Chapter Twelve Pricing Pricing Monopolies and other noncompetitive

Chapter Twelve Pricing

Pricing • Monopolies (and other noncompetitive firms) can use information about individual consumer’s demand curve to increase their profits. • Instead of setting a single price, such firms use nonuniform pricing. © 2007 Pearson Addison-Wesley. All rights reserved. 2

Pricing • Nonuniform Pricing – Charging consumers different prices for the same product or charging a single customer a price that depends on the number of units the customer buys • Price Discrimination – Practice in which a firm charges consumers different prices for the same good © 2007 Pearson Addison-Wesley. All rights reserved. 3

Pricing • In this chapter, we examine six main topics – Why and how firms price discriminate – Perfect price discrimination – Quantity discrimination – Multimarket price discrimination – Two-part tariffs – Tie-in sales © 2007 Pearson Addison-Wesley. All rights reserved. 4

Why and How Firms Price Discrimination • Why Price Discrimination Pays – For almost any good or service, some consumers are willing to pay more than others. © 2007 Pearson Addison-Wesley. All rights reserved. 5

Why Price Discrimination Pays • A firm earns a higher profit from price discrimination than from uniform pricing for two reasons. • First, a price-discrimination firm charges a higher price to customers who are willing to pay more than the uniform price, capturing some or all of their consumer surplus. © 2007 Pearson Addison-Wesley. All rights reserved. 6

Why Price Discrimination Pays • Second, a price-discrimination firm sells to some people who were not willing to pay as much as the uniform price. © 2007 Pearson Addison-Wesley. All rights reserved. 7

Table 12. 1 A Theater’s Profit Based on the Pricing Method Used © 2007 Pearson Addison-Wesley. All rights reserved. 8

Who Can Price Discriminate • For a firm to price discriminate successfully, three conditions must be met. • First, a firm must have market power. • Second, consumers must differ in their sensitivity to price (demand elasticities), and a firm must be able to identify how consumers differ in this sensitivity. © 2007 Pearson Addison-Wesley. All rights reserved. 9

Who Can Price Discriminate • Third, a firm must be able to prevent or limit resales to higher-price-paying customers by customers whom the firm charges relatively low prices. © 2007 Pearson Addison-Wesley. All rights reserved. 10

Preventing Resales • Resales are difficult or impossible for most services and when transaction costs are high. • Some firms act to raise transaction costs or otherwise make resales difficult. • A firm can prevent resales by vertically integrating: participating in more than one successive stage of the production and distribution chain for a good or service. © 2007 Pearson Addison-Wesley. All rights reserved. 11

Types of Price Discrimination • Perfect price discrimination (first-degree price discrimination) • Quantity discrimination (second-degree price discrimination) • Multimarket price discrimination (thirddegree price discrimination) © 2007 Pearson Addison-Wesley. All rights reserved. 12

Perfect Price Discrimination • A situation in which a firm sells each unit at the maximum amount any customer is willing to pay for it, so prices differ across customers and a given customers may pay more for some units than for others. © 2007 Pearson Addison-Wesley. All rights reserved. 13

Perfect Price Discrimination • If a firm with market power knows exactly how much each customer is willing to pay for each unit of its good and it can prevent resales, the firm charges each person his or her reservation price: the maximum amount a person would be willing to pay for a unit of output. © 2007 Pearson Addison-Wesley. All rights reserved. 14

Figure 12. 1 Perfect Price Discrimination 6 5 e 4 MC 3 MR = $6 MR = $5 MR = $4 1 2 3 Demand, Marginal revenue 2 1 0 1 2 © 2007 Pearson Addison-Wesley. All rights reserved. 3 4 5 6 Q, Units per day 15

Perfect Price Discrimination • A perfectly price-discriminating monopoly’s marginal revenue is the same as its price. • As the figure shows, the firm’s marginal revenue is on the first unit, on the second unit, and on the third unit. • As a result, the firm’s marginal revenue curve is its demand curve. © 2007 Pearson Addison-Wesley. All rights reserved. 16

Perfect Price Discrimination: Efficient but Hurts Consumers • A perfect price discrimination equilibrium is efficient and maximizes total welfare, where welfare is defined as the sum of consumer surplus and producer surplus. © 2007 Pearson Addison-Wesley. All rights reserved. 17

Perfect Price Discrimination: Efficient but Hurts Consumers • As such, this equilibrium has more in common with a competitive equilibrium than with a single-price-monopoly equilibrium. © 2007 Pearson Addison-Wesley. All rights reserved. 18

