1 First degree price discrimination1
Suppose a pro…t maximizing monopolist producing Q units of output faces the de-
mand curve P (Q) = 20 Q. It’s total cost when producing Q units of output is
C(Q) = 24 + Q2 .
a) If price discrimination is impossible, calculate both PS and pro…ts.
1.1 Setup
Pro…t Max rule is:
MC = MR: (1)
In particular, MC is:
d
C 0 (Q) = 24 + Q2 = 2Q (2)
dQ
Note that revenue is (P ) (Q). That is:
R = P Q = (20 Q) Q = 20Q Q2 : (3)
Therefore, MR is:
d
R0 (Q) = 20Q Q2 = 20 2Q: (4)
dQ
1.2 Solution
Hence, the monopolist maximizes pro…t by choosing Q = QM . Such QM makes the
following condition true:
R0 (Q) = C 0 (Q)
! 20 2Q = 2Q,
Solution is:
QM = 5: (5)
Note however, that the monopolist prices using the demand curve, so it will set
the price:
P (QM ) = 20 QM !
1
Carlos, 12/1/2010.
1
PM P (QM ) = 20 5 = 15: (6)
This means that the pro…ts for the monopolist are:
M
= RM CM : (7)
That is,
M 2
= P M QM 24 + QM !
M
= 15 (5) 24 + 52 = 26: (8)
Producer surplus is given by the sum of the following two areas:
P S M = A1 + A2 : (9)
Where A1 =Area of the triangle whose base is QM and height p; with p = M R
20 2QM = 20 2 (5) = 10:
That is,
QM p 5 (10)
A1 = = = 25: (10)
2 2
On the other hand, A2 = The area of the rectangle whose base is QM and height
is P M p = 15 10 = 5:
That is,
A2 = QM P M p = 5 (5) = 25: (11)
Therefore2 ,
P S M = A1 + A2 ! P S = 25 + 25 = 50: (12)
1.3 Allowing for …rst-degree price discrimination
b) Now, suppose the …rm can engage in …rst-degree price discrimination
[FDPD]. What’s the new pro…t and PS?
Note that in FDPD, the producer is able to extract all consumer’s surplus, by
pricing each unit at each consumer’s reservation price. Further, the outcome is Pareto
e¢ cient, i.e., there is no DWL.
2
R QM
Alternatively, the same two areas can be computed as 0
PM C 0 dQ =
R QM M 2 M 2 2 2
0
(15 2Q) dQ = 15Q 2 Q = 15 (5) 2 (5) = 50 = P S :
2
Note …rst that if:
MC = p (13)
Then, 2Q = 20 Q!
20
QE = = 6: 666 7: (14)
3
Note this further implies that:
20 40
P E = 20 = QE = 20
= 13: 333: (15)
3 3
Now, the new pro…ts for a FDPD monopolist will be:
~ =R
~ CE; (16)
where3 : Z QE
~
R (20 Q) dQ: (17)
0
And
2
C E = 24 + QE : (18)
Then, ~ = R
~ CE !
Triangle + Rectangle
z }| {
Z QE
2
~ = (20 Q) dQ 24 + QE : (19)
| 0
{z } | {z }
~ Cost (C E )
Revenue (R)
R QE R 20 E 1 E 2
20
3
Note …rst that: 0
(20 Q) dQ = 0
3
(20 Q) dQ = 20Q 2
Q :
0
Then,
2
~ = 20 20 1 20 1000
R = = 111: 11: (20)
3 2 3 9
This means that, ~ = R
~ CE !
3
Note this is nothing but the sum of the area of two geometric …gures. i.e., the area of a traingle
[Consumer Surplus (CSE ).], plus the area of the rectangle whose height is P E ; and length QE :
3
!
