Lecture 7: Product’s Pricing andConsumers’ Surplus

The effectiveness of competitive market

• Competitive market is a reference point in microanalysis.

• It is a general model which is general from technical• It is a general model which is general from technicalpoint and its assumptions are very general.

• It helps in the construction of special conditions in orderto describe the other market forms.

Diagram 1

• Equivalence point (p*, q*)

• According to demand function there are consumerswho want to pay a higher price of p* in order to buy alower quantity than q*.

• This difference in price is called Consumers Surplus.

• The producers would be willing to sell less quantitythan q* in lower price.

• This difference in price is called Producers Surplus.• This difference in price is called Producers Surplus.

• The main role in decisions making for both consumersand producers depends on the market effectiveness.

• The demand curve shows the marginal benefit of theconsumers and the supply curve shows the marginalcost.

• In case there are not externalities, there is effectiveequivalence.

• In such case social welfare which is the sum ofconsumers and producers surplus becomes maximum.

• When the equivalence is (p**, q**) the marginal cost ofproduction in such price level is lower than the price theconsumers are willing to pay for.

• That means that the producers can increase theproducts’ supply till the point of equating marginal costand products’ price.and products’ price.

Consumers’ Surplus

• For educational reasons it is interesting to use scaleddemand function.

• Diagram 2

• Assuming the combination (p1, q1).

• p1>p* , but he will pay only p*.

•The difference between the price he is willing to pay (p1)and the price he finally pays for (p*) is the consumerssurplus.

• Exactly the same process will be followed in case that theprice is p2, p3 etc.

•When the price is being reduced the consumers surplus isbeing increased.

•The surplus id the product of the surface (the acreage ofeach rectangle.

•No consumer is willing to demand o quantity mere than q*.

•Total surplus is due to the fact that the price is p* and nop1,p2 or p3.

Diagram 3 (Example 1)

Diagram 4

• Diagram 5

• When the price is p3 the consumers surplus (CS) ishigher than in the case of higher price (p2).

• The consumers surplus is higher in case price is p2and not p1.

• Given that p3<p2<p1, consumers surplus is beingreduced while product’s price is being increased.

Producers’ SurplusProducers’ Surplus

• The producer’s surplus is the difference between theprice producers offer the product and the price theyare willing to offer.

• Diagram 6

• Assuming the combination (p1, q1).

• That means that the marginal cost is equal to p1.

• The difference between the market’s price (p*) and theprice he requires to offer each product unit defines theproducers’ surplus.

• The producers surplus (PS) is another definition forproducers’ profits.

• The same sense is being followed for prices p2, p3• The same sense is being followed for prices p2, p3etc.

• Producers surplus (PS) is being reduced as productsprice is being reduced.

Diagram 7

Monopoly: Pricing

• There are many consumers in the market as ithappens in perfect competitive market as well.

• There is only one producer in the market.

• There are not substitute products.

• There are entry obstacles in the market.

• Main condition: MR(q) = MC(q).• Main condition: MR(q) = MC(q).

• In this type of market the price is a function of thesupply quantity.

• TR(q) = P(q)*q.

• MC(q) = P(q)*[1+1/eq,p)].

• P(q) = MC(q) * [1/1+1/eq,p)].

• In such case the price is dependent on the demandelasticity.

• The more elastic is the demand, the marginal cost istoo close to the monopoly price.

• The existence of less demand elasticity leadsmarginal cost to be far away form the monopolyprice.

• In monopoly there is an equivalence combination of• In monopoly there is an equivalence combination of(p*, q*).

• In perfect competition there is an equivalencecombination of [p(comb), q(comb)].

• It exists that q*<q(comb) and p*>p(comb).

Diagram 8

The Consumers Surplus in Monopoly

• The monopoly market is less effective than theperfect competitive market.

• The price p* leads to the reduction of consumerssurplus related to perfect competitive market as p*>p(comp).

• In such case the producers surplus becomes higher.

• The part DL does not belong to anybody.• The part DL does not belong to anybody.

• Each participant (producers, consumers) loses apart of the surplus.

• DL is the deadweight loss.

• Total welfare is less in the monopoly than in perfectcompetitive markets.

Diagram 9

Price discrimination and Consumers Surplus

• The deadweight loss is the main issue theentrepreneur in monopoly market has to treat inorder to eliminate its profits’ reduction.

• Price discrimination is the answer of this issue.

• Price discrimination is the policy of imposing differentprices for each consumer or groups of consumers.

Basic conditions for the price discrimination

• Market power which secures that the firm candetermine a higher price than the competitive one.

• Discrimination between consumers which impliesthat the firm can at least distinguish betweendifferent groups of consumers.

• Exclusion of arbitrage in sales. It is necessary that thefirm is able to discriminate between both differentconsumers groups and arbitrage sales. In other casethere is no sense.

First Degree price discrimination

• It is a theoretical case as the firm is able to perfectdistinguish the different consumers groups.

• The first degree price discrimination is as mucheffective as in perfect competitive markets.

• The main difference is that the consumers surplusbecomes producers surplus as a whole.

Diagram 10

Second Degree Price Discrimination

• The firm distinguishes the consumers groups in specialcategories.

• The firm tests the influence of an increase in price toeach group of consumers.

• It is based on the analysis of perfect price• It is based on the analysis of perfect pricediscrimination.

• It tests the influence in the each consumers groupsurplus.

• Diagram 11

• Diagram 12

Third Degree Price Discrimination

• In this case the firm can not perfect distinguish thegroup that each consumer belongs.

• In case the firm can not distinguish between 2 groupsof consumers should set P = MC.

Diagram 13