Chapter 11

Chapter 11Pricing with

Market Power

Chapter 11 Slide 2

Topics to be Discussed

Capturing Consumer Surplus

Price Discrimination

Intertemporal Price Discrimination and Peak-Load Pricing

Chapter 11 Slide 3

Topics to be Discussed

The Two-Part Tariff

Bundling

Advertising

Chapter 11 Slide 4

Introduction

Pricing without market power (perfect competition) is determined by market supply and demand.

The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits.

Chapter 11 Slide 5

Introduction

Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production.

Chapter 11 Slide 6


Quantity

$/Q

D

MR

Pmax

MC If price is raised above P*, the firm will lose

sales and reduce profit.PC

PC is the pricethat would exist in

a perfectly competitivemarket.

A

P*

Q*

P1

Between 0 and Q*, consumerswill pay more than

P*--consumer surplus (A).

B

P2

Beyond Q*, price willhave to fall to create a consumer surplus (B).

Chapter 11 Slide 7


•P*Q*: single P & Q @ MC=MR•A: consumer surplus with P*•B: P>MC & consumer would buy at a lower price•P1: less sales and profits•P2 : increase sales & and reduce revenue and profits•PC: competitive price

Quantity

$/Q

D

MR

Pmax

MCPC

A

P*

Q*

P1

B

P2

Chapter 11 Slide 8


Quantity

$/Q

D

MR

Pmax

MCPC

A

P*

Q*

P1

B

P2

QuestionHow can the firm

capture the consumer surplusin A and sell profitably in B?

AnswerPrice discrimination

Two-part tariffsBundling

Chapter 11 Slide 9


Price discrimination is the charging of different prices to different consumers for similar goods.

Chapter 11 Slide 10


First Degree Price DiscriminationCharge a separate price to each customer:

the maximum or reservation price they are willing to pay.

Chapter 11 Slide 11

P*

Q*

Without price discrimination,output is Q* and price is P*.Variable profit is the area

between the MC & MR (yellow).

Additional Profit From Perfect First-Degree Price Discrimination

Quantity

$/Q Pmax

With perfect discrimination, eachconsumer pays the maximumprice they are willing to pay.

Consumer surplus is the area above P* and between

0 and Q* output.

D = AR

MR

MC

Output expands to Q** and pricefalls to PC where MC = MR = AR = D.

Profits increase by the area above MCbetween old MR and D to output

Q** (purple)

Q**

PC

Chapter 11 Slide 12

P*

Q*

Consumer surplus when a single price P* is charged.

Variable profit when a single price P* is charged.

Additional profit fromperfect price discrimination

Quantity

$/Q Pmax

D = AR

MR

MC

Q**

PC

With perfect discrimination• Each customer pays their reservation price•Profits increase


Chapter 11 Slide 13

QuestionWhy would a producer have difficulty in

achieving first-degree price discrimination?

Answer

1) Too many customers (impractical)

2) Could not estimate the reservation price for each customer


Chapter 11 Slide 14


First Degree Price DiscriminationThe model does demonstrate the potential

profit (incentive) of practicing price discrimination to some degree.

Chapter 11 Slide 15


First Degree Price DiscriminationExamples of imperfect price discrimination

where the seller has the ability to segregate the market to some extent and charge different prices for the same product:

Lawyers, doctors, accountantsCar salesperson (15% profit margin)Colleges and universities

Chapter 11 Slide 16

First-Degree PriceDiscrimination in Practice

Quantity

D

MR

MC

$/Q

P2

P3

P*4

P5

P6

P1

Six prices exist resultingin higher profits. With a single price

P*4, there are few consumers andthose who pay P5 or P6 may have a surplus.

Q

Second-Degree Price Discrimination

Quantity

$/Q

D

MR

MCAC

P0

Q0

Without discrimination: P = P0 and Q = Q0. With second-degree

discrimination there are threeprices P1, P2, and P3.(e.g. electric utilities)

P1

Q1

1st Block

P2

Q2

P3

Q3

2nd Block 3rd Block

Second-degree pricediscrimination is pricing

according to quantityconsumed--or in blocks.

