Chapter 11,Pricing with Market Power,Chapter 11,2,Topics to be Discussed,Capturing Consumer Surplus Price Discrimination Intertemporal Price Discrimination and Peak-Load Pricing The Two-Part Tariff Bundling Advertising,Chapter 11,3,Introduction,Pricing without market power (perfect competition) is determined by market supply and demand The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits,Chapter 11,4,Introduction,Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production,Chapter 11,5,Capturing Consumer Surplus,All pricing strategies we will examine are means of capturing consumer surplus and transferring it to the producer Profit maximizing point of P* and Q* But some consumers will pay more than P* for a good Raising price will lose some consumers, leading to smaller profits Lowering price will gain some consumers, but lower profits,Chapter 11,6,Capturing Consumer Surplus,Quantity,$/Q,The firm would like to charge higher price to those consumers willing to pay it - A,Firm would also like to sell to those in area B but without lowering price to all consumers,Both ways will allow the firm to capture more consumer surplus,Chapter 11,7,Capturing Consumer Surplus,Price discrimination is the practice of charging different prices to different consumers for similar goods Must be able to identify the different consumers and get them to pay different prices Other techniques that expand the range of a firms market to get at more consumer surplus Tariffs and bundling,Chapter 11,8,Price Discrimination,First Degree Price Discrimination Charge a separate price to each customer: the maximum or reservation price they are willing to pay How can a firm profit? The firm produces Q* MR = MC We can see the firms variable profit the firms profit ignoring fixed costs Area between MR and MC Consumer surplus area between demand and price,Chapter 11,9,Price Discrimination,If the firm can price discriminate perfectly, each consumer is charged exactly what they are willing to pay MR curve is no longer part of output decision Incremental revenue is exactly the price at which each unit is sold the demand curve Additional profit from producing and selling an incremental unit is now the difference between demand and marginal cost,Chapter 11,10,Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow).,Perfect First-Degree Price Discrimination,Quantity,$/Q,With perfect discrimination, firm will choose to produce Q* increasing variable profits to include purple area.,Consumer surplus is the area above P* and between 0 and Q* output.,Chapter 11,11,First-Degree Price Discrimination,In practice, perfect price discrimination is almost never possible Impractical to charge every customer a different price (unless very few customers) Firms usually do not know reservation price of each customer Firms can discriminate imperfectly Can charge a few different prices based on some estimates of reservation prices,Chapter 11,12,First-Degree Price Discrimination,Examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product: Lawyers, doctors, accountants Car salesperson (15% profit margin) Colleges and universities (differences in financial aid),Chapter 11,13,First-Degree Price Discrimination in Practice,Quantity,$/Q,Six prices exist resulting in higher profits. With a single price P*4, there are fewer consumers.,Discriminating up to P6 (competitive price) will increase profits.,Chapter 11,14,Second-Degree Price Discrimination,In some markets, consumers purchase many units of a good over time Demand for that good declines with increased consumption Electricity, water, heating fuel Firms can engage in second-degree price discrimination Practice of charging different prices per unit for different quantities of the same good or service,Chapter 11,15,Second-Degree Price Discrimination,Quantity discounts are an example of second-degree price discrimination Ex: Buying in bulk at Sams Club Block pricing the practice of charging different prices for different quantities of “blocks” of a good Ex: electric power companies charge different prices for a consumer purchasing a set block of electricity,Chapter 11,16,Second-Degree Price Discrimination,$/Q,Without discrimination: P = P0 and Q = Q0. With second-degree discrimination there are three blocks with prices P1, P2, & P3.,Quantity,Different prices are charged for different quantities or “blocks” of same good.,Chapter 11,17,Third-Degree Price Discrimination,Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group Divides the market into two groups Each group has its own demand function,