Managerial Economics & Business StrategyOverviewStandard Pricing and Profits for Firms with Market PowerAn Algebraic ExampleA Simple Markup RuleAn ExampleMarkup Rule for Cournot OligopolySlide 8Extracting Consumer Surplus: Moving From Single Price MarketsFirst-Degree or Perfect Price DiscriminationPerfect Price DiscriminationCaveats:Second-Degree Price DiscriminationThird-Degree Price DiscriminationImplementing Third-Degree Price DiscriminationSlide 16Two-Part PricingHow Two-Part Pricing WorksBlock PricingSlide 20Optimal Quantity To Package: 4 UnitsOptimal Price for the Package: $24Costs and Profits with Block PricingCommodity BundlingAn Example that Illustrates Kodak’s MomentReservation Prices for Kodak Film and Developing by Type of ConsumerOptimal Film Price?Optimal Price for Developing?Total Profits by Pricing Each Item Separately?Pricing a “Bundle” of Film and DevelopingConsumer Valuations of a BundleWhat’s the Optimal Price for a Bundle?Peak-Load PricingCross-SubsidiesDouble MarginalizationTransfer PricingUpstream Division’s ProblemDownstream Division’s ProblemAnalysisUpstream Division’s “Monopoly Profits”Upstream’s Profits when Downstream Marks Price Up to $8Solutions for the Overall Firm?Pricing in Markets with Intense Price CompetitionConclusionManagerial Economics & Business StrategyChapter 11Pricing Strategies for Firms with Market PowerMcGraw-Hill/IrwinMichael R. Baye, Managerial Economics and Business StrategyCopyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.OverviewI. Basic Pricing StrategiesMonopoly & Monopolistic Competition Cournot OligopolyII. Extracting Consumer SurplusPrice Discrimination  Two-Part PricingBlock Pricing  Commodity BundlingIII. Pricing for Special Cost and Demand StructuresPeak-Load Pricing  Transfer PricingCross SubsidiesIV. Pricing in Markets with Intense Price CompetitionPrice Matching  Randomized PricingBrand Loyalty11-2Standard Pricing and Profits for Firms with Market PowerPriceQuantityP = 10 - 2Q1086421 2 3 4 5MCMR = 10 - 4QProfits from standard pricing= $811-3An Algebraic Example•P = 10 - 2Q•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) = $8.11-4A 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.11-5An 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.11-6Markup Rule for Cournot Oligopoly•Homogeneous product Cournot oligopoly.•N = total number of firms in the industry.•Market elasticity of demand EM .•Elasticity of individual firm’s demand is given by EF = N x EM.•Since P = [EF/(1+ EF)]  MC,•Then, P = [NEM/(1+ NEM)]  MC.•The greater the number of firms, the lower the profit-maximizing markup factor.11-7An Example•Homogeneous product Cournot industry, 3 firms.•MC = $10.•Elasticity of market demand = - ½.•Determine the profit-maximizing price?•EF = N EM = 3  (-1/2) = -1.5.•P = [EF/(1+ EF)]  MC.•P = [-1.5/(1- 1.5]  $10.•P = 3  $10 = $30.11-8Extracting 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.11-9First-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.11-10Perfect Price DiscriminationPrice QuantityD1086421 2 3 4 5 Profits*:.5(4-0)(10 - 2)= $16Total Cost* = $8MC* Assuming no fixed costs11-11Caveats:•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.11-12Second-Degree Price Discrimination•The practice of posting a discrete schedule of declining prices for different quantities.•Eliminates the information constraint present in first-degree price discrimination.•Example: Electric utilitiesPriceMCD$5$104Quantity$8211-13Third-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.11-14Implementing 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)]  MC11-15An 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.11-16Two-Part Pricing•When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.•Two-part pricing consists of a fixed fee and a per unit charge.Example: Athletic club memberships.11-17How Two-Part Pricing Works1. Set price at marginal cost.2. Compute consumer surplus.3. Charge a fixed-fee equal