1 capturing surplus chapter 12. 2 chapter twelve overview 1.introduction: airline tickets 2.price...
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1
CapturingSurplus
Chapter 12
2
Chapter Twelve Overview
1. Introduction: Airline Tickets
2. Price Discrimination• First Degree• Second Degree• Third Degree
3. Tie-in Sales• Requirements Tie-ins• Package Tie-ins (Bundling)
1. Introduction: Airline Tickets
2. Price Discrimination• First Degree• Second Degree• Third Degree
3. Tie-in Sales• Requirements Tie-ins• Package Tie-ins (Bundling)
Chapter Twelve
3Chapter Twelve
Uniform Price Vs. Price Discrimination
Definition: A monopolist charges a uniform price if it sets the same price for every unit of output sold.
While the monopolist captures profits due to an optimal uniform pricing policy, it does not receive the consumer surplus or dead-weight loss associated with this policy.
The monopolist can overcome this by charging more than one price for its product.
Definition: A monopolist price discriminates if it charges more than one price for the same good or service.
4Chapter Twelve
Forms of Price Discrimination
Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay. This willingness to pay is directly observable by the monopolist.
Definition: A policy of second degree price discrimination allows the monopolist to offer consumers a quantity discount.
Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed.
Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay. This willingness to pay is directly observable by the monopolist.
Definition: A policy of second degree price discrimination allows the monopolist to offer consumers a quantity discount.
Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed.
5Chapter Twelve
“Willingness to Pay” Curve
Definition: The consumer's maximum willingness to pay is called the consumer's reservation price.
Think of the demand curve as a "willingness to pay" curve. If the monopolist can observe the willingness to pay of each customer (based on, for example, residence, education, "look", etc), then the monopolist can observe demand perfectly and can "perfectly" price discriminate.
Definition: The consumer's maximum willingness to pay is called the consumer's reservation price.
Think of the demand curve as a "willingness to pay" curve. If the monopolist can observe the willingness to pay of each customer (based on, for example, residence, education, "look", etc), then the monopolist can observe demand perfectly and can "perfectly" price discriminate.
6Chapter Twelve
Forms of Price Discrimination
Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay. This willingness to pay is directly observable by the monopolist.
Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay. This willingness to pay is directly observable by the monopolist.
7
D
MCP1
PU E F
GH
J
K N
L
CS: E+F 0PS: G+H+K+L E+F+G+H+J+K+L+NTS: E+F+G+H+K+L E+F+G+H+J+K+L+NDWL: J+N 0
Chapter Twelve
MR
Quantity
Uniform Price Monopoly 1st Degree P.D. Monopoly
Uniform Price Vs. Price Discrimination
Price
8Chapter Twelve
Is it Reasonable?
The monopolist will continue selling units until the reservation price exactly equals marginal cost.
Therefore, a perfectly price discriminating monopolist will produce and sell the efficient quantity of output.
Note: Only if the monopolist can prevent resale can the monopolist capture the entire surplus.
9Chapter Twelve
Pricing Surplus – Monopoly
MC = 2P = 20 - QWhat is producer surplus if uniform pricing is followed?
MR = P + (P/Q)Q = 20 - Q - Q = 20 - 2Q
MR = MC => 20 - 2Q = 2 =>
Q* = 9P* = 11
PS= Revenue-TVC = PQ-2Q = 11(9)-2(9) = 81
10Chapter Twelve
Pricing Surplus – Monopoly
What will producer surplus be if the monopolist perfectly price discriminates?
P = MC => 20 - Q = 2 =>Q* = 18
Revenue - TVC = [18(20-2)(1/2) + 18(2)]-18(2) = 162
This is a gain in captured surplus of 81!
11
MR (uniform pricing)
D
MC
Quantity
Price
11
2
20
9 18 20
Chapter Twelve
First Degree Price Discrimination
What is the marginal revenue curve for a perfectly price discriminating monopolist?
When the monopolist sells an additional unit, it does not have to reduce the price on the other units it is selling. Therefore, MR = P. (i.e., the marginal revenue curve equals the demand curve.)
