Question

A monopolist is considering a choice between two alternative pricing strategies: (i) perfect price discrimination and (i) two-part pricing. Assume both strategies are feasible and the demand side of the market comprises identical consumers. Determine which of the two strategies will earn the monopolist the greatest profit For each strategy, determine the share of consumer surplus the monopolist is able to extract as profit. b.

Answer 1

A monopolist is considering a choice between two alternative pricing strategies:

1. Perfect price discrimination and
2. Two-part Pricing

By price discrimination we mean that the monopolist charges different prices from different consumers. By doing so, the monopolist can extract more consumer surplus (CS) and even more profits. This is called price discrimination because the monopolist, who has the market power, discriminates among consumers by charging higher prices from those who are willing to pay more and lower prices from those who are willing to pay less.

In case of 1^st degree price discrimination or perfect price discrimination, the monopolist can charge the reservation price from each consumer. The reservation price is the maximum price that each consumer is willing to pay for the product. In this way, the monopolist would be able to extract the entire CS. 1^st degree price discrimination is possible when the monopolist has the ability to determine what each consumer would be willing to pay.

Price (P) Supply Entire Producer Surplus Demand

The above diagram shows that there is no consumer surplus since each consumer pays the monopolist the reservation price. The monopolist gains the entire market surplus, that can be achieved. Perfect price discrimination will always have the level of output which is Pareto efficient as marginal willingness to pay = Marginal Cost (MC). The price and output level would be same as perfectly competitive markets and thus the inefficiency of a monopoly firm will be eliminated. There would not be any dead weight loss.

On the other hand, in two-part pricing is made up of two parts. A fixed one-time lump sum fee is charged which provides the right to the consumer to purchase the good. It can be called as entry fee or set-up charge. Then a price per unit of the good is charged by the monopolist.

Since, the market comprises of identical consumers, all the consumers face the same demand curve.

The monopolist can extract the entire consumer surplus by setting the two conditions:

1. Price = Marginal Cost (MC)
2. By setting the fixed fee = CS the monopolist can extract the entire CS for each consumer

If we assume there are N identical consumers, then the monopolist faces a demand curve Q(P) for each N consumer. Then the monopolist determines the optimal fixed fee by calculating each consumer’s CS. This CS is each to the area below the demand curve and above the supply curve.

Then we need to calculate the quantity demanded by each consumer by setting P=MC.

Now, we can calculate the profit since we know the optimal tariff per consumer, the quantity each consumer will demand and the price per unit of output.

Thus, ∏ = N* T + N*(P * Q ) – N*(MC * Q)

There are is no fixed cost, and P = MC, the profits become: ∏ = N* T + N*(MC * Q ) – N*(MC * Q) =N*T, which is quantity sold * the optimal tariff.

So, in this case as well, the monopolist extracts the entire consumer surplus.

Price (P) Optimal Tariff Optimal price level Quantity (Q)

Thus, in both the pricing strategies, the monopolist can capture the entire consumer surplus and maximize its profits.