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An
Economist's Pick-Up Line: "I Bet Your Demand Is More Elastic Than
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Producer Revenue and Demand Elasticity
David
Without using calculus, it is difficult to prove to students that percentages rather than absolute changes in prices and quantities demanded determine whether, and if so, how, the total revenue (expenditure) of producers (consumers) will change when the price of a product changes. I find it helpful to confront students with the data sets for price/quantity demanded in Table 24‑1; both sets may be viewed as coming from the same demand schedule, or each set may be viewed as coming from different schedules.
I II
P XD P XD
9 6 2 15
8 8 1 17
Table 25‑1
I then pose the questions: What is the same about each set and what is different? What I want students to recognize is that the slope between individual points is the same for both sets (‑1/2) but, whereas in the first set, a drop in price of $1 and an increase in quantity demanded of two units raises total revenue, in the second set a drop in price of $1 and an increase in quantity demanded of two units reduces total revenue. If absolute changes are the primary determinant of how total revenue will change when price does, the same absolute changes should result (at the least) in the same type of change in total revenue, which clearly is not the case. Although this numerical illustration is not a general proof, it is a sufficient basis for demonstrating that absolute changes are not, in fact, what is important. How percentage changes compare is what matters, and one may go on to notice that in set I, the percentage change in quantity demanded (approximately 14%) exceeds the percentage change in price (approximately 12%), while in set II, the percentage change in quantity demanded (approximately 7%) is less than the percentage change in price (approximately 40%).
An Economist's Pick-Up Line: "I Bet Your Demand Is More Elastic Than Mine"
Robert W. Wassmer, California State University-Sacramento
An example of price discrimination that evokes groans of disgust, and even a few chuckles, is describing the profit-maximizing reason that bars and entertainment places put on a ladies' or men's night. In my lecture I go through the standard diagram that shows why it is in the best interest of places to do this. I finish the lecture by stating, tongue in cheek, that I have now provided students with a great opening line they can use the next time they attend a "night" provided for the opposite sex. If you can get past the initial slap, the opening line should provide for at least a half hour's conversation in which they can demonstrate their superior intellectual ability. A napkin and pencil, or even swizzle sticks, makes for great tools to illustrate the concept.
Why Royalty Recipients Prefer Lower Prices
Joseph Zoric, Franciscan
University of
Many students find it hard to differentiate between maximum total revenue and maximum profit. To clarify this difference, I point to the rock group "Tom Petty and the Heartbreakers." Mr. Petty once accused his record company of charging too much for his album. He felt that many fans could not afford his album at the high price, and therefore, he urged the company, in fairness to his fans, to lower the price. I ask students why Tom seems so interested in his fans' welfare. He doesn't look much like Mother Teresa.
The answer is that he may be less interested in their welfare than in his own. Petty is probably paid a percentage of the revenues from the sale of his records, so his income would be highest if total revenues from his records were maximized. The record company, on the other hand, is interested in maximizing its own profits. A graph like Figure 25‑1 can be used to suggest that the firm wants to produce where MR=MC, but that Petty wants sales where MR=0. This would require price to be lowered from where MR=MC to where MR=0. Were Petty paid a fixed royalty per record, he would want to maximize the quantity sold and would naturally advocate a price of zero. This might make him appear heroic in the eyes of many fans, but only self‑interested to people who know a little economics.
Figure 25‑1
EDITORS' NOTE: You can extend this example to texts. Almost all authors sympathize with complaints about high textbook prices, but cynics may note that lower prices would yield more royalties.
Are Monopolies Always Profitable?
Ralph T. Byrns
Ask students for examples of potentially monopolized products that could not be profitable because demand would be everywhere below any reasonable estimates of the average costs of production. In addition to the "disposable razor blade sharpener" and the "panty hose reweaver" we've suggested in the text, you might have proposals for dehydrated water, exotic patent medicines, automatic baiters for people too squeamish to impale worms on fish hooks, electronic pancake turners, indoor plant waterers, winders for string collectors, and a host of other imaginary gadgets.
