Chapter 11 Pricing with Market Power

Chapter 11Slide 2 Topics to be Discussed Capturing Consumer Surplus Price Discrimination Intertemporal Price Discrimination and Peak-Load Pricing

Chapter 11Slide 3 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 11Slide 4 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 11Slide 5 Capturing Consumer Surplus Quantity $/Q D MR P max MC If price is raised above P*, the firm will lose sales and reduce profit. PCPC P C is the price that would exist in a perfectly competitive market. A P* Q* P1P1 Between 0 and Q*, consumers will pay more than P*--consumer surplus (A). B P2P2 Beyond Q*, price will have to fall to create a consumer surplus (B).

Chapter 11Slide 6 Price Discrimination First Degree Price Discrimination Charge a separate price to each customer: the maximum or reservation price they are willing to pay.

Chapter 11Slide 7 P* Q* Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow). Additional Profit From Perfect First- Degree Price Discrimination Quantity $/Q P max With perfect discrimination, each consumer pays the maximum price they are willing to pay. Consumer surplus is the area above P* and between 0 and Q* output. D = AR MR MC Output expands to Q** and price falls to P C where MC = MR = AR = D. Profits increase by the area above MC between old MR and D to output Q** (purple) Q** PCPC

Chapter 11Slide 8 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 Additional Profit From Perfect First- Degree Price Discrimination

Chapter 11Slide 9 Price Discrimination First Degree Price Discrimination 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:  Lawyers, doctors, accountants  Car salesperson (15% profit margin)  Colleges and universities

Chapter 11Slide 10 First-Degree Price Discrimination in Practice Quantity D MR MC $/Q P2P2 P3P3 P* 4 P5P5 P6P6 P1P1 Six prices exist resulting in higher profits. With a single price P* 4, there are fewer consumers and those who now pay P 5 or P 6 may have a surplus. Q

Second-Degree Price Discrimination Quantity $/Q D MR MC AC P0P0 Q0Q0 Without discrimination: P = P 0 and Q = Q 0. With second-degree discrimination there are three prices P 1, P 2, and P 3. (e.g. electric utilities) P1P1 Q1Q1 1st Block P2P2 Q2Q2 P3P3 Q3Q3 2nd Block3rd Block Second-degree price discrimination is pricing according to quantity consumed--or in blocks.

Second-Degree Price Discrimination Quantity $/Q D MR MC AC P0P0 Q0Q0 P1P1 Q1Q1 1st Block P2P2 Q2Q2 P3P3 Q3Q3 2nd Block3rd Block Economies of scale permit: Increase consumer welfare Higher profits

Chapter 11Slide 13 Price Discrimination Third Degree Price Discrimination 1) Divides the market into two-groups. 2)Each group has its own demand function.

Chapter 11Slide 14 Price Discrimination Third Degree Price Discrimination 3)Most common type of price discrimination.  Examples: airlines, liquor, vegetables, discounts to students and senior citizens.

Chapter 11Slide 15 Price Discrimination Third Degree 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)

Chapter 11Slide 16 Price Discrimination Third Degree Price Discrimination Objectives  MR 1 = MR 2  MR 1 = MR 2 = MC

Chapter 11Slide 17 Price Discrimination Third Degree Price Discrimination Determining relative prices

Chapter 11Slide 18 Price Discrimination Third Degree Price Discrimination Pricing: Charge higher price to group with a low demand elasticity

Chapter 11Slide 19 Price Discrimination Third Degree Price Discrimination Example: E 1 = -2 & E 2 = -4 P 1 should be 1.5 times as high as P 2

Chapter 11Slide 20 Third-Degree Price Discrimination Quantity D 2 = AR 2 MR 2 $/Q D 1 = AR 1 MR 1 Consumers are divided into two groups, with separate demand curves for each group. MR T MR T = MR 1 + MR 2

Chapter 11Slide 21 Third-Degree Price Discrimination Quantity D 2 = AR 2 MR 2 $/Q D 1 = AR 1 MR 1 MR T MC Q2Q2 P2P2 QTQT Q T : MC = MR T Group 1: P 1 Q 1 ; more inelastic Group 2: P 2 Q 2 ; more elastic MR 1 = MR 2 = MC MC depends on Q T Q1Q1 P1P1

Chapter 11Slide 22 The Economics of Coupons and Rebates Those consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand. Coupons and rebate programs allow firms to price discriminate. Price Discrimination

Chapter 11Slide 23 Price Elasticities of Demand for Users Versus Nonusers of Coupons Toilet tissue Stuffing/dressing Shampoo Cooking/salad oil Dry mix dinner Cake mix Price Elasticity ProductNonusersUsers

Chapter 11Slide 24 Cat food Frozen entrée Gelatin Spaghetti sauce Crème rinse/conditioner Soup Hot dogs Price Elasticity ProductNonusersUsers Price Elasticities of Demand for Users Versus Nonusers of Coupons

Chapter 11Slide 25 The Economics of Coupons and Rebates Cake Mix Nonusers of coupons: P E = Users: P E = -0.43

Chapter 11Slide 26 The Economics of Coupons and Rebates Cake Mix Brand (Pillsbury) P E Pillsbury 8 to 10 times P E all cake mix Example: elasticity of demand for Pillsbury cake mix P E Users of coupons: -4(-0.43 all cake mix) P E Nonusers: -2(-0.21 all cake mix)

Chapter 11Slide 27 The Economics of Coupons and Rebates Using: Price of nonusers should be 1.5 times users Or, if cake mix sells for $1.50, coupons should be 50 cents