Chapter 11 Pricing with Market Power



Chapter 11 Pricing with Market Power

( Topics to be Discussed

- Capturing Consumer Surplus

- Price Discrimination

- Intertemporal Price Discrimination and Peak-Load Pricing

- The Two-Part Tariff

- Bundling

( Perfect competition

- Pricing without market power (perfect competition) is determined by market supply and demand. : D=MR

( Imperfect competition

- Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production. :

- D ( MR

( Capturing Consumer Surplus : Page 370

( Price Discrimination

- Price discrimination is the charging of different prices to different consumers for similar goods.

- First Degree Price Discrimination

o Charge a separate price to each customer: the maximum or reservation price they are willing to pay.

- Second Degree Price Discrimination

o Charge a different price depending on the quantity consumed.

- Third Degree Price Discrimination

o Charge a different price depending on the elasticity.

( Question

Why would a producer have difficulty in achieving first-degree price discrimination?

1) Too many customers (impractical)

2) Could not estimate the reservation price for each customer

( Additional Profit From Perfect First-Degree Price Discrimination : Figure 11.2 on. p372

( First Degree Price Discrimination

- The model does demonstrate the potential profit (incentive) of practicing price discrimination to some degree.

- Examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product:

- Car salesperson (15% profit margin), Colleges and universities (subsidized loan).

- First-Degree Price Discrimination in Practice : Figure 11.3 on page 374

( Second-Degree Price Discrimination

- Charge a different price depending on the quantity consumed.

- Figure 11.4 on page 375

( Third Degree Price Discrimination

1) Divides the market into two-groups.

2) Each group has its own demand function.

3) Most common type of price discrimination.

4) Third-degree price discrimination is feasible when the seller can separate his/her market into groups who have different price elasticities of demand (e.g. business air travelers versus vacation air travelers, discounts to students and senior citizens.).

( Third Degree Price Discrimination :

- Objectives : on page 377

o MR1 = MR2

o MC1 = MR1 and MC2 = MR2

o MR1 = MR2 = MC

[pic]

[pic]

o Second group of customers: MR2 = MC

o MR1 = MR2 = MC

- Exercise 4 on page 409

( Third Degree Price Discrimination

- Determining relative prices

[pic]

[pic]

- Pricing: Charge higher price to group with a low demand elasticity

- Example: E1 = -2 & E2 = -4

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- P1 should be 1.5 times as high as P2 : Figure 11.5 on page 378

( Intertemporal Price : Discrimination and Peak-Load Pricing

- Separating the Market With Time

- Initial release of a product, the demand is inelastic (i.e., Book, Movie,Computer)

- Once this market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand (i.e., Paper back books Dollar Movies)

- Figure 11.7 on page 382

- Demand for some products may peak at particular times.

o Rush hour traffic

o Electricity - late summer afternoons

o Ski resorts on weekends

( Peak-Load Pricing

- Capacity restraints will also increase MC.

- Increased MR and MC would indicate a higher price.

- MR is not equal for each market because one market does not impact the other market.

( The Two-Part Tariff

- The purchase of some products and services can be separated into two decisions, and therefore, two prices.

- Examples

1) Amusement Park: Pay to enter & Pay for rides

2) Tennis Club : Pay to join & Pay to play

3) Rental of Mainframe Computers : Flat Fee & Processing Time

4) Safety Razor : Pay for razor & Pay for blades

( The Two-Part Tariff

- Pricing decision is setting the entry fee (T) and the usage fee (P).

- Choosing the trade-off between free-entry and high use prices or high-entry and zero use prices. : High entrance fee & no fee for ride VS No entrance fee and high fee for ride.

( Two-Part Tariff with a Single Consumer : Figure 11.9 on page 386

( Two-Part Tariff with Two Consumers : Figure 11.10 on page 387

( The Two-Part Tariff With Many Different Consumers : Figure 11.11

- No exact way to determine P* and T*.

- Must consider the trade-off between the entry fee T* and the use fee P*.

- To find optimum combination, choose several combinations of P,T.

( Bundling

- Bundling is packaging two or more products to gain a pricing advantage.

- Conditions necessary for bundling

o Heterogeneous customers

o Price discrimination is not possible

o Demands must be negatively correlated

- An example: Leasing Movie A and Movie B

- Page 393.

( Skip Relative Valuations on page 393.

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