Managerial Economics

Solution to problem set 2

Price discrimination (contd.)
Monopolistic Competition –
Short-term and long-term equilibrium

Sumit Sarkar, XLRI Jamshedpur

 Second degree price discrimination
– Block pricing

p p
Demand function: p = 10 – x Demand function: p = 10 – x
Revenue = 9 + 8 + 7 = 24 Revenue = 7*3 = 21
Revenue increases by 3
9
8
MC
7 7

E D

1 2 3 x 3 x
MR
Sumit Sarkar, XLRI
 Condition for block pricing:
◦ The firm must know (or have an idea) of individual
demand functions of the consumers.

Examples:
Typical FMCG pricing of lower price per unit for larger packs
E.g., soft drink priced at Rs. 30 for 400 ml pack, Rs. 45 for 750
ml pack, Rs. 60 for 1 ltr. pack and Rs. 85 for 2.25 ltr. pack.
Different tariff plans of telecom service providers (so
called “more you talk less you pay.”)
Monthly / bi-annual tickets in suburban / metro trains.
Frequent flyer programs by airlines.
Corporate discounts in hotels.

Sumit Sarkar, XLRI

 First degree (perfect) price discrimination
– Two part tariff

A first degree discriminating

p monopolist charges the price
equal to MC, but extracts
the entire consumers’
MC surplus in form of a fixed
p1 subscription / membership
fee.
p*

E
D
x1 x* x
MR
Sumit Sarkar, XLRI
 Condition for perfect price discrimination:
◦ The firm must know (or have an idea) of individual demand
functions of the consumers.
◦ The good / service should be such that it is possible to charge
membership / subscription charges
◦ Easier to do it when the MC is constant.

Examples of perfect price discrimination:

 Club membership / magazine (or journal) subscription fee.
 Supermarket membership
 Fixed monthly rental (and free calls / low call rates) for
telephone.
 Television pricing (the subscriber pays a sum to view a channel
for a stipulated period, irrespective of how may minutes the
subscriber is actually viewing the channel).

Sumit Sarkar, XLRI

TV Channel subscription

Sumit Sarkar, XLRI

Problem 1
By virtue of a product patent Blue Ocean Co. Pvt. Ltd. is a
monopoly producer of a particular enzyme. The forecasted
annual demand function is P = 1500 – 0.5Q. Q is the quantity
demanded and P is the price. Prices are in dollars per ounce and
quantities are in ounces. The annual cost of production and
distribution is given as C = 100000 + 100Q + 0.5Q2, where Q is
the quantity produced annually. Find the profit maximizing
quantity and the price. How much is the annual profit of Blue
Ocean Co. Pvt. Ltd.?
Problem 2
Suppose a government owned monopoly operates in a market wherein the
inverse demand function is given as P = 10 – 0.1 Q. the cost function is C
= 2Q + 0.1 Q2.
a. Find the profit maximizing price.

b. What should be the price if the government wants the price to be equal

to marginal cost?
c. How does the monopolist’s equilibrium change if the government

imposes a price ceiling at the price you found as your answer to

question (b)? Explain diagrammatically.
 Price ceiling
p(x)
MC

p*
C
MC =p c c

MC(x*) E D

x* xc x

MR
Sumit Sarkar, XLRI
Problem 3
Monopoly due to exclusive license
Cost: $3 to the Governments for each kilogram of pebble they

collect. For touching-up the pebbles they pay the artisans at the rate
of $4 per kilogram. Transportation and distribution cost $3 per
kilogram.
Two markets - one in the U.S.A and the other in Canada.

Q = 1000 –10P
US US

Q = 500 – 20 PCan,
Can
3.How much should Teesta Crafts sell in the U.S.A. every month
and at what price? 4. At what price?
5. No price discrimination: What should be the price that

maximizes profit for Teesta Crafts? 6. How much should they sell in
U.S.A. and how much in Canada per month?
Q = 1000 –10PUS
US
Or, P = [(1000 – Q ) / 10] = 100 – 0.1Q
US US US
Therefore, Revenue = Q (100 – 0.1Q )
US US
MR = (100 – 0.2Q )
US
 Cost = (3 + 4 + 3)Q MC = 10
 At monopolist’s equilibrium MR = MC
 (100 – 0.2QUS) = 10
 QUS = 90 / 0.2 = 450
Therefore, P = [100 – 0.1Q ] = (100 – 45) = 55
US US
 
Q
Can = 500 – 20 PCan
P
Can = [(500 – QCan) / 20] = 25 – 0.05QCan
Therefore, Revenue = Q
Can (25 – 0.05QCan)
MR = (25 – 0.1Q )
Can
At monopolist’s equilibrium MR = MC
 (25 – 0.1QUS) = 10

 QCan = 15 / 0.1 = 150

Therefore, P
Can = [25 – 0.05QCan] = (25 – 7.5) = 17.5
 Let PUS = PCan = P
 The aggregate demand function is:
 Q = 1500 –30P if, 0 < P < 25 (When P < 25 there is demand from
both USA and Canada)
 = 1000 –10P if, 25 < P < 100 (When P > 25 demand from
Canada becomes zero. )
Suppose, the profit maximizing price P* <
So, the firm should sell only in the 25
US market and we already found Revenue = [(1500 – Q) / 30]*Q
100
the profit maximizing price and
MR = [1500 – 2Q] / 30
quantity as $55 and 450 kg
respectively. MR = MC => = [(1500 – 2Q)] / 30] = 10
Q* = 600
Therefore, P* = [(1500 – Q) / 30] = 30
This contradicts our initial supposition
DUS that
P* < 25, which means, profit maximizing
price cannot be less than $25, i.e., the firm
should not sell in both markets.
 Monopolistic competition

 There are many buyers and sellers.

 Products are differentiated but are perceived as

close substitutes by the consumers.

 Advertising and marketing plays a major role.
 Entry and exit is free.

Sumit Sarkar, XLRI

 Implication of product differentiation on the
elasticity of the firm’s ‘own demand curve’
 Because of product differentiation the firm creates a set of ‘loyal’
value-seeking customers who continue to buy the firm’s product
even if it increases price.
 The price-seeking customers, however, leaves the firm and buys
cheaper substitute from the competitors.
 Since the number of price-seeking customers are much more
compared to the firm’s ‘loyal’ customers, a small increase (vis-à-
vis the average market price) results in huge demand attrition.
 Similarly, a small reduction in price attracts large number of
customers.
 This phenomenon makes the firm’s own demand much more
price elastic, compared to the market demand.

Sumit Sarkar, XLRI

 Firm’s own demand curve – from perfect
competition to monopolistic competition

Rs. Rs.

MR=AR
P*

AR

X x
Market Firm
MR

Sumit Sarkar, XLRI

 Monopolistic competitive firm
Firm is profit maximizer
 = Rev. – Cost
or,  = p (x) x – c (x) – F
p(x) is the firm’s ‘own demand’ function

First order condition,

x[dp(x)/dx] + p(x) = (dc(x)/dx)
or, MR = p(x)[ 1+ 1/] = MC
 is the price elasticity of firm’s ‘own demand’

Sumit Sarkar, XLRI

 Short-term Equilibrium

MC AC

P0

AR

x0 x
MR

Sumit Sarkar, XLRI

 From Short-term to Long-term equilibrium

AC1
MC AC

P0
P1

AR
AR1

x1 x0
MR
MR1
Sumit Sarkar, XLRI