Pricing with Market PowerChapter OutlineCapturing Consumer SurplusSlide 4First-Degree Price DiscriminationSlide 6Imperfect Price DiscriminationSecond-Degree Price DiscriminationThird-Degree Price DiscriminationSlide 10Slide 11Slide 12Slide 13The Economics of Coupons ad RebatesThe Economics of Coupons ad Rebates (cont.)A C T I V E L E A R N I N G 1 Third-Degree Price discriminationA C T I V E L E A R N I N G 1 AnswerIntertemporal Price Discrimination Peak-Load PricingSlide 19Peak-Load PricingPricing with Market PowerChapter 11Chapter Outline11.1 Capturing Consumer Surplus11.2 Price Discrimination11.3 Intertemporal Price Discrimination and Peak-Load PricingCapturing Consumer SurplusIf 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.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 between demand curve and MC curve.● variable profit Sum of profits on each incremental unit produced by a firm; i.e., profit ignoring fixed costs.First-Degree Price DiscriminationFirms 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, there are fewer consumers. The consumers now enjoy some surplus.Imperfect Price DiscriminationFirst-Degree Price Discrimination in PracticeSecond-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Creating Consumer GroupsIf third-degree price discrimination is feasible, how should the firm decide what price to charge each group of consumers? 1. 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.2. 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.Creating Consumer GroupsDetermining Relative PricesThird-Degree Price DiscriminationConsumers 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 quantity produced QT. Note that Q1 and Q2 are chosen so that MR1 = MR2 = MC.Third-Degree Price DiscriminationDetermining Relative PricesNo Sales to Smaller MarketEven 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 resulting increase in MC.Third-Degree Price DiscriminationCoupons 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 RebatesPrice Elasticities of Demand for Users versus Nonusers of CouponsPRICE ELASTICITYProduct Nonusers UsersToilet tissue −0.60 −0.66Stuffing/dressing −0.71 −0.96Shampoo −0.84 −1.04Cooking/salad oil −1.22 −1.32Dry mix dinners −0.88 −1.09Cake mix −0.21 −0.43Cat food −0.49 −1.13Frozen entrees −0.60 −0.95Gelatin −0.97 −1.25Spaghetti sauce −1.65 −1.81Creme rinse/conditioner −0.82 −1.12Soups −1.05 −1.22Hot dogs −0.59 −0.77The Economics of Coupons ad Rebates (cont.)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 – 20PUwhere 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?A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11 Third-Degree Price discriminationThird-Degree Price discriminationBMW should choose QE and QU so that MRE = MRU = MC .To find MRs, solve for the inverse demand functions:PE = 40,000 − 0.01QE and PU = 50,000 − 0.05QU .Since demand is linear in both cases:MRE = 40,000 − 0.02QE 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 = 1,000,00050,000 − 0.1QU = 20,000 , or QU = 300,000PE = 40,000 − 0.01(1,000,000) = $30,000PU = 50,000 − 0.05(300,000) = $35,000π = TR − TC = (30,000)(1,000,000) + (35,000)(300,000) − [10,000,000,000 + 20,000(1,300,000)] = $4.5 billion.A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11 AnswerAnswerIntertemporal Price DiscriminationPeak-Load Pricingintertemporal