Mark H. Maier,
In the town of Panamint near Death Valley, California, there is a single gas state, "Al's Gas." It is 40 miles from its nearest competitor. How much should Al charge for a gallon of gas? (In 1991, when gasoline was 90 cents per gallon in California's urban areas, it cost $1.80 at Al's in Death Valley.)
This example motivates discussion of monopoly pricing, in particularly the concept that monopolists will not charge the maximum possible price that any consumer will pay. In addition, the example raises the issue of substitutes when it seems there are none: Will consumers drive the extra 40 miles to buy gas? If consumers must buy Al's gas because their tanks are too low to drive 40 miles, how will they adjust their future buying habits in order to avoid Al's high prices?
Al claims that European visitors, accustomed to high gas prices, leave him tips, whereas U.S. visitors often complain in unprintable language when they read the price at the pump.
Ralph T. Byrns
Discuss whether the lone gas station in a small town is a monopolist. After considering the issue of contestability, extend this to the single daily newspaper in a large metropolitan area. Discuss whether the trend in many major markets towards one newspaper represents increasing monopolization. (Are radio, TV, and national papers (WSJ, NY Times) and news magazines sufficient competition?) Go one more step, and talk about how an absence of foreign competition (in e.g., steel, cameras, autos, bicycles, and electronics) because of trade barriers may yield inefficiency and the exercise of monopoly power. Challenge students for examples of monopolies that exist without government sanction.
Profit Maximization and the Concept of a "Marginal Profit"
Yung‑Ping Chen,
Profit maximization involves a comparison of total cost to total revenue at various possible levels of output. A firm can decide what quantity to produce by making this comparison of costs and revenues at successive increments of production. The firm must observe how its costs and revenues vary with its output. The rule for profit maximization follows from the comparison of marginal cost and marginal revenue. Marginal cost is the cost for producing one more unit of output. Marginal revenue is the revenue that one more unit of output yields. If the cost of producing one extra unit is less than the revenue from selling it, it will be profitable for the firm to add that unit to production. If, on the other hand, the cost of the additional unit that the firm contemplates producing is greater than the revenue it can generate, it will be unprofitable to produce that additional unit. Therefore, as long as marginal revenue exceeds marginal cost, the firm will want to produce more in order to increase its profit. If marginal revenue falls short of marginal cost, however, the firm will decide not to produce more. And when marginal cost equals marginal revenue, the firm will stop producing more.
This method of marginal analysis may be restated using the concept of "marginal profit." If marginal revenue exceeds marginal cost, the difference may be defined as marginal profit. That is, marginal profit is the profit that comes from one more unit added to production. The figures in Table 25‑2 illustrate this concept of marginal profit.
The column labeled "marginal profit" shows that marginal profit is $‑29 when the first unit is produced. When the second unit is produced, however, there is a marginal profit of $5. From then on, marginal profit increases form $33 to $57 to $71 to $81, then to $85 when the seventh unit is produced. Beyond the seventh unit, marginal profit declines from $83 to $75 to $61 to $41 and finally to $15. After that, when the thirteenth unit is produced, once again there is a negative marginal profit.
The largest marginal profit occurs when the seventh unit is produced, which yields $85 of marginal profit. There may be a temptation to conclude that this is the best situation for the firm because the marginal profit is the largest at that level of output. However, even though the marginal profit declines beginning with the eighth unit, that unit still enlarges the total profit by adding $83 to the total profit. The ninth unit adds $75 to the total profit, and the tenth unit adds $61 to the total profit. In the case of the eleventh unit, it adds $41 and even the twelfth unit still adds $15 to the total profit. Although each successive unit earns less and less marginal profit, the total profit nonetheless increases until it reaches the highest level of $578 with output level at twelve units. It is only after the twelfth unit, when marginal profit shows negative figures, that the firm's total profit declines. At the level of thirteen units, for example, total profit declines to $561. Thus a profit‑maximizing firm continues to increase its output as long as the marginal profit is greater than zero. Before that is reached, every unit the firm produced will add to the profit already accumulated. It may be said that the firm is building a "pyramid of marginal profits." Marginal profit, as explained earlier, is the difference between marginal revenue and marginal cost. When marginal revenue equals marginal cost at a certain level of output, the firm reaches the apex of the pyramid, as Figure 25‑2 shows.
