Transcript price discrimination

Chapter 10
Pricing with
Market Power
Table of Contents
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10-2
10.1
10.2
10.3
10.4
10.5
10.6
10.7
Price Discrimination
Perfect Price Discrimination
Group Price Discrimination
Nonlinear Price Discrimination
Two-Part Pricing
Bundling
Peak-Load Pricing
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Introduction
• Managerial Problem
– Heinz dominates the ketchup market in the U.S., Canada, and U.K. When Heinz goes
on sale, switchers purchase Heinz rather than the low-price generic ketchup.
– How can Heinz’s managers design a pattern of sales that maximizes Heinz’s profit?
Under what conditions does it pay for Heinz to have a policy of periodic sales?
• Solution Approach
– We need to examine how monopolies and other noncompetitive firms set prices.
These firms can earn a higher profit setting different prices for the same good or
service depending on consumer’s willingness to pay (non-uniform pricing).
• Empirical Methods
– Types of non-uniform pricing include price discrimination, two-part pricing, bundling,
and peak-load pricing.
– We will review the characteristics and conditions for each of these types of nonuniform pricing.
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10.1 Price Discrimination
• Why Price Discrimination Pays
– For almost any good or service, some consumers are willing to pay more
than others.
– Price discrimination increases profit above the uniform pricing level
through two channels.
• Channel 1: Higher Prices for Some
– Price discrimination can extract additional consumer surplus from
consumers who place a high value on the good.
– In panel a of Table 10.1, the theater sells the same number of seats but
makes more money from the college students. Students pay $20, seniors
pay $10 and the theater captures all consumer surplus from both groups.
• Channel 2: Attract New Customers
– Price discrimination can simultaneously sell to new customers who would
not be willing to pay the profit-maximizing uniform price.
– In panel b of Table 10.1, the theater increases profit by selling 5 more
tickets to seniors. Students pay $20 as before, seniors pay $10 and
neither group enjoys any consumer surplus.
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10.1 Price Discrimination
Table 10.1 Theater Profits Based on the
Pricing Method Used
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10.1 Price Discrimination
• 1st Condition, A Firm Must Have Market Power
– A monopoly, an oligopoly, or a monopolistically competitive firm might be
able to price discriminate. A perfectly competitive firm cannot.
• 2nd Condition, A Firm Must Identify Groups with Different Price
Sensitivity
– If consumers have different demands, a firm must identify how they
differ.
– Disneyland knows tourists and local residents differ in their willingness to
pay and use driver licenses to identify them.
• 3rd Condition, A Firm Must Prevent Resale
– If resale is easy, price discrimination doesn’t work because of only lowprice sales.
– The biggest obstacle to price discrimination is a firm’s inability to prevent
resale.
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10.1 Price Discrimination
• Price Discrimination and Equal Costs
– Price discrimination is based on charging different prices even for units of
a good that cost the same to produce.
• Different Prices and Different Costs
– Newsstand prices and subscription prices for magazines differ in large
part because of the higher cost of selling at a newsstand rather than
mailing magazines directly to consumers. This is not price discrimination.
• Price Discrimination
– If a magazine standard subscription rate is higher than a college student
subscription rate, it is price discrimination because the two subscriptions
are identical in every respect except the price.
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10.1 Price Discrimination
• Type 1, Perfect Price Discrimination
– The firm sells each unit at the maximum amount any customer is willing
to pay.
– Price differs across consumers, and may differ too for a given consumer.
• Type 2, Group Price Discrimination
– The firm charges each group of customers a different price, but it does
not charge different prices within the group.
• Type 3, Nonlinear Price Discrimination
– The firm charges a different price for large purchases than for small
quantities so that the price paid varies according to the quantity
purchased.
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10.2 Perfect Price Discrimination
• How a Firm Perfectly Price Discriminates
– A firm with market power that can prevent resale and has full information
about its customers’ willingness to pay price discriminates by selling each
unit at its reservation price—the maximum amount any consumer would
pay for it.
– The maximum price for any unit of output is given by the height of the
demand curve at that output level.
• Perfectly Price Discrimination: Price = MR
– A perfectly price-discriminating firm’s marginal revenue is the same as its
price.
– So, the firm’s marginal revenue curve is the same as its demand curve
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10.2 Perfect Price Discrimination
• Efficient But Consumer Surplus Equal to Zero
– Perfect price discrimination is efficient: It maximizes the sum of
consumer surplus and producer surplus.
– But, all the surplus goes to the firm, consumer surplus is zero.
