Chapter 11 Pricing with Market Power Topics to

Chapter 11 Pricing with Market Power

Topics to be Discussed l Capturing Consumer Surplus l Price Discrimination l Intertemporal Price Discrimination and Peak-Load Pricing © 2005 Pearson Education, Inc. Chapter 11 2

Introduction l Pricing without market power (perfect competition) is determined by market supply and demand. l The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits. © 2005 Pearson Education, Inc. Chapter 11 3

Introduction l Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production. © 2005 Pearson Education, Inc. Chapter 11 4

Capturing Consumer Surplus l All pricing strategies we will examine are means of capturing consumer surplus and transferring it to the producer l Profit maximizing point of P* and Q* m But some consumers will pay more that P* for a good. l Raising price will lose some consumers, leading to smaller profits l Lowering price will gains some consumers, but lower profits © 2005 Pearson Education, Inc. Chapter 11 5

Capturing Consumer Surplus $/Q Pmax The firm would like to charge higher price to those consumers willing to pay it - A A P 1 P* B Firm would also like to sell to those in area B but without lowering price to all consumers P 2 MC PC Both ways will allow the firm to capture more consumer surplus D Q* © 2005 Pearson Education, Inc. MR Chapter 11 Quantity 6

Capturing Consumer Surplus l Price discrimination is the practice of charging different prices to different consumers for similar goods. m Must be able to identify the different consumers and get them to pay different prices l Other techniques that expand the range of a firm’s market to get at more consumer surplus m Tariffs © 2005 Pearson Education, Inc. and bundling Chapter 11 7

Price Discrimination l First Degree Price Discrimination m Charge a separate price to each customer: the maximum or reservation price they are willing to pay. l How can a firm profit m m The firm produces Q* MR = MC We can see the firms variable profit – the firm’s profit ignoring fixed costs l. Area m between MR and MC Consumer surplus area between demand Price © 2005 Pearson Education, Inc. Chapter 11 8

Price Discrimination l If the firm can perfectly price discriminate, each consumer is charged exactly what they are willing to pay. m MR curve is no longer part of output decision m Incremental revenue is exactly the price at which each unit is sold – the demand curve m Additional profit from producing and selling an incremental unit is now the difference between demand marginal cost © 2005 Pearson Education, Inc. Chapter 11 9

Perfect First-Degree Price Discrimination $/Q Pmax Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow). Consumer surplus is the area above P* and between 0 and Q* output. With perfect discrimination, firm will choose to produce Q** increasing variable profits to include purple area. MC P* PC D = AR MR Q* © 2005 Pearson Education, Inc. Q** Chapter 11 Quantity 10

First-Degree Price Discrimination l In practice perfect price discrimination is almost never possible 1. 2. Impractical to charge every customer a different price (unless very few customers) Firms usually does not know reservation price of each customer l Firms can discriminate imperfectly m Can charge a few different prices based on some estimates of reservation prices © 2005 Pearson Education, Inc. Chapter 11 11

First-Degree Price Discrimination l 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: m Lawyers, doctors, accountants m Car salesperson (15% profit margin) m Colleges and universities (differences in financial aid) © 2005 Pearson Education, Inc. Chapter 11 12

First-Degree Price Discrimination in Practice Six prices exist resulting in higher profits. With a single price P*4, there are fewer consumers. $/Q P 1 P 2 P 3 MC P*4 Discriminating up to P 6 (competitive price) will increase profits P 5 P 6 D Q* © 2005 Pearson Education, Inc. MR Chapter 11 Quantity 13

Second-Degree Price Discrimination l In some markets, consumers purchase many units of a good over time m Demand for that good declines with increased consumption l Electricity, water, heating fuel m Firms can engage in second degree price discrimination l Practice of charging different prices per unit for different quantities of the same good or service © 2005 Pearson Education, Inc. Chapter 11 14

Second-Degree Price Discrimination l Quantity discounts are an example of second-degree price discrimination m Ex: Buying in bulk like at Sam’s Club l Block pricing – the practice of charging different prices for different quantities of “blocks” of a good m Ex: electric power companies charge different prices for a consumer purchasing a set block of electricity © 2005 Pearson Education, Inc. Chapter 11 15

