, since
𝑑𝑑𝑁𝑁 ∗ 1 𝑎𝑎 − 4 𝐶𝐶𝐶𝐶
=
𝑑𝑑𝑐𝑐 𝑏𝑏 4 𝐶𝐶𝐶𝐶
Advanced Microeconomic Theory 53
 Multiplant Monopolist
• Example 1 (continued):
– Note that when 𝑁𝑁 = 1, 𝑄𝑄 = 𝑞𝑞 𝑚𝑚 and 𝑝𝑝 = 𝑝𝑝𝑚𝑚 .
– Note that an increase in 𝑁𝑁 decreases 𝑞𝑞𝑗𝑗 and 𝜋𝜋𝑗𝑗 , as
𝑑𝑑𝑞𝑞𝑗𝑗 𝑎𝑎𝑏𝑏
=− 2
<0
𝑑𝑑𝑁𝑁 2 𝑏𝑏𝑏𝑏 + 𝑐𝑐
𝑑𝑑𝜋𝜋𝑗𝑗 𝑎𝑎2 𝑏𝑏
=− 2
<0
𝑑𝑑𝑁𝑁 4 𝑏𝑏𝑏𝑏 + 𝑐𝑐

Advanced Microeconomic Theory 54

 Multiplant Monopolist
• Example 2 (asymmetric plants):
– Consider a monopolist operating two plants with
marginal costs 𝑀𝑀𝐶𝐶1 𝑞𝑞1 = 10 + 20𝑞𝑞1 and 𝑀𝑀𝑀𝑀2 𝑞𝑞2 =
60 + 5𝑞𝑞2 , respectively. A linear demand function is
give by 𝑝𝑝 𝑄𝑄 = 120 − 3𝑄𝑄.
– Note that 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 ≠ 𝑀𝑀𝑀𝑀1 (𝑞𝑞1 ) + 𝑀𝑀𝑀𝑀2 (𝑞𝑞2 )
 This is a vertical (not a horizontal) sum.
– Instead, first invert the marginal cost functions
𝑀𝑀𝑀𝑀1 1
𝑀𝑀𝑀𝑀1 𝑞𝑞1 = 10 + 20𝑞𝑞1 ⟺ 𝑞𝑞1 = −
20 2
𝑀𝑀𝑀𝑀2
𝑀𝑀𝑀𝑀2 𝑞𝑞2 = 60 + 5𝑞𝑞2 ⟺ 𝑞𝑞2 = − 12
5
Advanced Microeconomic Theory 55
 Multiplant Monopolist
• Example 2 (continued):
– Second,
𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 1 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = 𝑞𝑞1 + 𝑞𝑞2 = − + − 12
20 2 5
1
= 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 − 12.5
4
– Hence, 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = 50 + 4𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
– Setting 𝑀𝑀𝑀𝑀 𝑄𝑄 = 120 − 6𝑄𝑄 = 50 + 4𝑄𝑄 = 𝑀𝑀𝑀𝑀𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 , we
obtain 𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = 7 and 𝑝𝑝 = 120 − 3 � 7 = 99.
– Since 𝑀𝑀𝑀𝑀 𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = 120 − 6 � 7 = 78, then
𝑀𝑀𝑀𝑀 𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = 𝑀𝑀𝑀𝑀1 𝑞𝑞1 ⟹ 78 = 10 + 20𝑞𝑞1 ⟹ 𝑞𝑞1 = 3.4
𝑀𝑀𝑀𝑀 𝑄𝑄𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 = 𝑀𝑀𝑀𝑀2 𝑞𝑞2 ⟹ 78 = 60 + 5𝑞𝑞2 ⟹ 𝑞𝑞2 = 3.6
Advanced Microeconomic Theory 56
Price Discrimination

Advanced Microeconomic Theory 57

 Price Discrimination
• Can the monopolist capture an even larger surplus?
– Charge 𝑝𝑝 > 𝑝𝑝𝑚𝑚 to those
who buy the product at 𝑝𝑝𝑚𝑚 p

and are willing to pay more

– Charge 𝑐𝑐 < 𝑝𝑝 < 𝑝𝑝𝑚𝑚 to
those who do not buy the
product at 𝑝𝑝𝑚𝑚 , but whose pm MC
willingness to pay for the
good is still higher than the
marginal cost of MR p(q)

production, 𝑐𝑐.
qm q* q
– With 𝑝𝑝𝑚𝑚 for all units, the
monopolist does not Selling these Selling these
units at p > p m units at p < p m
capture the surplus of
neither of these segments.
Advanced Microeconomic Theory 58
 Price Discrimination: First-degree
• First-degree (perfect) price discrimination:
– The monopolist charges to every customer his/her
maximum willingness to pay for the object.
Price

– Personalized price:
The first buyer pays
𝑝𝑝1 for the 𝑞𝑞1 units,
the second buyer
pays 𝑝𝑝2 for 𝑞𝑞2 − 𝑞𝑞1
D
units, etc.
q1... q2 Quantity

Advanced Microeconomic Theory 59

 Price Discrimination: First-degree
– The monopolist
continues doing so until p

the last buyer is willing Profits

to pay the marginal cost
of production.
– In the limit, the c ' (q)
monopolist captures all MR p(q)

the area below the

demand curve and qm q* q

above the marginal cost

(i.e., consumer surplus).
Advanced Microeconomic Theory 60
 Price Discrimination: First-degree
• Suppose that the monopolist can charge a fixed fee, 𝑟𝑟 ∗ ,
and an amount of the good, 𝑞𝑞∗ , that maximizes profits.
• PMP:
max 𝑟𝑟 − 𝑐𝑐𝑐𝑐
𝑟𝑟,𝑞𝑞
𝑠𝑠. 𝑡𝑡. 𝑢𝑢(𝑞𝑞) ≥ 𝑟𝑟
• Note that the monopolist raises the fee 𝑟𝑟 until 𝑢𝑢 𝑞𝑞 = 𝑟𝑟.
Hence we can reduce the set of choice variables
max 𝑢𝑢(𝑞𝑞) − 𝑐𝑐𝑐𝑐
𝑞𝑞
• FOC: 𝑢𝑢′ 𝑞𝑞∗ − 𝑐𝑐 = 0 or 𝑢𝑢′ 𝑞𝑞∗ = 𝑐𝑐.
– Intuition: the monopolist increases output until the
marginal utility that consumers obtain from additional
units coincides with the marginal cost of production
Advanced Microeconomic Theory 61
 Price Discrimination: First-degree
• Given the level of
production 𝑞𝑞∗ , the
optimal fee is
q*
∫ p (q )dq − c(q* )
p
Profits
=
0

