Chapter 11 Pricing with Market Power

Chapter 11Slide 2 Topics to be Discussed Capturing Consumer Surplus Price Discrimination Intertemporal Price Discrimination and Peak-Load Pricing The Two-Part Tariff

Chapter 11Slide 3 Introduction Pricing without market power (perfect competition) is determined by market supply and demand. The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits.

Chapter 11Slide 4 Introduction Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production.

Chapter 11Slide 5 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 Between 0 and Q*, consumers will pay more than P*--consumer surplus (A). B P2P2 Beyond Q*, price will have to fall to create a consumer surplus (B).

Chapter 11Slide 6 Capturing Consumer Surplus A: consumer surplus with P* B: P>MC & consumer would buy at a lower price P 1 : less sales and profits P 2 : increase sales & and reduce revenue and profits P C : competitive price Quantity $/Q D MR P max MC PCPC A P* Q* P1P1 B P2P2

Chapter 11Slide 7 Capturing Consumer Surplus Quantity $/Q D MR P max MC PCPC A P* Q* P1P1 B P2P2 Question How can the firm capture the consumer surplus in A and sell profitably in B? Answer Price discrimination Two-part tariffs

Chapter 11Slide 8 Capturing Consumer Surplus Price discrimination is the charging of different prices to different consumers for similar goods.

Chapter 11Slide 9 Price Discrimination First Degree Price Discrimination Charge a separate price to each customer: the maximum or reservation price they are willing to pay.

Chapter 11Slide 10 P* Q* Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow). Additional Profit From Perfect First- Degree Price Discrimination Quantity $/Q P max With perfect discrimination, each consumer pays the maximum price they are willing to pay. Consumer surplus is the area above P* and between 0 and Q* output. D = AR MR MC Output expands to Q** and price falls to P C where MC = MR = AR = D. Profits increase by the area above MC between old MR and D to output Q** (purple) Q** PCPC

Chapter 11Slide 11 P* Q* Consumer surplus when a single price P* is charged. Variable profit when a single price P* is charged. Additional profit from perfect price discrimination Quantity $/Q P max D = AR MR MC Q** PCPC With perfect discrimination Each customer pays their reservation price Profits increase Additional Profit From Perfect First- Degree Price Discrimination

Chapter 11Slide 12 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 Additional Profit From Perfect First- Degree Price Discrimination

Chapter 11Slide 13 Practice of charging different prices per unit for different quantities of the same good or service 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.

Second-Degree Price Discrimination Quantity $/Q D MR MC AC P0P0 Q0Q0 P1P1 Q1Q1 1st Block P2P2 Q2Q2 P3P3 Q3Q3 2nd Block3rd Block Economies of scale permit: Increase consumer welfare Higher profits

Chapter 11Slide 16 Price Discrimination Third Degree Price Discrimination 1) Divides the market into two-groups. 2)Each group has its own demand function.

Chapter 11Slide 17 Third-Degree Price Discrimination Quantity D 2 = AR 2 MR 2 $/Q D 1 = AR 1 MR 1 Consumers are divided into two groups, with separate demand curves for each group. MR T MR T = MR 1 + MR 2

Chapter 11Slide 18 Third-Degree Price Discrimination Quantity D 2 = AR 2 MR 2 $/Q D 1 = AR 1 MR 1 MR T MC Q2Q2 P2P2 QTQT Q T : MC = MR T Group 1: P 1 Q 1 ; more inelastic Group 2: P 2 Q 2 ; more elastic MR 1 = MR 2 = MC Q1Q1 P1P1 MC = MR 1 = MR 2

Chapter 11Slide 19 Intertemporal Price Discrimination and Peak-Load Pricing Separating the Market With Time Initial release of a product, the demand is inelastic  Book  Movie  Computer

Chapter 11Slide 20 Separating the Market With Time Once this market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand  Paper back books  Dollar Movies  Discount computers Intertemporal Price Discrimination and Peak-Load Pricing

Chapter 11Slide 21 Intertemporal 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.

Chapter 11Slide 22 Demand for some products may peak at particular times. Rush hour traffic Electricity - late summer afternoons Ski resorts on weekends Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing

Chapter 11Slide 23 Capacity restraints will also increase MC. Increased MR and MC would indicate a higher price. Peak-Load Pricing Intertemporal Price Discrimination and Peak-Load Pricing

Chapter 11Slide 24 MR is not equal for each market because one market does not impact the other market. Peak-Load Pricing Intertemporal Price Discrimination and Peak-Load Pricing

Chapter 11Slide 25 MR 1 D 1 = AR 1 MC P1P1 Q1Q1 Peak-load price = P 1. Peak-Load Pricing Quantity $/Q MR 2 D 2 = AR 2 Off- load price = P 2. Q2Q2 P2P2

Chapter 11Slide 26 The Two-Part Tariff The purchase of some products and services can be separated into two decisions, and therefore, two prices.

Chapter 11Slide 27 The Two-Part Tariff Examples 1)Amusement Park  Pay to enter  Pay for rides and food within the park 2)Tennis Club  Pay to join  Pay to play

Chapter 11Slide 28 The Two-Part Tariff Pricing decision is setting the entry fee (T) and the usage fee (P). Choosing the trade-off between free- entry and high use prices or high-entry and zero use prices.

Chapter 11Slide 29 Usage price P*is set where MC = D. Entry price T* is equal to the entire consumer surplus. T* Two-Part Tariff with a Single Consumer Quantity $/Q MC P* D

Chapter 11Slide 30 D 2 = consumer 2 D 1 = consumer 1 Q1Q1 Q2Q2 The price, P*, will be greater than MC. Set T* at the surplus value of D 2. T* Two-Part Tariff with Two Consumers Quantity $/Q MC A B C P*

Chapter 11Slide 31 The Two-Part Tariff The Two-Part Tariff With Many Different Consumers No exact way to determine P* and T*. Must consider the trade-off between the entry fee T* and the use fee P*.  Low entry fee: High sales and falling profit with lower price and more entrants.

Chapter 11Slide 32 The Two-Part Tariff The Two-Part Tariff With Many Different Consumers To find optimum combination, choose several combinations of P,T. Choose the combination that maximizes profit.

Chapter 11Slide 33 The Two-Part Tariff Rule of Thumb Similar demand: Choose P close to MC and high T Dissimilar demand: Choose high P and low T.

Chapter 11Slide 34 Summary Firms with market power are in an enviable position because they have the potential to earn large profits, but realizing that potential may depend critically on the firm’s pricing strategy. A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible.

Chapter 11Slide 35 Summary Ideally, the firm would like to perfectly price discriminate. The two-part tariff is another means of capturing consumer surplus.

End of Chapter 11 Pricing with Market Power