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

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

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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



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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.

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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 be willing to pay the profit-maximizing uniform price.
– In panel b of Table 10.1, the theater increases profit by selling 5 more tickets
to seniors. Students pay $20 as before, seniors pay $10 and neither group
enjoys any consumer surplus.
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10.1 Price Discrimination
Table 10.1 Theater Profits Based on the
Pricing Method Used

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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.

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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.

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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.

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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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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

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10.2 Perfect Price Discrimination
Figure 10.2 Competitive, Single-Price, and
Perfect Price Discrimination Outcomes

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10.2 Perfect Price Discrimination
• 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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10.3 Group Price Discrimination
• 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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10.3 Group Price Discrimination
Figure 10.3 Group Pricing of the Harry Potter
DVD

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10.3 Group Price Discrimination
• Profit: π(QA, QB) = πA(QA) + πB(QB) = [RA(QA) – mQA] + [RB(QB) –
mQB]
– Total profit is the sum of the American and British profits (π = πA + πB). 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.

• American Market: ∂π(QA, QB) /∂QA= 0
– ∂π(QA, QB) /∂QA= dRA(QA)/dQA – m = 0
– The monopoly sets MR = MC in this market, so MRA = dRA(QA)/dQA = m

• British Market: ∂π(QA, QB) /∂QB= 0
– ∂π(QA, QB) /∂QB= dRB(QB)/dQB – m = 0

– The monopoly sets MR = MC in this market, so MRB = dRB(QB)/dQB = m

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10.3 Group Price Discrimination
• Two Group Price Discrimination and Elasticities
– We know MRA = m = MRB
– We also know from Chapter 9 that MR = p (1 + 1/ε)
– So, MRA = pA (1 + 1/εA) = m = pB (1 + 1/εB) = MRB

• Implication: pB / pA = (1 + 1/εA) / (1 + 1/εB)
– The ratio of prices depend on the elasticity values in these two markets.
– Warner Brothers apparently believed that the British demand curve was
less elastic at its profit-maximizing prices than the U.S. demand curve (εB
≈ –1.0263, εA ≈ ‑1.0357). Consequently, Warner charged British consumers
34% more than U.S. customers, pB /pA = $39/$29 = 1.345.

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10.3 Group Price Discrimination
• 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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10.3 Group Price Discrimination
• Effects on Total Surplus: Group Price Discrimination vs. Perfect
Competition
– Consumer surplus is greater and more output is produced with perfect
competition than with group price discrimination.
– Group price discrimination transfers some of the competitive consumer
surplus to the firm as additional profit and causes deadweight loss due to
reduced output.

• Effects on Total Surplus: Group Price Discrimination vs. SinglePrice Monopoly
– From theory alone, we cannot tell whether total surplus is higher if the
monopoly uses group price discrimination or if it sets a single price.
– The closer the firm comes to perfect price discrimination using group price
discrimination (many groups rather than just two), the more output it
produces, and the less production inefficiency—the greater the total
surplus.

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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— 1st block—and $50 for the 2nd block. In panel b, the firm
can set only a single price of $30. When block pricing consumer surplus is
lower, total surplus is higher and deadweight loss is lower. The firm and
society are better off but consumers lose.
– The more block prices that a firm can set, the closer the firm gets to perfect
price discrimination.
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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 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 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.
– 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.

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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
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

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

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