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

Chapter 11Slide 3 Topics to be Discussed The Two-Part Tariff Bundling Advertising

Chapter 11Slide 4 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 5 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 6 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 7 Capturing Consumer Surplus P*Q*: single P & MC=MR 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 8 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 Bundling

Chapter 11Slide 9 Capturing Consumer Surplus Price discrimination is the charging of different prices to different consumers for similar goods.

Chapter 11Slide 10 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 11 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 12 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 13 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 14 Price Discrimination First Degree Price Discrimination The model does demonstrate the potential profit (incentive) of practicing price discrimination to some degree.

Chapter 11Slide 15 Price Discrimination First Degree Price Discrimination Examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product:  Lawyers, doctors, accountants  Car salesperson (15% profit margin)  Colleges and universities

Chapter 11Slide 16 First-Degree Price Discrimination in Practice Quantity D MR MC $/Q P2P2 P3P3 P* 4 P5P5 P6P6 P1P1 Six prices exist resulting in higher profits. With a single price P* 4, there are few consumers and those who pay P 5 or P 6 may have a surplus. Q

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

Chapter 11Slide 20 Price Discrimination Third Degree Price Discrimination 3)Most common type of price discrimination.  Examples: airlines, liquor, vegetables, discounts to students and senior citizens.

Chapter 11Slide 21 Price Discrimination Third Degree Price Discrimination 4) Third-degree price discrimination is feasible when the seller can separate his/her market into groups who have different price elasticities of demand (e.g. business air travelers versus vacation air travelers)

Chapter 11Slide 22 Price Discrimination Third Degree Price Discrimination Objectives  MR 1 = MR 2  MC 1 = MR 1 and MC 2 = MR 2  MR 1 = MR 2 = MC

Chapter 11Slide 23 Price Discrimination Third Degree Price Discrimination P 1 : price first group P 2 : price second group C(Q r ) = total cost of Q T = Q 1 + Q 2 Profit ( ) = P 1 Q 1 + P 2 Q 2 - C(Q r )

Chapter 11Slide 24 Price Discrimination Third Degree Price Discrimination Set incremental for sales to group 1 = 0

Chapter 11Slide 25 Price Discrimination Third Degree Price Discrimination Second group of customers: MR 2 = MC MR 1 = MR 2 = MC

Chapter 11Slide 26 Price Discrimination Third Degree Price Discrimination Determining relative prices

Chapter 11Slide 27 Price Discrimination Third Degree Price Discrimination Determining relative prices Pricing: Charge higher price to group with a low demand elasticity

Chapter 11Slide 28 Price Discrimination Third Degree Price Discrimination Example: E 1 = -2 & E 2 = -4 P 1 should be 1.5 times as high as P 2

Chapter 11Slide 29 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 30 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 elastic Group 2: P 2 Q 2 ; more inelastic MR 1 = MR 2 = MC Q T control MC Q1Q1 P1P1 MC = MR 1 at Q 1 and P 1

Chapter 11Slide 31 No Sales to Smaller Market Even if third-degree price discrimination is feasible, it doesn’t always pay to sell to both groups of consumers if marginal cost is rising.

Chapter 11Slide 32 No Sales to Smaller Market Quantity D2D2 MR 2 $/Q MC D1D1 MR 1 Q*Q* P*P* Group one, with demand D 1, are not willing to pay enough for the good to make price discrimination profitable.

Chapter 11Slide 33 The Economics of Coupons and Rebates Those consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand. Coupons and rebate programs allow firms to price discriminate. Price Discrimination

Chapter 11Slide 34 Price Elasticities of Demand for Users Versus Nonusers of Coupons Toilet tissue Stuffing/dressing Shampoo Cooking/salad oil Dry mix dinner Cake mix Price Elasticity ProductNonusersUsers

Chapter 11Slide 35 Cat food Frozen entrée Gelatin Spaghetti sauce Crème rinse/conditioner Soup Hot dogs Price Elasticity ProductNonusersUsers Price Elasticities of Demand for Users Versus Nonusers of Coupons