12Chapter Twelve
Definition: A policy of second degree price discrimination allows the monopolist to charge a different price to different consumers. While different consumers pay different prices, the reservation price of any one consumer cannot be directly observed.
Second Degree Price Discrimination
13Chapter Twelve
Two Part Tariff
Definition: A monopolist charges a two part tariff if it charges a per unit fee, r, plus a lump sum fee (paid whether or not a positive number of units is consumed), F.
This, effectively, charges demanders of a low quantity a different average price than demanders of a high quantity.
Example: hook-up charge plus usage fee for a telephone, club membership, or the like.
14
100
100 Q
P
10
90
4050
Chapter Twelve
Example:
All customers are identical and have demand
• P = 100 - Q• MC = AC = 10
Example:
All customers are identical and have demand
• P = 100 - Q• MC = AC = 10
Two Part Tariff
15Chapter Twelve
Two Part Tariff
What is the optimal two-part tariff?
Two steps:
(1) maximize the benefits to the consumers by charging r = MC = 10. (2) capture this benefit by setting F = consumer benefits = 4050.
What is the optimal two-part tariff?
Two steps:
(1) maximize the benefits to the consumers by charging r = MC = 10. (2) capture this benefit by setting F = consumer benefits = 4050.
16Chapter Twelve
Two Part Tariff
Any higher usage charge would result in a dead-weight loss that could not be captured by the monopolist. Any lower usage charge would result in selling at less than marginal cost.
In essence, the monopolist maximizes the size of the "pie", then sets the lump sum fee so as to capture the entire "pie" for itself.
The total surplus captured is the same as in the case of perfect price discrimination.
17Chapter Twelve
Block Tariff
Definition: If a consumer pays one price for one block of output and another price for another block of output, the consumer faces a block tariff
Definition: If a consumer pays one price for one block of output and another price for another block of output, the consumer faces a block tariff
18Chapter Twelve
Block Tariff
• P = 100 - Q• MC = AC = 10
Let Q1 be the largest quantity for which the first block rate applies so that p1(Q1) = 100 - Q1.
Let Q2 be the largest quantity purchased (so that the second block rate will apply between Q1 and Q2) so that p2(Q2) = 100 - Q2
19Chapter Twelve
Block Tariff
Then:
= p1(Q1)Q1 + p2(Q2)(Q2-Q1) - TC(Q2)
= (100 - Q1)Q1 + (100 - Q2)(Q2-Q1) - 10Q2
and we must choose Q1 and Q2 to maximize this profit…
MR1 = (100 - Q1) - Q1 - (100 - Q2) = 0
MR2 = (100 - Q2) - Q2 + Q1 = MC = 10
20Chapter Twelve
Key Equations
These are two equations in two unknowns that can be solved to obtain:
• Q1* = 30• Q2* = 60
• P1* = 70• P2* = 40 (a quantity discount)
These are two equations in two unknowns that can be solved to obtain:
• Q1* = 30• Q2* = 60
• P1* = 70• P2* = 40 (a quantity discount)
21
0 0
PP
Q Q
MC
Demand Demand
MR
10
55
45 100
100
40
70
100
30 60 100
450
450
4502700 2025
1012.5
1012.5
Chapter Twelve
Block Pricing
22Chapter Twelve
Block Pricing
If the monopolist could set a different block price for each customer, it would capture the same amount of surplus as a perfectly price discriminating monopolist.
If the monopolist could set a different block price for each customer, it would capture the same amount of surplus as a perfectly price discriminating monopolist.
23 Q
D - small D - large
MC
Chapter Twelve
Utility Pricing
24
P1
P2
Q1s Q1L Q2L Q
Additional CS
MC
Additional PS
Chapter Twelve
D - small D - large
Utility Pricing
25Chapter Twelve
Third Degree Price Discrimination
Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed.
Example: Movie ticket sales to older people or students at discount
• Suppose that marginal costs for the two markets are the same. How does a monopolist maximize profit with this type of price discrimination?
Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed.