Second-Degree Price Discrimination

Quantity

$/Q

D

MR

MCAC

P0

Q0

P1

Q1

1st Block

P2

Q2

P3

Q3

2nd Block 3rd Block

Economies of scale permit:•Increase consumer welfare•Higher profits

Chapter 11 Slide 19


Third Degree Price Discrimination

1) Divides the market into two-groups.

2) Each group has its own demand function.

Chapter 11 Slide 20



3) Most common type of pricediscrimination.

Examples: airlines, liquor, vegetables, discounts to students and senior citizens.

Chapter 11 Slide 21



4) Third-degree price discrimination is feasible when the seller can separate his/her market into groups who have different price elasticities of demand (e.g. business air travelers versus vacation air travelers)

Chapter 11 Slide 22


Third Degree Price DiscriminationObjectives

MR1 = MR2

MC1 = MR1 and MC2 = MR2

MR1 = MR2 = MC

Chapter 11 Slide 23


Third Degree Price DiscriminationP1: price first group

P2: price second group

C(Qr) = total cost of QT = Q1 + Q2

Profit ( ) = P1Q1 + P2Q2 - C(Qr)

Chapter 11 Slide 24


Third Degree Price DiscriminationSet incremental for sales to group 1 = 0

0(

11

)11

1

QC

QQP

Q

MCQCMR

QQP

11

1

11 )(

Chapter 11 Slide 25


Third Degree Price DiscriminationSecond group of customers: MR2 = MC

MR1 = MR2 = MC

Chapter 11 Slide 26


Third Degree Price DiscriminationDetermining relative prices

)11()11(11

222111 EPMREPMREPMR d

:Then :Recall

Chapter 11 Slide 27


Third Degree Price DiscriminationDetermining relative prices

Pricing: Charge higher price to group with a low demand elasticity

)11()11(

1

2

2

1

EE

PP

:And

Chapter 11 Slide 28


Third Degree Price DiscriminationExample: E1 = -2 & E2 = -4

P1 should be 1.5 times as high as P2

5.12143)211()411(

2

1

PP

Chapter 11 Slide 29

Third-Degree Price Discrimination

Quantity

D2 = AR2

MR2

$/Q

D1 = AR1MR1

Consumers are divided intotwo groups, with separate

demand curves for each group.

MRT

MRT = MR1 + MR2

Chapter 11 Slide 30

Third-Degree Price Discrimination

Quantity

D2 = AR2

MR2

$/Q

D1 = AR1MR1

MRT

MC

Q2

P2

QT

•QT: MC = MRT

•Group 1: P1Q1 ; more elastic•Group 2: P2Q2; more inelastic•MR1 = MR2 = MC•QT control MC

Q1

P1

MC = MR1 at Q1 and P1

Chapter 11 Slide 31

No Sales to Smaller Market

Even if third-degree pricediscrimination is feasible, it doesn’t

always pay to sell to both groupsof consumers if marginal cost is rising.

Chapter 11 Slide 32

No Sales to Smaller Market

Quantity

D2

MR2

$/Q

MC

D1

MR1 Q*

P*

Group one, with demand D1, are not

willing to pay enoughfor the good to

make pricediscrimination profitable.

Chapter 11 Slide 33

The Economics of Coupons and Rebates

Those consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand.

Coupons and rebate programs allow firms to price discriminate.


Chapter 11 Slide 34

Price Elasticities of Demand for Users Versus Nonusers of Coupons

Toilet tissue -0.60 -0.66

Stuffing/dressing -0.71 -0.96

Shampoo -0.84 -1.04

Cooking/salad oil -1.22 -1.32

Dry mix dinner -0.88 -1.09

Cake mix -0.21 -0.43

Price ElasticityProduct Nonusers Users

Chapter 11 Slide 35

Cat food -0.49 -1.13

Frozen entrée -0.60 -0.95

Gelatin -0.97 -1.25

Spaghetti sauce -1.65 -1.81

Crème rinse/conditioner -0.82 -1.12

Soup -1.05 -1.22

Hot dogs -0.59 -0.77

Price ElasticityProduct Nonusers Users

Price Elasticities of Demand for Users Versus Nonusers of Coupons

Chapter 11 Slide 36


Cake Mix

Nonusers of coupons: PE = -0.21

Users: PE = -0.43

Chapter 11 Slide 37


Cake Mix Brand (Pillsbury)

