IO, Lecture 1

Introduction. Monopolistic markets-1

Elena Paltseva

NES
Oct 2021

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Introduction

I Teacher: Elena Paltseva, [email protected]

I Associate Professor at SITE, Stockholm School of Economics
I Interests: political economy, industrial organization, energy
and resource economics, gender economics etc.
I O¢ ce hours: by appointment
I Teaching assistant: Dmitrii Urentsov, [email protected]

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Practicalities

I Course: 2 lectures and 1 exercise class a week (on average)

I Lectures:Wednesday+Friday (normally)
I Exercise classes: Friday
I participate in the exercise classes - easier to survive the course!
I 2 problem sets + COVID project+ …nal exam (180 min)
I Grade = Final Exam (60%) + two problem sets (10%
each) + COVID project (20%, in pairs)
I Attendance: not compulsory
I BUT: those with attendance below 50% will not be allowed
to re-take the …nal exam.

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Practicalities (cont.)
I Course has a web-page in my.nes. Please check it regularly:
I A preliminary syllabus has already been uploaded on the
home-page.
I Problem sets and additional practice exercises will be uploaded
along the way.
I Lecture notes will also be uploaded
I Literature:
I Textbooks:
I Tirole, Jean: The Theory of Industrial Organization, The MIT
Press, 1995
I Belle‡ame, P. and M. Peitz, 2010/2014, “Industrial
Organization: Markets and Strategies”, Cambridge University
Press
I Shy, Oz: Industrial Organization, The MIT Press, 1995
I Papers
I see syllabus and my.nes

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COVID project
I Goal: to analyze the impact of COVID-19 + restrictions on
market of your choice in Russia/Russian region/city
I Ideally: …nd a market with a few big players and look at their
strategic responses/actions.
I But you can also take a market with many …rms.
I Think/look for the information about
I How the demand has been a¤ected and why? Which policy
measures have a¤ected it?
I Same for supply
I What happens in related markets/any spillovers e¤ects?
I How …rms are responding to this situation?
I How is government involved? How should it be involved?
I Any long-term consequences for this market?
I Great if you apply what you learned in the course
I But may look more like a consulting project - is OK, as
consulting and IO are very close.
I Deadline: Nov 29st, 2021
I split in groups of 2 by Nov 3rd, 2021, see course webpage 5
Plan for next two classes:
I Introduction: The topic of IO
I General topic: Monopoly
I Today:
I reminder: single-product monopolist
I multi-product monopolist
I Monopolistic discrimination
I reminder about monopolistic discrimination of 1st and 3rd
degree
I Next time: continue with monopolistic discrimination
I 2nd-degree
I two-part tari¤ vs. fully non-linear pricing
I tie-in sales (if time permits)
I intertemporal discrimination
I repeated purchase and durable-good monopolist

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Introduction: the topic of IO

I IO is a study of …rms, markets, and their interactions outside

of perfectly competitive environment
I = in presence of market power
I Market power = ability to raise price above (marginal) cost
I Is there market power?
I How do …rms acquire and maintain market power?
I What are the implications of market power?
I Is there a role for policy regarding market power?

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Monopoly
I We start with the case of full market power - monopoly
I Monopoly = a sole supplier of a good for which there is no
close substitute
I not a price taker, unlike in perfect competition
I Sources of monopolistic power
I Merger
I Technological advantage
I technology, know-how
I access to critical resource
I State-created monopoly
I patents, legislation
I Natural monopoly
I e¢ cient size of a …rm is too large, only one …rm survives on
the market

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Monopoly: reminder
I Assume
I monopolist produces only one good, which is given
I its quality is known to the consumer
I If there is no price discrimination, monopolist solves

max pD (p ) C (D (p ))
p

or
max qP (q ) C (q )
q

I FOC:
P (q m ) + q m P 0 (q m ) = C 0 (q m )
I or
MR (q m ) = MC (q m )

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Monopoly: reminder (cont.)
I We can rewrite

P (q m ) + q m P 0 (q m ) = C 0 (q m )

as
P (q m ) C 0 (q m ) q m P 0 (q m )
=
P (q m ) P (q m )
I what is on the LHS? on the RHS?
I
P (q m ) C 0 (q m ) q m ∂P
=
P (q m ) P (q m ) ∂q m
I

LernerIndex = 1/εdp
∂D (p m ) p m
where εdp is demand elasticity w/r to price, ε = ∂p D (p m )
I Lower elasticity leads to a higher mark-up!

