E LMAR G.

W OLFSTETTER , M AY 12, 2014

A DVANCED M ICROECONOMICS (T UTORIAL )

E XERCISE S HEET 4 - A NSWERS AND H INTS

We appreciate any comments and suggestions
that may help to improve these solution sets.

Exercise 1 (Second-Degree Price Discrimination).

Consider a monopolist with zero costs who serves two costumers with different demand functions.
He knows the (inverse) demand functions but he cannot tell the costumers apart (he does not know
who is type 1 and who is type 2).

1. Two Part Tariff. Suppose the monopolist can induce price discrimination by using a menu
of two–part tariffs {(t1 , f1 ), (t2 , f2 )}. Tariffs are made up of a fixed price (lump–sum price)
fi and an unit price ti . Each costumer can choose a tariff and then buy as many units as he
wishes according to the conditions.
The demand functions are:

X1 (p) = 1 − p; and X2 (p) = 2 − 2p

Question: what are the optimal tariffs?

Profit Maximization Problem (PMP) of the monopolist:

max π = f1 + t1 X1 (t1 ) + f2 + t2 X2 (t2 ) (1)

(t1 , f1 );(t2 , f2 )

subject to the following constraints:

U1 (t1 , f1 ) ≥ 0 (Type 1’s PC) (2)

U2 (t2 , f2 ) ≥ 0 (Type 2’s PC) (3)
U1 (t1 , f1 ) ≥ U1 (t2 , f2 ) (Type 1’s IC) (4)
U2 (t2 , f2 ) ≥ U2 (t1 , f1 ) (Type 2’s IC) (5)

where PC stands for participation constraint and IC for incentive compatibility constraint.
Consumers’ utility:
Z Xi (t)
Ui (t, f ) = Pi (y)dy − (tXi (t) + f ), i ∈ {1, 2}
0

where the first term on the right hand-side is the consumer’s total willingness to pay for Xi (t)
units of goods.
Working hypothesis: constraints (2) and (5) are binding. When constraint (2) is binding we
have:
Z X1 (t1 )
U1 (t1 , f1 ) = P1 (y)dy − (t1 X1 (t1 ) + f1 ) = 0
0

1
 Substitute the inverse demand function P1 (y) = 1 − y and type 1’s demand at unit price t1
which is X1 (t1 ) = 1 − t1 , we get:
Z X1 (t1 )
1 1
f1 (t1 ,t2 ) = P1 (y)dy − t1 X1 (t1 ) = − t1 + t12
0 2 2
When constraint (5) is binding, we have

U2 (t2 , f2 ) = U2 (t1 , f1 )

where
Z X2 (t2 )
U2 (t2 , f2 ) = P2 (y)dy − (t2 X2 (t2 ) + f2 )
0
Z X2 (t1 )
U2 (t1 , f1 ) = P2 (y)dy − (t1 X2 (t1 ) + f1 )
0

f2 can also be solved as a function of t1 and t2 :

Z X2 (t2 )
f2 (t1 ,t2 ) = P2 (y)dy − t2 X2 (t2 ) + (t1 X2 (t1 ) + f1 )
X2 (t1 )
1 1
= + t1 − t12 − 2t2 + t22
2 2
We substitute f1 (t1 ,t2 ), f2 (t1 ,t2 ), X1 (t1 ) and X2 (t2 ) into the monopolist’s objective function
(1) and reduce the the monopolist’s PMP to
1 1 1
max π{t1 ,t2 } = − t1 + t12 + t1 (1 − t1 ) +
2 2 2
1
+ t1 − t12 − 2t2 + t22 + t2 · 2(1 − t2 )
2
=1 − t12 + t1 − t22

The first order conditions are

∂π
= −2t1 + 1 = 0
∂t1
∂π
= −2t2 = 0
∂t2

Solving the two conditions, we get t1 = 12 and t2 = 0. Substitute them back into f1 (t1 ,t2 ) and
f2 (t1 ,t2 ), we obtain the optimal fixed fees: f1 = 81 and f2 = 78 .
Check constraints (3) and (4).
1
Constraint(3) is fulfilled since U2 (t2 , f2 ) = 8 > 0.
Constraint(4) is fulfilled since U1 (t1 , f1 ) = 0 > U1 (t2 , f2 ) = − 83 .
Therefore, the working hypothesis is confirmed.

2. Second-degree Price Discrimination. Suppose the monopolist offers a menu of price–quantity

combinations ((x1 , T1 ), (x2 , T2 )). A customer who chooses tariff i gets the quantity xi and pays
the price Ti . Participation is voluntary. The inverse demand functions are given. Determine
the optimal tariffs.

