Chapter 10 Pricing with Market Power. © 2014 Pearson Education, Inc. All rights reserved.10-2 Table of Contents 10.1 Price Discrimination 10.2 Perfect.

Chapter 10 Pricing with Market Power

© 2014 Pearson Education, Inc. All rights reserved.10-2 Table of Contents 10.1 Price Discrimination 10.2 Perfect Price Discrimination 10.3 Group Price Discrimination 10.4 Nonlinear Price Discrimination 10.5 Two-Part Pricing 10.6 Bundling 10.7 Peak-Load Pricing

© 2014 Pearson Education, Inc. All rights reserved.10-3 Introduction Managerial Problem –Heinz dominates the ketchup market in the U.S., Canada, and U.K. When Heinz goes on sale, switchers purchase Heinz rather than the low-price generic ketchup. –How can Heinz’s managers design a pattern of sales that maximizes Heinz’s profit? Under what conditions does it pay for Heinz to have a policy of periodic sales? Solution Approach –We need to examine how monopolies and other noncompetitive firms set prices. These firms can earn a higher profit setting different prices for the same good or service depending on consumer’s willingness to pay (non-uniform pricing). Empirical Methods –Types of non-uniform pricing include price discrimination, two-part pricing, bundling, and peak-load pricing. –We will review the characteristics and conditions for each of these types of non- uniform pricing.

© 2014 Pearson Education, Inc. All rights reserved.10-4 10.1 Price Discrimination Why Price Discrimination Pays –For almost any good or service, some consumers are willing to pay more than others. –Price discrimination increases profit above the uniform pricing level through two channels. Channel 1: Higher Prices for Some –Price discrimination can extract additional consumer surplus from consumers who place a high value on the good. –In panel a of Table 10.1, the theater sells the same number of seats but makes more money from the college students. Students pay $20, seniors pay $10 and the theater captures all consumer surplus from both groups. Channel 2: Attract New Customers –Price discrimination can simultaneously sell to new customers who would not be willing to pay the profit-maximizing uniform price. –In panel b of Table 10.1, the theater increases profit by selling 5 more tickets to seniors. Students pay $20 as before, seniors pay $10 and neither group enjoys any consumer surplus.

© 2014 Pearson Education, Inc. All rights reserved.10-6 10.1 Price Discrimination 1 st Condition, A Firm Must Have Market Power –A monopoly, an oligopoly, or a monopolistically competitive firm might be able to price discriminate. A perfectly competitive firm cannot. 2 nd Condition, A Firm Must Identify Groups with Different Price Sensitivity –If consumers have different demands, a firm must identify how they differ. –Disneyland knows tourists and local residents differ in their willingness to pay and use driver licenses to identify them. 3 rd Condition, A Firm Must Prevent Resale –If resale is easy, price discrimination doesn’t work because of only low- price sales. –The biggest obstacle to price discrimination is a firm’s inability to prevent resale.

© 2014 Pearson Education, Inc. All rights reserved.10-7 10.1 Price Discrimination Price Discrimination and Equal Costs –Price discrimination is based on charging different prices even for units of a good that cost the same to produce. Different Prices and Different Costs –Newsstand prices and subscription prices for magazines differ in large part because of the higher cost of selling at a newsstand rather than mailing magazines directly to consumers. This is not price discrimination. Price Discrimination –If a magazine standard subscription rate is higher than a college student subscription rate, it is price discrimination because the two subscriptions are identical in every respect except the price.

© 2014 Pearson Education, Inc. All rights reserved.10-8 10.1 Price Discrimination Type 1, Perfect Price Discrimination –The firm sells each unit at the maximum amount any customer is willing to pay. –Price differs across consumers, and may differ too for a given consumer. Type 2, Group Price Discrimination –The firm charges each group of customers a different price, but it does not charge different prices within the group. Type 3, Nonlinear Price Discrimination –The firm charges a different price for large purchases than for small quantities so that the price paid varies according to the quantity purchased.

© 2014 Pearson Education, Inc. All rights reserved.10-9 10.2 Perfect Price Discrimination How a Firm Perfectly Price Discriminates –A firm with market power that can prevent resale and has full information about its customers’ willingness to pay price discriminates by selling each unit at its reservation price—the maximum amount any consumer would pay for it. –The maximum price for any unit of output is given by the height of the demand curve at that output level. Perfectly Price Discrimination: Price = MR –A perfectly price-discriminating firm’s marginal revenue is the same as its price. –So, the firm’s marginal revenue curve is the same as its demand curve