Chapter 11Slide 36 The Economics of Coupons and Rebates Cake Mix Nonusers of coupons: P E = Users: P E = -0.43

Chapter 11Slide 37 The Economics of Coupons and Rebates Cake Mix Brand (Pillsbury) P E : 8 to 10 times cake mix P E Example P E Users: -4 P E Nonusers: -2

Chapter 11Slide 38 The Economics of Coupons and Rebates Using: Price of nonusers should be 1.5 times users Or, if cake mix sells for $1.50, coupons should be 50 cents

Chapter 11Slide 39 Airline Fares Differences in elasticities imply that some customers will pay a higher fare than others. Business travelers have few choices and their demand is less elastic. Casual travelers have choices and are more price sensitive.

Chapter 11Slide 40 Elasticities of Demand for Air Travel Price Income Fare Category ElasticityFirst-ClassUnrestricted CoachDiscount

Chapter 11Slide 41 Airline Fares The airlines separate the market by setting various restrictions on the tickets. Less expensive: notice, stay over the weekend, no refund Most expensive: no restrictions

Chapter 11Slide 42 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 43 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 44 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 45 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 46 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 47 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 48 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 49 How to Price a Best Selling Novel What Do You Think? 1)How would you arrive at the price for the initial release of the hardbound edition of a book?

Chapter 11Slide 50 How to Price a Best Selling Novel What Do You Think? 2)How long do you wait to release the paperback edition? Could the popularity of the book impact your decision?

Chapter 11Slide 51 What Do You Think? 3)How do you determine the price for the paperback edition? How to Price a Best Selling Novel

Chapter 11Slide 52 The Two-Part Tariff The purchase of some products and services can be separated into two decisions, and therefore, two prices.

Chapter 11Slide 53 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 54 The Two-Part Tariff Examples 3)Rental of Mainframe Computers  Flat Fee  Processing Time 4)Safety Razor  Pay for razor  Pay for blades

Chapter 11Slide 55 The Two-Part Tariff Examples 5)Polaroid Film  Pay for the camera  Pay for the film

Chapter 11Slide 56 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 57 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 58 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

Chapter 11Slide 59 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 60 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 61 Two-Part Tariff with Many Different Consumers T Profit :entry fee :sales T* Total profit is the sum of the profit from the entry fee and the profit from sales. Both depend on T.

Chapter 11Slide 62 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 63 The Two-Part Tariff Two-Part Tariff With A Twist Entry price (T) entitles the buyer to a certain number of free units  Gillette razors with several blades  Amusement parks with some tokens  On-line with free time

Chapter 11Slide 64 Polaroid Cameras 1971 Polaroid introduced the SX-70 camera What Do You Think? How would you price the camera and film?

Chapter 11Slide 65 Polaroid Cameras Hint

Chapter 11Slide 66 Pricing Cellular Phone Service Question Why do cellular phone providers offer several different plans instead of a single two-part tariff with an access fee and per- unit charge?

Chapter 11Slide 67 Bundling Bundling is packaging two or more products to gain a pricing advantage. Conditions necessary for bundling Heterogeneous customers Price discrimination is not possible Demands must be negatively correlated

Chapter 11Slide 68 Bundling An example: Leasing “Gone with the Wind” & “Getting Gerties Garter.” The reservation prices for each theater and movie are: Gone with the Wind Getting Gertie’s Garter Theater A$12,000$3,000 Theater B$10,000$4,000

Chapter 11Slide 69 Bundling Renting the movies separately would result in each theater paying the lowest reservation price for each movie: Maximum price Wind = $10,000 Maximum price Gertie = $3,000 Total Revenue = $26,000

Chapter 11Slide 70 Bundling If the movies are bundled: Theater A will pay $15,000 for both Theater B will pay $14,000 for both If each were charged the lower of the two prices, total revenue will be $28,000.

