MICROECONOMICS: Theory & Applications Chapter 12: Product Pricing with Monopoly Power By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 10th Edition, Copyright 2009 PowerPoint prepared by Della L. Sue, Marist College

Learning Objectives Explain price discrimination, the various degrees of price discrimination, and how price discrimination can increase a firm’s profit. Spell out the three necessary conditions for a firm to be able to engage in price discrimination. Demonstrate how, under third-degree price discrimination, market segments that have less elastic demand end up being charged a higher price all else being equal. (continued) Copyright 2009 John Wiley & Sons, Inc.

Learning Objectives (continued) Explore how two-part tariffs, a form of second-degree price discrimination, can increase a firm’s profit. Show how intertemporal price discrimination, a type of third-degree price discrimination, can increase a firm’s profit. Copyright 2009 John Wiley & Sons, Inc.

Price Discrimination Definition – the practice of charging different prices for the same product when there is no cost difference to the producer in supplying the product Why would a firm want to price discriminate? To increase profit To increase total surplus (consumer surplus plus producer surplus) Copyright 2009 John Wiley & Sons, Inc.

Types of Price Discrimination First-degree (perfect) price discrimination – a policy in which each unit of output is sold for the maximum price a consumer will pay Second-degree price discrimination (block pricing) – the use of a schedule of prices such that the price per unit declines with the quantity purchased by a particular consumer Third-degree price discrimination (market segmentation) – a situation in which each consumer faces a single price and can purchase as much as desired at that price, but the price differs among categories of consumers Copyright 2009 John Wiley & Sons, Inc.

First-Degree (Perfect) Price Discrimination MR curve coincides with the demand curve. The price schedule is tailored to each consumer. The monopolist captures all of the consumer surplus. The profit-maximizing output level is efficient. Figure 12.1 Copyright 2009 John Wiley & Sons, Inc.

Second-Degree Price Discrimination (Block Pricing) Consumers are charged a different price for different quantities, with the schedule of prices set to extract the entire consumer surplus. The same price schedule confronts all consumers. Figure 12.2 Copyright 2009 John Wiley & Sons, Inc.

Third-Degree Price Discrimination (Market Segmentation) The price differs among categories of consumers. Examples: Faculty discounts at the college bookstore Telephone companies charging different monthly rates for business customers than for residential customers Movie theaters charging different prices for a matinee showing than for an evening showing Copyright 2009 John Wiley & Sons, Inc.

Three Necessary Conditions for Price Discrimination The product seller must possess some degree of monopoly power; that is, a downward-sloping demand curve. The seller must have some means of approximating the maximum amount buyers are willing to pay for each unit of output. The seller must be able to prevent resale or arbitrage of the product among the market segments. Copyright 2009 John Wiley & Sons, Inc.

Relevance of Demand Elasticity in Price Discrimination [Figure 12.3] Copyright 2009 John Wiley & Sons, Inc.

Price and Output Determination Under Price Discrimination [Figure 12 Copyright 2009 John Wiley & Sons, Inc.

Intertemporal Price Discrimination A form of third-degree price discrimination in which different market segments are willing to pay different prices depending on the time at which they purchase the good MC is constant Figure 12.5 Copyright 2009 John Wiley & Sons, Inc.

Peak-Load Pricing A pricing policy in which different prices are charged for peak and off-peak periods MC is not constant Price is set where SMC intersects the demand curve Figure 12.6 Copyright 2009 John Wiley & Sons, Inc.

Advantages of Peak-Load Pricing A more efficient distribution of usage between the peak and off-peak periods results. The required capacity during peak demand is less than that required under uniform pricing, resulting in a cost saving. Copyright 2009 John Wiley & Sons, Inc.

Two-Part Tariffs A form of second-degree price discrimination in which a firm charges consumers a fixed fee per time period for the right to purchase the product at a uniform per-unit price Entry fee – the fixed fee charged per time period Figure 12.7 Copyright 2009 John Wiley & Sons, Inc.

Two-Part Tariff with Different Demands When consumers have different demand curves, a different entry fee must be charged to each consumer. Figure 12.8 Copyright 2009 John Wiley & Sons, Inc.

Effect of a Two-Part Tariff on Price An increase in the entry fee coupled with a price that is lower than the price charged in a simple monopoly (charging a uniform price and no entry fee) will increase profit Figure 12.9 Copyright 2009 John Wiley & Sons, Inc.

The Mathematics behind Price Discrimination Goal: maximize profit Profit-maximizing condition: MRA = MRB = MC Price will be lower in the market with the more elastic demand curve since: PA(1-1/ηA) = PB(1-1/ηB) Copyright 2009 John Wiley & Sons, Inc.

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