Managerial Economics and Strategy

Third Edition

Chapter 10
Pricing with Market Power

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Managerial Problem
Sale Prices

• Heinz dominates the ketchup market in the United States, Canada, and the United
Kingdom. When Heinz goes on sale, switchers purchase Heinz rather than other brand.

• How can Heinz’s managers design a pattern of sales that maximizes Heinz’s profit?
Under what conditions does it pay for Heinz to have a policy of periodic sales?

Solution Approach

• We need to examine how monopolies and other noncompetitive firms set prices. These
firms can earn a higher profit setting different prices for the same good or service
depending on consumer’s willingness to pay (nonuniform pricing).

Empirical Methods

• Types of nonuniform pricing include price discrimination, two-part pricing, bundling,

and peak-load pricing.

• We will review the characteristics and conditions for each of these types of nonuniform
pricing.

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Learning Objectives (1 of 2)
10.1 Conditions for Price Discrimination
List the conditions necessary to price discriminate
10.2 Perfect Price Discrimination
Show how perfect price discrimination extracts all surplus
from consumers
10.3 Group Price Discrimination
Describe how a firm sets different prices for various
consumer groups to raise its profit
10.4 Nonlinear Price Discrimination
Demonstrate how a firm can increase its profit by charging
prices based on the quantities consumers buy

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Learning Objectives (2 of 2)
10.5 Two-Part Pricing
Illustrate how a firm may raise its profit by charging an
access fee and a per-unit price
10.6 Bundling
Determine when a firm can increase its profit by selling
related products in a bundle
10.7 Peak-Load Pricing
Explain why firms charge higher prices in periods of peak
demand

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10.1 Conditions for Price Discrimination (1 of 6)

• Price discrimination occurs when a firm charges different prices for a good.
– Common Confusion: It can’t pay for a firm to charge some consumers a
different price than others.
– However, many (but not all) firms can profit by price discriminating.

Why Price Discrimination Pays

• For almost any good or service, some consumers are willing to pay more than
others.
• Price discrimination increases profit above the uniform pricing level through
two channels:
– Channel 1: Higher prices for some
– Channel 2: Attract new customers

(Both channels are explained in next slide.)

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10.1 Conditions for Price Discrimination (2 of 6)

Price discrimination increases profit above the uniform pricing level through two
channels:
• Channel 1: Higher Prices for Some
– Price discrimination can extract additional C S from consumers who place
a high value on the good.
– In panel a of Table 10.1, the theater sells the same number of seats but
makes more money from the college students. Students pay $20, seniors
pay $10, and the theater captures all C S from both groups.
• Channel 2: Attract New Customers
– Price discrimination can simultaneously sell to new customers who would
not be willing to pay the profit-maximizing uniform price.
– In panel b of Table 10.1, the theater increases profit by selling five more
tickets to seniors. Students pay $20 as before, seniors pay $10, and
neither group enjoys any C S.

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Table 10.1
Theater Profits Based on the Pricing Method Used

(a) No Extra Customers from Price Discrimination

Pricing Profit from 10 College Students Profit from 20 Senior Citizens Total Profit

Uniform, $10 $100 $200 $300

Uniform, $20 $200 $0 $200
Price discrimination* $200 $200 $400

(b) Extra Customers from Price Discrimination

Pricing Profit from 10 College Students Profit from 5 Senior Citizens Total Profit

Uniform, $10 $100 $50 $150

Uniform, $20 $200 $0 $200

Price $200 $50 $250

discrimination*

*The theater price discriminates by charging college students $20 and senior citizens $10.
Notes: College students go to the theater if they are charged no more than $20. Senior citizens are
willing to pay up to $10. The theater’s marginal cost for an extra customer is zero.

