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1 Capturing Surplus Chapter 12. 2 Chapter Twelve Overview 1.Introduction: Airline Tickets 2.Price Discrimination First Degree Second Degree Third Degree.

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Presentation on theme: "1 Capturing Surplus Chapter 12. 2 Chapter Twelve Overview 1.Introduction: Airline Tickets 2.Price Discrimination First Degree Second Degree Third Degree."— Presentation transcript:

1 1 Capturing Surplus Chapter 12

2 2 Chapter Twelve Overview 1.Introduction: Airline Tickets 2.Price Discrimination First Degree Second Degree Third Degree 3.Tie-in Sales Requirements Tie-ins Package Tie-ins (Bundling) 1.Introduction: Airline Tickets 2.Price Discrimination First Degree Second Degree Third Degree 3.Tie-in Sales Requirements Tie-ins Package Tie-ins (Bundling) Chapter Twelve

3 3 Uniform Price Vs. Price Discrimination Definition: A monopolist charges a uniform price if it sets the same price for every unit of output sold. While the monopolist captures profits due to an optimal uniform pricing policy, it does not receive the consumer surplus or dead-weight loss associated with this policy. The monopolist can overcome this by charging more than one price for its product. Definition: A monopolist price discriminates if it charges more than one price for the same good or service.

4 4 Chapter Twelve Forms of Price Discrimination Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay. This willingness to pay is directly observable by the monopolist. Definition: A policy of second degree price discrimination allows the monopolist to offer consumers a quantity discount. Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed. Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay. This willingness to pay is directly observable by the monopolist. Definition: A policy of second degree price discrimination allows the monopolist to offer consumers a quantity discount. Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed.

5 5 Chapter Twelve Willingness to Pay Curve Definition: The consumer's maximum willingness to pay is called the consumer's reservation price. Think of the demand curve as a "willingness to pay" curve. If the monopolist can observe the willingness to pay of each customer (based on, for example, residence, education, "look", etc), then the monopolist can observe demand perfectly and can "perfectly" price discriminate. Definition: The consumer's maximum willingness to pay is called the consumer's reservation price. Think of the demand curve as a "willingness to pay" curve. If the monopolist can observe the willingness to pay of each customer (based on, for example, residence, education, "look", etc), then the monopolist can observe demand perfectly and can "perfectly" price discriminate.

6 6 Chapter Twelve Forms of Price Discrimination Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay. This willingness to pay is directly observable by the monopolist.

7 7 D MC P1P1 PUPU E F G H J K N L CS: E+F 0 PS: G+H+K+L E+F+G+H+J+K+L+N TS: E+F+G+H+K+L E+F+G+H+J+K+L+N DWL: J+N 0 Chapter Twelve MR Quantity Uniform Price Monopoly 1st Degree P.D. Monopoly Uniform Price Vs. Price Discrimination Price

8 8 Chapter Twelve Is it Reasonable? The monopolist will continue selling units until the reservation price exactly equals marginal cost. Therefore, a perfectly price discriminating monopolist will produce and sell the efficient quantity of output. Note: Only if the monopolist can prevent resale can the monopolist capture the entire surplus.

9 9 Chapter Twelve Pricing Surplus – Monopoly MC = 2 P = 20 - Q What is producer surplus if uniform pricing is followed? MR = P + ( P/ Q)Q = 20 - Q - Q = Q MR = MC => Q = 2 => Q* = 9 P* = 11 PS= Revenue-TVC = PQ-2Q = 11(9)-2(9) = 81

10 10 Chapter Twelve Pricing Surplus – Monopoly What will producer surplus be if the monopolist perfectly price discriminates? P = MC => 20 - Q = 2 =>Q* = 18 Revenue - TVC = [18(20-2)(1/2) + 18(2)]- 18(2) = 162 This is a gain in captured surplus of 81!

