Pricing with Market Power

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Pricing with Market Power
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Price Discrimination

• First Degree Price Discrimination charging each
  consumer their exact willingness to pay
• No consumer surplus, very profitable for the
  firm, but not very plausible
• Second Degree Price Discrimination setting a
  menu of options and allowing consumers to
  self-select
• Good option when you cant determine an
  individuals willingness to pay
• Third Degree Price Discrimination charging
  different prices for different groups
• Not as profitable as 1st degree PD but better
  than a uniform price

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Third Degree Price Discrimination

• The underlying assumption in 3rd Degree PD is
  that different groups have different demands for
  the product
• Senior citizens have less interest in seeing
  movies
• Parents can always show little children cartoon
  videos at home, so childrens demand for movies
  is low
• The firm basically treats each group as a
  separate market and sets the appropriate price
  by maximizing profit

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Mathematically

• Suppose we are looking at a movie theater selling
  tickets to (a) senior citizens and (b) all other
  adults
• The theaters profit can be written
• You simply maximize this profit by choosing ps
  and pa

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Other Methods of 3rd Degree PD

• A common way to separate consumers into groups is
  to use TIME
• High-wage, high-income people typically value
  their time more than low-wage, low-income people
  (and may have a more inelastic demand for certain
  goods)
• There are ways to offer the low-wage/low-demand
  consumers a lower price based on their lower
  value of time

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More Price Discrimination

• Price-match guarantees offering to meet (or
  beat) a lower price from a competitor
• The consumer must be AWARE that a lower price
  exists
• Only a consumer with enough time to search for
  all prices will be able to take advantage of this
  lower price
• Mail-in Rebates requiring the consumer to spend
  time to take advantage of the offer
• You need to take the 5 or 10 minutes to fill out
  the rebate form if youd like to get the 2 cash
  back (do you think Donald Trump does this?)

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Two-Part Pricing

• When it isnt 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.
• Athletic club memberships
• Country club memberships
• Blockbuster REWARDS program

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How Two-Part Pricing Works
1. Set price at marginal cost. 2. Compute
consumer surplus. 3. Charge a fixed-fee equal to
consumer surplus.
Price
10
8
6
Fixed Fee Profits 16
Per Unit Charge
4
MC
2
D
1 2 3 4 5
Quantity
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Block Pricing

• The practice of packaging multiple units of a
  product together and selling them as one package.
• Examples
• Paper
• Six-packs of drinks
• Different sizes of bags of potato chips

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An Algebraic Example

• Typical consumers demand is P 10 - 2Q
• C(Q) 2Q
• Optimal number of units in a package?
• Optimal package price?

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Optimal Price for the Package 24
Price
Consumers valuation of 4 units .5(8)(4)
(2)(4) 24
10
8
6
4
MC AC
2
D
1 2 3 4 5
Quantity
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Commodity Bundling

• The practice of bundling two or more products
  together and charging one price for the bundle
• Examples
• Vacation packages
• Computers and software
• Film and developing
• Home theater set (stereo, speakers, DVD player,
  etc.)

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An Example that Illustrates Sonys Strategy

• Total market size is 4 million consumers
• Four types of consumers
• 25 will use only Sony DVD players (Type 1)
• 25 will use only Sony stereo equipment (Type 2)
• 25 will use only Sony DVD players and Sony
  stereo equipment (Type 3)
• 25 have no preference (Type 4)
• Zero costs (for simplicity)
• Maximum price each type of consumer will pay is
  as follows

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Reservation Prices for Sony DVD players and
stereos by Type of Consumer
D Sony DVD loyal, S Sony stereo loyal, DS
loyal to both, N neither
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Optimal DVD Player Price?
At a price of 30, all types will buy (profits of
120 Million)
At a price of 40, only first three types will
buy (profits of 120 Million)
Optimal Price is 80, to earn profits of 80 x 2
million 160 Million
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Optimal Price for Stereo?
At a price of 60, only S type buys (profits of
60 Million)
At a price of 40, only S and DS types buy
(80 Million)
At a price of 20, all types buy (profits of 80
Million)
Optimal Price is 30, to earn profits of 30 x 3
million 90 Million
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Total Profits by Pricing Each Item Separately

• The optimal price to charge for Sony DVD players
  is 80
• This earns Sony a profit of 160 million
• The optimal price to charge for Sony Stereo
  equipment is 30
• This earns Sony a profit of 90 million
• The total profit to Sony is 250 million

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Pricing a Bundle of a DVD player and stereo
equipment together as a Home Theater System
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Consumer Valuations of a Bundle
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Consumer Valuations of a Bundle
Optimal Bundle Price 100 (for profits of 300
million)
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Required Tie-In Sales

• Bundling is sometimes also referred to as a
  tie-in sale
• The consumer, however, has the option to purchase
  either OR both of the goods
• In required tie-in sales, the consumer is
  required to purchase both goods (you cannot buy
  one separately)
• Examples
• Mach 3 Turbo razor vs. Schick Quattro
• Sony Playstation 2 vs. Microsoft X-Box
• Polaroid instant camera
• Photocopiers (Xerox)

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Peak-Load Pricing

• Charging a higher price during peak times (i.e.
  high demand times)
• Examples
• Electricity pricing (the price per kilowatt hour
  changes depending on what time of dayso do you
  laundry at midnight)
• Rental properties (renting a place at the Jersey
  shore is pretty cheap in January)
• Car Rentals (the price of car rentals is higher
  during the summervacation season)
• Matinee vs. Regular Admission (movie theaters
  charge lower prices during the daylower demand
  period)

