Economics of Management Strategy BEE3027 Lecture 4

Non-linear Pricing In this section we will deal with ways how a monopoly (or a firm with market power) can capture surplus from consumers. These are more sophisticated approaches to pricing than the standard models of industrial organisation, which assume firms charge a single price for each unit sold.

Monopoly problem Standard monopolist sets MR = MC to determine optimal output and price. Typical consequence of that is that there are consumers who would be served in a perfectly competitive market but are not: –Deadweight loss. How can the problem be overcome?

1 st Degree Price discrimination In this (rather unrealistic) case, the monopolist can determine each consumer’s reservation price and charge that price. As a result, the monopolist will extract the whole consumer surplus. It is economically efficient, but it is debatable whether this is desirable.

3 rd Degree Price discrimination Here, the monopolist is not able to perfectly distinguish each consumer’s reservation price. However it can screen consumers into types: –E.g. Students, OAPs. As such, it can charge different prices to different types of consumers.

3 rd Degree Price discrimination 3 rd Degree Price Discrimination can be beneficial to consumers. A key factor is the relative size of the two groups and their demand elasticities. Often, one group will “subsidise” the other. –Students pay cheaper prices for cinema tickets

2 nd Degree Price discrimination Another alternative for a monopolist is to give quantity discounts: –It can charge different prices for different blocks of units a consumer purchases. This type of pricing scheme is used quite commonly by utility companies. –EDF Energy charges a price for the first block of Kwatts and a lower one for the second block.

2 nd Degree Price discrimination P = 10 - q Monopolist now chooses two blocks of units to sell at different prices: –q1 at p1 –(q2 – q1) at p2. Profits are given by: Monopolist takes q1as given and maximises profit. MR2 = MC =>

2 nd Degree Price discrimination Plug the optimal q2 into the original profit function to obtain: Which when simplified gives:

2 nd Degree Price discrimination Calculating the profit maximising condition: Plugging the value of q1 back into q2 gives:

2 nd Degree Price discrimination So, if c=0: So, the first block of units is more expensive than the second block of units! This allows the monopolist to extract extra consumer surplus away from the DWL area: –More efficient!

Two-Part Tariff Many services that we purchase charge consumers with annual membership charges rather than a per- unit fee. –Gym; –Sports clubs; –Theatres; –Amusement parks. The logic is that even a monopolist cannot usually extract all consumer surplus. By adding an extra pricing instrument, the monopolist is able to extract all CS.

Two-Part Tariff The logic behind two-part tariff is that the monopolist will set P=MC to determine optimal output and set F = CS to extract full surplus. However, there are several problems: –Monopolist does not necessarily know individual demand schedules perfectly; –Consumers will have different demand schedules, hence if it sets F too high, it may lose some (or all) customers! –Still, two-part tariffs are quite common