Monopoly Pricing & Price Discrimination: Study Notes
Hey everyone! Welcome to this important (and actually quite interesting!) chapter on Monopoly. Ever wondered why your student Octopus card gives you a cheaper MTR ride, or why there's only one electricity provider in your area? This chapter has the answers!
We'll break down how a single seller in a market—a monopolist—decides on its price and how it can cleverly charge different prices to different people. Don't worry if this sounds tricky, we'll go step-by-step with simple examples. Let's get started!
Part 1: Simple Monopoly Pricing (Uniform Pricing)
This is where a monopolist charges the same price for every unit of the good it sells. Think of a company that sells its product at one single price to all customers.
What Makes a Firm a Monopolist?
A monopoly is a market structure with only one seller. This single seller has significant control over the market price, making it a price searcher. Remember from the compulsory part, monopoly power can come from:
- High set-up costs: e.g., building a city-wide electricity grid.
- Natural monopoly: It's more efficient for one firm to supply the whole market.
- Legal restrictions: The government grants exclusive rights, like patents or licenses.
- Public ownership: e.g., government-run services.
The Monopolist's Demand and Marginal Revenue
This is super important! In perfect competition, a firm faces a horizontal demand curve. But a monopolist IS the market, so it faces the entire downward-sloping market demand curve.
To sell more, a monopolist must lower its price. This leads to a crucial relationship:
For a monopolist, Marginal Revenue (MR) is always less than Price (P).
Why is MR < P?
Think about it like this: To sell one extra movie ticket, the cinema has to lower the price. But it's not just the new customer who gets the lower price—everyone buying a ticket now pays less. This "loss" on all the previous units means the extra revenue (marginal revenue) from selling one more ticket is less than the price it sells for.
Numerical Example: The Relationship between P and MR
Let's see it with numbers. Notice how MR is always lower than P (except for the very first unit).
| Price (P) | Quantity (Q) | Total Revenue (TR = P x Q) | Marginal Revenue (MR = Change in TR / Change in Q) |
|---|---|---|---|
| $10 | 1 | $10 | $10 |
| $9 | 2 | $18 | $8 |
| $8 | 3 | $24 | $6 |
| $7 | 4 | $28 | $4 |
Graphical Representation
Graphically, the MR curve is always below the Demand (AR) curve and is typically twice as steep.
(Imagine a graph here: a downward sloping Demand curve, with a steeper MR curve starting at the same point on the vertical axis but falling faster and crossing the horizontal axis halfway to where the Demand curve does).
How a Monopolist Maximizes Profit
The golden rule for profit maximization is the same for all firms: Produce where Marginal Revenue equals Marginal Cost.
$$Profit Maximization Rule: MR = MC$$
Step-by-Step Guide to Finding Price and Output:
This is a classic exam question, so let's nail it down!
- Step 1 (Find Quantity): Find the point where the MR and MC curves intersect. Look down from this point to the horizontal axis to find the profit-maximizing quantity (Qm).
- Step 2 (Find Price): From that quantity (Qm), move vertically UP to the Demand Curve. Then, look across to the vertical axis to find the profit-maximizing price (Pm).
Common Mistake Alert!
A very common error is to take the price from the MR=MC intersection point. DO NOT do this! The price is always determined by what consumers are willing to pay, which is shown by the Demand Curve.
Numerical Example: Finding the Profit-Maximizing Point
Let's add Marginal Cost (MC) to our earlier table. Assume MC is constant at $4 for simplicity.
| Q | P | MR | MC | Decision |
|---|---|---|---|---|
| 1 | $10 | $10 | $4 | MR > MC, produce more |
| 2 | $9 | $8 | $4 | MR > MC, produce more |
| 3 | $8 | $6 | $4 | MR > MC, produce more |
| 4 | $7 | $4 | $4 | MR = MC, PROFIT MAXIMIZED! |
| 5 | $6 | $2 | $4 | MR < MC, produce less |
The profit-maximizing quantity is 4 units, and the price charged is $7.
Monopoly and Efficiency: Is it good for society?
In short, no. Simple monopoly pricing is inefficient. Why? Because it creates a deadweight loss.
- Allocative Efficiency occurs when a good is produced up to the point where the last unit provides a marginal benefit to consumers equal to its marginal cost of production. In other words, where Price (MB) = MC.