Second-Degree Price Discrimination $/Q Without discrimination: P = P 0 and Q = Q 0. With second-degree discrimination there are three blocks with prices P 1, P 2, & P 3. Different prices are charged for different quantities or “blocks” of same good P 1 P 0 P 2 AC MC P 3 D MR Q 1 1 st Block © 2005 Pearson Education, Inc. Q 0 2 nd Block Q 2 Q 3 Quantity 3 rd Block Chapter 11 16

Third-Degree Price Discrimination l Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group 1. 2. Divides the market into two-groups. Each group has its own demand function. © 2005 Pearson Education, Inc. Chapter 11 17

Price Discrimination l Third Degree Price Discrimination l Most common type of price discrimination. m Examples: airlines, premium v. non-premium liquor, discounts to students and senior citizens, frozen v. canned vegetables, magazines. © 2005 Pearson Education, Inc. Chapter 11 18

Third-Degree Price Discrimination l Some characteristic is used to divide the consumer groups l Typically elasticities of demand differ for the groups m College students and senior citizens are not usually willing to pay as much as others because of lower incomes m These groups are easily distinguishable with ID’s © 2005 Pearson Education, Inc. Chapter 11 19

Creating Consumer Groups l If third degree price-discrimination is feasible, how can the firm decide what to charge each group of consumers? 1. 2. Total output should be divided between groups so that MR for each group are equal. Total output is chosen so that MR for each group of consumers is equal to the MC of production © 2005 Pearson Education, Inc. Chapter 11 20

Third-Degree Price Discrimination l Algebraically m P 1: price first group m P 2: price second group m C(QT) = total cost of producing output QT = Q 1 + Q 2 m Profit: © 2005 Pearson Education, Inc. = P 1 Q 1 + P 2 Q 2 - C(QT) Chapter 11 21

Third-Degree Price Discrimination l Firm should increase sales to each group until incremental profit from last unit sold is zero l Set incremental for sales to group 1 = 0 © 2005 Pearson Education, Inc. Chapter 11 22

Third-Degree Price Discrimination l First group of consumers: m MR 1= MC l Can do the same thing for the second group of consumers l Second group of customers: m MR 2 = MC l Combining these conclusions gives m MR 1 = MR 2 = MC © 2005 Pearson Education, Inc. Chapter 11 23

Third-Degree Price Discrimination l Determining relative prices m Thinking of relative prices that should be charged to each group of consumers and relating them to price elasticities of demand may be easier. © 2005 Pearson Education, Inc. Chapter 11 24

Third-Degree Price Discrimination l Determining relative prices m Equating MR 1 and MR 2 gives the following relationship that must hold for prices m The higher price will be charged to consumer with the lower demand elasticity © 2005 Pearson Education, Inc. Chapter 11 25

Third-Degree Price Discrimination l Example m E 1 = -2 & E 2 = -4 m P 1 should be 1. 5 times as high as P 2 © 2005 Pearson Education, Inc. Chapter 11 26

Third-Degree Price Discrimination $/Q Consumers are divided into two groups, with separate demand curves for each group. MRT = MR 1 + MR 2 D 2 = AR 2 MRT MR 2 MR 1 © 2005 Pearson Education, Inc. D 1 = AR 1 Chapter 11 Quantity 27

Third-Degree Price Discrimination $/Q MC = MR 1 at Q 1 and P 1 • QT: MC = MRT • Group 1: more inelastic • Group 2: more elastic • MR 1 = MR 2 = MCT • QT control MC MC P 2 D 2 = AR 2 MCT MR 2 D 1 = AR 1 MR 1 Q 1 © 2005 Pearson Education, Inc. Q 2 Chapter 11 QT Quantity 28

No Sales to Smaller Market l Even if third-degree price discrimination is possible, it may not be feasible to try and sell to both groups m It is possible that the demand for one group is so low, it would not be profitable to lower price enough to sell to that group. © 2005 Pearson Education, Inc. Chapter 11 29

No Sales to Smaller Market Group one, with demand D 1, are not willing to pay enough for the good to make price discrimination profitable. $/Q MC P* D 2 MC=MR 1 =MR 2 MR 1 D 1 Q* © 2005 Pearson Education, Inc. Chapter 11 Quantity 30

