Group Assignment

COURSE: DEGREE: COURSE CODE: FACILITATOR: SEMISTER: Participants SOBE, Peter A. PAUL, Vicent B. SAMALI, Innocent KIPESHA, Godwin Intermediate Microeconomics Bachelor of Economics & Finance (III) AFU 08107 Mr. Mwaitete Cairo V Registration number BEF/0005/T.2010 BEF/0085/T.2010 BEF/0029/T.2010 BEF/0031/T.2010 Signature .. .. ... .. ..

KIMWERI, Hilolimus BEF/0016/T.2010

DATE OF SUBMISSION: January 2013

Questions 1. What is price discrimination 2. Describe and demonstrate how monopolist maximize profit under price discrimination 3. What is classical oligopoly? Differentiate between non collusive oligopoly and collusive oligopoly.

Monopoly
The term monopoly is derived from Greek words 'mono' which means single and 'poly' which means seller. So, monopoly is a market structure, where there only a single seller producing a product having no close substitutes1. Following are the features or characteristics of Monopoly; A single seller has complete control over the supply of the commodity. There are no close substitutes for the product. There is no free entry and exit because of some restrictions i.e. barriers to entry exists. There is no competition. Monopolist is a price maker. Since there is a single firm, the firm and industry are one and same i.e. firm coincides the industry. Monopoly firm faces downward sloping demand curve, this means the firm can sell more at lower price i.e. MR< PRICE.

Monopolist may either charge his consumer the same price or different prices to the same good consumed for him to maximize profit.

http://kalyan-city.blogspot.com/2010/11/monopoly-market-structure-meaning.html accessed on 5th Jan 2013 at

1103Hours

CONDITIONS REQUIRED FOR PRICE DISCRIMINATION TO WORK Monopoly power Firms must have some price setting power, so we don't see price discrimination in perfectly competitive markets. Easy identification of different markets The firm must be able to identify different market segments, such as domestic users and industrial users. Markets must be kept separate, either by time, physical distance and nature of use Elasticity of demand There must be a different price elasticity of demand for the product from each group of consumers. This allows the firm to extract consumer surplus by varying the price leading to additional revenue and profit. Separation of the market The firm must be able to split the market into different sub-groups of consumers and then prevent the good or service being resold between consumers. (For example a rail operator must make it impossible for someone paying a "cheap fare" to resell to someone expected to pay a higher fare. This is easier in the provision of services rather than goods. No seepage actions There must be no seepage between the two markets, which means that a consumer cannot purchase at the low price in the elastic sub-market, and then re-sell to other consumers in the inelastic sub-market, at a higher price.

Costs of separating the market The costs of separating the market and selling to different sub-groups (or market segments) must not be prohibitive2.

PRICE DISCRIMINATION
A monopolist may be able to engage in a policy of price discrimination if the above condition holds. This occurs when a firm charges different price to different groups of consumers for an identical good or service, for reasons not associated with the costs of production. It refers to the practice of tailoring a firms price practices to fit specific situations for the purpose of extracting maximum profit. It is important to stress that charging different prices for similar goods is not price discrimination. For example, price discrimination does not occur when a rail company charges a higher price for a first class seat. This is because the price premium over a second-class seat can be explained by differences in the cost of providing the service.

Degrees for price discrimination

First degree price discrimination First-degree discrimination, alternatively known as perfect price discrimination, occurs when a firm charges different price for every unit consumed. If successful, firm can extract all consumer surpluses that lie beneath the demand curve and turn it into extra producer revenue (or producer surplus). This is impossible to achieve unless the firm knows every consumers preferences and, as a result, is unlikely to occur in the real world. The

http://www.tutor2u.net/economics/content/topics/monopoly/price_discrimination.htm accessed on 5th Jan 2013 at

1243Hours

transactions costs involved in finding out through market research what each buyer is prepared to pay is the main block or barrier to a business engaging in this form of price discrimination3. The reality is that, although optimal pricing can and does take place in the real world, most suppliers and consumers prefer to work with price lists and price menus from which trade can take place rather than having to negotiate a price for each unit of a product bought and sold.