© 2014 Pearson Education, Inc. All rights reserved.10-10 10.2 Perfect Price Discrimination Efficient But Consumer Surplus Equal to Zero –Perfect price discrimination is efficient: It maximizes the sum of consumer surplus and producer surplus. –But, all the surplus goes to the firm, consumer surplus is zero. –In Figure 10.2, at the competitive market equilibrium, e c, consumer surplus is A + B + C and producer surplus is D + E. At the perfect price discrimination equilibrium, Qd=Qc, no deadweight loss occurs, all surplus goes to the monopoly. –Consumer surplus is greatest with competition, lower with single- price monopoly, and eliminated by perfect price discrimination

© 2014 Pearson Education, Inc. All rights reserved.10-12 10.2 Perfect Price Discrimination Individual Price Discrimination –Perfect price discrimination is rarely fully achieved in practice. –Firms can still increase profits with imperfect individual price discrimination: charge individual-specific prices to different consumers, which may or may not be the consumers’ reservation prices. Transaction Costs and Price Discrimination –It is often too difficult or costly to gather information about each customer’s reservation price for each unit of the product (high transaction costs). –However, recent advances in computer technologies have lowered these transaction costs. –Hotels, car and truck rental companies, cruise lines, airlines, and other firms are increasingly using individual price discrimination.

© 2014 Pearson Education, Inc. All rights reserved.10-13 10.3 Group Price Discrimination Conditions for Group Price Discrimination –Group price discrimination: potential customers are divided into two or more groups with different prices for each group (single price within a group). –Consumer groups may differ by age, location, or in other ways. –A firm must have market power, be able to identify groups with different reservation prices, and prevent resale. Group Price Discrimination with Two Groups –Warner Brothers, legal monopoly by copyright, produces and sells the Harry Potter and the Deathly Hallows Part 2 DVD. –Warner engaged in group price discrimination by charging different prices in various countries. Resale is not possible because DVDs have incompatible formats. –A graphical and mathematical approach in next slides.

© 2014 Pearson Education, Inc. All rights reserved.10-14 10.3 Group Price Discrimination Group Price Discrimination: A Graphic Approach –If a firm can prevent resale between countries and has a common MC, then it can maximize profit by acting like a traditional monopoly in each country separately. –In Figure 10.3, resale between the U.S. and the U.K. is not possible (different DVD formats) and the common constant MC = m = $1. – Warner acts as a traditional monopoly in each country. U.S. market: MR A =1, Q A =5.8, p A =$29. U.K. market: MR B =1, Q B =2, p B =$39. –Warner price group discriminates and maximizes profit.

© 2014 Pearson Education, Inc. All rights reserved.10-16 10.3 Group Price Discrimination Profit: (Q A, Q B ) = π A (Q A ) + π B (Q B ) = [R A (Q A ) – mQ A ] + [R B (Q B ) – mQ B ] –Total profit is the sum of the American and British profits ( π = π A + π B ). In each country, profit is revenue minus cost (both depend on the Q sold in each country). –To maximize profit: differentiate the monopoly’s profit function with respect to each quantity, holding the other quantity fixed, and set derivatives equal to zero. American Market: ∂ (Q A, Q B ) / ∂ Q A = 0 –∂ (Q A, Q B ) / ∂ Q A = dR A (Q A )/dQ A – m = 0 –The monopoly sets MR = MC in this market, so MR A = dR A (Q A )/dQ A = m British Market: ∂ (Q A, Q B ) / ∂ Q B = 0 –∂ (Q A, Q B ) / ∂ Q B = dR B (Q B )/dQ B – m = 0 –The monopoly sets MR = MC in this market, so MR B = dR B (Q B )/dQ B = m

© 2014 Pearson Education, Inc. All rights reserved.10-17 10.3 Group Price Discrimination Two Group Price Discrimination and Elasticities –We know MR A = m = MR B –We also know from Chapter 9 that MR = p (1 + 1/ε) –So, MR A = p A (1 + 1/ε A ) = m = p B (1 + 1/ε B ) = MR B Implication: p B / p A = (1 + 1/ε A ) / (1 + 1/ε B ) –The ratio of prices depend on the elasticity values in these two markets. –Warner Brothers apparently believed that the British demand curve was less elastic at its profit-maximizing prices than the U.S. demand curve ( B  –1.0263,  A  ‑ 1.0357). Consequently, Warner charged British consumers 34% more than U.S. customers, p B / p A = $39/$29 = 1.345.

© 2014 Pearson Education, Inc. All rights reserved.10-18 10.3 Group Price Discrimination Identifying Groups: Divide Buyers Based on Observable Characteristics –The firm believes observable characteristics are associated with unusually high or low reservation prices or demand elasticities. –Movie theaters price discriminate using the age of customers. Higher prices for adults than for children. Identifying Groups: Divide Buyers Based on Their Actions –Allow consumers to self-select the group to which they belong depending on their opportunity cost of time. –Customers may be identified by their willingness to spend time to buy a good at a lower price (buy at the store; low opportunity cost) or to order goods and services in advance of delivery (phone or online shopping; high opportunity cost).

