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Pricing with market power

Managerial Economics, January 2013


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LECTURE OUTLINE

Capturing Consumer Surplus

Price Discrimination

Inter-temporal Price Discrimination and Peak-Load

Pricing

The Two-Part Tariff

Bundling

Advertising


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WHY STUDY PRICING DECISIONS?

Pricing is a key managerial decision. These examples illustratesome of the complexities associated with product pricing.

For example, how should managers set their basic prices?

Why do firms use coupons and rebates?

Why some customers are charged higher prices than othersfor the same product?

Why do firms bundle products?

Why would a firm ever give its product away for free?

Why do some firms offer volume discounts?


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Pricing objective

A firm has market power if

it faces a down sloping demand curve.

Firms with market power can raise price without losing all customers

to competitors.

The demand curve reflects

consumer willingness and ability to buy.

The firms pricing objective is

to maximize shareholder value.


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CAPTURING CONSUMER SURPLUS

Capturing Consumer Surplus

If a firm can charge only one price forall its customers, that price will be P*and the quantity produced will be Q*.

Ideally, the firm would like to charge ahigher price to consumers willing topay more than P*, thereby capturingsome of the consumer surplus underregionA of the demand curve.

The firm would also like to sell toconsumers willing to pay prices lowerthan P*, but only if doing so does notentail lowering the price to otherconsumers.

In that way, the firm could alsocapture some of the surplus underregion B of the demand curve.

price discrimination Practice of charging different prices todifferent consumers for similar goods.


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Price sensitivity

The optimal price markup over marginal cost dependson the elasticity of demand.

The optimal markup decreases as demand becomes

more elastic:

It is optimal to charge high prices when customers arenot very price-sensitive.


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First-Degree Price Discrimination

reservation price Maximum price that acustomer is willing to pay for a good. first-degree price discrimination Practice of

charging each customer her reservation price.

Additional Profit from Perfect First-Degree

Price Discrimination

Because the firm charges each consumer herreservation price, it is profitable to expandoutput to Q**.

When only a single price, P*, is charged, thefirms variable profit is the area between the

marginal revenue and marginal cost curves.

With perfect price discrimination, this profitexpands to the area between the demandcurve and the marginal cost curve.

variable profit Sum of profits on each incremental unit

produced by a firm; i.e., profit ignoring fixed costs.


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First-Degree Price Discrimination inPractice

Firms usually dont know the

reservation price of everyconsumer, but sometimesreservation prices can be roughlyidentified.

Here, six different prices arecharged. The firm earns higherprofits, but some consumers mayalso benefit.

With a single price P*4, there arefewer consumers.

The consumers who now pay P5 or

P6 enjoy a surplus.

Perfect Price DiscriminationThe additional profit from producing and selling an incremental

unit is now the difference between demand and marginal cost.

Imperfect Price Discrimination

First-Degree Price Discrimination


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second-degree price discrimination Practice of charging differentprices per unit for different quantities of the same good or service.

block pricing Practice of charging different prices for differentquantities or blocks of a good.

Second-Degree Price Discrimination

Different prices are charged fordifferent quantities, or blocks, of

the same good. Here, there arethree blocks, with correspondingprices P1, P2, and P3.

There are also economies ofscale, and average and marginalcosts are declining. Second-degree price discrimination canthen make consumers better offby expanding output and loweringcost.

Second-Degree Price Discrimination


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third-degree price discrimination Practice of dividingconsumers into two or more groups with separate demandcurves and charging different prices to each group.

Creating Consumer Groups

If third-degree price discrimination is feasible, how should the firmdecide what price to charge each group of consumers?

1. We know that however much is produced, total output shouldbe divided between the groups of customers so that marginal

revenues for each group are equal.

2. We know that totaloutput must be such that the marginalrevenue for each group of consumers is equal to the marginalcost of production.

Third Degree Price Discrimination


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third-degree price discrimination Practice of dividingconsumers into two or more groups with separate demandcurves and charging different prices to each group.