Diagram from managerial economics theory and practice page 421 Explanations; If P1 is an equilibrium price and Q1 equilibrium quantity, for consumer at Q if charged price P1 will not exploit all amounts he was willing to pay since he is willing to pay price P. charging price P to consumer with quantity Q will exploit all of his surplus and results to increase in firms profit i.e. Pricing down the demand curve, this capture all the consumer surpluses, and this is what first degree price discrimination suggests. Second degree price discrimination Second-degree price discrimination means charging a different price for different quantities, such as quantity discounts for bulk purchases.
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http://www.tutor2u.net/economics/revision-notes/a2-micro-price-discrimination.html accessed on 5th Jan 2013 at

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Second degree price discrimination sometimes referred as volume discounting differs from first degree price discrimination in the manner in which the firm attempt to extract consumer surplus. In the case of second degree price discrimination, seller attempts to maximize profits by selling products in blocks or bundle rather than one unit at a time. Examples of second degree price discrimination Peak and Off-Peak Pricing; peak and off-peak pricing is common in the telecommunications industry, leisure retailing and in the travel sector. Telephone companies separate markets by time, There are three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper weekend rate. Early-bird discounts extra cash-flow; the low cost airlines follow a different pricing strategy to the one outlined above. Customers booking early with carriers such as EasyJet will normally find lower prices if they are prepared to commit themselves to a flight by booking early. This gives the airline the advantage of knowing how full their flights are likely to be and a source of cashflow in the weeks and months prior to the service being provided. Closer to the date and time of the scheduled service, the price rises, on the simple justification that consumers demand for a flight becomes more inelastic the nearer to the time of the service. People who book late often regard travel to their intended destination as a necessity and they are therefore likely to be willing and able to pay a much higher price very close to departure.

Third degree price discrimination Third-degree price discrimination means charging a different price to different consumer groups. For example, cinema goers can be subdivided into adults and children. Third-degree discrimination is the commonest type. Examples of third degree price discrimination include Cinemas and theatres cutting prices to attract younger and older audiences and Student discounts for rail travel, restaurant meals and holidays.

Diagram for price discrimination of the third degree4

If we assume marginal cost (MC) is constant across all markets, whether or not the market is divided, it will equal average total cost (ATC). Profit maximization will occur at the price and output where MC = MR. If the market can be separated, the price and output in the inelastic submarket will be P and Q and P1 and Q1 in the elastic sub-market. When the markets are separated, profits will be the area MC, P,X,Y + MC1,P1,X1,Y1. If the market cannot be separated, and the two submarkets are combined, profits will be the area MC2,P2,X2,Y2. If the profit from separating the sub-markets is greater than for combining the sub-markets, then the rational profit maximizing monopolist will discriminate price. Discrimination is only worth undertaking if the profit from separating the markets is greater than from keeping the markets combined, and this will depend upon the elasticitys of demand in the sub-markets. Consumers in the inelastic sub-market will be charged the higher price, and those in the elastic sub-market will be charged the lower price. The aims of price discrimination
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http://economicsonline.co.uk/Business_economics/Price_discrimination.html accessed on 5th Jan 2013 at

1500Hours

It must be remembered that the main aim of price discrimination is to increase the total revenue and/or profits of the supplier, price discrimination helps suppliers to off-load excess capacity and can also be used as a technique to take market share away from rival firms. Sometimes price discrimination is an important tool for the government to provide welfare to his people by charging high price to able people so as to compensate for cheap prices offered to unable group of people. Government use elasticity of demand factor in determining who to charge what kind of price. A good example can be traced from TANESCO company which is the monopoly supplier of electricity here in Tanzania, in which urban people pay Tsh320,000/= for electricity line servicing which compensate to low rate of Tsh170,000/= charged to rural electricity servicing. Some consumers do benefit from this type of pricing - they are "priced into the market" when with one price they might not have been able to afford a product. For most consumers however the price they pay reflects pretty closely what they are willing to pay. In this respect, price discrimination seeks to extract consumer surplus and turn it into producer surplus or monopoly profit. Derivation on how monopolist maximize profit under price discrimination

