Pricing Strategies for Firms with Market Power Chapter 11 Pricing Strategies for Firms with Market Power McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Outline Basic pricing strategies Chapter Overview Chapter Outline Basic pricing strategies Review of the basic rule of profit maximization A simple pricing rule for monopoly and monopolistic competition A simple pricing rule for Cournot oligopoly Strategies that yield even greater profits Exacting surplus from consumers Pricing strategies for special cost and demand structures Pricing strategies in markets with intense price competition

Chapter Overview Introduction In Chapter 10 a general set of tools was developed to examine situations where economic agents’ decisions impacted rivals’ payoffs. The concept of a dominant strategies, Nash equilibria and subgame perfect equilibria were explored. In this chapter, we focus on pricing strategies in environments where firms have some market power. Many of these strategies permit firms to earn profits that are greater than those of a single-price monopolist. Price discrimination Two-part pricing Block pricing Commodity bundling Peak-load pricing

Review of Basic Profit Maximization Basic Pricing Strategies Review of Basic Profit Maximization Firms with market power face a downward-sloping demand. Implication: there is a trade-off between selling many units at a low price and selling a few units at a high price. Managers of firms with market power balance these competing forces by selecting the quantity that equates marginal revenue 𝑀𝑅 and marginal cost 𝑀𝐶 , and charging the maximum price that consumer will pay for this level of output.

Basic Profit Maximization In Action Basic Pricing Strategies Basic Profit Maximization In Action Suppose the (inverse) demand for a firm’s product is given by 𝑃=10−2𝑄 and the cost function is 𝐶 𝑄 =2𝑄. What is the profit-maximizing level of output and price for this firm? Answer: The marginal revenue function is: 𝑀𝑅=10−4𝑄. The marginal cost function is: 𝑀𝐶=2. Equating these two functions yields 10−4𝑄=2, so 𝑄=2. The profit-maximizing price is 𝑃=10−2 2 =$6.

Simple Pricing Rule: Monopoly and Monopolistic Competition Basic Pricing Strategies Simple Pricing Rule: Monopoly and Monopolistic Competition What if estimates of the demand and cost functions are not available? Managers have a “crude” estimate of marginal cost; the price paid to a supplier. the price elasticity of demand, since it is typically available for a representative firm in an industry. With this information, the monopoly and monopolistically competitive firm’s profit-maximizing price (markup) is computed from: 𝑃 1+ 𝐸 𝐹 𝐸 𝐹 =𝑀𝐶 , where 𝑀𝑅=𝑃 1+ 𝐸 𝐹 𝐸 𝐹 . So, set price such that: 𝑃= 𝐸 𝐹 1+𝐸 𝐹 𝑀𝐶.

Simple Pricing Rule In Action: Problem Basic Pricing Strategies Simple Pricing Rule In Action: Problem The manager of a convenience store competes in a monopolistically competitive market and buys cola from a supplier at a price of $1.25 per liter. The manager thinks that because there are several supermarkets nearby, the demand for cola sold at her store is slightly more elastic than the elasticity for the representative food store. Specifically, the elasticity of demand for cola sold by her store is −4. What price should the manager charge for a liter of cola to maximize profits?

Simple Pricing Rule In Action: Answer Basic Pricing Strategies Simple Pricing Rule In Action: Answer The marginal cost of cola to the firm is $1.25, or 5 4 per liter, and the markup factor is 4 1−4 = 4 3 . The profit-maximizing pricing rule for a monopolistically competitive firm is: 𝑃= 4 3 5 4 = 5 3 , or about $1.67 per liter.

Simple Pricing Rule: Cournot Oligopoly Basic Pricing Strategies Simple Pricing Rule: Cournot Oligopoly When each of the 𝑁 firms operating in a Cournot oligopoly has identical cost structures and produces similar products, the simple profit-maximizing price (markup) in Cournot equilibrium is: 𝑃= 𝑁𝐸 𝑀 1+𝑁𝐸 𝑀 𝑀𝐶 , where 𝐸 𝑀 is the market elasticity of demand.

Beyond the Single-Price-Per-Unit Model Strategies that Yield Even Greater Profits Beyond the Single-Price-Per-Unit Model In some markets, managers can enhance profits beyond those resulting from charging all consumers a single, per-unit price. Models that yield greater profits fall into three categories: Pricing strategies: that extract surplus from consumers. for special cost and demand structures. in markets with intense price competition.

Models that Extract Surplus from Consumers Strategies that Yield Even Greater Profits Models that Extract Surplus from Consumers This section covers the following models of surplus extraction: Price discrimination (first, second and third degrees) Two-part pricing Block pricing Commodity bundling Each strategy is appropriate for firms with various cost structures and degrees of market interdependence.

