This document summarizes key concepts from a chapter on capturing surplus. It discusses how firms with market power, such as monopolies, can capture consumer surplus to increase profits through practices like price discrimination, tie-ins and bundling, and advertising. The three main types of price discrimination covered are first degree, second degree, and third degree price discrimination, which involve charging different prices to different consumers or consumer groups.

1. Ch 12: Capturing Surplus
•Any firm with market power (such as a
monopolist) has an incentive to capture (obtain)
consumer surplus in order to increase its profits
•Consumer surplus can be captured though:
-Price Discrimination
-Tie-In’s and Bundling
-Advertising
-Often capturing surplus is disguised as (or
intended as) a beneficial program
1

2. Chapter 12: Capturing Surplus
In this chapter we will cover:
12.1 Price Discrimination
12.1.1 First Degree Price Discrimination
12.1.2 Second Degree Price Discrimination
12.1.3 Third Degree Price Discrimination
12.2 Tie-In’s
12.3 Bundling
12.4 Advertising
2

3. TYPES OF MARKET STRUCTURE
Are products differentiated?
How many
producers
are there?
Oligopoly
Perfect
competiti
on
No
One
Few
Many
Yes
Monopoli
stic
competiti
on
Not
applicable
Monopoly
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

4. HOW A MONOPOLIST MAXIMIZES PROFIT
• MR is below the demand curve…
• An increase in production by a monopolist has
two opposing effects on revenue:
– A quantity effect: One more unit is sold, increasing
total revenue by the price at which the unit is sold.
– A price effect: To sell the last unit, the monopolist
must cut the market price on all units sold. This
decreases total revenue.
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

5. A MONOPOLIST’S DEMAND, TOTAL REVENUE,
AND MARGINAL REVENUE CURVES
A
MR
TR
D
(a)
9 20
$1,000
–200
–400
500
550
0
50
Quantity of diamonds
(b)
0 10 20
$5,000
4,000
3,000
2,000
1,000
Total
Revenue
B
C
Demand and marginal revenue
Total Revenue
Price, cost, marginal
revenue of demand
Price effect = –
$450
Quantity effect =
+$500
Marginal revenue
= $50
Quantity effect dominates
price effect.
Price effect dominates
quantity effect.
10
Quantity of diamonds
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

6. PROFIT MAXIMIZATION FOR A MONOPOLY
• Profit maximization consists of two steps:
1.Choosing a quantity
Rule: Choose Q where MR = MC.
2.Choosing a price
Choose the highest price you can get away with, which is the
highest price consumers will pay for that quantity.
– Rule: Once you’ve picked your quantity, follow the graph to
the demand curve, which shows you how much consumers
will pay.
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

7. THE MONOPOLIST’S PROFIT-MAXIMIZING
OUTPUT AND PRICE
The price De Beers can charge per diamond is found by going to the point
on the demand curve directly above point A, (point B here)—$600 per
diamond. It makes a profit of $400 × 8 = $3,200.
B
C
MR
Monopoly
profit
MC = ATC
D
$1,000
200
600
–200
–400
0
Quantity of diamonds
8 10 20
16
A
PC
PM
QM QC
Price, cost,
marginal revenue
of demand
Monopolist’s
optimal point
Perfectly competitive
industry’s optimal point
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

8. • IS THERE A MONOPOLY SUPPLY CURVE?
• You might be tempted to ask about the supply
curve of a monopolist. But this is a
meaningless question:
• Monopolists don’t have supply curves- since
they control prices there is no set relationship
between Price and Quantity supplied.
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

9. MONOPOLY CAUSES INEFFICIENCY
(a) Total surplus with perfect competition (b) Total surplus with monopoly
D
MC =ATC MC =ATC
Quantity
QC
PC
QM
PM
D
MR
Quantity
Price,
cost
Profit
Deadweight
loss
Consumer surplus with
perfect competition
Consumer surplus
with monopoly
Price, cost,
marginal
revenue
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

10. DEALING WITH NATURAL MONOPOLY
• Natural monopolies are a different story: They
bring lower costs…
•
• …but there’s no guarantee the firm will voluntarily
pass along its cost savings to consumers.
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

11. DEALING WITH NATURAL MONOPOLY
• What can public policy do about this? Two
common answers:
–Public (government) ownership: But publicly
owned companies are often poorly run.
–Price regulation: A price ceiling imposed on a
monopolist does not create shortages if it is not
set too low.
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