Output Marginal Marginal Marginal Total
Level Cost Revenue Profit Profit
0 0 0 0 0
1 $131 $102 $‑29 $‑29
2 97 102 5 ‑24
3 69 102 33 9
4 47 102 57 66
5 31 102 71 137
6 21 102 81 218
7 17 102 85 303
8 19 102 83 386
9 27 102 75 461
10 41 102 61 522
11 61 102 41 563
12 87 102 15 578
13 119 102 ‑17 561
14 157 102 ‑55 506
15 201 102 ‑99 407
Table 25‑2 Illustration of Marginal Profit
Figure 25‑2
Price and Marginal Revenue in Imperfect Competition
Thomas J. Shea,
Using the relationship between the margin and the average (see Marginal and Average Relationships by Thomas J. Shea) one can more easily explain why the demand and marginal revenue curves are graphed they way they are in imperfect competition, i.e. the marginal revenue curve always lies below the demand curve, and therefore why marginal revenue is always less than price. This concept is necessary if the student is to grasp the criticism that imperfect competitors produce less and charge a higher price than perfect competitors as well as the more sophisticated argument that they do not charge a price equal to marginal cost.
Since all averages are simply some total divided by some quantity, the average revenue is simply total revenue divided by quantity. But if we were to take the total revenue equation TR = P x Q and divide both sides by Q, we'd find that TR/Q = P or TR/Q is actually our demand curve. Thus, AR is another name for demand.
We know that demand curves are downward sloping. From our discussion of average and marginal relationships we know that when the average is decreasing, the margin must be below the average. Thus, we must draw the marginal revenue curve below the demand curve and know that in every instance marginal revenue is less than price.
Profit Maximization in Action: Markup Pricing
Daniel Y. Lee,
Some of my students, most of whom are majoring in business, complain that what they learn in economics courses are only theories and not practical tools that can be used in the real world. They say that, for example, no managers of real companies know what their marginal revenue and marginal cost curves look like and, therefore, cannot use them in practice. I combine the concepts of price discrimination and markup pricing to help these naysayers see how the critical thinking skills they learn in economics can be also useful in the business world.
First, explain the conclusion of third-degree price discrimination: a profit-maximizing seller (who supply his output where MR = MC) would charge a higher price to the buyers whose demand is relatively inelastic and a lower price to the customers with elastic demand. Next, explain the concept of markup pricing, the practice used by managers of real firms and present some statistics showing how the sellers' markup percentage is higher for the items with relatively low price elasticity of demand than those with elastic demand. The practice of markup pricing is consistent with the profit maximization rule taught in the classroom!
Managers may not realize it, but they are applying the MR = MC rule in setting their prices.
Maximum Profit vs. Maximum Sales vs. Minimum Costs
Joseph E. Pluta, St. Edward's University
Students
occasionally have difficulty distinguishing between the goals of profit
maximization, cost minimization, and sales maximization. Since each of these
strategies at one point or another appears to be "good" for the firm,
the fact that they may be in conflict is often puzzling to students. To
demonstrate that each strategy is likely to produce a different output level, I
construct Figure 25‑3 to reflect demand conditions facing an imperfectly
competitive firm. Profit maximization occurs at an output level of Q1,
cost minimization at an output level of Q2, and the
dollar value of sales (or total revenue) is maximized at Q3 (Q4
and Q5 are break even points where economic profit
equals zero).
An output level which accomplishes more than one of these goals simultaneously is possible but unlikely. TR and profit can both be maximized only if MR = MC = 0. Profit can be maximized and ATC minimized in long run equilibrium under pure competition. I have found this diagram useful for discussing the general case where each strategy produces different levels of output as well as the exceptions noted above.
Figure 25‑3 Profit Maximization vs. Cost Minimization vs. Sales Maximization
Shu‑chin Shen,
Students studying the theory of monopoly for the first time find the concept that monopolies have no supply curve perplexing. Some texts explain the idea with a terse statement that students can hardly understand. Others use complex graphs to show that under monopoly, as demand shifts, one equilibrium quantity can associate with two or more prices (or vice versa), which disproves the existence of a supply curve, because a supply curve implies that each supply price has only one corresponding quantity. This approach has two short‑comings. First, most students seem unreceptive to such reasoning. Second, the graphs are too complex for instructors to demonstrate with accuracy on the blackboard so that the student can see clearly what is proved or disproved. One such graph showing one equilibrium quantity associated with two prices is illustrated in Figure 25‑4.