𝑟𝑟 ∗ = 𝑢𝑢 𝑞𝑞∗
pm
• Intuition: the
monopolist charges a c ' (q)

fee 𝑟𝑟 ∗ that coincides r*

MR p(q)

with the utility that the qm q CE = q* q

consumer obtains
from consuming 𝑞𝑞∗ .
Advanced Microeconomic Theory 62
 Price Discrimination: First-degree
• Example:
– A monopolist faces inverse demand curve 𝑝𝑝 𝑞𝑞 =
20 − 𝑞𝑞 and constant marginal costs 𝑐𝑐 = $2.
– No price discrimination:
𝑀𝑀𝑀𝑀 = 𝑀𝑀𝑀𝑀 ⟹ 20 − 2𝑞𝑞 = 2 ⟹ 𝑞𝑞𝑚𝑚 = 9
𝑝𝑝𝑚𝑚 = $11, 𝜋𝜋 𝑚𝑚 = $81
– Price discrimination:
𝑝𝑝 𝑄𝑄 = 𝑀𝑀𝑀𝑀 ⟹ 20 − 𝑄𝑄 = 2 ⟹ 𝑄𝑄 = 18
18 × 20 − 2
𝜋𝜋 = = $162
2
Advanced Microeconomic Theory 63
 Price Discrimination: First-degree
• Example (continued):

Advanced Microeconomic Theory 64

 Price Discrimination: First-degree
• Summary:
– Total output coincides with that in perfect
competition
– Unlike in perfect competition, the consumer does
not capture any surplus
– The producer captures all the surplus
– Due to information requirements, we do not see
many examples of it in real applications
 Financial aid in undergraduate education (“tuition
discrimination”)
Advanced Microeconomic Theory 65
 Price Discrimination: First-degree
• Example (two-block pricing):
– A monopolist faces a
inverse demand curve
𝑝𝑝 𝑞𝑞 = 𝑎𝑎 − 𝑏𝑏𝑞𝑞 , with
constant marginal costs
𝑐𝑐 < 𝑎𝑎.
– Under two-block pricing,
the monopolist sells the
first 𝑞𝑞1 units at a price
𝑝𝑝(𝑞𝑞1 ) = 𝑝𝑝1 and the
remaining 𝑞𝑞2 − 𝑞𝑞1 units
at a price 𝑝𝑝(𝑞𝑞2 ) = 𝑝𝑝2 .
Advanced Microeconomic Theory 66
 Price Discrimination: First-degree
• Example (continued):
– Profits from the first 𝑞𝑞1 units
𝜋𝜋1 = 𝑝𝑝 𝑞𝑞1 � 𝑞𝑞1 − 𝑐𝑐𝑞𝑞1 = (𝑎𝑎 − 𝑏𝑏𝑞𝑞1 − 𝑐𝑐)𝑞𝑞1
while from the remaining 𝑞𝑞2 − 𝑞𝑞1 units
𝜋𝜋2 = 𝑝𝑝 𝑞𝑞2 � 𝑞𝑞2 − 𝑞𝑞1 − 𝑐𝑐 � (𝑞𝑞2 −𝑞𝑞1 )
= (𝑎𝑎 − 𝑏𝑏𝑞𝑞2 − 𝑐𝑐)(𝑞𝑞2 −𝑞𝑞1 )
– Hence total profits are
𝜋𝜋 = 𝜋𝜋1 + 𝜋𝜋2
= 𝑎𝑎 − 𝑏𝑏𝑞𝑞1 − 𝑐𝑐 𝑞𝑞1 + (𝑎𝑎 − 𝑏𝑏𝑞𝑞2 − 𝑐𝑐)(𝑞𝑞2 −𝑞𝑞1 )
Advanced Microeconomic Theory 67
 Price Discrimination: First-degree
• Example (continued):
– FOCs:
𝜕𝜕𝜋𝜋
= 𝑎𝑎 − 2𝑏𝑏𝑞𝑞1 − 𝑐𝑐 − 𝑎𝑎 + 𝑏𝑏𝑞𝑞2 + 𝑐𝑐 = 0
𝜕𝜕𝑞𝑞1
𝜕𝜕𝜕𝜕
= −𝑏𝑏 𝑞𝑞2 − 𝑞𝑞1 + 𝑎𝑎 − 𝑏𝑏𝑞𝑞2 − 𝑐𝑐 = 0
𝜕𝜕𝑞𝑞2
– Solving for 𝑞𝑞1 and 𝑞𝑞2
𝑎𝑎 − 𝑐𝑐 2(𝑎𝑎 − 𝑐𝑐)
𝑞𝑞1 = 𝑞𝑞2 =
3𝑏𝑏 3𝑏𝑏
which entails prices of
𝑎𝑎 − 𝑐𝑐 2𝑎𝑎 + 𝑐𝑐 𝑎𝑎 + 2𝑐𝑐
𝑝𝑝 𝑞𝑞1 = 𝑎𝑎 − 𝑏𝑏 � = 𝑝𝑝 𝑞𝑞2 =
3𝑏𝑏 3 3
where 𝑝𝑝 𝑞𝑞1 > 𝑝𝑝 𝑞𝑞2 since 𝑎𝑎 > 𝑐𝑐.
Advanced Microeconomic Theory 68
 Price Discrimination: First-degree
• Example (continued):
– The monopolist’s profits from each block are
𝜋𝜋1 = 𝑝𝑝 𝑞𝑞1 − 𝑐𝑐 � 𝑞𝑞1
2𝑎𝑎 + 𝑐𝑐 𝑎𝑎 − 𝑐𝑐 2 𝑎𝑎 − 𝑐𝑐 2
= − 𝑐𝑐 � =
3 3𝑏𝑏 𝑏𝑏 3
𝜋𝜋2 = 𝑝𝑝 𝑞𝑞2 − 𝑐𝑐)(𝑞𝑞2 − 𝑞𝑞1
𝑎𝑎 + 2𝑐𝑐 2 𝑎𝑎 − 𝑐𝑐 𝑎𝑎 − 𝑐𝑐 1 𝑎𝑎 − 𝑐𝑐 2
= − 𝑐𝑐 � − =
3 3𝑏𝑏 3𝑏𝑏 𝑏𝑏 3
𝑎𝑎−𝑐𝑐 2
– Thus, 𝜋𝜋 = 𝜋𝜋1 + 𝜋𝜋2 = , which is larger than
3𝑏𝑏
𝑢𝑢 𝑎𝑎−𝑐𝑐 2
those arising from uniform pricing , 𝜋𝜋 = .
4𝑏𝑏
Advanced Microeconomic Theory 69
Price Discrimination: Third-degree
• Third degree price discrimination:
– The monopolist charges different prices to two or more
groups of customers (each group must be easily recognized
by the seller).
• Example: youth vs. adult at the movies, airline tickets
– Firm’s PMP:
max 𝑝𝑝1 𝑥𝑥1 𝑥𝑥1 + 𝑝𝑝2 𝑥𝑥2 𝑥𝑥2 − 𝑐𝑐𝑥𝑥1 − 𝑐𝑐𝑥𝑥2
𝑥𝑥1 ,𝑥𝑥2
– FOCs:
𝑝𝑝1 𝑥𝑥1 + 𝑝𝑝1′ 𝑥𝑥1 𝑥𝑥1 − 𝑐𝑐 = 0 ⟹ 𝑀𝑀𝑀𝑀1 = 𝑀𝑀𝑀𝑀
𝑝𝑝2 𝑥𝑥2 + 𝑝𝑝2′ 𝑥𝑥2 𝑥𝑥2 − 𝑐𝑐 = 0 ⟹ 𝑀𝑀𝑀𝑀2 = 𝑀𝑀𝑀𝑀
– FOCs coincides with those of a regular monopolist who
serves two completely separated markets practicing
uniform pricing .
Advanced Microeconomic Theory 70
Price Discrimination: Third-degree
– Example: 𝑝𝑝1 𝑥𝑥1 = 38 − 𝑥𝑥1 for adults and 𝑝𝑝2 𝑥𝑥2 = 14 −
1/4𝑥𝑥2 for seniors, with 𝑀𝑀𝑀𝑀 = $10 for both markets.
𝑀𝑀𝑀𝑀1 𝑥𝑥1 = 𝑀𝑀𝑀𝑀 ⟹ 38 − 2𝑥𝑥1 = 10 ⟹ 𝑥𝑥1 = 14 𝑝𝑝1 = $24
𝑀𝑀𝑀𝑀2 𝑥𝑥2 = 𝑀𝑀𝑀𝑀 ⟹ 14 − 1/2𝑥𝑥2 = 10 ⟹ 𝑥𝑥2 = 8 𝑝𝑝2 = $12
p1
p2