The Economics of Coupons and Rebates l 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. l Coupons and rebate programs allow firms to price discriminate. © 2005 Pearson Education, Inc. Chapter 11 31

The Economics of Coupons and Rebates l About 20 – 30% of consumers use coupons or rebates l Firms can get those with higher elasticities of demand to purchase the good who would not normally buy it. l Table 11. 1 shows how elasticities of demand vary for coupon/rebate users and non users © 2005 Pearson Education, Inc. Chapter 11 32

Price Elasticities of Demand: Users v. Nonusers of Coupons © 2005 Pearson Education, Inc. Chapter 11 33

Airline Fares l Differences in elasticities imply that some customers will pay a higher fare than others. l Business travelers have few choices and their demand is less elastic. l Casual travelers and families are more price sensitive and will therefore be choosier. © 2005 Pearson Education, Inc. Chapter 11 34

Elasticities of Demand for Air Travel © 2005 Pearson Education, Inc. Chapter 11 35

Airline Fares l There are multiple fares for every route flown by airlines l They separate the market by setting various restrictions on the tickets. m Must stay over a Saturday night m 21 -day advance, 14 -day advance m Basic restrictions – can change ticket to only certain days m Most expensive: no restrictions – first class © 2005 Pearson Education, Inc. Chapter 11 36

Other Types of Price Discrimination l Intertemporal Price Discrimination m Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time m Initial release of a product, the demand is inelastic l Hard back v. paperback book l New release movie l Technology © 2005 Pearson Education, Inc. Chapter 11 37

Intertemporal Price Discrimination l Once this market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand. l This can be seen graphically looking at two different groups of consumers – one willing to buy right now and one willing to wait. © 2005 Pearson Education, Inc. Chapter 11 38

Intertemporal Price Discrimination $/Q Initially, demand is less elastic resulting in a price of P 1 Over time, demand becomes more elastic and price is reduced to appeal to the mass market. P 2 D 2 = AR 2 AC = MC MR 1 Q 1 © 2005 Pearson Education, Inc. MR 2 D 1 = AR 1 Q 2 Chapter 11 Quantity 39

Other Types of Price Discrimination l Peak-Load Pricing m Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be higher. l Demand for some products may peak at particular times. m m Rush hour traffic Electricity - late summer afternoons Ski resorts on weekends Movies on weekends © 2005 Pearson Education, Inc. Chapter 11 40

Peak-Load Pricing l Objective is to increase efficiency by charging customers close to marginal cost m Increased MR and MC would indicate a higher price. m Total surplus is higher because charging close to MC m Can measure efficiency gain from peak-load pricing © 2005 Pearson Education, Inc. Chapter 11 41

Peak-Load Pricing l With third-degree price discrimination, the MR for all markets was equal l MR is not equal for each market because one market does not impact the other market with peak-load pricing. m Price and sales in each market are independent m Ex: electricity, movie theaters © 2005 Pearson Education, Inc. Chapter 11 42

Peak-Load Pricing $/Q MC MR=MC for each group. Group 1 has higher demand during peak times P 1 D 1 = AR 1 P 2 MR 1 D 2 = AR 2 MR 2 Q 2 © 2005 Pearson Education, Inc. Q 1 Chapter 11 Quantity 43

How to Price a Best Selling Novel l How would you arrive at the price for the initial release of the hardbound edition of a book? m Hard-back and paperback books are ways for the company to price discriminate. m How does the company determine what price to sell the hard-back and paperback books for? m How doe the company determine when to release the paperback? © 2005 Pearson Education, Inc. Chapter 11 44

How to Price a Best Selling Novel l Company must divide consumers into two groups: m Those willing to buy more expensive hard back m Those willing to wait for paperback l Have to be strategic abut when to release paperback after hardback m Publishers © 2005 Pearson Education, Inc. typically wait 12 to 18 months Chapter 11 45

How to Price a Best Selling Novel l Publishers must use estimates of past books to determine how much to sell a new book. l Hard to determine the demand for a NEW book. l New books are typically sold for about the same price to take this into account. l Demand for paperbacks is more elastic so we should expect it to be priced lower. © 2005 Pearson Education, Inc. Chapter 11 46