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Determining Relative Prices

No Sales to Smaller Market

Even if third-degree price discriminationis feasible, it may not pay to sell to both

groups of consumers if marginal cost isrising.

Here the first group of consumers, withdemand D1, are not willing to pay muchfor the product.

It is unprofitable to sell to them because

the price would have to be too low tocompensate for the resulting increase inmarginal cost.



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PRICE DISCRIMINATION

Coupons provide a means of pricediscrimination.

Studies show that only about 20 to 30percent of all consumers regularly

bother to clip, save, and use coupons.Rebate programs work the same way.

Only those consumers with relatively price-sensitivedemands bother to send in the materials and request

rebates.

Again, the program is a means of price discrimination.


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PRICE DISCRIMINATION

TABLE Price Elasticities of Demand for Users versus Nonusers

of Coupons

PRICE Elasticity

Product Nonusers Users

Toilet tissue 0.60 0.66

Stuffing/dressing 0.71 0.96

Shampoo 0.84 1.04

Cooking/salad oil 1.22 1.32

Dry mix dinners 0.88 1.09

Cake mix 0.21 0.43

Cat food 0.49 1.13

Frozen entrees 0.60 0.95

Gelatin 0.97 1.25

Spaghetti sauce 1.65 1.81

Creme rinse/conditioner 0.82 1.12

Soups 1.05 1.22

Hot dogs 0.59 0.77


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Effective price discrimination

Two conditions are necessary for profitable pricediscrimination.

First, different price elasticities of demand must exist in varioussubmarkets for the product (customers must be heterogeneous).

Second, the firm must be able to identify submarkets andrestrict transfers among consumers across different submarkets.


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Identifying demand segments

Key elements that should distinguish segments:

Own price elasticity;

Wilingness to pay.

Segments are separated through:

Buyers characteristics: personal/institutional,

sociological, demographical, ;

Buyers own behavior.


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Separating demand segments

Easier for services than for products.

Might be based on geographical dimensions:

Transportation costs.

Might be based on characteristics of the product:

Example: Softwares for students.


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INTERTEMPORAL PRICE DISCRIMINATIONAND PEAK-LOAD PRICING

intertemporal price discrimination Practice of separatingconsumers with different demand functions into different groups bycharging different prices at different points in time.

peak-load pricing Practice of charging higher prices during peakperiods when capacity constraints cause marginal costs to be high.

Intertemporal Price Discrimination

Consumers are divided into groupsby changing the price over time.

Initially, the price is high. The firm

captures surplus from consumerswho have a high demand for thegood and who are unwilling to waitto buy it.

Later the price is reduced to appealto the mass market.


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INTERTEMPORAL PRICE DISCRIMINATIONAND PEAK-LOAD PRICING

Peak-Load Pricing

Demands for some goods andservices increase sharply duringparticular times of the day or year.

Charging a higher price P1 duringthe peak periods is more profitablefor the firm than charging a singleprice at all times.

It is also more efficient becausemarginal cost is higher during peakperiods.


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THE TWO-PART TARIFF

two-part tariff Form of pricing in which consumersare charged both an entry and a usage fee.

Single Consumer

Two-Part Tariff with a Single Consumer

The consumer has demand curveD.

The firm maximizes profit by settingusage fee Pequal to marginal cost

and entry fee T* equal to the entiresurplus of the consumer.


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THE TWO-PART TARIFF

Two Consumers

Two-Part Tariff with Two Consumers

The profit-maximizing usage fee P*will exceed marginal cost.

The entry fee T* is equal to thesurplus of the consumer with thesmaller demand.

The resulting profit is2T* + (P* MC)(Q1 + Q2). Note thatthis profit is larger than twice the

area of triangleABC.


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THE TWO-PART TARIFF

Many ConsumersTwo-Part Tariff with Many Different Consumers

Total profit is the sum of the profit from the

entry fee a and the profit from sales s. Both

a and s depend on T, the entry fee.