2
The PMP of the monopolist:
max π = T1 + T2 (6)
(x1 ,T1 ),(x2 ,T2 )

subject to the following constraints:

U1 (x1 , T1 ) ≥ 0 (Type 1’s PC) (7)

U2 (x2 , T2 ) ≥ 0 (Type 2’s PC) (8)
U1 (x1 , T1 ) ≥ U1 (x2 , T2 ) (Type 1’s IC) (9)
U2 (x2 , T2 ) ≥ U2 (x1 , T1 ) (Type 2’s IC) (10)

For each one of the three pairs of demand functions, we always have P2 (x) > P1 (x), therefore,
type 2 consumer is always the high type (with high demand). Again we solve the problem
with the working hypothesis that the lower type’s participation constraint (7) and the the high
type’s incentive constraint (10) bind and in the end confirm that constraints (8) and (9) are
satisfied.
Consumers’s utilities: Z x
Ui (x, T ) = Pi (y)dy − T
0
The binding constraint (7) can be written as:
Z x1
U1 (x1 , T1 ) = P1 (x)dx − T1 = 0 (11)
0

which delivers
Z x1
T1 (x1 , x2 ) = P1 (x)dx (12)
0

From binding constraint (10), we have U2 (x2 , T2 ) = U2 (x1 , T1 ) where

Z x2
U2 (x2 , T2 ) = P2 (x)dx − T2
Z0 x1
U2 (x1 , T1 ) = P2 (x)dx − T1
0

Solve for T2 as a function of x1 and x2 , we have

Z x2 Z x1 Z x2
T2 (x1 , x2 ) = T1 (x1 , x2 ) + P2 (x)dx = P1 (x)dx + P2 (x)dx (13)
x1 0 x1

Now we can reduce the PMP of the monopolist to:

Z x1 Z x2
max π(x1 , x2 ) = T1 (x1 , x2 ) + T2 (x1 , x2 ) = 2 P1 (x)dx + P2 (x)dx
x1 ,x2 0 x1

such that
x1 ≥ 0, x2 ≥ 0
The Kuhn-Tucker conditions are:
∂π
= 2P1 (x1 ) − P2 (x1 ) ≤ 0, x1 ≥ 0, and x1 (2P1 (x1 ) − P2 (x1 )) = 0
∂ x1
∂π
= P2 (x2 ) ≤ 0, x2 ≥ 0, and x2 P2 (x2 ) = 0
∂ x2

Now consider the three pairs of demand functions separately:

3
 (a) P1 (x) = 1 − x and P2 (x) = 1 − 21 x
The Kuhn-Tucker Conditions become:
∂π 1 3 3
= 2(1 − x1 ) − (1 − x1 ) = 1 − x1 ≤ 0, x1 ≥ 0, and x1 (1 − x1 ) = 0
∂ x1 2 2 2
∂π 1 1
= 1 − x2 ≤ 0, x2 ≥ 0, and x2 (1 − x2 ) = 0
∂ x2 2 2
2
whose solution is x1 = 3 and x2 = 2. Plug x1 and x2 into equations (12) and (13), we
get T1 = 49 and T2 = 89 .
(b) P1 (x) = 1 − x and P2 (x) = a(1 − x), 1 < a < 2
The Kuhn-Tucker Conditions become:
∂π
= (2 − a)(1 − x1 ) ≤ 0, x1 ≥ 0, and x1 (2 − a)(1 − x1 ) = 0
∂ x1
∂π
= a(1 − x2 ) ≤ 0, x2 ≥ 0, and x2 a(1 − x2 ) = 0
∂ x2
whose solution is x1 = 1 and x2 = 1. Plug x1 and x2 into equations (12) and (13, we get
T1 = 21 and T2 = 12 .
(c) P1 (x) = 1 − x and P2 (x) = 2 − x
The Kuhn-Tucker Conditions become:
∂π
= −x1 ≤ 0, x1 ≥ 0, and x1 ∗ (−x1 ) = 0
∂ x1
∂π
= 2 − x2 ≤ 0, x2 ≥ 0, and x2 (2 − x2 ) = 0
∂ x2
whose solution is x1 = 0 and x2 = 2. Plug x1 and x2 into equations (12) and (13), we
get T1 = 0 and T2 = 2.

3. Optimality Comparison.
A two–part tariff {(t1 , f1 ), (t2 , f2 )} can be replicated by a price–quantity combination
{(x1 , T1 ), (x2 , T2 )} such that xi = Xi (ti ) and Ti = fi +ti Xi (ti ). This does not generally work the
other way round. If you try to replicate the optimal price–quantity combination by a two–part
tariff, then the upper type’s incentive constraint is usually violated. He will not choose (t2 , f2 )
as intended since (t1 , f1 ) gives him a higher utility. With a two–part tariff the upper type can
choose the quantity he likes, whereas the quantity is fixed in the price–quantity combination.
We show this by the example of the demand functions from 1/2a.
In order to translate a price-quantity combination into a 2-part tariff, one has to design a
two-part tariff, such that the demanded quantities and the total payments are the same. That
is our starting point. We take the optimal price quantity combination from exercise 2a.
   
2 4 8
{(xt , Tt ), (x2 , T2 )} = , , 2,
3 9 9

The corresponding two-part tariff must lead to the same demand: Therefore,

4
 2 1
t1 = P1 (x1 ) = 1 − =
3 3
1
t2 = P2 (x2 ) = 1 − · 2 = 0
2

Now, in order to generate the same payments as with the price-quantity combination, we
must have that

4 1 2 2
f1 = T1 − t1 x1 = − · =
9 3 3 9
8 8
f2 = T2 − t2 x2 = − 0 · 2 =
9 9

However, this violates customer 2’s incentive constraint as

Z x2
8 1
U2 (t2 , f2 ) = P2 (y)dy − t2 x2 − f2 = 1 − 0 −
=
0 9 9
Z X2 (t1 )
8 4 2 2
< U2 (t1 , f1 ) = P2 (y)dy − t1 X2 (t1 ) − f1 = − − =
0 9 9 9 9

which completes the proof (by counterexample) that not each price-quantity combination can
be replicated by an equivalent two-part tariff.