2
~ = 1000 20 1000 616 128
24 + = = = 42: 667: (21)
9}
| {z 3 9 9 3
~
Revenue (R)
| {z }
Cost (C E )
On the other hand, the new producer surplus4 , will be:
Z QE
P S~ = (P (C 0 )) dx: (22)
0
R QE R QE
Then, P S~ = 0
((20 Q) (2Q)) dQ = 0
((20 3Q)) dQ = 20QE 3 2E
2
Q =
20 3 20 2 200
20 3 2 3
= 3 :
200
P S~ = = 66: 667: (23)
3
2 Second degree price discrimination
Consider a market with a 100 identical individuals, each with the demand schedule
for electricity of P = 10 qi : They are served by an electric utility which operates
with a a …xed cost of 1; 200 and a constant MC of 2.
A regulator would like to introduce a two-part tari¤, where S is a …xed sub-
scription charge and m is a usage charge per unit of electricity consumed. How
should the regulator set S and m to maximize the sum of CS and PS,
while allowing the …rm to earn exactly zero economic pro…t?
First note that
Xn
Q= qi = nq: (24)
i=1
Next, observe that p = 10 qi = 10 q ! p = 10 q ! q = 10 p:
Then,
Q = nq = n (10 p) = 100 (10 p) = 1000 100p: (25)
Which implies that:
4 20 1
Which is simply the area of triangle whose height is QE ; and lenght 20:That is, 3 (20) 2 =
200
3 :
4
1
Q = 1000 100p ! p = 10 Q: (26)
100
Note that in a Pareto e¢ cient outcome,
p = M C: (27)
Then,
1 1
10 Q = M C = 2 ! 10 Q = 2 ! QE = 800: (28)
100 100
This
R QE further0 meansRthat CS is the area:
QE 1
0
(p C ) dx ! 0
10 100 Q 2 dx !
Z 800
1
CS = 10 Q 2 dQ = 3200: (29)
0 100
Note that if
Q
Q = nq ! = q: (30)
n
That is, each of the 100 consumers consumes:
800
q= = 8 = (q = 8) = 8: (31)
100
Then, the optimal two-part tari¤ will be to set S~ to be the full consumer surplus
(with zero DWL), and set usage fee m equal to M C, i.e.,:
~
S~ = CS = 3200 ! S = Sn = 3200=100 = 32
: (32)
m = C0 = 2
That is, each consumer in the market pays a subscription fee of $32, and a usage
fee =MC=$2.
However, for the monopoly to earn zero pro…ts, the regulator will need to subtract
a lump sum of $3; 200 from the monopolist’s revenue. In this way the monopolist
earns zero economic pro…t and consumer and producer surplus are maximized.
3 Third-degree price discrimination
A monopolist faces two market segments. In each market segment, the demand curve
is of the constant elasticity form. In market segment 1, the price elasticity of demand
5
is -3, while in segment two it is -1.5. The monopolist has a constant MC of 5 per
unit in both markets.
What is the monopolist’s pro…t maximizing price in each segment?
3.1 Solution
Note that if we let Q = AP ; then dd log(Q)
log(P )
dq p
= dp q
= : That is, the demand function
Q = AP has a constant elasticity, :
As usual, the pro…t Max rule is given by
MC = MR (33)
And
R = P Q: (34)
So,
M R = P 0 Q + P: (35)
Then, we have that M C = M R implies:
C 0 = P 0 Q + P: (36)
Note that the last expression can be written as5 :
Q 1 C0 j j
C0 = P P0 +1 ! C0 = P 1 ! =P (37)
P j j (j j 1)
Hence6 ,
8
< (P )S1 = C 0 j S1 j 5j 3j
(j S1 j 1)
= (j 3j 1)
= 15
2
= 7: 5
C 0 j S2 j
: (38)
: (P )S2 = = 5j 1:5j
= 15 = 15
(j S2 j 1) (j 1:5j 1) 1
5 1 C0
This expression can also be written like in class:C 0 = P 1 + !P = 1:
6
Less confusingly
( (avoiding the absolute values):
S1 S1 0
C 0 (P ) = S1 C1 = (35(3)1) = 15
2 = 7: 5
P = 1= S2 S2 0 5(1:5) :
(P ) = S2 1 = (1:5 1) = 15
C
1 = 15