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10.1 Conditions for Price Discrimination (3 of 6)

Which Firms Can Price Discriminate

• First Condition, A Firm Must Have Market Power
– A monopoly, oligopoly, or monopolistically competitive firm might be able
to price discriminate. A perfectly competitive firm cannot.
• Second Condition, A Firm Must Identify Groups with Different Price Sensitivity
– A firm must identify how consumers have different demands.
– Disneyland knows tourists and local residents differ in their willingness to
pay and use driver licenses to identify them.
• Third Condition, A Firm Must Prevent Resale
– If resale is easy, price discrimination doesn’t work because of only low-
price sales.
– The biggest obstacle to price discrimination is a firm’s inability to prevent
resale.

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10.1 Conditions for Price Discrimination (4 of 6)

Managerial Implication: Preventing Resale

• Preventing resale is easier in certain industries than in others.
– Resale is difficult or impossible for most services.
– Even for physical goods, resale is difficult when transaction costs are
high.
– The more valuable and widely consumed a product is, the more likely it is
that transaction costs are low enough to allow resale.
• In industries where resale is initially easy, managers can act to make resale
more costly.
– Some firms act to raise transaction costs or otherwise make resale
difficult. Firms require I D cards or issue country-specific warranties.
– Governments frequently aid price discrimination by preventing resale.
Government tariffs (taxes on imports) limit resale by making it expensive
to buy a branded good in a low-price country and resell it in a high-price
country.

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10.1 Conditions for Price Discrimination (5 of 6)

Not All Price Differences are Price Discrimination

• Different Prices and Different Costs
– e-book and hardcopy versions of the same book sell for different
prices in large part because these different versions have different
costs. This price difference reflects the lower marginal cost of
selling an e-book. Therefore, it is not price discrimination.
• Price Discrimination and Equal Costs
– Price discrimination is based on charging different prices even for
units of a good that cost the same to produce.
– If a magazine standard subscription rate is higher than a college
student subscription rate, it is price discrimination because the
two subscriptions are identical in every respect except the price.

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10.1 Conditions for Price Discrimination (6 of 6)

Types of Price Discrimination

• Type 1, Perfect Price Discrimination
– The firm sells each unit at the maximum amount any customer is
willing to pay.
– Price differs across consumers and may differ too for a given
consumer.
• Type 2, Group Price Discrimination
– The firm charges each group of customers a different price, but it
does not charge different prices within the group.
• Type 3, Nonlinear Price Discrimination
– The firm charges a different price for large purchases than for
small quantities so that the price paid varies according to the
quantity purchased.

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10.2 Perfect Price Discrimination (1 of 3)
How a Firm Perfectly Price Discriminates
• A firm with market power that can prevent resale and has full information
about its customers’ willingness to pay price discriminates by selling each
unit at its reservation price—the maximum amount any consumer would pay
for it.
• The maximum price for any unit of output is given by the height of the demand
curve at that output level.
• Perfectly Price Discrimination: Price = M R
– A perfectly price-discriminating firm’s marginal revenue is the same as its
price. So, the firm’s marginal revenue curve is the same as its demand
curve.
– In Figure 10.1, the monopoly sells 4 units at prices equal to
Each consumer pays its reservation
price, the demand curve is the M R curve. The firm’s revenue is $18 and if
fixed cost is zero, its profit equals

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Figure 10.1
Perfect Price Discrimination

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10.2 Perfect Price Discrimination (2 of 3)
Perfect Price Discrimination is Efficient But Harms Some
Consumers
• Perfect price discrimination is efficient: It maximizes the sum of
consumer surplus and producer surplus.
• But, all the surplus goes to the firm, consumer surplus is zero.

– In Figure 10.2, at the competitive market equilibrium,

consumer surplus is A + B + C and producer surplus is D +
E.
– At the perfect price discrimination equilibrium, Q d=Q c, no
deadweight loss occurs, all surplus goes to the monopoly.

• Consumer surplus is the greatest with competition, lower with single-

price monopoly, and eliminated by perfect price discrimination.

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Figure 10.2
Competitive, Single-Price, and Perfect Price Discrimination Outcomes

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10.2 Perfect Price Discrimination (3 of 3)

Individual Price Discrimination

• Perfect price discrimination is rarely fully achieved in practice.