– In Figure 10.2, at the competitive market equilibrium, ec,
consumer surplus is A + B + C and producer surplus is D + E. At
the perfect price discrimination equilibrium, Qd=Qc, no
deadweight loss occurs, all surplus goes to the monopoly.
– Consumer surplus is greatest with competition, lower with singleprice monopoly, and eliminated by perfect price discrimination
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10.2 Perfect Price Discrimination
Figure 10.2 Competitive, Single-Price, and
Perfect Price Discrimination Outcomes
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10.2 Perfect Price Discrimination
• Individual Price Discrimination
– Perfect price discrimination is rarely fully achieved in practice.
– Firms can still increase profits with imperfect individual price
discrimination: charge individual-specific prices to different consumers,
which may or may not be the consumers’ reservation prices.
• Transaction Costs and Price Discrimination
– It is often too difficult or costly to gather information about each
customer’s reservation price for each unit of the product (high transaction
costs).
– However, recent advances in computer technologies have lowered these
transaction costs.
– Hotels, car and truck rental companies, cruise lines, airlines, and other
firms are increasingly using individual price discrimination.
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10.3 Group Price Discrimination
• Conditions for Group Price Discrimination
– Group price discrimination: potential customers are divided into two or
more groups with different prices for each group (single price within a
group).
– Consumer groups may differ by age, location, or in other ways.
– A firm must have market power, be able to identify groups with different
reservation prices, and prevent resale.
• Group Price Discrimination with Two Groups
– Warner Brothers, legal monopoly by copyright, produces and sells the
Harry Potter and the Deathly Hallows Part 2 DVD.
– Warner engaged in group price discrimination by charging different prices
in various countries. Resale is not possible because DVDs have
incompatible formats.
– A graphical and mathematical approach in next slides.
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10.3 Group Price Discrimination
• Group Price Discrimination: A Graphic Approach
– If a firm can prevent resale between countries and has a common
MC, then it can maximize profit by acting like a traditional
monopoly in each country separately.
– In Figure 10.3, resale between the U.S. and the U.K. is not
possible (different DVD formats) and the common constant MC =
m = $1.
– Warner acts as a traditional monopoly in each country. U.S.
market: MRA=1, QA=5.8, pA=$29. U.K. market: MRB=1, QB=2,
pB=$39.
– Warner price group discriminates and maximizes profit.
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10.3 Group Price Discrimination
Figure 10.3 Group Pricing of the Harry Potter
DVD
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10.3 Group Price Discrimination
• Profit: (QA, QB) = πA(QA) + πB(QB) = [RA(QA) – mQA] +
[RB(QB) – mQB]
– Total profit is the sum of the American and British profits (π = πA + πB). In
each country, profit is revenue minus cost (both depend on the Q sold in
each country).
– To maximize profit: differentiate the monopoly’s profit function with
respect to each quantity, holding the other quantity fixed, and set
derivatives equal to zero.
• American Market: ∂(QA, QB) /∂QA= 0
– ∂(QA, QB) /∂QA= dRA(QA)/dQA – m = 0
– The monopoly sets MR = MC in this market, so MRA =
dRA(QA)/dQA = m
• British Market: ∂(QA, QB) /∂QB= 0
– ∂(QA, QB) /∂QB= dRB(QB)/dQB – m = 0
– The monopoly sets MR = MC in this market, so MRB =
dRB(QB)/dQB = m
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10.3 Group Price Discrimination
• Two Group Price Discrimination and Elasticities
– We know MRA = m = MRB
– We also know from Chapter 9 that MR = p (1 + 1/ε)
– So, MRA = pA (1 + 1/εA) = m = pB (1 + 1/εB) = MRB
• Implication: pB / pA = (1 + 1/εA) / (1 + 1/εB)
– The ratio of prices depend on the elasticity values in these two markets.
– Warner Brothers apparently believed that the British demand curve was
less elastic at its profit-maximizing prices than the U.S. demand curve (B
 –1.0263, A  -1.0357). Consequently, Warner charged British
consumers 34% more than U.S. customers, pB /pA = $39/$29 = 1.345.
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10.3 Group Price Discrimination
• Identifying Groups: Divide Buyers Based on Observable
Characteristics
– The firm believes observable characteristics are associated with unusually
high or low reservation prices or demand elasticities.
– Movie theaters price discriminate using the age of customers. Higher
prices for adults than for children.
• Identifying Groups: Divide Buyers Based on Their Actions
– Allow consumers to self-select the group to which they belong depending
on their opportunity cost of time.
– Customers may be identified by their willingness to spend time to buy a
good at a lower price (buy at the store; low opportunity cost) or to order
goods and services in advance of delivery (phone or online shopping; high
opportunity cost).