PE: 8 to 10 times cake mix PE

Example

PE Users: -4

PE Nonusers: -2

Chapter 11 Slide 38


Using:

Price of nonusers should be 1.5 times users

Or, if cake mix sells for $1.50, coupons should be 50 cents

)11()11(

1

2

2

1

EE

PP

Chapter 11 Slide 39

Airline Fares

Differences in elasticities imply that some customers will pay a higher fare than others.

Business travelers have few choices and their demand is less elastic.

Casual travelers have choices and are more price sensitive.

Chapter 11 Slide 40

Elasticities of Demand for Air Travel

Price -0.3 -0.4 -0.9

Income 1.2 1.2 1.8

Fare CategoryElasticity First-Class Unrestricted Coach Discount

Chapter 11 Slide 41

Airline Fares

The airlines separate the market by setting various restrictions on the tickets.Less expensive: notice, stay over the

weekend, no refundMost expensive: no restrictions

Chapter 11 Slide 42

Intertemporal PriceDiscrimination and Peak-Load Pricing

Separating the Market With TimeInitial release of a product, the demand is

inelasticBookMovieComputer

Chapter 11 Slide 43

Separating the Market With TimeOnce this market has yielded a maximum

profit, firms lower the price to appeal to a general market with a more elastic demand

Paper back booksDollar MoviesDiscount computers


Chapter 11 Slide 44

Intertemporal Price Discrimination

Quantity

AC = MC

$/Q

Over time, demand becomesmore elastic and price

is reduced to appeal to the mass market.

Q2

MR2

D2 = AR2

P2

D1 = AR1MR1

P1

Q1

Consumers are dividedinto groups over time.

Initially, demand is lesselastic resulting in a

price of P1 .

Chapter 11 Slide 45

Demand for some products may peak at particular times.Rush hour trafficElectricity - late summer afternoonsSki resorts on weekends


Peak-Load Pricing

Chapter 11 Slide 46

Capacity restraints will also increase MC.

Increased MR and MC would indicate a higher price.

Peak-Load Pricing


Chapter 11 Slide 47

MR is not equal for each market because one market does not impact the other market.

Peak-Load Pricing


Chapter 11 Slide 48

MR1

D1 = AR1

MC

P1

Q1

Peak-load price = P1 .

Peak-Load Pricing

Quantity

$/Q

MR2

D2 = AR2

Off- load price = P2 .

Q2

P2

Chapter 11 Slide 49

How to Price a Best Selling Novel

What Do You Think?

1) How would you arrive at the price for the initial release of the hardbound

edition of a book?

Chapter 11 Slide 50


What Do You Think?

2) How long do you wait to release the paperback edition? Could the

popularity of the book impact your decision?

Chapter 11 Slide 51

What Do You Think?

3) How do you determine the price for the paperback edition?


Chapter 11 Slide 52

The Two-Part Tariff

The purchase of some products and services can be separated into two decisions, and therefore, two prices.

Chapter 11 Slide 53

The Two-Part Tariff

Examples

1) Amusement ParkPay to enterPay for rides and food within the park

2) Tennis ClubPay to joinPay to play

Chapter 11 Slide 54

The Two-Part Tariff

Examples

3) Rental of Mainframe ComputersFlat FeeProcessing Time

4) Safety RazorPay for razorPay for blades

Chapter 11 Slide 55

The Two-Part Tariff

Examples

5) Polaroid FilmPay for the cameraPay for the film

Chapter 11 Slide 56

The Two-Part Tariff

Pricing decision is setting the entry fee (T) and the usage fee (P).

Choosing the trade-off between free-entry and high use prices or high-entry and zero use prices.

Chapter 11 Slide 57

Usage price P*is set whereMC = D. Entry price T* is equal to the entire consumer surplus.