For a firm is practicing price discrimination; the total output of the firm will be given by: Q = Q1 + Q2 (i) Where: Q total output Q1 output of firm1 Q2 output in firm2 By the law of demand, the quantity sold in each market will vary inversely with the selling price, if the demand function of each group is known, the total revenue earned by the firm selling its product in each market will be: TR (Q) = TR1 (Q1) + TR2 (Q2) Where: But: TR TR1 TR2 8 .. (ii) = = = total revenue P1Q1 P2Q2

The total cost of producing the goods and services is a function of the total output TC (Q) = TC (Q1+Q2) .......................................... (iii)

The marginal cost of producing the same for both markets should be the same Thus by chain rule:
() 1 1

. (iv)

Since Q/ Q1 = 1; likewise for Q2,

() 2

.. (v)

Since Q/Q2 = 1; equation (ii) and (iii) simply affirms that the marginal cost of producing the good or service remains the same regardless of the market in which it is sold. Upon combining equation (i) and (v) the firms profit function may be written as ( Q1,Q2) = TR1(Q1) + TR2(Q2) TC(Q1 + Q2) (vi)

Equation (vi) indicates the profit function of both Q1 and Q2. The objective of the firm is to maximize profit with respect to both Q1 and Q2. Taking the first partial derivative of the profit function with respect to Q1 and Q2, the setting of the resulting equation is zero, we obtain;
1 2 1 1 2 1

= 0 .. (vii, a)

2 2

=0

.. (vii, b)

Solving question (vii, a) and (vii, b) simultaneously with respect to Q1 and Q2 yields the profit maximization unit sales in the two markets. Assuming that the second order conditions are satisfied, the first order condition for profit maximization may be written as; MC = MR1 = MR2 Since TR1 = P1Q1 and TR2 =P2Q2
1 1 1 1 1 1 1 1

MR1 = P1
= P1 1 +
1 1

+ Q1

= P1 1 +

MR1

P1 1 +

1 1

Thus, the same apply to market to, it will be given by MR2 = P2 +

Where:

1 is the price elasticity of demand for market1 2- is the price elasticity of demand for market2

By the profit maximization condition in equation (vii), it postulates that the firm will charge the same price in the two markets if and only if 1 = 2. When 1 2, the firm will charge different prices. In fact when 1 2 the firm should charge a comparatively higher price in firm 1 and comparatively lower price in firm two. When 1 2, the firm in question should charge a comparatively lower price in firm 1and comparatively higher price in firm 2.5 CLASSICAL OLIGOPOLY. These are models which developed by different economist try to explain and predict the behavior of oligopoly firms. There are variety and complex models which describing the operation of an oligopolistic market because you can have two to 10 firms competing on the basis of price, quantity, technological innovations, marketing, advertising and reputation. Fortunately, there are a series of simplified models that attempt to describe market behavior under certain circumstances. Some of the better-known models are the Cournot-Nash model, Bertrand model and the Stackelberg competition.6 These can be explained as follows; 1. BERTRAND MODEL Firms can compete on several variables, and levels, for example, they can compete based on their choices of prices, quantity, and quality. The most basic and fundamental competition pertains to pricing choices. The Bertrand Model is examines the interdependence between rivals' decisions in terms of pricing decisions.
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Thomas J Webster (2003) Managerial Economics Theory and PracticeLubin school of Business Pace University

New York, Academic Press

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http://en.wikipedia.org/wiki/Oligopoly accessed on 5th January 2013 at 1400 hours

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The assumptions of the model are: 1. There are two firms in the market, that is firm 1and 2 2. Goods produced are homogenous, - products are perfect substitutes. 3. Firms set prices simultaneously. 4. Each firm has the same constant marginal cost of c. The equilibrium of the firms will set at the point where the prices are same, i.e. p1 = p2 = p, and that it will be equal to the marginal cost, in other words, the perfectly competitive outcome. This is a very powerful model in that it says that price competition is so intense that all you need is two firms to achieve the perfect competitive outcome. We will show equilibrium through logical arguments. Using logical arguments: 1. Firm's will never price above the monopoly's price 2. In equilibrium, all firm's prices are the same that is p1=p2=p 3. In equilibrium, prices must be at the marginal cost, that is p1 = p2 = p = c. Notice that in making the arguments we have always stated the firm's choice as a function of the other firm's choice, pi*(pj), where ij, and i, j(1,2). This is known as a reaction function. 2. OURNOT NASH MODEL Cournot competition is one where firms simultaneously choose their optimal quantity produced instead of prices. The manner in which we derive a solution is through examining what the best strategy each has given their believes in what their competition would do. ASSUMPTION OF THE MODEL There are two equally positioned firms; The firms compete on the basis of quantity rather than price. Each firm makes an output decision assuming that the other firms behavior is fixed. 11

The market demand curve is assumed to be linear and marginal costs are constant.

