The monopoly nonproblem: taking price discrimination seriously.

• Author: Shmanske, Stephen

One of the most important distinctions that economists teach is that between competition and monopoly, or, more accurately, that between price takers and price searchers. The distinction is pervasive. It shows up in the simple diagrammatics of profit maximization, in the welfare economics of the deadweight loss to monopoly, in the monopolistic competition model, in classic duopoly, in the arithmetic of the value of the marginal product and the marginal revenue product, in partly disguised form in monopsony models, in basic theoretical prescriptions for industrial policy and antitrust, not to mention on examinations at every level from principles to the Ph.D. comprehensives. An understanding of the distinction is an absolute requirement for students at all levels.

Economists themselves sometimes tend to be smug in their understanding and application of the distinction. They always present the simpler model of price-taking behavior first. By comparison, they regard the more complex model of monopoly, of the price searcher, as an improvement. When studying firm behavior, economists make the leap from models with exogenous prices to models with endogenous price setting, and they look with jaded eyes upon many of the models in the management sciences because those models treat the quantity demanded or the price as constant in order to examine some other dimension of decision making. (1) Allowing price to vary along a downward-sloping demand curve represents a huge improvement over fixed-price models.

Notwithstanding the improvement that a consideration of price searching brings to the analysis, economists should not smugly accept the standard presentation of monopoly because the price-searching model itself is saddled with a hidden, simplifying assumption that removes all relevance from the model: the assumption that all units must be sold at the same price. This uniform price assumption is untenable on theoretical grounds and unrealistic on empirical grounds. More important, the uniform-price assumption is not benign with respect to its effect on the conclusions drawn from the model. We have the worst of all possible worlds: a model with an unrealistic hidden or simplifying assumption that yields implications for policy that are not robust when the assumption is relaxed. The best that can be said for the monopoly model is that it is better than the price-taker models because it considers a downward-sloping demand curve. Still, the standard price-searcher model is woefully inadequate.

The remedy for this inadequacy is to treat nonlinear pricing and price discrimination much more centrally and seriously flora the outset. Textbooks generally do not do so currently. Most textbook treatments suggest that the market structures worthy of consideration include price-taking competition and uniform-price monopoly; monopolistic competition and classic oligopoly receive less attention. Price discrimination, when it comes up, is most often treated in an offhand manner as an extension of the monopoly model. Indeed, in my own casual survey of twelve principles texts and ten intermediate theory texts, I found that the proportion of the coverage of the monopoly model that is devoted to price discrimination averages only 23 percent. (2)

The current emphasis is all wrong. In the next section, I review the current treatment, arguing that economists spend too much time juxtaposing price taking and price searching as if they were the only relevant forms of seller behavior. Economists even go so far as to present policy prescriptions based on market structure as depicted in the textbooks and the simple application of these models. In this approach, price discrimination is an afterthought, an interesting but computationally and diagrammatically complex extension that in some instances distorts the market equilibrium even more than does the nondiscriminating monopolist. Price discrimination may even seem to be interesting only occasionally because of the list of preconditions that must be met for the monopolist to be able to charge different prices for different units.

I then describe what needs to be done to change this emphasis. Economists should give more attention--in both research and textbook presentations--to the costs and benefits of price discrimination, the empirical measurement of price discrimination, and the strategic theory of price discrimination with multiple sellers. The professional literature in these areas is still in its infancy. Perhaps a humbler approach in textbooks, one that details the deficiencies of the distinction between price taker and price searcher and that points the student in the direction of learning more about what we do not currently know, will encourage future generations of students and economists to tackle these issues. However, this changed emphasis will not come about until economists repudiate for the most part the uniform-price monopoly model.

Critique of the Dominant Paradigm

Competition/Monopoly or Price Taker/Price Searcher

The authors of virtually every economics textbook at the principles and intermediate levels expend a great deal of effort in introducing and distinguishing between monopoly and competition. What most students probably understand intuitively becomes needlessly tortured as the literal "single seller" notion of monopoly brings up quibbles about whether brand-name differentiation confers monopoly or whether the local geographical monopoly of the corner grocery store should be the target of interventionist policy. The conclusion from these quibbles is that every seller is either a monopolist or not, depending on how narrowly or broadly one defines the relevant market. No doubt a clear difference exists between a single-seller public utility and the multiple sellers in any of a number of obviously atomistic markets. But what is the essence of the distinction?

This question has two answers, and, in my opinion, textbooks traditionally focus too much on the wrong one. By and large, textbooks concentrate on differences between price takers and price searchers. The right answer, however, has to do with the distinction between closed markets and open markets, not simply with the number of sellers. (3) Monopoly status is a privilege granted by governments that allows privileged firms to be free from competition. The actual number of sellers in a closed market may be one, as in the case of a local cable franchise, or many, as in the case of taxicab medallion holders, but the restriction on entry is what consumers naturally recognize as restricting their choices and causing the "monopoly" problem. When markets are open, consumers naturally gain from the lower prices or better qualities that entrants are free to offer. In this view, governments are the cause of the monopoly problem and laissez-faire government policy is the appropriate prescription. Quite simply, closed markets restrict consumer choice, and open markets allow innovations that lower prices, raise quality, or introduce new products. This issue, however, is not my theme in the present article.

The open-market/closed-market approach to the monopoly problem usually gets only a fraction of the attention that the standard paradigm gives to a distinction between competition and monopoly that focuses on the slope of the demand curve--namely, the price-taker/price-searcher distinction. According to this view, in competitive markets the market sets the price, and the sellers take the price as a given in their decision making. The individual firm is then painstakingly analyzed as the language of marginal or incremental reasoning is developed and the diagram of the profit-maximizing, price-taking firm is presented and explained. Following this instruction, the relationship of price takers to the market is described and theorems are developed with respect to profits and losses, entry and exit, and Pareto optimality.

Alternatively, monopolists face the whole market demand curve, which by the first law of demand must be downward sloping. Such a seller is a price searcher and must work with a trade-off between price and quantity. After doing a little arithmetic and developing the familiar monopoly diagram, the economist derives the price-searching equilibrium conditions and derides the monopolist for restricting output in order to raise price and profit. The wielder of the standard model then delights in claiming that neither the high price nor the high profits are the real problem (they are simply transfers from consumers to producers), which is that the restricted quantity distorts resource...