Study Unit 11Pricing with Market Power

• Why and how is consumer surplus captured.• How is price discrimination used to capture

consumer surplus.• How is market power used to implement two-

part tariff.• Pricing strategy of bundling.• Use of advertising by firms.

Outcomes

Capturing consumer surplus

• How do firms with market power capture more consumer surplus and transfer it to the producer?– Pricing Strategies!

• Can achieve by charging different prices to different consumers and not just a single price.

• Basis for price discrimination:– Practice of charging different prices to different

consumers for similar goods.

Capturing consumer surplus

Capturing consumer surplus

• Problem:– How to identify different consumers?– How to get them to pay different prices?

Price discrimination

• Three broad forms:– First Degree Price Discrimination• Perfect Price Discrimination• Imperfect Price Discrimination

– Second Degree Price Discrimination– Third Degree Price Discrimination

First-Degree Price Discrimination

• If firm could → Charge maximum price customer willing to pay. = Reservation Price

• Assume consumer buy one unit.• Practice of charging reservation price

= First-degree price discrimination

First-Degree Price Discrimination

First-Degree Price Discrimination• How does this affect profit?– Add profit from each additional unit bought= Variable profit (Yellow)

• Perfect price discrimination:– Variable profit given for each unit = Demand curve – MC– Never possible!• Impossible to charge different price to different

consumers.• Firm usually doesn’t know reservation price.

First-Degree Price Discrimination

• Imperfect price discrimination:– Charging few different prices based on estimates of

reservation price– Used by doctors, lawyers, architects or accountants

First-Degree Price Discrimination

Second-Degree Price Discrimination• Consumer purchase many different units =

reservation price will decline• Example: water, heat, fuel and electricity• Willingness to pay decline with increased

consumption.– Conservation easier and more worthwhile if price

then high= Second-degree price discrimination

Practice of charging different prices per unit for different quantities of the same good or service

Second-Degree Price Discrimination

Second-Degree Price Discrimination

• Another example = Block pricing and quantity discounts

• Block Pricing: Practice of charging different prices for different quantities or blocks of a good

• Quantity discounts = Different prices for different quantities purchased.

Third-Degree Price discrimination

• Practice of dividing consumers into:– two or more groups – with separate demand curves, and – charging different prices for each group.

• Examples:– Regular vs. special airfares– Canned or frozen vegetables– Discounts to students or senior citizens

Third-Degree Price discrimination

• Which price to pay?– Create consumer groups:• According to socio-economic characteristics• Divide total output between groups• MR1=MR2=MC

– Determine relative price:• Relate to elasticity of demand• P1/P2 = (1+1/E2) / (1+1/E1)

Third-Degree Price discrimination

Third-Degree Price discrimination

• Not always worthwhile to sell to more than one group.– Demand too

small– MC to high

Intertemporal price discrimination• Practice of:– Separating consumers – With different demand functions into different groups– By charging different prices– At different points in time

• Example: – Higher price for first-run movie and lower price after

a year.– High price for hard-cover book and bring out a

paperback version later at a lower price

Intertemporal price discrimination

Peak-loading pricing

• The practice of:– Charging higher prices– During peak periods– When capacity constraints cause high MC

• Increase economic efficiency by charging price close to MC.

• Example of peak times:– Amusement park over weekends and holidays– Roads during morning and afternoon traffic

Peak-loading pricing

Two-part tariff

• Only need to know the definition on page 406• Leave page 407-413• Definition:– Form of pricing in which consumer is charged both

entry and usage fee.– Example: Amusement park entry fee and price

per ride.

Bundling• ‘Gone with the wind’ and ‘Getting Gertie’s

Garter’• Theatres had to lease both• Two films were bundled = sold as a package• Bundling:– The practice of selling two or more products as a

package.– Why bundle?• When customer has heterogeneous demands and firm

can’t price discriminate.

Bundling

• Used to firms advantage:– Reservation price for two films

– Rented separately: Max price $10 000 = Theatre B– Total revenue = $26 000– If bundled: A = $15 000 and B = $14 000– Thus charge $14 000 and revenue total = $28 000

Gone with the Wind Getting Gertie’s Garter

Theater A $12 000 $3 000

Theater B $10 000 $4 000

Relative valuations

• Why is bundling profitable?– Relative valuations of the two films are reversed– Thus, demand negatively correlated: Willing to

pay more for ‘wind’ than ‘Gertie’.– Why is this critical?• Make demand positively correlated• Describe preferences in next graph

Bundling

Bundling

Bundling

Bundling

Bundling

Mixed bundling

• Selling two or more goods both as a package and individually.

• Packaged price below separate price.• Pure bundling: Selling products only as a

package.• Mixed bundling ideal strategy for negatively

correlated demands.

Mixed bundling

Mixed bundling

Bundling in practice

• Buy vehicle and add-on’s: radio, sunroof, metallic colour, etc.

• When will manufacturers include add-on’s and when not.

• Going on vacation and paying for add-on’s: excursions, etc.

Bundling in practice

Tying

• Practice of requiring a customer to purchase one good in order to purchase another.

• Pure bundling a common form of tying.• Example: Sell copy machine and must get

paper.

Advertising

• Firms with market power have another important decision: How much to advertise?

• Advertising spending = A• Choose advertising expenditure to maximise

profit.

∏ = PQ(P,A) – C(Q) - A

Effects of Advertising