COURNOT-NASH EQUILIBRIUM The Cournot-Nash equilibrium is determined by each firm reacts to a change in the output of the other firm. The path to equilibrium is a series of actions and reactions. The pattern continues until a point is reached where neither firm desires to change what it is doing, given how it believes the other firm will react to any change. The equilibrium is the intersection of the two firms reaction functions. The reaction function shows how one firm reacts to the quantity choice of the other firm. For example, assume that the firm 1s demand function is P = (M - Q2) - Q1 where Q2 is the quantity produced by the other firm and Q1 is the amount produced by firm 1, M is the quantity of market and that marginal cost is CM. Firm 1 wants to know its maximizing quantity and price. Firm 1 begins the process by following the profit maximization rule of equating marginal revenue to marginal costs. Firm 1s total revenue function is RT = Q1 P= Q1 (M - Q2 - Q1) = M Q1- Q1Q2 - Q12. The marginal revenue function is

RM = CM M - Q2 - 2Q1 = CM 2Q1 = (M-CM) - Q2 Q1 = (M-CM)/2 - Q2/2 .. [1.1] Q2 = 2(M-CM) - 2Q1 ... [1.2] Equation 1.1 is the reaction function for firm 1. Equation 1.2 is the reaction function for firm 2. To determine the Cournot-Nash equilibrium you can solve the equations simultaneously. The equilibrium quantities can also be determined graphically. The equilibrium solution would be at the intersection of the two reaction functions. 3. THE STACKELBERG LEADERSHIP MODEL This is a strategic game in economics in which the leader firm moves first and then the follower firms move sequentially. It is named after the German economist Heinrich Freiherr von Stackelberg in 1934 which described the model. In game theory terms, the players of this game are a leader and a follower and they compete on quantity. The Stackelberg leader is sometimes 12

referred to as the Market Leader. There are some further constraints upon the sustaining of a Stackelberg equilibrium. The leader must know exactly that the follower observes his action. 7 The follower must have no means of committing to a future non-Stackelberg follower action and the leader must know this. Indeed, if the 'follower' could commit to a Stackelberg leader action and the 'leader' knew this, the leader's best response would be to play a Stackelberg follower action. Assumptions of Stackelberg model 1. Risk neutral firms maximize profits. 2. Firms produce a homogeneous product.

3. All cost functions are known to all firms. 4. 5. 6. 7. Firms meet once and cannot make binding agreements. The leader selects his quantity (capacity). The followers observe leader output and select their quantities. Price is chosen (by an auctioneer) to clear the market.

Firms may engage in Stackelberg competition if one has some sort of advantage enabling it to move first. More generally, the leader must have commitment power. Moving observably first is the most obvious means of commitment: once the leader has made its move, it cannot undo it - it is committed to that action. Moving first may be possible if the leader was the incumbent monopoly of the industry and the follower is a new entrant. Holding excess capacity is another means of commitment. Notice that the Stackelberg outcome differs significantly from the Cournot equilibrium outcome (in terms of the equilibrium quantity of production for both firms). Specifically, we see that the Stackelberg leader ends up producing more in the Stackelberg equilibrium and the follower produces less (compared to the Cournot outcome). This is result of the first-mover advantage.