T*

Two-Part Tariff with a Single Consumer

Quantity

$/Q

MCP*

D

Chapter 11 Slide 58

D2 = consumer 2

D1 = consumer 1

Q1Q2

The price, P*, will be greater than MC. Set T* at the surplus value of D2.T*

Two-Part Tariff with Two Consumers

Quantity

$/Q

MC

A

BC

ABC e than twicmore )()(2 21

**

QQxMCPT

Chapter 11 Slide 59

The Two-Part Tariff

The Two-Part Tariff With Many Different ConsumersNo exact way to determine P* and T*.Must consider the trade-off between the

entry fee T* and the use fee P*.Low entry fee: High sales and falling

profit with lower price and more entrants.

Chapter 11 Slide 60

The Two-Part Tariff

The Two-Part Tariff With Many Different ConsumersTo find optimum combination, choose

several combinations of P,T.Choose the combination that maximizes

profit.

Chapter 11 Slide 61

Two-Part Tariff withMany Different Consumers

T

Profit

a :entry fee

s :sales

Total

T*

Total profit is the sum of the profit from the entry fee andthe profit from sales. Both

depend on T.

entrantsnnQMCPTTnsa

)()()(

Chapter 11 Slide 62

The Two-Part Tariff

Rule of ThumbSimilar demand: Choose P close to MC

and high TDissimilar demand: Choose high P and low

T.

Chapter 11 Slide 63

The Two-Part Tariff

Two-Part Tariff With A TwistEntry price (T) entitles the buyer to a

certain number of free unitsGillette razors with several bladesAmusement parks with some tokensOn-line with free time

Chapter 11 Slide 64

Polaroid Cameras

1971 Polaroid introduced the SX-70 camera

What Do You Think?How would you price the camera and film?

Chapter 11 Slide 65

Polaroid Cameras

Hint

cameras producing of costfilm producing of cost

sold cameras of numbersold film ofquantity

camera of pricefilm of price

)()(

)()(

2

1

21

nCQC

nQTP

nCQCnTPQ

Chapter 11 Slide 66

Pricing Cellular Phone Service

QuestionWhy do cellular phone providers offer

several different plans instead of a single two-part tariff with an access fee and per-unit charge?

Chapter 11 Slide 67

Bundling

Bundling is packaging two or more products to gain a pricing advantage.

Conditions necessary for bundlingHeterogeneous customersPrice discrimination is not possibleDemands must be negatively correlated

Chapter 11 Slide 68

Bundling

An example: Leasing “Gone with the Wind” & “Getting Gerties Garter.”The reservation prices for each theater and

movie are:

Gone with the Wind Getting Gertie’s Garter

Theater A $12,000 $3,000Theater B $10,000 $4,000

Chapter 11 Slide 69

Bundling

Renting the movies separately would result in each theater paying the lowest reservation price for each movie:Maximum price Wind = $10,000Maximum price Gertie = $3,000

Total Revenue = $26,000

Chapter 11 Slide 70

Bundling

If the movies are bundled:Theater A will pay $15,000 for bothTheater B will pay $14,000 for both

If each were charged the lower of the two prices, total revenue will be $28,000.

Chapter 11 Slide 71

Bundling

Negative Correlated: Profitable to Bundle

A pays more for Wind ($12,000) than B ($10,000).

B pays more for Gertie ($4,000) than A ($3,000).

Relative Valuations

Chapter 11 Slide 72

Bundling

If the demands were positively correlated (Theater A would pay more for both films as shown) bundling would not result in an increase in revenue.

Gone with the Wind Getting Gertie’s Garter

Theater A $12,000 $4,000Theater B $10,000 $3,000

Relative Valuations

Chapter 11 Slide 73

Bundling

If the movies are bundled:Theater A will pay $16,000 for bothTheater B will pay $13,000 for both

If each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films separately.

Chapter 11 Slide 74

Bundling

Bundling Scenario: Two different goods and many consumersMany consumers with different reservation

price combinations for two goods

Chapter 11 Slide 75

Reservation Pricesr2

(reservationprice Good 2)

r1 (reservation priceGood 1)

$5

$10

$5 $10

$6

$3.25 $8.25

$3.25

ConsumerA

ConsumerC

ConsumerB

Consumer A is willing to pay up to $3.25 for good 1 andup to $6 for good 2.

