Pricing Strategies for Firms with Market Power

Mir Ahasan Kabir, Ph.D.

Department of Economics
University of Toronto
[Link]@[Link]

November 27, 2024

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Overview

1 Introduction
2 The Basics of Pricing Strategy
3 Direct Price Discrimination I: Perfect (First-Degree) Price
Discrimination
4 Direct Price Discrimination II: Segmenting (Third-Degree) Price
Discrimination
5 Indirect (Second-Degree) Price Discrimination
6 Bundling
7 Advanced Pricing Strategies
8 Conclusion

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Introduction

In Chapter 9, we examined how firms with market power can generate

positive economic profit by influencing the price at which their products or
services are sold – but this is based on the assumption that firms must
charge the same price to all customers.

In this chapter, we explore alternative pricing strategies and show that

when a firm with market power can discriminate among customers,
additional surplus (beyond that achieved by a single-price monopolist) can
be generated.

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The Basics of Pricing Strategy
A pricing strategy is a firm’s plan for setting the price of its product
given the market conditions it faces and its desire to maximize profit.

For a perfectly competitive firm, the pricing strategy is straightforward:

charge the equilibrium market price and take zero economic profit in the
long run.

For firms with market power, strategies can become more complex.
For a single-price producer, the optimal strategy is to increase
production until marginal revenue is equal to marginal cost, which
yields maximum profit.
However, some firms with market power are able to charge different
prices to different customers (price discrimination).
Price Discrimination: The practice of charging different prices to different
consumers for the same product.
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The Basics of Pricing Strategy

When Can a Firm Price Discriminate?

There are two requirements:

1 The firm must have market power.

Without market power, firms must charge all customers the market
equilibrium price.
2 The firm must prevent resale and arbitrage.
Arbitrage is the practice of reselling a product at a price higher than
its original selling price.
If this requirement is not met, customers subject to a lower price could
simply purchase excess product and resell to those facing the higher
price.

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The Basics of Pricing Strategy

Ultimately, the exact kind of pricing strategy will depend on the

information available to the firm.
1 If a firm can identify its customers’ demands before they buy. . .

It can practice direct price discrimination and charge different prices to

different customers based on observable characteristics of the
customers.
If the firm has detailed and complete information about each
customer’s own demand curve before he/she buys, it can practice
perfect or first-degree price discrimination (Section 10.2).
If the information about the firm’s customers is less detailed, a firm
may be able to discriminate by customer group, which is called
segmenting or third-degree price discrimination (Section 10.3).

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The Basics of Pricing Strategy

2 If a firm can identify its customers differing demands only after they
make a purchase. . .
The firm can try indirect or second-degree price discrimination (Section
10.4).
Under the right conditions, firms can also make a pricing package by
bundling together different products (Section 10.5).
It can also pursue block pricing and two-part tariffs (Section 10.6)
3 If a firm’s customers have the same demand curves. . .
There are still some pricing strategies that a firm can use to make more
profit such as block pricing and two-part tariffs (Section 10.6)

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The Basics of Pricing Strategy

Figure 10.1 Overview of Pricing Strategies

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Direct Price Discrimination I: Perfect (First-Degree) Price
Discrimination

When to Use It: Perfect (First-Degree) Price Discrimination

1 The firm has market power and can prevent resale.
2 The firm’s customers have different demand curves.
3 The firm has complete information about every customer and can
identify each one’s level of demand before purchase.
If a firm is able to observe characteristics of demand prior to purchase, it
can increase producer surplus through direct price discrimination.
A pricing strategy in which firms charge different prices to different
customers based on observable characteristics of the customers

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Direct Price Discrimination I: Perfect (First-Degree) Price
Discrimination

When to Use It: Perfect (First-Degree) Price Discrimination

In the extreme case that the firm has complete information about
customers, it can engage in perfect price discrimination.
Also called first-degree price discrimination, it is a type of direct price
discrimination in which a firm charges each customer exactly
according to his or her willingness to pay.

What does this mean for consumer surplus?

It is driven to zero under perfect price discrimination!

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Direct Price Discrimination I: Perfect (First-Degree) Price
Discrimination

Figure 10.2 Perfect (First-Degree) Price Discrimination

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

When to Use It: Segmenting (Third-Degree) Price Discrimination

1 The firm has market power and can prevent resale.
2 The firm’s customers have different demand curves.
3 The firm can directly identify specific groups of customers (but not
individual customers) with different price sensitivities before purchase.

