Managerial economics strategy by m perloff and brander chapter 10 pricing with market power

• Channel 1: Higher Prices for Some – Price discrimination can extract additional consumer surplus from consumers who place a high value on the good.. 10-7 10.1 Price Discrimination • P

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Chapter 10Pricing with Market Power

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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

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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).

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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

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10-5

10.1 Price Discrimination Table 10.1 Theater Profits Based on the Pricing Method Used

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• 1st 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

• 2nd 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

• 3rd Condition, A Firm Must Prevent Resale

– If resale is easy, price discrimination doesn’t work because of only price sales

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10-7

• 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

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• 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

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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

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• 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, ec,

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 price monopoly, and eliminated by perfect price discrimination

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• 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

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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

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• 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: MRA=1, QA=5.8, pA=$29 U.K market: MRB=1, QB=2,

pB=$39.

– Warner price group discriminates and maximizes profit.

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10-15

Figure 10.3 Group Pricing of the Harry Potter

DVD

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• Profit: (QA, QB) = πA(QA) + πB(QB) = [RA(QA) – mQA] + [RB(QB) –

mQB]

– 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

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10-17

• Two Group Price Discrimination and Elasticities

 –1.0263, A  1.0357) Consequently, Warner charged British ‑1.0357) Consequently, Warner charged British

consumers 34% more than U.S customers, p B /p A = $39/$29 = 1.345

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• 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)

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• Effects on Total Surplus: Group Price Discrimination vs

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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

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10.4 Nonlinear Price Discrimination

Figure 10.4 Block Pricing

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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

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10.5 Two-Part Pricing Figure 10.5 Two-Part Pricing with Identical Consumers

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10.5 Two-Part Pricing

• Two-Part Pricing with Different Consumers

– Two-part pricing is more complex if consumers have different demand

– In Figure 10.6, the monopoly faces two consumers Valerie’s demand

curve is D1 in panel a, and Neal’s demand curve is D2 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

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10-25

10.5 Two-Part Pricing Figure 10.6 Two-Part Pricing with Different Consumers

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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)

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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

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– 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

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10.6 Bundling Tables 10.2 Negatively Correlated Reservation Prices

Table 10.3 Positively Correlated Reservation Prices

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– 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

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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

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10.6 Bundling Table 10.4 Reservation Prices and Mixed Bundling

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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

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