Chapter 11 Slide 76

Consumption Decisions WhenProducts are Sold Separately

r2

r1

P2

IIConsumers buy

only good 2

22

11

PRPR

P1

Consumers fall intofour categories basedon their reservation

price.IConsumers buy

both goods

22

11

PRPR

IIIConsumers buy

neither good

22

11

PRPR

IVConsumers buy

only Good 1

22

11

PRPR

Chapter 11 Slide 77

Consumption DecisionsWhen Products are Bundled

r2

r1

Consumers buy the bundlewhen r1 + r2 > PB

(PB = bundle price).PB = r1 + r2 or r2 = PB - r1

Region 1: r > PB

Region 2: r < PB

r2 = PB - r1

I

II

Consumersbuy bundle

(r > PB)

Consumers donot buy bundle

(r < PB)

Chapter 11 Slide 78

The effectiveness of bundling depends upon the degree of negative correlation between the two demands.

Consumption DecisionsWhen Products are Bundled

Chapter 11 Slide 79

Reservation Prices

r2

r1

P2

P1

If the demands are perfectly positivelycorrelated, the firm

will not gain by bundling.It would earn the same

profit by selling the goods separately.

Chapter 11 Slide 80

Reservation Prices

r2

r1

If the demands are perfectly negatively

correlated bundling is the ideal strategy--all the

consumer surplus canbe extracted and a higher

profit results.

Chapter 11 Slide 81

Movie Example

r2

r1

Bundling pays due to negative correlation

(Wind)

(Gertie)

5,000 14,00010,000

5,000

10,000

12,000

4,0003,000

B

A

Chapter 11 Slide 82

Bundling

Mixed BundlingSelling both as a bundle and separately

Pure BundlingSelling only a package

Chapter 11 Slide 83

Mixed Versus Pure Bundlingr2

r110 20 30 40 50 60 70 80 90 100

10

20

30

40

50

60

70

80

90

100

C2 = MC2

C2 = 30

Consumer A, for example, has a reservation price for good 1 that is below marginal cost c1.

With mixed bundling, consumer A is induced to buy only good 2, while

consumer D is induced to buy only good 1,reducing the firm’s cost.

A

B

D

C

C1 = MC1

C1 = 20 With positive marginalcosts, mixed bundling may be more profitable

than pure bundling.

Chapter 11 Slide 84

Bundling

ScenarioPerfect negative correlationSignificant marginal cost

Mixed vs. Pure Bundling

Chapter 11 Slide 85

Bundling

ObservationsReservation price is below MC for some

consumersMixed bundling induces the consumers to buy only

goods for which their reservation price is greater than MC

Mixed vs. Pure Bundling

Chapter 11 Slide 86

Bundling Example

Sell SeparatelyConsumers B,C, and D buy 1 and A buys 2

Pure BundlingConsumers A, B, C, and D buy the bundle

Mixed BundlingConsumer D buys 1, A buys 2, and B & C buys

the bundle

Chapter 11 Slide 87

Bundling Example

Sell separately $50 $90 ---- $150

Pure bundling ---- ---- $100 $200

Mixed bundling $89.95 $89.95 $100 $229.90

C1 = $20

C2 = $30

P1 P2 PB Profit

Chapter 11 Slide 88

Bundling

Sell Separately3($50 - $20) + 1($90 - $30) = $150

Pure Bundling4($100 - $20 - $30) = $200

Mixed Bundling ($89.95 - $20) + ($89.95 - $30) - 2($100 - $20 - $30) =

$229.90

C1 = $20 C2 = $30

Chapter 11 Slide 89

Bundling

Question

If MC = 0, would mixed bundling still be the most profitable strategy with perfect negative correlation?

Chapter 11 Slide 90

Mixed Bundlingwith Zero Marginal Costs

r2

r120 40 60 80 100

20

40

60

80

100

120

120

In this example, consumers B and C are willing to pay $20 more for the bundle

than are consumers A and D. With mixed bundling, the price of the bundle

can be increased to $120.A & D can be charged $90 for a single good.