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Monopoly: reminder (cont.)

I On which part of demand curve does monopoly operate?

I when demand elasticity ε > 1
I otherwise monopolist’s revenue is decreasing in quantity

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MR (q m ) = P (q m ) + q m P 0 (q m ) = 1 P (q m ) < 0
ε
I How does monopolistic pricing look in case of
I linear demand?
I constant elasticity of demand q = p ε?

I How does monopoly price change with marginal cost?

I (weakly) increases
I prove at home.

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Monopoly: reminder (cont.)
I Is monopolistic pricing socially optimal?
I DWL

I Shall the government tax monopoly to restore e¢ ciency?

I No, subsidize!
I derive the rate of e¢ ciency-restoring per unit subsidy t
at home.
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Monopoly: reminder (cont.)

I Is monopoly bad?
I DWL compared to competitive solution
I Price distortions
I Cost distortions (weaker incentives to innovate?)
I Rent-seeking to maintain monopoly power
I more?
I Are there any bene…ts of a monopoly?
I incentives for innovation if monopoly status can be maintained
(promise of pro…ts)
I more?

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Monopoly: multiple products
I Assume: monopolist produces several goods (and has
monopolistic power at all respective mkts)
I Demands
qi = D i ( p )
I Cost of production
C (q1 , q2 , ..., qn )
I Monopolist solves
n
max
p 1 ,p 2 ,...,p n
∑ pi D i ( p ) C (D1 (p ), D2 (p ), ..., Dn (p ))
i =1
I FOCs for each j:
n n
∂Di (p ) ∂C (D1 (p ), D2 (p ), ..., Dn (p )) ∂Di (p )
D j ( p ) + ∑ pi =∑
i =1 ∂pj i =1 ∂(Di (p )) ∂pj
I Several cases
I dependent demands (+/-)
I dependent costs (+/-)
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Case 1: independent demands, independent costs
I C (D1 (p ), D2 (p ), ..., Dn (p )) = ∑ni=1 Ci (Di (p ))
I D j ( pj )
I What happens?
I FOCs for each j
n n
∂Di (p ) ∂C (D1 (p ), D2 (p ), ..., Dn (p )) ∂Di (p )
D j ( p ) + ∑ pi =∑
i =1 ∂pj i =1 ∂(Di (p )) ∂pj

becomes
∂Dj (p ) ∂Cj (Dj (p )) ∂Dj (p ) ∂Dj
D j ( p ) + pj = = Cj0
∂pj ∂(Dj (p )) ∂pj ∂pj
I Rewrite it
pj C0 1
=
pj εj
I Markets are fully separated!
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Case 2: dependent demands, independent costs
I FOCs take the following form
n n
∂Di (p ) ∂Ci (Di (p )) ∂Di (p )
D j ( p ) + ∑ pi =∑
i =1 ∂pj i =1 ∂ (Di (p )) ∂pj
I or
∂Dj (p ) n ∂Dj (p ) n
∂D (p ) ∂D (p )
D j ( p ) + pj + ∑ pi i = Cj0 + ∑ Ci0 i
∂pj i 6 =j
∂p j ∂p j i 6 =j
∂pj
I or equivalently
∂Dj (p ) n
∂Di (p )
pj Cj0
∂pj
= Dj ( p ) ∑ pi Ci0
∂pj
i 6 =j
∂D j (p )
I divide both parts by ∂ p j pj

pj Cj0 Dj ( p ) n pi Ci0 ∂Di (p )

pj
= ∂D j (p ) ∑ ∂D j (p ) ∂pj
pj ∂p j i 6 = j pj ∂ p
j

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Case 2: dependent demands, independent costs (cont)
I Rewrite
pj Cj0 1 n
( pi Ci0 ) ∂Di (p )
pj
= ∑ ∂D (p )
εjj i 6 =j pj j ∂p j
∂pj

I Convenient reference point: collection of n independent

monopolist producers for each good
∂D i (p )
I What happens if the goods are substitutes, > 0? why?
∂p j
I Multi-product monopoly prices are higher than those of the
collection of n independent monopolist producers
I internalize the demand-driven externality (do not be so afraid
of demand switch)
∂D i (p )
I What happens if the goods are complements, < 0?
∂p j
why?
I Multi-product monopoly prices are lower than those of the
collection of n independent monopolist producers
I lower the price to increase demand for the other product too
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Example: Goodwill e¤ect

I Low prices in the …rst period increase demand both in the …rst
and in the second period
I Model
I two periods
I demand: D1 (p1 ), D2 (p2 , p1 ), where ∂∂Dp12 < 0
I e.g., there is an word of mouth information coming from the
period 1 consumers
I cost: C1 (q1 ), C2 (q2 )
I discounting δ between periods
I What happens?