• Firms can still increase profits significantly with imperfect individual price
discrimination:
– Charge individual-specific prices to different consumers, which may or
may not be the consumers’ reservation prices.
• Transaction Costs and Price Discrimination
– It is often too difficult or costly to gather information about each
customer’s reservation price for each unit of the product (high transaction
costs).
– However, recent advances in computer technologies have lowered these
transaction costs.
– Hotels, car and truck rental companies, cruise lines, airlines, and other
firms are increasingly using individual price discrimination.

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10.3 Group Price Discrimination (1 of 8)
• Group price discrimination occurs when potential customers are divided into
two or more groups with different prices for each group (single price within a
group).
• The two conditions for group price discrimination are:
– Consumer groups may differ by age, location, or in other ways.
– A firm must have market power, be able to identify groups with different
reservation prices and prevent resale.

Group Price Discrimination with Two Groups

• Tesla has the legal monopoly to produce and sell the Tesla S based on its
patent rights. It was the only seller of luxury electric cars in 2012 and remains
with little competition by 2018.
• Tesla engages in group price discrimination by charging different prices in
various countries. Resale is not possible because Tesla honors its warranty
only in the region or country where the car is sold.
• A graphical and mathematical approach is provided in next slides.

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10.3 Group Price Discrimination (2 of 8)
A Graphical Approach for Group Price Discrimination

• If a firm can prevent resale between countries and has a common

M C, then it can maximize profit by acting like a traditional
monopoly in each country separately.
– In Figure 10.3, resale between the United States and Europe
is not possible (country-specific warranty); common constant
M C = m = $30k.

– Tesla acts as a traditional monopoly in each country. U.S. market:

European market:

– Tesla price group discriminates and maximizes profit.

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Figure 10.3
Group Pricing of the Tesla S Car

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10.3 Group Price Discrimination (3 of 8)
Group Price Discrimination: Using Calculus

• Profit:
– Total profit is the sum of the American and European profits In each
country, profit is revenue minus cost (both depend on the Q sold in each country).
– To maximize profit: differentiate the monopoly’s profit function with respect to each
quantity, holding the other quantity fixed, and set derivatives equal to zero.

• American Market:
–
– The monopoly sets M R = M C in this market,
so
• European Market:
–
– The monopoly sets M R = M C in this market,
so

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10.3 Group Price Discrimination (4 of 8)
Prices and Elasticities

• We know
• We also know from Chapter 9 that
• So,
• Implication:

– The ratio of prices depend on the elasticity values in these two

markets.
– Tesla apparently believes that the European demand curve is less
elastic at its profit-maximizing prices than the U.S. demand curve

– Consequently, Tesla charges European consumers 62.5% more

than U.S. customers,
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10.3 Group Price Discrimination (5 of 8)
Identifying Groups
• Divide buyers based on observable characteristics
– The firm believes observable characteristics are associated
with unusually high or low reservation prices or demand
elasticities.
– Movie theaters price discriminate using the age of customers.
Higher prices for adults than for children.
• Divide buyers based on their actions
– Allow consumers to self-select the group to which they belong
depending on their opportunity cost of time.
– Customers may be identified by their willingness to spend time to
buy a good at a lower price (buy at the store; low opportunity
cost) or to order goods and services in advance of delivery
(phone or online shopping; high opportunity cost).

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10.3 Group Price Discrimination (6 of 8)
Managerial Implication:
Discounts
• To make sure that price
discrimination pays,
managers should only give
discounts to those
consumers who are willing
to incur a cost, such as
their time, to obtain the
discount.

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10.3 Group Price Discrimination (7 of 8)
Managerial Implication: Discounts
• Consumers willing to spend extra time to obtain a discount are typically more
price sensitive than others.
• Skilled managers use a variety of methods to induce customers to self-identify
as being price sensitive by incurring a cost.
– Coupons—firms divide customers into two groups, charging coupon
clippers less than nonclippers.
– Airline Tickets—airline customers indicate whether they are likely to be
business travelers or vacationers. Airlines offer high-price tickets with no
strings attached and low-price fares with restrictions.
– Reverse Auctions—Priceline.com and others use a name-your-own-price
or “reverse” auction to identify price-sensitive customers.
– Rebates—Why do many firms offer a rebate of, say, $5 instead of
reducing the price on their product by $5? The reason is that a consumer
must incur an extra, time-consuming step to receive the rebate.

