Market Structures

Lessons

Senior 5 · Economics

Market Structures

5 lessons

Lesson 4 of 5

Controlling monopoly and price discrimination

45 min

Who decides what a bus ride costs?

A passenger on a Kigali city bus does not pay whatever the bus company would like to charge. Public transport fares in Rwanda are set by the Rwanda Utilities Regulatory Authority (RURA), and so are the tariffs for grid electricity and piped water. A foreign tourist buying a gorilla-trekking permit in Volcanoes National Park, on the other hand, pays the Rwanda Development Board (RDB) far more than a Rwandan citizen pays for the same hour with the same gorillas. The first is a government controlling market power; the second is a seller using it to charge different buyers different prices. This lesson studies both.

Why governments control monopoly

Lesson 3 showed that an unregulated monopolist restricts output, charges a price above marginal cost and creates a deadweight loss. It may also let its costs drift upward, neglect quality, or use its power against suppliers and workers. Governments use several tools to limit these costs while keeping any benefits, such as economies of scale.

Method	How it works	Strengths and weaknesses
Price regulation	A regulator sets a maximum price, or caps how fast prices may rise	Raises output and lowers price (diagram below); but the regulator needs accurate cost data, and a firm may cut quality to protect profit
Competition (anti-trust) law	Bans agreements to fix prices, abuse of a dominant position, and mergers that would reduce competition; offenders are fined	Tackles the cause, but cases are slow and need skilled investigators. In Rwanda the Rwanda Inspectorate, Competition and Consumer Protection Authority (RICA) enforces the competition and consumer protection law
Public ownership (nationalisation)	The state owns and runs the monopoly, aiming at public service rather than maximum profit	Can price for social goals and extend service to poor areas; but may be inefficient, and losses fall on taxpayers
Removing barriers (liberalisation)	Ending exclusive licences, cutting import tariffs, opening networks to rival suppliers	Brings real competition; impossible for a true natural monopoly
Taxation	A lump-sum or profits tax takes part of the abnormal profit	Redistributes income, but does not change price or output; a per-unit tax would raise the price further
Subsidy	Paying a natural monopoly to price at marginal cost	Achieves P = MC where MC is below ATC; costs public money
Consumer protection and standards	Rules on quality, safety, information and complaints	Protects buyers but does not lower price

How a maximum price can raise a monopolist's output

Set the maximum price $P_{\max}$ where demand meets MC. The firm cannot charge more, so up to $Q_{r}$ its demand curve becomes the horizontal line at $P_{\max}$ , and selling an extra unit no longer requires a price cut: along that stretch $\text{MR} = P_{\max}$ . The firm's MC now meets this new MR at $Q_{r}$ . Output rises from $Q_{m}$ to $Q_{r}$ , the price falls from $P_{m}$ to $P_{\max}$ , and because $P = \text{MC}$ at $Q_{r}$ , the deadweight loss disappears. This is the opposite of what a maximum price does in a competitive market, where it causes a shortage.

Warning

Setting P = MC can bankrupt a natural monopoly. For a natural monopoly, MC lies below ATC at the output the market demands (average cost is still falling). A price equal to MC is then below ATC, and the firm makes a loss. Regulators either set price equal to average cost (P = ATC: normal profit, but some allocative inefficiency) or set P = MC and pay a subsidy to cover the loss.

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Price discrimination

Definition

Price discrimination: charging different prices to different buyers, or for different units, of the same product, where the price differences are not due to differences in the cost of supplying them.

Not price discrimination: charging more for delivery to a distant district (the cost really is higher), or for a first-class seat (a different product).

Conditions that make it possible

Market power. The seller must be a price maker; a perfectly competitive firm cannot charge above the market price.
Separate markets with no resale. Buyers who pay the low price must not be able to resell to those charged the high price (no arbitrage). Services such as transport, medical care and electricity cannot be resold, and markets can be separated by identity documents, time, place or age.
Different price elasticities of demand in the separate markets. Otherwise there is nothing to gain from charging different prices.

Three degrees of price discrimination

Degree	What the seller does	Illustration
First degree (perfect)	Charges each buyer the most he or she is willing to pay, capturing all consumer surplus	A private doctor or lawyer setting each client's fee after judging their means; bargaining in an open market
Second degree	Charges different prices for different quantities or blocks of consumption	Electricity priced in monthly blocks, with the first block of units cheaper; bulk discounts
Third degree	Divides buyers into groups with different elasticities and charges each group a different price	Tourist and citizen park fees; student and adult fares; cheaper night-time data bundles

The third-degree rule: equal marginal revenue in every market

A discriminating monopolist allocates output so that the last unit earns the same marginal revenue in every market, and that MR equals marginal cost:

\text{MR}_A = \text{MR}_B = \text{MC}

If MR were higher in market A than in B, moving one unit from B to A would raise revenue at no extra cost. The result is a higher price where demand is less elastic and a lower price where it is more elastic.

Worked example 1: two markets, one product

A firm sells in market A, demand $P_{A} = 120 - 2 Q_{A}$ , and market B, demand $P_{B} = 60 - Q_{B}$ . Its marginal cost is constant at 20 (illustrative). Resale between the markets is impossible.

Market A: $\text{MR}_A = 120 - 4Q_A = 20 \Rightarrow Q_A = 25,\; P_A = 120 - 50 = 70$ .

Market B: $\text{MR}_B = 60 - 2Q_B = 20 \Rightarrow Q_B = 20,\; P_B = 60 - 20 = 40$ .

