Pricing with Market Power Chapter 11 Chapter Outline 11 1 Capturing Consumer Surplus 11 2 Price Discrimination 11 3 Intertemporal Price Discrimination and Peak Load Pricing Capturing Consumer Surplus If firm can charge only one P for all customers price will be P and quantity Q The firm could increase surplus if it could charge different prices to consumers with different willingness to pay Capturing Consumer Surplus Price discrimination Practice of charging different prices to different consumers for similar goods First Degree Price Discrimination reservation price Maximum price that a customer is willing to pay for a good first degree price discrimination Practice of charging each customer her reservation price First Degree Price Discrimination variable profit Sum of profits on each incremental unit produced by a firm i e profit ignoring fixed costs Firm charges each consumer her reservation price hence it is profitable to expand output to Q When only a single price P is charged firm s variable profit is the area between MR and MC curves With perfect price discrimination profit expands to the area Imperfect Price Discrimination First Degree Price Discrimination in Practice Firms usually don t know the reservation price of every consumer but sometimes reservation prices can be roughly identified Here six different prices are charged The firm earns higher profits but some consumers may also benefit With a single price P 4 Second Degree Price Discrimination second degree price discrimination Practice of charging different prices per unit for different quantities of the same good or service block pricing Practice of charging different prices for different quantities or blocks of a good Third Degree Price Discrimination third degree price discrimination Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group Third Degree Price Discrimination 1 2 Creating Consumer Groups If third degree price discrimination is feasible how should the firm decide what price to charge each group of consumers We know that however much is produced total output should be divided between the groups of customers so that marginal revenues for each group are equal We know that total output must be such that the marginal revenue for each group of consumers is equal to the marginal cost of production Third Degree Price Discrimination Creating Consumer Groups Determining Relative Prices Third Degree Price Discrimination Consumers are divided into 2 groups with separate demand curves The optimal prices and quantities are such that the MR from each group is the same and equal to MC Here group 1 with demand curve D1 is charged P1 and group 2 with the more elastic demand curve D2 is charged the lower price P2 MC depends on the total Third Degree Price Discrimination Determining Relative Prices No Sales to Smaller Market Even if third degree price discrimination is feasible it may not pay to sell to both groups of consumers if MC is rising Here the first group of consumers with demand D1 are not willing to pay much for the product It is unprofitable to sell to them because the price would have to be too low to compensate for the The Economics of Coupons ad Rebates Coupons provide a means of price discrimination Studies show that only about 20 to 30 percent of all consumers regularly bother to clip save and use coupons Rebate programs work the same way Only those consumers with relatively price sensitive demands bother to send in the materials and request rebates Again the program is a means of price discrimination The Economics of Coupons ad Rebates cont Price Elasticities of Demand for Users versus Nonusers of Coupons PRICE Product Nonusers ELAST Users ICITY Toilet tissue 0 60 0 66 Stuffing dressing 0 71 0 96 Shampoo 0 84 1 04 Cooking salad oil 1 22 1 32 Dry mix dinners 0 88 1 09 Cake mix 0 21 0 43 Cat food 0 49 1 13 Frozen entrees 0 60 0 95 Gelatin 0 97 1 25 Spaghetti sauce 1 65 1 81 Creme rinse conditioner 0 82 1 12 Soups 1 05 1 22 Hot dogs 0 59 0 77 ACTIVE LEARNING 1 Third Degree Price discrimination Suppose that BMW can produce any quantity of cars at a constant marginal cost equal to 20 000 and a fixed cost of 10 billion You are asked to advise the CEO as to what prices and quantities BMW should set for sales in Europe and in the United States The demand for BMWs in each market is given by QE 4 000 000 100 PE and QU 1 000 000 20PU where the subscript E denotes Europe the subscript U denotes the United States Assume that BMW can restrict U S sales to authorized BMW dealers only Prices and costs are in dollars What quantity of BMWs should the firm sell in each market and what should the price be in each market What should the total profit be ACTIVE LEARNING 1 Answer BMW should choose QE and QU so that MRE MRU MC To find MRs solve for the inverse demand functions PE 40 000 0 01QE PU 50 000 0 05QU Since demand is linear in both cases MRE 40 000 0 02QE and and MRU 50 000 0 1QU Setting each MR equal to MC and solving for quantity yields 40 000 0 02QE 20 000 or QE 1 000 000 50 000 0 1QU 20 000 or QU 300 000 PE 40 000 0 01 1 000 000 30 000 PU 50 000 0 05 300 000 35 000 TR TC 30 000 1 000 000 35 000 300 000 10 000 000 000 20 000 1 300 000 4 5 billion Intertemporal Price Discrimination Peak Load Pricing intertemporal price discrimination Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time peak load pricing Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be high Intertemporal Price Discrimination Consumers are divided into groups by changing the price over time Initially the price is high The firm captures surplus from consumers who have a high demand for the good and who are unwilling to wait to buy it Later the price is Peak Load Pricing Demands for some goods and services increase sharply during particular times of the day or year Charging a higher price P1 during the peak periods is more profitable for the firm than charging a single price at all times It is also more efficient because