Surplus Extraction: First-Degree Price Discrimination Strategies that Yield Even Greater Profits Surplus Extraction: First-Degree Price Discrimination Price discrimination is the practice of charging different prices to consumers for the same good or service. First-degree price discrimination is the practice of charging each consumer the maximum price he or she would be willing to pay for each unit of the good purchased. Implication: the firm extracts all surplus from consumers and earns the highest possible profit. Problem: managers rarely know each consumers’ maximum willingness to pay for each unit of the product.

Surplus Extraction: First-Degree Price Discrimination In Action Strategies that Yield Even Greater Profits Surplus Extraction: First-Degree Price Discrimination In Action Price MC $10 Firm profit under first-degree price discrimination $4 Demand Quantity 5

Surplus Extraction: Second-Degree Price Discrimination Strategies that Yield Even Greater Profits Surplus Extraction: Second-Degree Price Discrimination Second-degree price discrimination is the practice of posting a discrete schedule of declining prices for different ranges of quantity. Implication: firm extracts some surplus from consumers without needing to know the identity of various consumers’ demand.

Surplus Extraction: Second-Degree Price Discrimination In Action Strategies that Yield Even Greater Profits Surplus Extraction: Second-Degree Price Discrimination In Action Price MC $10 $7.60 Contribution to profits under second-degree price discrimination $5.20 Demand 2 4 Quantity

Surplus Extraction: Third-Degree Price Discrimination Strategies that Yield Even Greater Profits Surplus Extraction: Third-Degree Price Discrimination Third-degree price discrimination is the practice of charging different prices based on systematic differences in demand across demographic consumer groups. Implication: marginal revenue will be different for each group. That is, if there are two groups, 𝑀𝑅 1 > 𝑀𝑅 2 , for example.

Surplus Extraction: Third-Degree Price Discrimination Rule Strategies that Yield Even Greater Profits Surplus Extraction: Third-Degree Price Discrimination Rule To maximize profits, a firm with market power produces the output at which the marginal revenue (left-hand side of the following equations) to each group equals marginal cost. 𝑃 1 1+ 𝐸 1 𝐸 1 =𝑀𝐶 𝑃 2 1+ 𝐸 2 𝐸 2 =𝑀𝐶

Strategies that Yield Even Greater Profits Surplus Extraction: Third-Degree Price Discrimination Rule In Action: Problem You are the manager of a pizzeria that produces at a marginal cost of $6 per pizza. The pizzeria is a local monopoly near campus. During the day, only students eat at your restaurant. In the evening, while students are studying, faculty members eat there. If students have an elasticity of demand for pizza of −4 and faculty has an elasticity of demand of −2, what should your pricing policy be to maximize profits?

Strategies that Yield Even Greater Profits Surplus Extraction: Third-Degree Price Discrimination Rule In Action: Answer Assuming faculty would be unwilling to purchase cold pizzas from students, the conditions for effective third-degree price discrimination hold. It will be profitable to charge a “lunch menu” price and a “dinner menu” price. These prices are determined as follows: 𝑃 𝐿 1−4 −4 =$6 𝑃 𝐷 1−2 −2 =$6 Solving these equations yield, 𝑃 𝐿 =$8 and 𝑃 𝐿 =$12.

Surplus Extraction: Two-Part Pricing Strategies that Yield Even Greater Profits Surplus Extraction: Two-Part Pricing Two-part pricing is a pricing strategy whereby a firm with market power charges a fixed fee for the right to purchase its goods, plus a per-unit charge for each unit purchased.

Surplus Extraction: Two-Part Pricing In Action Strategies that Yield Even Greater Profits Surplus Extraction: Two-Part Pricing In Action Price $10 Fixed fee = $32 = profits Consumer surplus = $0 Per-unit fee = $2 $2 MC = AC Demand 8 Quantity

Surplus Extraction: Block Pricing Strategies that Yield Even Greater Profits Surplus Extraction: Block Pricing Block pricing is a pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-or-none decision to purchase. The profit-maximizing price on a package is the total value the consumer receives for the package.

Surplus Extraction: Block Pricing In Action Strategies that Yield Even Greater Profits Surplus Extraction: Block Pricing In Action Price $10 Price charged for a block of 8 units = $48 Profit with block pricing = $32 $2 MC = AC Demand 8 Quantity

Surplus Extraction: Commodity Bundling Strategies that Yield Even Greater Profits Surplus Extraction: Commodity Bundling Commodity bundling is the practice of bundling several different products together and selling them at a single “bundle price.” Key assumption: Consumers differ with respect to the amounts they are willing to pay for multiple products sold by a firm. Managers cannot observe different consumers’ valuations.