Figure 25‑4 Why There is No Monopoly Supply Curve
I have found that the "no monopoly supply curve" solution can be explained by simply mentioning that in pure competition, supply prices are independent variables, with the corresponding quantities supplied being the dependent variables. In a monopoly, on the other hand, the equilibrium price and quantity supplied are determined simultaneously where marginal revenue equals marginal cost. Since marginal revenue under monopoly is not price but is, rather, derived from the demand curve on which the equilibrium price corresponding to the quantity supplied is found, the equilibrium price is neither an independent variable in relation to the quantity supplied, nor is it a supply price. As demand shifts and the intersection of marginal revenue and marginal cost moves, the equilibrium price and/or quantity changes, but the analysis above is unaffected. Without supply prices as independent variables there can be no supply curve.
Students can easily see this reasoning from standard graphs for the monopoly firm. Immediately following this explanation, however, the student should be cautioned that no supply curve does not mean no "supply" for the monopoly firm. The "supply" cannot be represented by a curve, but by points on the firm's demand curve, as determined by the intersection of marginal revenue and marginal cost curves.
Price Discrimination in the Sale of Education
Eric K. Steger,
The following example helps illustrate price discrimination. I ask my students, "Why is the tuition higher priced for junior and senior level courses relative to the freshman and sophomore level courses at our University?" Some students say, "It costs more to teach them because the class sizes are usually smaller than for freshman and sophomore courses." I agree, but ask if cost differences fully explain tuition differentials? My position to the students is "no" because I explain to them that once a student begins at a university, it is costly to transfer to another university. Potential problems in transferring course credits, personal adjustment costs, etc. make the student's demand for education relatively inelastic in the face of a tuition price increase. I explain that our state legislature uses the concept of price elasticity of demand in the sale of education.
Illustrating Price Discrimination and Elasticity
Tom Riddell,
A student recently related the following incident: She went into a record store in mid‑November and found the price of recent releases to be $5.99. Later on, in early December, she returned to the same record store and found that the prices had been raised to $7.99. In the discussion that followed, students very easily grasped the ideas that the demand for records and tapes was different at different times of the year and that the store had determined that the demand during the holiday season was less elastic. There were also several comments about the holiday spirit of the record store and expressions of the hypothetical effect on their demands at that store.
Examples of Price Discrimination
Mark Zupan,
Among the examples of price discrimination that I provide my students are the following:
1. College tuition‑‑I lead into this example by asking my students whether they are all paying an identical price for getting the same sheepskin. I also ask them how schools acquire information on the prices different people are willing to pay for going to college. Answer: the detailed financial aid forms people have to fill out when applying for tuition remission.
2. Airline
tickets whose prices depend on such factors as the age of the passenger, (e.g.,
senior citizen or student fares), how many days prior to the flight the ticket
is purchased, and whether the passenger stays over on a Saturday. I tell my
students how, even with the typical restrictions that are imposed, airlines are
not always able to prevent resale. Major corporations, for example, that
consistently fly 10 people back‑and‑forth on an daily basis between
3. Season passes to
4. Magazine subscription renewal offers that offer a lower price the longer you refrain from renewing I bring in an example of how a magazine kept on sending me renewal notices and kept on lowering the price they offered the longer I did not respond.
5. The book publisher policy of printing a more expensive hardbound version of a book first and then, several months later, issuing a less‑expensive paperback version‑I tell my class about how I fought a losing battle over holding out and waiting for the paper‑back version of Tom Clancy's Patriot Games to come out. For two months after reading Clancy's Red Storm Rising and The Hunt for Red October I stuck to my guns and would walk by the campus bookstore and just glance at the display of Patriot Games in the main window. And then my time‑varying preferences got the best of me.
6. Economic periodical prices that depend on whether one is a library, a full professor, an associate professor, an assistant professor or a graduate student‑I bring in examples from AER and JPE.