Therefore = a + s = n(T)T+ (P MC)Q(n)

where n is the number of entrants, whichdepends on the entry fee T, and Q is the rateof sales, which is greater the larger is n.

Here T* is the profit-maximizing entry fee,

given P. To calculate optimum values forPandT, we can start with a number forP, find theoptimum T, and then estimate the resultingprofit.

Pis then changed and the corresponding Trecalculated, along with the new profit level.


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THE TWO-PART TARIFF

Most telephone service ispriced using a two-part tariff:a monthly access fee, whichmay include some freeminutes, plus a per-minute

charge for additional minutes.

This is also true for cellular phone service, which has grown explosively,both in the United States and around the world.

Because providers have market power, they must think carefully aboutprofit-maximizing pricing strategies.

The two-part tariff provides an ideal means by which cellular providerscan capture consumer surplus and turn it into profit.


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THE TWO-PART TARIFF


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BUNDLING

Practice of selling two or more products as a package.To see how a film company can use customer heterogeneity to itsadvantage, suppose that there are two movie theaters and that theirreservation prices for these two films are as follows:

If the films are rented separately, the maximum price that could becharged forWindis $10,000 because charging more would excludeTheaterB. Similarly, the maximum price that could be charged forGertie is $3000.

But suppose the films are bundled. We can charge each theater$14,000 for the pair of films and earn a total revenue of $28,000.


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BUNDLING

Why is bundling more profitable than selling the films separately?Because the relative valuations of the two films are reversed.

The demands are negatively correlatedthe customer willing topay the most forWindis willing to pay the least forGertie.

To see why this is critical, suppose demands werepositivelycorrelatedthat is, TheaterA would pay more forboth films:

If we bundled the films, the maximum price that could becharged for the package is $13,000, yielding a totalrevenue of $26,000, the same as by renting the filmsseparately.


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BUNDLING

Relative Valuations

Reservation Prices

Reservation prices r1 and r2 fortwo goods are shown for three

consumers, labeled A, B, and C.ConsumerA is willing to pay up to$3.25 for good 1 and up to $6 forgood 2.


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BUNDLING

Relative Valuations

Consumption Decisions When

Products Are Sold Separately

The reservation prices ofconsumers in region I exceed the

prices P1 and P2 for the twogoods, so these consumers buyboth goods.Consumers in regions II and IVbuy only one of the goods,and consumers in region III buyneither good.


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BUNDLING

Relative Valuations

Consumption Decisions When

Products Are Bundled

Consumers compare the sum oftheir reservation prices r1+ r2, with

the price of the bundle PB.

They buy the bundle only ifr1 + r2is at least as large as PB.


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BUNDLING

Relative Valuations

Reservation Prices

Figure 11.15

In (a), because demands are perfectly positively correlated, the firm does not gain bybundling: It would earn the same profit by selling the goods separately.

In (b), demands are perfectly negatively correlated. Bundling is the ideal strategyallthe consumer surplus can be extracted.


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BUNDLING

Relative Valuations

Movie Example

Figure 11.16

ConsumersA and B are two movietheaters. The diagram shows their

reservation prices for the films Gonewith the Windand GettingGertiesGarter.

Because the demands are negativelycorrelated, bundling pays.


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BUNDLING

mixed bundling Selling two or more goods both as apackage and individually.

pure bundling Selling products only as a package.

Mixed versus Pure Bundling

With positive marginal costs, mixedbundling may be more profitable thanpure bundling.

ConsumerA has a reservation price forgood 1 that is below marginal cost c1,and consumerD has a reservation

price for good 2 that is below marginalcost c2.

With mixed bundling, consumerA isinduced to buy only good 2, andconsumerD is induced to buy onlygood 1, thus reducing the firms cost.


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BUNDLING

Lets compare three strategies:

1. Selling the goods separately at prices P1 = $50 and P2 = $90.2. Selling the goods only as a bundle at a price of $100.3. Mixed bundling, whereby the goods are offered separately at

prices P1 = P2 = $89.95, or as a bundle at a price of $100.