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10.3 Group Price Discrimination (8 of 8)
Effects of Group Price Discrimination on Total Surplus
• Group price discrimination results in inefficient production and consumption.
However, how T S compares to other results?

Group Price Discrimination Versus Competition

• C S is greater and more output is produced with perfect competition than with
group price discrimination.
• Group price discrimination transfers some of the competitive C S to the firm as
additional profit and causes deadweight loss due to reduced output.

Group Price Discrimination Versus Single-Price Monopoly

• From theory alone, we cannot tell whether T S is higher if the monopoly uses
group price discrimination or if it sets a single price.
• The closer the firm comes to perfect price discrimination using group price
discrimination (many groups rather than just two), the more output it produces,
and the less production inefficiency—the greater the T S.

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10.4 Nonlinear Price Discrimination (1 of 2)
• Many firms, with market power
and no resale, are unable to
determine high reservation prices.
However, such firms know a
typical customer’s demand curve
is downward sloping.
• Such a firm can price discriminate
by letting the price each customer
pays vary with the number of
units the customer buys
(nonlinear price discrimination).

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10.4 Nonlinear Price Discrimination (2 of 2)
• Block Pricing Versus Single Price
– A firm charges one price per unit for the first block purchased and
a different price per unit for subsequent blocks. Used by utility
firms.
– In panel a of Figure 10.4, the firm charges a price of $70 on any
quantity between 1 and 20—first block—and $50 for the second
block. In panel b, the firm can set only a single price of $30. When
block pricing, C S is lower, T S is higher and deadweight loss is
lower. The firm and society are better off but consumers lose.
– Common Confusion: Quantity discounts help consumers.
However, Changing from uniform monopoly pricing to nonlinear
price discrimination often reduces consumer surplus, as in Figure
10.4.
– The more block prices that a firm can set, the closer the firm gets
to perfect price discrimination.

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Figure 10.4
Block Pricing

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10.5 Two-Part Pricing (1 of 2)
• With two-part pricing the firm charges each consumer a lump-sum access
fee for the right to buy as many units of the good as the consumer wants at a
per-unit price.
– A consumer’s overall expenditure for amount q consists of an access fee,
A, and a per-unit price, p. So, expenditure is E = A + p q.
– To do it, a firm must have market power, know how individual demand
curves vary across its customers and prevent resale.

Two-Part Pricing with Identical Consumers

• With identical customers, a firm can set a two-part price that is efficient (p = M
C) and all total surplus goes to the firm (C S = 0).
– In panel a of Figure 10.5, the monopoly charges a per-unit price, p, equal
to the marginal cost of 10, and an access fee, A = 2,450 = C S. The firm’s
total profit is 2,450 times the number of identical customers.
– If the firm were to charge a p > M C, it would sell fewer units and make a
smaller profit. For instance, p = 20 in panel b of Figure 10.5.

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Figure 10.5
Two-Part Pricing with Identical Consumers

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10.5 Two-Part Pricing (2 of 2)
Two-Part Pricing with Differing Consumers
• Two-part pricing is more complex if consumers have different demand curves.

• Having two different demands implies consumers have different C S. Two-part

pricing would require the monopolist to charge different access fees, and this
may not be possible.

– In Figure 10.6, the monopoly faces two consumers. Valerie’s demand

curve is in panel a, and Neal’s demand curve is in panel b.

– If the monopoly can charge different prices, it sets price for both
customers at p = M C = 10 and access fee of 2,450 to Valerie and 4,050
to Neal. π = 6,500
– If the monopoly cannot charge its customers different access fees, it sets
its per-unit price at p = 20, where Valerie purchases 60 and Neal buys 80
units. It charges both the same access fee of
which is Valerie’s C S. π = 5,000

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Figure 10.6
Two-Part Pricing with Different Consumers

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10.6 Bundling (1 of 7)
Bundling Characteristics
• Firms with market power often pursue a pricing strategy called bundling.
– Bundling consists of selling multiple goods or services for a single price.

