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

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Presentation on theme: "Chapter 18 Pricing Policies McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved."— Presentation transcript:

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 Monopolists 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 arent 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 customers 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 customers 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 18-7

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 consumers surplus at that per-unit price Maximizes aggregate surplus Leaves the consumer no surplus 18-9

10 Price Discrimination Based on Observable Characteristics Most often a firms 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 groups demand curve separately Set price to maximize profit earned from that group 18-10

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 18-11

12 Figure 18.5:Profit-Maximizing Price to Two Groups 18-12

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, wont 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 18-13

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 18-14

15 Figure 18.7: Welfare Effects of Price Discrimination 18-15

16 Price Discrimination and Market Power In a competitive market, firms cant 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 18-16

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 18-17

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 18-18

19 Figure 18.9: Two-Part Tariff with Two Types of Consumers 18-19

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 Clearvoices 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: $

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 18-21

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 18-22

23 Figure 18.10: Benefits of Raising the Per-Minute Charge 18-23

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 18-24

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 Clearvoices 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 18-25

26 Figure 18.11: Menu of Two-Part Tariffs 18-26

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 18-27

28 Figure 18.12: Capping Minutes 18-28

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 18-29


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