Pricing with Market Power

PRICE DISCRIMINATION

TWO-PART TARIFF

BUNDLING

PRICE DISCRIMINATION

1. Economic Definition: charging different prices for various services even when the cost are not correspondingly different. The ratios of price to marginal costs for various services are not equal:

P1/MC1 P2/MC2

where

P1 and P2 are prices charged in markets 1 and 2, and MC1 and MC2 are marginal costs in markets 1 and 2.

Rationale for Price Discrimination:

A. Social viewpoint: improve resource allocation

B. Firm viewpoint: increases profits

2. Requirements for Price Discrimination

a. Segment the markets- identify the markets and keep buyers in one market segment from selling to the other market segments

b. Different price elasticities of demand in the market segments. Otherwise, P/MC would be equal in the market segments

c. Monopoly power so that price can exceed marginal cost

3. Types of Price Discrimination

a. Perfect (First Degree) - charge each person a price equal to their willingness to pay. Total revenue is the area under the demand curve.

b. Block (Second Degree)

c. Other bases (Third Degree) such as time of day, income, location, etc. This is the type we will emphasize.

Demand

Perfect Block

Third Degree

Demand

Price Price

Price Price

Q

Q

Q Q

Market Segment 1(Business Travelers)

Market Segment 2(Vacation Travelers)

New Car Dealer

P1

P2

P3

Q1 Q2 Q3

Block Utility Rates

4. General Rule for Profit Maximizing Price Discrimination

Assume two markets, A and B, for the same product.

General Rule:

MRA = MRB = MC

where Qtotal = Qmkt A + Qmkt B

ExampleMidwest Appliance sells the same appliance in Chicago

and Milwaukee. The marginal cost of producing the appliance for either market is $8 per unit and its fixed costs are $410. Its total cost is:

TC = 410 + 8 QM + 8 QC

The demand and marginal revenue in Milwaukee and Chicago are:

PM= 750 - 10 QM PC=495 - 5 QC

MRM = 750 - 20 QM MRC = 495 - 10 QC

If the firm can price discriminate, what prices should it charge?

MC

MRM

PM

MRM = 750-20QM = 8 = MCQM=37.1 and PM=379

MRC

PC

MC

MRC = 495-10QC = 8 = MCQC=48.7 and PC = $251.50

Milwaukee Chicago

Profits = (379)(37.1)+(251.50)(48.7)-410-8(37.1)-(8)(48.7) = 25188.20

500 500

Single Price reduces Profits

MC

MR

QC = 99 - .2 PQM = 75 - .1 PQ = 174 - .3 P

P = 580 - 10/3 QMR = 580 - 20/3 QMC = 8P

Q

MR = 580 - 20/3 Q = 8 = MCQ = 85.8P= 294

Profits = (294)(85.8) - 410 - 8(85.8) = 24,128.80

500

Two Part Tariff

Charge an up front fee for right to buy product

Disney World

Golf and tennis clubs

Another way of capturing consumer surplus

$/unit

1

1 2 3 4 5 6 7 8 9 10

2

3

4

5

6

7

8

9

10 Two-Part Tariff

Demand Curve for an Individual

Demand Curve: P = 10 - Q, MC = 2

Optimal Pricing: Q = 4, P = 6

Q

MC = 2

Profits = Q(P-AC) = 4(6-2) = $16

CS = (1/2)(4)(4) = $8

MR = 10 - 2Q

With an entrance fee of $8, the monopolist’s profit increases to $24

$/unit

1

1 2 3 4 5 6 7 8 9 10

2

3

4

5

6

7

8

9

10 Two-Part Tariff

Demand Curve for an Individual

Q

MC = 2

CS = (1/2)(8)(8) = $32

With an entrance fee of $32, the monopolist’s profit is $32

Demand Curve: P = 10 - Q, MC = 2

Set P = 2

$/unit

1

1 2 3 4 5 6 7 8 9 10

2

3

4

5

6

7

8

9

10

Disneyland’s Two-Part Tariff

Demand Curve for an Individual

Q

MC = 0

CS = (1/2)(10)(10) = $50

With an entrance fee of $50, the monopolist’s

profit is to $50

Demand Curve: P = 10 - Q, MC = 0

Set P = 0

Bundling

We can extract higher profits by bundling products whose demands are negatively correlated.

If we price individually, a high price losses customers willing to pay a low price

Profitable BundlingTheater

Movie Alvin Palace

Casablanca 12,000 $9,000

Godfather 8,000 10,000

Bundle 20,000 19,0001. If separately leased, must charge

Casablanca $9,000

Godfather 8,000 or $17,000 total2. Can charge $19,000 for both combined

3. As long as inverse relationship between

them, bundling works

Bundling Not Profitable Alvin Palace

Casablanca 12,000 9,000Godfather 8,000 7,000Positive relationship