© 2014 Pearson Education, Inc. All rights reserved.10-19 10.3 Group Price Discrimination Effects on Total Surplus: Group Price Discrimination vs. Perfect Competition –Consumer surplus is greater and more output is produced with perfect competition than with group price discrimination. –Group price discrimination transfers some of the competitive consumer surplus to the firm as additional profit and causes deadweight loss due to reduced output. Effects on Total Surplus: Group Price Discrimination vs. Single-Price Monopoly –From theory alone, we cannot tell whether total surplus is higher if the monopoly uses group price discrimination or if it sets a single price. –The closer the firm comes to perfect price discrimination using group price discrimination (many groups rather than just two), the more output it produces, and the less production inefficiency—the greater the total surplus.

© 2014 Pearson Education, Inc. All rights reserved.10-20 10.4 Nonlinear Price Discrimination Characteristics and Conditions –Many firms, with market power and no resale, are unable to determine high reservation prices. However, such firms know a typical customer’s demand curve is downward sloping. –Such a firm can price discriminate by letting the price each customer pays vary with the number of units the customer buys (nonlinear price discrimination). Block Pricing vs. Single Price –A firm charges one price per unit for the first block purchased and a different price per unit for subsequent blocks. Used by gas, electric, water, and other utilities. –In panel a of Figure 10.4, the firm charges a price of $70 on any quantity between 1 and 20— 1 st block—and $50 for the 2 nd block. In panel b, the firm can set only a single price of $30. When block pricing consumer surplus is lower, total surplus is higher and deadweight loss is lower. The firm and society are better off but consumers lose. –The more block prices that a firm can set, the closer the firm gets to perfect price discrimination.

© 2014 Pearson Education, Inc. All rights reserved.10-22 10.5 Two-Part Pricing Characteristics and Conditions –Two-part pricing: a firm charges each consumer a lump-sum access fee for the right to buy as many units of the good as the consumer wants at a per-unit price. –A consumer’s overall expenditure for amount q consists of two parts: an access fee, A, and a per-unit price, p. Therefore, expenditure is E = A + pq. –To do it, a firm must have market power, know how individual demand curves vary across its customers, and prevent resale. Two Part Pricing with Identical Consumers –With identical customers, a firm can set a two-part price that is efficient (p = MC) and all total surplus goes to the firm (CS = 0). –In panel a of Figure 10.5, the monopoly charges a per-unit fee price, p, equal to the marginal cost of 10, and an access fee, A = 2,450 = CS. The firm’s total profit is 2,450 times the number of identical customers. –If the firm were to charge a price above its marginal cost of 10, it would sell fewer units and make a smaller profit. For instance, p = 20 in panel b of Figure 10.5.

© 2014 Pearson Education, Inc. All rights reserved.10-24 10.5 Two-Part Pricing Two-Part Pricing with Different Consumers –Two-part pricing is more complex if consumers have different demand curves. –Having two different demands implies consumers have different consumer surpluses. Two-part pricing would require the monopolist to charge different access fees, and this may not be possible. Example –In Figure 10.6, the monopoly faces two consumers. Valerie’s demand curve is D 1 in panel a, and Neal’s demand curve is D 2 in panel b. –If the monopoly can charge different prices, it sets price for both customers at p = MC = 10 and access fee of 2,450 to Valerie and 4,050 to Neal. π = 6,500 –If the monopoly cannot charge its customers different access fees, it sets its per-unit price at p = 20, where Valerie purchases 60 and Neal buys 80 units. It charges both the same access fee of 1,800 = A 1, which is Valerie’s CS. π = 5,0 00

© 2014 Pearson Education, Inc. All rights reserved.10-26 10.6 Bundling Bundling and Types of Bundling –Firms with market power often pursue a pricing strategy called bundling: selling multiple goods or services for a single price. –Most goods are bundles of many separate parts. However, firms sometimes bundle even when there are no production advantages and transaction costs are small. –Bundling allows firms to increase their profit by charging different prices to different consumers based on the consumers’ willingness to pay. –Some firms engage in pure bundling: only a package deal is offered (a cable company sells a bundle of Internet, phone, and television for a single price, no service separately) –Other firms use mixed bundling: goods are available as a package or separately.

© 2014 Pearson Education, Inc. All rights reserved.10-27 10.6 Bundling Pure Bundling –Microsoft Works is a pure bundle. Word and Excel programs are not sold individually but only as part of the bundle Works. –Whether it pays for Microsoft to sell a bundle or sell the programs separately depends on how reservation prices for the components vary across customers. –Bundling increases profits if reservation prices are negatively correlated and it reduces profits it they are positively correlated. –We assume the marginal cost of producing an extra copy of either type of software is essentially zero; fixed cost is negligible so that the firm’s revenue equals its profit; the firm must charge all customers the same price—it cannot price discriminate.