• Most goods are bundles of many separate parts.

• However, firms sometimes bundle even when there are no production

advantages and transaction costs are small.
• Bundling allows firms to increase their profit by charging different prices to
different consumers based on the consumers’ willingness to pay.
– Pure bundling: Only a package deal is offered (a cable company sells a
bundle of internet, phone, and television for a single price, no service
separately).
– Mixed bundling: Goods are available as a package or separately.

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10.6 Bundling (2 of 7)
Pure Bundling
• M S Office is currently a pure bundle. Main components, Word and
Excel, are only sold as part of the bundle.
• Whether it pays for Microsoft to sell a bundle or sell the programs
separately depends on how reservation prices for the components
vary across customers.
• Bundling increases profits if reservation prices are negatively
correlated, and it reduces profits if they are positively correlated.
• We assume the marginal cost of producing an extra copy of either
type of software is essentially zero; fixed cost is negligible so that the
firm’s revenue equals its profit; the firm must charge all customers the
same price—it cannot price discriminate.

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10.6 Bundling (3 of 7)
Profitable pure bundling example
• Table 10.2 shows the reservation prices for two customers and two products.
– The reservation prices are negatively correlated: The customer who has
the higher reservation price for one product has the lower reservation
price for the other product.
– If the firm sells the two products separately, it maximizes its profit by
charging $90 for the word processor and selling it to both consumers, and
selling the spreadsheet program for $50 to both consumers. The firm’s
total profit from selling the programs separately is $280 ($180 + $100).
– If the firm sells the two products in a bundle, it maximizes its profit by
charging 160, selling to both customers, and earning $320. Pure bundling
is more profitable.
– Pure bundling is more profitable because the firm captures more of the
consumers’ potential C S—their reservation prices.

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Table 10.2
Negatively Correlated Reservation Prices

Word Spreadsheet Bundle

Blank

Processor
Alisha $120 $50 $170
Bob $90 $70 $160
Profit-maximizing price $90 $50 $160
Units sold 2 2 2

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10.6 Bundling (4 of 7)
Nonprofitable pure bundling example
• Table 10.3 shows the reservation prices for two customers and two products.
– The reservation prices are positively correlated: A higher reservation
price for one product is associated with a higher reservation price for the
other product.
– If the programs are sold separately, the firm charges $90 for the word
processor, sells to both consumers and earns $180. However, it makes
more charging $90 for the spreadsheet program and selling it only to
Carol. The firm’s total profit if it prices separately is $270 ($180 + $90).
– If the firm uses pure bundling, it maximizes its profit by charging $130 for
the bundle, selling to both customers, and making $260.
– Because the firm earns more selling the programs separately, $270, than
when it bundles them, $260, pure bundling is not profitable in this
example. As long as reservation prices are positively correlated, pure
bundling cannot increase the profit.

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Table 10.3
Positively Correlated Reservation Prices

Word Spreadsheet Bundle

Blank

Processor
Carol $100 $90 $190
Dmitri $90 $40 $130
Profit-maximizing price $90 $90 $130
Units sold 2 1 2

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10.6 Bundling (5 of 7)
Mixed Bundling

• Consumers are allowed to buy the pure bundle or any of its components separately.

• Table 10.4 shows the reservation prices of four potential customers for two products.
– Aaron, a writer, places high value on the word processing program but has
relatively little use for a spreadsheet. Dorothy, an accountant, has the opposite
pattern of preferences. Brigitte and Charles have intermediate reservation prices
that are negatively correlated.
– If the firm prices each program separately, it maximizes its profit by charging $90
for each product and selling each to three customers. It earns $540 in total.
– If the firm engages in pure bundling, it can charge $150 for the bundle, sell to all
four consumers, and earns $600 total.
– If the firm does mixed bundling, it can charge $160 for the bundle to two
consumers and $120 for each product separately to the other two consumers. It
earns $640 in total.