12. UNREGULATED AND REGULATED NATURAL
MONOPOLY
If the monopoly’s price is regulated at PR, consumer
surplus rises (and profits fall).
(a) Total surplus with an unregulated
natural monopolist
(b) Total surplus with a regulated
natural monopolist
QM QR
PM
D
MC
MR
ATC
Quantity
Consumer
surplus
QR*
D
MC
MR
ATC
Quantity
PR*
Price, cost,
marginal
revenue
Price, cost,
marginal
revenue
Profit
Consumer
surplus
C O P Y R I G H T 2 0 1 5 W O R T H P U B L I S H E R S

13. 13
• PRICE DISCRIMINATION is the act of charging
different prices to different consumers in order
to capture consumer surplus.
• Like burns, three basic types of price
discrimination exist:
 First Degree
 Second Degree
 Third Degree
(unlike burns, 1st degree is the “worst”)

14. 14
• In order for price discrimination to take place:
1) A firm must have market power
-a PC firm that raises price will get zero sales
2) The firm must be able to distinguish between
consumers
-the firm must know consumer demand or
elasticity of demand
3) The firm must be able to prevent resale

15. 15
In first degree price discrimination, the
monopolist charges each consumer their
maximum willingness to pay (ie: each quantity
is sold at its intersection on the demand curve)
Examples:
-Auctions (higher willingness to pays will push up
price)
-Sizing up customers (asking questions relating to
living arrangements and work, evaluating dress
and speech patterns)

16. 16
MC=S
Demand
MR
QM
PM
PC
QC
A
B
C
D
E
DWL = C+E
CS with monopoly: A
PS with monopoly:B+D

17. 17
MC=S
Demand
MR
QM
PM
PC
QC
A
B
C
D
E
DWL = ZERO!
CS with 1st Degree Price Dis.: 0
PS with 1ST Degree PD: A+B+C+D+E

18. 18
 First Degree Price Discrimination ELIMINATES
consumer surplus (each consumer pays their
maximum amount)
 First Degree Price Discrimination ELIMINATES
deadweight loss (monopolists are able to
provide goods to more consumers)
 FDPD is hard to accomplish and VERY
vulnerable to resale

19. 19
 For the monopolist,
MR=P+(ΔP/ΔQ)Q
 But since increased sales do not affect the
price of any other goods sold,
(ΔP/ΔQ)Q=0
 Therefore, MR=P=D (The MR curve is the
demand curve)

20. 20
Calculate CS,PS and DWL with and without 1st
Degree Price Discrimination. Assume that:
P=48-2Qd
MC=4Q
Without:
MR=MC
48-4Q=4Q
6=Q
P=48-2Q
P=48-2(6)=36
MC=4Q
MC=4(6)=24
With Price Discrimination:
MR=D=MC
48-2Q=4Q
8=Q (PC Q)
Min P=48-2Q
Min P=48-2(8)=32 (PC P)

21. 21
MC=S
Demand
MR
6
36
24
8
A
B
C
D
E
Surplus w/ monopoly = A+B+D
Surplus w/ monopoly = (A+B+D+C+E)
–(C+E)
Surplus w/ monopoly = ½(b)(h)
- ½(b)(h)
= ½(48)(8)
- ½(12)(2)
=192-12
=180
48
32

22. 22
MC=S
Demand
MR
6
36
24
8
A
B
C
D
E
Surplus w/ 1st Degree Price
Discrimination = A+B+D+C+E
= ½(b)(h)
= ½(48)(8)
=192
48
32

23. 23
 Second degree price discrimination deals with
price discounts:
-Selling at a discount price after a certain
number of goods are purchased
 Second degree price discrimination also
involves offering separate membership and per
unit price plans that consumers CHOOSE
between
-ie: Cell phones, club memberships, bus pass

24. 24
 In block pricing the first “block” of goods is
sold at a given price, and the next “block” of
goods is sold at a lower price
 A consumer pays P1 for the first Q1 good, then
P2 for any goods above Q1
 There can be more than 2 different blocks of
prices

25. 25
0
P
Q
Demand
Block Pricing
10
40
70
100
30 60 100
• Here a price of 70 applies
to the first 30 goods,
followed by a price of 40
for the next 30 goods
• Note: P=100-Qd
MC

26. 26
Block Pricing and Surplus
0
P
Q
Demand
10
40
70
100
30 60 100
450
450
450
900
900
900
• Consumer Surplus (Red)
= 900
• Producer Surplus (Blue)
= 2700
• Deadweight Loss (Gold)
= 450
MC