p1 = $24

p2 = $12
MC = $10
$10
p ( x1 ) p ( x2 )
MR1 MR2

x1 = 14 x1 x2 = 8 x2

Market 1 Market 2
Adults at the movies Seniors at the movies
Advanced Microeconomic Theory 71
 Price Discrimination: Third-degree
• Using the Inverse Elasticity Pricing Rule (IERP), we
can obtain the prices
𝑐𝑐 𝑐𝑐
𝑝𝑝1 𝑥𝑥1 = and 𝑝𝑝2 𝑥𝑥2 =
1−1/𝜀𝜀1 1−1/𝜀𝜀2
where 𝑐𝑐 is the common marginal cost
• Then, 𝑝𝑝1 𝑥𝑥1 > 𝑝𝑝2 𝑥𝑥2 if and only if
𝑐𝑐 𝑐𝑐 1 1
> ⟹1− <1−
1−1/𝜀𝜀1 1−1/𝜀𝜀2 𝜀𝜀2 𝜀𝜀1
1 1
⟹ > ⟹ 𝜀𝜀2 < 𝜀𝜀1
𝜀𝜀2 𝜀𝜀1
• Intuition: the monopolist charges lower price in
the market with more elastic demand.
Advanced Microeconomic Theory 72
Price Discrimination: Third-degree
• Example (Pullman-Seattle route):
– The price-elasticity of demand for business-class
seats is -1.15, while that for economy seats is -1.52
– From the IEPR,
𝑀𝑀𝑀𝑀
𝑝𝑝𝐵𝐵 = ⟹ 0.13𝑝𝑝𝐵𝐵 = 𝑀𝑀𝑀𝑀
1 − 1/1.15
𝑀𝑀𝑀𝑀
𝑝𝑝𝐸𝐸 = ⟹ 0.34𝑝𝑝𝐸𝐸 = 𝑀𝑀𝑀𝑀
1 − 1/1.52
– Hence, 0.13𝑝𝑝𝐵𝐵 = 0.34𝑝𝑝𝐸𝐸 or 𝑝𝑝𝐵𝐵 = 2.62𝑝𝑝𝐸𝐸
 Airline maximizes its profits by charging business-class
seats a price 2.62 times higher than that of economy-
class seats Advanced Microeconomic Theory 73
 Price Discrimination: Second-degree
• Second-degree price discrimination:
– The monopolist cannot observe the type of each
consumer (e.g., his willingness to pay).
– Hence the monopolist offers a menu of two-part
tariffs, (𝐹𝐹𝐿𝐿 , 𝑞𝑞𝐿𝐿 ) and (𝐹𝐹𝐻𝐻 , 𝑞𝑞𝐻𝐻 ), with the property
that the consumer with type 𝑖𝑖 = {𝐿𝐿, 𝐻𝐻} has the
incentive to self-select the two-part tariff (𝐹𝐹𝑖𝑖 , 𝑞𝑞𝑖𝑖 )
meant for him.

Advanced Microeconomic Theory 74

 Price Discrimination: Second-degree
• Assume the utility function of type 𝑖𝑖 consumer
𝑈𝑈𝑖𝑖 𝑞𝑞𝑖𝑖 , 𝐹𝐹𝑖𝑖 = 𝜃𝜃𝑖𝑖 𝑢𝑢 𝑞𝑞𝑖𝑖 − 𝐹𝐹𝑖𝑖
where
– 𝑞𝑞𝑖𝑖 is the quantity of a good consumed
– 𝐹𝐹𝑖𝑖 is the fixed fee paid to the monopolist for 𝑞𝑞𝑖𝑖
– 𝜃𝜃𝑖𝑖 measures the valuation consumer assigns to the
good, where 𝜃𝜃𝐻𝐻 > 𝜃𝜃𝐿𝐿 , with corresponding
probabilities 𝑝𝑝 and 1 − 𝑝𝑝.
• The monopolist’s constant marginal cost 𝑐𝑐
satisfies 𝜃𝜃𝑖𝑖 > 𝑐𝑐 for all 𝑖𝑖 = {𝐿𝐿, 𝐻𝐻}.
Advanced Microeconomic Theory 75
 Price Discrimination: Second-degree
• The monopolist must guarantee that
1) both types of customers are willing to
participate (“participation constraint”)
 the two-part tariff meant for each type of customer
provides him with a weakly positive utility level

2) customers do not have incentives to choose the

two-part tariff meant for the other type of
customer (“incentive compatibility”)
 type 𝑖𝑖 customer prefers (𝐹𝐹𝑖𝑖 , 𝑞𝑞𝑖𝑖 ) over (𝐹𝐹𝑗𝑗 , 𝑞𝑞𝑗𝑗 ) where
𝑗𝑗 ≠ 𝑖𝑖
Advanced Microeconomic Theory 76
 Price Discrimination: Second-degree
• The participation constraints (PC) are
𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐿𝐿 ) − 𝐹𝐹𝐿𝐿 ≥ 0 𝑃𝑃𝑃𝑃𝐿𝐿
𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝐹𝐹𝐻𝐻 ≥ 0 𝑃𝑃𝑃𝑃𝐻𝐻
• The incentive compatibility conditions are
𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐿𝐿 ) − 𝐹𝐹𝐿𝐿 ≥ 𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝐹𝐹𝐻𝐻 𝐼𝐼𝐶𝐶𝐿𝐿
𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝐹𝐹𝐻𝐻 ≥ 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐿𝐿 ) − 𝐹𝐹𝐿𝐿 𝐼𝐼𝐼𝐼𝐻𝐻

