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Fernando & Yvonn Quijano

Prepared by:

2008 Prentice Hall Business Publishing Microeconomics Pindyck/Rubinfeld, 7e.

Pricing with

Market Power

11

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2 of 41Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

CHAPTER 11 OUTLINE

11.1 Capturing Consumer Surplus

11.2 Price Discrimination

11.3 Intertemporal Price Discrimination and Peak-Load

Pricing

11.4 The Two-Part Tariff

11.5 Bundling

11.6 Advertising

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CAPTURING CONSUMER SURPLUS11.1

Capturing Consumer Surplus

Figure 11.1

If a firm can charge only one price forall its customers, that price will be P*and the quantity produced will be Q*.

Ideally, the firm would like to charge ahigher price to consumers willing topay more than P*, thereby capturingsome of the consumer surplus underregionAof the demand curve.

The firm would also like to sell toconsumers willing to pay prices lowerthan P*, but only if doing so does notentail lowering the price to otherconsumers.

In that way, the firm could alsocapture some of the surplus underregion Bof the demand curve.

price discrimination Practice ofcharging different prices to different

consumers for similar goods.

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PRICE DISCRIMINATION11.2

First-Degree Price Discrimination

reservation price Maximum price that a customeris willing to pay for a good.

first-degree price discrimination Practice ofcharging each customer her reservation price.

Additional Profit from Perfect First-Degree

Price Discrimination

Figure 11.2

Because the firm charges each consumer herreservation price, it is profitable to expandoutput to Q**.

When only a single price, P*, is charged, thefirms variable profit is the area between the

marginal revenue and marginal cost curves.

With perfect price discrimination, this profitexpands to the area between the demandcurve and the marginal cost curve.

variable profit Sum of profits on each incremental

unit produced by a firm; i.e., profit ignoring fixed costs.

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First-Degree Price Discrimination

First-Degree Price Discrimination inPractice

Figure 11.3

Firms usually dont know the

reservation price of everyconsumer, but sometimesreservation prices can be roughlyidentified.

Here, six different prices arecharged. The firm earns higherprofits, but some consumers mayalso benefit.

With a single price P*4, there arefewer consumers.

The consumers who now pay P5or

P6enjoy a surplus.

Perfect Price Discrimination

The additional profit from producing and selling an incremental

unit is now the difference between demand and marginal cost.

Imperfect Price Discrimination

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Second-Degree Price Discrimination

second-degree price discrimination Practice of charging differentprices per unit for different quantities of the same good or service.

block pricing Practice of charging different prices for differentquantities or blocks of a good.

Second-Degree Price Discrimination

Figure 11.4

Different prices are charged fordifferent quantities, or blocks, of

the same good. Here, there arethree blocks, with correspondingprices P1, P2, and P3.

There are also economies ofscale, and average and marginalcosts are declining. Second-degree price discrimination canthen make consumers better offby expanding output and loweringcost.

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Third-Degree Price Discrimination

third-degree price discrimination Practice of dividing consumersinto two or more groups with separate demand curves and chargingdifferent prices to each group.

Creating Consumer Groups

If third-degree price discrimination is feasible, how should the firm decidewhat price to charge each group of consumers?

1. We know that however much is produced, total output should bedivided between the groups of customers so that marginal revenues foreach group are equal.

2. We know that totaloutput must be such that the marginal revenue foreach group of consumers is equal to the marginal cost of production.

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third-degree price discrimination Practice of dividing consumersinto two or more groups with separate demand curves and chargingdifferent prices to each group.

Creating Consumer Groups

(11.1)

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Determining Relative Prices

(11.2)


Figure 11.5

Consumers are divided into two groups, withseparate demand curves for each group. Theoptimal prices and quantities are such thatthe marginal revenue from each group is thesame and equal to marginal cost.

Here group 1, with demand curve D1, ischarged P1,

and group 2, with the more elastic demandcurve D2, is charged the lower price P2.

Marginal cost depends on the total quantityproduced QT.

Note that Q1and Q2are chosen so that

MR1= MR2= MC.

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Determining Relative Prices

No Sales to Smaller Market

Figure 11.6

Even if third-degree price discriminationis feasible, it may not pay to sell to both

groups of consumers if marginal cost isrising.

Here the first group of consumers, withdemand D1, are not willing to pay muchfor the product.

It is unprofitable to sell to them because

the price would have to be too low tocompensate for the resulting increase inmarginal cost.