Surplus Extraction: Commodity Bundling In Action Strategies that Yield Even Greater Profits Surplus Extraction: Commodity Bundling In Action How does the manager price a computer and monitor? Price separately: Charge $1,500 for computer and $200 for monitors. Profit (assuming zero cost) is: 2×$1,500+2×$200=$3,400. Commodity bundling: Charge $1,800 for a bundle consisting of a computer and monitor. Profit (assuming zero cost) is: 2×$1,800=$3,600. Consumer Valuation of Computer Valuation of Monitor 1 $2,000 $200 2 $1,500 $300

Special Demand and Costs: Peak-Load Pricing Strategies that Yield Even Greater Profits Special Demand and Costs: Peak-Load Pricing Peak-load pricing is a pricing strategy in which higher prices are charged during peak hours than during off-peak hours.

Special Demand and Costs: Peak-Load Pricing In Action Strategies that Yield Even Greater Profits Special Demand and Costs: Peak-Load Pricing In Action Price MC 𝑃 𝐻 Demand High 𝑃 𝐿 MR High MR Low Demand Low 𝑄 𝐿 𝑄 𝐻 Quantity

Special Demand and Costs: Cross-Subsidies Strategies that Yield Even Greater Profits Special Demand and Costs: Cross-Subsidies Cross-subsidy is a pricing strategy in which profits gained from the sale of one product are used to subsidize sales of a related product. Principle: Whenever the demands for two products produced by a firm are interrelated through costs or demand, the firm may enhance profits by cross-subsidization: selling one product at or below cost and the other product above cost.

Special Demand and Costs: Transfer Pricing Strategies that Yield Even Greater Profits Special Demand and Costs: Transfer Pricing Transfer pricing is a pricing strategy in which a firm optimally sets the internal price at which an upstream division sells an input to a downstream division. Important since most division managers are provided an incentive to maximize their own division’s profits. Transfer pricing aligns division manager’s incentives with that of the overall firm, and increases overall firm’s profit.

Special Demand and Costs: Double Marginalization Strategies that Yield Even Greater Profits Special Demand and Costs: Double Marginalization Consider a large firm with two divisions: upstream division is the sole provider of a key input. downstream division uses the input produced by the upstream division to produce the final output. Upstream division has market power and incentive to maximize divisional profits leads managers to produce where 𝑀𝑅 𝑈 = 𝑀𝐶 𝑈 . Implication: 𝑃 𝑈 > 𝑀𝐶 𝑈 . A similar situation exists for the downstream division; profit-maximization leads to 𝑃 𝐷 > 𝑀𝐶 𝐷 . Both divisions mark price up over marginal cost resulting in a phenomenon called double marginalization.

Special Demand and Costs: Transfer Pricing Rule Strategies that Yield Even Greater Profits Special Demand and Costs: Transfer Pricing Rule Transfer pricing is used to overcome double marginalization. A transfer pricing rule sets the internal price at which an upstream division sells inputs to a downstream division in order to maximize the overall firm profits. Require the upstream division to produce such that its marginal cost, 𝑀𝐶 𝑈 , equals the net marginal revenue (𝑁𝑅𝑀 𝐷 ) to the downstream division: 𝑁𝑅𝑀 𝐷 = 𝑀𝑅 𝐷 − 𝑀𝐶 𝐷 = 𝑀𝐶 𝑈

Intense Price Competition: Price Matching Strategies that Yield Even Greater Profits Intense Price Competition: Price Matching Price matching is a strategy in which a firm advertises a price and a promise to match any lower price offered by a competitor. Used to mitigate the stark outcome associated with firms competing in a homogeneous-product, Bertrand oligopoly. Outcome: If all firms in the market adopt a price matching policy, all firms can set the monopoly price and earn monopoly profits; instead of the zero profits it would earn in the usual one-shot Bertrand oligopoly. Potential issues: Dealing with false consumer claims of low prices. Competitor’s with lower cost structures.

Intense Price Competition: Inducing Brand Loyalty Strategies that Yield Even Greater Profits Intense Price Competition: Inducing Brand Loyalty Brand loyal customers continue to buy a firm’s product even if another firm offers a (slightly) better price. Strategy used to mitigate the tension of Bertrand competition. Methods for inducing brand loyalty. Advertising campaigns. “Frequent-buyer” programs.

Intense Price Competition: Randomized Pricing Strategies that Yield Even Greater Profits Intense Price Competition: Randomized Pricing Randomized pricing is a strategy in which a firm intentionally varies its price in an attempt to “hide” price information from consumers and rivals. Benefits of randomized pricing to firms: Consumers cannot learn from experience which firm charges the lowest price in the market. Reduces the ability of rival firms to undercut a firm’s price. Not always profitable.

Conclusion First degree price discrimination, block pricing, and two part pricing permit a firm to extract all consumer surplus. Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus. Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization. Different strategies require different information.