Ch.10 Pricing with Market Power

3rd Condition, A Firm Must Prevent Resale

-If resale is easy, price discrimination doesn't work because of only low-price sales. -The biggest obstacle to price discrimination is a firm's inability to prevent resale.

Nonlinear Price Discrimination: Characteristics

Many firms, with market power and no resale, are unable to determine high reservation prices. However, such firms know a typical customer's demand curve is downward sloping. Such a firm can price discriminate by letting the price each customer pays vary with the number of units the customer buys (nonlinear price discrimination).

Different Prices and Different Costs

Newsstand prices and subscription prices for magazines differ in large part because of the higher cost of selling at a newsstand rather than mailing magazines directly to consumers. This is not price discrimination

Two Group Price Discrimination and Elasticities

We know MRA = m = MRB We also know from Chapter 9 that MR = p (1 + 1/ε) So, MRA = pA (1 + 1/εA) = m = pB (1 + 1/εB) = MRB

Identifying Groups: Divide Buyers Based on Their Actions

- Allow consumers to self-select the group to which they belong depending on their opportunity cost of time. - Customers may be identified by their willingness to spend time to buy a good at a lower price (buy at the store; low opportunity cost) or to order goods and services in advance of delivery (phone or online shopping; high opportunity cost).

Effects on Total Surplus: Group Price Discrimination vs. Perfect Competition

- Consumer surplus is greater and more output is produced with perfect competition than with group price discrimination. - Group price discrimination transfers some of the competitive consumer surplus to the firm as additional profit and causes deadweight loss due to reduced output.

Why Price Discrimination Pays

- For almost any good or service, some consumers are willing to pay more than others. - Price discrimination increases profit above the uniform pricing level through two channels.

Effects on Total Surplus: Group Price Discrimination vs. Single-Price Monopoly

- From theory alone, we cannot tell whether total surplus is higher if the monopoly uses group price discrimination or if it sets a single price. - The closer the firm comes to perfect price discrimination using group price discrimination (many groups rather than just two), the more output it produces, and the less production inefficiency—the greater the total surplus.

Conditions for Group Price Discrimination

- Group price discrimination: potential customers are divided into two or more groups with different prices for each group (single price within a group). - Consumer groups may differ by age, location, or in other ways. - A firm must have market power, be able to identify groups with different reservation prices, and prevent resale.

Group Price Discrimination: A Graphic Approach

- If a firm can prevent resale between countries and has a common MC, then it can maximize profit by acting like a traditional monopoly in each country separately. - In Figure 10.3, resale between the U.S. and the U.K. is not possible (different DVD formats) and the common constant MC = m = $1. - Warner acts as a traditional monopoly in each country. U.S. market: MRA=1, QA=5.8, pA=$29. U.K. market: MRB=1, QB=2, pB=$39. - Warner price group discriminates and maximizes profit.

Perfect Price Discrimination: Efficient But Consumer Surplus Equal to Zero

- Perfect price discrimination is efficient: It maximizes the sum of consumer surplus and producer surplus. - But, all the surplus goes to the firm, consumer surplus is zero.

Individual Price Discrimination

- Perfect price discrimination is rarely fully achieved in practice because firms lack full information about individuals' reservation price. - Firms can still increase profits with imperfect individual price discrimination: charge individual-specific prices to different consumers, which may or may not be the consumers' reservation prices.

Channel 1: Higher Prices for Some

- Price discrimination can extract additional consumer surplus from consumers who place a high value on the good. - In panel a of Table 10.1, the theater sells the same number of seats but makes more money from the college students. Students pay $20, seniors pay $10 and the theater captures all consumer surplus from both groups.

Channel 2: Attract New Customers

- Price discrimination can simultaneously sell to new customers who would not be willing to pay the profit-maximizing uniform price. - In panel b of Table 10.1, the theater increases profit by selling 5 more tickets to seniors. Students pay $20 as before, seniors pay $10 and neither group enjoys any consumer surplus.

Identifying Groups: Divide Buyers Based on Observable Characteristics

- The firm believes observable characteristics are associated with unusually high or low reservation prices or demand elasticities. - Movie theaters price discriminate using the age of customers. Higher prices for adults than for children.

Implication: pB / pA = (1 + 1/εA) / (1 + 1/εB)

- The ratio of prices depend on the elasticity values in these two markets. - Warner Brothers apparently believed that the - British demand curve was less elastic at its profit-maximizing prices than the U.S. demand curve (B -1.0263, A ‑1.0357). Consequently, Warner charged British consumers 34% more than U.S. customers, pB /pA = $39/$29 = 1.345.

