Chapter 10 Pricing with Market Power 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 10-2 © 2014 Pearson Education, Inc All rights reserved 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 – – 10-3 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 nonuniform pricing © 2014 Pearson Education, Inc All rights reserved 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 more tickets to seniors Students pay $20 as before, seniors pay $10 and neither group enjoys any consumer surplus 10-4 © 2014 Pearson Education, Inc All rights reserved 10.1 Price Discrimination Table 10.1 Theater Profits Based on the Pricing Method Used 10-5 © 2014 Pearson Education, Inc All rights reserved 10.1 Price Discrimination • 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 lowprice sales – The biggest obstacle to price discrimination is a firm’s inability to prevent resale 10-6 © 2014 Pearson Education, Inc All rights reserved 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 10-7 © 2014 Pearson Education, Inc All rights reserved 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 10-8 © 2014 Pearson Education, Inc All rights reserved 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 10-9 © 2014 Pearson Education, Inc All rights reserved 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, 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 singleprice monopoly, and eliminated by perfect price discrimination 10-10 © 2014 Pearson Education, Inc All rights reserved 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 perunit 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 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 10-22 © 2014 Pearson Education, Inc All rights reserved 10.5 Two-Part Pricing Figure 10.5 Two-Part Pricing with Identical Consumers 10-23 © 2014 Pearson Education, Inc All rights reserved 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 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 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 = A1 , which is Valerie’s CS π = 5,000 10-24 © 2014 Pearson Education, Inc All rights reserved 10.5 Two-Part Pricing Figure 10.6 Two-Part Pricing with Different Consumers 10-25 © 2014 Pearson Education, Inc All rights reserved 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 10-26 © 2014 Pearson Education, Inc All rights reserved 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 10-27 © 2014 Pearson Education, Inc All rights reserved 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 10-28 © 2014 Pearson Education, Inc All rights reserved 10.6 Bundling Tables 10.2 Negatively Correlated Reservation Prices Table 10.3 Positively Correlated Reservation Prices 10-29 © 2014 Pearson Education, Inc All rights reserved 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 10-30 © 2014 Pearson Education, Inc All rights reserved 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 10-31 © 2014 Pearson Education, Inc All rights reserved 10.6 Bundling Table 10.4 Reservation Prices and Mixed Bundling 10-32 © 2014 Pearson Education, Inc All rights reserved 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 10-33 © 2014 Pearson Education, Inc All rights reserved 10.7 Peak-Load Pricing Prices & Peak Demand 10-34 © 2014 Pearson Education, Inc All rights reserved Figure 10.7 Peak-Load Pricing 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 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 10-35 © 2014 Pearson Education, Inc All rights reserved Figure 10.1 Perfect Price Discrimination 10-36 © 2014 Pearson Education, Inc All rights reserved ... 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,... derivatives equal to zero • American Market: ∂π(QA, QB) /∂QA= – ∂π(QA, QB) /∂QA= dRA(QA)/dQA – m = – The monopoly sets MR = MC in this market, so MRA = dRA(QA)/dQA = m • British Market: ∂π(QA, QB) /∂QB=... 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