Example: Movie ticket sales to older people or students at discount
• Suppose that marginal costs for the two markets are the same. How does a monopolist maximize profit with this type of price discrimination?
26Chapter Twelve
Set the marginal revenue in each market equal to marginal cost. (i.e., the monopolist maximizes total profits by maximizing profits from each group individually.)
This implies that MR1 = MC = MR2 at the optimum. Otherwise, the monopolist could raise revenues by switching sales from the low MR group to the high MR group.
MC = AC = 20
P1 = 100 - Q1
P2 = 80 - 2Q2
Set the marginal revenue in each market equal to marginal cost. (i.e., the monopolist maximizes total profits by maximizing profits from each group individually.)
This implies that MR1 = MC = MR2 at the optimum. Otherwise, the monopolist could raise revenues by switching sales from the low MR group to the high MR group.
MC = AC = 20
P1 = 100 - Q1
P2 = 80 - 2Q2
Optimal Pricing
ExampleExample
27Chapter Twelve
MR1 = 100 - 2Q1 = MC = 20MR2 = 80 - 4Q2 = MC = 20
Q1* = 40Q2* = 15
P1* = 60P2* = 50
MR1 = 100 - 2Q1 = MC = 20MR2 = 80 - 4Q2 = MC = 20
Q1* = 40Q2* = 15
P1* = 60P2* = 50
Optimal Pricing
ExampleExample
28
0
80
50
20 40 Q
P
Demand 2
MR2Chapter Twelve
0
100
100
20
60
P
Demand 1
MR1
Third Degree Price Discrimination
Q
Market 1Market 1 Market 2Market 2
29Chapter Twelve
Tie-in Sales – Requirements
Definition: A tie-in sale occurs if customer can buy one product only if they agree to purchase another product as well.
• Requirements tie-in sales occur when a firm requires customers who buy one product from the firm to buy another product from the firm.
A requirements tie-in sale may be used in place of price discrimination when the firm cannot observe the relative willingness to pay of different customers.
30Chapter Twelve
Tie-in Sales – Bundling
• Package tie-in sales (or bundling) occur when goods are combined so that customers cannot buy either good separately.
Bundling may be used in place of price discrimination to increase producer surplus when consumers have different willingness to pay for the goods sold in the bundle.
But bundling does not always pay…
31Chapter Twelve
Tie-in Sales – Bundling
32Chapter Twelve
Tie-in Sales – Bundling
Optimal Pricing Policy
Without bundling: pc = $1500 pm = $600
• Profit cm = $800
With bundling: pb = $1800
• Profit b = $1000
Optimal Pricing Policy
Without bundling: pc = $1500 pm = $600
• Profit cm = $800
With bundling: pb = $1800
• Profit b = $1000
33Chapter Twelve
Tie-in Sales – Bundling
34Chapter Twelve
Tie-in Sales – Bundling
Optimal Pricing Policy
Without bundling: pc = $1500 pm = $600
• Profit cm = $800
With bundling: pb = $2100
• Profit b = $800
In general, bundling a pair of goods only pays if their demands are negatively correlated (customers who are willing to pay relatively more for good A are not willing to pay as much for good B).
Optimal Pricing Policy
Without bundling: pc = $1500 pm = $600
• Profit cm = $800
With bundling: pb = $2100
• Profit b = $800
In general, bundling a pair of goods only pays if their demands are negatively correlated (customers who are willing to pay relatively more for good A are not willing to pay as much for good B).
35Chapter Twelve
Reservation Price
The reason is that the price is determined by the purchaser with the lowest reservation price.
If reservation prices for the two goods are negatively correlated, bundling reduces the dispersion of reservation prices and so raises the price at which additional units can be sold.
The reason is that the price is determined by the purchaser with the lowest reservation price.
If reservation prices for the two goods are negatively correlated, bundling reduces the dispersion of reservation prices and so raises the price at which additional units can be sold.
36Chapter Twelve
Advertising
The firm can capture surplus using nonprice strategies such as advertising.
The firm can capture surplus using nonprice strategies such as advertising.
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