Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Managerial Economics & Business Strategy Chapter 11 Pricing Strategies for Firms with Market Power

11-2 Overview I. Basic Pricing Strategies –Monopoly & Monopolistic Competition –Cournot Oligopoly II. Extracting Consumer Surplus –Price Discrimination Two-Part Pricing –Block Pricing Commodity Bundling III. Pricing for Special Cost and Demand Structures –Peak-Load Pricing Transfer Pricing –Cross Subsidies IV. Pricing in Markets with Intense Price Competition –Price Matching Randomized Pricing –Brand Loyalty

11-3 Pricing Strategies  Firms with market power have some influence over the prices they charge.  Optimal pricing strategies vary depending on the underlying market structure and the instruments available to influence demand (advertising).

11-4 Standard Pricing and Profits for Firms with Market Power Price Quantity P = Q MC MR = Q Profits from standard pricing = $8

11-5 Profit Max  Firms with market power face downward sloping demand curves for their product.  Profit maximizing price is the maximum price that consumers will pay for this level of output.

11-6 An Algebraic Example  P = Q  C(Q) = 2Q  If the firm must charge a single price to all consumers, the profit-maximizing price is obtained by setting MR = MC.  Q = 2, so Q* = 2.  P* = (2) = 6.  Profits = (6)(2) - 2(2) = $8.

11-7 Using Demand and Elasticity in Pricing Decisions  For small producers that lack detailed information about demand publically available information must suffice.  General information about demand and elasticities can be used to effect pricing decisions.  A simple markup rule follows:

11-8 A Simple Markup Rule  Suppose the elasticity of demand for the firm’s product is E F.  Since MR = P[1 + E F ]/ E F.  Setting MR = MC and simplifying, yields this simple pricing formula: P = [E F /(1+ E F )]  MC.  The optimal price is a simple markup over relevant costs! –More elastic the demand, lower markup. –Less elastic the demand, higher markup.

11-9 An Example  Elasticity of demand for Kodak film is -2.  P = [E F /(1+ E F )]  MC  P = [-2/(1 - 2)]  MC  P = 2  MC  Price is twice marginal cost.  Fifty percent of Kodak’s price is margin above manufacturing costs.

11-10 Mark Up  Important points:  The more elastic the demand for the firm’s product the lower the profit maximizing markup.  The higher the MC the higher the price.

11-11 Cournot Oligopoly  Each firm believes that its rivals will hold their output constant if it changes its own output.  The ultimate solution relies on the intersection of reaction functions.  If there are N identical firms in a Cournot oligopoly, the profit maximizing price for a firm is:  P = [NE M /1+ NE M ] MC  Where N is the number of firms in the industry, E M is the market elasticity of demand, and MC is marginal cost.

11-12 Markup Rule for Cournot Oligopoly  Homogeneous product Cournot oligopoly.  N = total number of firms in the industry.  Market elasticity of demand E M.  Elasticity of individual firm’s demand is given by E F = N x E M.  Since P = [E F /(1+ E F )]  MC,  Then, P = [NE M /(1+ NE M )]  MC.  The greater the number of firms, the lower the profit-maximizing markup factor.

11-13 An Example  Homogeneous product Cournot industry, 3 firms.  MC = $10.  Elasticity of market demand = - ½.  Determine the profit-maximizing price?  E F = N E M = 3  (-1/2) =  P = [E F /(1+ E F )]  MC.  P = [-1.5/(1- 1.5]  $10.  P = 3  $10 = $30.

11-14 Another Example  Homogeneous product Cournot industry, 10 firms.  MC = $10.  Elasticity of market demand = - ½.  Determine the profit-maximizing price?  E F = N E M = 10  (-1/2) = -5.0  P = [E F /(1+ E F )]  MC.  P = [-5.0/(1- 5.0]  $10.  P = 1.25  $10 = $12.50.

11-15 Extracting Consumer Surplus: Moving From Single Price Markets  Most models examined to this point involve a “single” equilibrium price.  In reality, there are many different prices being charged in the market.  Managers can price discriminate given some basic assumptions.

11-16 Extracting Consumer Surplus: Moving From Single Price Markets  Price discrimination is the practice of charging different prices to consumer for the same good to achieve higher profits.  The three basic forms of price discrimination are: –First-degree (or perfect) price discrimination. –Second-degree price discrimination. –Third-degree price discrimination.

11-17 First-Degree or Perfect Price Discrimination  Practice of charging each consumer the maximum amount he or she will pay for each incremental unit.  Permits a firm to extract all surplus from consumers by charging exactly each potential consumer’s WTP.

11-18 Perfect Price Discrimination Price Quantity D Profits*:.5(4-0)(10 - 2) = $16 Total Cost* = $8 MC * Assuming no fixed costs

11-19 Caveats:  In practice, transactions costs and information constraints make this difficult to implement perfectly (but car dealers and some professionals come close).  Price discrimination won’t work if consumers can resell the good.