7. Frequent flyer programs for airlines and frequent stayer programs offered by hotel chains‑A recent Wall Street Journal article pointed out that there are now also frequent parker programs offered by certain parking lots located near major metropolitan airports.
8. Car selling techniques‑‑Car dealers manage to sell the same model at very different prices. I am always amazed at the statistics concerning the number of people who buy a car at the full, list price. All too few people seem to haggle the price down. During the haggling period, moreover, many dealerships employ a method for finding out how much a customer is willing to pay by having the salesperson act as a supposed intermediary between the customer and the dealership owner. After getting the customer to reveal his/her bid, the salesperson typically goes off to the dealership owner to plead the customer's case. Quite frequently, I suspect, such a technique serves to make the customer sweat, allows the salesperson and owner to share information about the customer and to plot selling strategy, and ultimately decreases the extent to which a customer is willing to haggle.
The all‑time classic example
of price discrimination that I relate to my students, however, involves a story
about how my carpets recently got cleaned and how I probably got fleeced in the
process. Intent on selling my condominium and buying a house, I decided to hire
the Ajax Company (the names have been changed to protect the sleazy and guilty
slimeballs) to have my carpets steam‑cleaned. The carpets probably had
not been cleaned in over five years and showed it. I selected
The whole
affair started off quite innocuously. Two guys from
Step #1 involved their asking about when the last time my carpets had been cleaned. They began clucking disapprovingly when they found out that it was at least over five years ago. They tried to make me feel guilty by telling me that a carpet needs to be cleaned at least once every six months.
Step #2 involved their looking at
some of the spots in the carpet very closely. The guys from
When I resisted and stuck to the
basic treatment, the men from
Encountering
my intransigence on the $525 offer, the men from
When I continued to insist on just
the basic treatment, they moved to Step #5: playing up the personal ethics of
professional carpet cleaners. They insisted that they would feel horrible if
they had to leave my place knowing they had not done a good job; that it would
just hurt them inside knowing they had given my carpet only a half‑hearted
treatment. As I walked away from them and headed to work on a paper on the
personal computer in one of my bedrooms, the men from
After starting to prime their equipment and letting me think about things for awhile (Step #6) as I tried to work on my paper, one of the guys from Ajax came over to me and made their "very last" and "best" offer: $120 to do just the living room as a trial case. Feeling guilty about having so mistreated my carpet and about offending the professional ethics of carpet cleaners, I caved in on the offer. Since my bedroom carpets were in pretty good shape, I agreed to let them do "the works" on my living room carpet for $110.
As soon as
the guys from
After spending half an hour applying every special treatment known to humanity, which couldn't have cost more than an additional $10, to my living room carpet, the guys form Ajax came over to chat with me some more. They simultaneously started to clean the carpet in the entrance to one of my bedrooms, "for free," they claimed (Step #8).
When I shoo‑ed them out of my bedroom, they proceeded to inform me about the small rip in my living room carpet and how they would fix it, "for free," they said again, with one of their extra‑special glues if only I would allow them to do the carpet in the two bedrooms, Step #9, not "for free," of course.
I managed
to keep the guys from
POSTSCRIPT:
The day after the cleaning, my fiancée discovered that the watch she had left
over at my place was missing. After tearing apart both her place and mine, we
became convinced that the men from
Car Dealers and Perfect Price Discrimination
Jack Adams,
Point out to student that in most instances, at the official sticker price, the typical automobile firm will sell zero units (cars). In fact, the "actual" price is undefined with only a bottom limit unknown in an exact manner to the consumer. As the bartering proceeds, it becomes quite clear that the dealer is attempting to move the consumer up the demand curve within an ever narrowing price band in an attempt to implicitly extract all consumer surpluses, as illustrated in Figure 25‑5. The friendly car dealer should theoretically accept all price offers above or equal to short‑run marginal cost. While it becomes quite clear that this is not perfect price discrimination (first degree), it is a rather interesting attempt at A. C. Pigou's offspring.
Figure 25‑5
Verification: Have student volunteers approach some local car dealer and observe the resultant pricing policy outcome.