11 11 MR (uniform pricing) D MC Quantity Price Chapter Twelve First Degree Price Discrimination What is the marginal revenue curve for a perfectly price discriminating monopolist? When the monopolist sells an additional unit, it does not have to reduce the price on the other units it is selling. Therefore, MR = P. (i.e., the marginal revenue curve equals the demand curve.)

12 12 Chapter Twelve Definition: A policy of second degree price discrimination allows the monopolist to charge a different price to different consumers. While different consumers pay different prices, the reservation price of any one consumer cannot be directly observed. Second Degree Price Discrimination

13 13 Chapter Twelve Two Part Tariff Definition: A monopolist charges a two part tariff if it charges a per unit fee, r, plus a lump sum fee (paid whether or not a positive number of units is consumed), F. This, effectively, charges demanders of a low quantity a different average price than demanders of a high quantity. Example: hook-up charge plus usage fee for a telephone, club membership, or the like.

14 Q P Chapter Twelve Example: All customers are identical and have demand P = Q MC = AC = 10 Example: All customers are identical and have demand P = Q MC = AC = 10 Two Part Tariff

15 15 Chapter Twelve Two Part Tariff What is the optimal two-part tariff? Two steps: (1) maximize the benefits to the consumers by charging r = MC = 10. (2) capture this benefit by setting F = consumer benefits = What is the optimal two-part tariff? Two steps: (1) maximize the benefits to the consumers by charging r = MC = 10. (2) capture this benefit by setting F = consumer benefits = 4050.

16 16 Chapter Twelve Two Part Tariff Any higher usage charge would result in a dead- weight loss that could not be captured by the monopolist. Any lower usage charge would result in selling at less than marginal cost. In essence, the monopolist maximizes the size of the "pie", then sets the lump sum fee so as to capture the entire "pie" for itself. The total surplus captured is the same as in the case of perfect price discrimination.

17 17 Chapter Twelve Block Tariff Definition: If a consumer pays one price for one block of output and another price for another block of output, the consumer faces a block tariff

18 18 Chapter Twelve Block Tariff P = Q MC = AC = 10 Let Q1 be the largest quantity for which the first block rate applies so that p 1 (Q 1 ) = Q 1. Let Q 2 be the largest quantity purchased (so that the second block rate will apply between Q 1 and Q 2 ) so that p 2 (Q 2 ) = Q 2

19 19 Chapter Twelve Block Tariff Then: = p 1 (Q 1 )Q 1 + p 2 (Q 2 )(Q 2 -Q 1 ) - TC(Q 2 ) = (100 - Q 1 )Q 1 + (100 - Q 2 )(Q 2 -Q 1 ) - 10Q 2 and we must choose Q 1 and Q 2 to maximize this profit… MR 1 = (100 - Q 1 ) - Q 1 - (100 - Q 2 ) = 0 MR 2 = (100 - Q 2 ) - Q 2 + Q 1 = MC = 10

20 20 Chapter Twelve Key Equations These are two equations in two unknowns that can be solved to obtain: Q 1 * = 30 Q 2 * = 60 P 1 * = 70 P 2 * = 40 (a quantity discount) These are two equations in two unknowns that can be solved to obtain: Q 1 * = 30 Q 2 * = 60 P 1 * = 70 P 2 * = 40 (a quantity discount)

21 P P Q Q MC Demand MR Chapter Twelve Block Pricing

22 22 Chapter Twelve Block Pricing If the monopolist could set a different block price for each customer, it would capture the same amount of surplus as a perfectly price discriminating monopolist.

23 23 Q D - small D - large MC Chapter Twelve Utility Pricing

24 24 P1P1 P2P2 Q 1s Q 1L Q 2L Q Additional CS MC Additional PS Chapter Twelve D - small D - large Utility Pricing

25 25 Chapter Twelve Third Degree Price Discrimination Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed. Example: Movie ticket sales to older people or students at discount Suppose that marginal costs for the two markets are the same. How does a monopolist maximize profit with this type of price discrimination? Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed. Example: Movie ticket sales to older people or students at discount Suppose that marginal costs for the two markets are the same. How does a monopolist maximize profit with this type of price discrimination?