Two-Part Pricing with Different Consumers

- Two-part pricing is more complex if consumers have different demand curves. - Having two different demands implies consumers have different consumer surpluses. Two-part pricing would require the monopolist to charge different access fees, and this may not be possible

Group Price Discrimination with Two Groups

- Warner Brothers, legal monopoly by copyright, produces and sells the Harry Potter and the Deathly Hallows Part 2 DVD. - Warner engaged in group price discrimination by charging different prices in various countries. Resale is not possible because DVDs have incompatible formats. - A graphical and mathematical approach in next slides.

Two Part Pricing with Identical Consumers

- With identical customers, a firm can set a two-part price that is efficient (p = MC) and all total surplus goes to the firm (CS = 0). - In panel a of Figure 10.5, the monopoly charges a per-unit fee price, p, equal to the marginal cost of 10, and an access fee, A = 2,450 = CS. The firm's total profit is 2,450 times the number of identical customers. - If the firm were to charge a price above its marginal cost of 10, it would sell fewer units and make a smaller profit. For instance, p = 20 in panel b of Figure 10.5.

1st Condition, A Firm Must Have Market Power

-A monopoly, an oligopoly, or a monopolistically competitive firm might be able to price discriminate. A perfectly competitive firm cannot.

2nd Condition, A Firm Must Identify Groups with Different Price Sensitivity

-If consumers have different demands, a firm must identify how they differ. -Disneyland knows tourists and local residents differ in their willingness to pay and use driver licenses to identify them.

Transaction Costs and Price Discrimination

-It is often too difficult or costly to gather information about each customer's reservation price for each unit of the product (high transaction costs). - However, recent advances in computer technologies have lowered these transaction costs. - Hotels, car and truck rental companies, cruise lines, airlines, and other firms are increasingly using individual price discrimination.

Nonlinear Price Discrimination: Block Pricing vs. Single Price

A firm charges one price per unit for the first block purchased and a different price per unit for subsequent blocks. Used by gas, electric, water, and other utilities.

Bundling

Firms with market power often pursue a pricing strategy called bundling: selling multiple goods or services for a single price. Most goods are bundles of many separate parts. However, firms sometimes bundle even when there are no production advantages and transaction costs are small.

Price Discrimination

If a magazine standard subscription rate is higher than a college student subscription rate, it is price discrimination because the two subscriptions are identical in every respect except the price.

Bundling allows firms to increase their profit by _____ to different consumers based on the consumers' _____

charging different prices; willingness to pay.

Requirement tie in sales

(another form of bundling) - Requires customers who buy one product from a firm to make all concurrent and subsequent purchases of a related product from that firm. - This requirement allows the firm to identify heavier users and charge them more per unit.

Two Part Pricing

- A firm charges each consumer a lump-sum access fee for the right to buy as many units of the good as the consumer wants at a per-unit price. - A consumer's overall expenditure for amount q consists of two parts: an access fee, A, and a per-unit price, p. Therefore, expenditure is E = A + pq. - To do it, a firm must have market power, know how individual demand curves vary across its customers, and prevent resale.

Perfect Price Discrimination: How a Firm Perfectly Price Discriminates?

- A firm with market power that can PREVENT resale and has FULL information about its customers' willingness to pay price discriminates by selling each unit at its RESERVATION price—the maximum amount any consumer would pay for it. - The maximum price for any unit of output is given by the height of the demand curve at that output level.

Perfect Price Discrimination: Perfectly Price Discrimination, Price = MR

- A perfectly price-discriminating firm's marginal revenue is the same as its price. - So, the firm's marginal revenue curve is the same as its demand curve

Price Discrimination and Equal Costs

Price discrimination is based on charging different prices even for units of a good that cost the same to produce.

Additional information for table 10.1

Suppose the only movie theater in town has 2 types of customers (college students and senior citizens). Students are willing to pay $20 and seniors are willing to pay $10. Assume the theater has no cost. The profit = (Revenue- Cost) so its just revenue. Assume MC =0. Assume theater is large enough.

Type 3: Nonlinear Price Discrimination

The firm charges a different price for large purchases than for small quantities so that the price paid varies according to the quantity purchased.

Type 2: Group Price Discrimination

The firm charges each group of customers a different price, but it does not charge different prices within the group.

Types of Price Discrimination Type 1: Perfect Price Discrimination

The firm sells each unit at the maximum amount any customer is willing to pay. Price differs across consumers, and may differ too for a given consumer.

The reservation prices are positively correlated:

a higher reservation price for one product is associated with a higher reservation price for the other product.

Mixed bundling

goods are available as a package or separately.

Pure bundling

only a package deal is offered (a cable company sells a bundle of Internet, phone, and television for a single price, no service separately)

The reservation prices are negatively correlated:

the customer who has the higher reservation price for one product has the lower reservation price for the other product.