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10.3 Group Price Discrimination
• Effects on Total Surplus: Group Price Discrimination vs.
Perfect Competition
– Consumer surplus is greater and more output is produced with perfect
competition than with group price discrimination.
– Group price discrimination transfers some of the competitive consumer
surplus to the firm as additional profit and causes deadweight loss due to
reduced output.
• Effects on Total Surplus: Group Price Discrimination vs.
Single-Price Monopoly
– From theory alone, we cannot tell whether total surplus is higher if the
monopoly uses group price discrimination or if it sets a single price.
– The closer the firm comes to perfect price discrimination using group price
discrimination (many groups rather than just two), the more output it
produces, and the less production inefficiency—the greater the total
surplus.
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10.4 Nonlinear Price
Discrimination
• Characteristics and Conditions
– Many firms, with market power and no resale, are unable to determine
high reservation prices. However, such firms know a typical customer’s
demand curve is downward sloping.
– Such a firm can price discriminate by letting the price each customer pays
vary with the number of units the customer buys (nonlinear price
discrimination).
• Block Pricing vs. Single Price
– A firm charges one price per unit for the first block purchased and a
different price per unit for subsequent blocks. Used by gas, electric,
water, and other utilities.
– In panel a of Figure 10.4, the firm charges a price of $70 on any quantity
between 1 and 20— 1st block—and $50 for the 2nd block. In panel b, the
firm can set only a single price of $30. When block pricing consumer
surplus is lower, total surplus is higher and deadweight loss is lower. The
firm and society are better off but consumers lose.
– The more block prices that a firm can set, the closer the firm gets to
perfect price discrimination.
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10.4 Nonlinear Price
Discrimination
Figure 10.4 Block Pricing
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10.5 Two-Part Pricing
• Characteristics and Conditions
– Two-part pricing: a firm charges each consumer a lump-sum access fee
for the right to buy as many units of the good as the consumer wants at a
per-unit price.
– A consumer’s overall expenditure for amount q consists of two parts: an
access fee, A, and a per-unit price, p. Therefore, expenditure is E = A +
pq.
– To do it, a firm must have market power, know how individual demand
curves vary across its customers, and prevent resale.
• Two Part Pricing with Identical Consumers
– With identical customers, a firm can set a two-part price that is efficient
(p = MC) and all total surplus goes to the firm (CS = 0).
– In panel a of Figure 10.5, the monopoly charges a per-unit fee price, p,
equal to the marginal cost of 10, and an access fee, A = 2,450 = CS. The
firm’s total profit is 2,450 times the number of identical customers.
– If the firm were to charge a price above its marginal cost of 10, it would
sell fewer units and make a smaller profit. For instance, p = 20 in panel b
of Figure 10.5.
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10.5 Two-Part Pricing
Figure 10.5 Two-Part Pricing with Identical
Consumers
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10.5 Two-Part Pricing
• Two-Part Pricing with Different Consumers
– Two-part pricing is more complex if consumers have different demand
curves.
– Having two different demands implies consumers have different consumer
surpluses. Two-part pricing would require the monopolist to charge
different access fees, and this may not be possible.
• Example
– In Figure 10.6, the monopoly faces two consumers. Valerie’s demand
curve is D1 in panel a, and Neal’s demand curve is D2 in panel b.
– If the monopoly can charge different prices, it sets price for both
customers at p = MC = 10 and access fee of 2,450 to Valerie and 4,050
to Neal. π = 6,500
– If the monopoly cannot charge its customers different access fees, it sets
its per-unit price at p = 20, where Valerie purchases 60 and Neal buys 80
units. It charges both the same access fee of 1,800 = A1 , which is
Valerie’s CS. π = 5,000
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10.5 Two-Part Pricing
Figure 10.6 Two-Part Pricing with Different
Consumers
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10.6 Bundling
• Bundling and Types of Bundling
– Firms with market power often pursue a pricing strategy called
bundling: selling multiple goods or services for a single price.
– Most goods are bundles of many separate parts. However, firms
sometimes bundle even when there are no production advantages
and transaction costs are small.
– Bundling allows firms to increase their profit by charging different
prices to different consumers based on the consumers’
willingness to pay.
– Some firms engage in pure bundling: only a package deal is
offered (a cable company sells a bundle of Internet, phone, and
television for a single price, no service separately)
– Other firms use mixed bundling: goods are available as a package
or separately.
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10.6 Bundling
• Pure Bundling
– Microsoft Works is a pure bundle. Word and Excel
programs are not sold individually but only as part of the
bundle Works.
