Lecture Notes 8

Pricing with Market Power

Prof. Geunyong Park

 Outline
2

➢ Capturing Consumer Surplus

➢ Price Discrimination Monopolistic Equilibrium

➢ First Degree Price Discrimination
➢ Second Degree Price Discrimination
➢ Third Degree Price Discrimination
➢ Inter-temporal Price Discrimination
➢ Economics of Coupons/Rebates
➢ Two-Part Tariff
 Review of Uniform Pricing (in Monopoly)
3

➢ The optimal quantity (𝑄 ∗ ) is

determined at 𝑀𝑅 = 𝑀𝐶.

➢ If the firm produces a smaller

output (𝑄1 ), it sacrifices some
profit that could be earned from
producing more because 𝑀𝑅 >
𝑀𝐶.

➢ Expanding output from 𝑄 ∗ to 𝑄2

would reduce profit because the
additional cost would exceed the
additional revenue.
 Capturing More Consumer Surplus
4

➢ The firm might charge different

prices to different customers.

➢ Ideally, the firm would like to

charge a higher price to
consumers willing to pay more
than P*.

➢ The firm would also like to sell to

consumers willing to pay prices
lower than P*.
 Pricing Discrimination
5

➢ Price Discrimination
Practice of charging different prices to different consumers for
identical/similar goods.
➢ Pricing of a product over different quantities (beer price)
➢ Pricing of a product over various consumer segments (airline fares)
➢ Pricing through upfront fixed fees and per-unit prices (country club)

➢ Reservation price
Maximum price that a customer is willing to pay for a good.

➢ Variable profit
Sum of profits on each incremental unit produced by a firm; i.e., profit
ignoring fixed costs.
 Example: Tuition Fees for New Students
6
 Example: Airline Fares
7

➢ The details of segmentation rules are

various. For the Singapore Airlines, the
segmentation rules were:
➢ Ticket Types:
Economy Standard/Economy Flexi/Premium
Economy/Business/First Suites
 First-Degree (or Perfect) Price Discrimination
8

➢ First-Degree Price Discrimination

Pricing each unit sold at the consumer's maximum willingness to pay. This
willingness to pay is directly observable by the monopolist.
➢ Recall we can think of the demand curve as a "willingness to pay" curve.
➢ The consumer's maximum willingness to pay is called the consumer's reservation
price.

➢ If the monopolist can observe the willingness to pay of each customer,

then the monopolist can observe demand perfectly and can "perfectly"
price discriminate.
 First-Degree (or Perfect) Price Discrimination
9

➢ Because the firm charges each

consumer her reservation price, it is
profitable to expand output to Q**.

➢ When only a single price, P*, is

charged, the firm’s variable profit is
the area between the marginal
revenue and marginal cost curves.

➢ With perfect price discrimination, this

profit expands to the area between
the demand curve and the marginal
cost curve.
 First-Degree Price Discrimination in Practice
10

➢ Firms 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.
 Example: Pricing at Spa
11

➢ Therapists ask customers for great deal of information – occupation,

home address, office address – to use this for price discrimination.
➢ What does your home address have to do with facial/spa treatment?
(U Town vs Sentosa Cove?)
 Second-Degree Price Discrimination
12

➢ 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.
➢ Tiered pricing: Practice of charging different prices for different quantities of
“blocks” of a good

➢ Examples:
➢ Electric power companies charge different prices for a consumer purchasing a set
block of electricity.
➢ Frequent flyer program
➢ Free shipping for purchase above $100
 Second-Degree Price Discrimination
13

➢ Different prices are charged for

different quantities. Here, there are
three blocks, with corresponding
prices P1, P2, and P3.

➢ There are also economies of scale.

Second-degree price discrimination
can then make consumers better off
by expanding output and lowering
cost.
 Third-Degree Price Discrimination
14

➢ Third-Degree Price Discrimination

Practice of dividing consumers into two or more groups with separate
demand curves and charging different prices to each group.
➢ Direct market segmentation
➢ Implementation needs fixed identifiable characteristics
(such as age, gender, nationality, etc.)

➢ Examples:
➢ MRT fare for senior citizens and students
➢ Textbooks: Microeconomics Global Ed
NUS COOP: S$63.10
Australia Pearson: A$153.95 (=S$175.50)
US Amazon.com: US$193.98 (=S$259.88)
 Third-Degree Price Discrimination
15

➢ Consumers are divided into two

groups, with separate demand
curves for each group.

➢ 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.