Advanced Microeconomic Theory 77

 Price Discrimination: Second-degree
• Rearranging the four inequalities, the
monopolist’s profit maximization problem
becomes:
max 𝑝𝑝 𝐹𝐹𝐻𝐻 − 𝑐𝑐𝑞𝑞𝐻𝐻 + 1 − 𝑝𝑝 [𝐹𝐹𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐿𝐿 ]
𝐹𝐹𝐿𝐿 ,𝑞𝑞𝐿𝐿 ,𝐹𝐹𝐻𝐻 ,𝑞𝑞𝐻𝐻
𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐿𝐿 ) ≥ 𝐹𝐹𝐿𝐿
𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) ≥ 𝐹𝐹𝐻𝐻
𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐿𝐿 ) − 𝑢𝑢(𝑞𝑞𝐻𝐻 ) + 𝐹𝐹𝐻𝐻 ≥ 𝐹𝐹𝐿𝐿
𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝑢𝑢(𝑞𝑞𝐿𝐿 ) + 𝐹𝐹𝐿𝐿 ≥ 𝐹𝐹𝐻𝐻

Advanced Microeconomic Theory 78

 Price Discrimination: Second-degree
• Both 𝑃𝑃𝑃𝑃𝐻𝐻 and 𝐼𝐼𝐼𝐼𝐻𝐻 are expressed in terms of the
fee 𝐹𝐹𝐻𝐻
– The monopolist increases 𝐹𝐹𝐻𝐻 until such fee coincides
with the lowest of 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) and 𝜃𝜃𝐻𝐻 [𝑢𝑢(𝑞𝑞𝐻𝐻 ) −
𝑢𝑢(𝑞𝑞𝐿𝐿 )] + 𝐹𝐹𝐿𝐿 for all 𝑖𝑖 = {𝐿𝐿, 𝐻𝐻}
– Otherwise, one (or both) constraints will be violated,
leading the high-demand customer to not participate

Advanced Microeconomic Theory 79

Price Discrimination: Second-degree

Advanced Microeconomic Theory 80

 Price Discrimination: Second-degree
• High-demand customer:
– Let us show that 𝐼𝐼𝐼𝐼𝐻𝐻 is binding
– An indirect way to show that
𝐹𝐹𝐻𝐻 = 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝑢𝑢(𝑞𝑞𝐿𝐿 ) + 𝐹𝐹𝐿𝐿
is to demonstrate that 𝐹𝐹𝐻𝐻 < 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 )
– Proving this by contradiction, assume that
𝐹𝐹𝐻𝐻 = 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 )

Advanced Microeconomic Theory 81

 Price Discrimination: Second-degree
– Then, 𝐼𝐼𝐼𝐼𝐻𝐻 can be written as
𝐹𝐹𝐻𝐻 − 𝜃𝜃𝐻𝐻 𝑢𝑢 𝑞𝑞𝐿𝐿 + 𝐹𝐹𝐿𝐿 ≥ 𝐹𝐹𝐻𝐻
⟹ 𝐹𝐹𝐿𝐿 ≥ 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐿𝐿 )
– Combining this result with the fact that 𝜃𝜃𝐻𝐻 > 𝜃𝜃𝐿𝐿 ,
𝐹𝐹𝐿𝐿 ≥ 𝜃𝜃𝐻𝐻 𝑢𝑢 𝑞𝑞𝐿𝐿 > 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿
which implies 𝐹𝐹𝐿𝐿 > 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿
– However, this violates 𝑃𝑃𝑃𝑃𝐿𝐿
 We then reached a contradiction
 Thus, 𝐹𝐹𝐻𝐻 < 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 )
 𝐼𝐼𝐼𝐼𝐻𝐻 is binding but 𝑃𝑃𝑃𝑃𝐻𝐻 is not.
Advanced Microeconomic Theory 82
 Price Discrimination: Second-degree
• Low-demand customer:
– Let us show that 𝑃𝑃𝑃𝑃𝐿𝐿 binding
– Similarly as for the high-demand customer, an
indirect way to show that
𝐹𝐹𝐿𝐿 = 𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐿𝐿 )
is to demonstrate that 𝐹𝐹𝐿𝐿 < 𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐿𝐿 ) − 𝑢𝑢(𝑞𝑞𝐻𝐻 ) + 𝐹𝐹𝐻𝐻
– Proving this by contradiction, assume that
𝐹𝐹𝐿𝐿 = 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 − 𝑢𝑢 𝑞𝑞𝐻𝐻 + 𝐹𝐹𝐻𝐻

Advanced Microeconomic Theory 83

 Price Discrimination: Second-degree
– Then, 𝐼𝐼𝐼𝐼𝐻𝐻 can be written as
𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝑢𝑢(𝑞𝑞𝐿𝐿 ) + 𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐿𝐿 ) − 𝑢𝑢(𝑞𝑞𝐻𝐻 ) + 𝐹𝐹𝐻𝐻 = 𝐹𝐹𝐻𝐻
⟹ 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝑢𝑢(𝑞𝑞𝐿𝐿 ) = 𝜃𝜃𝐿𝐿 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝑢𝑢(𝑞𝑞𝐿𝐿 )
⟹ 𝜃𝜃𝐻𝐻 = 𝜃𝜃𝐿𝐿

which violates the initial assumption 𝜃𝜃𝐻𝐻 > 𝜃𝜃𝐿𝐿

 We reached a contradiction
 Thus, 𝐹𝐹𝐿𝐿 < 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 − 𝑢𝑢 𝑞𝑞𝐻𝐻 + 𝐹𝐹𝐻𝐻
 𝑃𝑃𝑃𝑃𝐿𝐿 is binding but 𝐼𝐼𝐼𝐼𝐿𝐿 is not

Advanced Microeconomic Theory 84

 Price Discrimination: Second-degree
• In summary:
– From 𝑃𝑃𝑃𝑃𝐿𝐿 binding we have
𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 = 𝐹𝐹𝐿𝐿
– From 𝐼𝐼𝐼𝐼𝐻𝐻 binding we have
𝜃𝜃𝐻𝐻 𝑢𝑢 𝑞𝑞𝐻𝐻 − 𝑢𝑢 𝑞𝑞𝐿𝐿 + 𝐹𝐹𝐿𝐿 = 𝐹𝐹𝐻𝐻
– In addition,
• 𝑃𝑃𝑃𝑃𝐿𝐿 binding implies that 𝐼𝐼𝐼𝐼𝐿𝐿 holds, and
• 𝐼𝐼𝐼𝐼𝐻𝐻 binding entails that 𝑃𝑃𝑃𝑃𝐻𝐻 is also satisfied,
• That is, all four constraints hold.