– Whether it pays for Microsoft to sell a bundle or sell the
programs separately depends on how reservation prices for
the components vary across customers.
– Bundling increases profits if reservation prices are
negatively correlated and it reduces profits it they are
positively correlated.
– We assume the marginal cost of producing an extra copy of
either type of software is essentially zero; fixed cost is
negligible so that the firm’s revenue equals its profit; the
firm must charge all customers the same price—it cannot
price discriminate.
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10.6 Bundling
• Profitable Pure Bundling: Reservation Prices Negatively
Correlated
– Table 10.2 shows the reservation prices for two customers and two
products.
– The reservation prices are negatively correlated: the customer who has
the higher reservation price for one product has the lower reservation
price for the other product.
– If the firm sells the two products separately, it maximizes its profit by
charging $90 for the word processor and selling it to both consumers, and
selling the spreadsheet program for $50 to both consumers. The firm’s
total profit from selling the programs separately is $280 (= $180 +
$100).
– If the firm sells the two products in a bundle, it maximizes its profit by
charging 160, selling to both customers, and earning $320. Pure bundling
is more profitable.
– Pure bundling is more profitable because the firm captures more of the
consumers’ potential consumer surplus—their reservation prices.
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10.6 Bundling
Tables 10.2 Negatively Correlated Reservation Prices
Table 10.3 Positively Correlated Reservation Prices
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10.6 Bundling
• Non-Profitable Pure Bundling: Reservation Prices Positive
Correlated
– Table 10.3 shows the reservation prices for two customers and two
products.
– The reservation prices are positively correlated: a higher reservation price
for one product is associated with a higher reservation price for the other
product.
– If the programs are sold separately, the firm charges $90 for the word
processor, sells to both consumers, and earns $180. However, it makes
more charging $90 for the spreadsheet program and selling it only to
Carol. The firm’s total profit if it prices separately is $270 (= $180 +
$90).
– If the firm uses pure bundling, it maximizes its profit by charging $130 for
the bundle, selling to both customers, and making $260.
– Because the firm earns more selling the programs separately, $270, than
when it bundles them, $260, pure bundling is not profitable in this
example. As long as reservation prices are positively correlated, pure
bundling cannot increase the profit.
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10.6 Bundling
• Mixed Bundling
– Under mixed bundling, consumers are allowed to buy the pure
bundle or to buy any of the bundle’s components separately.
– Table 10.4 shows the reservation prices of four potential
customers for two products.
– Aaron, a writer, places high value on the word processing
program but has relatively little use for a spreadsheet. Dorothy,
an accountant, has the opposite pattern of preferences. Brigitte
and Charles have intermediate reservation prices that are
negatively correlated.
– If the firm prices each program separately, it maximizes its profit
by charging $90 for each product and selling each to three
customers. It earns $540 total.
– If the firm engage in pure bundling, it can charge $150 for the
bundle, sell to all four consumers, and earns $600 total.
– If the firm does mixed bundling, it can charge $160 for the
bundle to two consumers and $120 for each product separately to
the other two consumers. It earns $640 total.
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10.6 Bundling
Table 10.4 Reservation Prices and Mixed
Bundling
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10.6 Bundling
• Requirement Tie-In Sales
– Requirement tie in sales is another form of bundling: requires customers
who buy one product from a firm to make all concurrent and subsequent
purchases of a related product from that firm.
– This requirement allows the firm to identify heavier users and charge
them more per unit.
• Example
– If a printer manufacturer can require that consumers buy their ink
cartridges only from the manufacturer, then that firm can capture most of
the consumers’ surplus.
– Heavy users of the printer, who presumably have a less elastic demand
for it, pay the firm more than light users because of the high cost of the
ink cartridges.
– Printer firms such as Hewlett-Packard (HP) write their warranties to
strongly encourage consumers to use only their cartridges and not to refill
them.
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10.7 Peak-Load Pricing
Prices & Peak Demand
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Figure 10.7 Peak-Load
Pricing
Managerial Solution
• Managerial Problem
– How can Heinz’s managers design a pattern of sales that
maximizes Heinz’s profit? Under what conditions does it
pay for Heinz to have a policy of periodic sales?
• Solution
– By putting Heinz on sale periodically, Heinz’s managers can
price discriminate.
– Every n days, the typical consumer buys either Heinz or
generic ketchup. Switchers are price sensitive, always
know when Heinz is on sale and buy it. Loyal customers do
not distort their shopping patterns solely to buy Heinz on
sale.
– If there are more switchers than loyal customers, then
having sales is more profitable than selling at a uniform
price to only loyal customers.
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Figure 10.1 Perfect Price
Discrimination
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