26 26 Chapter Twelve Set the marginal revenue in each market equal to marginal cost. (i.e., the monopolist maximizes total profits by maximizing profits from each group individually.) This implies that MR 1 = MC = MR 2 at the optimum. Otherwise, the monopolist could raise revenues by switching sales from the low MR group to the high MR group. MC = AC = 20 P 1 = Q 1 P 2 = Q 2 Set the marginal revenue in each market equal to marginal cost. (i.e., the monopolist maximizes total profits by maximizing profits from each group individually.) This implies that MR 1 = MC = MR 2 at the optimum. Otherwise, the monopolist could raise revenues by switching sales from the low MR group to the high MR group. MC = AC = 20 P 1 = Q 1 P 2 = Q 2 Optimal Pricing Example

27 27 Chapter Twelve MR 1 = Q 1 = MC = 20 MR 2 = Q 2 = MC = 20 Q 1 * = 40 Q 2 * = 15 P 1 * = 60 P 2 * = 50 MR 1 = Q 1 = MC = 20 MR 2 = Q 2 = MC = 20 Q 1 * = 40 Q 2 * = 15 P 1 * = 60 P 2 * = 50 Optimal Pricing Example

28 Q P Demand 2 MR 2 Chapter Twelve P Demand 1 MR 1 Third Degree Price Discrimination Q Market 1 Market 2

29 29 Chapter Twelve Tie-in Sales – Requirements Definition: A tie-in sale occurs if customer can buy one product only if they agree to purchase another product as well. Requirements tie-in sales occur when a firm requires customers who buy one product from the firm to buy another product from the firm. A requirements tie-in sale may be used in place of price discrimination when the firm cannot observe the relative willingness to pay of different customers.

30 30 Chapter Twelve Tie-in Sales – Bundling Package tie-in sales (or bundling) occur when goods are combined so that customers cannot buy either good separately. Bundling may be used in place of price discrimination to increase producer surplus when consumers have different willingness to pay for the goods sold in the bundle. But bundling does not always pay…

31 31 Chapter Twelve Tie-in Sales – Bundling

32 32 Chapter Twelve Tie-in Sales – Bundling Optimal Pricing Policy Without bundling: pc = $1500 pm = $600 Profit cm = $800 With bundling: pb = $1800 Profit b = $1000 Optimal Pricing Policy Without bundling: pc = $1500 pm = $600 Profit cm = $800 With bundling: pb = $1800 Profit b = $1000

33 33 Chapter Twelve Tie-in Sales – Bundling

34 34 Chapter Twelve Tie-in Sales – Bundling Optimal Pricing Policy Without bundling: pc = $1500 pm = $600 Profit cm = $800 With bundling: pb = $2100 Profit b = $800 In general, bundling a pair of goods only pays if their demands are negatively correlated (customers who are willing to pay relatively more for good A are not willing to pay as much for good B). Optimal Pricing Policy Without bundling: pc = $1500 pm = $600 Profit cm = $800 With bundling: pb = $2100 Profit b = $800 In general, bundling a pair of goods only pays if their demands are negatively correlated (customers who are willing to pay relatively more for good A are not willing to pay as much for good B).

35 35 Chapter Twelve Reservation Price The reason is that the price is determined by the purchaser with the lowest reservation price. If reservation prices for the two goods are negatively correlated, bundling reduces the dispersion of reservation prices and so raises the price at which additional units can be sold. The reason is that the price is determined by the purchaser with the lowest reservation price. If reservation prices for the two goods are negatively correlated, bundling reduces the dispersion of reservation prices and so raises the price at which additional units can be sold.

36 36 Chapter Twelve Advertising The firm can capture surplus using nonprice strategies such as advertising.


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