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PRICING WITH MARKET POWER - I. Overview Price discrimination Inter-temporal price discrimination Example of peak load pricing Capacity determination under.

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Presentation on theme: "PRICING WITH MARKET POWER - I. Overview Price discrimination Inter-temporal price discrimination Example of peak load pricing Capacity determination under."— Presentation transcript:


2 Overview Price discrimination Inter-temporal price discrimination Example of peak load pricing Capacity determination under peak load pricing (not available in text)

3 Introduction: the underlying idea Pricing with market power enables the producer to capture some of the consumer surplus. But it requires the individual producer to know much more about the characteristics of demand as well as the capability to manage production and the supply chain.

4 Capturing Consumer Surplus Quantity $/Q D MR P max MC If price is raised above P*, the firm will lose sales and reduce profit. PCPC P C is the price that would exist in a perfectly competitive market. A P* Q* P1P1 Within [0-Q*], consumers willing to pay more than P*-- indicated by consumer surplus (area A). B P2P2 To sell above Q*, price will have to fall to create a consumer surplus (B).

5 Price Discrimination Price discrimination is the charging of different prices to different consumers for similar goods. –First degree price discrimination Charge a separate price to each customer: the maximum or reservation price they are willing to pay –Second degree price discrimination Pricing according to quantity consumed – or in blocks –Third degree price discrimination Dividing the market into two or more groups, each having its own demand function and different price elasticities of demand

6 P* Q* Consumer surplus when a single price P* is charged. Part of producer surplus when a single price P* is charged. Additional profit from perfect price discrimination, i.e., Deadweight loss being converted into monopoly profit. Quantity $/Q P max D = AR MR MC Q** PCPC With perfect discrimination Each customer pays his reservation price Profits increase Additional Profit From Perfect First- Degree Price Discrimination

7 Implementing First-Degree Price Discrimination Question: Why would a producer have difficulty in achieving first-degree price discrimination? Answer: 1) Too many customers (impractical); 2) Could not estimate the reservation price for each customer –Examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product: Lawyers, doctors, accountants Car salesperson (15% profit margin) Colleges and universities

8 Second-Degree Price Discrimination Quantity $/Q D MR MC AC P0P0 Q0Q0 Without discrimination: P = P 0 and Q = Q 0. With second-degree discrimination there are three prices P 1, P 2, and P 3. (e.g. electric utilities) P1P1 Q1Q1 1st Block P2P2 Q2Q2 P3P3 Q3Q3 2nd Block3rd Block Second-degree price discrimination is pricing according to quantity consumed--or in blocks. What happens to deadweight loss?

9 Third Degree Price Discrimination 1) Divides the market into groups. 2)Each group has its own demand function. Most common type of price discrimination: Examples: airlines, liquor, vegetables, discounts to students and senior citizens. Third-degree price discrimination is feasible when the seller can separate his/her market into groups who have different price elasticities of demand (e.g. business air travelers versus vacation air travelers) and there is no seepage across those groups

10 MC = MR 1 = P 1 (1+1/E 1 ) = MR 2 = P 2 (1+1/E 2 ) => P 1 /P 2 = (1+1/E 2 )/(1+1/E 1 ) => Pricing: Charge higher price to group with a lower demand elasticity Relative prices under Third-degree price discrimination

11 Third-Degree Price Discrimination Quantity D 2 = AR 2 MR 2 $/Q D 1 = AR 1 MR 1 MR T MC P1 P2 Q1 Q2 Qt How do you get MR T from MR 1 and MR 2 ? Through horizontal or vertical addition?

12 No Sales to Smaller Market under Third Degree Price Discrimination Quantity D2D2 MR 2 $/Q MC D1D1 MR 1 Q*Q* P*P* Group one, with demand D 1, is not willing to pay enough for the good to make price discri- mination profitable.

13 Case-let: The Economics of Coupons and Rebates Those consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand. Coupons and rebate programs allow firms to price discriminate.

14 Price Elasticities of Users/ Nonusers of Coupons ProductNon-usersUsers (larger in magnitude) Toilet tissue Stuffing/dressing Shampoo Cooking/salad oil Dry mix dinner Cake mix Cat food Frozen entrée Gelatin Spaghetti sauce Crème rinse/conditioner Soup Hot dogs

15 Economics of Coupons and Rebates (continued) Elasticity of demand for Pillsbury cake mix VS. all cake mix –Users of coupons: -4 (Pillsbury)-0.43 (all) –Nonusers: -2 (Pillsbury) (all) Thus, P E for Pillsbury 8 to 10 times P E for all cake mix Using: Price of non-users should be 1.5 times users –Or, if cake mix sells for $1.50, coupons should be 50 cents

16 Elasticities of Demand for Air Travel Fare Category ElasticityFirst-Class Unrestricted Coach Discount ticket Price Income

17 Case-let on Airline Fares Differences in elasticities imply that some customers will pay a higher fare than others. Business travelers have few choices and their demand is less elastic. Casual travelers have choices and are more price sensitive. The airlines separate the market by setting various restrictions on the tickets. –Less expensive: notice, stay over the weekend, no refund –Most expensive: no restrictions

18 A possible case of dumping in global market Price etc. AR d MR d AR w = MR w MR t AC MC QuantityQdQd PdPd QtQt Does opening of a global competitive market help the monopolist, and if so, how? Can it be brought under purview of anti-dumping measures?

19 Can discriminating monopoly be socially useful? Price etc. AR 1 MR 1 AC MC QuantityQ2Q2 P2P2 While a monopolist in either market cant work given higher costs, a discriminating monopolist across the two markets can make >0, due to economies of scale, when two markets are combined. MR 2 CMR AR 2 CAR P1P1 Q1Q1 >0

20 Inter-temporal Price Discrimination Separating the Market With Time: –When a product is initially released, its demand is inelastic Movie Book Computer –Once the market has yielded a maximum profit, firms lower the price to appeal to the general market with a more elastic demand Paper back books Dollar Movies Discount computers

21 Inter-temporal Price Discrimination Quantity AC = MC $/Q Over time, demand becomes more elastic and price is reduced to appeal to the mass market. Q2Q2 MR 2 D 2 = AR 2 P2P2 D 1 = AR 1 MR 1 P1P1 Q1Q1 Consumers are divided into groups over time. Initially, demand is less elastic resulting in a price of P 1. Note MC need not be the same over time; Hence MR 1 need not be equal to MR 2.

22 Distinctive features of peak load pricing Demand for some products may peak at particular times, e.g., rush hour traffic, electricity consumption in summer afternoon Markets may be separated on basis of time. During peak demand time, capacity restraints will increase MC. Increased MC would indicate a higher price MR is not equal for each market because one market does not impact the other market

23 MR 1 D 1 = AR 1 MC P1P1 Q1Q1 Peak-load price = P 1. Peak-Load Pricing (when further investment in capacity not needed) Quantity $/Q MR 2 D 2 = AR 2 Off- load price = P 2. Q2Q2 P2P2

24 Capacity Determination under Peak Load Pricing Model b B P1P1 P2P2 X*=X 2 D2D2 DTDT D1D1 MR T MR 2 MR 1 MC MR1 MR2 Prices etc. Capacity How do you get MR T in this situation – through vertical or horizontal addition of MR 1 & MR 2 ? X1X1

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