Chapter 5

Pricing Strategies for Firms with

Market Power

©2005 Pearson Education, Inc.

Measuring Monopoly Power
 Could measure monopoly power by the extent to
which price is greater than MC for each firm
 Lerner’s Index of Monopoly Power

◦L = (P - MC)/P

©2005 Pearson Education, Inc. Chapter 10 2

Measuring Monopoly Power
 The larger the value of L (between 0 and
1) the greater the monopoly power
◦ L is expressed in terms of Ed
 L = (P - MC)/P = -1/Ed
 Ed is elasticity of demand for a firm, not
the market

©2005 Pearson Education, Inc. Chapter 10 3

Rule of Thumb for Pricing
 Pricing for any firm with monopoly
power:
◦ If Ed is large, markup is small
◦ If Ed is small, markup is large

MC
P
1 1 Ed 

©2005 Pearson Education, Inc. Chapter 10 4

Elasticity of Demand and Price
Markup
The more elastic is $/Q
$/Q demand, the less the
markup.

MC P* MC

P*
P*-MC
D
P*-MC

MR

D
MR

Q* Quantity Q* Quantity
Markup Pricing: Supermarkets &
Convenience Stores
 Supermarkets

1. Several firms
2. Similar product
3. Ed  10 for individual stores
MC MC
4.P    1.11( MC )
1  1  .1 0.9
5. Prices set about 10 - 11% above MC.

©2005 Pearson Education, Inc. Chapter 10 6

Markup Pricing: Supermarkets &
Convenience Stores
 Convenience Stores

1. Higher prices than supermarkets

2. Convenience differentiates them
3. Ed  5
MC MC
4.P    1.25(MC )
1  1 5  0.8
5. Prices set about 25% above MC.

©2005 Pearson Education, Inc. Chapter 10 7

Markup Pricing: Supermarkets &
Convenience Stores
 Convenience stores have more monopoly
power
 Convenience stores do have higher
profits than supermarkets, however
◦ Volume is far smaller and average fixed costs
are larger

©2005 Pearson Education, Inc. Chapter 10 8

Deadweight Loss from Monopoly
Power
$/Q

Lost Consumer Surplus Because of the

higher price,
consumers lose
MC A+B and
Deadweight
Loss producer gains
Pm A-C.

A
B
PC
C
AR=D

MR

Qm QC Quantity

©2005 Pearson Education, Inc. Chapter 10 9

Limiting Market Power
 Market power harms some players in the
market – buyer or seller
 Market power reduces output, leading to
deadweight loss
 Excessive market power could raise
problems of equity and fairness

©2005 Pearson Education, Inc. Chapter 10 10

Limiting Market Power

 What can we do to limit market power

and keep it from being used anti-
competitively?
◦ Tax away monopoly profits and redistribute to
consumers
 Difficult to measure and find all those who lost
◦ Direct price regulation of natural monopolies
◦ Keep firms from acquiring excessive market
power
 Antitrust laws

©2005 Pearson Education, Inc. Chapter 10 11

Price
Discrimination

Chapter 4 12
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

©2005 Pearson Education, Inc. Chapter 11 13

Capturing Consumer Surplus
$/Q The firm would like to
charge higher price to
Pmax those consumers
A willing to pay it - A
P1 Firm would also like to
sell to those in area B but
P* B without lowering price to
all consumers
P2
MC Both ways will allow
the firm to capture
PC more consumer
surplus
D

Q* MR Quantity
©2005 Pearson Education, Inc. Chapter 11 14
Capturing Consumer Surplus
 Price discrimination is the practice of
charging different prices to different
consumers for similar goods
◦ Must be able to identify the different
consumers and get them to pay different
prices

©2005 Pearson Education, Inc. Chapter 11 15

Perfect First-Degree Price
Discrimination
$/Q Without price discrimination,
output is Q* and price is P*. Consumer surplus is the area
Variable profit is the area above P* and between
Pmax 0 and Q* output.
between the MC & MR (yellow).

With perfect discrimination, firm

MC will choose to produce Q**
P* increasing variable profits to
include purple area.

