Managerial Economics & Business
Strategy
Chapter 11
Pricing Strategies for Firms with
Market Power
Standard Pricing and Profits for Firms 11-2
with Market Power
Price
Profits from standard pricing
10 = $8
2 MC
P = 10 - 2Q
1 2 3 4 5 Quantity
MR = 10 - 4Q
11-3
An Algebraic Example
• P = 10 - 4Q
• C(Q) = 2Q
• If the 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.
11-4
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.
11-5
An Example
• 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.
11-6
Extracting Consumer Surplus: 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.
11-7
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.
11-8
Perfect Price Discrimination
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
11-9
Caveats:
• In practice, 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.
11-10
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
11-11
Third-Degree Price Discrimination
• 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.
11-12
Implementing Third-Degree Price
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
11-13
An Example
• 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
• PJ = [EJ/(1+ EJ)] MC = [-2.5/(1 - 2.5)] $3 = $5
• Kodak’s optimal third-degree pricing strategy is to
charge a higher price in the US, where demand is
less elastic.
11-14
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.