Microeconomics (ECS2601) 11 - Pricing with market power (Ch 11)

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ECS 2601Microeconomics

Errol Goetsch 078 573 5046 [email protected] 082 770 4569 [email protected]

www.facebook.com/ecs2601

Boston | UNISA 2015Unit 11 – Pricing with Market Power

mailto:[email protected]

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01 – Prior Learning02 – Elasticity03 - Consumer Behaviour04 – Individual and market demand05 – Uncertainty and consumer behaviour06 - Production07 – Cost of Production08 – Profit maximisation and competitive supply09 – The analysis of competitive markets10 – Market power – monopoly and monopsony11 – Pricing with market power12 – Monopolistic competition and oligopoly13 – Game theory and competitive strategy14 – Markets for factor inputs15 – Investment, time and capital markets16 – General equilibrium and economic efficiency17 – Markets with asymmetric information18 – Externalities and public goods

11 Pricing with market powerDefinition11.1 Capturing Consumer SurplusPricing strategies to capture consumer surplus11.2 Price DiscriminationDefinition11.2.1 1st DegreePerfect 1st Degree discriminationNormal 1st Degree discrimination11.2.2 2nd DegreeGraph11.2.3 3rd DegreeGraphAlgebraAlgebra and GraphDetermining relative pricesLimit on 3rd Degree price discriminationCoupons and rebates11.3 Other types of Price Discrimination11.3.1 Inter-temporal Price Discrimination11.3.2 Peak-Load Pricing11.4 Practical examplePricing a hardback

MicroeconomicsLearning units 01 - 18

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11 The MarketMarket Power: Ability of a seller or buyer to affect P

Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production.

FactorMarket

Household

GoodsMarket

Firm

Sell Buy

Buy Sell

Government

I

G

C

M

X

FinancialMarket

Price

Quantity

DEMAND & SUPPLY

i E

Z

Y

TS

P

NPrice

Quantity

DEMAND & SUPPLY

Competitive firmP = MCMonopoly firmP > MC.

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11.1 Capturing Consumer SurplusPricing strategies capture consumer surplus and transfer it to the producer

Quantity

$/Q

D

MR

Pmax

MCPC

Charge higher price to those consumers

willing to pay it - A

P*

Q*

A

P1

Charge lower price to customers in area B

without lowering price to all consumers

B

P2

Profit maximizing point of P* and Q*

OpportunitySome consumers will pay more than P* for a good.

ProblemRaising price will lose some consumers, leading to smaller profits

Lowering price will gain some consumers, but reduce profits

SolutionCharge different prices and capture more consumer surplus

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11.2 Price DiscriminationPractice of charging different prices to different consumers for similar goods.

Requirement

Identify the different consumers and get them to pay different prices

Charge separate price ...

11.2.1 1st Degree

Per person, based on individual maximum / reservation price

11.2.2 2nd Degree

Per unit, based on for quantities of consumption

11.2.3 3rd Degree

Per segment, based on separating customers with different demand curves and charging them different prices

11.3.1 Inter-temporal Price Discrimination

Over time, based on separating consumers with different demand curves and charging different prices at different times.

11.3.2 Peak-Load Pricing

Higher prices for peak periods when capacity constraints raise marginal costsTariffs and bundling

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11.2.1 1st Degree Perfect Price DiscriminationPractice of charging different prices to different consumers for similar goods.

P*

Q* Quantity

$/QConsumer surplusArea above P* and between0 and Q* output.

Pmax

D = AR

MR

MC

Q**

PC

In practice, perfect price discrimination is almost never possible. Impractical to charge every customer a different price (unless very few customers)

Firms usually does not know reservation price of each customer

Without price discrimination,output is Q* and price is P*.Variable profit is the area between the MC & MR (yellow).

The firm produces Q* MR = MCArea between MR and MCConsumer surplus area between demand and Price

If the firm can perfectly price discriminate, each consumer is charged exactly what they are willing to pay.MR curve is no longer part of output decisionIncremental revenue is exactly the price at which each unit is sold – the demand curveAdditional profit from producing and selling an incremental unit is now the difference between demand and marginal cost

With perfect discrimination, firm will choose to produce Q** increasing variable profits to include purple area.

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11.2.1 1st Degree Price DiscriminationPractice of charging different prices to different consumers for similar goods.

If…

Firms can discriminate imperfectly

Then …

Can charge a few different prices based on some estimates of reservation prices

e.g.

Lawyers, doctors, accountants

Car salesperson (15% profit margin)

Colleges and universities (differences in financial aid)

D

MR

MC

$/Q

P2

P3

P1

P5

P6

P*4

Q*

Discriminating up to P6 (competitive price) will

increase profits

6 prices exist, resulting

in higher profits. With 1 price

P*4, there are fewer

consumers.

Quantity

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11.2.2 2nd Degree Price DiscriminationCharging diff prices per unit for diff quantities of same good / service

$/Q Without discrimination: P = P0 and Q = Q0. With 2nd degree discrimination, there are 3 blocks with prices P1, P2, & P3.

D

MR

MCAC

P0

Q0Q1

P1

1st Block

P2

Q2

2nd Block

P3

Q3

3rd Block

Different prices are charged for

different quantities or “blocks” of

same good

In some markets, consumers purchase many units of a good over time

Demand for that good declines with increased consumption

Electricity, water, heating fuel

Quantity discounts are an example of second-degree price discrimination

Block pricing – the practice of charging different prices for different quantities of “blocks” of a good

Quantity

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11.2.3 3rd Degree Price DiscriminationDividing segments with sep demand curves and charging them different prices

Most common type

airlines, premium v. non-premium liquor, discounts to students and senior citizens, frozen v. canned vegetables, magazines.

