Source: ECN 312, Lecture 16, Part 2 (Arizona State University)
Difficulty: Intermediate | Prerequisites: Basic monopoly theory, price discrimination concepts (see Part 1 of these notes), consumer and producer surplus, demand curves, marginal cost.
This is the second half of Lecture 16. Having covered price discrimination (charging different prices for different units or groups), the lecture now turns to two more monopolist strategies, bundling and two-part tariffs, and then moves beyond pure monopoly into monopolistic competition, where firms sell differentiated products. The Hotelling model provides intuition for why competitors cluster together (in location or in product space), and the welfare analysis shows why monopolistic competition still produces inefficiency even when profits are driven to zero. You need the price discrimination material from Part 1 as background, plus basic monopoly theory.
Bundling packages goods together to reduce the spread in consumers' willingness to pay, letting the firm charge more. Two-part tariffs split the price into a fixed entry fee (capturing consumer surplus) and a per-unit charge (set near marginal cost). Monopolistic competition arises when firms sell differentiated products: free entry drives profits to zero, but price stays above marginal cost, so the market is inefficient with excess capacity.
Bundling
Selling two or more goods together as a single package. Think of it as Microsoft Office: Word, Excel and PowerPoint sold as one product rather than three separate purchases.
Two-part tariff
A pricing scheme with two components: a fixed fee to "get in" and a per-unit price for consumption. In simple terms, this is how a theme park works: you pay admission (fixed fee) and then pay per ride (per-unit charge).
Product differentiation
Firms sell goods that are similar but not identical, giving each firm a degree of market power over its own variant. Think of it as different smartphone brands: each has a monopoly on its exact product, but they all compete for the same buyers.
Monopolistic competition
A market structure in which many firms sell differentiated products, each with some market power but with free entry that drives long-run economic profit to zero. In simple terms, this is the world most consumer-facing businesses inhabit: restaurants, clothing brands, apps.
Hotelling model
A spatial competition model showing that two competing firms will locate right next to each other at the centre of the market (minimum differentiation), even though the socially optimal arrangement spreads them apart. Think of it as why two food trucks at a festival both park in the middle of the street.
Excess capacity
In monopolistic competition, each firm produces below the output level that would minimise its average cost. The market has too many firms making too-similar products, each operating below efficient scale.
Bundling works because it reduces the dispersion (spread) in consumers' willingness to pay across products, making the market less price-sensitive and allowing the firm to charge more.
Worked example
Two consumers, two products (Word and Excel), negligible marginal costs.
Word | Excel | |
|---|---|---|
Consumer 1 | $60 | $50 |
Consumer 2 | $50 | $60 |
Pricing options:
Price each at $60: sell one copy of each (only the consumer willing to pay $60 buys). Revenue = $120.
Price each at $50: sell two copies of each. Revenue = $200.
Bundle both for $110: both consumers value the bundle at $110 (60 + 50 = 110, and 50 + 60 = 110). Sell two bundles. Revenue = $220.
Bundling wins because both consumers' total willingness to pay is identical ($110), even though their individual valuations differ. The bundle compresses the dispersion in willingness to pay from $10 per product down to $0 for the package.
A two-part tariff splits the price into a fixed fee (the "entry" charge) and a per-unit price. The classic example is a theme park: pay for admission, then pay per ride.
How the monopolist optimises
Set the per-unit price p* for rides. At that price, the consumer demands x* rides and enjoys a certain amount of consumer surplus.
The maximum admission fee the park can charge is exactly that consumer surplus: the consumer is willing to pay up to their entire surplus just to get in and access rides at price p*.
As the per-unit price rises, the consumer's surplus (and therefore their willingness to pay for entry) falls, and vice versa.
The key insight
If the park can charge each customer their individual consumer surplus as the entry fee, the optimal per-unit price is marginal cost. This is because setting p = MC maximises the total surplus available, and the entry fee captures it all. This is equivalent to perfect price discrimination.
The Disneyland conclusion
Disneyland charges a high entry fee and does not charge per ride. This implies that the marginal cost of an additional ride is less than the transaction cost of collecting individual ride fees. The pricing schedule approximates first-degree price discrimination.
Pure monopolies are rare. Most firms face competitors selling similar products. When firms sell differentiated products (each has a monopoly on its own variant, but substitutes exist), we call the market structure monopolistic competition.
The Hotelling model (spatial competition)
Imagine a street with consumers evenly distributed along it.
One food truck: locates at the centre to minimise the average distance to all consumers.
Two food trucks selling the same food: the socially optimal placement is at the one-third and two-thirds points. But each truck has an incentive to move towards the centre to capture more than half the market.
The equilibrium: both trucks locate right next to each other at the centre. Neither can gain by moving once they are both there.
Application to product differentiation
The Hotelling result extends beyond physical location. Competitors will imitate each other's products as closely as possible to capture each other's customers. This is why competing brands often look strikingly similar (the "minimum differentiation" result).
Zero-profit equilibrium
With free entry, new firms enter until economic profit is zero. As more firms enter with differentiated products, each firm's demand curve shifts inward (fewer units at every price) and becomes more elastic (more substitutes available). In the long run, the demand curve is tangent to the average cost curve: the firm earns zero economic profit.