C

10 90

10

90 AB

D

Chapter 11 Slide 91

Sell separately $80 $80 ---- $320

Pure bundling ---- ---- $100 $400

Mixed bundling $90 $90 $120 $420

P1 P2 PB Profit

Mixed Bundlingwith Zero Marginal Costs

Chapter 11 Slide 92

Bundling

Question

Why is mixed bundling more profitable with MC = 0?

Chapter 11 Slide 93

Bundling

Bundling in PracticeAutomobile option packagesVacation travelCable television

Chapter 11 Slide 94

Bundling

Mixed Bundling in PracticeUse of market surveys to determine

reservation pricesDesign a pricing strategy from the survey

results

Chapter 11 Slide 95

Mixed Bundling in Practice

r2

r1

The firm can first choose a pricefor the bundle and then try individual

prices P1 and P2 until total profitis roughly maximized.

P2

PB

PBP1

The dots are estimates of reservation prices for a

representative sample of consumers.

Chapter 11 Slide 96

The Complete Dinner Versus a la Carte:A Restaurant’s Pricing Problem

Pricing to match consumer preferences for various selections

Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.

Chapter 11 Slide 97

Bundling

TyingPractice of requiring a customer to

purchase one good in order to purchase another.

ExamplesXerox machines and the paper IBM mainframe and computer cards

Chapter 11 Slide 98

Bundling

TyingAllows the seller to meter the customer and

use a two-part tariff to discriminate against the heavy user

McDonald’sAllows them to protect their brand name.

Chapter 11 Slide 99

Advertising

AssumptionsFirm sets only one priceFirm knows Q(P,A)

How quantity demanded depends on price and advertising

Chapter 11 Slide 100

Q0

0

P0

Q1

1

P1

AR

MR

AR and MR are averageand marginal revenue whenthe firm doesn’t advertise.

MC

If the firm advertises, its average and marginalrevenue curves shift to

the right -- average costsrise, but marginal cost

does not.

AR’

MR’

AC’

Effects of Advertising

Quantity

$/Q

AC


Advertising

Choosing Price and Advertising Expenditure

adv. of MC full1

)(),(

AQMC

AQPMR

AQCAPPQ

Ads


Advertising

A Rule of Thumb for Advertising

ratio sales toAdv.

1)(

pricingfor /1/)(

PQA

AQ

QA

PMCP

AQP-MC

EPMCP P


Advertising

A Rule of Thumb for Advertising

Thumb of Rule

demand of elasticity Adv.

P

)(1)(

))((

PA

A

EEPQAEPMCPEAQQA


Advertising

A Rule of Thumb for AdvertisingTo maximize profit, the firm’s

advertising-to-sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand.


Advertising

An ExampleR(Q) = $1 million/yr$10,000 budget for A (advertising--1% of

revenues)EA = .2 (increase budget $20,000, sales

increase by 20%EP = -4 (markup price over MC is substantial)


Advertising

Question

Should the firm increase advertising?


Advertising

YESA/PQ = -(2/-.4) = 5%Increase budget to $50,000


Advertising

QuestionsWhen EA is large, do you advertise more or

less?When EP is large, do you advertise more or

less?


Advertising

Advertising: In PracticeEstimate the level of advertising for each of

the firmsSupermarketsConvenience storesDesigner jeansLaundry detergents

)3.01.0;10( to AP EE

);5( smallvery AP EE

)13.;43( to to AP EE

);43(

largevery to

A

P

EE


Summary

Firms with market power are in an enviable position because they have the potential to earn large profits, but realizing that potential may depend critically on the firm’s pricing strategy.

A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible.


Summary

Ideally, the firm would like to perfectly price discriminate.

The two-part tariff is another means of capturing consumer surplus.

When demands are heterogeneous and negatively correlated, bundling can increase profits.


Summary

Bundling is a special case of tying, a requirement that products be bought or sold in some combination.

Advertising can further increase profits.

End of Chapter 11Pricing with

Market Power

Chapter 11

Documents

separate price

qif price

consumer surplusquantity

pmc consumer

consumer surplusin

additional profit

market powerchapter

market supply