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Coupons provide a means ofprice discrimination.

Studies show that only about 20to 30 percent of all consumersregularly bother to clip, save, and

use coupons.Rebate programs work the same way.

Only those consumers with relatively price-sensitivedemands bother to send in the materials and requestrebates.

Again, the program is a means of price discrimination.

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TABLE 11.1 Price Elasticities of Demand for Users versus

Nonusers of Coupons

PRICE ELASTICITY

Product Nonusers Users

Toilet tissue 0.60 0.66

Stuffing/dressing 0.71 0.96

Shampoo 0.84 1.04

Cooking/salad oil 1.22 1.32

Dry mix dinners 0.88 1.09

Cake mix 0.21 0.43

Cat food 0.49 1.13

Frozen entrees 0.60 0.95

Gelatin 0.97 1.25

Spaghetti sauce 1.65 1.81

Creme rinse/conditioner 0.82 1.12

Soups 1.05 1.22

Hot dogs 0.59 0.77

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Travelers are often amazed at the variety of fares available forround-trip flights from New York to Los Angeles.

Recently, for example, the first-class fare was above $2000; theregular (unrestricted) economy fare was about $1700, andspecial discount fares (often requiring the purchase of a tickettwo weeks in advance and/or a Saturday night stayover) could

be bought for as little as $400.

These fares provide a profitable form of price discrimination.The gains from discriminating are large because different typesof customers, with very different elasticities of demand,purchase these different types of tickets.

TABLE 11.2 Elasticities of Demand for Air Travel

FARE CATEGORY

Elasticity First Class Unrestricted Coach Discounted

Price 0.3 0.4 0.9

Income 1.2 1.2 1.8

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INTERTEMPORAL PRICE DISCRIMINATIONAND PEAK-LOAD PRICING

11.3

Intertemporal Price Discrimination

intertemporal price discrimination Practice of separating

consumers with different demand functions into differentgroups by charging different prices at different points in time.

peak-load pricing Practice of charging higher prices duringpeak periods when capacity constraints cause marginal coststo be high.

Intertemporal Price Discrimination

Figure 11.7

Consumers are divided into groupsby changing the price over time.

Initially, the price is high. The firm

captures surplus from consumerswho have a high demand for thegood and who are unwilling to waitto buy it.

Later the price is reduced to appealto the mass market.

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11.3

Peak-Load Pricing

Peak-Load Pricing

Figure 11.8

Demands for some goods andservices increase sharply duringparticular times of the day or year.

Charging a higher price P1duringthe peak periods is more profitablefor the firm than charging a singleprice at all times.

It is also more efficient becausemarginal cost is higher during peakperiods.

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11.3

Publishing both hardbound and paperbackeditions of a book allows publishers to pricediscriminate.

Some consumers want to buy a newbestseller as soon as it is released, even if

the price is $25. Other consumers, however,will wait a year until the book is available inpaperback for $10.

The key is to divide consumers into two groups, so that those who arewilling to pay a high price do so and onlythose unwilling to pay a high

price wait and buy the paperback.

It is clear, however, that those consumers willing to wait for the paperbackedition have demands that are far more elastic than those of bibliophiles.

It is not surprising, then, that paperback editions sell for so much less thanhardbacks.

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THE TWO-PART TARIFF11.4

two-part tariff Form of pricing in which

consumers are charged both an entry and ausage fee.

Single Consumer

Two-Part Tariff with a Single Consumer

Figure 11.9

The consumer has demand curveD.

The firm maximizes profit by settingusage fee Pequal to marginal cost

and entry fee T* equal to the entiresurplus of the consumer.

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Two Consumers

Two-Part Tariff with Two Consumers

Figure 11.10

The profit-maximizing usage fee P*will exceed marginal cost.

The entry fee T* is equal to thesurplus of the consumer with thesmaller demand.

The resulting profit is2T* + (P* MC)(Q1+ Q2). Note thatthis profit is larger than twice the

area of triangleABC.

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Many Consumers

Two-Part Tariff with Many Different Consumers

Figure 11.11

Total profit is the sum of the profit from the

entry fee aand the profit from sales s. Both

aand sdepend on T, the entry fee.

Therefore

= a+ s= n(T)T+ (P MC)Q(n)

where nis the number of entrants, whichdepends on the entry fee T, and Qis the rateof sales, which is greater the larger is n.

Here T* is the profit-maximizing entry fee,

given P. To calculate optimum values for PandT, we can start with a number for P, find theoptimum T, and then estimate the resultingprofit.

