Economic Rationale for Monopoly Behaviour and Potential Impacts

1. Introduction

Monopoly is considered a price maker which can decide the price and quantity in the market according to the market demand. In addition to the single price strategy, a monopolist can increase the profit through three types of price discrimination. However, each type of price discrimination could result in different impacts on social welfare. This essay will examine the monopoly behaviour of using three types of price discrimination and analyse how the price discrimination impacts on social welfare.

A monopoly is “a market that has only one seller but many buyers” (Pindyck and Rubinfeld, 2015, p. 365). This type of monopoly is also known as a pure monopoly. To become a monopoly, it needs to create entry barriers for other potential competitors. For example, an electricity utility requires a high investment for the initial infrastructure, but the economies of scale provide the firm with an advantage in production cost. A monopoly can also form because of the protection of the law. For example, Royal Mail is a monopoly granted by the UK government, and Microsoft has the patent of the Windows system. However, being the sole producer in the market does not mean it can change the price whatever it wants. As a price-maker, the market downward-sloping demand curve would influence the price and the output of the product. To maximise the monopolist’s profit, it needs to produce at the point when marginal revenue equals to marginal cost. Although the MR=MC point gives the monopoly the profit-maximised output, this output is considered inefficiently allocated. Since the price is higher than the marginal cost, it creates the deadweight loss in the market (Figure1). Compared with the optimal social welfare point P=MC, the deadweight loss leads to the decrease of social welfare, and the consumer surplus decreases and transfers to producer surplus.

Figure 1. the deadweight loss in single price monopoly

In a monopoly market, charging the same price per unit to all the consumers might be a straightforward way to decide and calculate the profit, but is it possible for the monopolist to use its monopoly power to take advantage? The monopolist might benefit the most through price discrimination (Pigou,1920). According to Pigou (1920), price discrimination can be divided into three degrees. First-degree price discrimination charges the price each consumer is willing to pay regarding the demand curve. In second-degree price discrimination, the monopolist provides the consumers with a price menu. The consumers purchase more quantity, and the monopolist offers the price discount to increase the profit and encourage the consumers to purchase more goods (Varian,1989). Lastly, third-degree price discrimination is to sperate the consumers into submarkets depending on gender, age or time of purchase. Each type of price discrimination works in different ways. The next section will discuss the impacts of the behaviour on the profit and social welfare according to these three types of price discrimination.

2. Price discrimination and the impact on the social welfare

As Varian (1989) points out, to enact price discrimination, three necessary conditions which are monopoly power, ability to sort the consumers and preventing resale need to realise in the market. As the three conditions are satisfied, the monopolist can exercise its monopoly power to take advantage and influence the profit and social welfare in the market. The function of the three types of price discrimination would be shown in the following sections.

2.1  First-degree price discrimination

First-degree price discrimination is also known as perfect price discrimination. In the perfect price discrimination, “the monopolist has complete information about the valuations of the buyers, then he can charge each buyer their true valuation” (Bergmann et al.,2015, p. 921). Since each consumer is charged by the price individual is willing to pay, the consumer surplus with perfect price discrimination is zero and all transfers to producer surplus (Figure2). More importantly, there is no deadweight loss in perfect price discrimination, and this means the output allocation is socially efficient. Perfect price discrimination is often considered unpractical because it is almost impossible and costly for the monopolist to precisely observe each consumers’ characteristics and individual demand curve (Pigou, 1920; Lesson and Sobel, 2007).

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Without considering the cost of implementing perfect price discrimination, output of first-degree price discrimination is allocated efficiently and socially efficient since the deadweight loss does not exist. However, the cost to observe types of consumers should be included when considering social efficiency. The work of Lesson and Sobel (2007) shows that enacting perfect price discrimination needs a hefty cost to segregate different types of consumers and prevent resale. As Lesson and Sobel (2007) has indicated, when the cost of implementing perfect price discrimination is higher than the decrease of deadweight loss, the outcome is not socially efficient. That is, in this condition, the excess cost becomes waste in the society. The monopolist only aims to transfer the consumer surplus into its private profit. Therefore, to make perfect price discrimination an advantage for the monopolist and the society, the monopolist needs to take account into the cost of implementing perfect price discrimination and decide whether is worthy or not.

Figure 2. the social welfare in first-degree price discrimination

2.2  Second-degree price discrimination

Compared to charging the consumers’ highest valuation per unit, second-degree price discrimination uses non-linear pricing strategy (Varian, 1989). The Price discount is a prevalent second-degree price discrimination. The monopolist offers a price schedule to “induce consumers with high valuations to pay higher prices than consumers with low valuation” (Carroll and Coates, 1999, p. 469). For example, when the consumer purchases more quantity of the same products, the price per unit decreases. The monopolist provides the price menu for the consumers, and the consumers decide and select the quantity they are willing to purchase. This behaviour is considered the self-selection. Furthermore, the blocking price is also a type of second-degree price discrimination (Pindyck and Rubinfeld, 2015). For instance, the charge of a taxi ride and electricity service. The price would differ depending on quantity purchased located in which block. As shown in figure3, in the first block, when the quantity purchased is less than