PRICING WITH MARKET POWER - I

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PRICING WITH MARKET POWER - I
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Overview

• Price discrimination
• Inter-temporal price discrimination
• Example of peak load pricing
• Capacity determination under peak load pricing
  (not available in text)

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Introduction the underlying idea

• Pricing with market power enables the producer to
  capture some of the consumer surplus.
• But it requires the individual producer to know
  much more about the characteristics of demand as
  well as the capability to manage production and
  the supply chain.

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

• Price discrimination is the charging of different
  prices to different consumers for similar goods.
• First degree price discrimination
• Charge a separate price to each customer the
  maximum or reservation price they are willing to
  pay
• Second degree price discrimination
• Pricing according to quantity consumed or in
  blocks
• Third degree price discrimination
• Dividing the market into two or more groups, each
  having its own demand function and different
  price elasticities of demand

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Additional Profit From Perfect First-Degree Price
Discrimination

• With perfect discrimination
• Each customer pays his
• reservation price
• Profits increase

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Implementing 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
• 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

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Second-Degree Price Discrimination
/Q
What happens to deadweight loss?
Quantity
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Third Degree Price Discrimination

• 1) Divides the market into groups.
• 2) Each group has its own demand function.
• Most common type of price discrimination
• Examples airlines, liquor, vegetables, discounts
  to students and senior citizens.
• 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) and there is no seepage
  across those groups

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Relative prices under Third-degree price
discrimination

• MC MR1 P1(11/E1) MR2 P2(11/E2)
• gt P1/P2 (11/E2)/(11/E1)
• gt Pricing Charge higher price to group with a
  lower demand elasticity

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Third-Degree Price Discrimination
/Q
P1
How do you get MRT from MR1 and MR2? Through
horizontal or vertical addition?
P2
D2 AR2
MRT
MR2
D1 AR1
MR1
Quantity
Qt
Q1
Q2
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No Sales to Smaller Market under Third Degree
Price Discrimination
/Q
Quantity
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Case-let The Economics of Coupons and Rebates

• 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.

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Price Elasticities of Users/ Nonusers of Coupons

• Product Non-users Users (larger in magnitude)
• 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
• 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

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Economics of Coupons and Rebates (continued)

• Elasticity of demand for Pillsbury cake mix VS.
  all cake mix
• Users of coupons -4 (Pillsbury) -0.43 (all)
• Nonusers -2 (Pillsbury) -0.21 (all)
• Thus, PE for Pillsbury 8 to 10 times PE for all
  cake mix
• Using
• Price of non-users should be 1.5 times users
• Or, if cake mix sells for 1.50, coupons should
  be 50 cents

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Elasticities of Demand for Air Travel

• Fare Category
• Elasticity First-Class Unrestricted Coach
  Discount ticket
• Price -0.3 -0.4 -0.9
• Income 1.2 1.2 1.8

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Case-let on Airline Fares

• Differences in elasticities imply that some
  customers will pay a higher fare than others.
• Business travelers have few choices and their
  demand is less elastic.
• Casual travelers have choices and are more price
  sensitive.
• The airlines separate the market by setting
  various restrictions on the tickets.
• Less expensive notice, stay over the weekend, no
  refund
• Most expensive no restrictions

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A possible case of dumping in global market

• Price etc.

Does opening of a global competitive market help
the monopolist, and if so, how? Can it be brought
under purview of anti-dumping measures?
MC
AC
Pd
MRt
ARw MRw
Qt
MRd
Quantity
Qd
ARd
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Can discriminating monopoly be socially useful?

• Price etc.

While a monopolist in either market cant work
given higher costs, a discriminating monopolist
across the two markets can make ?gt0, due to
economies of scale, when two markets are
combined.
MC
AC
P1
?gt0
P2
CAR
AR2
Q1
CMR
MR1
Quantity
Q2
MR2
AR1
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Inter-temporal Price Discrimination

• Separating the Market With Time
• When a product is initially released, its demand
  is inelastic
• Movie
• Book
• Computer
• Once the market has yielded a maximum profit,
  firms lower the price to appeal to the general
  market with a more elastic demand
• Paper back books
• Dollar Movies
• Discount computers

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Inter-temporal Price Discrimination
/Q
Note MC need not be the same over time Hence MR1
need not be equal to MR2.
Quantity
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Distinctive features of peak load pricing

• Demand for some products may peak at particular
  times, e.g., rush hour traffic, electricity
  consumption in summer afternoon
• Markets may be separated on basis of time. During
  peak demand time, capacity restraints will
  increase MC. Increased 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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Peak-Load Pricing (when further investment in
capacity not needed)
/Q
Quantity
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Capacity Determination under Peak Load Pricing
Model
How do you get MRT in this situation through
vertical or horizontal addition of MR1 MR2?
DT
Prices etc.
MRT
D2
MR2
P2
MR1
P1
B
MC
X1
b
D1
MR2
MR1
Capacity
XX2