27. 27
Normal Monopoly Surplus
0
P
Q
MC
Demand
MR
55
45 100
100
2025
1012.5
1012.5
• Consumer Surplus
(Red) = 1012.5
• Producer Surplus
(Blue) = 2025
• Deadweight Loss
(Gold) = 1012.5

28. 28
 In this example quantity discounts increased
producer surplus
 Since the quantity sold on the market also
increased, DWL decreased compared to the
typical monopoly
 Note that if prices decrease due to a
decreasing MC, this is not considered price
discrimination

29. 29
 Some goods (such as cell phones or music
clubs) carry a plan/membership fee and a cost
per unit/use
 Often multiple plans exist, each with different
fixed and variable fees
 Multiple plans often exist in order for the
monopolist to price discriminate

30. 30
Membership and Per Unit Costs
0
P
Q
Demand
.10
.40.
.70
1.00
3 6 9 10
In this market for long
distance, MC=$0.10,
P=$0.10, and CS=$4.05.
Therefore a firm could
capture most consumer
surplus by charging $0.10
per minute plus a plan fee
of up to $4.05.

31. 31
Membership and Per Unit Costs
0
P
Q
Demand
.10
.40
.70
1.00
2 6 9 10
Not all consumers are alike,
so the firm offers different
plans for different
consumers. Here if
P=$0.70, CS=$0.30.
Therefore the firm could
offer a price of $0.70 per
minute with a plan fee of
up to $0.30.

32. 32
 Price plans are only effective price
discrimination if different consumers
automatically choose different plans
 Assume 2 customers:
Customer A – makes 30 long distance calls
Customer B – makes 100 long distance calls
 Assume 2 plans:
Plan I - $1 per call, $50 plan fee
Plan II - $2 per call

33. 33
 Customer A
-Spends $80 on plan I
-Spends $60 on plan II
-Picks plan II
 Customer B
-Spends $150 on plan I
-Spends $200 on plan II
-Picks plan I
 Effective Price Discrimination

34. 34
 Third degree price discrimination charges
different prices to different consumer groups,
or segments of society (each with different
demand schedules)
 Examples:
-Student and seniors movie prices
-Regular and farm gasoline
-Bus passes
-”Customer Appreciation Days”
-Tuesday deals at restaurants

35. 35
 In order to price discriminate, the firm must
separate different demand schedules
 SCREENING separates consumers based on
characteristics that are:
1) Easily identified (age, status)
2) Strongly related to a useful consumer
characteristic (willingness to pay, elasticity
of demand, available income, etc.)

36. 36
Third Degree Price Discrimination
0 0
100
100
20
60
80
50
20 40 Q
Q
P P
Market 1 Market 2
Demand 1
Demand 2
MR1 MR2

37. 37
Third-Degree Price Discrimination
• Suppose that the demand curves in two
separated markets are given by
Q1 = 24 – P1
Q2 = 24 – 2P2
• Suppose that MC = 6
• Profit maximization requires that
MR1 = 24 – 2Q1 = 6 = MR2 = 12 – Q2

38. 38
Third-Degree Price Discrimination
• Optimal choices and prices are
Q1 = 9P1 = 15
Q2 = 6P2 = 9
• Profits for the monopoly are
 = (P1 - 6)Q1 + (P2 - 6)Q2 = 81 + 18 = 99

39. 39
Third-Degree Price Discrimination
• The allocational impact of this policy can be
evaluated by calculating the deadweight losses
in the two markets
– the competitive output would be 18 in market 1
and 12 in market 2
DW1 = 0.5(P1-MC)(18-Q1) = 0.5(15-6)(18-9) = 40.5
DW2 = 0.5(P2-MC)(12-Q2) = 0.5(9-6)(12-6) = 9

40. 40
Third-Degree Price Discrimination
• If this monopoly was to pursue a single-price
policy, it would use the demand function
Q = Q1 + Q2 = 48 – 3P
• So marginal revenue would be
MR = 16 – 2Q/3
• Profit-maximization occurs where
Q = 15 P = 11

41. 41
Third-Degree Price Discrimination
• The deadweight loss is smaller with one price
than with two:
DW = 0.5(P-MC)(30-Q) = 0.5(11-6)(15) = 37.5

42. 42
Two-Part Tariffs
• Because the average price paid by any
demander is
p’ = T/q = a/q + p
this tariff is only feasible if those who pay
low average prices (those for whom q is
large) cannot resell the good to those who
must pay high average prices (those for
whom q is small)