Advanced Microeconomic Theory 85

 Price Discrimination: Second-degree
• The monopolist’s expected PMP can then be written as
unconstrained problem, as follows,

max 𝑝𝑝 𝐹𝐹𝐻𝐻 − 𝑐𝑐𝑞𝑞𝐻𝐻 + 1 − 𝑝𝑝 [𝐹𝐹𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐿𝐿 ]

𝑞𝑞𝐿𝐿 ,𝑞𝑞𝐻𝐻 ≥0
= 𝑝𝑝 𝜃𝜃𝐻𝐻 𝑢𝑢 𝑞𝑞𝐻𝐻 − 𝑢𝑢 𝑞𝑞𝐿𝐿 + 𝐹𝐹𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐻𝐻
𝐹𝐹𝐻𝐻
+ 1 − 𝑝𝑝 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐿𝐿
𝐹𝐹𝐿𝐿
= 𝑝𝑝 𝜃𝜃𝐻𝐻 𝑢𝑢 𝑞𝑞𝐻𝐻 − 𝑢𝑢 𝑞𝑞𝐿𝐿 + 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐻𝐻
𝐹𝐹𝐿𝐿
+ 1 − 𝑝𝑝 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐿𝐿
= 𝑝𝑝 𝜃𝜃𝐻𝐻 𝑢𝑢 𝑞𝑞𝐻𝐻 − 𝜃𝜃𝐻𝐻 − 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐻𝐻
+(1 − 𝑝𝑝) 𝜃𝜃𝐿𝐿 𝑢𝑢 𝑞𝑞𝐿𝐿 − 𝑐𝑐𝑞𝑞𝐿𝐿

Advanced Microeconomic Theory 86

 Price Discrimination: Second-degree
• FOC with respect to 𝑞𝑞𝐻𝐻 :
𝑝𝑝 𝜃𝜃𝐻𝐻 𝑢𝑢′ (𝑞𝑞𝐻𝐻 ) − 𝑐𝑐 = 0 ⟹ 𝜃𝜃𝐻𝐻 𝑢𝑢′ (𝑞𝑞𝐻𝐻 ) = 𝑐𝑐
– which coincides with that under complete information.
– That is, there is not output distortion for high-demand buyer
– Informally, we say that there is “no distortion at the top”.

• FOC with respect to 𝑞𝑞𝐿𝐿 :

𝑝𝑝 −(𝜃𝜃𝐻𝐻 − 𝜃𝜃𝐿𝐿 )𝑢𝑢′ (𝑞𝑞𝐿𝐿 ) + 1 − 𝑝𝑝 𝜃𝜃𝐿𝐿 𝑢𝑢′ (𝑞𝑞𝐿𝐿 ) − 𝑐𝑐 = 0

which can be re-written as

𝑢𝑢′ (𝑞𝑞𝐿𝐿 ) 𝜃𝜃𝐿𝐿 − 𝑝𝑝𝜃𝜃𝐻𝐻 = 1 − 𝑝𝑝 𝑐𝑐
Advanced Microeconomic Theory 87
 Price Discrimination: Second-degree
• Dividing both sides by 1 − 𝑝𝑝 , we obtain
′ 𝜃𝜃𝐿𝐿 −𝑝𝑝𝜃𝜃𝐻𝐻
𝑢𝑢 (𝑞𝑞𝐿𝐿 ) = 𝑐𝑐
1−𝑝𝑝

• The above expression can alternatively be written as

′ 𝑝𝑝
𝑢𝑢 (𝑞𝑞𝐿𝐿 ) 𝜃𝜃𝐿𝐿 − 𝜃𝜃𝐻𝐻 − 𝜃𝜃𝐿𝐿 = 𝑐𝑐
1−𝑝𝑝

Advanced Microeconomic Theory 88

 Price Discrimination: Second-degree
• 𝑢𝑢′ (𝑞𝑞𝐿𝐿 ) � 𝜃𝜃𝐿𝐿 depicts the socially optimal output 𝑞𝑞𝐿𝐿𝑠𝑠𝑠𝑠 , i.e., that
arising under complete information
• The output offered to high-demand customers is socially
efficient due to the absence of output distortion for high-
type agents
• The output offered to low-
demand customers entails
a distortion, i.e., 𝑞𝑞𝐿𝐿 < 𝑞𝑞𝐿𝐿𝑠𝑠𝑠𝑠
• Per-unit price for high-type
and low-type differs, i.e.,
𝐹𝐹𝐻𝐻 ≠ 𝐹𝐹𝐿𝐿
– Monopolist practices price
discrimination among the
two types of customers.

Advanced Microeconomic Theory 89

 Price Discrimination: Second-degree
• Since constraint 𝑃𝑃𝑃𝑃𝐿𝐿 binds while 𝑃𝑃𝑃𝑃𝐻𝐻 does not,
then only the high-demand customer retains a
positive utility level, i.e., 𝜃𝜃𝐻𝐻 𝑢𝑢(𝑞𝑞𝐻𝐻 ) − 𝐹𝐹𝐻𝐻 > 0.
• The firm’s lack of information provides the high-
demand customer with an “information rent.”
– Intuitively, the information rent emerges from the
seller’s attempt to reduce the incentives of the high-
type customer to select the contract meant for the
low type.
– The seller also achieves self-selection by setting an
attractive output for the low-type buyer, i.e., 𝑞𝑞𝐿𝐿 is
lower than under complete information.

Advanced Microeconomic Theory 90

 Price Discrimination: Second-degree
• Example:
– Consider a monopolist selling a textbook to two
types of graduate students, low- and high-
demand, with utility function
𝑞𝑞𝑖𝑖2
𝑈𝑈𝑖𝑖 (𝑞𝑞𝑖𝑖 , 𝐹𝐹𝑖𝑖 ) = − 𝜃𝜃𝑖𝑖 𝑞𝑞𝑖𝑖 − 𝐹𝐹𝑖𝑖
2
where 𝑖𝑖 = {𝐿𝐿, 𝐻𝐻} and 𝜃𝜃𝐻𝐻 > 𝜃𝜃𝐿𝐿 .
– Hence, the UMP of type 𝑖𝑖 student is
𝑞𝑞𝑖𝑖2
max − 𝜃𝜃𝑖𝑖 𝑞𝑞𝑖𝑖 − 𝐹𝐹𝑖𝑖 s. t. 𝑝𝑝𝑞𝑞𝑖𝑖 + 𝐹𝐹𝑖𝑖 ≤ 𝑤𝑤𝑖𝑖
𝑞𝑞𝑖𝑖 2
where 𝑤𝑤𝑖𝑖 > 0 denotes the student’s wealth.
Advanced Microeconomic Theory 91
 Price Discrimination: Second-degree
• Example (continued):
– By Walras’ law, the constraint binds
𝐹𝐹𝑖𝑖 = 𝑤𝑤𝑖𝑖 − 𝑝𝑝𝑞𝑞𝑖𝑖
– Then, the UMP can be expressed as
𝑞𝑞𝑖𝑖 2
max − 𝜃𝜃𝑖𝑖 𝑞𝑞𝑖𝑖 − (𝑤𝑤𝑖𝑖 − 𝑝𝑝𝑞𝑞𝑖𝑖 )
𝑞𝑞𝑖𝑖 2
– FOCs wrt 𝑞𝑞𝑖𝑖 yields the direct demand function:
𝑞𝑞𝑖𝑖 − 𝜃𝜃𝑖𝑖 + 𝑝𝑝 = 0 or 𝑞𝑞𝑖𝑖 = 𝜃𝜃𝑖𝑖 − 𝑝𝑝

Advanced Microeconomic Theory 92

 Price Discrimination: Second-degree
• Example (continued):
– Assume that the proportion of high-demand (low-
demand) students is 𝛾𝛾 (1 − 𝛾𝛾, respectively).
– The monopolist’s constant marginal cost is 𝑐𝑐 > 0,
which satisfies 𝜃𝜃𝑖𝑖 > 𝑐𝑐 for all 𝑖𝑖 = {𝐿𝐿, 𝐻𝐻}.
𝜃𝜃𝐻𝐻 +𝑐𝑐
– Consider for simplicity that 𝜃𝜃𝐿𝐿 > .
2