\text{Profit} = (70 - 20)(25) + (40 - 20)(20) = 1\,250 + 400 = 1\,650

Check with elasticities. At those points $e_A = \frac{1}{2} \times \frac{70}{25} = 1.4$ and $e_B = 1 \times \frac{40}{20} = 2$ . The higher price is in the market with the lower elasticity, as the rule predicts.

Worked example 2: what does discrimination add?

Suppose the same firm had to charge one price in both markets. Add the quantities demanded at each price (for prices below 60, where both markets buy):

Q = Q_A + Q_B = \left(60 - \frac{P}{2}\right) + (60 - P) = 120 - \frac{3P}{2} \;\Rightarrow\; P = 80 - \frac{2Q}{3}

\text{MR} = 80 - \frac{4Q}{3} = 20 \;\Rightarrow\; Q = 45,\; P = 80 - 30 = 50

Profit with one price $= (50 - 20) \times 45 = 1\,350$ . Discrimination raises profit by $1\,650 - 1\,350 = 300$ . Buyers in market A pay more (70 instead of 50) and buy less; buyers in market B pay less (40 instead of 50) and buy more.

Is price discrimination good or bad?

Arguments for	Arguments against
Lower-income or more price-sensitive groups (students, citizens, off-peak users) may pay less and gain access	Consumers in the less elastic market pay more and lose consumer surplus
Extra revenue may keep a service running that a single price could not cover (a rural bus route, a hospital)	Transfers income from consumers to the producer; first-degree removes all consumer surplus
Output may rise, especially under first-degree discrimination, reducing the deadweight loss	Can be used to drive out rivals, by pricing low only where competitors operate
Spreads use of capacity: off-peak prices fill empty seats and idle power stations	Can feel unfair and may be based on nationality, age or gender

Important

Discuss. RDB charges foreign tourists much more than Rwandan citizens for a gorilla-trekking permit. (a) Which conditions for price discrimination does this market satisfy, and how is resale prevented? (b) In which group is demand likely to be less elastic, and why? (c) Give one argument that the policy serves the public interest and one against.

EconplusDal, "Price Discrimination: First, Second and Third Degree" (about 11 minutes). Note how each degree changes the consumer surplus, and compare his third-degree diagram with the two-market drawing above.

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Practice

Give four reasons why governments control monopolies.
Explain two methods a government can use to control a monopoly, with one limitation of each.
Using a diagram, explain why a maximum price set where demand meets MC can increase a monopolist's output.
Define price discrimination and state the three conditions needed for it.
Classify each as first-, second- or third-degree price discrimination: (a) a cheaper fare for students showing a card; (b) a lower price per unit for a buyer of 50 bags of cement than for a buyer of 1; (c) a seller who bargains a separate price with each customer.
A monopolist sells in two markets with demand $P_{1} = 100 - 2 Q_{1}$ and $P_{2} = 70 - Q_{2}$ , and constant MC = 10. Find the output and price in each market.
Explain why a discriminating monopolist charges a higher price in the market where demand is less elastic.
"Price discrimination always harms consumers." Evaluate this statement.

Show answersHide answers

Any four: high prices; restricted output and deadweight loss; allocative inefficiency (P > MC); X-inefficiency and high costs; poor quality and little choice; exploitation of suppliers or workers; unequal income distribution.
For example: price regulation (limitation: the regulator needs cost data, and the firm may cut quality); competition law (slow, needs skilled staff); nationalisation (may be inefficient, losses fall on taxpayers); removing barriers (impossible for a natural monopoly); taxing profit (no change in output).
Diagram as in the lesson: the maximum price makes AR and MR horizontal up to the demand curve; MC meets the new MR further right, so output rises from Qm to Qr and price falls to Pmax.
Charging different prices for the same product for reasons not related to cost. Conditions: market power; separable markets with no resale; different price elasticities of demand.
(a) Third degree; (b) second degree; (c) first degree.
Market 1: MR = 100 − 4Q₁ = 10, Q₁ = 22.5, P₁ = 55. Market 2: MR = 70 − 2Q₂ = 10, Q₂ = 30, P₂ = 40.
Profit is maximised where MR is equal in each market and equal to MC. Since $\text{MR} = P\left(1 - \frac{1}{e}\right)$ , equal MR needs a higher P where e is lower. Buyers with less elastic demand cut their purchases little when the price rises, so charging them more raises revenue.
Against the statement: groups with elastic demand pay less and may only be served because of discrimination; the extra revenue can keep services running; output can rise. For it: consumers in the inelastic market pay more; first-degree removes all consumer surplus. Conclusion: some consumers gain and some lose, so "always" is too strong.

Sources and credits

Regulation of transport fares, electricity and water tariffs: Rwanda Utilities Regulatory Authority. Competition and consumer protection: Rwanda Inspectorate, Competition and Consumer Protection Authority. Gorilla permits: Visit Rwanda, Rwanda Development Board. Stated as general facts, without prices.
Video: Y2 19) Price Discrimination - First, Second and Third Degree, EconplusDal, embedded from YouTube.

Written by Ganzaa: the text, the two diagrams (computed from the stated demand and cost functions), the tables, the worked examples and the practice items. All prices and quantities in the examples are illustrative.

1Who decides what a bus ride costs?

2Why governments control monopoly

3How a maximum price can raise a monopolist's output

4Price discrimination