Varian R. Hal (2003) Intermediate Microeconomics; 6th Edition,W.W. Norton & Company,Inc; New York- USA 13

An oligopoly is a market structure in which a few firms dominate. When a market is shared between a few firms, it is said to be highly concentrated. Although only a few firms dominate, it is possible that many small firms may also operate in the market. Oligopolies may be identified using concentration ratios, which measure the proportion of total market share controlled by a given number of firms. When there is a high concentration ratio in an industry, economists tend to identify the industry as an oligopoly. Collusive oligopolies Another key feature of oligopolistic markets is that firms may attempt to collude, rather than compete. If colluding, participants act like a monopoly and can enjoy the benefits of higher profits over the long term. Types of collusion Overt Overt collusion occurs when there is no attempt to hide agreements, such as the when firms form trade associations like the Association of Petrol Retailers. Covert Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid detection by regulators, such as when fixing prices. Forms of collusion Formal collusion The most common type of formal collusion is through the cartel; where a small number of rival firms, selling a similar product, come to the conclusion that it is in their joint interests to formally collude rather than compete, they may establish a cartel arrangement in which they agree to set an industry price and output which enables them to achieve a common objective.

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This is likely to involve the setting of agreed output quotas for each member in order to maintain the agreed price. A successful cartel arrangement, from the point of view of the participating firms, would be one in which the cartel acts like a single monopolist to maximise profits of individual members. This is illustrated in figure 1 below.

Figure 1 Profit maximisation for the cartel This is the familiar monopoly diagram, with each curve representing the aggregated

situation for all the firms in the cartel. In order to maximise profits, MC is equated with MR and a price of OP is set, with an output of OQ, which represents the potential level of sales. The allocation of this market quota between members could be decided by such criteria as geography, productive capacity or pre-cartel market share, or cartel members, having set a price of OP, could engage in non-price competition to each gain as large a slice of OQ as they can. In practice, cartels may tend to be rather fragile and may not last for very long. This is because individual members may have an incentive to break a promise on the agreement by secretly undercutting the cartel price. The almost inevitable necessity to limit output to keep price high will tend to leave individual firms with spare productive capacity, and provide the temptation to increase profits by expanding output. Such an expansion would not only generate profit on the additional sales, but would also increase the profits on existing sales, as average fixed costs would fall as output expanded. As the end result of successful collusion will be to create a situation similar to monopoly, with its consequent drawbacks and loss of economic efficiency, cartels are illegal in many countries,. Various cartels do, however, operate internationally, the most famous of which is OPEC(Organization of the Petroleum Exporting Countries). Another example of an international 15

cartel is IATA (The International Air Transport Association) which has sought to set prices for international airline routes. However, the experience of both these cartels has been one of price cutting amongst its members, particularly during periods of declining product demand and competition from non-members. Informal or tacit collusion The most usual method of tacit collusion is price leadership. This occurs where one firm sets a price that is subsequently accepted as the market price by the other producers. There need be no formal or written agreement for this to happen; it is sufficient that firms believe this to be the best way of maintaining or increasing their profits. An example of price leadership is provided by the Ford Motor Company who has often been the first to raise prices in the car industry. NON COLLUSIVE/COMPETITIVE OLIGOPOLIES When competing, oligopolists prefer non-price competition in order to avoid price wars. A price reduction may achieve strategic benefits, such as gaining market share, or deterring entry, but the danger is that rivals will simply reduce their prices in response. This leads to little or no gain, but can lead to falling revenues and profits. Hence, a far more beneficial strategy may be to undertake non-price competition. Pricing strategies of oligopolies Oligopolies may pursue the following pricing strategies: 1. Oligopolists may use predatory pricing to force rivals out of the market. This means keeping price artificially low, and often below the full cost of production. 2. They may also operate a limit-pricing strategy to deter entrants, which is also called entry forestalling price. 3. Oligopolists may collude with rivals and raise price together, but this may attract new entrants.

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4. Cost-plus pricing is a straightforward pricing method, where a firm sets a price by calculating average production costs and then adding a fixed mark-up to achieve a desired profit level. Cost-plus pricing is also called rule of thumb pricing. Non-price strategies Non-price competition is the favoured strategy for oligopolists because price competition can lead to destructive price wars examples include: 1. Trying to improve quality and after sales servicing, such as offering extended guarantees. 2. Spending on advertising, sponsorship and product placement - also called hidden advertising is very significant long been to many by oligopolists. firms in The UK's

football Premiership has

sponsored

oligopolies,

including Barclays Bank and Carling. 3. Sales promotion, such as buy-one-get-one-free (BOGOF), is associated with the large supermarkets, which is a highly oligopolistic market, dominated by three or four large chains. 4. Loyalty schemes, which are common in the supermarket sector. Kinked demand curve The reaction of rivals to a price change depends on whether price is raised or lowered. The elasticity of demand, and hence the gradient of the demand curve, will be also be different. The demand curve will be kinked, at the current price.