Pis then changed and the corresponding Trecalculated, along with the new profit level.

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In 1971, Polaroid introduced its SX-70 camera.This camera was sold, not leased, toconsumers. Nevertheless, because film wassold separately, Polaroid could apply a two-parttariff to the pricing of the SX-70.

Why did the pricing of Polaroids cameras andfilm involve a two-part tariff?

Because Polaroid had a monopoly on both its camera and the film, onlyPolaroid film could be used in the camera.

How should Polaroid have selected its prices for the camera and film? It

could have begun with some analytical spadework. Its profit is given by = PQ+ nT C1(Q) C2(n)

where Pis the price of the film, Tthe price of the camera, Qthe quantity offilm sold, nthe number of cameras sold, and C1(Q) and C2(n) the costs ofproducing film and cameras, respectively.

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Most telephone serviceis priced using a two-part tariff: a monthlyaccess fee, which mayinclude some free

minutes, plus a per-minute charge foradditional minutes.

This is also true for cellular phone service, which hasgrown explosively, both in the United States and around

the world.Because providers have market power, they must thinkcarefully about profit-maximizing pricing strategies.

The two-part tariff provides an ideal means by whichcellular providers can capture consumer surplus and turn it

into profit.

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BUNDLING11.5

bundling Practice of selling two or

more products as a package.To see how a film company can use customer heterogeneity to itsadvantage, suppose that there are two movie theaters and that theirreservation prices for these two films are as follows:

If the films are rented separately, the maximum price that could becharged for Windis $10,000 because charging more would exclude

Theater B. Similarly, the maximum price that could be charged forGertieis $3000.

But suppose the films are bundled. TheaterAvalues the pair of filmsat $15,000 ($12,000 + $3000), and Theater Bvalues the pair at$14,000 ($10,000 + $4000). Therefore, we can charge each theater$14,000 for the pair of films and earn a total revenue of $28,000.

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BUNDLING11.5

Relative Valuations

Why is bundling more profitable than selling the films separately?Because the relative valuations of the two films are reversed.

The demands are negatively correlatedthe customer willing to paythe most for Wind is willing to pay the least for Gertie.

To see why this is critical, suppose demands werepositivelycorrelatedthat is, TheaterAwould pay more for bothfilms:

If we bundled the films, the maximum price that could be chargedfor the package is $13,000, yielding a total revenue of $26,000,the same as by renting the films separately.

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BUNDLING11.5

Relative Valuations

Reservation Prices

Figure 11.12

Reservation prices r1and r2fortwo goods are shown for three

consumers, labeledA, B, and C.ConsumerA is willing to pay up to$3.25 for good 1 and up to $6 forgood 2.

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BUNDLING11.5

Relative Valuations

Consumption Decisions When

Products Are Sold Separately

Figure 11.13

The reservation prices ofconsumers in region I exceed the

prices P1and P2for the twogoods, so these consumers buyboth goods.Consumers in regions II and IVbuy only one of the goods,and consumers in region III buyneither good.

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BUNDLING11.5

Relative Valuations

Consumption Decisions When

Products Are Bundled

Figure 11.14

Consumers compare the sum oftheir reservation prices r1+ r2, with

the price of the bundle PB.

They buy the bundle only if r1+ r2is at least as large as PB.

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BUNDLING11.5

Relative Valuations

Reservation Prices

Figure 11.15

In (a), because demands are perfectly positively correlated, the firm does not gain bybundling: It would earn the same profit by selling the goods separately.

In (b), demands are perfectly negatively correlated. Bundling is the ideal strategyallthe consumer surplus can be extracted.

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BUNDLING11.5

Relative Valuations

Movie Example

Figure 11.16

ConsumersAand Bare two movietheaters. The diagram shows their

reservation prices for the films Gonewith the Windand Getting GertiesGarter.

Because the demands are negativelycorrelated, bundling pays.

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BUNDLING11.5

Mixed Bundling

mixed bundling Selling two or more goods both as apackage and individually.

pure bundling Selling products only as a package.

Mixed versus Pure Bundling

Figure 11.17

With positive marginal costs, mixedbundling may be more profitable thanpure bundling.

ConsumerAhas a reservation price forgood 1 that is below marginal cost c1,and consumer Dhas a reservation

price for good 2 that is below marginalcost c2.