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

When to Use It: Segmenting (Third-Degree) Price Discrimination

In most cases, direct price discrimination requires too much information;
however, firms may be able to use common characteristics to engage in
segmenting (third degree price discrimination).
A type of direct price discrimination in which a firm charges different
prices to different groups (segments) of customers based on the
identifiable attributes of those groups.
In third-degree price discrimination, a firm is able to extract surplus in
excess of that collected by a single-price monopolist but not as much
as under first-degree price discrimination.
Examples: senior citizen and student discounts

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination
Consider an example with two consumer groups: The Ironman
Cozumel 70.3 Triathlon is a prestigious annual race. Two types of
consumers would like to enter the race:
1 Locals

2 People who fly in from somewhere else (usually the United States)

Do you think this situation might present a good case for third-degree
price discrimination?
Does the firm have market power?
Yes, this is a well-known, prestigious event.
Do the customers have different demand curves?
It is reasonable to think that international customers may have
different demand characteristics from those of the locals.
Can the firm identify groups and prevent resale?
Yes, requiring identification should allow for effective segmentation.
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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

How might the demand curves differ between local and international
customers?
Income differences between U.S. and Mexican triathletes
U.S. competitors are likely to have higher incomes and be less sensitive
to the fee.
The entrance fee as a share of total cost of attending the triathlon
(airfare, hotel, etc.) is smaller for international athletes, which should
make them less sensitive to the fee.

The two consumer groups can be described graphically.

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

Figure 10.3 Segmenting Entry Fees at the Ironman Cozumel 70.3 Triathlon

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

The Benefits of Segmenting: A Mathematical Approach

Traveling triathlon participants have demand

QT = 1, 700 − 5PT

while locals have demand

QL = 2, 400 − 10PL
As suggested, locals are more price-sensitive than travelers.

The marginal cost to the organizer of adding participants is assumed to be

constant at $100.

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

We follow the steps from Chapter 9 and first determine the marginal
revenue curves for each group of participants.

Travelers Locals
QT = 1, 700 − 5PT QL = 2, 400 − 10PL
PT = 340 − 0.2QT PL = 240 − 0.1QL
MRT = 340 − 0.4QT MRL = 240 − 0.2QL

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination
Setting marginal revenue equal to marginal cost for each group:

Travelers Locals
MRT = MC MRL = MC
340 − 0.4QT = 100 240 − 0.2QL = 100
QT = 600 QL = 700

And using the demand curves to solve for price:

Travelers Locals
PT = 340 − 0.2QT = $220 PL = 240 − 0.1QL = $170
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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

Total producer surplus is the area below price but above marginal cost,
summed over the two consumer groups:

Travelers Locals
PST = (220 − 100) ∗ 600 PSL = (170 − 100) ∗ 700
= $72, 000 = $49, 000

PScombined = $121, 000

How does this compare to the single-price monopolist?

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination
First, find the equation for the market demand area to the right of the
kink is
Q = 1, 700 − 5P + 2, 400 − 15P = 4, 100 − 15P
4,100 Q
Inverse demand is P = 15 − 15

4,100 2Q
and marginal revenue is MR = 15 − 15

Setting marginal revenue equal to marginal cost yields the single-price

equilibrium quantity
MR = MC
4, 100 2Q
− = 100
15 15
Q = 1, 300
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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

And plugging in 1,300 to the market demand curve yields

4, 100 1, 300
P= − = $186.67
15 15
As expected, the market price is slightly higher than the local price under
segmentation but lower than the traveler price.

Producer surplus for the single-price monopolist is

PS = (186.67 − 100) ∗ 1, 300 = $112, 671

This is less than the $121,000 achieved when the market can be
segmented.

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

How Much Should Each Segment Be Charged?

Segmenting monopolists treat each segment as a different market.

Therefore, the Lerner index can be used to compute the optimal
markup for each segment.
From Chapter 9, the markup formula is given as
P − MC 1
=
P } −E D
| {z
%markup

The monopolist will solve this formula for each segment.