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Cross-Subsidies

• Prices charged for one product are subsidized by
  the sale of another product
• May be profitable when there are significant
  demand complementarities effects
• Examples
• Software (the price of Microsoft Windows
  subsidizes Internet Explorer)
• Restaurant meals (since drinks are very
  profitable, bars and restaurants are able to
  offer appetizers and food at lower prices)

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A Restaurant Example

• Many restaurants offer separate lunch and dinner
  menus
• You may not be able to purchase your favorite
  salad or sandwich during dinner hoursWhy?
• The answer is peak-load pricing AND cross-subsidy
• Demand is highest during the dinner period, so
  the restaurant wants to sell only its high-priced
  options
• Also, for most restaurants, the dinner rush
  subsidizes being open during lunch

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Recap of Pricing Strategies

• First degree price discrimination, block pricing,
  and two part pricing permit a firm to extract all
  consumer surplus.
• Commodity bundling, second-degree and third
  degree price discrimination permit a firm to
  extract some (but not all) consumer surplus.
• Simple uniform pricing is the easiest to
  implement, but leave consumers with the most
  surplus
• Different strategies require different
  information.

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What are some price discrimination strategies
that your firm could use???
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Three Advanced Strategies

• The pricing strategies we just looked at focus on
  how the firm can manipulate their pricing to best
  address consumer demand
• There are also some pricing strategies that are
  addressed specifically at harming the firms
  RIVALS
• Limit Pricing to Prevent Entry
• Predatory Pricing to Lessen Competition
• Raising Rivals Costs to Lessen Competition

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Limit Pricing

• Strategy where an incumbent (existing firm)
  prices below the monopoly price in order to keep
  potential entrants out of the market.
• Goal is to lessen competition by eliminating
  potential competitors incentives to enter the
  market.

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Monopoly Profits

• This monopolist is earning positive economic
  profits.
• These profits may induce other firms to enter the
  market.
• Questions
• Can the monopolist prevent entry?
• If so, is it profitable to do so?

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Limit Pricing

• Incumbent produces QL instead of monopoly output
  (QM)
• Resulting price, PL, is lower than monopoly price
  (PM)
• Residual demand curve is the market demand (DM)
  minus QL .
• Entry is not profitable because entrants
  residual demand lies below AC
• Optimal limit pricing results in a residual
  demand such that, if the entrant entered and
  produced Q units, its profits would be zero.

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This graph shows

• The monopolist may charge a price below the
  monopolists profit-maximizing price
• This generates higher sales for the monopolist
  and, therefore, leaves very little residual
  demand for the entrant
• Since the demand is so low, the entrant will
  actually not enter
• The monopoly survives

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Potential Problems with Limit Pricing

• Net present value the loss of profits today
  may, in fact, not be worth the stream of future
  profits
• In that case, you are better off allowing the
  firm to enter
• Entrant knows the strategy if the entrant knows
  what your firm is doing, they may also realize
  that your current price is unprofitable so you
  would change the price if they enter

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Limit Pricing

• IF the current loss IS worth the future profits,
  then the monopolist will want to do something to
  try and signal to the entrant that the monopolist
  is COMITTED to this price level (whether they
  really are or not)

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Predatory Pricing

• Strategy of pricing below marginal cost to drive
  competitors out of business, then raising price
  to enjoy the higher profits resulting from
  lessened competition.
• Goal is to lessen competition by eliminating
  existing competitors.

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Potential Problems with Predatory Pricing

• Counter strategies
• Stop production (in the short run)
• Purchase from the predator at the reduced price
  and stockpile until predatory pricing is over
• Rivals can sue under the Sherman Act
• But it is often difficult for rivals to prove
  their case
• Upfront losses incurred to drive out rivals may
  exceed the present value of future monopoly
  profits
• Predator must have deeper pockets than prey

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Raising Rivals Costs

• Strategy where a firm increases the marginal or
  fixed costs of rivals to distort their incentives
• Not always profitable, but may be profitable as
  the following example shows

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Cournot Example

• Suppose we have the following Cournot reaction
  functions
• What if firm 1 does something to impact firm 2s
  marginal costs? (i.e. something to increase c2)

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Raising a Rivals Marginal Cost

• Cournot duopoly
• Initial equilibrium at point A
• Firm 1 raises the marginal cost of Firm 2, moving
  equilibrium to point B.
• Firm 1 gains market share and profits.

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How Can I Raise My Rivals Costs?

• Direct Methods I could interfere with my
  rivals production or selling methods
• To an extreme, you could damage or destroy your
  rivals property/factory
• Marketing experiments example
• Interference through Government Regulation
  Since many government regulations contain
  grandfather clauses, new regulation may help
  raise the costs of potential entrants
• Production of Complements if you own a
  complement to your rivals product, you can use
  that as leverage
• Comcast vs. DirectTV examples

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Raising Rivals Costs

• Raising wages or other input prices you may be
  able to negotiate contracts with suppliers such
  that your rivals costs increase
• For example, all the U.S. automobile
  manufacturers negotiate with a single union. All
  manufacturers will eventually have to abide by
  the same negotiated wages, hours, etc.
• If your firm uses relatively less labor, it might
  be a good strategy to negotiate a generous
  contract with the union

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Investing in Research and Development (R D)

• What happens when expensive RD can help me lower
  my marginal costs?