© 2014 Pearson Education, Inc. All rights reserved.10-28 10.6 Bundling Profitable Pure Bundling: Reservation Prices Negatively Correlated –Table 10.2 shows the reservation prices for two customers and two products. –The reservation prices are negatively correlated: the customer who has the higher reservation price for one product has the lower reservation price for the other product. –If the firm sells the two products separately, it maximizes its profit by charging $90 for the word processor and selling it to both consumers, and selling the spreadsheet program for $50 to both consumers. The firm’s total profit from selling the programs separately is $280 (= $180 + $100). –If the firm sells the two products in a bundle, it maximizes its profit by charging 160, selling to both customers, and earning $320. Pure bundling is more profitable. –Pure bundling is more profitable because the firm captures more of the consumers’ potential consumer surplus—their reservation prices.

© 2014 Pearson Education, Inc. All rights reserved.10-30 10.6 Bundling Non-Profitable Pure Bundling: Reservation Prices Positive Correlated –Table 10.3 shows the reservation prices for two customers and two products. –The reservation prices are positively correlated: a higher reservation price for one product is associated with a higher reservation price for the other product. –If the programs are sold separately, the firm charges $90 for the word processor, sells to both consumers, and earns $180. However, it makes more charging $90 for the spreadsheet program and selling it only to Carol. The firm’s total profit if it prices separately is $270 (= $180 + $90). –If the firm uses pure bundling, it maximizes its profit by charging $130 for the bundle, selling to both customers, and making $260. –Because the firm earns more selling the programs separately, $270, than when it bundles them, $260, pure bundling is not profitable in this example. As long as reservation prices are positively correlated, pure bundling cannot increase the profit.

© 2014 Pearson Education, Inc. All rights reserved.10-31 10.6 Bundling Mixed Bundling –Under mixed bundling, consumers are allowed to buy the pure bundle or to buy any of the bundle’s components separately. –Table 10.4 shows the reservation prices of four potential customers for two products. –Aaron, a writer, places high value on the word processing program but has relatively little use for a spreadsheet. Dorothy, an accountant, has the opposite pattern of preferences. Brigitte and Charles have intermediate reservation prices that are negatively correlated. –If the firm prices each program separately, it maximizes its profit by charging $90 for each product and selling each to three customers. It earns $540 total. –If the firm engage in pure bundling, it can charge $150 for the bundle, sell to all four consumers, and earns $600 total. –If the firm does mixed bundling, it can charge $160 for the bundle to two consumers and $120 for each product separately to the other two consumers. It earns $640 total.

© 2014 Pearson Education, Inc. All rights reserved.10-33 10.6 Bundling Requirement Tie-In Sales –Requirement tie in sales is another form of bundling: requires customers who buy one product from a firm to make all concurrent and subsequent purchases of a related product from that firm. –This requirement allows the firm to identify heavier users and charge them more per unit. Example –If a printer manufacturer can require that consumers buy their ink cartridges only from the manufacturer, then that firm can capture most of the consumers’ surplus. –Heavy users of the printer, who presumably have a less elastic demand for it, pay the firm more than light users because of the high cost of the ink cartridges. –Printer firms such as Hewlett-Packard (HP) write their warranties to strongly encourage consumers to use only their cartridges and not to refill them.

© 2014 Pearson Education, Inc. All rights reserved.10-35 Managerial Solution Managerial Problem –How can Heinz’s managers design a pattern of sales that maximizes Heinz’s profit? Under what conditions does it pay for Heinz to have a policy of periodic sales? Solution –By putting Heinz on sale periodically, Heinz’s managers can price discriminate. –Every n days, the typical consumer buys either Heinz or generic ketchup. Switchers are price sensitive, always know when Heinz is on sale and buy it. Loyal customers do not distort their shopping patterns solely to buy Heinz on sale. –If there are more switchers than loyal customers, then having sales is more profitable than selling at a uniform price to only loyal customers.

Chapter 10 Pricing with Market Power. © 2014 Pearson Education, Inc. All rights reserved.10-2 Table of Contents 10.1 Price Discrimination 10.2 Perfect.

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Chapter 10 Pricing with Market Power. © 2014 Pearson Education, Inc. All rights reserved.10-2 Table of Contents 10.1 Price Discrimination 10.2 Perfect.

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Presentation on theme: "Chapter 10 Pricing with Market Power. © 2014 Pearson Education, Inc. All rights reserved.10-2 Table of Contents 10.1 Price Discrimination 10.2 Perfect."— Presentation transcript:

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