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
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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
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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
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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
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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
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7. Figure 18.2: Perfect Price Discrimination Sales Quantity
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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
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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
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10. 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
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11. 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
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12. Figure 18.5:Profit-Maximizing Price to Two Groups
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13. 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
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14. 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
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15. Figure 18.7: Welfare Effects of Price Discrimination
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16. 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
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17. 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
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18. 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
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19. Figure 18.9: Two-Part Tariff with Two Types of Consumers
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20. 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
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21. 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
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22. 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
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23. Figure 18.10: Benefits of Raising the Per-Minute Charge
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24. 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
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25. 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
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26. Figure 18.11: Menu of Two-Part Tariffs
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27. 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
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28. Figure 18.12: Capping Minutes
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29. 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
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