– This implies that each type of student would buy

the textbook, both when the firm practices
uniform pricing and when it sets two-part tariffs
 Exercise.
Advanced Microeconomic Theory 93
Advertising in Monopoly

Advanced Microeconomic Theory 94

 Advertising in Monopoly
• Advertising: non-price strategy to capture
surplus
• The monopolist must balance the additional
demand that advertising entails and its
associated costs (𝐴𝐴 dollars)
• The monopolist solves
max 𝑝𝑝 � 𝑞𝑞 𝑝𝑝, 𝐴𝐴 − 𝑇𝑇𝑇𝑇 𝑞𝑞 𝑝𝑝, 𝐴𝐴 − 𝐴𝐴
𝐴𝐴
where the demand function 𝑞𝑞 𝑝𝑝, 𝐴𝐴 depends
on price and advertising.
Advanced Microeconomic Theory 95
 Advertising in Monopoly
• Taking FOCs with respect to 𝐴𝐴,
𝜕𝜕𝑞𝑞 𝑝𝑝,𝐴𝐴 𝜕𝜕𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕 𝑝𝑝,𝐴𝐴
𝑝𝑝 � − � −1=0
𝜕𝜕𝜕𝜕 �
𝜕𝜕𝜕𝜕 𝜕𝜕𝜕𝜕
𝑀𝑀𝑀𝑀

Rearranging, we obtain
𝜕𝜕𝜕𝜕 𝑝𝑝,𝐴𝐴
𝑝𝑝 − 𝑀𝑀𝑀𝑀 =1
𝜕𝜕𝜕𝜕
• Let us define the advertising elasticity of demand
% increse in 𝑞𝑞 𝜕𝜕𝜕𝜕 𝑝𝑝,𝐴𝐴 𝐴𝐴
𝜀𝜀𝑞𝑞,𝐴𝐴 = = �
% increse in 𝐴𝐴 𝜕𝜕𝜕𝜕 𝑞𝑞
Or, rearranging,
𝑞𝑞 𝜕𝜕𝜕𝜕 𝑝𝑝,𝐴𝐴
𝜀𝜀𝑞𝑞,𝐴𝐴 � =
𝐴𝐴 𝜕𝜕𝜕𝜕

Advanced Microeconomic Theory 96

 Advertising in Monopoly
• We can then rewrite the above FOC as
𝑞𝑞
𝑝𝑝 − 𝑀𝑀𝑀𝑀 𝜀𝜀𝑞𝑞,𝐴𝐴 � = 1
𝐴𝐴
𝜕𝜕𝜕𝜕 𝑝𝑝,𝐴𝐴
𝜕𝜕𝜕𝜕
• Dividing both sides by 𝜀𝜀𝑞𝑞,𝐴𝐴 and rearranging
1 𝐴𝐴
𝑝𝑝 − 𝑀𝑀𝑀𝑀 = �
𝜀𝜀𝑞𝑞,𝐴𝐴 𝑞𝑞
• Dividing both sides by 𝑝𝑝
𝑝𝑝−𝑀𝑀𝑀𝑀 1 𝐴𝐴
= �
𝑝𝑝 𝜀𝜀𝑞𝑞,𝐴𝐴 𝑝𝑝�𝑞𝑞
Advanced Microeconomic Theory 97
 Advertising in Monopoly
𝑝𝑝−𝑀𝑀𝑀𝑀 1
• From the Lerner index, we know that =− .
𝑝𝑝 𝜀𝜀𝑞𝑞,𝑝𝑝
Hence,
1 1 𝐴𝐴
− = �
𝜀𝜀𝑞𝑞,𝑝𝑝 𝜀𝜀𝑞𝑞,𝐴𝐴 𝑝𝑝�𝑞𝑞
• And rearranging
𝜀𝜀𝑞𝑞,𝐴𝐴 𝐴𝐴
− =
𝜀𝜀𝑞𝑞,𝑝𝑝 𝑝𝑝�𝑞𝑞
– The right-hand side represents the advertising-to-sales
ratio.
– For two markets with the same 𝜀𝜀𝑞𝑞,𝑝𝑝 , the advertising-to-
sales ratio must be larger in the market where demand is
more sensitive to advertising (higher 𝜀𝜀𝑞𝑞,𝐴𝐴 ).
Advanced Microeconomic Theory 98
 Advertising in Monopoly
• Example:
– If the price-elasticity in a given monopoly market
is 𝜀𝜀𝑞𝑞,𝑝𝑝 = −1.5 and the advertising-elasticity is
𝜀𝜀𝑞𝑞,𝐴𝐴 = 0.1, the advertising-to-sales ratio should be
𝐴𝐴 0.1
= − = 0.067
𝑝𝑝�𝑞𝑞 −1.5

– Advertising should account for 6.7% of this

monopolist’s revenue.

Advanced Microeconomic Theory 99

Regulation of Natural
Monopolies

Advanced Microeconomic Theory 100

 Regulation of Natural Monopolies
• Natural monopolies: Monopolies that exhibit
decreasing cost structures, with the MC curve
lying below the AC curve.
• Hence, having a single firm serving the entire
market is cheaper than having multiple firms, as
aggregate average costs for the entire industry
would be lower.

Advanced Microeconomic Theory 101

 Regulation of Natural Monopolies
• Unregulated natural
monopolist maximizes
profits at the point where
MR=MC, producing 𝑄𝑄1
units and selling them at
a price 𝑝𝑝1 .
• Regulated natural
monopolist will charge 𝑝𝑝2
(where demand crosses
MC) and produce 𝑄𝑄2
units.
• The production level 𝑄𝑄2
implies a loss of 𝑝𝑝2 − 𝑐𝑐2
per unit.
Advanced Microeconomic Theory 102
 Regulation of Natural Monopolies
• Dilemma with natural monopolies:
– abandon the policy of setting prices equal to
marginal cost, OR
– continue applying marginal cost pricing but
subsidize the monopolist for his losses
• Solution to the dilemma:
– A multi-price system that allows for price
discrimination
– Charging some users a high price while
maintaining a low price to other users
Advanced Microeconomic Theory 103
 Regulation of Natural Monopolies
• Multi-price system:
– a high price 𝑝𝑝1
– a low price 𝑝𝑝2
• Benefit: (𝑝𝑝1 − 𝑐𝑐1 ) per unit
in the interval from 0 to 𝑄𝑄1
• Loss: (𝑐𝑐2 − 𝑝𝑝2 ) per unit in
the interval (𝑄𝑄2 − 𝑄𝑄1 )
• The monopolist price
discriminates iff
𝑝𝑝1 − 𝑐𝑐1 𝑄𝑄1 >
(𝑐𝑐2 − 𝑝𝑝2 )(𝑄𝑄2 − 𝑄𝑄1 )
Advanced Microeconomic Theory 104
 Regulation of Natural Monopolies
• An alternative regulation:
– allow the monopolist to charge a price above
marginal cost that is sufficient to earn a “fair” rate
of return on capital investments
• Two difficulties:
– what is a “fair” rate of return
– overcapitalization

Advanced Microeconomic Theory 105

 Regulation of Natural Monopolies
• Overcapitalization of natural monopolies:
– Suppose a production function of the form 𝑞𝑞 =
𝑓𝑓(𝑘𝑘, 𝑙𝑙). An unregulated monopoly with profit
function 𝑝𝑝𝑓𝑓 𝑘𝑘, 𝑙𝑙 − 𝑤𝑤𝑤𝑤 − 𝑟𝑟𝑟𝑟 has a rate of return
on capital, 𝑟𝑟. Suppose furthermore that the rate of
return on capital investments, 𝑟𝑟, is constrained by
a regulatory agency to be equal to 𝑟𝑟0 .