Chapter 11Slide 71 Bundling Negative Correlated: Profitable to Bundle A pays more for Wind ($12,000) than B ($10,000). B pays more for Gertie ($4,000) than A ($3,000). Relative Valuations

Chapter 11Slide 72 Bundling If the demands were positively correlated (Theater A would pay more for both films as shown) bundling would not result in an increase in revenue. Gone with the Wind Getting Gertie’s Garter Theater A$12,000$4,000 Theater B$10,000$3,000 Relative Valuations

Chapter 11Slide 73 Bundling If the movies are bundled: Theater A will pay $16,000 for both Theater B will pay $13,000 for both If each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films separately.

Chapter 11Slide 74 Bundling Bundling Scenario: Two different goods and many consumers Many consumers with different reservation price combinations for two goods

Chapter 11Slide 75 Reservation Prices r 2 (reservation price Good 2) r 1 (reservation price Good 1) $5 $10 $5$10 $6 $3.25$8.25 $3.25 Consumer A Consumer C Consumer B Consumer A is willing to pay up to $3.25 for good 1 and up to $6 for good 2.

Chapter 11Slide 76 Consumption Decisions When Products are Sold Separately r2r2 r1r1 P2P2 II Consumers buy only good 2 P1P1 Consumers fall into four categories based on their reservation price. I Consumers buy both goods III Consumers buy neither good IV Consumers buy only Good 1

Chapter 11Slide 77 Consumption Decisions When Products are Bundled r2r2 r1r1 Consumers buy the bundle when r 1 + r 2 > P B (P B = bundle price). P B = r 1 + r 2 or r 2 = P B - r 1 Region 1: r > P B Region 2: r < P B r 2 = P B - r 1 I II Consumers buy bundle (r > P B ) Consumers do not buy bundle (r < P B )

Chapter 11Slide 78 The effectiveness of bundling depends upon the degree of negative correlation between the two demands. Consumption Decisions When Products are Bundled

Chapter 11Slide 79 Reservation Prices r2r2 r1r1 P2P2 P1P1 If the demands are perfectly positively correlated, the firm will not gain by bundling. It would earn the same profit by selling the goods separately.

Chapter 11Slide 80 Reservation Prices r2r2 r1r1 If the demands are perfectly negatively correlated bundling is the ideal strategy--all the consumer surplus can be extracted and a higher profit results.

Chapter 11Slide 81 Movie Example r2r2 r1r1 Bundling pays due to negative correlation (Wind) (Gertie) 5,000 14,000 10,000 5,000 10,000 12,000 4,000 3,000 B A

Chapter 11Slide 82 Bundling Mixed Bundling Selling both as a bundle and separately Pure Bundling Selling only a package

Chapter 11Slide 83 Mixed Versus Pure Bundling r2r2 r1r C 2 = MC 2 C 2 = 30 Consumer A, for example, has a reservation price for good 1 that is below marginal cost c 1. With mixed bundling, consumer A is induced to buy only good 2, while consumer D is induced to buy only good 1, reducing the firm’s cost. A B D C C 1 = MC 1 C 1 = 20 With positive marginal costs, mixed bundling may be more profitable than pure bundling.

Chapter 11Slide 84 Bundling Scenario Perfect negative correlation Significant marginal cost Mixed vs. Pure Bundling

Chapter 11Slide 85 Bundling Observations Reservation price is below MC for some consumers Mixed bundling induces the consumers to buy only goods for which their reservation price is greater than MC Mixed vs. Pure Bundling

Chapter 11Slide 86 Bundling Example Sell Separately Consumers B,C, and D buy 1 and A buys 2 Pure Bundling Consumers A, B, C, and D buy the bundle Mixed Bundling Consumer D buys 1, A buys 2, and B & C buys the bundle

Chapter 11Slide 87 Bundling Example Sell separately$50$90----$150 Pure bundling $100$200 Mixed bundling$89.95$89.95$100$ C 1 = $20 C 2 = $30 P1P1 P2P2 PBPB Profit

Chapter 11Slide 88 Bundling Sell Separately 3($50 - $20) + 1($90 - $30) = $150 Pure Bundling 4($100 - $20 - $30) = $200 Mixed Bundling ($ $20) + ($ $30) - 2($100 - $20 - $30) = $ C 1 = $20 C 2 = $30

Chapter 11Slide 89 Bundling Question If MC = 0, would mixed bundling still be the most profitable strategy with perfect negative correlation?