A characteristic is used to segment groups with different elasticities of demand

e.g. College students and senior citizens are distinguishable with ID’s

$/Q

D1 = AR1MR1

MRT

MRT = MR1 + MR2

D2 = AR2

MR2

Consumers are divided intotwo groups, with separate

demand curves for each group.

Total output should be divided between groups so that MR for each group are equal.

Total output is chosen so that MR for each group of consumers is equal to the MC of production

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First group of consumers:

MR1= MC

Can do the same thing for the second group of consumers

Second group of customers:

MR2 = MC

Combining these conclusions gives

MR1 = MR2 = MC

Determining relative prices

Thinking of relative prices that should be charged to each group of consumers and relating them to price elasticities of demand may be easier.

Recall: MR=P (1+1 /Ed)Then: MR1 =P1(1+1/E1)=MR2 =P 2(1+1 /E2)

E1 and E2 elasticities of demand for each group

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Firm should increase sales to each group until incremental profit from last unit sold is 0

Set incremental for sales to group 1 = 0

AlgebraicallyP1: price first groupP2: price second groupC(QT) = total cost of producing outputQT = Q1 + Q2Profit: = P1Q1 + P2Q2 - C(QT)

Quantity

D2 = AR2

MR2

$/Q

D1 = AR1MR1

MRT

MC

Q2

P2

QT: MC = MRT

Group 1: more inelasticGroup 2: more elasticMR1 = MR2 = MCT

QT control MC

Q1

P1

MC = MR1 at Q1 and P1

QT

MCT

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11.2.3 3rd Degree Price DiscriminationDetermining relative prices

Equating MR1 and MR2 gives the following relationship that must hold for prices

The higher price will be charged to consumer with the lower demand elasticity

Even if third-degree price discrimination is possible, it may not be feasible to try and sell to both groups

ExampleE1 = -2 & E2 = -4P1 should be 1.5 times as high as P2

P1P2

=(1+1/E2 )

(1+1/E1 )

1 1

=1 +

=1 + -4

=1 -0.25

=0.75

= 1.51 + 1 1 + 1 1 -0.50 0.5

-2

P1

E2

P2

E1

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11.2.3 3rd Degree Price DiscriminationNo Sales to Smaller Market

Even if third-degree price discrimination is possible, it may not be feasible to try and sell to both groups

Quantity

D2

MR2

$/Q

MC

D1MR1

Group 1, with demand D1, are not willing to pay enoughfor the good to make price discrimination profitable.

Q*

P*

MC=MR1=MR2

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11.2.3 3rd Degree Price DiscriminationCoupons and rebate programs allow firms to price discriminate

Price elastic consumers (20-30%) use coupons/rebates more oftenFirms encourage them to buy when they normally would not.Elasticities of demand vary for users and non usersDifferences in elasticities imply that some customers will pay a higher fare than others. Business travelers have few choices and their demand is less elastic. Casual travelers and families are more price sensitive and will therefore be choosier. There are multiple fares for every route flown by airlines. They separate the market by setting various restrictions on the tickets e.g.● Must stay over a Saturday night● 21-day advance, 14-day advance● Basic restrictions – can change

ticket to only certain daysMost expensive: no restrictions – 1st class

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11.3.1 Other Types of Price DiscriminationInter-temporal Price Discrimination

Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time.

Once 1st market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand. This can be seen graphically looking at two different groups of consumers – one willing to buy right now and one willing to wait. Initial release of a product, the demand is inelastic e.g.

Hard back v. paperback book / New release movie / Technology Quantity

AC = MC

$/QOver time, demand becomes

more elastic and price is reduced to appeal to the

mass market.

MR2

D2 = AR2

Q2

P2

D1 = AR1MR1

P1

Q1

Initially, demand is lesselastic resulting in a

price of P1 .

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11.3.2 Other Types of Price DiscriminationPeak-Load Pricing

Demand for some products may peak at particular times.Rush hour trafficElectricity - summerSki resorts on weekendsMovies on weekends

Increases efficiency by charging customers close to marginal cost. Increased MR and MC would indicate a higher price. Total surplus is higher because charging close to MC. Can measure efficiency gain from peak-load pricing

With 3rd degree discrimination, MR for all markets was equalMR not = for each market because 1 market does not impact the other with peak-load pricing. Price and sales in each market are independent

MR1

D1 = AR1

MC

P1

Q1 Quantity

$/Q

MR2

D2 = AR2

Q2

P2

MR=MC for each group. Group 1 has higher demand during peak times

Higher prices for peak periods when capacity constraints raise marginal costs

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11.4 Practical examplePricing a hardback's initial release

Hard-back and paperback books are ways for the company to price discriminate.

1. How does the firm determine its price for hard-back and paperback books?2. How does the company determine when to release the paperback?

Company must divide consumers into two groups:Those willing to buy more expensive hard backThose willing to wait for paperback

Have to be strategic abut when to release paperback after hardback

Publishers typically wait 12 to 18 months Publishers must use estimates of past books to determine how much to sell a new book. Hard to determine the demand for a NEW book.

New books are typically sold for about the same price to take this into account.Demand for paperbacks is more elastic so we should expect it to be priced lower.

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Microeconomics (ECS2601) 11 - Pricing with market power (Ch 11)

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