Advanced Microeconomic Theory 106

 Regulation of Natural Monopolies
• PMP:
𝐿𝐿 = 𝑝𝑝𝑝𝑝 𝑘𝑘, 𝑙𝑙 − 𝑤𝑤𝑤𝑤 − 𝑟𝑟𝑟𝑟
+𝜆𝜆 𝑤𝑤𝑤𝑤 + 𝑟𝑟0 𝑘𝑘 − 𝑝𝑝𝑝𝑝(𝑘𝑘, 𝑙𝑙)
where 0 < 𝜆𝜆 < 1.
• FOCs:
𝜕𝜕𝐿𝐿
= 𝑝𝑝𝑓𝑓𝑙𝑙 − 𝑤𝑤 + 𝜆𝜆 𝑤𝑤 − 𝑝𝑝𝑓𝑓𝑙𝑙 = 0
𝜕𝜕𝑙𝑙
𝜕𝜕𝜕𝜕
= 𝑝𝑝𝑓𝑓𝑘𝑘 − 𝑟𝑟 + 𝜆𝜆 𝑟𝑟0 − 𝑝𝑝𝑓𝑓𝑘𝑘 = 0
𝜕𝜕𝑘𝑘
𝜕𝜕𝜕𝜕
= 𝑤𝑤𝑤𝑤 + 𝑟𝑟0 𝑘𝑘 − 𝑝𝑝𝑝𝑝 𝑘𝑘, 𝑙𝑙 = 0
𝜕𝜕𝜕𝜕
Advanced Microeconomic Theory 107
 Regulation of Natural Monopolies
• From the first FOC:
𝑝𝑝𝑓𝑓𝑙𝑙 = 𝑤𝑤
• From the second FOC:
1 − 𝜆𝜆 𝑝𝑝𝑓𝑓𝑘𝑘 = 𝑟𝑟 − 𝜆𝜆𝑟𝑟0
and rearranging
𝑟𝑟−𝜆𝜆𝑟𝑟0 𝜆𝜆(𝑟𝑟0 −𝑟𝑟)
𝑝𝑝𝑓𝑓𝑘𝑘 = = 𝑟𝑟 −
1−𝜆𝜆 1−𝜆𝜆
– Since 𝑟𝑟0 > 𝑟𝑟 and 0 < 𝜆𝜆 < 1, then 𝑝𝑝𝑓𝑓𝑘𝑘 < 𝑟𝑟.
– Hence, the firm would hire more capital than under
unregulated condition, where 𝑝𝑝𝑓𝑓𝑘𝑘 = 𝑟𝑟.
Advanced Microeconomic Theory 108
 Regulation of Natural Monopolies
• 𝑝𝑝𝑓𝑓𝑘𝑘 is the value of the
marginal product of capital
– It is decreasing in 𝑘𝑘 (due to
diminishing marginal
return, i.e., 𝑓𝑓𝑘𝑘𝑘𝑘 < 0)
𝜆𝜆(𝑟𝑟0 −𝑟𝑟)
• 𝑟𝑟 and 𝑟𝑟 − are the
1−𝜆𝜆
marginal cost of additional
units of capital in the
unregulated and regulated
monopoly, respectively
𝜆𝜆(𝑟𝑟0 −𝑟𝑟)
𝑟𝑟 > 𝑟𝑟 −
1−𝜆𝜆
• Example: electricity and
water suppliers
Advanced Microeconomic Theory 109
 Regulation of Natural Monopolies
• An alternative illustration
of the overcapitalization
(Averch-Johnson effect)
• Before regulation, the
firm selects (𝐿𝐿𝐵𝐵𝐵𝐵 , 𝐾𝐾 𝐵𝐵𝐵𝐵 )
• After regulation, the firm
selects (𝐿𝐿𝐴𝐴𝑅𝑅 , 𝐾𝐾 𝐴𝐴𝑅𝑅 ),
where 𝐾𝐾 𝐴𝐴𝐴𝐴 > 𝐾𝐾 𝐵𝐵𝑅𝑅 but
𝐿𝐿𝐴𝐴𝐴𝐴 < 𝐿𝐿𝐵𝐵𝑅𝑅
• The overcapitalization
result only captures the
substitution effect of a
cheaper input.
– Output effect?
Advanced Microeconomic Theory 110
Monopsony

Advanced Microeconomic Theory 111

 Monopsony
• Monopsony: A single buyer of goods and services
exercises “buying power” by paying prices below
those that would prevail in a perfectly
competitive context.
• Monopsony (single buyer) is analogous to that of
a monopoly (single seller).
• Examples: a coal mine, Walmart Superstore in a
small town, etc.

