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Chapter 18 Pricing Policies McGraw-Hill/Irwin

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1 Chapter 18 Pricing Policies McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2 Main Topics Price discrimination: pricing to extract surplus
Perfect price discrimination Price discrimination based on observable customer characteristics Price discrimination base on self-selection 18-2

3 Price Discrimination: Pricing to Extract Surplus
Monopolist’s profit would be larger if he could solve two problems Consumers who buy some of the product receive some consumer surplus Monopolist could increase profit if he could charge them a higher price Consumers aren’t buying some units that they value less than the monopoly price but more than marginal cost Monopolist could increase profit if he could charge these buyers less for those units of the good Monopolist might be able to do better by price discriminating: charging different prices for different units of the same good 18-3

4 Price Discrimination: Pricing to Extract Surplus
To be able to price discriminate: A firm must have some market power If not, a price above marginal cost will result in zero sales The good or service must be difficult to resell Otherwise few sales will occur at the higher price Firm must also be able to distinguish sales for which the purchasers have a high willingness to pay from those they have a low willingness to pay A monopolist can perfectly price discriminate if he knows perfectly the customer’s willingness to pay for each unit he sells and can charge a different price for each unit 18-4

5 Price Discrimination: Pricing to Extract Surplus
Usually, a firm does not perfectly know a customer’s willingness to pay Two different ways to distinguish purchases for which the customer has a high vs. a low willingness to pay Price discrimination is based on observable customer characteristics when a firm can distinguish consumers with a high vs. low willingness to pay Price discrimination is based on self-selection when the firm offers a menu of alternatives Designed so that customers will make choices based on their willingness to pay In quantity-dependent pricing, the price a consumer pays for an additional unit depends on how many units she has bought 18-5

6 Perfect Price Discrimination
Under perfect price discrimination, the firm knows perfectly its customers’ willingness to pay Can set the price for each individual consumer equal to her willingness to pay Marginal revenue curve coincides with the market demand curve Profit-maximizing sales quantity occurs where the market demand curve crosses the marginal cost curve Monopolist produces the same quantity as would occur in a competitive industry Each consumer consumes the same quantity as they would under perfect competition No deadweight loss 18-6

7 Figure 18.2: Perfect Price Discrimination Sales Quantity

8 Two-Part Tariffs Two-part tariffs are another quantity-dependent pricing plan that allows a perfectly discriminating monopolist to maximize profit With a two-part tariff, consumers pay a fixed fee plus a separate per-unit price for each unit they buy Examples: amusement parks, rental car companies Commonly used by monopolists and firms whose market power falls short of monopoly Advantage is simplicity: name just two prices To maximize profit, set per-unit charge equal to marginal cost 18-8

9 Figure 18.4: Profit with a Two-Part Tariff
Per-unit charge equals marginal cost Fixed fee is the consumer’s surplus at that per-unit price Maximizes aggregate surplus Leaves the consumer no surplus 18-9

10 Sample Problem 1 (18.2): If the ice cream company from figure 18.2 (page 669) sells to Juan (whose demand curve is shown on page 524) using a two-part tariff with a per-cone price on $1.50, what is the largest fixed fee it can charge Juan and still persuade Juan to make a purchase? How does its total revenue from Juan under this two-part tariff compare to its total revenue from Juan when it sells Juan four cones, each priced at Juan’s willingness to pay for it? What is its total profit from Juan?

11 Price Discrimination Based on Observable Characteristics
Most often a firm’s ability to price discriminate is imperfect May be able to sort consumers into rough groups based on observable characteristics But know no more about their willingness to pay Cannot engage in quantity-dependent pricing because cannot track purchases Example: small town movie theater with four consumer groups (adults, seniors, students, kids) To maximize profit consider each group’s demand curve separately Set price to maximize profit earned from that group 18-11

12 Price Discrimination Based on Observable Characteristics
Set different prices whenever the groups have different elasticities of demand Charge a higher price to groups with less elastic demand Generally the group that will face the higher price is the one with the less elastic demand at the profit-maximizing no-discrimination price Starting at that price, monopolist will: Raise the price of the less elastic group Lower the price of the more elastic group Can find optimal prices and quantities for each group using algebra 18-12

13 Figure 18.5:Profit-Maximizing Price to Two Groups

14 Sample Problem 2 (18.4) Suppose moviegoer’s demand functions are QS = 800 – 100P and QA = 1600 – 100P for students and other adults respectively. Marginal cost is $3 per ticket. What prices will the monopolist set when she can discriminate and when she cannot? How will discrimination affect her profit?

15 Welfare Effects of Imperfect Price Discrimination
Profit is at least as large with discrimination as without Can always charge every group the same price, won’t charge different prices unless it benefits the firm Price discrimination affects different groups of consumers differently Worse off it my price rises as a result of discrimination, better off if it falls Two main effects on consumer and aggregate surplus: Different consumers pay different prices, inefficient because a consumer who faces a low price and decides to buy may have a lower willingness to pay than a consumer who faces a high price and decides not to buy May encourage the monopolist to sell more, increase both consumer and aggregate surplus Opposing effects can combine to either raise or lower consumer and aggregate surplus 18-15

16 Welfare Effects of Imperfect Price Discrimination
In Figure 18.7, total consumer surplus is smaller with discrimination The gain to college students is smaller than the loss to other adults Aggregate surplus is also smaller with discrimination Gain in profit ($800) is smaller than the loss in consumer surplus ($1,200) The number of tickets sold is the same But inefficiently distributed with discrimination 18-16

