Slide 1Chapter OutlineIntroductionReview of Basic Profit MaximizationBasic Profit Maximization In ActionSimple Pricing Rule: Monopoly and Monopolistic CompetitionSimple Pricing Rule In Action: ProblemSimple Pricing Rule In Action: AnswerSimple Pricing Rule: Cournot OligopolyBeyond the Single-Price-Per-Unit ModelModels that Extract Surplus from ConsumersSurplus Extraction: First-Degree Price DiscriminationSlide 13Surplus Extraction: Second-Degree Price DiscriminationSlide 15Surplus Extraction: Third-Degree Price DiscriminationSurplus Extraction: Third-Degree Price Discrimination RuleSlide 18Slide 19Surplus Extraction: Two-Part PricingSurplus Extraction: Two-Part Pricing In ActionSurplus Extraction: Block PricingSurplus Extraction: Block Pricing In ActionSurplus Extraction: Commodity BundlingSurplus Extraction: Commodity Bundling In ActionSpecial Demand and Costs: Peak-Load PricingSpecial Demand and Costs: Peak-Load Pricing In ActionSpecial Demand and Costs: Cross-SubsidiesSpecial Demand and Costs: Transfer PricingSpecial Demand and Costs: Double MarginalizationSpecial Demand and Costs: Transfer Pricing RuleIntense Price Competition: Price MatchingIntense Price Competition: Inducing Brand LoyaltyIntense Price Competition: Randomized PricingConclusionCHAPTER 11Pricing Strategies for Firms with Market Power© 2014 by McGraw-Hill Education. All Rights Reserved.Chapter Outline•Basic pricing strategies–Review of the basic rule of profit maximization–A simple pricing rule for monopoly and monopolistic competition–A simple pricing rule for Cournot oligopoly•Strategies that yield even greater profits–Exacting surplus from consumers–Pricing strategies for special cost and demand structures–Pricing strategies in markets with intense price competitionCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-2Chapter OverviewIntroduction•In Chapter 10 a general set of tools was developed to examine situations where economic agents’ decisions impacted rivals’ payoffs. The concept of a dominant strategies, Nash equilibria and subgame perfect equilibria were explored.•In this chapter, we focus on pricing strategies in environments where firms have some market power. Many of these strategies permit firms to earn profits that are greater than those of a single-price monopolist.–Price discrimination–Two-part pricing–Block pricing–Commodity bundling–Peak-load pricingCopyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-3Chapter OverviewReview of Basic Profit Maximization•Firms with market power face a downward-sloping demand.–Implication: there is a trade-off between selling many units at a low price and selling a few units at a high price.•Managers of firms with market power balance these competing forces by selecting the quantity that equates marginal revenue and marginal cost , and charging the maximum price that consumer will pay for this level of output.• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-4Basic Pricing StrategiesBasic Profit Maximization In Action•Suppose the (inverse) demand for a firm’s product is given by and the cost function is . What is the profit-maximizing level of output and price for this firm?•Answer:–The marginal revenue function is: .–The marginal cost function is: .–Equating these two functions yields , so . The profit-maximizing price is .• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-5Basic Pricing StrategiesSimple Pricing Rule: Monopoly and Monopolistic Competition•What if estimates of the demand and cost functions are not available?–Managers have a “crude” estimate of •marginal cost; the price paid to a supplier.•the price elasticity of demand, since it is typically available for a representative firm in an industry. •With this information, the monopoly and monopolistically competitive firm’s profit-maximizing price (markup) is computed from: , where .•So, set price such that: .• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-6Basic Pricing StrategiesSimple Pricing Rule In Action: Problem•The manager of a convenience store competes in a monopolistically competitive market and buys cola from a supplier at a price of $1.25 per liter. The manager thinks that because there are several supermarkets nearby, the demand for cola sold at her store is slightly more elastic than the elasticity for the representative food store. Specifically, the elasticity of demand for cola sold by her store is . What price should the manager charge for a liter of cola to maximize profits?• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-7Basic Pricing StrategiesSimple Pricing Rule In Action: Answer•The marginal cost of cola to the firm is , or per liter, and the markup factor is .•The profit-maximizing pricing rule for a monopolistically competitive firm is:, or about per liter.• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-8Basic Pricing StrategiesSimple Pricing Rule: Cournot Oligopoly•When each of the firms operating in a Cournot oligopoly has identical cost structures and produces similar products, the simple profit-maximizing price (markup) in Cournot equilibrium is:, where is the market elasticity of demand.• Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-9Basic Pricing StrategiesBeyond the Single-Price-Per-Unit Model•In some markets, managers can enhance profits beyond those resulting from charging all consumers a single, per-unit price.•Models that yield greater profits fall into three categories:–Pricing strategies:•that extract surplus from consumers.•for special cost and demand structures.•in markets with intense price competition.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-10Strategies that Yield Even Greater ProfitsModels that Extract Surplus from Consumers•This section covers the following models of surplus extraction:–Price discrimination (first, second and third degrees)–Two-part pricing–Block pricing–Commodity bundling•Each strategy is appropriate for firms with various cost structures and degrees of market interdependence.Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.11-11Strategies that Yield Even Greater ProfitsSurplus Extraction: First-Degree Price Discrimination•Price