+

Module 3
Pricing Strategies for Firms with
Market Power
 11-2
+ Overview

I. Basic Pricing Strategies

 Monopoly & Monopolistic Competition
 Cournot Oligopoly

II. Extracting Consumer Surplus

 Price Discrimination Two-Part Pricing
 Block Pricing Commodity Bundling

III. Pricing for Special Cost and Demand Structures

 Peak-Load Pricing Transfer Pricing
 Cross Subsidies

IV. Pricing in Markets with Intense Price Competition

 Price Matching Randomized Pricing
 Brand Loyalty
 11-3
+ Standard Pricing and Profits for
Firms with Market Power
Price
Profits from standard pricing
10 = $8

2 MC
P = 10 - 2Q
1 2 3 4 5 Quantity
MR = 10 - 4Q
 11-4
+
An Algebraic Example

P = 10 - 2Q
 C(Q) = 2Q
 Ifthe firm must charge a single price to all
consumers, the profit-maximizing price is
obtained by setting MR = MC.
 10 - 4Q = 2, so Q* = 2.
 P* = 10 - 2(2) = 6.
 Profits = (6)(2) - 2(2) = $8.
 11-5
+ A Simple Markup Rule
 Suppose the elasticity of demand for the firm’s product is
EF.

 Since MR = P[1 + EF]/ EF.

 Setting MR = MC and simplifying yields this simple pricing

formula:

P = [EF/(1+ EF)]  MC.

 The optimal price is a simple markup over relevant costs!

 More elastic the demand, lower markup.
 Less elastic the demand, higher markup.
+ An Example
11-6

 Elasticity of demand for Kodak film is -2.

 P = [EF/(1+ EF)]  MC

 P = [-2/(1 - 2)]  MC

 P = 2  MC

 Price is twice marginal cost.

 Fifty percent of Kodak’s price is margin above manufacturing

costs.
+ Markup Rule for Cournot Oligopoly
11-7

 Homogeneous product Cournot oligopoly.

N = total number of firms in the industry.
 Market elasticity of demand EM .
 Elasticity
of individual firm’s demand is given
by EF = N x EM.
 Since P = [EF/(1+ EF)]  MC,
 Then, P = [NEM/(1+ NEM)]  MC.
 Thegreater the number of firms, the lower the
profit-maximizing markup factor.
 11-8
+ An Example
 Homogeneous product Cournot industry, 3
firms.
 MC = $10.
 Elasticity of market demand = - ½.
 Determine the profit-maximizing price?
 EF = N EM = 3  (-1/2) = -1.5.
P = [EF/(1+ EF)]  MC.
P = [-1.5/(1- 1.5]  $10.
P = 3  $10 = $30.
+ Extracting Consumer Surplus:
11-9

Moving From Single Price Markets

 Most models examined to this point involve a

“single” equilibrium price.
 In reality, there are many different prices being
charged in the market.
 Price discrimination is the practice of charging
different prices to consumer for the same good
to achieve higher prices.
 The three basic forms of price discrimination
are:
 First-degree (or perfect) price discrimination.
 Second-degree price discrimination.
 Third-degree price discrimiation.
 11-10
+ First-Degree or Perfect
Price Discrimination

 Practice
of charging each consumer the
maximum amount he or she will pay for each
incremental unit.
 Permits
a firm to extract all surplus from
consumers.
+ Perfect Price Discrimination
11-11

Price

Profits*:
10
.5(4-0)(10 - 2)
= $16
8

4 Total Cost* = $8

2 MC
D

1 2 3 4 5 Quantity
* Assuming no fixed costs
+ Caveats:
11-12

 Inpractice, transactions costs and

information constraints make this difficult to
implement perfectly (but car dealers and
some professionals come close).
 Price
discrimination won’t work if
consumers can resell the good.
 11-13
Second-Degree
Price Discrimination
Price
 The practice of posting
a discrete schedule of $10 MC
declining prices for
different quantities. $8

