1 Microeconomics, 2 nd Edition David Besanko and Ronald Braeutigam Chapter 12: Pricing to Capture Surplus Value Prepared by Katharine Rockett © 2006 John Wiley & Sons, Inc.

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

3 Prices for UA Flight 815

4 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 its output.

5 Example: Uniform Pricing vs. Price Discrimination MR D MC Quantity Price Uniform Price Monopoly 1st Degree P.D. Monopoly

6 Example: Uniform Pricing vs. Price Discrimination MR D MC Quantity Price 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+G+G+H+J+K+L+N DWL: J+N 0 Uniform Price Monopoly 1st Degree P.D. Monopoly

7 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: The consumer's maximum willingness to pay is called the consumer's reservation price.

8 Recall… We can 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.

9 Is this reasonable? Think of buying a car… 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.

10 Example: 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 Mc=dvc/dq, 2=dvc/dq, 2=1/dq*dvc (*1/dq), 1/q*vc=2, vc=2q PS= Revenue-TVC = PQ-2Q = 11(9)-2(9) = 81

11 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!

12 Example: First Degree Price Discrimination MR (uniform pricing) D MC Quantity Price

13 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.) 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.

14 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…

15 Example: All customers are identical and have demand P = Q I MC = AC = 10

16 Example: Two-Part Tariff 100 Q P

17 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 = Why?

18 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.

19 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

20 P = Q MC = AC = 10 Let Q 1 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

21 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

22 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)

23 Example: Block Pricing 0 P Q Demand Quantity Discrimination

24 Example: Block Pricing 0 0 P P Q Q MC Demand Quantity Discrimination Single-Price Monopoly MR

25 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.

26 Example: Utility Pricing Q D - small D - large MC

27 Example: Utility Pricing P1P1 P2P2 Q 1s Q 1L Q 2L Q D - small D - large Additional CS MC Additional PS

28 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?

29 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. Example MC = AC = 20 P 1 = Q 1 P 2 = Q 2 What is the optimal price for each group?

30 MR 1 = Q 1 = MC = 20 MR 2 = Q 2 = MC = 20 Q 1 * = 40 Q 2 * = 15 P 1 * = 60 P 2 * = 50

31 Example: Third Degree Price Discrimination Q P Market 1 Demand 1 MR 1

32 Example: Third Degree Price Discrimination QQ P P Market 1 Market 2 Demand 1 Demand 2 MR 1 MR 2

33 Definition: A tie-in sale occurs if customer can buy one product only if they agree to purchase another product as well. 1. 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.

34 2. 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…

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36 Optimal Pricing Policy Without bundling: p c = $1500 p m = $600 Profit cm = $800 With bundling: p b = $1800 Profit b = $1000

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38 Optimal Pricing Policy Without bundling: p c = $1500 p m = $600 Profit cm = $800 With bundling: p b = $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).

39 1. Price discrimination generally allows a monopolist (or any firm with market power) to capture more surplus than a uniform pricing policy. 2.First degree (or perfect) price discrimination allows the monopoly to produce efficiently and capture all the resulting surplus. 3. Second degree price discrimination may or may not allow as much surplus to be created and captured as perfect price discrimination, depending on the precise form of the discrimination. 4. Third degree price discrimination generally does not create or allow as much capture of surplus.

40 5. In order to capture surplus from any form of price discrimination, a firm must have some market power, have some information on the differential willingness to pay of customers and must be able to prevent resale (arbitrage) among customers. 6.Tie-in sales may be used in place of price discrimination, when price discrimination is not possible, in order to allow the monopolist to capture additional surplus.