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Price stickiness Even when there is a large rise in marginal cost, price tends to stick close to its original, given the high price elasticity of demand for any price rise.

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At price P, and output Q, revenue will be maximised. Maximising profits If marginal revenue and marginal costs are added it is possible to show that profits will also be maximised at price P. Profits will always be maximised when MC = MR, and so long as MC cuts MR in its vertical portion, then profit maximisation is still at P. Furthermore, if MC changes in the vertical portion of the MR curve, price still sticks at P. Even when MC moves out of the vertical portion, the effect on price is minimal, and consumers will not gain the benefit of any cost reduction. A game theory approach to price stickiness Pricing strategies can also be looked at in terms of game theory; that is in terms of strategies and payoffs. There are three possible price strategies, with different pay-offs and risks:

Raise price Lower price Keep price constant

The choice of strategy will depend upon the pay-offs, which depends upon the actions of competitors. Raising price or lowering price could lead to a beneficial pay-off, but both strategies can lead to losses, which could be potentially disastrous. In short, changing price is too risky to undertake. Therefore, although keeping price constant will not lead to the single best outcome, it may be the least risky strategy for an oligopolist. The Prisoners Dilemma Game theory also predicts that: There is a tendency for cartels to form because co-operation is likely to be highly rewarding. Co-operation reduces the uncertainty associated with the mutual interdependence of rivals in an 19

oligopolistic market. While cartels are unlawful in most countries, they may still operate, with members concealing their unlawful behaviour. Cartels are designed to protect the interests of members, and the interests of consumers may suffer because of: 1. Higher prices or hidden prices, such as the hidden charges in credit card transactions 2. Lower output 3. Restricted choice or other limiting conditions associated with the transaction A classic game called the Prisoner's Dilemma is often used to demonstrate the interdependence of oligopolists. The disadvantages of oligopolies Oligopolies can be criticised on a number of obvious grounds, including: 1. High concentration reduces consumer choice. 2. Cartel-like behaviour reduces competition and can lead to higher prices and reduced output. 3. Firms can be prevented from entering a market because of deliberate barriers to entry. 4. There is a potential loss of economic welfare. 5. Oligopolists may be allocatively and productively inefficient. Oligopolies tend to be both allocatively and productively inefficient. At profit maximising equilibrium, P, price is above MC, and output, Q, is less than the productively efficient output, Q1, at point A.

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The advantages of oligopolies However, oligopolies may provide the following benefits: 1. Oligopolies may adopt a highly competitive strategy, in which case they can generate similar benefits to more competitive market structures, such as lower prices. Even though there are a few firms, making the market uncompetitive, their behaviour may be highly competitive. 2. Oligopolists may be dynamically efficient in terms of innovation and new product and process development. The super-normal profits they generate may be used to innovate, in which case the consumer may gain. 3. Price stability may bring advantages to consumers and the macro-economy because it helps consumers plan ahead and stabilises their expenditure, which may help stabilise the trade cycle.

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Reference
http://kalyan-city.blogspot.com/2010/11/monopoly-market-structure-meaning.html accessed on 5th Jan 2013 at 1103Hours

http://www.tutor2u.net/economics/content/topics/monopoly/price_discrimination.htm accessed on 5th Jan 2013 at 1243Hours

http://www.tutor2u.net/economics/revision-notes/a2-micro-price-discrimination.html accessed on 5th Jan 2013 at 1409Hours http://economicsonline.co.uk/Business_economics/Price_discrimination.html accessed on 5th Jan 2013 at 1500Hours

http://en.wikipedia.org/wiki/Oligopoly accessed on 5th January 2013 at 1400 hours

Thomas J Webster (2003) Managerial Economics Theory and Practice Lubin school of Business Pace University New York, Academic Press Varian R. Hal (2003) Intermediate Microeconomics; 6th Edition,W.W. Norton & Company,Inc; New York- USA

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