➢ Marginal cost depends on the

total quantity produced QT. Note
that Q1 and Q2 are chosen so that
MR1 = MR2 = MC.
 Example: Importing Durians
16

➢ Suppose that you import Durian from Malaysia to supply NUS and SMU.
Your decisions include:
➢ How many durians to import (𝑄𝑇 )
➢ How many to sell at NUS (𝑄1 ) and SMU (𝑄2 ) at which prices (𝑃1, 𝑃2 )

➢ For simplicity, let’s assume 𝑀𝐶 = 20 and the demand functions are

given by
𝑃1 = 100 − 𝑄1 ,
𝑃2 = 80 − 2𝑄2 .
 Example: Importing Durians
17

𝑀𝑅1 = 100 − 2𝑄1 and 𝑀𝑅2 = 80 − 4𝑄2

Since 𝑀𝑅1 = 𝑀𝑅2 = 𝑀𝐶 = 20, we have 𝑄1 = 40 and 𝑄2 = 15.
Substituting 𝑄1 and 𝑄2 into the demand curves give 𝑃1 = 60 and 𝑃2 = 50.
 Inter-temporal Price Discrimination
18

➢ Intertemporal Price Discrimination

Practice of separating consumers with different demand functions into
different groups by charging different prices at different points in time.
➢ Peak-load pricing: Practice of charging higher prices during peak periods when
capacity constraints cause marginal costs to be high.

➢ Two groups of consumers: one willing to pay more to get the product
early and one willing to wait.
➢ Initial release of a product, the demand is inelastic.
➢ Once market with inelastic demand has yielded a maximum profit, firms lower the
price to appeal to a general market with a more elastic demand.
 Inter-temporal Price Discrimination
19

➢ Consumers are divided into groups

by changing the price over time.

➢ Initially, the price is high. The firm

captures surplus from consumers
who have a high demand for the
good and who are unwilling to
wait to buy it.

➢ Later the price is reduced to

appeal to the mass market.
 Example: Pricing Best-selling Novel
20

➢ Publishing both hardbound and paperback

editions of a book allows publishers to price
discriminate.

➢ Some consumers want to buy a new bestseller as

soon as it is released, even if the price is $25.
Other consumers, however, will wait a year until
the book is available in paperback for $10.

➢ The key is to divide consumers into two groups, so that those who are willing to pay
a high price do so and only those unwilling to pay a high price wait and buy the
paperback.

➢ It is clear, however, that those consumers willing to wait for the paperback edition
have demands that are far more elastic than those of bibliophiles.
 Coupons and Rebate
21

➢ Coupon and rebates are means for price discrimination.

➢ Collecting coupons is costly! Many consumers do not redeem coupons,

because they place a higher value on time than money.
➢ Only a portion (20-30% on average) regularly use coupons in buying goods and
services. These consumers are more price-sensitive. So, lowering prices to those
consumers would raise quantity demanded. Consumers who are less price-sensitive
are willing to pay “higher prices” without taking trouble to clip coupons.

➢ By issuing coupons, a seller can target a discount at the consumer segment

that is relatively more price elastic.
 Coupons and Rebate
22

➢ Step 1: Estimating the elasticity of demand for different groups and

obtaining the value of marginal cost

➢ Suppose a manager believes that elasticity of demand for coupon users

(call them group 1) is –5, and for non-users (call them group 2) is –2.5,
and MC = 0.8, she can calculate the optimal value of coupons.

➢ Step 2: Applying the rule of thumb for pricing

P1 = MC/(1+1/e1) = (0.8)/[1– (1/5)] = 1,
P2 = MC/(1+1/e2) = (0.8)/[1– (1/2.5)] = 1.33.

➢ Since you don’t know who to charge $1.33 and who to charge $1, you
simply charge $1.33 for the product and issue the coupon worth $0.33.
 The Two-Part Tariff
23

➢ Two-part tariff
Form of pricing in which consumers are charged both an entry and a usage
fee.

➢ Examples: amusement park, golf club, electric toothbrush, etc.

➢ 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 Tariff
24

➢ Suppose that the consumer has

demand curve D, which is known
to the supplier, and marginal cost
is constant.

➢ The firm maximizes profit by

setting usage fee P equal to
marginal cost and entry fee T*
equal to the entire surplus of the
consumer.
 Two-Part Tariff
25

➢ Suppose that there are two

consumers (D1 & D2). The profit-
maximizing usage fee P* will
exceed marginal cost.

➢ The entry fee T* is equal to the

surplus of the consumer with the
smaller demand.

➢ The resulting profit is

2T* + (P* − MC)(Q1 + Q2).
Note that this profit is larger
than twice the area of triangle
ABC.
 Example: Pricing Mobile Data Plans
26

➢ Telecommunications operators provide different data plans, which includes some amount
of free data each month, plus a per-gigabyte fee for any additional data used in that
month and a fixed monthly access charge independent of the amount of data.

MONTHLY ACCESS
DATA USAGE MONTHLY PRICE CHARGE OVERAGE FEE
A. VERIZON A. VERIZON A. VERIZON A. VERIZON
1GB $30 $20 $15/GB
3GB $45 $20 $15/GB
6GB $60 $20 $15/GB
12GB $80 $20 $15/GB
18GB $100 $20 $15/GB
B. SPRINT B. SPRINT B. SPRINT B. SPRINT
1GB $20 $45 None1
3GB $30 $45 None
6GB $45 $45 None
12GB $60 $45 None
24GB $80 $45 None