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Table 10.4
Reservation Prices and Mixed Bundling

Word Processor Spreadsheet Bundle

Blank

Aaron $120 $30 $150

Brigitte $110 $90 $200
Charles $90 $110 $200
Dorothy $30 $120 $150

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10.6 Bundling (6 of 7)
Requirement Tie-In Sales

• Requirement tie-in sales is another form of bundling: Requires customers who buy one
product from a firm to make all concurrent and subsequent purchases of a related
product from that firm.

• This requirement allows the firm to identify heavier users and charge them more per
unit.

• Example
– If a printer manufacturer can require that consumers buy their ink cartridges only
from the manufacturer, then that firm can capture most of the consumers’ surplus.
– Heavy users of the printer, who presumably have a less elastic demand for it, pay
the firm more than light users because of the high cost of the ink cartridges.
– Unfortunately for such a printer manufacturer, the Magnuson-Moss Warranty
Improvement Act of 1975 forbids any manufacturer from using such tie-in
provisions as a condition of warranty.

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10.6 Bundling (7 of 7)
Managerial Implication: Ties that Bind
• Managers can increase profit by promoting consumer loyalty. Despite the
Magnuson-Moss Act, such loyalty can be induced through warranty provisions.
• Printer firms such as Hewlett-Packard (H P) write their warranties and promote
ads to strongly encourage consumers to use only their cartridges and not to
refill them.
• Are these warranty restrictions and advertising claims sufficient to induce most
consumers to buy cartridges only from H P? Apparently so.
– In 2018, H P prices for a Deskjet 1112 printer and a tri-color ink cartridge
were $29.99 and $37.99, respectively.
– If most customers bought inexpensive cartridges or refills from other
firms, H P would not sell its printer at a rock-bottom price.
– H P demonstrates that the benefits of requirement tie-in sales can be
achieved through careful wording of warranties and advertising.

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10.7 Peak-Load Pricing (1 of 3)

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10.7 Peak-Load Pricing (2 of 3)
• Peak-load pricing: Charging higher prices during periods of peak demand
than in other periods

Peak-load Pricing with a Capacity Constraint

• Firms commonly use peak-load pricing when they face a production capacity
constraint.

– In Figure 10.7, a hotel has a maximum capacity of rooms. Its MC = m

up to

– During the low season, is the demand. The hotel maximizes profit
where The hotel has excess capacity.
– During the high season, is the demand. The firm maximizes profit
where in the vertical section. The price is no excess

capacity.

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Figure 10.7
Peak-Load Pricing

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10.7 Peak-Load Pricing (3 of 3)
Dynamic Pricing
• Under dynamic pricing or surge pricing, sellers frequently change prices
based on current market conditions.
• Dynamic pricing is based on the same principle as traditional peak-load pricing
—charging more in times of high demand.
• The difference is that instead of committing to a set pattern of pricing, a seller
using dynamic pricing changes its price at any time, quickly responding to
changing market conditions in “real time.
– Uber’s website indicates that during high-demand situations (bad weather,
rush hours, or special events), “fares may increase to help ensure those
who need a ride can get one.” The Uber mobile app reports a surge
multiplier when surge pricing is in effect.
– Some highway toll authorities use dynamic pricing for special express
lanes. They vary the toll to ensure that the express lane remains
uncongested.

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Managerial Solution
Sale Prices
• How can Heinz’s managers design a pattern of sales that maximizes Heinz’s
profit? Under what conditions does it pay for Heinz to have a policy of periodic
sales?

Solution
• By putting Heinz on sale periodically, Heinz’s managers can price discriminate.

• Every n days, the typical consumer buys either Heinz or generic ketchup.
Switchers are price sensitive, always know when Heinz is on sale and buy it.
Loyal customers do not distort their shopping patterns solely to buy Heinz on
sale.
• If there are more switchers than loyal customers, then having sales is more
profitable than selling at a uniform price to only loyal customers.

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