Transcript Chapter 1

Chapter 11
Pricing with
Market Power
Topics to be Discussed

Capturing Consumer Surplus

Price Discrimination

Intertemporal Price Discrimination and
Peak-Load Pricing

The Two-Part Tariff
Chapter 11
Slide 2
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 3
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 4
Capturing Consumer Surplus
$/Q
Pmax
Between 0 and Q*, consumers
will pay more than
P*--consumer surplus (A).
A
P1
P*
B
PC is the price
that would exist in
a perfectly competitive
market.
P2
MC
PC
If price is raised above
P*, the firm will lose
sales and reduce profit.
D
Beyond Q*, price will
have to fall to create a
consumer surplus (B).
MR
Q*
Chapter 11
Quantity
Slide 5
Capturing Consumer Surplus
$/Q
Pmax
A
P1
•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
P*
B
P2
MC
PC
D
MR
Q*
Chapter 11
Quantity
Slide 6
Capturing Consumer Surplus
$/Q
Pmax
Question
How can the firm
capture the consumer surplus
in A and sell profitably in B?
A
P1
P*
B
P2
MC
PC
Answer
Price discrimination
Two-part tariffs
D
MR
Q*
Chapter 11
Quantity
Slide 7
Capturing Consumer Surplus

Price discrimination is the charging of
different prices to different consumers
for similar goods.
Chapter 11
Slide 8
Price Discrimination

First Degree Price Discrimination

Chapter 11
Charge a separate price to each customer:
the maximum or reservation price they are
willing to pay.
Slide 9
Additional Profit From Perfect FirstDegree Price Discrimination
$/Q
Pmax
Without price discrimination,
output is Q* and price is P*.
Variable profit is the area
between the MC & MR (yellow).
Consumer surplus is the area
above P* and between
0 and Q* output.
MC
P*
With perfect discrimination, each
consumer pays the maximum
price they are willing to pay.
PC
D = AR
Output expands to Q** and price
falls to PC where MC = MR = AR = D.
Profits increase by the area above MC
between old MR and D to output
Q** (purple)
MR
Q*
Chapter 11
Q**
Quantity
Slide 10
Additional Profit From Perfect FirstDegree Price Discrimination
$/Q
Pmax
Consumer surplus when a
single price P* is charged.
With perfect discrimination
• Each customer pays their
reservation price
•Profits increase
Variable profit when a
single price P* is charged.
MC
P*
Additional profit from
perfect price discrimination
PC
D = AR
MR
Q*
Chapter 11
Q**
Quantity
Slide 11
Additional Profit From Perfect FirstDegree Price Discrimination

Question


Why 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 12
Second-Degree Price Discrimination

Practice of charging different prices per
unit for different quantities of the same
good or service
Chapter 11
Slide 13
Second-Degree Price Discrimination
Second-degree price
discrimination is pricing
according to quantity
consumed--or in blocks.
$/Q
P1
Without discrimination: P = P0
and Q = Q0. With second-degree
discrimination there are three
prices P1, P2, and P3.
(e.g. electric utilities)
P0
P2
AC
P3
MC
D
MR
Q1
1st Block
Q0
Q2
Q3
2nd Block 3rd Block
Quantity
Second-Degree Price Discrimination
$/Q
Economies of scale permit:
•Increase consumer welfare
•Higher profits
P1
P0
P2
AC
P3
MC
D
MR
Q1
1st Block
Q0
Q2
Q3
2nd Block 3rd Block
Quantity
Price Discrimination

Third Degree Price Discrimination
1) Divides the market into two-groups.
2) Each group has its own demand
function.
Chapter 11
Slide 16
Third-Degree Price Discrimination
$/Q
Consumers are divided into
two groups, with separate
demand curves for each group.
MRT = MR1 + MR2
D2 = AR2
MRT
MR2
MR1
D1 = AR1
Quantity
Chapter 11
Slide 17
Third-Degree Price Discrimination
$/Q
MC = MR1 = MR2
P1
•QT: MC = MRT
•Group 1: P1Q1 ; more inelastic
•Group 2: P2Q2; more elastic
•MR1 = MR2 = MC
MC
P2
D2 = AR2
MRT
MR2
D1 = AR1
MR1
Q1
Chapter 11
Q2
QT
Quantity
Slide 18
Intertemporal Price
Discrimination and Peak-Load Pricing