43. 43
Two-Part Tariffs
• One feasible approach for profit
maximization would be for the firm to set p
= MC and then set a equal to the consumer
surplus of the least eager buyer
– this might not be the most profitable approach
– in general, optimal pricing schedules will
depend on a variety of contingencies

44. 44
Two-Part Tariffs
• Suppose there are two different buyers with
the demand functions
q1 = 24 - p1
q2 = 24 - 2p2
• If MC = 6, one way for the monopolist to
implement a two-part tariff would be to set
p1 = p2 = MC = 6
q1 = 18 q2 = 12

45. 45
Two-Part Tariffs
• With this marginal price, demander 2
obtains consumer surplus of 36
– this would be the maximum entry fee that can
be charged without causing this buyer to leave
the market
• This means that the two-part tariff in this
case would be
T(q) = 36 + 6q

46. 46
 Youth often have more time to shop around
and lower disposable income
-Different demand = different price
 Seniors are often more sensitive to price
-Different demand = different price
 Identity cards can verify age and prevent
arbitrage (reselling of goods)

47. 47
 Products are more expensive when first
released; those who MUST have a new good
(ie: Tickle Me Elmo) have different demands
than those who can wait
 Cell phone calls are cheaper (often free) at
night, due to different types of consumers
-Business calls during day
-Personal calls at night
 Different consumer groups visit restaurants
Fridays compared to Tuesdays ->Tuesday
dinner specials

48. 48
 Coupons and Rebates take time to collect or
redeem
 Consumers willing to use coupons and rebates
are more price sensitive
 Different price elasticities = different prices
 In general, rebates and discounts are offered
to consumers who are more price sensitive
(elastic demands)

49. 49
 Another way companies can offer essentially
the same product is through quality and
convenience differences.
 Higher willingness to pay will want to buy
higher quality
 Higher willingness to pay will want higher
convenience

50. 50
 Quality Examples: Cars (luxury and base),
Computers (with or without a dedicated
graphics card), Software (Windows 8, Windows
8.1, Windows 8.1 Pro)
 Convenience Examples: Last minute ticket
sales, customer support, cancellation ability
(ie: airplane tickets)

51. 51
First Degree
-Each consumer pays their maximum
willingness to pay
Second Degree
-Consumers sort themselves into different
price categories (quantity discounts or plans)
Third Degree
-Firms sort consumers into different price
categories

52. 52
A firm can capture consumer surplus by allowing
consumers to purchase one good (tying
product) only if it agrees to buy another (tied
product
ie: Buy an hp printer, and be forced to buy hp ink
ie: Buying an ipod and being forced to use itunes
ie: Buying an Iphone and being forced to sign up
for a data plan
ie: Warranties being voided if off-brand parts or
off-brand services are used (Weak Tie-In Sale)

53. 53
Tie in sales extends market power from the
TYING product (ie: ipad) to the TIED product
(ie: itunes)
ie: itunes can have higher prices than it could if
the market was competitive
-another way of using tie-in sales is by making
guarantees invalid if non-brand parts or
components are used

54. 54
Bundling is a type of tie in where a consumer can
only buy good A if it also buys good B
simultaneously.
 TV channel packages
 Furnaces and Furnace installation
 Cars with passenger air bags
 Laptop with webcam
Bundling forces consumers to buy all goods
when they may not buy them individually:

55. 55
Two people are looking to replace their furnace. The
handyman realizes the value of a new furnace,
and would pay up to $4000 for one, but is only
willing to pay $1000 for installation.
A typical homeowner doesn’t realize all the benefits
of a new furnace, so would pay $3000 for one,
but has no installation experience and would pay
$2000 for installation.
A firm’s costs are $2000 for the furnace and $500 for
installation

56. 56
At individual prices: (f=furnace, i=installation)
Pf=$3000, sells two furnaces for $2000 profit
Pf=$4000, sells one furnace for $2000 profit
Pi=$1000, sells two installs for $1000 profit
Pi=$2000, sells one install for $1500 profit
At a bundled price:
Pb=$5000, sells two bundles for $5000 profit
Which is why it is hard to buy a furnace without a
furnace install bundled in.

57. 57
Bundling is only possible if customers’ demands are
negatively correlated.
That is, if consumers are willing to pay more for
different goods.
(Note that in the above example, both people may
be technically indifferent between buying and not
buying the various goods at listed prices.
To ensure the consumer buys, the goods need to be
priced slightly below their willingness to pay, ie:
Bundle price of $4999.)