PC

D = AR

MR

Q** Quantity
Q*
©2005 Pearson Education, Inc. Chapter 11 16
First-Degree Price Discrimination

 In practice, perfect price discrimination

is almost never possible
1. Impractical to charge every customer a
different price (unless very few customers)
2. Firms usually do not know reservation price
of each customer
 Firms can discriminate imperfectly
◦ Can charge a few different prices based on
some estimates of reservation prices

©2005 Pearson Education, Inc. Chapter 11 17

First-Degree Price Discrimination

 Examples:
◦ Lawyers, doctors, accountants
◦ Car salesperson (15% profit margin)
◦ Colleges and universities (differences in
financial aid)

©2005 Pearson Education, Inc. Chapter 11 18

First-Degree Price
Discrimination in Practice
$/Q Six prices exist resulting
in higher profits. With a single price
P*4, there are fewer consumers.
P1
P2 Discriminating up to
P3 P6 (competitive price)
MC will increase profits.
P*4

P5
P6

MR
Q* Quantity

©2005 Pearson Education, Inc. Chapter 11 19

Second-Degree Price Discrimination

 Practice of charging different prices per

unit for different quantities of the same
good or service
 In some markets, consumers purchase
many units of a good over time
 Electricity, water, heating fuel

©2005 Pearson Education, Inc. Chapter 11 20

Second-Degree Price
Discrimination
 Block pricing – the practice of charging
different prices for different quantities of
“blocks” of a good
◦ Ex: electric power companies charge different
prices for a consumer purchasing a set block
of electricity

©2005 Pearson Education, Inc. Chapter 11 21

Second-Degree Price Discrimination

$/Q Without discrimination:

Different prices are
charged for different P = P0 and Q = Q0. With
P1 quantities or second-degree
“blocks” of same discrimination there are
P0 good. three blocks with prices
P1, P2, & P3.

P2
AC
P3 MC

D
MR
Q1 Q0 Q2 Q3 Quantity
1st Block 2nd Block 3rd Block
©2005 Pearson Education, Inc. Chapter 11 22
Third-Degree Price Discrimination

 Practice of dividing consumers into two

or more groups with separate demand
curves and charging different prices to
each group
1. Divides the market into two groups
2. Each group has its own demand function

©2005 Pearson Education, Inc. Chapter 11 23

Third-Degree Price Discrimination

 Most common type of price

discrimination
◦ Examples: airlines, premium vs. non-premium
liquor, discounts to students and senior
citizens, frozen vs. canned vegetables

©2005 Pearson Education, Inc. Chapter 11 24

Third-Degree Price Discrimination

 Typically, elasticities of demand differ for

the groups
◦ College students and senior citizens are not
usually willing to pay as much as others
because of lower incomes
◦ These groups are easily distinguishable with
ID’s

©2005 Pearson Education, Inc. Chapter 11 25

Price setting
 How can the firm decide what to charge
each group of consumers?
1. Total output should be divided between
groups so that MR for each group is equal
2. Total output is chosen so that MR for each
group of consumers is equal to the MC of
production

©2005 Pearson Education, Inc. Chapter 11 26

Third-Degree Price Discrimination
 Algebraically
◦ P1: price first group
◦ P2: price second group
◦ C(QT) = total cost of producing output
Q T = Q1 + Q 2
◦ Profit:  = P1Q1 + P2Q2 - C(QT)

©2005 Pearson Education, Inc. Chapter 11 27

Third-Degree Price Discrimination
Firm should increase sales to each group

until incremental profit from last unit sold
is zero
 ( P1Q1 ) C
   0  MR1  MC
Q1 Q1 Q1
 ( P2Q2 ) C
   0  MR2  MC
Q2 Q2 Q2
MR1  MR2  MC
©2005 Pearson Education, Inc. Chapter 11 28
Third-Degree Price Discrimination
$/Q
$/Q $/Q

Pa MRT = MRA + MRB

Pb
P1

MC
P2

MCT MCT
DB = ARB DT = ART

MRB
MRA DA = ARA
MRT
©2005 Pearson
Q1 Education, Inc.
Quantity Q2 Chapter 11
Quantity 29 QT Quantity
Third-Degree Price Discrimination
 Determining relative prices
◦ Thinking of relative prices that should be
charged to each group of consumers and
relating them to price elasticities of demand
may be easier

Recall: MR  P 1  1 Ed 
Then: MR1  P1 (1  1 E1 )  MR2  P2 (1  1 E2 )
E1 and E2 elasticities of demand for each group

©2005 Pearson Education, Inc. Chapter 11 30

Third-Degree Price Discrimination
 Determining relative prices
◦ The higher price will be charged to consumer
with the lower demand elasticity

P1 ( 1  1 E 2 )

P2 ( 1  1 E1 )

©2005 Pearson Education, Inc. Chapter 11 31

Third-Degree Price Discrimination
 Example
◦ E1 = -2 and E2 = -4
◦ P1 should be 1.5 times as high as P2

P1 (1  1 4) 3 / 4
   1.5
P2 (1  1 2) 1 / 2

©2005 Pearson Education, Inc. Chapter 11 32

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 and families are more
price-sensitive and will therefore be
choosier