Why it is still inefficient
Even at zero profit, price remains above marginal cost. The market does not reach an efficient equilibrium. There is excess capacity: too many firms, each producing a shallow variety of products at less than the cost-minimising scale.
The deadweight loss persists because each firm retains some market power (its product is slightly differentiated), but competition erodes the ability to price-discriminate or earn profit from that power.
Microsoft Office bundles Word, Excel and PowerPoint. Individually, consumers' willingness to pay varies widely per product; the bundle compresses that variation and lets Microsoft charge a higher total price.
Razors and razor blades follow a two-part tariff: the handle is sold cheaply (or given away), and the blades carry a high per-unit price. The entry fee is low; the per-unit charge is where the profit sits.
Theme parks (Disneyland, Six Flags) charge high admission and either free or low-cost rides, approximating perfect price discrimination through the entry fee.
Competing smartphone brands (Apple vs Samsung) illustrate the Hotelling model: their flagship products converge in design, features and price point, clustering in the "centre" of the product space.
Students often think bundling always increases revenue. It does not. Bundling works best when consumers' valuations of the individual goods are negatively correlated (one values Word more, the other values Excel more). If both consumers value the same product most, bundling may not help.
A common mistake is treating two-part tariffs and price discrimination as unrelated. A two-part tariff where the entry fee equals consumer surplus is equivalent to first-degree price discrimination.
Students frequently assume monopolistic competition is efficient because profits are zero. Zero profit means P = AC, but price is still above marginal cost, so there is deadweight loss.
The Hotelling model tempts students to conclude that firms always cluster. The minimum-differentiation result depends on the assumptions (uniform distribution, identical products, no price competition). More complex models can produce maximum differentiation.
⚠️ Bundling numerical examples are common: be ready to compare revenue under separate pricing vs bundle pricing with a willingness-to-pay table.
⚠️ Two-part tariff questions often ask you to identify the optimal entry fee (= consumer surplus at the per-unit price) and the optimal per-unit price (= marginal cost, if the firm can charge personalised entry fees).
⚠️ For monopolistic competition, know the zero-profit tangency condition: demand is tangent to the AC curve in long-run equilibrium. Be able to draw and explain it.
⚠️ The Hotelling model is a conceptual favourite: expect a question asking you to explain why firms cluster or to apply the logic to product differentiation beyond physical location.
⚠️ Understand why monopolistic competition is inefficient despite zero profits: P > MC, excess capacity, deadweight loss persists.
True or false: Bundling is most effective when consumers have similar valuations for each individual good. (False, it works best when valuations are negatively correlated)
Fill in the blank: In a two-part tariff, the optimal per-unit price (when personalised entry fees are possible) equals _______. (Marginal cost)
True or false: In long-run monopolistic competition, firms earn zero economic profit. (True)
True or false: The Hotelling model predicts that competing firms will spread out evenly across the market. (False, they cluster at the centre)
Fill in the blank: In monopolistic competition, the zero-profit condition requires the demand curve to be _______ to the average cost curve. (Tangent)
Q: Two consumers value products A and B as follows: Consumer 1 values A at $80 and B at $30; Consumer 2 values A at $40 and B at $70. Marginal costs are zero. What is the revenue-maximising bundle price?
A: Consumer 1's total willingness to pay is $110; Consumer 2's is also $110. Set the bundle price at $110 and sell to both. Revenue = $220. Selling separately at best yields $80 + $70 = $150 (pricing each at the higher valuation) or $40 + $30 = $70 × 2 = $140 (pricing each at the lower valuation to sell two units). Bundling wins.
Q: A theme park has constant marginal cost of $2 per ride. A consumer's demand for rides is q = 20 – 2p. What per-ride price and admission fee maximise the park's profit from this consumer?
A: Set p = MC = $2. At that price, q = 20 – 2(2) = 16 rides. Consumer surplus = ½ × (10 – 2) × 16 = $64 (the demand curve hits zero quantity at p = 10). The admission fee = $64. Total revenue from this consumer = $64 + ($2 × 16) = $96.
Q: Explain the excess capacity result in monopolistic competition.
A: In long-run equilibrium, free entry drives profit to zero, so the demand curve is tangent to the average cost curve. Because the demand curve is downward-sloping, the tangency occurs on the falling portion of the AC curve, to the left of its minimum. Each firm produces less than the output that would minimise its average cost. There are too many firms, each underproducing, which is the excess capacity.
Q: In the Hotelling model with two vendors on a street, why is the Nash equilibrium at the centre, and why is this socially suboptimal?
A: Each vendor captures all consumers closer to it than to the rival. If one vendor is to the left of centre, the other can move just to its right and capture more than half the market. Both keep moving inward until they meet at the centre. This is a Nash equilibrium because neither can gain by moving. It is socially suboptimal because consumers at the ends of the street must now travel further than they would if the vendors were at the one-third and two-thirds points.
Bundling and two-part tariffs are extensions of the price discrimination framework from Part 1 of these notes. The welfare analysis of monopolistic competition connects to general equilibrium and efficiency: even with free entry and zero profit, markets with differentiated products do not reach the competitive ideal. The Hotelling model reappears in political science (median voter theorem) and in industrial organisation whenever firms choose product positioning.
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