Pricing Policies chapter 18 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objectives Define price discrimination and the conditions necessary for price discrimination to be successful. Identify various ways that a firm can price discriminate. Describe the outcome of perfect price discrimination and its welfare effects. Identify a monopolist’s profit-maximizing prices when it can discriminate based on observable customer characteristics and calculate the welfare effects of that discrimination. Understand how pricing based on self-selection can increase a firm’s profit. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Overview Identify the conditions required for successful price discrimination, and discuss different ways that a firm can price discriminate Study the firm’s profit-maximizing pricing strategy and consider the consequences for consumer and aggregate welfare Observe how self-selection can increase a firm’s profit Consider the practice of selling goods together as a bundle Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Price Discrimination Price discrimination: when a firm charges different prices for different units of the same good In order to price discriminate a firm must have some market power Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Perfect Price Discrimination A monopolist can engage in perfect price discrimination if he knows a customer’s willingness to pay for each unit he sells, and can charge a different price for each unit Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Two-Part Tariffs Two-part tariff: consumers pay a fixed fee if they buy anything at all, plus a separate per-unit price for each unit they buy With a per-unit price of $1.50, the demand will be for 3 units. This leaves a consumer surplus of $2.25 (light-green triangle), so they would be willing to pay a weekly fee of $2.25, and no more Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Profit with a Two-Part Tariff and Identical Consumers By lowering its per-minute charge from 20 to 10 cents, equal to its marginal cost, and raising its fixed fee, the firm can increase its profit to the maximum possible Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Observable Customer Characteristics Observable customer characteristics: when a firm can distinguish, even if imperfectly, consumers with a high versus low willingness to pay Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Profit-Maximizing Prices to Two Groups of Consumers Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Profit-Maximizing Price without Discrimination Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Welfare Effects of Imperfect Price Discrimination Price discrimination has two main effects on aggregate surplus Different consumers pay different prices. As a result, a consumer with a low willingness to pay but facing a low price may decide to buy the good while a consumer with a higher willingness to pay may decide to not buy the good when faced with a higher price, resulting in inefficiency Price discrimination may encourage the monopolist to sell more tickets The two opposing effects can combine to either raise or lower aggregate surplus Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Changes in Consumer Welfare with Price Discrimination Adults lose $1,600 Students gain $400 Decrease in consumer surplus = $1,200 Increase in profit = $800 => Decrease in aggregate surplus Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Price Discrimination Can Increase Consumer and Aggregate Surplus Without price discrimination a monopolist will abandon selling to low-demand consumers Price discrimination in some cases will lead to more goods sold, making both aggregate and consumer surplus higher Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Price Discrimination Based on Self-Selection Self-selection: when the firm offers a menu of alternatives, designed so that different customers will make different choices based on their willingness to pay Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Quantity-Dependent Pricing Quantity-dependent pricing: the price a consumer pays for an additional unit depends on how many units the consumer has bought $8 = fixed fee = PS for DH consumer $8 = fixed fee = producer surplus for DL consumer $32.50 = consumer surplus for DH consumer Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Using Menus to Increase Profit Can increase profit from the two-part tariff if: Deadweight loss could be eliminated More could be extracted from the surplus of high-demand consumers Accomplished by offering consumers a choice from a pair of two-part tariffs, with each tariff plan designed to attract a specific type of consumer Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Menu of Two-Part Tariffs Producer surplus = $7.50 Producer surplus = $12.50 $4.50 = fixed fee $4.50 = fixed fee $8 = variable profit $3 = variable profit Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Eliminating the Deadweight Loss of High-Demand Consumers Offer a pair of two-part tariffs: one designed for low-demand consumers and the other for high-demand consumers Set a per-unit charge for high-demand consumers equal to its marginal cost. The fixed fee must be set as large as possible without causing the high demand consumer to choose the other two part tariff instead Eliminates deadweight loss for high-demand consumers Extracts extra surplus through the plan’s fixed fee, earning a greater profit Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Making the Low-Demand Plan Less Attractive to High-Demand Consumers Making the low-demand plan less a attractive to high-demand consumers increases profit The option to choose the plan intended for low-demand consumers determines the fixed fee that one can charge a high-demand consumer If the surplus a high-demand consumer has for the low-demand plan is reduced, the fixed fee for the high-demand plan can be increased This is done by limiting the number of minutes a consumer can purchase the low-demand plan to the number that low-demand consumers want Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Capping Minutes In the Low-Demand Plan Producer surplus = $40.50 Producer surplus = $7.50 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Bundling Bundling: selling several products together as a package Technologically efficient Increase a firm’s ability to extract consumer surplus, particularly when the WTP of the bundled products are negatively correlated Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Mixed Bundling Mixed bundling: selling several products together as a package while also offering those products for sale individually Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Review Under certain conditions, a firm with market power can increase its profit by charging different amounts for different units of the same good A monopolist can perfectly price discriminate when he knows a customer’s willingness to pay for every unit he sells When a monopolist cannot distinguish among different groups it may be able to price discriminate by offering each customer a menu of alternatives Bundling can be a profitable strategy when the WTPs for each bundled product are negatively correlated Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Looking Forward Next we will focus on another type of market—oligopoly—where firms still have market power, though not as much as a monopolist Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.