Study Unit 11 Pricing with Market Power
Jan 18, 2018
Study Unit 11Pricing with Market Power
• Why and how is consumer surplus captured.• How is price discrimination used to capture
consumer surplus.• How is market power used to implement two-
part tariff.• Pricing strategy of bundling.• Use of advertising by firms.
Outcomes
Capturing consumer surplus
• How do firms with market power capture more consumer surplus and transfer it to the producer?– Pricing Strategies!
• Can achieve by charging different prices to different consumers and not just a single price.
• Basis for price discrimination:– Practice of charging different prices to different
consumers for similar goods.
Capturing consumer surplus
Capturing consumer surplus
• Problem:– How to identify different consumers?– How to get them to pay different prices?
Price discrimination
• Three broad forms:– First Degree Price Discrimination• Perfect Price Discrimination• Imperfect Price Discrimination
– Second Degree Price Discrimination– Third Degree Price Discrimination
First-Degree Price Discrimination
• If firm could → Charge maximum price customer willing to pay. = Reservation Price
• Assume consumer buy one unit.• Practice of charging reservation price
= First-degree price discrimination
First-Degree Price Discrimination
First-Degree Price Discrimination• How does this affect profit?– Add profit from each additional unit bought= Variable profit (Yellow)
• Perfect price discrimination:– Variable profit given for each unit = Demand curve – MC– Never possible!• Impossible to charge different price to different
consumers.• Firm usually doesn’t know reservation price.
First-Degree Price Discrimination
• Imperfect price discrimination:– Charging few different prices based on estimates of
reservation price– Used by doctors, lawyers, architects or accountants
First-Degree Price Discrimination
Second-Degree Price Discrimination• Consumer purchase many different units =
reservation price will decline• Example: water, heat, fuel and electricity• Willingness to pay decline with increased
consumption.– Conservation easier and more worthwhile if price
then high= Second-degree price discrimination
Practice of charging different prices per unit for different quantities of the same good or service
Second-Degree Price Discrimination
Second-Degree Price Discrimination
• Another example = Block pricing and quantity discounts
• Block Pricing: Practice of charging different prices for different quantities or blocks of a good
• Quantity discounts = Different prices for different quantities purchased.
Third-Degree Price discrimination
• Practice of dividing consumers into:– two or more groups – with separate demand curves, and – charging different prices for each group.
• Examples:– Regular vs. special airfares– Canned or frozen vegetables– Discounts to students or senior citizens
Third-Degree Price discrimination
• Which price to pay?– Create consumer groups:• According to socio-economic characteristics• Divide total output between groups• MR1=MR2=MC
– Determine relative price:• Relate to elasticity of demand• P1/P2 = (1+1/E2) / (1+1/E1)
Third-Degree Price discrimination
Third-Degree Price discrimination
• Not always worthwhile to sell to more than one group.– Demand too
small– MC to high
Intertemporal price discrimination• Practice of:– Separating consumers – With different demand functions into different groups– By charging different prices– At different points in time
• Example: – Higher price for first-run movie and lower price after
a year.– High price for hard-cover book and bring out a
paperback version later at a lower price
Intertemporal price discrimination
Peak-loading pricing
• The practice of:– Charging higher prices– During peak periods– When capacity constraints cause high MC
• Increase economic efficiency by charging price close to MC.
• Example of peak times:– Amusement park over weekends and holidays– Roads during morning and afternoon traffic
Peak-loading pricing
Two-part tariff
• Only need to know the definition on page 406• Leave page 407-413• Definition:– Form of pricing in which consumer is charged both
entry and usage fee.– Example: Amusement park entry fee and price
per ride.
Bundling• ‘Gone with the wind’ and ‘Getting Gertie’s
Garter’• Theatres had to lease both• Two films were bundled = sold as a package• Bundling:– The practice of selling two or more products as a
package.– Why bundle?• When customer has heterogeneous demands and firm
can’t price discriminate.
Bundling
• Used to firms advantage:– Reservation price for two films
– Rented separately: Max price $10 000 = Theatre B– Total revenue = $26 000– If bundled: A = $15 000 and B = $14 000– Thus charge $14 000 and revenue total = $28 000
Gone with the Wind Getting Gertie’s Garter
Theater A $12 000 $3 000
Theater B $10 000 $4 000
Relative valuations
• Why is bundling profitable?– Relative valuations of the two films are reversed– Thus, demand negatively correlated: Willing to
pay more for ‘wind’ than ‘Gertie’.– Why is this critical?• Make demand positively correlated• Describe preferences in next graph
Bundling
Bundling
Bundling
Bundling
Bundling
Mixed bundling
• Selling two or more goods both as a package and individually.
• Packaged price below separate price.• Pure bundling: Selling products only as a
package.• Mixed bundling ideal strategy for negatively
correlated demands.
Mixed bundling
Mixed bundling
Bundling in practice
• Buy vehicle and add-on’s: radio, sunroof, metallic colour, etc.
• When will manufacturers include add-on’s and when not.
• Going on vacation and paying for add-on’s: excursions, etc.
Bundling in practice
Tying
• Practice of requiring a customer to purchase one good in order to purchase another.
• Pure bundling a common form of tying.• Example: Sell copy machine and must get
paper.
Advertising
• Firms with market power have another important decision: How much to advertise?
• Advertising spending = A• Choose advertising expenditure to maximise
profit.
∏ = PQ(P,A) – C(Q) - A
Effects of Advertising