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Goodwill e¤ect (cont.)
I Monopolist solves

max p1 D1 (p1 ) + δp2 D2 (p2 , p1 ) C1 (D1 (p1 )) δC2 (D2 (p2, p1 ))

p 1 ,p 2

I Monopolist’s FOCs

∂D2 (p2 , p1 ) ∂C2 (D2 (p2 , p1 )) ∂D2 (p2 , p1 )

D 2 ( p2 ) + p2 =
∂p2 ∂(D2 (p2 , p1 )) ∂p2
∂D (p )
1 1
D1 (p1 ) + p1 ∂p
h 1 i
(p 2 ,p 1 ) ∂C 2 (D 2 (p 2 ,p 1 )) ∂D 2 (p 2 ,p 1 ) ∂C 1 (D 1 (p 1 )) ∂D 1 (p 1 )
+δ p2 ∂D 2 ∂p 1 ∂(D 2 (p 2 ,p 1 )) ∂p 1 = ∂(D 1 (p 1 )) ∂p 1

I monopolistic price in the second period

I price below the single-period myopic level in the …rst period
I more output in the …rst period to increase demand in the
second period

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Case 3: independent demands, dependent costs
I FOCs
∂Dj ∂C ∂Dj
Dj + pj=
∂pj ∂Dj ∂pj
I The same formula as in case of a single product but the
marginal cost depends on the total output
I Example: Learning by Doing
I cost reduced over time due to learning
I Model
I two periods
I demand each period: Dt (pt )
I cost: C1 (q1 ), C2 (q2 , q1 ), where ∂∂Cq12 < 0
I discounting δ between periods
I What happens?
I SOLVE AT HOME
I How does the outcome you get compare to the outcome of
"goodwill" model? What are the di¤erent economic channels?
I if questions, read Tirole (Chapter 1)
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Monopolistic price discrimination
I Ine¢ ciency of monopoly:
I Wants to charge price>MC
I But if charges higher prices to some customers, loses some
other (whose willingness to pay is only slightly above MC)
I What if can charge di¤erent prices to di¤erent customers?
I Or, better yet, charge di¤erent prices to di¤erent customers for
di¤erent units of output
I “Degrees” of price discrimination
I First – perfect
I Can charge di¤erent prices for di¤erent consumers for di¤erent
units
I Second – nonlinear pricing, “menu of contracts”
I Cannot distinguish consumers, but can charge non-uniform
"prices" depending on the amount consumed
I Third – spatial, “grouping”
I Can only charge uniform prices but can distinguish consumers
I Which one?
I Depends on information and on costs of resale 21
Reminder: Perfect price discrimination

I Charge marginal willingness to pay for each unit

I Produce as long as P>MC
I Hence no deadweight loss
I BUT Monopoly appropriates all surplus
p

Monopoly profit

MC
D

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Reminder: 3rd degree price discrimination

I Monopolist serving m markets

I no re-sale between the markets
m m
max ∑ pi Di (pi ) C ( ∑ Di (pi ))
i =1 i =1

I FOCs
m
Di (p ) + pi Di0 (p ) = C 0 ( ∑ Di (pi ))
i =1

I or equivalently
pi Ci0 (Q ) 1
=
pi εi
I Higher prices in less elastic markets

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Reminder: 3rd degree price discrimination

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Reminder: welfare in 3rd degree price discrimination

I Does 3rd degree price discrimination improve welfare?

I of monopolist? of consumers? total?
I Monopolist
I yes (revealed preference argument)
I Consumers
I low-elasticity markets prefer uniform price,
I high-elasticity markets prefer discrimination (show at home!)

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Reminder: welfare in 3rd degree price discrimination

I Total welfare?
p1 p2 p
Large demand Small demand Total demand

D1 D1+D2

p1_mon p1+2_mon
D2
p2_mon MC

q1 q2
MR1 MR2 MR1+2 q1+ q2
I

I necessary condition: 3rd degree price discrimination increases

welfare only if increases output (show at home!)
I E.g. allows to serve a market that would not be served under
uniform price

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