Figure 12. 2 Competitive, Single-Price, and Perfect Discrimination Equilibria p 1 A ps MC es B C pc = MCc ec E D MCs Demand, MRd MC 1 MRs Qs © 2007 Pearson Addison-Wesley. All rights reserved. Qc = Qd Q, Units per day 19

Figure 12. 2 Competitive, Single-Price, and Perfect Discrimination Equilibria • In the competitive market equilibrium, , price is , quantity is , consumer surplus is , producer surplus is , and there is no deadweight loss. • In the single-price monopoly equilibrium, , price is , quantity is , consumer surplus falls to , producer surplus is , and deadweight loss is. © 2007 Pearson Addison-Wesley. All rights reserved. 20

Figure 12. 2 Competitive, Single-Price, and Perfect Discrimination Equilibria • In the perfect discrimination equilibrium, the monopoly sells each unit at the customer’s reservation price on the demand curve. • It sells units, where the last unit is sold at its marginal cost. • Customers have no consumer surplus, but there is no deadweight loss. © 2007 Pearson Addison-Wesley. All rights reserved. 21

Transaction Costs and Perfect Price Discrimination • Transaction costs are a major reason why these firms do not perfectly price discriminate: It is too difficult or costly to gather information about each customer’s price sensitivity. © 2007 Pearson Addison-Wesley. All rights reserved. 22

Transaction Costs and Perfect Price Discrimination • Many other firms believe that, taking the transaction costs into account, it pays to use quantity discrimination, multimarket price discrimination, or other nonlinear pricing methods rather than try to perfectly price discriminate. © 2007 Pearson Addison-Wesley. All rights reserved. 23

Quantity Discrimination • A situation in which a firm charges a different price for large quantities than for small quantities but all customers who buy a given quantity pay the same price. © 2007 Pearson Addison-Wesley. All rights reserved. 24

Quantity Discrimination • Most customers are willing to pay more for the first unit than for successive units: The typical customer’s demand curve is downward sloping. • The price varies only with quantity: All customers pay the same price for a given quantity. © 2007 Pearson Addison-Wesley. All rights reserved. 25

Figure 12. 3 Quantity Discrimination (a) Quantity Discrimination (b) Single-Price Monopoly 90 70 90 A= $200 E = $450 60 C= $200 50 B= $1, 200 30 F = $900 D= $200 m G = $450 30 Demand m Demand MR 0 20 40 90 Q, Units per day © 2007 Pearson Addison-Wesley. All rights reserved. 0 30 90 Q, Units per day 26

Figure 12. 3 Quantity Discrimination • If this monopoly engages in quantity discounting, it makes a larger profit (producer surplus) than it does if it sets a single price, and welfare is greater. © 2007 Pearson Addison-Wesley. All rights reserved. 27

Figure 12. 3 Quantity Discrimination a) With quantity discounting, profit is and welfare is. b) If it sets a single price (so that its marginal revenue equals its marginal cost), the monopoly’s profit is , and welfare is. © 2007 Pearson Addison-Wesley. All rights reserved. 28

Multimarket Price Discrimination • A situation in which a firm charges different groups of customers different prices but charges a given customer the same price for every unit of output sold. © 2007 Pearson Addison-Wesley. All rights reserved. 29

Multimarket Price Discrimination with Two Groups • How does a monopoly set its prices if it sells to two (or more) groups of consumers with different demand curves and if resales between the two groups are impossible? © 2007 Pearson Addison-Wesley. All rights reserved. 30

Multimarket Price Discrimination with Two Groups • Because the monopoly equates the marginal revenue for each group to its common marginal cost, , the marginal revenues for the two countries are equal: (12. 1) © 2007 Pearson Addison-Wesley. All rights reserved. 31

Multimarket Price Discrimination with Two Groups • Rewriting Equation 12. 1 using these expressions for marginal revenue, we find that (12. 2 ) • The ratio of prices in the two countries depends only on demand elasticities in those countries: (12. 3) © 2007 Pearson Addison-Wesley. All rights reserved. 32

Figure 12. 4 Multimarket Pricing of Harry Potter DVD (a) United States (b) United Kingdom 35 29 D A D B CS B p = 18 B CS p = 15 A 1 MR A MR p. A p. B DWL m 9. 4 19. 47 Q , Million sets per year A © 2007 Pearson Addison-Wesley. All rights reserved. DWL B A 1 B m 1 2. 2 4. 53 Q , Million sets per year B 33