Chapter 11Slide 90 Mixed Bundling with Zero Marginal Costs r2r2 r1r In this example, consumers B and C are willing to pay $20 more for the bundle than are consumers A and D. With mixed bundling, the price of the bundle can be increased to $120. A & D can be charged $90 for a single good. C A B D

Chapter 11Slide 91 Sell separately$80$80----$320 Pure bundling $100$400 Mixed bundling$90$90$120$420 P1P1 P2P2 PBPB Profit Mixed Bundling with Zero Marginal Costs

Chapter 11Slide 92 Bundling Question Why is mixed bundling more profitable with MC = 0?

Chapter 11Slide 93 Bundling Bundling in Practice Automobile option packages Vacation travel Cable television

Chapter 11Slide 94 Bundling Mixed Bundling in Practice Use of market surveys to determine reservation prices Design a pricing strategy from the survey results

Chapter 11Slide 95 Mixed Bundling in Practice r2r2 r1r1 The firm can first choose a price for the bundle and then try individual prices P 1 and P 2 until total profit is roughly maximized. P2P2 PBPB PBPB P1P1 The dots are estimates of reservation prices for a representative sample of consumers.

Chapter 11Slide 96 The Complete Dinner Versus a la Carte: A Restaurant’s Pricing Problem Pricing to match consumer preferences for various selections Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.

Chapter 11Slide 97 Bundling Tying Practice of requiring a customer to purchase one good in order to purchase another. Examples  Xerox machines and the paper  IBM mainframe and computer cards

Chapter 11Slide 98 Bundling Tying Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy user McDonald’s  Allows them to protect their brand name.

Chapter 11Slide 99 Advertising Assumptions Firm sets only one price Firm knows Q(P,A)  How quantity demanded depends on price and advertising

Chapter 11Slide 100 Q0Q0 P0P0 Q1Q1 P1P1 AR MR AR and MR are average and marginal revenue when the firm doesn’t advertise. MC If the firm advertises, its average and marginal revenue curves shift to the right -- average costs rise, but marginal cost does not. AR’ MR’ AC’ Effects of Advertising Quantity $/Q AC

Chapter 11Slide 101 Advertising Choosing Price and Advertising Expenditure

Chapter 11Slide 102 Advertising A Rule of Thumb for Advertising

Chapter 11Slide 103 Advertising A Rule of Thumb for Advertising

Chapter 11Slide 104 Advertising A Rule of Thumb for Advertising To maximize profit, the firm’s advertising-to-sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand.

Chapter 11Slide 105 Advertising An Example R(Q) = $1 million/yr $10,000 budget for A (advertising--1% of revenues) E A =.2 (increase budget $20,000, sales increase by 20% E P = -4 (markup price over MC is substantial)

Chapter 11Slide 106 Advertising Question Should the firm increase advertising?

Chapter 11Slide 107 Advertising YES A/PQ = -(2/-.4) = 5% Increase budget to $50,000

Chapter 11Slide 108 Advertising Questions When E A is large, do you advertise more or less? When E P is large, do you advertise more or less?

Chapter 11Slide 109 Advertising Advertising: In Practice Estimate the level of advertising for each of the firms  Supermarkets  Convenience stores  Designer jeans  Laundry detergents

Chapter 11Slide 110 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 111 Summary Ideally, the firm would like to perfectly price discriminate. The two-part tariff is another means of capturing consumer surplus. When demands are heterogeneous and negatively correlated, bundling can increase profits.

Chapter 11Slide 112 Summary Bundling is a special case of tying, a requirement that products be bought or sold in some combination. Advertising can further increase profits.

End of Chapter 11 Pricing with Market Power