 Eliminates the $5
information constraint
present in first-degree
price discrimination.
 Example: Electric
utilities D
2 4
Quantity
+ Third-Degree Price Discrimination
11-14

 The practice of charging different

groups of consumers different prices
for the same product.
 Group must have observable
characteristics for third-degree price
discrimination to work.
 Examples include student discounts,
senior citizen’s discounts, regional &
international pricing.
+ Implementing Third-Degree Price
11-15

Discrimination

 Suppose the total demand for a product is

comprised of two groups with different
elasticities, E1 < E2.
 Notice
that group 1 is more price sensitive than
group 2.
 Profit-maximizing prices?
 P1 = [E1/(1+ E1)]  MC
 P2 = [E2/(1+ E2)]  MC
+ An Example
11-16

 Suppose the elasticity of demand for Kodak

film in the US is EU = -1.5, and the elasticity of
demand in Japan is EJ = -2.5.
 Marginal cost of manufacturing film is $3.
 PU = [EU/(1+ EU)]  MC = [-1.5/(1 - 1.5)]  $3 =
$9
= [EJ/(1+ EJ)]  MC = [-2.5/(1 - 2.5)]  $3 =
 PJ
$5
 Kodak’s optimal third-degree pricing
strategy is to charge a higher price in the US,
where demand is less elastic.
 11-17
+ Two-Part Pricing
 When it isn’t feasible to charge different
prices for different units sold, but demand
information is known, two-part pricing may
permit you to extract all surplus from
consumers.
 Two-part pricing consists of a fixed fee and
a per unit charge.
 Example: Athletic club memberships.
 11-18

How Two-Part Pricing Works

Price 1. Set price at marginal cost.

2. Compute consumer surplus.

10
3. Charge a fixed-fee equal to
8 consumer surplus.

6 Fixed Fee = Profits* = $16

Per Unit 4
Charge
2 MC
D

1 2 3 4 5
* Assuming no fixed costs
Quantity
+ Block Pricing
11-19

 The practice of packaging multiple units of an identical

product together and selling them as one package.

 Examples
 Paper.
 Six-packs of soda.
 Different sized of cans of green beans.
 11-20
+ An Algebraic Example

 Typical consumer’s demand is P = 10 - 2Q

 C(Q) = 2Q

 Optimal number of units in a package?

 Optimal package price?

 11-21
+
Optimal Quantity To Package: 4 Units
Price

10

2 MC = AC
D

1 2 3 4 5 Quantity
+ Optimal Price for the Package: $24
11-22

Price Consumer’s valuation of 4

units = .5(8)(4) + (2)(4) = $24
10 Therefore, set P = $24!

2 MC = AC
D

1 2 3 4 5 Quantity
 11-23
+ Costs and Profits with Block
Pricing
Price

10
Profits* = [.5(8)(4) + (2)(4)] – (2)(4)
8 = $16

4 Costs = (2)(4) = $8

2 MC = AC
D

1 2 3 4 5 Quantity

* Assuming no fixed costs

 11-24
+
Commodity Bundling

 The practice of bundling two or more products together and

charging one price for the bundle.

 Examples
 Vacation packages.
 Computers and software.
 Film and developing.
+ An Example that Illustrates
11-25

Kodak’s Moment
 Totalmarket size for film and developing is 4
million consumers.
 Four types of consumers
 25% will use only Kodak film (F).
 25% will use only Kodak developing (D).
 25% will use only Kodak film and use only Kodak developing (FD).
 25% have no preference (N).

 Zero costs (for simplicity).

 Maximum price each type of consumer will
pay is as follows:
 11-26

Peak-Load Pricing

Price
 When demand during MC
peak times is higher
than the capacity of the
firm, the firm should
PH
engage in peak-load DH
pricing.
PL
MRH
 Charge a higher price (PH)
during peak times (DH).
DL
 Charge a lower price (PL) MRL
during off-peak times (DL).
QL QH Quantity
 11-27
+
Cross-Subsidies
 Prices charged for one product are subsidized by the sale of
another product.