Identifying Groups • Firms use two approaches to divide customers into groups. • One method is to divide buyers into groups based on observable characteristics of consumers that the firm believes are associated with unusually high or low price elasticities. © 2007 Pearson Addison-Wesley. All rights reserved. 34

Identifying Groups • Another approach is to identify and divide consumers on the basis of their actions: The firm allows consumers to self-select the group to which they belong. © 2007 Pearson Addison-Wesley. All rights reserved. 35

Welfare Effects of Multimarket Price Discrimination • Multimarket price discrimination results in inefficient production and consumption. • As a result, welfare under multimarket price discrimination is lower than that under competition or perfect price discrimination. © 2007 Pearson Addison-Wesley. All rights reserved. 36

Multimarket Price Discrimination Versus Competition • Consumer surplus is greater and more output is produced with competition (or perfect price discrimination) than with multimarket price discrimination. © 2007 Pearson Addison-Wesley. All rights reserved. 37

Multimarket Price Discrimination Versus Single-Price Monopoly • From theory alone, we can’t tell whether welfare is higher if the monopoly uses multimarket price discrimination or if it sets a single price. • Both types of monopolies set price above marginal cost, so too little is produced relative to competition. © 2007 Pearson Addison-Wesley. All rights reserved. 38

Multimarket Price Discrimination Versus Single-Price Monopoly • The closer the multimarket-pricediscriminating monopoly comes to perfectly price discrimination (say, by dividing its customers into many groups rather than just two), the more output it produces, so the less the production inefficiency there is. © 2007 Pearson Addison-Wesley. All rights reserved. 39

Two-Part Tariffs • Two-part tariff – A pricing system in which the firm charges a customer a lump-sum fee (the first tariff or price) for the right to buy as many units of the good as the consumer wants at a specified price (the second tariff). © 2007 Pearson Addison-Wesley. All rights reserved. 40

A Two-Part Tariff with Identical Consumers • If all the monopoly’s customers are identical, a monopoly that knows its customers’ demand curve can set a two -part tariff that has the same two properties as the perfect price discrimination equilibrium. © 2007 Pearson Addison-Wesley. All rights reserved. 41

A Two-Part Tariff with Identical Consumers • First, the efficient quantity, , is sold because the price of the last unit equals marginal cost. • Second, all consumer surplus is transferred from consumers to the firm. © 2007 Pearson Addison-Wesley. All rights reserved. 42

Figure 12. 5 Two-Part Tariff (a) Consumer 1 (b) Consumer 2 100 80 D 2 D 1 A = $3, 200 2 A = $1, 800 1 20 10 0 B = $600 1 C = $50 1 20 m 60 70 80 q , Units per day 1 © 2007 Pearson Addison-Wesley. All rights reserved. 10 0 C = $50 2 B = $800 2 m 80 90 100 q , Units per day 2 43

Figure 12. 5 Two-Part Tariff • Two-part tariff – If all consumers have the demand curve in panel a, a monopoly can capture all the consumer surplus with a two-part tariff by which it charges a price, , equal to the marginal cost, , for each item and a lump-sum membership fee of. © 2007 Pearson Addison-Wesley. All rights reserved. 44

A Two-Part Tariff with Nonidentical Consumers • Suppose that the monopoly has two customers, Consumer 1 in panel a and Consumer 2 in panel b. © 2007 Pearson Addison-Wesley. All rights reserved. 45

A Two-Part Tariff with Nonidentical Consumers • If the monopoly can treat its customers differently, it maximizes its profit by setting and charging Consumer 1 a fee equal to its potential consumer surplus, , and Consumer 2 a fee of , for a total profit of $6, 500. © 2007 Pearson Addison-Wesley. All rights reserved. 46

A Two-Part Tariff with Nonidentical Consumers • If the monopoly must charge all consumers the same price, it maximizes its profit at $5, 000 by setting and charging both customers a lump-sum fee equal to the potential consumer surplus of Consumer 1, . © 2007 Pearson Addison-Wesley. All rights reserved. 47

Tie-In Sales • Tie-in sale – A type of nonlinear pricing in which customers can buy one product only if they agree to buy another product as well. © 2007 Pearson Addison-Wesley. All rights reserved. 48

Tie-In Sales • Requirement tie-in sale – A tie-in sale in which customers who buy one product from a firm are required to make all their purchases of another product from that firm. © 2007 Pearson Addison-Wesley. All rights reserved. 49

Tie-In Sales • Bundling (package tie-in sale) – A type of tie-in sale in which two goods are combined so that customers cannot buy either good separately. © 2007 Pearson Addison-Wesley. All rights reserved. 50