Pricing with Market Power

1
Chapter 11

• Pricing with Market Power

2
Topics to be Discussed

• Capturing Consumer Surplus
• Price Discrimination
• Intertemporal Price Discrimination and Peak-Load
  Pricing

3
Introduction

• Pricing without market power (perfect
  competition) is determined by market supply and
  demand.
• The individual producer must be able to forecast
  the market and then concentrate on managing
  production (cost) to maximize profits.

4
Introduction

• Pricing with market power (imperfect competition)
  requires the individual producer to know much
  more about the characteristics of demand as well
  as manage production.

5
Capturing Consumer Surplus
/Q
If price is raised above P, the firm will lose
sales and reduce profit.
Quantity
6
Price Discrimination

• First Degree Price Discrimination
• Charge a separate price to each customer the
  maximum or reservation price they are willing to
  pay.

7
Additional Profit From Perfect First-Degree Price
Discrimination
/Q
Pmax
With perfect discrimination, each consumer pays
the maximum price they are willing to pay.
Quantity
8
Additional Profit From Perfect First-Degree Price
Discrimination

• Question
• Why would a producer have difficulty in achieving
  first-degree price discrimination?
• Answer
• 1) Too many customers (impractical)
• 2) Could not estimate the reservation price for
  each customer

9
Price Discrimination

• First Degree Price Discrimination
• Examples of imperfect price discrimination where
  the seller has the ability to segregate the
  market to some extent and charge different prices
  for the same product
• Lawyers, doctors, accountants
• Car salesperson (15 profit margin)
• Colleges and universities

10
First-Degree PriceDiscrimination in Practice
/Q
Quantity
11
Second-Degree Price Discrimination
/Q
Quantity
12
Second-Degree Price Discrimination
/Q

• Economies of scale permit
• Increase consumer welfare
• Higher profits

P1
P0
P2
P3
Q0
Q1
Q2
Q3
Quantity
1st Block
2nd Block
3rd Block
13
Price Discrimination

• Third Degree Price Discrimination
• 1) Divides the market into two-groups.
• 2) Each group has its own demand function.

14
Price Discrimination

• Third Degree Price Discrimination
• 3) Most common type of price discrimination.
• Examples airlines, liquor, vegetables, discounts
  to students and senior citizens.

15
Price Discrimination

• Third Degree Price Discrimination
• 4) Third-degree price discrimination is
  feasible when the seller can separate his/her
  market into groups who have different price
  elasticities of demand (e.g. business air
  travelers versus vacation air travelers)

16
Price Discrimination

• Third Degree Price Discrimination
• Objectives
• MR1 MR2
• MR1 MR2 MC

17
Price Discrimination

• Third Degree Price Discrimination
• Determining relative prices

18
Price Discrimination

• Third Degree Price Discrimination
• Pricing Charge higher price to group with a low
  demand elasticity

19
Price Discrimination

• Third Degree Price Discrimination
• Example E1 -2 E2 -4
• P1 should be 1.5 times as high as P2

20
Third-Degree Price Discrimination
/Q
Quantity
21
Third-Degree Price Discrimination
/Q
D2 AR2
MRT
MR2
D1 AR1
MR1
Quantity
22
The Economics of Coupons and Rebates
Price Discrimination

• Those consumers who are more price elastic will
  tend to use the coupon/rebate more often when
  they purchase the product than those consumers
  with a less elastic demand.
• Coupons and rebate programs allow firms to price
  discriminate.

23
Price Elasticities of Demand for Users Versus
Nonusers of Coupons

• 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 dinner -0.88 -1.09
• Cake mix -0.21 -0.43

24
Price Elasticities of Demand for Users Versus
Nonusers of Coupons

• Cat food -0.49 -1.13
• Frozen entrée -0.60 -0.95
• Gelatin -0.97 -1.25
• Spaghetti sauce -1.65 -1.81
• Crème rinse/conditioner -0.82 -1.12
• Soup -1.05 -1.22
• Hot dogs -0.59 -0.77

25
The Economics of Coupons and Rebates

• Cake Mix
• Nonusers of coupons PE -0.21
• Users PE -0.43

26
The Economics of Coupons and Rebates

• Cake Mix Brand (Pillsbury)
• PE Pillsbury 8 to 10 times PE all cake mix
• Example elasticity of demand for Pillsbury cake
  mix
• PE Users of coupons -4 (-0.43 all cake mix)
• PE Nonusers -2 (-0.21 all cake mix)

27
The Economics of Coupons and Rebates

• Using
• Price of nonusers should be 1.5 times users
• Or, if cake mix sells for 1.50, coupons should
  be 50 cents