©2005 Pearson Education, Inc. Chapter 11 33

Elasticities of Demand for
Air Travel

©2005 Pearson Education, Inc. Chapter 11 34

Practice
Suppose that BMW can produce any quantity of cars at a
constant marginal cost equal to $20,000 and a fixed cost of
$10 billion.You are asked to advise the CEO as to what prices
and quantities BMW should set for sales in Europe and in the
United States.The demand for BMWs in each market is given
by:
QE = 4,000,000 - 100P
and QU = 1,000,000 - 20PU
where the subscript E denotes Europe and the subscript U
denotes the United States. Assume that BMW can restrict
U.S. sales to authorized BMW dealers only.
a. What quantity of BMWs should the firm sell in each
market, and what should the price be in each market? What
should the total profit be?
b. If BMW were forced to charge the same price in each
market, what would be the quantity sold in each market, the
equilibrium price, and the company’s profit?
©2005 Pearson Education, Inc. Chapter 4 35
Other Types of Price Discrimination
 Intertemporal Price Discrimination
◦ Practice of separating consumers with
different demand functions into different
groups by charging different prices at different
points in time
◦ Initial release of a product, the demand is
inelastic
 Hard back vs. paperback book
 New release movie
 Technology

©2005 Pearson Education, Inc. Chapter 11 36

Intertemporal Price Discrimination
$/Q
Initially, demand is less Over time, demand becomes
elastic, resulting in a more elastic and price
P1 price of P1 . is reduced to appeal to the
mass market.

P2
D2 = AR2

AC = MC

MR2
MR1 D1 = AR1

Q1 Q2 Quantity
©2005 Pearson Education, Inc. Chapter 11 37
Other Types of Price Discrimination
 Peak-Load Pricing
◦ Practice of charging higher prices during peak
periods when capacity constraints cause
marginal costs to be higher
 Demand for some products may peak at
particular times
◦ Rush hour traffic
◦ Electricity - late summer afternoons
◦ Ski resorts on weekends

©2005 Pearson Education, Inc. Chapter 11 38

Peak-Load Pricing
$/Q MC MR=MC for each
group. Group 1
P1 has higher
demand during
peak times.

D1 = AR1

P2

MR1

D2 = AR2
MR2
Q2 Q1 Quantity
©2005 Pearson Education, Inc. Chapter 11 39
The Two-Part Tariff
 Form of pricing in which consumers are charged both
an entry and usage fee
◦ Ex: amusement park, golf course, telephone service
 A fee is charged upfront for right to use/buy the
product
 An additional fee is charged for each unit the
consumer wishes to consume
◦ Pay a fee to play golf and then pay another fee for each game
you play

©2005 Pearson Education, Inc. Chapter 11 40

The Two-Part Tariff
 Pricing decision is setting the entry fee
(T) and the usage fee (P)
 Choosing the trade-off between free-
entry and high-use prices or high-entry
and zero-use prices
 Single Consumer
◦ Assume firm knows consumer demand
◦ Firm wants to capture as much consumer
surplus as possible

©2005 Pearson Education, Inc. Chapter 11 41

Two-Part Tariff with a Single
Consumer
$/Q Usage price P* is set equal to MC.
Entry price T* is equal to the entire
T* consumer surplus.
Firm captures all consumer
surplus as profit.

MC
P*

Quantity
©2005 Pearson Education, Inc. Chapter 11 42
Two-Part Tariff with Two Consumers
 Two consumers, but firm can only set one entry fee
and one usage fee
 Will no longer set usage fee equal to MC
◦ Could make entry fee no larger than CS of consumer with
smallest demand
 Firm should set usage fee above MC
 Set entry fee equal to remaining consumer surplus of
consumer with smaller demand
 Firm needs to know demand curves

©2005 Pearson Education, Inc. Chapter 11 43

Two-Part Tariff with Two Consumers
$/Q The price, P*, will be
T* greater than MC. Set T*
at the surplus value of D2.

A
  2T *  ( P *  MC )(Q1  Q2 )
 more than twice ABC
MC
B
C D1 = consumer 1

D2 = consumer 2

Q2 Q1 Quantity
©2005 Pearson Education, Inc. Chapter 11 44
The Two-Part Tariff with Many
Consumers
 No exact way to determine P* and T*
 Must consider the trade-off between the
entry fee T* and the use fee P*
◦ Low entry fee: more entrants and more profit
from sales of item
◦ As entry fee becomes smaller, number of
entrants is larger and profit from entry fee
will fall

©2005 Pearson Education, Inc. Chapter 11 45

The Two-Part Tariff with Many
Consumers
 To find optimum combination, choose
several combinations of P and T
 Find combination that maximizes profit
 Firm’s profit is divided into two
components
◦ Each is a function of entry fee, T assuming a
fixed sales price, P

©2005 Pearson Education, Inc. Chapter 11 46

Two-Part Tariff with Many Different
Consumers
Profit    a   s  n(T )T  ( P  MC)Q(n)
n  entrants
Total profit is the sum of the
profit from the entry fee and
the profit from sales. Both
depend on T.