The Maitre D' as a Price Discriminator
Gary Galles,
Considering
the role of a maitre d' can be a useful way of illustrating several points
about price discrimination. A maitre d' who takes tips in exchange for
preferential seating, e.g., for a
Several points can be developed from this example.
1. The maitre d' does the discriminating directly rather than the management, because the transactions and information costs of effective discrimination would be too high in the absence of the self‑revealed value of tips offered for prime seats. This can illustrate 2 points: if price discrimination is too costly to employ (the costs of implementation exceed the gains), it does not take place (and a discussion of what factors affect the gains and costs can be started), and as costs of price discrimination fall (via self‑revealed information in this case), more of it will take place.
2. Just because the maitre d' does the discriminating does not mean he captures all the gains. Competition from others for this valuable position will reduce the wage the owner must pay to acquire those services, so that much of the gain is actually captured by the owners even though they don't do the price discriminating. The maitre d' selected will be one with a comparative advantage in price discriminating, and he will receive a higher income (in the form of economic rent) to the extent of his differential skill at that task.
3. Because the maitre d' is the lowest cost monitor of such things as who comes, what they tend to tip, how often they return, etc. and because the potential present value of future tip income is an important incentive to provide appropriate service to customers, such tipping may be the most efficient way to both reveal values and induce appropriate responses.
4. Since shows are a public good to the audience (with different values to the patrons, however), tip discrimination may be the financing mechanism closest to "tax shares equal to marginal benefit shares" typically used as one benchmark for public goods pricing.
5. Since this tipping behavior increases revenue to owners and leads them to cater relatively more to "big spenders" by better revealing their preferences, better shows (as seen by patrons) can be financed and seats more efficiently allocated via this mechanism, which can potentially benefit all patrons (vs. the preference revealing problems typical of public goods).
6. The extent of the potential gains increase with the "quality" (cost) of the show, the number of seats, the differences between seat locations and the average income of the patrons, explaining why this practice isn't universal.
7. This analysis can also be extended, if desired, to valet parking.
Price Discrimination and Social Values
Herbert M. Bernstein,
To emphasize that monopoly is not always a clear cut good or bad situation, I graph the standard price discrimination model that shows how a monopolist maximizes profits by charging those with less elastic demands higher prices than those with more elastic demands. I first use the example of a monopolist physician who charges the rich more than the poor. The class invariably perceives this situation is "fair". I then change the example to that of an urban supermarket chain that charges higher prices to the poor than to the rich (emphasizing that there is no difference in per unit costs in both neighborhoods). The difference between the two examples is that the rich have the less elastic demand for medical services while the poor, due to relative immobility, have the less elastic demand for food. When the class maintains that the supermarket chain is "unfair", I point out that one diagram covers both situations. Isn't discrimination always bad? This usually elicits a fervent discussion.
Total Revenue Impact of Price Discrimination
David J. Jobson,
Students can better appreciate the revenue enhancing potential of price discrimination by actually computing and comparing pre and post discrimination revenues. This example uses discount coupons--a price discrimination technique with which all students are familiar.
and Gordon Tullock (Homewood, Il: Richard D. Irwin, Inc., 1975).
Figure 25-6
Above is the demand curve for Happy Hound dog food. Use the three prices shown ($2.50, $3.00, $3.25) to determine which price would give the greatest total receipts.*
"A
price of $____ will give maximum total receipts of $____ per day. Now assume Happy Hound decides to price
discriminate by charging $3.25 to all those willing and able to pay this price. A $.75 cents-off coupon is printed and issued
to attract other (price sensitive) customers.
The maximum possible total receipts possible under this arrangement is
$____ per day."*
*Show all calculations.
Answer key
A price of $3.00 will give maximum total receipts of $66,000 per day. Now assume Happy Hound decides to price discriminate by charging $3.25 to all those willing and able to pay this price. A $.75 cents-off coupon is printed and issued to attract other-price sensitive-customers. The maximum possible total receipts possible under this arrangement is $80,000 per day.*
*Show all calculations.