With mixed bundling, consumerAisinduced to buy only good 2, andconsumer Dis induced to buy onlygood 1, thus reducing the firms cost.

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BUNDLING11.5

Mixed Bundling

Lets compare three strategies:

1. Selling the goods separately at prices P1= $50 and P2= $90.

2. Selling the goods only as a bundle at a price of $100.

3. Mixed bundling, whereby the goods are offered separately at

prices P1= P2= $89.95, or as a bundle at a price of $100.

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BUNDLING11.5

Mixed Bundling

Mixed Bundling with Zero Marginal Costs

Figure 11.18

If marginal costs are zero, and if consumers

demands are not perfectly negatively correlated,mixed bundling is still more profitable than purebundling.

In this example, consumers Band Care willing topay $20 more for the bundle than are consumersAand D.

With pure bundling, the price of the bundle is $100.With mixed bundling, the price of the bundle can beincreased to $120 and consumersAand Dcan stillbe charged $90 for a single good.

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BUNDLING11.5

Bundling in Practice

Mixed Bundling in Practice

Figure 11.19

The dots in this figure are estimates ofreservation prices for a representativesample of consumers.

A company could first choose a price

for the bundle, PB, such that a diagonalline connecting these prices passesroughly midway through the dots.The company could then try individualprices P1and P2.

GivenP1, P2, and PB, profits can becalculated for this sample of

consumers. Managers can then raiseor lower P1, P2, and PBand seewhether the new pricing leads to higherprofits. This procedure is repeated untiltotal profit is roughly maximized.

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BUNDLING11.5

For a restaurant, mixed bundlingmeans offering both complete dinners(the appetizer, main course, anddessert come as a package) and an la carte menu (the customer buys the

appetizer, main course, and dessertseparately).

This strategy allows the la carte menu to be priced to capture consumersurplus from customers who value some dishes much more highly thanothers.

At the same time, the complete dinner retains those customers who havelower variations in their reservation prices for different dishes (e.g.,customers who attach moderate values to both appetizers and desserts).

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BUNDLING11.5

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BUNDLING11.5

Tying

tying Practice of requiring a customer topurchase one good in order to purchase another.

Why might firms use this kind of pricing practice?

One of the main benefits of tying is that it often allows a firm

to meter demandand thereby practice price discriminationmore effectively.

Tying can also be used to extend a firms market power.

Tying can have other uses. An important one is to protectcustomer goodwill connected with a brand name.

This is why franchises are often required to purchase inputsfrom the franchiser.

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ADVERTISING*11.6

Effects of Advertising

Figure 11.20

AR and MR are average and marginalrevenue when the firm doesnt advertise,

and AC and MC are average andmarginal cost.

The firm produces Q0and receives a

priceP0.

Its total profit 0is given by the gray-shaded rectangle.

If the firm advertises, its average andmarginal revenue curves shift to theright.

Average cost rises (to AC) but marginal

cost remains the same.

The firm now produces Q1(where MR =MC), and receives a price P1.

Its total profit, 1, is now larger.

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The price Pand advertising expenditureA to maximizeprofit, is given by:

The firm should advertise up to the point that

=full marginal cost ofadvertising

(11.3)

Advertising leads to increased output.

But increased output in turn means increased productioncosts, and this must be taken into account whencomparing the costs and benefits of an extra dollar ofadvertising.

ADVERTISING*11.6

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First, rewrite equation (11.3) as follows:

Now multiply both sides of this equation byA/PQ, theadvertising-to-sales ratio.

advertising-to-sales ratio Ratio of a firms

advertising expenditures to its sales.

advertising elasticity of demand Percentagechange in quantity demanded resulting from a 1-percentincrease in advertising expenditures.

A Rule of Thumb for Advertising

(11.4)

ADVERTISING*11.6

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Convenience stores have lower priceelasticities of demand (around 5), but their

advertising-to-sales ratios are usually lessthan those for supermarkets (and are oftenzero). Why?

Because convenience stores mostly servecustomers who live nearby; they may

ADVERTISING*11.6

need a few items late at night or may simply not want to drive to thesupermarket.

Advertising is quite important for makers of designer jeans, who will have

advertising-to-sales ratios as high as 10 or 20 percent.

Laundry detergents have among the highest advertising-to-sales ratios of allproducts, sometimes exceeding 30 percent, even though demand for any onebrand is at least as price elastic as it is for designer jeans. What justifies allthe advertising? A very large advertising elasticity.

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ADVERTISING*11.6

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