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

Question 1 Suppose an upscale movie theater has two locations - one in

Boston, MA and one in Charlotte, NC. In Boston, the price elasticity of
demand is -3 and in Charlotte, it is -2. If the marginal cost of movie ticket
is $6, what are the optimal prices in each location?
A Boston: $9; Charlotte: $12
B Boston: $12; Charlotte: $9
C Boston: $8; Charlotte: $10
D Boston: $7; Charlotte: $15

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination

Question 1 - Correct Answer Suppose an upscale movie theater has two

locations - one in Boston, MA and one in Charlotte, NC. In Boston, the
price elasticity of demand is -3 and in Charlotte, it is -2. If the marginal
cost of movie ticket is $6, what are the optimal prices in each location?
A Boston: $9; Charlotte: $12 (Correct Answer)
B Boston: $12; Charlotte: $9
C Boston: $8; Charlotte: $10
D Boston: $7; Charlotte: $15

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Direct Price Discrimination II: Segmenting (Third-Degree)
Price Discrimination
Ways to Directly Segment Customers
By customer characteristics
Age (e.g., senior citizen discounts)
Gender (e.g., ladies night specials)
May sometimes run afoul of anti-discrimination laws

By past purchase behavior Repeat customers may be more price

sensitive (e.g., software updates less expensive than initial purchase).
By location Based on local demand characteristics, prices are often
different regionally (e.g., chain restaurants have higher prices in
airports than other locations).
Over time Prices are higher when something is new as with games
and hardcover books but, over time, the game will decrease in price
and a paperback will be less expensive.
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Indirect (Second-Degree) Price Discrimination

When to Use It: Indirect (Second-Degree) Price Discrimination

1 The firm has market power and can prevent resale.
2 The firm’s customers have different demand curves.
3 The firm cannot directly identify which customers have which type of
demand before purchase.
Indirect (second-degree) price discrimination is a pricing strategy in
which customers pick among a variety of pricing options offered by the
firm.

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Indirect (Second-Degree) Price Discrimination

Indirect (Second-Degree) Price Discrimination through Quantity

Discounts

Firms often use quantity discounts to price-discriminate.

The practice of charging a lower per-unit price to customers who buy
larger quantities
Relies on a concept known as incentive compatibility
The requirement under an indirect price discrimination strategy is that
the price offered to each consumer group be chosen by that group.
Firms must be careful not to discount too steeply on large quantities
or else they will cannibalize consumers from the uninterested
consumer segment.

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Indirect (Second-Degree) Price Discrimination

Indirect (Second-Degree) Price Discrimination through Versioning

Versioning is a pricing strategy in which a firm offers different product

options designed to attract different types of consumers.
Common example: air travel for leisure versus business passengers
For versioning to work, the marginal cost of the products offered to
different consumers need not be equal.
The only requirement: the markup must be higher for the segment
with the less elastic demand.

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Indirect (Second-Degree) Price Discrimination

Consider the car manufacturer Toyota

The firm offers two brands—Toyota and Lexus-with similar models.
Assume the following willingness to pay for two car models:
Table 10.1: Consumer Valuations for Camrys and ESs
Toyota Camry Lexus ES 350
Budget consumer $30,000 $33,000
Luxury consumer $33,000 $44,000
What if Toyota charges $28,000 for the Camry and $38,000 for the
ES 350?
Budget consumers will purchase the Camry and gain $2,000 surplus per
car (they would get - $5,000 if purchase the Lexus ES).
Luxury consumers will purchase the ES 350 and gain $6,000 surplus
per car (they would only get $5,000 in surplus if they buy the Camry).
This pricing scheme would be incentive compatible.
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Indirect (Second-Degree) Price Discrimination

Consider the car manufacturer Toyota

The firm offers two brands—Toyota and Lexus-with similar models.
Assume the following willingness to pay for two car models:
Table 10.1: Consumer Valuations for Camrys and ESs
Toyota Camry Lexus ES 350
Budget consumer $30,000 $33,000
Luxury consumer $33,000 $44,000
What if Toyota charges $41,000 for the ES 350?
The budget consumers would still buy the Camry.
Luxury consumers now find the Camry preferable (5, 000versus3,000
consumer surplus).
Prices are NOT incentive compatible, as only Camrys would be sold.

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Bundling

Bundling is a pricing strategy in which a firm sells two or more products

together at a single price.

When to Use It: Bundling

The firm has market power and can prevent resale.
The firm sells a second product, and consumers’ demand for that
product is negatively correlated with their demand for the first
product.

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Bundling

Examples of Bundling

Cable and satellite television providers

In general, there is little flexibility in choosing a menu of channels
from the cable company.
Cable companies have resisted attempts to decouple channels. Why?

