Transcript IPPTChap014x

Learning Objectives
 Explain why uniform pricing does not generate maximum
possible total revenue and how price discrimination can
generate more revenue
 Explain how to practice first‐degree price discrimination
 Explain how to practice second‐degree price
discrimination
 Explain how to practice third‐degree price discrimination
 Determine profit‐maximizing prices when a firm sells
multiple products related in consumption and explain how
firms can profitably bundle products for a single price
 Understand why cost‐plus pricing usually fails to
maximize profit
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Advanced Pricing Techniques
 Price discrimination
 Multiple products
 Cost-plus pricing
14-2
Capturing Consumer Surplus
 Uniform pricing
~ Charging the same price for every unit of the
product
 Price discrimination
~ More profitable alternative to uniform pricing
~ Market conditions must allow this practice to
be profitably executed
~ Technique of charging different prices for the
same product
~ Used to capture consumer surplus (turning
consumer surplus into profit)
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The Trouble with Uniform Pricing
(Figure 14.1)
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Price Discrimination
 Exists when the price-to-marginal cost
ratio differs between two products:
PA
PB

MC A MCB
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Price Discrimination
Three conditions necessary to practice
price discrimination profitably:
1) Firm must possess some degree of market
power
2) A cost-effective means of preventing resale
between lower- and higher-price buyers
(consumer arbitrage) must be implemented
3) Price elasticities must differ between
individual buyers or groups of buyers
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First-Degree (Perfect)
Price Discrimination
 Every unit is sold for the maximum price
each consumer is willing to pay
~ Allows the firm to capture entire consumer
surplus
 Difficulties
~ Requires precise knowledge about every
buyer’s demand for the good
~ Seller must negotiate a different price for every
unit sold to every buyer
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First-Degree (Perfect) Price
Discrimination (Figure 14.2)
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Second-Degree Price Discrimination
 Lower prices are offered for larger
quantities and buyers can self-select
the price by choosing how much to buy
 When the same consumer buys more
than one unit of a good or service at a
time, the marginal value placed on
additional units declines as more units
are consumed
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Second-Degree Price Discrimination
 Two-part pricing
~ Charges buyers a fixed access charge (A) to
purchase as many units as they wish for a constant
fee (f) per unit
~ Total expenditure (TE) for q units is: TE  A  fq
TE A  fq
Average price (p) is: p 

q
q
A
 f
q
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Second-Degree Price Discrimination
 When consumers have identical
demands, entire consumer surplus can
be captured by:
~ Setting f *= MC
~ Setting A* = consumer surplus (CS)
 Optimal usage fee when two groups of
buyers have identical demands is the
level for which MRf = MCf
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Inverse Demand Curve for Each of 100
Identical Senior Golfers (Figure 14.3)
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Demand at Northvale Golf Club
(Figure 14.4)
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Second-Degree Price Discrimination
 Declining block pricing
~ Offers quantity discounts over successive
discrete blocks of quantities purchased
 Most customers are willing to pay more
for the first unit than for successive
units:
~ the typical customer’s demand curve is
downward sloping.
 Block-pricing schedules - charge one
price for the first few units (a block) of
14-14
usage and a different price for
Application: Buying
Discounts
Firms use various approaches to induce
consumers to indicate whether they have
relatively high or low elasticities of
demand.
By spending extra time to obtain a
discount, price-sensitive consumers are
able to differentiate themselves.
~
~
~
~
Coupons
Airline Tickets
Reverse Auction
Rebates
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Block Pricing with Five Blocks
(Figure 14.5)
14-16
Block Pricing
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Block Pricing (cont.)
Consumer pays 70*20 + 50*20. Monopolist charges single price and sells
30 units at $60.
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Third-Degree Price Discrimination
 If a firm sells in two markets, 1 & 2
~ Allocate output (sales) so MR1 = MR2
~ Optimal total output is that for which
MRT = MC
 For profit-maximization, allocate sales
of total output so that
MRT = MC = MR1 = MR2
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Third-Degree Price Discrimination
 Equal-marginal-revenue principle
~ Allocating output (sales) so MR1 = MR2
which will maximize total revenue for the
firm (TR1 + TR2)
~ More elastic market gets lower price
~ Less elastic market gets higher price
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Allocating Sales Between Markets
(Figure 14.6)
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Constructing the Marginal Revenue
Curve (Figure 14.7)
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Profit-Maximization Under Third-Degree
Price Discrimination (Figure 14.8)
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Multiple Products
 Related in consumption
~ For two products, X & Y, produce & sell
levels of output for which
MRX = MCX and MRY = MCY
~ MRX is a function not only of QX but also
of QY (as is MRY) – conditions must be
satisfied simultaneously
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Bundling Multiple Products
 When price discrimination is not possible,
bundling multiple goods and charging a
single price can be more profitable than
charging individual prices for multiple
goods
 Two conditions for profitable bundling
~ Consumers must have different demand
prices for each good in the bundle
~ Demand prices must be negatively correlated
across consumer types
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Cost-Plus Pricing
 Common technique for pricing when firms
do not wish to estimate demand & cost
conditions to apply the MR = MC rule for
profit-maximization
 Price charged represents a markup
(margin) over average cost:
P = (1 + m) ATC
Where m is the markup on unit cost
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Cost-Plus Pricing
 Does not generally produce profitmaximizing price
~ Fails to incorporate information on demand
& marginal revenue
~ Uses average, not marginal, cost
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Practical Problems with
Cost-Plus Pricing (Figure 14.9)
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Summary
 Managers wish to avoid uniform pricing because it
creates too much consumer surplus
~ Price discrimination: charging different prices for the same
product for the purpose of capturing consumer surplus and
turning it into economic profit
 Under first-degree price discrimination, the firm charges
each consumer the maximum price he is willing to pay
for every unit he purchases
 Second-degree price discrimination reduces the
average price as the amount purchased increases and
lets buyers self-select the price they pay by choosing
how much to buy
~ Two methods: two-part pricing and declining block pricing
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Summary
 When a firm sells in two distinct markets, 1 & 2, it can
practice third-degree price discrimination by allocating
output or sales between the two markets such that
MR1 = MR2
 When a firm produces two products, X & Y, the firm
maximizes profit by producing and selling output levels
for which MRX = MCX and MRY = MCY
 Managers who use cost-plus pricing to set prices will fail
to maximize profit because cost-plus pricing faces a
number of practical and theoretical problems
~ Cost-plus pricing is flawed because it employs average rather
than marginal cost, and it does not incorporate consideration of
demand conditions
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