11-20 Second-Degree Price Discrimination  The practice of posting a discrete schedule of declining prices for different quantities.  Eliminates the information constraint present in first-degree price discrimination.  Example: Electric utilities Price MC D $5 $10 4 Quantity $8 2

11-21 Third-Degree Price Discrimination  The practice of charging different groups of consumers different prices for the same product.  Group must have observable characteristics for third-degree price discrimination to work.  Examples include student discounts, senior citizen’s discounts, regional & international pricing.

11-22 Implementing Third-Degree Price Discrimination  Suppose the total demand for a product is comprised of two groups with different elasticities, E 1 < E 2.  Notice that group 1 is more price sensitive than group 2.  Profit-maximizing prices?  P 1 = [E 1 /(1+ E 1 )]  MC  P 2 = [E 2 /(1+ E 2 )]  MC

11-23 Implementing Third-Degree Price Discrimination  For profit max firms should equate the MR from selling to each group to MC.  Output should be allocated so that MR 1 = MR 2.  If MR 1 > MR 2 then the firm could allocate more output to market 1 and less to 2 until the MR for the two markets are equal.

11-24 Implementing Third-Degree Price Discrimination  For TDPD to enhance profits differences must exist in the elasticity of demand of various consumers.  The firm must be able to determine the elasticity differences.  Retired individuals, students, business versus leisure travelers.  See demonstration problem 11-4 page 407.

11-25 Another Example  Suppose the elasticity of demand for Kodak film in the US is E U = -1.5, and the elasticity of demand in Japan is E J =  Marginal cost of manufacturing film is $3.  P U = [E U /(1+ E U )]  MC = [-1.5/( )]  $3 = $9  P J = [E J /(1+ E J )]  MC = [-2.5/( )]  $3 = $5  Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic.

11-26 Two-Part Pricing  When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.  Two-part pricing consists of a fixed fee and a per unit charge. –Example: Athletic club memberships.

11-27 How Two-Part Pricing Works 1. Set price at marginal cost. 2. Compute consumer surplus. 3.Charge a fixed-fee equal to consumer surplus. 4.All profits are derived from the fixed fee. Quantity D MC Fixed Fee = Profits* = $16 Price Per Unit Charge * Assuming no fixed costs

11-28 Charging a Monopoly Price  From the previous example:  If the firm charged one price rather than a two-part pricing scheme:  Inverse D curve is P = Q  MR = 10-4Q; MC = 2  Setting MR = MC yields an optimal Q = 2 and P = $6.  Therefore TR = $12 and profits = $12-4 = $8

11-29 Block Pricing  The practice of packaging multiple units of an identical product together and selling them as one package.  Examples –Paper towels –Six-packs of soda.

11-30 An Algebraic Example  Typical consumer’s demand is P = Q  C(Q) = 2Q  Optimal number of units in a package?  Optimal package price?

11-31 Optimal Quantity To Package: 4 Units Price Quantity D MC = AC

11-32 Optimal Price for the Package: $24 Price Quantity D MC = AC Consumer’s valuation of 4 units =.5(8)(4) + (2)(4) = $24 Therefore, set P = $24!

11-33 Costs and Profits with Block Pricing Price Quantity D MC = AC Profits* = [.5(8)(4) + (2)(4)] – (2)(4) = $16 Costs = (2)(4) = $8 * Assuming no fixed costs

11-34 Profitable Block Pricing  By charging a block price for a package and not allowing the consumer to buy single units the firm earns greater profits.  The firm is expropriating the consumer surplus that would have been earned at a lower per unit price.  Forces consumers to make an all or nothing choice.

11-35 Commodity Bundling  The practice of bundling two or more products together and charging one price for the bundle.  Examples –Vacation packages. –Computers and software. –Automobile companies offering “packages” –Film and developing.

11-36 An Example that Illustrates Kodak’s Moment  Total market size for film and developing is 4 million consumers.  Four types of consumers –25% will use only Kodak film (F). –25% will use only Kodak developing (D). –25% will use only Kodak film and use only Kodak developing (FD). –25% have no preference (N).  Zero costs (for simplicity).  Maximum price each type of consumer will pay is as follows:

11-37 Reservation Prices for Kodak Film and Developing by Type of Consumer

11-38 Optimal Film Price? Optimal Price is $8; only types F and FD buy resulting in profits of $8 x 2 million = $16 Million. At a price of $4, only types F, FD, and D will buy (profits of $12 Million). At a price of $3, all will types will buy (profits of $12 Million).

11-39 Optimal Price for Developing? Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million. At a price of $6, only “D” type buys (profits of $6 Million). At a price of $4, only “D” and “FD” types buy (profits of $8 Million). At a price of $2, all types buy (profits of $8 Million).

11-40 Total Profits by Pricing Each Item Separately? Total Profit = Film Profits + Development Profits = $16 Million + $9 Million = $25 Million Surprisingly, the firm can earn even greater profits by bundling!