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Bundling
Consider two consumers, Madison and Dakota, who are looking to
subscribe to a cable service with two channels—ESPN and the truTV.
First, consider positively correlated demand. (As demand for one
channel increases across consumers, demand for the other increases as
well.)
Table 10.2: Positively Correlated Valuations per Subscriber-Month
ESPN truTV Bundle
Madison $9.00 $1.00 $10.00
Dakota $10.00 $1.50 $11.50
Without bundling, the company can charge a maximum of $9 for
ESPN and $1 for the History Channel, for a total of $20 in revenue, if
they want both Madison and Dakota to subscribe.
With bundling, they can charge a maximum of $10 for the bundle and
get both customers.
No benefit to bundling with positive correlation.
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Bundling

Now consider the same market, but with negatively correlated demand.
Table 10.3: Negatively Correlated Valuations per Subscriber-Month

ESPN truTV Bundle

Madison $9.00 $1.50 $10.50
Dakota $10.00 $1.00 $11.00

Once again, without bundling, the company can charge a maximum

of $9 for ESPN and $1 for the History Channel, for a total of $20 in
revenue, if they want both Madison and Dakota to subscribe.
However, with bundling, they can charge a maximum of $10.50 for
the bundle and keep both consumers, increasing total revenue to $21
for the two consumers.

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Bundling

Mixed Bundling
Pure bundling is a type in which the firm offers products only as a bundle.

Alternatively, in mixed bundling, the firm offers consumers the choice of

buying two or more products separately or as a bundle.
Example: Value meals at fast-food restaurants

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Advanced Pricing Strategies

When to Use It: Block Pricing and Two-Part Tariffs

1 The firm has market power and can prevent resale.
2 The firm’s customers may have either identical or different demand
curves.
Block pricing is the practice of reducing the price of a good when the
customer buys more of it.
Unlike indirect price discrimination (quantity discounts), block pricing
does not consider buyers’ demand curves.

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Advanced Pricing Strategies

Figure 10.6 Block Pricing

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Advanced Pricing Strategies

A two-part tariff is a pricing strategy in which the payment has two

components, a per-unit price and a fixed fee.

Examples:
Video game systems: fixed fee (console), per-unit price (games)
Zipcar: fixed fee (annual membership), per-unit price (hourly rental
fee)
Popular clubs: fixed fee (cover charge), per-unit price (beverages)
Amazon Prime: fixed fee (yearly charge), per-unit price (any
purchases)

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Advanced Pricing Strategies

Figure 10.7 Two-Part Tariff

By adding a fixed monthly fee equal to A + B + C, the firm can lower the
per-minute price to $10 per GB, where D = MC (the competitive
outcome). It can set a fixed fee equal to the consumer’s surplus and
collect the entire amount of surplus.

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Advanced Pricing Strategies

Question 1 An attorney who specializes in making living wills interviews

each client beforehand to assess each client’s maximum willingness to pay
for a living will. The attorney then charges each client what she believes is
their maximum willingness to pay. This type of pricing strategy is most
closely aligned with which of these pricing strategies?
A Bundling
B Two-Part Tariffs
C Perfect (First-Degree) Price Discrimination
D Indirect (Second-Degree) Price Discrimination

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Advanced Pricing Strategies

Question 1 An attorney who specializes in making living wills interviews

each client beforehand to assess each client’s maximum willingness to pay
for a living will. The attorney then charges each client what she believes is
their maximum willingness to pay. This type of pricing strategy is most
closely aligned with which of these pricing strategies?
A Bundling
B Two-Part Tariffs
C Perfect (First-Degree) Price Discrimination (correct answer)
D Indirect (Second-Degree) Price Discrimination

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Advanced Pricing Strategies

Question 2 A health club charges a low annual membership fee for the
right to use their facilities in addition to charging its members a visit fee
each time they visit the club. This type of pricing strategy is most closely
aligned with which of these pricing strategies?
A Bundling
B Two-Part Tariffs
C Perfect (First-Degree) Price Discrimination
D Indirect (Second-Degree) Price Discrimination

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Advanced Pricing Strategies

Question 2 A health club charges a low annual membership fee for the
right to use their facilities in addition to charging its members a visit fee
each time they visit the club. This type of pricing strategy is most closely
aligned with which of these pricing strategies?
A Bundling
B Two-Part Tariffs (correct answer)
C Perfect (First-Degree) Price Discrimination
D Indirect (Second-Degree) Price Discrimination

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Conclusion

In this chapter, we explored how firms with market power may increase
producer surplus beyond that achieved with a single price.
None of the strategies will work if the firm does not have market
power.
The firm must always prevent resale (or market or product attributes
must make resale unrealistic).
Each strategy entails charging different consumers different prices.
In some cases, the firm decides who to charge each price, but in
others, consumers self-select, which requires incentive compatibility.
In the next chapter, we examine firms with degrees of market power that
fall between perfect competition and monopoly:
Oligopoly
Monopolistic competition

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 Questions ???
Comments !!!
Suggestions ...

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