1. Pricing with Market Power
PRICE DISCRIMINATION
TWO-PART TARIFF
BUNDLING

2. PRICE DISCRIMINATION
1. Economic Definition: charging different prices for various services even when the cost are not correspondingly different. The ratios of price to marginal costs for various services are not equal:
P1/MC P2/MC2
where
P1 and P2 are prices charged in markets 1 and 2, and MC1 and MC2 are marginal costs in markets 1 and 2.

3. Rationale for Price Discrimination:
A. Social viewpoint: improve resource allocation
B. Firm viewpoint: increases profits

4. Example of Socially Beneficial Price Discrimination
Cost: New Bus Service costs $25 per day
Demand: 10 customers are willing to pay $2 per trip
10 customers are willing to pay only $1 per trip
Benefits = $30 and Cost = $25 and
Without Discrimination, there are no profits and maybe no service
With Discrimination, service is profitable
2.5
Total Benefits 2
Total Cost
1.25
Average Cost 1
Demand
Riders 10 20

5. 2. Requirements for Price Discrimination
a. Segment the markets- identify the markets and keep buyers in one market segment from selling to the other market segments
b. Different price elasticities of demand in the market segments. Otherwise, P/MC would be equal in the market segments
c. Monopoly power so that price can exceed marginal cost

6. 3. Types of Price Discrimination
a. Perfect (First Degree) - charge each person a price equal to their willingness to pay. Total revenue is the area under the demand curve.
b. Block (Second Degree)
c. Other bases (Third Degree) such as time of day, income, location, etc. This is the type we will emphasize.

7. Price Perfect Price Block Demand Demand Q Q Third Degree Price Price
New Car Dealer
Block Utility Rates
Third Degree
Price
Price
Market Segment 1
(Business Travelers)
Market Segment 2
(Vacation Travelers) Q Q

8. 4. General Rule for Profit Maximizing Price Discrimination
Assume two markets, A and B, for the same product.
General Rule:
MRA = MRB = MC
where Qtotal = Qmkt A + Qmkt B

9. Example
Midwest Appliance sells the same appliance in Chicago and Milwaukee. The marginal cost of producing the appliance for either market is $8 per unit and its fixed costs are $410. Its total cost is:
TC = QM + 8 QC
The demand and marginal revenue in Milwaukee and Chicago are:
PM= QM PC= QC
MRM = QM MRC = QC
If the firm can price discriminate, what prices should it charge?

10. Milwaukee Chicago MRC = 495-10QC = 8 = MC MRM = 750-20QM = 8 = MC
500
500 PM PC MC MC
MRM
MRC
MRM = QM = 8 = MC
QM=37.1 and
PM=379
MRC = QC = 8 = MC
QC=48.7 and
PC = $251.50
Profits = (379)(37.1)+(251.50)(48.7)-410-8(37.1)-(8)(48.7) =

11. Single Price reduces Profits
QC = P
QM = P
Q = P
P = /3 Q
MR = /3 Q
MC = 8
500 P MC Q MR
MR = /3 Q = 8 = MC
Q = 85.8
P= 294
Profits = (294)(85.8) (85.8) = 24,128.80

12. Price Discrimination Example
American Ex-Im Shipping Co. operates a general cargo carrier service between New York and several Western European ports. It hauls two major categories of freight: Manufactured items and semimanufactured raw materials.
The demand functions for these two classes of goods are:
P1 = Q1
P2 = 80 - Q2
where Qi = tons of freight moved. The total cost function is:
TC = (Q1 + Q2)
a. Calculate the firm’s total profit function
b. What are the profit-maximizing levels of price and output for the two freight categories?
c. At these level of output, calculate the marginal revenue in each market

13. d. What are American’s total profits if it is effectively able to charge different prices in the two markets?
e. If American is required by law to charge the same per-ton rate to all users, calculate the new profit maximizing level of price and output. What are the profits in this situation?
f. Explain the difference in profit levels between the discriminating and nondiscriminating cases. To do this one should calculate the point price elasticity of demand under the nondiscriminating price-output solution.

14. Two Part Tariff Charge an up front fee for right to buy product
Disney World
Golf and tennis clubs
Another way of capturing consumer surplus

15. Profits = Q(P-AC) = 4(6-2) = $16 Demand Curve for an Individual
$/unit 10
Two-Part Tariff 9
Demand Curve: P = 10 - Q, MC = 2
Optimal Pricing: Q = 4, P = 6 8 7
CS = (1/2)(4)(4) = $8 6
Profits = Q(P-AC) = 4(6-2) = $16 5
With an entrance fee of $8, the monopolist’s profit increases to $24 4 3
MC = 2 2
Demand Curve for an Individual 1
MR = Q Q 1 2 3 4 5 6 7 8 9 10

16. Two-Part Tariff $/unit10
Two-Part Tariff 9
Demand Curve: P = 10 - Q, MC = 2
Set P = 2 8 7
CS = (1/2)(8)(8) = $32 6
With an entrance fee of $32, the monopolist’s profit is $32 5 4 3
MC = 2 2
Demand Curve for an Individual 1 Q 1 2 3 4 5 6 7 8 9 10

17. Disneyland’s Two-Part Tariff
$/unit 10
Disneyland’s Two-Part Tariff 9
Demand Curve: P = 10 - Q, MC = 0
Set P = 0 8 7
CS = (1/2)(10)(10) = $50 6
With an entrance fee of $50, the monopolist’s profit is to $50 5 4 3 2
MC = 0
Demand Curve for an Individual 1 Q 1 2 3 4 5 6 7 8 9 10

18. Two Part Tariff MC demand MC demand Golf Club: Pro Golfers
1. No membership fee
$4 green fees
Profits = (4-2)(2)=4
2. Membership fee $8
$2 Green Fees
Profits = $8
Pro Golfers 4 MC 2
demand 2 MR
Pro & Occasional
Golfers
Set Membership T* and
Green Fee P* which Maximizes
Profits =2T* + (P*-MC)(Q1+Q2) 4 T* PT MC 2
demand Q1 Q2

19. Bundling
We can extract higher profits by bundling products whose demands are negatively correlated.
If we price individually, a high price losses customers willing to pay a low price

20. Profitable Bundling Theater Movie Alvin Palace
Casablanca 12,000 $9,000
Godfather 8,000 10,000
Bundle 20,000 19,000
1. If separately leased, must charge
Casablanca $9,000
Godfather 8,000 or $17,000 total
2. Can charge $19,000 for both combined
3. As long as inverse relationship between
them, bundling works
Bundling Not Profitable
Alvin Palace
Casablanca 12,000 9,000
Godfather ,000 7,000
Positive relationship