58. 58
Sometimes a firm can increase profits by offering a
bundle AND individual items.
This can attract customers who are uninterested in
the bundle.
Consider customer C who would pay $4500 for a
furnace, but only $250 for installation.
He wouldn’t buy the bundle, but he would buy a
furnace for $4499, giving the firm $2499 profit.
Note that neither other consumer would want the
furnace for that price; they’d prefer the bundle.

59. 59
Advertising is an example of a NONPRICE
strategy a firm can use to increase
profits.
Advertising carries a cost, but also shifts out
the demand curve, allowing for greater
sales at a higher price:

60. 60
Price
Quantity
D2
MR2
MC
D1
MR1
AC2
AC1
AC increases
due to
advertising
costs, but
profit may
also increase

61. 61
How much should a firm advertise?
A firm should advertise until
MRadvertising=MCadvertising
Note that not all firms benefit from
advertising (ie: electricity monopoly can’t
really increase electricity demand through
advertising)

62. 62
Regulation of Monopoly
• Natural monopolies such as the utility,
communications, and transportation
industries are highly regulated in many
countries

63. 63
Regulation of Monopoly
• Many economists believe that it is
important for the prices of regulated
monopolies to reflect marginal costs of
production accurately
• An enforced policy of marginal cost pricing
will cause a natural monopoly to operate at
a loss
– natural monopolies exhibit declining average
costs over a wide range of output

64. 64
Regulation of Monopoly
Quantity
Price
D
MR
AC
MC
Because natural monopolies exhibit
decreasing costs, MC falls below AC
C1
P1
Q1
An unregulated monopoly will
maximize profit at Q1 and P1
C2
P2
Q2
If regulators force the
monopoly to charge a
price of P2, the firm will
suffer a loss because P2 <
C2

65. 65
cover the losses on the sales to low-
price customers
The profits on the sales to high-price
customers are enough to
Regulation of Monopoly
Quantity
Price
D
AC
MC
Suppose that the regulatory commission allows the
monopoly to charge a price of P1 to some users
P1
Q1
C1
Other users are offered the lower price of P2
P2
Q2
C2

66. 66
Regulation of Monopoly
• Another approach followed in many
regulatory situations is to allow the
monopoly to charge a price above marginal
cost that is sufficient to earn a “fair” rate of
return on investment
– if this rate of return is greater than that which
would occur in a competitive market, there is
an incentive to use relatively more capital than
would truly minimize costs

67. 67
Regulation of Monopoly
• Suppose that a regulated utility has a
production function of the form
q = f(k,l)
• The firm’s actual rate of return on capital is
defined as
k
w
k
pf
s
l
l 

)
,
(

68. 68
Regulation of Monopoly
• Suppose that s is constrained by regulation
to be equal to s0, then the firm’s problem is
to maximize profits
 = pf(k,l) – wl – vk
subject to this constraint
• The Lagrangian for this problem is
L = pf(k,l) – wl – vk + [wl + s0k – pf(k,l)]

69. 69
Regulation of Monopoly
• If =0, regulation is ineffective and the
monopoly behaves like any profit-
maximizing firm
• If =1, the Lagrangian reduces to
L = (s0 – v)k
which (assuming s0>v), will mean that the
monopoly will hire infinite amounts of
capital – an implausible result

70. 70
Regulation of Monopoly
• Therefore, 0<<1 and the first-order
conditions for a maximum are:
0
)
( 







l
l
l
pf
w
w
pf
L
0
)
( 0 







k
k pf
s
v
pf
k
L
0
)
,
(
0 






l
l k
pf
s
w
L

71. 71
Regulation of Monopoly
• Because s0>v and <1, this means that
pfk < v
• The firm will hire more capital than it would
under unregulated conditions
– it will also achieve a lower marginal
productivity of capital

72. Chapter 12 Summary
Price Discrimination can occur when a firm
Has Market Power
Can distinguish between consumers
Can prevent resale
First Degree Price Discrimination charges the
maximum to everyone
Second Degree Price Discrimination allows
consumers to sort themselves into different
prices
72

73. Chapter 12 Summary
Third Degree Price Discrimination allows the
firm to sort consumers into different prices
Price discrimination DECREASES deadweight
loss
Tie-in sales and bundling increases the
demand for individual goods that are grouped
together, thus increasing profits
Advertising increases costs and demand
And may increase profits
73