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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 Chapter 11 Slide 2 Introduction Pricing without market power (perfect competition) is determined by market supply and demand. The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits. Chapter 11 Slide 3 Introduction Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production. Chapter 11 Slide 4 Capturing Consumer Surplus $/Q Pmax Between 0 and Q*, consumers will pay more than P*--consumer surplus (A). A P1 P* B PC is the price that would exist in a perfectly competitive market. P2 MC PC If price is raised above P*, the firm will lose sales and reduce profit. D Beyond Q*, price will have to fall to create a consumer surplus (B). MR Q* Chapter 11 Quantity Slide 5 Capturing Consumer Surplus $/Q Pmax A P1 •A: consumer surplus with P* •B: P>MC & consumer would buy at a lower price •P1: less sales and profits •P2 : increase sales & and reduce revenue and profits •PC: competitive price P* B P2 MC PC D MR Q* Chapter 11 Quantity Slide 6 Capturing Consumer Surplus $/Q Pmax Question How can the firm capture the consumer surplus in A and sell profitably in B? A P1 P* B P2 MC PC Answer Price discrimination Two-part tariffs D MR Q* Chapter 11 Quantity Slide 7 Capturing Consumer Surplus Price discrimination is the charging of different prices to different consumers for similar goods. Chapter 11 Slide 8 Price Discrimination First Degree Price Discrimination Chapter 11 Charge a separate price to each customer: the maximum or reservation price they are willing to pay. Slide 9 Additional Profit From Perfect FirstDegree Price Discrimination $/Q Pmax Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow). Consumer surplus is the area above P* and between 0 and Q* output. MC P* With perfect discrimination, each consumer pays the maximum price they are willing to pay. PC D = AR Output expands to Q** and price falls to PC where MC = MR = AR = D. Profits increase by the area above MC between old MR and D to output Q** (purple) MR Q* Chapter 11 Q** Quantity Slide 10 Additional Profit From Perfect FirstDegree Price Discrimination $/Q Pmax Consumer surplus when a single price P* is charged. With perfect discrimination • Each customer pays their reservation price •Profits increase Variable profit when a single price P* is charged. MC P* Additional profit from perfect price discrimination PC D = AR MR Q* Chapter 11 Q** Quantity Slide 11 Additional Profit From Perfect FirstDegree Price Discrimination Question Why would a producer have difficulty in achieving first-degree price discrimination? Answer 1) Too many customers (impractical) 2) Could not estimate the reservation price for each customer Chapter 11 Slide 12 Second-Degree Price Discrimination Practice of charging different prices per unit for different quantities of the same good or service Chapter 11 Slide 13 Second-Degree Price Discrimination Second-degree price discrimination is pricing according to quantity consumed--or in blocks. $/Q P1 Without discrimination: P = P0 and Q = Q0. With second-degree discrimination there are three prices P1, P2, and P3. (e.g. electric utilities) P0 P2 AC P3 MC D MR Q1 1st Block Q0 Q2 Q3 2nd Block 3rd Block Quantity Second-Degree Price Discrimination $/Q Economies of scale permit: •Increase consumer welfare •Higher profits P1 P0 P2 AC P3 MC D MR Q1 1st Block Q0 Q2 Q3 2nd Block 3rd Block Quantity Price Discrimination Third Degree Price Discrimination 1) Divides the market into two-groups. 2) Each group has its own demand function. Chapter 11 Slide 16 Third-Degree Price Discrimination $/Q Consumers are divided into two groups, with separate demand curves for each group. MRT = MR1 + MR2 D2 = AR2 MRT MR2 MR1 D1 = AR1 Quantity Chapter 11 Slide 17 Third-Degree Price Discrimination $/Q MC = MR1 = MR2 P1 •QT: MC = MRT •Group 1: P1Q1 ; more inelastic •Group 2: P2Q2; more elastic •MR1 = MR2 = MC MC P2 D2 = AR2 MRT MR2 D1 = AR1 MR1 Q1 Chapter 11 Q2 QT Quantity Slide 18 Intertemporal Price Discrimination and Peak-Load Pricing Separating the Market With Time Chapter 11 Initial release of a product, the demand is inelastic Book Movie Computer Slide 19 Intertemporal Price Discrimination and Peak-Load Pricing Separating the Market With Time Chapter 11 Once this market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand Paper back books Dollar Movies Discount computers Slide 20 Intertemporal Price Discrimination Consumers are divided into groups over time. Initially, demand is less elastic resulting in a price of P1 . $/Q P1 Over time, demand becomes more elastic and price is reduced to appeal to the mass market. P2 D2 = AR2 AC = MC MR1 Q1 Chapter 11 MR2 D1 = AR1 Q2 Quantity Slide 21 Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing Demand for some products may peak at particular times. Rush hour traffic Electricity - late summer afternoons Ski resorts on weekends Chapter 11 Slide 22 Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing Capacity restraints will also increase MC. Increased MR and MC would indicate a higher price. Chapter 11 Slide 23 Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing MR is not equal for each market because one market does not impact the other market. Chapter 11 Slide 24 Peak-Load Pricing $/Q MC Peak-load price = P1 . P1 D1 = AR1 Off- load price = P2 . P2 MR1 D2 = AR2 MR2 Q2 Chapter 11 Q1 Quantity Slide 25 The Two-Part Tariff The purchase of some products and services can be separated into two decisions, and therefore, two prices. Chapter 11 Slide 26 The Two-Part Tariff Examples 1) Amusement Park Pay to enter Pay for rides and food within the park 2) Tennis Club Chapter 11 Pay to join Pay to play Slide 27 The Two-Part Tariff Pricing decision is setting the entry fee (T) and the usage fee (P). Choosing the trade-off between freeentry and high use prices or high-entry and zero use prices. Chapter 11 Slide 28 Two-Part Tariff with a Single Consumer $/Q T* P* Usage price P*is set where MC = D. Entry price T* is equal to the entire consumer surplus. MC D Quantity Chapter 11 Slide 29 Two-Part Tariff with Two Consumers $/Q T* The price, P*, will be greater than MC. Set T* at the surplus value of D2. 2T * ( P* MC ) x(Q1 Q2 ) more than twic e ABC A P* MC B C D1 = consumer 1 D2 = consumer 2 Q2 Chapter 11 Q1 Quantity Slide 30 The Two-Part Tariff The Two-Part Tariff With Many Different Consumers No exact way to determine P* and T*. Must consider the trade-off between the entry fee T* and the use fee P*. Chapter 11 Low entry fee: High sales and falling profit with lower price and more entrants. Slide 31 The Two-Part Tariff The Two-Part Tariff With Many Different Consumers To find optimum combination, choose several combinations of P,T. Choose the combination that maximizes profit. Chapter 11 Slide 32 The Two-Part Tariff Rule of Thumb Similar demand: Choose P close to MC and high T Dissimilar demand: Choose high P and low T. Chapter 11 Slide 33 Summary Firms with market power are in an enviable position because they have the potential to earn large profits, but realizing that potential may depend critically on the firm’s pricing strategy. A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible. Chapter 11 Slide 34 Summary Ideally, the firm would like to perfectly price discriminate. The two-part tariff is another means of capturing consumer surplus. Chapter 11 Slide 35 End of Chapter 11 Pricing with Market Power