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BUNDLING

Mixed Bundling with Zero Marginal Costs

If marginal costs are zero, and if consumers

demands are not perfectly negatively correlated,mixed bundling is still more profitable than purebundling.

In this example, consumers B and Care willing topay $20 more for the bundle than are consumersAand D.

With pure bundling, the price of the bundle is $100.With mixed bundling, the price of the bundle can beincreased to $120 and consumersA and D can stillbe charged $90 for a single good.


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BUNDLING IN PRACTICE

Mixed Bundling in Practice

The dots in this figure are estimates ofreservation prices for a representativesample of consumers.

A company could first choose a price

for the bundle, PB, such that a diagonalline connecting these prices passesroughly midway through the dots.The company could then try individualprices P1 and P2.

Given P1, P2, and PB, profits can becalculated for this sample of

consumers. Managers can then raiseor lowerP1, P2, and PB and seewhether the new pricing leads to higherprofits. This procedure is repeated untiltotal profit is roughly maximized.


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BUNDLING

For a restaurant, mixed bundling meansoffering both complete dinners (theappetizer, main course, and dessertcome as a package) and an la carte

menu (the customer buys the appetizer,main course, and dessert separately).

This strategy allows the la carte menu to be priced to captureconsumer surplus from customers who value some dishes much

more highly than others.

At the same time, the complete dinner retains those customers whohave lower variations in their reservation prices for different dishes(e.g., customers who attach moderate values to both appetizersand desserts).


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BUNDLING


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BUNDLING

tying => Practice of requiring a customer to purchaseone good in order to purchase another.

Why might firms use this kind of pricing practice?

One of the main benefits of tying is that it often allows a firm tometer demandand thereby practice price discrimination moreeffectively.

Tying can also be used to extend a firms market power.

Tying can have other uses. An important one is to protectcustomer goodwill connected with a brand name.

This is why franchises are often required to purchase inputs fromthe franchiser.


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ADVERTISING

Effects of Advertising

AR and MR are average and marginalrevenue when the firm doesnt advertise,

and AC and MC are average andmarginal cost.

The firm produces Q0 and receives a

price P0.

Its total profit 0 is given by the gray-shaded rectangle.

If the firm advertises, its average andmarginal revenue curves shift to theright.

Average cost rises (to AC) but marginal

cost remains the same.

The firm now produces Q1(where MR =MC), and receives a price P1.

Its total profit, 1, is now larger.


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The price Pand advertising expenditureA to maximize profit, isgiven by:

The firm should advertise up to the point that

=fullmarginal cost ofadvertising

Advertising leads to increased output.

But increased output in turn means increased production costs,and this must be taken into account when comparing the costsand benefits of an extra dollar of advertising.

ADVERTISING


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First, rewrite equation as follows:

Now multiply both sides of this equation byA/PQ, the

advertising-to-sales ratio.advertising-to-sales ratio Ratio of afirms advertising expenditures to its sales.

advertising elasticity of demand Percentagechange in quantity demanded resulting from a 1-percent increase in advertising expenditures.

A Rule of Thumb for Advertising

ADVERTISING


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Convenience stores have lower priceelasticities of demand (around 5), but their

advertising-to-sales ratios are usually lessthan those for supermarkets (and are oftenzero). Why?

Because convenience stores mostly servecustomers who live nearby; they may

ADVERTISING

need a few items late at night or may simply not want to drive to thesupermarket.

Advertising is quite important for makers of designer jeans, who will haveadvertising-to-sales ratios as high as 10 or 20 percent.

Laundry detergents have among the highest advertising-to-sales ratios of allproducts, sometimes exceeding 30 percent, even though demand for any onebrand is at least as price elastic as it is for designer jeans. What justifies all

the advertising? A very large advertising elasticity.


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ADVERTISING

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