11-41 Pricing a “Bundle” of Film and Developing

11-42 Consumer Valuations of a Bundle

11-43 What’s the Optimal Price for a Bundle? Optimal Bundle Price = $10 (for profits of $30 million)

11-44 Peak Load and Cross Subsidy Pricing  Appropriate for firms with special cost and demand structures.  Peak load pricing – when demand is so high that capacity cannot serve all customers at the same price.  Different groups of demanders are those that purchase at different times of the day.  Firm discriminates by charging different prices at different times of day.

11-45 Peak-Load Pricing  When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.  Charge a higher price (P H ) during peak times (D H ).  Charge a lower price (P L ) during off-peak times (D L ). Quantity Price MC MR L PLPL QLQL QHQH DHDH MR H DLDL PHPH

11-46 Cross-Subsidies  Relevant when a firm has cost complementarities and demand for a group of products is interdependent  The profits earned from the sales of one product subsidize the sale of another product.  May be profitable when there are significant demand complementarities.  Examples –Browser and server software. –Drinks and meals at restaurants. –Adobe Acrobat and Reader.

11-47 Double Marginalization leading to Transfer Pricing  Consider a large firm with two divisions: –the upstream division is the sole provider of a key input. –the downstream division uses the input produced by the upstream division to produce the final output.  Incentives to maximize divisional profits leads the upstream manager to produce where MR U = MC U. –Implication: P U > MC U.

11-48 Double Marginalization  Similarly, when the downstream division has market power and has an incentive to maximize divisional profits, the manager will produce where MR D = MC D. –Implication: P D > MC D.  Thus, both divisions mark up price over marginal cost resulting in in a phenomenon called double marginalization. –Result: less than optimal overall profits for the firm.

11-49 Transfer Pricing  To overcome double marginalization, the internal price at which an upstream division sells inputs to a downstream division should be set in order to maximize the overall firm profits.  To achieve this goal, the upstream division produces such that its marginal cost, MC u equals the net marginal revenue to the downstream division (NMR d ): NMR d = MR d - PMC d = MC u

11-50 Upstream Division’s Problem  Demand for the final product P = Q.  C(Q) = 2Q.  Suppose the upstream manager sets MR = MC to maximize profits.  Q = 2, so Q* = 2.  P* = (2) = $6, so upstream manager charges the downstream division $6 per unit.

11-51 Downstream Division’s Problem  Demand for the final product P = Q.  Downstream division’s marginal cost is the $6 charged by the upstream division.  Downstream division sets MR = MC to maximize profits.  Q = 6, so Q* = 1.  P* = (1) = $8, so downstream division charges $8 per unit.

11-52 Analysis  This pricing strategy by the upstream division results in less than optimal profits!  The upstream division needs the price to be $6 and the quantity sold to be 2 units in order to maximize profits. Unfortunately,  The downstream division sets price at $8, which is too high; only 1 unit is sold at that price. –Downstream division profits are $8  1 – 6(1) = $2.  The upstream division’s profits are $6  1 - 2(1) = $4 instead of the monopoly profits of $6  2 - 2(2) = $8.  Overall firm profit is $4 + $2 = $6.

11-53 Upstream Division’s “Monopoly Profits” Price Quantity P = Q MC = AC MR = Q Profit = $8

11-54 Upstream Firm’s Profits when Downstream Marks Price Up to $8 Price Quantity P = Q MC = AC MR = Q Profit = $4 Downstream Price

11-55 Solutions for the Overall Firm?  Provide upstream manager with an incentive to set the optimal transfer price of $2 (upstream division’s marginal cost).  Overall profit with optimal transfer price:

11-56 Pricing in Markets with Intense Price Competition (Bertrand Oligopoly)  Price Matching –Advertising a price and a promise to match any lower price offered by a competitor. –No firm has an incentive to lower their prices. –Each firm charges the monopoly price and shares the market. –No need for the firm to monitor competitors –Consumers are required to demonstrate a lower price. –Firm can price discriminate between those who found a lower price and those that did not.

11-57 Pricing in Markets with Intense Price Competition (Bertrand Oligopoly)  Induce brand loyalty –Some consumers will remain “loyal” to a firm; even in the face of price cuts. –Advertising campaigns and “frequent- user” style programs can help firms induce loyalty among consumers.

11-58 Pricing in Markets with Intense Price Competition (Bertrand Oligopoly)  Randomized Pricing –A strategy of constantly changing prices. –Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price. –Reduces the ability of rival firms to undercut a firm’s prices.

11-59 Conclusion  First degree price discrimination, block pricing, and two part pricing permit a firm to extract all consumer surplus.  Commodity bundling, second-degree and third degree price discrimination permit a firm to extract some (but not all) consumer surplus.  Simple markup rules are the easiest to implement, but leave consumers with the most surplus and may result in double-marginalization.  Different strategies require different information.