- A monopolist produces where P > MC. This means the value consumers place on an extra unit (P) is greater than the cost to make it (MC). Society would be better off if more was produced, but the monopolist restricts output to keep the price high.
Illustrating Inefficiency
On a graph, we can see:
- Consumer Surplus: The area below the demand curve and above the monopoly price (Pm). It's smaller than in perfect competition.
- Producer Surplus: The area above the MC curve and below the monopoly price (Pm). It's larger than in perfect competition.
- Deadweight Loss (DWL): A triangle area that represents the loss of total surplus (both consumer and producer) because the monopolist under-produces. This is the measure of inefficiency.
Comparison: Monopoly vs. Perfect Competition
| Feature | Perfect Competition | Monopoly |
|---|---|---|
| Price | Lower (P = MC) | Higher (P > MC) |
| Output | Higher | Lower |
| Efficiency | Efficient (No Deadweight Loss) | Inefficient (Has Deadweight Loss) |
Key Takeaway for Part 1
A simple monopolist maximizes profit by producing where MR = MC, which results in a lower quantity and a higher price compared to a perfectly competitive market. This leads to allocative inefficiency and a deadweight loss to society.
Part 2: Price Discrimination
Now for the clever part! What if a monopolist could charge different prices to different people? That's price discrimination.
What is Price Discrimination?
Price discrimination is the practice of selling the exact same good or service at different prices to different buyers, where the price difference is NOT due to a difference in the cost of production.
Example: An adult and a student pay different prices for the same movie ticket. The cinema's cost to show the movie is the same for both people.
Conditions for Price Discrimination
For a firm to be able to price discriminate, three conditions must be met. (Memorise these!)
- Monopoly Power: The firm must be a price searcher with some control over the price. A price taker in perfect competition cannot do this.
- Market Segmentation: The firm must be able to divide its buyers into different groups based on their willingness to pay (or price elasticity of demand). e.g., students, adults, senior citizens.
- No Resale (No Arbitrage): It must be difficult or impossible for the group buying at a low price to resell the product to the group charged a high price. You can't buy a student MTR discount and sell it to an adult!
Types of Price Discrimination
The syllabus requires you to know three types. The key is to understand the definition and have solid examples for each.
1. First-degree Price Discrimination (Perfect Price Discrimination)
- What it is: The seller charges each and every consumer the maximum price they are willing to pay. The seller extracts all the consumer surplus.
- Is it common? No, it's very rare because it's hard for sellers to know every individual's maximum willingness to pay.
- Examples: A skilled seller bargaining in a tourist market, trying to size up each customer and get the highest price. An online auction where people bid their maximum price.
2. Second-degree Price Discrimination (By Quantity)
- What it is: The seller charges different prices per unit for different quantities or "blocks" of the same good.
- The idea: It's a way to offer bulk discounts. The more you buy, the cheaper the price per unit becomes.
- Examples:
- Electricity bills: the price per kWh might be higher for the first 100 kWh and lower for consumption above that.
- Supermarket deals like "Buy 2, get 1 free". The price per item is lower if you buy three instead of one.
3. Third-degree Price Discrimination (By Group)
- What it is: The seller divides consumers into different groups and charges a different price to each group. This is the most common type you'll see.
- The idea: Groups that are less sensitive to price (inelastic demand, like business travellers) are charged more. Groups that are more sensitive to price (elastic demand, like students) are charged less.
- Examples:
- By Age: Child, adult, and senior citizen prices for movie tickets or theme parks.
- By Status: Student discounts on software, public transport (MTR), and museum entry.
- By Time: Peak vs. off-peak phone call rates or electricity prices. "Early bird" dinner specials.
- By Location: Resident vs. non-resident prices for certain attractions.
A Final Important Note!
According to the HKDSE syllabus, you are NOT expected to know how to determine the price and output under price discrimination, nor are you expected to analyse its efficiency implications. Just focus on the meaning, conditions, types, and examples!
Key Takeaway for Part 2
Price discrimination involves charging different prices for the same product. It requires monopoly power, market segmentation, and no resale. The main types are first-degree (perfect), second-degree (by quantity), and third-degree (by group).
Great job getting through this topic! Keep reviewing the key graphs and definitions, and you'll be well-prepared for any questions that come your way.