17 Figure 18.7: Welfare Effects of Price Discrimination

18 Sample Problem 3 (18.8) What is the effect of discrimination on consumer and aggregate surplus in exercise 18.4?

19 Price Discrimination and Market Power
In a competitive market, firms can’t price discriminate Price discrimination is a sign of a market that is not perfectly competitive Can be difficult to determine whether price discrimination exists in a market Different prices may reflect cost differences Market does not have to be very far from perfectly competitive to exhibit discrimination Oligopolists may price discriminate more than monopolists 18-19

20 Price Discrimination Based on Self-Selection
Often firms cannot distinguish between groups of consumers based on observable characteristics Price discrimination may still be possible Offer a menu of alternatives If properly designed, customers with different willingness to pay will choose different alternatives A common practice Examples: supermarket discounts for shoppers who clip coupons, wireless phone companies with multiple calling plans 18-20

21 Quantity-Dependent Pricing and Self-Selection
Recall that a perfectly discriminating monopolist maximizes profit with a two-part tariff This level of profit is not achievable when consumers’ characteristics are not directly observable If given the choice between two plans with the same per-minute price, all consumers will opt for the low-demand (low fixed fee) plan Consumers will not self-select based on willingness to pay The monopolist can often do better by raising the per-unit charge above its marginal cost Can do even better by offering a menu of different two-part tariffs 18-21

22 Figure 18.9: Two-Part Tariff with Two Types of Consumers

23 Clearvoice Wireless Example
Clearvoice is a wireless telephone monopolist in a rural area Two types of consumers, high-demand and low-demand Distinct monthly demand curves for wireless minutes for each group Clearvoice’s marginal cost is 10 cents If could observe consumer characteristics, would offer two-part tariff with 10-cent per-minute price Fixed fee for low-demand customers: $8 Fixed fee for high-demand customers: $40.50 18-23

24 Profit-Maximizing Two-Part Tariff
Suppose Clearvoice wants to offer a single two-part tariff Per-minute price of 10 cents and monthly fee of $40.50 High-demand customers accept Low-demand customers reject Per-minute price of 10 cents and monthly fee of $8 All consumer accept Which plan is better? If there are a large number of low-demand customers, $8 monthly fee is better May be even more profitable to raise per-minute fee above marginal cost 18-24

25 Profit-Maximizing Two-Part Tariff
If the monopolist plans on selling to both types of consumer it is always profitable to raise the per-unit price at least a little above marginal cost Regardless of the types’ relative proportions Would like to extract some of high-demand consumers’ surplus without changing surplus of low-demand consumer (already zero) Raise per-unit price to get more surplus from high-demand consumers Adjust fixed fee so low-demand consumers’ surplus is unchanged The smaller the faction of low-demand consumer, the more worthwhile it is to raise the per-unit price Deadweight loss from low-demand consumers increases 18-25

26 Figure 18.10: Benefits of Raising the Per-Minute Charge

27 Using Menus to Increase Profit
Can do even better by offering a menu of two-part tariffs, each designed to attract a specific type of consumer Can eliminate some deadweight loss by introducing a second tariff plan Extract more surplus from high-demand consumers by making the low-demand plan less attractive to high-demand customers 18-27

28 Eliminating Deadweight Loss of High-Demand Consumers
Suppose Clearvoice offers a pair of two-part tariffs One designed for low-demand consumers: Per-minute price of 20 cents, fixed fee of $4.50 Second option intended to attract high-demand customers: Per-minute price of 10 cents, equal to Clearvoice’s marginal cost Fixed fee should be set as high as possible without causing high-demand consumer to choose the other plan With menu of plans: Firm profits are higher from high-demand consumers Profits from low-demand consumers are the same Deadweight loss from high-demand consumers is eliminated and extracted as surplus 18-28

29 Figure 18.11: Menu of Two-Part Tariffs

30 Making the Low-Demand Plan Less Attractive
Can increase profit even more by making the low-demand plan less attractive to high-demand consumers That plan determines the fixed fee the firm can charge a high-demand consumer It is the level that makes the high-demand consumer indifferent between the two plans Limit the number of minutes a consumer can purchase in the 20-cent-per-minute plan Set the limit equal to the number low-demand consumers want Will have no effect on value a low-demand consumer derives Make the plan less attractive to high-demand customers Will increase the fixed fee Clearvoice can charge high-demand consumers for the 10-cent-per-minute plan 18-30

31 Figure 18.12: Capping Minutes

32 Menu of Two-Part Tariffs
A firm can often profit by offering a menu of choices Designed for different types of consumers To maximize its profits, firm should try to make each plan attractive to one group only And unattractive to other consumer groups Firm benefits from setting the per-unit price in the plan intended for consumers with the highest willingness to pay equal to the marginal cost Eliminates deadweight loss for those consumers 18-32

33 Sample Problem 4 (18.12): Air Shangrila sells to both tourist and business travelers on its single route. Tourists always stay over on Saturday nights, while business travelers never do. The weekly demand function of tourists is QT = 6,000 – 10P, and the weekly demand function of business travelers is QB = 1,000 – P. If the marginal cost of a ticket is $200, what prices should Air Shangrila set for its tourist and business tickets? If the government passes a law that says all tickets must cost the same, what price will Air Shangrila set?

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