 Total
 a :entry fee
 s:sales
T* T
©2005 Pearson Education, Inc. Chapter 11 47
The Two-Part Tariff
 Rule of Thumb
◦ Similar demand: Choose P close to MC and
high T
◦ Dissimilar demand: Choose high P and low T
◦ Ex: Disneyland in California and Disney world
in Florida have a strategy of high entry fee and
charge nothing for ride

©2005 Pearson Education, Inc. Chapter 11 48

The Two-Part Tariff With a Twist
 Entry price (T) entitles the buyer to a certain number
of free units
◦ Gillette razors sold with several blades
◦ Amusement park admission comes with some tokens
◦ On-line fees with free time
 Can set higher entry fee without losing many
consumers
◦ Higher entry fee captures either surplus without driving
them out of the market
◦ Captures more surplus of large customers

©2005 Pearson Education, Inc. Chapter 11 49

Bundling
 Bundling is packaging two or more
products to gain a pricing advantage
 Conditions necessary for bundling
◦ Heterogeneous customers
◦ Price discrimination is not possible
◦ Demands must be negatively correlated

©2005 Pearson Education, Inc. Chapter 11 50

Bundling
 When film company leased “Gone with
the Wind,” it required theaters to also
lease “Getting Gertie’s Garter”
 Why would a company do this?
◦ Company must be able to increase revenue
◦ We can see the reservation prices for each
theater and movie

©2005 Pearson Education, Inc. Chapter 11 51

Bundling
Gone with the Wind Getting Gertie’s Garter

Theater A $12,000 $3,000

Theater B $10,000 $4,000

 Renting the movies separately would result in

each theater paying the lowest reservation
price for each movie:
◦ Maximum price Wind = $10,000
◦ Maximum price Gertie = $3,000
 Total Revenue = $26,000
©2005 Pearson Education, Inc. Chapter 11 52
Bundling
 If the movies are bundled:
◦ Theater A will pay $15,000 for both
◦ Theater B will pay $14,000 for both
 If each were charged the lower of the
two prices, total revenue will be $28,000
 The movie company will gain more
revenue ($2000) by bundling the movie

©2005 Pearson Education, Inc. Chapter 11 53

Relative Valuations
 More profitable to bundle because
relative valuation of two films are
reversed
 Demands are negatively correlated
◦ A pays more for Wind ($12,000) than B
($10,000)
◦ B pays more for Gertie ($4,000) than A
($3,000)

©2005 Pearson Education, Inc. Chapter 11 54

Chapter 11 (M.Baye)
18.
As a manager of a chain of movie theaters that are
monopolies in their respective markets, you have noticed
much higher demand on weekends than during the week.You
therefore conducted a study that has revealed two different
demand curves at your movie theaters. On weekends, the
inverse demand function is P = 20 - 0.001Q;
on weekdays, it is P = 15 - 0.002Q.
You acquire legal rights from movie producers to show their
films at a cost of $25,000 per movie, plus a $2.50 “royalty” for
each moviegoer entering your theaters (the average
moviegoer in your market watches a movie only once). Devise
a pricing strategy to maximize your firm’s profits.
©2005 Pearson Education, Inc. Chapter 4 55
BAA is a private company that operates some of the largest airports
`
in the United Kingdom, including Heathrow and Gatwick. Suppose
that BAA recently commissioned your consulting team to prepare a
report on traffic congestion at Heathrow. Your report indicates that
Heathrow is more likely to experience significant congestion
between July and September than at other time of the year.
Based on your estimates, demand is Q1= 600- 0.25P where is
quantity demanded for runway time slots between July and
September. Demand during the remaining nine months of the year
is Q2 =220 - 0.1P, where is quantity demanded for runway time
slots. The additional cost BAA incurs each time one of the 80
different airlines utilizes the runway is £1,100 provided 80 or fewer
airplanes use the runway on a given day. When more than 80
airplanes use Heathrow’s runways, the additional cost incurred by
BAA is £6 billion (the cost of building an additional runway and
terminal). BAA currently charges airlines a uniform fee of £1,712.50
each time the runway is utilized. As a consultant to BAA, devise a
pricing plan that would enhance Heathrow’s profitability.
©2005 Pearson Education, Inc. Chapter 4 56