Chapter 12 Capturing Surplus Chapter Twelve Overview 1.Introduction: Airline Tickets 3.Price Discrimination • First Degree • Second Degree • Third Degree 5.Tie-in Sales • Requirements Tie-ins • Package Tie-ins (Bundling) Chapter Twelve Uniform Price Vs Price Discrimination Definition: A monopolist charges a uniform price if it sets the same price for every unit of output sold While the monopolist captures profits due to an optimal uniform pricing policy, it does not receive the consumer surplus or dead-weight loss associated with this policy The monopolist can overcome this by charging more than one price for its product Definition: A monopolist price discriminates if it charges more than one price for the same good or service Chapter Twelve Forms of Price Discrimination Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay This willingness to pay is directly observable by the monopolist Definition: A policy of second degree price discrimination allows the monopolist to offer consumers a quantity discount Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed Chapter Twelve “Willingness to Pay” Curve Definition: The consumer's maximum willingness to pay is called the consumer's reservation price Think of the demand curve as a "willingness to pay" curve If the monopolist can observe the willingness to pay of each customer (based on, for example, residence, education, "look", etc), then the monopolist can observe demand perfectly and can "perfectly" price discriminate Chapter Twelve Forms of Price Discrimination Definition: A policy of first degree (or perfect) price discrimination prices each unit sold at the consumer's maximum willingness to pay This willingness to pay is directly observable by the monopolist Chapter Twelve Uniform Price Vs Price Discrimination Uniform Price Monopoly 1st Degree P.D Monopoly Price CS: E+F PS: G+H+K+L E+F+G+H+J+K+L+N TS: E+F+G+H+K+L E+F+G+H+J+K+L+N DWL: J+N PU E F G P1 K H MC J N L MR D Quantity Chapter Twelve Is it Reasonable? Buying a Car The monopolist will continue selling units until the reservation price exactly equals marginal cost Therefore, a perfectly price discriminating monopolist will produce and sell the efficient quantity of output Note: Only if the monopolist can prevent resale can the monopolist capture the entire surplus Chapter Twelve Pricing Surplus – Monopoly MC = P = 20 - Q What is producer surplus if uniform pricing is followed? MR = P + (∆P/∆Q)Q = 20 - Q - Q = 20 - 2Q MR = MC => 20 - 2Q = => Q* = P* = 11 PS= Revenue-TVC = PQ-2Q = 11(9)-2(9) = 81 Chapter Twelve Pricing Surplus – Monopoly What will producer surplus be if the monopolist perfectly price discriminates? P = MC => 20 - Q = =>Q* = 18 Revenue - TVC = [18(20-2)(1/2) + 18(2)]18(2) = 162 This is a gain in captured surplus of 81! Chapter Twelve Block Pricing If the monopolist could set a different block price for each customer, it would capture the same amount of surplus as a perfectly price discriminating monopolist Chapter Twelve Utility Pricing D - small D - large MC Chapter Twelve Q Utility Pricing D - small D - large Additional CS P1 Additional PS P2 MC Q1s Q1L Q2L Chapter Twelve Q Third Degree Price Discrimination Definition: A policy of third degree price discrimination offers a different price for each segment of the market (or each consumer group) when membership in a segment can be observed Example: Movie ticket sales to older people or students at discount • Suppose that marginal costs for the two markets are the same How does a monopolist maximize profit with this type of price discrimination? Chapter Twelve Optimal Pricing Set the marginal revenue in each market equal to marginal cost (i.e., the monopolist maximizes total profits by maximizing profits from each group individually.) This implies that MR1 = MC = MR2 at the optimum Otherwise, the monopolist could raise revenues by switching sales from the low MR group to the high MR group MC = AC = 20 Example P1 = 100 - Q1 P2 = 80 - 2Q2 Chapter Twelve Optimal Pricing MR1 = 100 - 2Q1 = MC = 20 MR2 = 80 - 4Q2 = MC = 20 Q1* = 40 Q2* = 15 Example P1* = 60 P2* = 50 Chapter Twelve Third Degree Price Discrimination P 100 P Market Demand 80 60 Market Demand 50 20 MR1 100 Q Chapter Twelve 20 MR2 40 Q Tie-in Sales – Requirements Definition: A tie-in sale occurs if customer can buy one product only if they agree to purchase another product as well • Requirements tie-in sales occur when a firm requires customers who buy one product from the firm to buy another product from the firm A requirements tie-in sale may be used in place of price discrimination when the firm cannot observe the relative willingness to pay of different customers Chapter Twelve Tie-in Sales – Bundling • Package tie-in sales (or bundling) occur when goods are combined so that customers cannot buy either good separately Bundling may be used in place of price discrimination to increase producer surplus when consumers have different willingness to pay for the goods sold in the bundle But bundling does not always pay… Chapter Twelve Tie-in Sales – Bundling Negatively Correlated Preferences Reservation Price Computer Monitor Customer $1,200 $600 Customer $1,500 $400 Marginal Cost $1,000 $300 Chapter Twelve Tie-in Sales – Bundling Optimal Pricing Policy Without bundling: pc = $1500 pm = $600 • Profit cm = $800 With bundling: pb = $1800 • Profit b = $1000 Chapter Twelve Tie-in Sales – Bundling Positively Correlated Preferences Reservation Price Computer Monitor Customer $1,200 $400 Customer $1,500 $600 Marginal Cost $1,000 $300 Chapter Twelve Tie-in Sales – Bundling Optimal Pricing Policy Without bundling: pc = $1500 pm = $600 • Profit cm = $800 With bundling: pb = $2100 • Profit b = $800 In general, bundling a pair of goods only pays if their demands are negatively correlated (customers who are willing to pay relatively more for good A are not willing to pay as much for good B) Chapter Twelve Reservation Price The reason is that the price is determined by the purchaser with the lowest reservation price If reservation prices for the two goods are negatively correlated, bundling reduces the dispersion of reservation prices and so raises the price at which additional units can be sold Chapter Twelve Advertising The firm can capture surplus using nonprice strategies such as advertising Chapter Twelve ... Two steps: (1) maximize the benefits to the consumers by charging r = MC = 10 (2) capture this benefit by setting F = consumer benefits = 4050 Chapter Twelve Two Part Tariff Any higher usage charge... Discrimination 100 70 Single Price Monopoly 100 Demand Demand 450 55 450 40 2700 1 012. 5 2025 450 10 P 30 60 100 Q Chapter Twelve 1 012. 5 45 MR MC 100 Q Block Pricing If the monopolist could set a different... discriminating monopolist Chapter Twelve Utility Pricing D - small D - large MC Chapter Twelve Q Utility Pricing D - small D - large Additional CS P1 Additional PS P2 MC Q1s Q1L Q2L Chapter Twelve Q Third