Pricing

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Pricing

• ECG 507
• Professor Allen
• Fall 2005

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1. 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.

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2. 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.

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3. Capturing Consumer Surplus
/Q
Pmax
A
If price is raised above P, the firm will lose
sales and reduce profit.
P1
P
B
P2
MC
PC
D
MR
Quantity
Q
5
4. Capturing Consumer Surplus
/Q
Pmax
A
If price is lowered the firm gains sales, but
loses revenue on previous sales and lowers
profits.
P1
P
B
P2
MC
PC
D
MR
Quantity
Q
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5. Capturing Consumer Surplus
/Q
Pmax
A
How can the firm capture the consumer surplus in
A and B?
P1
P
B
P2
MC
PC
D
MR
Quantity
Q
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6. Capturing Consumer Surplus

• Price discrimination is the charging of different
  prices to different consumers.
• Major types
• Same good, different prices (cars, cosmetics)
• Price diff gt cost diff (club floors in hotels)
• Price varies with consumption (pizza)
• Price varies by location (cement)

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7. Firms price discriminate when

• Monopoly power in each market
• Able to identify each group
• No chance for arbitrage

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8. Principles of price discrimination

• MR has to be the same in each market
• If not, you could increase TR by shifting output
  from one market to another
• MR in each market MC
• If not, you could increase profits by cutting
  back output if MC gt MR (or increasing output if
  MR gt MC)

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9. Price Discrimination

• Using Elasticity to Set Price in Third Degree
  Discrimination

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10. Price Discrimination

• Using Elasticity to Set Price in Third Degree
  Discrimination

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11. Third-Degree Price Discrimination
/Q
Consumers are divided into two groups, with
separate demand curves for each group.
D2 AR2
MR2
D1 AR1
MR1
Quantity
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12. Third-Degree Price Discrimination
/Q
MRT MR1 MR2
D2 AR2
MRT
MR2
MR1
D1 AR1
Quantity
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13. Third-Degree Price Discrimination
/Q
P1
MC MR1 at Q1 and P1
MC
D2 AR2
MRT
MR2
D1 AR1
MR1
QT
Q1
Quantity
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14. Third-Degree Price Discrimination
/Q
MC MR2 at Q2 and P2 The more inelastic
the demand, the higher the price.
P1
MC
P2
D2 AR2
MRT
MR2
D1 AR1
MR1
QT
Q1
Q2
Quantity
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15. Second-Degree Price Discrimination
/Q
Second-degree price discrimination is
pricing according to quantity consumed--or in
blocks.
P1
P0
P2
P3
Q0
Q1
Q2
Q3
Quantity
1st Block
2nd Block
3rd Block
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16. Price Discrimination

• First Degree Price Discrimination
• Charge a separate price to each customer the
  maximum or reservation price they are willing to
  pay.
• Examples Professions, car dealers, private
  universities

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17. Perfect First-Degree Price Discrimination
/Q
Without price discrimination, output is Q and
price is P. Variable profit is the area between
the MC MR (yellow).
Pmax
MC
P
D
MR
Quantity
Q
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18. Perfect First-Degree Price Discrimination
/Q
Consumer surplus is the area above P and
between 0 and Q output.
Pmax
MC
P
D AR
MR
Quantity
Q
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19. Perfect First-Degree Price Discrimination
/Q
Output expands to Q and price falls to PC where
MC MR AR D. Profits increase by the area
above MC between old MR and D to output Q
(purple)--no consumer surplus.
Pmax
MC
P
PC
D AR
MR
Quantity
Q
Q
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20. Perfect First-Degree Price Discrimination
/Q
Consumer surplus when a single price P is
charged.
Pmax
Variable profit when a single price P is
charged.
MC
P
Additional profit from perfect price
discrimination
PC
D AR
MR
Quantity
Q
Q
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21. Intertemporal Price Discrimination

• Separating the Market With Time
• Initial release of a product, the demand is
  inelastic
• Hard cover books
• New release movies
• Latest fashions

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22. Intertemporal Price Discrimination

• Separating the Market With Time
• Once this market has yielded a maximum profit,
  firms lower the price to appeal to a general
  market with a more elastic demand
• Paper back books
• Dollar Movies
• Discount rack

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23. Peak-Load Pricing

• Demand for some products may peak at particular
  times.
• Rush hour traffic
• Electricity - late summer afternoons
• Ski resorts on weekends

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24. Peak-Load Pricing

• Capacity restraints will also increase MC.
• Increased MR and MC would indicate a higher
  price.
• MR is not equal for each market because one
  market does not impact the other market.

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25. Peak-Load Pricing
/Q
MC
D1 AR2
MR1
Quantity
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26. Peak-Load Pricing
MC
/Q
Peak-load price P1 .
P1
D1 AR2
MR1
Quantity
Q1
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27. Peak-Load Pricing
Off- load price P2 .
/Q
MC
P1
D1 AR2
P2
MR1
D2 AR2
MR2
Quantity
Q1
Q2