Problem 2 A monopoly has a marginal cost o... [FREE SOLUTION]

Chapter 12: Problem 2

A monopoly has a marginal cost of zero and faces two groups of consumers. At first, the monopoly could not prevent resale, so it maximized its profit by charging everyone the same price, $p=\$ 5 .$ No one from the first group chose to purchase. Now the monopoly can prevent resale, so it decides to price discriminate. Will total output necessarily expand? Why or why not? What happens to profit and consumer surplus?

Short Answer

Expert verified

Total output may not necessarily expand; it depends on demand elasticity. Profit increases, while consumer surplus typically decreases.

Step by step solution

Understanding the Initial Condition

Initially, the monopoly has a marginal cost of zero and set a uniform price of $5 due to inability to prevent resale. However, the first group of consumers did not purchase at this price, meaning their willingness to pay was lower than $5.

Impact of Preventing Resale

By preventing resale, the monopoly now has the opportunity to set different prices for different groups of consumers based on their respective willingness to pay, a practice known as price discrimination.

Analyzing Price Discrimination

Under price discrimination, the monopoly can set a lower price for the first group and a potentially higher price for the second, depending on their willingness to pay. This strategy aims to capture more consumer segments.

Effect on Total Output

With price discrimination, the total output can remain the same, increase, or decrease, depending on how the monopoly adjusts the price for each consumer group. If prices decrease for some groups, more consumers will buy the product, possibly increasing total output. Conversely, if higher prices are set for the second group, some might buy less, which could decrease total output.

Effect on Profit

Typically, price discrimination allows the monopoly to capture consumer surplus by setting a price closer to the maximum each consumer is willing to pay, thus increasing profits compared to a single-price strategy.

Effect on Consumer Surplus

Consumer surplus generally decreases under price discrimination because the monopoly captures more of the surplus by setting prices closer to consumer willingness to pay. Some consumers may now pay less than before if they belong to the group that benefits from a reduced price, slightly increasing their surplus.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Marginal Cost

The marginal cost refers to the cost of producing one additional unit of a product. In this exercise, the monopoly operates with a marginal cost of zero. This means that producing extra units does not incur any additional costs for the monopoly.
Since there are no additional costs to consider when increasing production, the monopoly focuses entirely on its pricing strategy to maximize profit.
The fact that the marginal cost is zero simplifies the monopoly's decision-making process. The only thing they need to worry about is setting the right price that will maximize their profit and not cost considerations.

Price Discrimination

Price discrimination is a strategy used by monopolies where different prices are charged to different consumer groups.
This pricing strategy is based on each group's willingness to pay. It is important because it allows the monopoly to potentially increase its profits by capturing more consumer surplus.

First-degree price discrimination involves charging each consumer the maximum price they are willing to pay.
Second-degree price discrimination offers different prices based on the quantity purchased or usage rate.
Third-degree price discrimination, which applies in this scenario, involves segmenting consumers into different groups and charging them different prices based on their willingness to pay.

By preventing resale, the monopoly in this exercise can engage in third-degree price discrimination. This can potentially expand its total sales by reducing the price for the first group, previously priced out of the market.

Consumer Surplus

Consumer surplus represents the difference between what consumers are willing to pay for a good or service and what they actually pay.
When monopolies engage in price discrimination, they aim to capture as much consumer surplus as possible, thereby reducing the amount consumers "save."
In a single-price scenario, consumer surplus might be relatively high if the set price is lower than what some consumers are willing to pay. When price discrimination is employed:

The overall consumer surplus usually decreases because prices are set closer to each group's willingness to pay.
Some consumers in certain groups might benefit if prices are lowered, as with the first group in the exercise.
Conversely, the consumer surplus for other groups may reduce if they end up paying higher prices.

So, while the first group might see an increase in surplus, others will see theirs diminish.

Profit Maximization

Profit maximization is the primary goal for a monopoly. It involves setting a price and output level that results in the highest possible profit.
When the monopoly could not price discriminate, it set a uniform price that did not allow it to sell to the entire market, especially failing to make any sales to the first consumer group.

With price discrimination, the monopoly can tailor its prices to each group, capturing more consumer surplus and increasing its profits.
The profit gains mainly arise from selling more units to the different customer groups at varying prices aligned with their maximum willingness to pay.
This strategy is more effective than a single price strategy, as it allows adjustments that meet different market dynamics.

Thus, preventing resale and introducing price discrimination aligns perfectly with the monopoly's goal of profit maximization.

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