$3.25 x 20,000= $65,000
$3.00 x 22,000= 66,000
$2.50 x 26,000= 65,000
$3.25 x 20,000= $65,000 from those paying full price
Plus: $2.50 x 6,000= 15,000 from coupon users
$80,000 Total Revenue
Surgical and Consumer Surplus Extraction
Charles Diamond,
Marshallian consumer surplus is a difficult concept for most students to grasp. The problem invariably arises when discussing the average market price and the prices above the average that some consumers would willingly pay if they had to. One example I give is to tell the students to imagine having been told by a doctor that you have appendicitis and that the going rate for the operation is $2,000. Next I tell the students to imagine being on the operating table, split wide open when the surgeon directs the anesthesiologist to remove the laughing gas mask so that he can talk with you about a subject that is no laughing matter. The surgeon says, "I have removed your appendix and all is OK but now I want to know how much you are willing to pay for me to close you up." At this point, rather than bid the average price you were quoted up front, you would probably bid much higher to close the operation. This way the surgeon has removed your appendix and any surplus valuation of the operation above the average price you may have had.
A less bizarre example addresses discriminatory pricing policies once allegedly prevalent in the computer industry. IBM knew that if it set its average forecasted price for a computer, that it would lose much of the potential revenue that could be extracted from the many buyers who would have paid a great deal more than the average price. I ask my students to think of all the technology "nuts" they know who must have the latest PC equipment, stereos and so on as soon as available regardless of price. To capture this surplus value (the difference between average market price and the consumer's reservation price), IBM and other electronics companies initially set high prices for their new products and then, gradually, allowed the selling price to trickle down over time.
Monopolistic Affection Suppliers and Social Welfare
Ralph T. Byrns
Use the example of a couple's exchange of affection as an example of the potential behavior of a monopoly supplier. Emphasize that the "price" can be strictly subjective, and need not be monetary. The demander of affection may "pay" by hauling out the trash, maintaining the family car, taking primary responsibility for child care, doing the laundry, cooking, etc. A lecture that keeps student attention can use the standard sorts of graphs that we use to illustrate the profit maximizing behavior of a monopolist. Tell the following story during your lecture, beginning with Figure 25‑7.
If your partner is "desperate" for affection (i.e., has a less than perfectly elastic demand for affection) from you, then it is possible to exploit this desperation (i.e., extract a subjective price for affection from you in excess of the subjective marginal cost to you of providing it) just as firms with monopoly power can charge a high market price for their goods to `desperate' buyers.
You can elaborate this story in a variety of ways. For example, you can discuss the withholding of affection as a tactic to drive up the price your student(s) receive (a common strategy during many courtships.) This parallels the way monopolies hold production down to keep price up. Then illustrate graphically why such a strategy (reducing affection) is inefficient. Extend the example to show that subjective "price" discrimination can lead toward greater efficiency in the exchange of affection. In a bilateral exchange of affection, such "price" discrimination is fairly common, with the partners frequently trading the roles of exploiter and exploitee.
Conclude by suggesting that the best of all possible (romantic) worlds occurs when the very inelastic demander of affection receives huge amounts of affection at a subjectively low price from an enthusiastic supplier, who in turn views the price received as very high, and so supplies an enormous quantity of affection. (This combination generates large amounts of both consumers surplus and producers surplus.) This example also works well when presenting bilateral monopoly models. This lecture is an enjoyable and instructive way for students to learn the monopoly model. A similar example is contained in the first edition of The New World of Economics, by Richard Mackenzie
Figure 25‑7
Monopolies and Second Best Solutions
David Hemenway,
To illustrate the theory of the second best, I assume that all markets are perfectly competitive except one, and there are two problems in that market: large negative externalities are generated by the production process, and the industry is monopolized. Then eliminating the monopoly may worsen rather than improve the situation.
I also explain that the "second best" notion‑‑that if there are a number of problems, fixing one may make the situation worse‑‑is possible in all areas. For example, if the gas stove leaks AND the pilot light isn't working, fixing the pilot light may not improve matters. Similarly if the pressure regulator for the furnace is defective, it is not always desirable to fix the oil burner. In medical care, if a patient has both a high CO2 and a low O2 in her lungs (as may be caused by a drug overdose), giving her oxygen (O2) can stop her breathing entirely.