Economic Analysis for Management

Lecture 21

DoMS, IIT Kanpur

Pricing with Market Power
Introduction

▶ Markets are usually not perfectly competitive. Every firm, therefore,

enjoys some amount of market power.
▶ This means, the firms can set price at a higher level than marginal
cost, and make supernormal profit.
▶ We discussed what the government can do to maximize welfare of
the society as a whole.
▶ In this chapter, we discuss what the firms can do, to increase their
profit
▶ Three pricing strategies: price discrimination, two-part tariff, and
bundling.
Capturing Consumer Surplus

▶ It cannot capture the

▶ We learnt in the last topic, that
deadweight loss (= J + N)
a monopolist charges uniform either, because lowering price
price for all quantities it sells. will again decrease profit.
▶ The profit maximizing output
and price for a firm are given
by: Qm and Pm .
▶ Producer surplus = G + H + K
+ L.
▶ There is some positive
consumer surplus (= E + F)
that the monopolist cannot
capture, because raising price
will reduce profit.
Source: Besanko and Braeutigam, 5e
Price Discrimination
▶ Price discrimination can take three broad forms, which we call first-,
second-, and third-degree price discrimination.
▶ First-degree price discrimination: The firm tries to price each unit at
the consumer’s reservation price (i.e., the maximum price that the
consumer is willing to pay for that unit).
▶ Example: Selling product in an auction.The buyer usually bids (very close
to) her reservation price.
▶ Second-degree price discrimination: The firm offers consumers quantity
discounts — the price per unit goes down if the consumer buys more units.
▶ Example: $50 per unit price for buying between 1 and 9 units, $40 per unit
for 10 to 99 units etc.
▶ Third-degree price discrimination: The firm identifies different
consumer groups, or segments, in the market, each with a different
demand curve. Then, to maximize profit, the firm sets a price for each
segment by equating marginal revenue and marginal cost.
▶ Example: Business class and economy class in airplanes.
First-degree price discrimination

▶ Ideally, a firm would like to charge a different price to each of its

customers. If it could, it would charge each customer the maximum
price that the customer is willing to pay for each unit bought.
▶ Call this maximum price the customer’s reservation price.
▶ The practice of charging each customer his or her reservation price
is called perfect first-degree price discrimination.
▶ A perfect price discrimination will lead to the seller capturing all of
the consumer surplus.

▶ However, in practice, perfect first-degree price discrimination is

difficult to attain.
▶ So, in most cases, firms discriminate by charging a few different
prices based on customers’ reservation prices.
▶ Think of a lawyer charging different prices to different clients.
Additional profit from first-degree price discrimination

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Additional profit from first-degree price discrimination
▶ When the firm charges only one price P ∗ , we can find the total
profit by adding the incremental profit for each unit sold, till Q ∗ .
▶ Profit is highest for the first unit, because difference between MR
and MC is largest. It keeps reducing for each addditional unit sold,
till the last unit when MR = MC.
▶ If the firm could perfectly price discriminate, the MR is no more
valid. Instead, the incremental revenue earned from each additional
unit sold is simply the price paid for that unit. It is therefore given
by the demand curve.
▶ The cost structure has remained same.
▶ The additional profit in this case is given by the difference between
the demand curve and the marginal cost for that unit.
▶ Quantity sold is now Q ∗∗ .
▶ All consumer surplus as well as the deadweight loss has now been
captured by the producer.
Imperfect first-degree price discrimination
▶ The firm charges six different prices. The firm makes more profit.
The consumer surplus is also positive.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Second-Degree Price Discrimination

▶ In some markets, as each consumer purchases many units of a good

over any given period, his reservation price declines with the number
of units purchased. Examples include a company buying inputs for
its production, consuming electricity etc.
▶ Second-degree price discrimination is the practice of charging
different prices per unit for different quantities of the same good or
service.
▶ Quantity discount is one example. One unit of a book is priced at
Rs. 500, but 4 units can be sold at Rs. 1800.
▶ Another exxample is block-pricing. In this case, rather than for each
quantity, different price is charged for different blocks of goods
purchased.
▶ In the presence of economies of scale, firms are able to lower the
cost when higher amount of goods are purchased.
Second-Degree Price Discrimination
▶ The average and the marginal costs are declining due to economies
of scale.
▶ The firm sells Qi quantity at Pi price.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Third-Degree Price Discrimination

▶ Third-degree price discrimination is the practice of dividing

consumers into two or more groups with separate demand curves
and charging different prices to each group.
▶ Example: Market for perfumes, discounts to students for a book.
▶ If third-degree price discrimination is feasible, how should the firm
decide what price to charge each group of consumers?
▶ 1. Total output should be divided between the groups of customers
so that marginal revenues for each group are equal. If not, then
there is a scope to shift output to the group that gives higher MR.
▶ 2. Total output must be such that the marginal revenue for each
group of consumer is equal to the marginal cost of production.
Otherwise, the firm would be better-off producing a different total
unit.
Third-Degree Price Discrimination - II

▶ Let there be two group of consumers.

▶ Let P1 and P2 be the prices charged to two group of consumers.
▶ Q1 and Q2 are the quantities sold to them. QT = Q1 + Q2 .
▶ Total profit π = P1 Q1 + P2 Q2 − C (QT ).
▶ Setting the marginal profit equal to marginal cost for each group of
consumers: dπ/dQi = dPi Qi /dQi − dC (QT )/dQi = 0.
▶ Or, MR1 = MR2 = MC .
Third-Degree Price Discrimination - III

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Third-Degree Price Discrimination - IV
▶ If the demand curve one group of consumers is such that the
marginal revenue for this group can never be equal to the other
group, the firm should sell only to the group with ‘higher’ MR.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Intertemporal Price Discrimination
▶ The objective is to divide consumers into high-demand and
low-demand groups by charging a high price at first, and then a
lower price after some time.
▶ Example: iPhone, movies, new book releases.

Source: Microeconomics 8e, by Pindyck and Rubinfeld

Peak-Load Pricing

▶ For some goods and services demand peaks at particular times -

roads in rush hours, electricity during summer afternoons.
▶ In such cases firms can set different prices based on demand at
those times.

Source: Microeconomics 8e, by Pindyck and Rubinfeld