 May be profitable when there are significant demand

complementarities effects.

 Examples
 Browser and server software.
 Drinks and meals at restaurants.
Double Marginalization
11-28
+

 Consider a large firm with two divisions:

 the upstream division is the sole provider of a key input.
 the downstream division uses the input produced by the upstream
division to produce the final output.

 Incentives
to maximize divisional profits leads the
upstream manager to produce where MRU = MCU.
 Implication: PU > MCU.

 Similarly, when the downstream division has market

power and has an incentive to maximize divisional
profits, the manager will produce where MRD = MCD.
 Implication: PD > MCD.

 Thus, both divisions mark price up over marginal

cost resulting in in a phenomenon called double
marginalization.
 Result: less than optimal overall profits for the firm.
 11-29
+
Transfer Pricing

 Toovercome double marginalization, the

internal price at which an upstream division
sells inputs to a downstream division should be
set in order to maximize the overall firm profits.
 Toachieve this goal, the upstream division
produces such that its marginal cost, MCu,
equals the net marginal revenue to the
downstream division (NMRd):
NMRd = MRd - MCd = MCu
+ Upstream Division’s Problem
11-30

 Demand for the final product P = 10 - 2Q.

 C(Q) = 2Q.
 Supposethe upstream manager sets MR =
MC to maximize profits.
 10 - 4Q = 2, so Q* = 2.
 P*
= 10 - 2(2) = $6, so upstream manager
charges the downstream division $6 per unit.
 11-31
+
Downstream Division’s Problem

 Demand for the final product P = 10 - 2Q.

 Downstream division’s marginal cost is the $6
charged by the upstream division.
 Downstream division sets MR = MC to maximize
profits.
 10 - 4Q = 6, so Q* = 1.
 P*
= 10 - 2(1) = $8, so downstream division
charges $8 per unit.
+ Analysis
11-32

 Thispricing strategy by the upstream division

results in less than optimal profits!
 Theupstream division needs the price to be $6
and the quantity sold to be 2 units in order to
maximize profits. Unfortunately,
 Thedownstream division sets price at $8, which is
too high; only 1 unit is sold at that price.
 Downstream division profits are $8  1 – 6(1) = $2.

 The upstream division’s profits are $6  1 - 2(1) =

$4 instead of the monopoly profits of $6  2 - 2(2)
= $8.
 Overall firm profit is $4 + $2 = $6.
+ Upstream Division’s
11-33

“Monopoly Profits”
Price

10 Profit = $8

2 MC = AC
P = 10 - 2Q

1 2 3 4 5 Quantity
MR = 10 - 4Q
+ Upstream’s Profits when
11-34

Downstream Marks Price Up to

$8
Price

Downstream 10 Profit = $4
Price
8

2 MC = AC
P = 10 - 2Q

1 2 3 4 5 Quantity
MR = 10 - 4Q
 11-35

Solutions for the Overall Firm?

 Provide upstream manager with an incentive

to set the optimal transfer price of $2
(upstream division’s marginal cost).
 Overall profit with optimal transfer price:
  $6  2  $2  2  $8
+ Pricing in Markets with Intense Price
11-36

Competition
 Price Matching
 Advertising a price and a promise to match any lower price
offered by a competitor.
 No firm has an incentive to lower their prices.
 Each firm charges the monopoly price and shares the market.
 Induce brand loyalty
 Some consumers will remain “loyal” to a firm; even in the face
of price cuts.
 Advertising campaigns and “frequent-user” style programs can
help firms induce loyal among consumers.
 Randomized Pricing
 A strategy of constantly changing prices.
 Decreases consumers’ incentive to shop around as they cannot
learn from experience which firm charges the lowest price.
 Reduces the ability of rival firms to undercut a firm’s prices.
+ Conclusion 11-37

 First
degree price discrimination, block pricing,
and two part pricing permit a firm to extract all
consumer surplus.
 Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
 Simple markup rules are the easiest to implement,
but leave consumers with the most surplus and
may result in double-marginalization.
 Different strategies require different information.