Separating the Market With Time

Chapter 11
Initial release of a product, the demand is
inelastic

Book

Movie

Computer
Slide 19
Intertemporal Price
Discrimination and Peak-Load Pricing

Separating the Market With Time

Chapter 11
Once this market has yielded a maximum
profit, firms lower the price to appeal to a
general market with a more elastic demand

Paper back books

Dollar Movies

Discount computers
Slide 20
Intertemporal Price Discrimination
Consumers are divided
into groups over time.
Initially, demand is less
elastic resulting in a
price of P1 .
$/Q
P1
Over time, demand becomes
more elastic and price
is reduced to appeal to the
mass market.
P2
D2 = AR2
AC = MC
MR1
Q1
Chapter 11
MR2
D1 = AR1
Q2
Quantity
Slide 21
Intertemporal Price
Discrimination and Peak-Load Pricing
Peak-Load Pricing

Demand for some products may peak at
particular times.

Rush hour traffic

Electricity - late summer afternoons

Ski resorts on weekends
Chapter 11
Slide 22
Intertemporal Price
Discrimination and Peak-Load Pricing
Peak-Load Pricing

Capacity restraints will also increase
MC.

Increased MR and MC would indicate a
higher price.
Chapter 11
Slide 23
Intertemporal Price
Discrimination and Peak-Load Pricing
Peak-Load Pricing

MR is not equal for each market
because one market does not impact
the other market.
Chapter 11
Slide 24
Peak-Load Pricing
$/Q
MC
Peak-load
price = P1 .
P1
D1 = AR1
Off- load
price = P2 .
P2
MR1
D2 = AR2
MR2
Q2
Chapter 11
Q1
Quantity
Slide 25
The Two-Part Tariff

The purchase of some products and
services can be separated into two
decisions, and therefore, two prices.
Chapter 11
Slide 26
The Two-Part Tariff

Examples
1) Amusement Park

Pay to enter

Pay for rides and food within the park
2) Tennis Club
Chapter 11

Pay to join

Pay to play
Slide 27
The Two-Part Tariff

Pricing decision is setting the entry
fee (T) and the usage fee (P).

Choosing the trade-off between freeentry and high use prices or high-entry
and zero use prices.
Chapter 11
Slide 28
Two-Part Tariff with a Single Consumer
$/Q
T*
P*
Usage price P*is set where
MC = D. Entry price T*
is equal to the entire
consumer surplus.
MC
D
Quantity
Chapter 11
Slide 29
Two-Part Tariff with Two Consumers
$/Q
T*
The price, P*, will be
greater than MC. Set T*
at the surplus value of D2.
  2T *  ( P*  MC ) x(Q1  Q2 )
 more than twic e ABC
A
P*
MC
B
C
D1 = consumer 1
D2 = consumer 2
Q2
Chapter 11
Q1
Quantity
Slide 30
The Two-Part Tariff

The Two-Part Tariff With Many Different
Consumers

No exact way to determine P* and T*.

Must consider the trade-off between the
entry fee T* and the use fee P*.

Chapter 11
Low entry fee: High sales and falling
profit with lower price and more entrants.
Slide 31
The Two-Part Tariff

The Two-Part Tariff With Many Different
Consumers

To find optimum combination, choose
several combinations of P,T.

Choose the combination that maximizes
profit.
Chapter 11
Slide 32
The Two-Part Tariff

Rule of Thumb

Similar demand: Choose P close to MC
and high T

Dissimilar demand: Choose high P and low
T.
Chapter 11
Slide 33
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.
Chapter 11
Slide 34
Summary

Ideally, the firm would like to perfectly
price discriminate.

The two-part tariff is another means of
capturing consumer surplus.
Chapter 11
Slide 35
End of Chapter 11
Pricing with
Market Power