Home / Courses / Intermediate Microeconomics / Unit 8

Intermediate Microeconomics Unit 8: Monopoly and Price Discrimination

A monopolist sets marginal revenue equal to marginal cost and charges a markup that depends on demand elasticity; price discrimination lets it capture more surplus and can change total welfare.

Covers: Marginal revenue and elasticity, Monopoly pricing and the markup rule, Deadweight loss of monopoly, Natural monopoly and regulation, First- and second-degree price discrimination, Third-degree price discrimination, Two-part tariffs and bundling

Study guide

A monopolist faces the whole market demand curve, so selling one more unit requires lowering the price on all units. Its marginal revenue is therefore below price: MR = P(1 + 1/ε). For linear inverse demand P = a − bQ, MR = a − 2bQ. Profit is maximized where MR = MC, and the price is read off the demand curve at that quantity. Because MC is positive, MR must be positive, so a monopolist always operates on the elastic part of demand. Rearranging gives the markup rule P = MC/(1 + 1/ε), or the Lerner index (P − MC)/P = −1/ε.

Monopoly is inefficient. At the monopoly output, price exceeds marginal cost, so there are buyers willing to pay more than the cost of extra units that are never produced. The deadweight loss is the triangle between demand and MC from the monopoly quantity to the competitive quantity. With linear demand and constant MC, monopoly output is half the competitive output and the DWL is half of the monopoly's profit. A natural monopoly has falling average cost over the market's range; regulators who force P = MC leave it with a loss equal to its fixed cost, so they often use average-cost pricing instead.

Price discrimination means charging different prices for the same good for reasons unrelated to cost. First-degree discrimination charges each buyer her full willingness to pay for every unit; it produces the efficient quantity but leaves consumers with no surplus. Second-degree discrimination offers a menu, such as quantity discounts, versions or two-part tariffs, and lets buyers sort themselves. Third-degree discrimination charges different prices to identifiable groups, applying MR = MC in each market, so the less elastic group pays more. It requires the firm to identify groups and prevent resale.

A two-part tariff charges an entry fee plus a per-unit price. With identical consumers, the best tariff sets the unit price equal to marginal cost and the fee equal to each consumer's surplus, reaching the first-degree outcome. With different types, the fee is limited by what the low-demand type will pay, so the firm usually sets the unit price above marginal cost to collect more from heavy users. Bundling sells goods together; it raises revenue when buyers' values for the components are negatively correlated, because the bundle values are more similar than the separate values.

Key ideas

• A monopolist sets MR = MC and charges the demand price at that quantity.
• MR = P(1 + 1/ε), so a monopolist always produces where demand is elastic.
• The markup rule is P = MC/(1 + 1/ε); the Lerner index equals −1/ε.
• Monopoly creates deadweight loss because P > MC at the chosen output.
• Natural monopolies face a trade-off between efficient MC pricing and break-even AC pricing.
• Third-degree discrimination charges higher prices in less elastic markets.
• Two-part tariffs and bundling are ways to capture consumer surplus.

Formulas and rules

Common mistakes

• Reading the monopoly price from the MR curve instead of the demand curve.
• Setting P = MC for a monopolist.
• Thinking a monopolist might operate on the inelastic part of demand.
• Giving the lower price to the less elastic group under third-degree discrimination.
• Counting monopoly profit as deadweight loss; profit is a transfer from consumers.

Before the test, make sure you can

• Derive MR from a demand curve and find the monopoly price and quantity.
• Use the markup rule and Lerner index to link price, cost and elasticity.
• Calculate monopoly profit and deadweight loss.
• Analyze natural monopoly regulation with MC pricing and AC pricing.
• Identify and solve first-, second- and third-degree price discrimination problems.
• Design a two-part tariff for identical and for different consumers.
• Explain when bundling raises revenue.

Words to know

Monopoly

A single seller of a good with no close substitutes and barriers to entry.

Marginal revenue

The change in total revenue from selling one more unit; below price for a monopolist.

Markup rule

P = MC/(1 + 1/ε): the less elastic demand is, the higher the markup.

Lerner index

(P − MC)/P, a measure of market power; equals −1/ε at the monopoly optimum.

Deadweight loss of monopoly

Surplus lost because the monopolist produces less than the quantity where P = MC.

Natural monopoly

An industry where one firm can supply the market at lower average cost than two or more firms.

Average-cost pricing

A regulation setting price where demand meets average cost so the firm breaks even.

Price discrimination

Charging different prices for the same good for reasons not related to cost.

First-degree price discrimination

Charging each buyer her maximum willingness to pay for each unit.

Second-degree price discrimination

Offering a menu of prices or packages so that buyers sort themselves.

Third-degree price discrimination

Charging different prices to separate, identifiable groups of buyers.

Two-part tariff

A pricing scheme with a fixed entry fee plus a per-unit price.

Bundling

Selling two or more goods together as a package.

Arbitrage (resale)

Buying at a low price and reselling at a higher one; it undermines price discrimination.

Pass-through

The share of a cost or tax increase passed on to buyers in a higher price.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.