Study Unit 11 Pricing with Market Power

Why and how is consumer surplus captured. How is price discrimination used to capture consumer surplus. How is market power used to implement two- part tariff. Pricing strategy of bundling. Use of advertising by firms. Outcomes

Capturing consumer surplus How do firms with market power capture more consumer surplus and transfer it to the producer? – Pricing Strategies! Can achieve by charging different prices to different consumers and not just a single price. Basis for price discrimination: – Practice of charging different prices to different consumers for similar goods.

Capturing consumer surplus

Problem: – How to identify different consumers? – How to get them to pay different prices?

Price discrimination Three broad forms: – First Degree Price Discrimination Perfect Price Discrimination Imperfect Price Discrimination – Second Degree Price Discrimination – Third Degree Price Discrimination

First-Degree Price Discrimination If firm could → Charge maximum price customer willing to pay. =Reservation Price Assume consumer buy one unit. Practice of charging reservation price =First-degree price discrimination

First-Degree Price Discrimination

How does this affect profit? – Add profit from each additional unit bought = Variable profit (Yellow) Perfect price discrimination: – Variable profit given for each unit = Demand curve – MC – Never possible! Impossible to charge different price to different consumers. Firm usually doesn’t know reservation price.

First-Degree Price Discrimination Imperfect price discrimination: – Charging few different prices based on estimates of reservation price – Used by doctors, lawyers, architects or accountants

First-Degree Price Discrimination

Second-Degree Price Discrimination Consumer purchase many different units = reservation price will decline Example: water, heat, fuel and electricity Willingness to pay decline with increased consumption. – Conservation easier and more worthwhile if price then high = Second-degree price discrimination Practice of charging different prices per unit for different quantities of the same good or service

Second-Degree Price Discrimination

Another example = Block pricing and quantity discounts Block Pricing: Practice of charging different prices for different quantities or blocks of a good Quantity discounts = Different prices for different quantities purchased.

Third-Degree Price discrimination Practice of dividing consumers into: – two or more groups – with separate demand curves, and – charging different prices for each group. Examples: – Regular vs. special airfares – Canned or frozen vegetables – Discounts to students or senior citizens

Third-Degree Price discrimination Which price to pay? – Create consumer groups: According to socio-economic characteristics Divide total output between groups MR1=MR2=MC – Determine relative price: Relate to elasticity of demand P1/P2 = (1+1/E2) / (1+1/E1)

Third-Degree Price discrimination

Not always worthwhile to sell to more than one group. – Demand too small – MC to high

Intertemporal price discrimination Practice of: – Separating consumers – With different demand functions into different groups – By charging different prices – At different points in time Example: – Higher price for first-run movie and lower price after a year. – High price for hard-cover book and bring out a paperback version later at a lower price

Intertemporal price discrimination

Peak-loading pricing The practice of: – Charging higher prices – During peak periods – When capacity constraints cause high MC Increase economic efficiency by charging price close to MC. Example of peak times: – Amusement park over weekends and holidays – Roads during morning and afternoon traffic

Peak-loading pricing

Two-part tariff Only need to know the definition on page 406 Leave page Definition: – Form of pricing in which consumer is charged both entry and usage fee. – Example: Amusement park entry fee and price per ride.

Bundling ‘Gone with the wind’ and ‘Getting Gertie’s Garter’ Theatres had to lease both Two films were bundled = sold as a package Bundling: – The practice of selling two or more products as a package. – Why bundle? When customer has heterogeneous demands and firm can’t price discriminate.

Bundling Used to firms advantage: – Reservation price for two films – Rented separately: Max price $ = Theatre B – Total revenue = $ – If bundled: A = $ and B = $ – Thus charge $ and revenue total = $ Gone with the WindGetting Gertie’s Garter Theater A$12 000$3 000 Theater B$10 000$4 000

Relative valuations Why is bundling profitable? – Relative valuations of the two films are reversed – Thus, demand negatively correlated: Willing to pay more for ‘wind’ than ‘Gertie’. – Why is this critical? Make demand positively correlated Describe preferences in next graph

Bundling

Mixed bundling Selling two or more goods both as a package and individually. Packaged price below separate price. Pure bundling: Selling products only as a package. Mixed bundling ideal strategy for negatively correlated demands.

Mixed bundling

Bundling in practice Buy vehicle and add-on’s: radio, sunroof, metallic colour, etc. When will manufacturers include add-on’s and when not. Going on vacation and paying for add-on’s: excursions, etc.

Bundling in practice

Tying Practice of requiring a customer to purchase one good in order to purchase another. Pure bundling a common form of tying. Example: Sell copy machine and must get paper.

Advertising Firms with market power have another important decision: How much to advertise? Advertising spending = A Choose advertising expenditure to maximise profit. ∏ = PQ(P,A) – C(Q) - A

Effects of Advertising