Chapter 11 Pricing with Market Power Topics to be Discussed  Capturing Consumer Surplus  Price Discrimination  Intertemporal Price Discrimination and Peak-Load Pricing  The Two-Part Tariff Chapter 11 Slide Introduction  Pricing without market power (perfect competition) is determined by market supply and demand  The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits Chapter 11 Slide 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 Chapter 11 Slide Capturing Consumer Surplus $/Q Pmax Between and Q*, consumers will pay more than P* consumer surplus (A) A P1 P* B P2 PC is the price that would exist in a perfectly competitive market MC PC If price is raised above P*, the firm will lose sales and reduce profit D Beyond Q*, price will have to fall to create a consumer surplus (B) MR Q* Chapter 11 Quantity Slide Capturing Consumer Surplus $/Q Pmax A P1 •A: consumer surplus with P* •B: P>MC & consumer would buy at a lower price •P1: less sales and profits •P2 : increase sales & and reduce revenue and profits •PC: competitive price P* B P2 MC PC D MR Q* Chapter 11 Quantity Slide Capturing Consumer Surplus $/Q Pmax Question How can the firm capture the consumer surplus in A and sell profitably in B? A P1 P* B P2 MC PC Answer Price discrimination Two-part tariffs D MR Q* Chapter 11 Quantity Slide Capturing Consumer Surplus  Price discrimination is the charging of different prices to different consumers for similar goods Chapter 11 Slide Price Discrimination  First Degree Price Discrimination  Charge a separate price to each customer: the maximum or reservation price they are willing to pay Chapter 11 Slide Additional Profit From Perfect FirstDegree Price Discrimination $/Q Pmax Without price discrimination, output is Q* and price is P* Variable profit is the area between the MC & MR (yellow) Consumer surplus is the area above P* and between and Q* output MC P* With perfect discrimination, each consumer pays the maximum price they are willing to pay PC D = AR Output expands to Q** and price falls to PC where MC = MR = AR = D Profits increase by the area above MC between old MR and D to output Q** (purple) MR Q* Chapter 11 Q** Quantity Slide Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing Peak-Load Pricing  Demand for some products may peak at particular times  Rush hour traffic  Electricity  Ski - late summer afternoons resorts on weekends Chapter 11 Slide Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing Peak-Load Pricing  Capacity restraints will also increase MC  Increased MR and MC would indicate a higher price Chapter 11 Slide Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing Peak-Load Pricing  MR is not equal for each market because one market does not impact the other market Chapter 11 Slide Peak-Load Pricing $/Q MC P1 Peak-load price = P1 D1 = AR1 Off- load price = P2 P2 MR1 D2 = AR2 MR2 Q2 Chapter 11 Q1 Quantity Slide The Two-Part Tariff  The purchase of some products and services can be separated into two decisions, and therefore, two prices Chapter 11 Slide The Two-Part Tariff  Examples 1) Amusement Park  Pay to enter  Pay for rides and food within the park 2) Tennis Club  Pay to join  Pay to play Chapter 11 Slide The Two-Part Tariff  Pricing decision is setting the entry fee (T) and the usage fee (P)  Choosing the trade-off between freeentry and high use prices or high-entry and zero use prices Chapter 11 Slide Two-Part Tariff with a Single Consumer $/Q T* Usage price P*is set where MC = D Entry price T* is equal to the entire consumer surplus MC P* D Quantity Chapter 11 Slide Two-Part Tariff with Two Consumers $/Q T* The price, P*, will be greater than MC Set T* at the surplus value of D2 π = 2T * + ( P * − MC ) x(Q1 + Q2 ) π more than twice ABC A P* MC B C D1 = consumer D2 = consumer Q2 Chapter 11 Q1 Quantity Slide The Two-Part Tariff  The Two-Part Tariff With Many Different 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: High sales and falling profit with lower price and more entrants Chapter 11 Slide The Two-Part Tariff  The Two-Part Tariff With Many Different Consumers  To find optimum combination, choose several combinations of P,T  Choose the combination that maximizes profit Chapter 11 Slide 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 Chapter 11 Slide Summary  Firms with market power are in an enviable position because they have the potential to earn large profits, but realizing that potential may depend critically on the firm’s pricing strategy  A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible Chapter 11 Slide Summary  Ideally, the firm would like to perfectly price discriminate  The two-part tariff is another means of capturing consumer surplus Chapter 11 Slide End of Chapter 11 Pricing with Market Power ... Price Discrimination and Peak-Load Pricing  The Two-Part Tariff Chapter 11 Slide Introduction  Pricing without market power (perfect competition) is determined by market supply and demand  The... price Chapter 11 Slide Intertemporal Price Discrimination and Peak-Load Pricing Peak-Load Pricing Peak-Load Pricing  MR is not equal for each market because one market does not impact the other market. .. producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits Chapter 11 Slide Introduction  Pricing with market power (imperfect competition) requires