Advanced Microeconomic Theory 112

 Monopsony
• Consider that the monopsony faces competition in the
product market, where prices are given at 𝑝𝑝 > 0, but is
a monopsony in the input market (e.g., labor services).
• Assume an increasing and concave production
function, i.e., 𝑓𝑓𝑓 𝑥𝑥 > 0 and 𝑓𝑓𝑓𝑓 𝑥𝑥 ≤ 0.
– This yields a total revenue of 𝑝𝑝𝑝𝑝 𝑥𝑥 .
• Consider a cost function 𝑤𝑤 𝑥𝑥 � 𝑥𝑥, where 𝑤𝑤(𝑥𝑥) denotes
the inverse supply function of labor 𝑥𝑥.
– Assume that 𝑤𝑤𝑤 𝑥𝑥 > 0 for all 𝑥𝑥.
– This indicates that, as the firm hires more workers, labor
becomes scarce, thus increasing the wages of additional
workers.
Advanced Microeconomic Theory 113
 Monopsony
• The monopsony PMP is
max 𝑝𝑝𝑝𝑝 𝑥𝑥 − 𝑤𝑤 𝑥𝑥 𝑥𝑥
𝑥𝑥
• FOC wrt the amount of labor services 𝑥𝑥 yields
𝑝𝑝𝑓𝑓 ′ 𝑥𝑥 ∗ − 𝑤𝑤 𝑥𝑥 ∗ − 𝑤𝑤 ′ 𝑥𝑥 ∗ 𝑥𝑥 ∗ = 0
⟹ 𝑝𝑝𝑓𝑓 ′ 𝑥𝑥 ∗ = 𝑤𝑤 𝑥𝑥 ∗ + 𝑤𝑤 ′ 𝑥𝑥 ∗ 𝑥𝑥 ∗
𝐴𝐴 𝐵𝐵
– 𝐴𝐴: “marginal revenue product” of labor.
– 𝐵𝐵: “marginal expenditure” (ME) on labor.
 The additional worker entails a monetary outlay of 𝑤𝑤 𝑥𝑥 ∗ .
 Hiring more workers make labor become more scarce,
ultimately forcing the monopsony to raise the prevailing wage
on all inframarginal workers, as captured by 𝑤𝑤 ′ 𝑥𝑥 ∗ 𝑥𝑥 ∗ .
Advanced Microeconomic Theory 114
 Monopsony
• Monopsonist hiring and salary decisions.
– The marginal revenue
product of labor, 𝑝𝑝𝑓𝑓 ′ 𝑥𝑥 ,
is decreasing in 𝑥𝑥 given
that 𝑓𝑓𝑓𝑓 𝑥𝑥 ≤ 0.
– The labor supply, 𝑤𝑤 𝑥𝑥 , is
increasing in 𝑥𝑥 since
𝑤𝑤 ′ (𝑥𝑥) > 0.
– The marginal expenditure
(ME) on labor lies above
the supply function w 𝑥𝑥
since 𝑤𝑤 ′ 𝑥𝑥 > 0.
– The monopsony hires 𝑥𝑥 ∗
workers at a salary of
𝑤𝑤 𝑥𝑥 ∗ . Advanced Microeconomic Theory 115
 Monopsony
• A deadweight loss from monopsony is
𝑥𝑥 𝑃𝑃𝑃𝑃
𝐷𝐷𝐷𝐷𝐷𝐷 = ∫𝑥𝑥 ∗ 𝑝𝑝𝑓𝑓 ′ 𝑥𝑥 − 𝑤𝑤 𝑥𝑥 𝑑𝑑𝑑𝑑
• That is, the area below the marginal revenue product
and above the supply curve, between 𝑥𝑥 ∗ and 𝑥𝑥 𝑃𝑃𝑃𝑃
workers.

Advanced Microeconomic Theory 116

 Monopsony
• We can write the monopsony profit-maximizing
condition, i.e., 𝑝𝑝𝑓𝑓 ′ 𝑥𝑥 ∗ = 𝑤𝑤 𝑥𝑥 ∗ + 𝑤𝑤 ′ 𝑥𝑥 ∗ 𝑥𝑥 ∗ , in
terms of labor supply elasticity, using the
following steps:
′ ∗ ∗𝜕𝜕𝜕𝜕 𝑥𝑥 ∗ ∗
𝑝𝑝𝑓𝑓 𝑥𝑥 = 𝑤𝑤 𝑥𝑥 + ∗ 𝑥𝑥
𝜕𝜕𝑥𝑥
𝜕𝜕𝜕𝜕 𝑥𝑥 ∗ 𝑥𝑥 ∗
= 𝑤𝑤 𝑥𝑥 ∗ 1 +
𝜕𝜕𝑥𝑥 ∗ 𝑤𝑤 𝑥𝑥 ∗
• And rearranging,
′ ∗ ∗ 1
𝑝𝑝𝑓𝑓 𝑥𝑥 = 𝑤𝑤 𝑥𝑥 1 + 𝜕𝜕𝑥𝑥∗𝑤𝑤 𝑥𝑥∗
𝜕𝜕𝜕𝜕 𝑥𝑥∗

Advanced Microeconomic Theory 117

 Monopsony
𝜕𝜕𝑥𝑥 ∗ 𝑤𝑤 𝑥𝑥 ∗
• Since represents the elasticity of labor
𝜕𝜕𝜕𝜕 𝑥𝑥 ∗
supply 𝜀𝜀, then
′ ∗ ∗ 1
𝑝𝑝𝑓𝑓 𝑥𝑥 = 𝑤𝑤 𝑥𝑥 1+
𝜀𝜀

• Intuitively, as 𝜀𝜀 → ∞ (labor supply becoming

perfectly elastic), the behavior of the
monopsonist approaches that of a pure
competitor.

Advanced Microeconomic Theory 118

 Monopsony
• The equilibrium condition above is also sufficient
as long as
𝑝𝑝𝑝𝑝𝑝𝑝 𝑥𝑥 ∗ − 2𝑤𝑤𝑤 𝑥𝑥 ∗ − 𝑤𝑤𝑤𝑤 𝑥𝑥 ∗ 𝑥𝑥 ∗ < 0
• Since 𝑓𝑓𝑓𝑓 𝑥𝑥 ∗ < 0, 𝑤𝑤𝑤 𝑥𝑥 ∗ > 0 (by assumption),
we only need that either:
a) the supply function is convex, i.e., 𝑤𝑤 ′′ (𝑥𝑥 ∗ ) > 0;
or
b) if it is concave, i.e., 𝑤𝑤𝑤𝑤 𝑥𝑥 ∗ < 0, its concavity is
not very strong, that is
𝑝𝑝𝑝𝑝𝑝𝑝 𝑥𝑥 ∗ − 2𝑤𝑤𝑤 𝑥𝑥 ∗ < 𝑤𝑤𝑤𝑤 𝑥𝑥 ∗ 𝑥𝑥 ∗
Advanced Microeconomic Theory 119
 Monopsony
• Example:
– Consider a monopsonist with production function
𝑓𝑓 𝑥𝑥 = 𝑎𝑎𝑎𝑎, where 𝑎𝑎 > 0, and facing a given
market price 𝑝𝑝 > 0 per unit of output.
– Labor supply is 𝑤𝑤 𝑥𝑥 = 𝑏𝑏𝑏𝑏, where 𝑏𝑏 > 0.
– The marginal revenue product of hiring an
additional worker is
𝑝𝑝𝑓𝑓 ′ 𝑥𝑥 = 𝑝𝑝𝑝𝑝
– The marginal expenditure on labor is
𝑤𝑤 𝑥𝑥 + 𝑤𝑤 ′ 𝑥𝑥 𝑥𝑥 = 𝑏𝑏𝑏𝑏 + 𝑏𝑏𝑏𝑏 = 2𝑏𝑏𝑏𝑏
Advanced Microeconomic Theory 120
 Monopsony
• Example (continued):
– Setting them equal to each other, 𝑎𝑎𝑎𝑎 = 2𝑏𝑏𝑥𝑥 ∗ ,
yields a profit-maximizing amount of labor:
∗
𝑎𝑎𝑎𝑎
𝑥𝑥 =
2𝑏𝑏
– 𝑥𝑥 ∗ increases in the price of output, 𝑝𝑝, and in the
marginal productivity of labor, 𝑎𝑎; but decreases in
the slope of labor supply, 𝑏𝑏.
– Sufficiency holds since
𝑝𝑝𝑝𝑝𝑝𝑝 𝑥𝑥 ∗ − 2𝑤𝑤𝑤 𝑥𝑥 ∗ = 𝑝𝑝𝑝 − 2𝑏𝑏 < 0 = 𝑤𝑤𝑤𝑤 𝑥𝑥 ∗ 𝑥𝑥 ∗
Advanced Microeconomic Theory 121