C H A P T E R 11 Pricing with Market Power CHAPTER OUTLINE 11.1 Capturing Consumer Surplus A s we explained in Chapter 10, market power is quite common Many industries have only a few producers, so that each producer has some monopoly power And many firms, as buyers of raw materials, labor, or specialized capital goods, have some monopsony power in the markets for these factor inputs The problem faced by the managers of these firms is how to use their market power most effectively They must decide how to set prices, choose quantities of factor inputs, and determine output in both the short and long run to maximize profit Managers of firms with market power have a harder job than those who manage perfectly competitive firms A firm that is perfectly competitive in output markets has no influence over market price As a result, its managers need worry only about the cost side of the firm’s operations, choosing output so that price is equal to marginal cost But the managers of a firm with monopoly power must also worry about the characteristics of demand Even if they set a single price for the firm’s output, they must obtain at least a rough estimate of the elasticity of demand to determine what that price (and corresponding output level) should be Furthermore, firms can often much better by using a more complicated pricing strategy—for example, charging different prices to different customers To design such pricing strategies, managers need ingenuity and even more information about demand This chapter explains how firms with market power set prices We begin with the basic objective of every pricing strategy: capturing consumer surplus and converting it into additional profit for the firm Then we discuss how this goal can be achieved using price discrimination—charging different prices to different customers, sometimes for the same product and sometimes for small variations in the product Because price discrimination is widely practiced in one form or another, it is important to understand how it works Next, we discuss the two-part tariff—requiring customers to pay in advance for the right to purchase units of a good at a later time (and at additional cost) The classic example of this is an amusement park, where customers pay a fee to enter and then additional fees for each ride Although amusement parks may seem like a rather specialized market, there are many other examples of two-part tariffs: the price of a Gillette razor, which gives the owner the opportunity to purchase Gillette razor blades; a tennis club, where members pay an annual fee and then an hourly rate for court time; or the monthly subscription 400 11.2 Price Discrimination 401 11.3 Intertemporal Price Discrimination and Peak-Load Pricing 410 11.4 The Two-Part Tariff 414 *11.5 Bundling 419 *11.6 Advertising 429 Appendix: The Vertically Integrated Firm 439 LIST OF EXAMPLES 11.1 The Economics of Coupons and Rebates 408 11.2 Airline Fares 409 11.3 How to Price a Best-Selling Novel 413 11.4 Pricing Cellular Phone Service 417 11.5 The Complete Dinner versus la Carte: A Restaurant’s Pricing Problem 427 11.6 Advertising in Practice 432 399