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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.

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

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

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.)

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.

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 discrimination*	$200	$50	$250

*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.

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.

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.

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.

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.

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 M R1, M R2, M R3, and M R4 ($6, $5, $4, and $3). 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 $6 ($18 − $12).

Figure 10.1 Perfect Price Discrimination

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, e c, 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.

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

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.

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.

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.

Figure 10.3 Group Pricing of the Tesla S Car

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 (π = π A + π E). 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

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,

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).

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.

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.

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.

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).

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.

Figure 10.4 Block Pricing

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.

Figure 10.5 Two-Part Pricing with Identical Consumers

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 1,800 = A1 , which is Valerie’s C S. π = 5,000

Figure 10.6 Two-Part Pricing with Different Consumers

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.

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.

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.

Table 10.2 Negatively Correlated Reservation Prices

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

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.

Table 10.3 Positively Correlated Reservation Prices

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

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.

Table 10.4 Reservation Prices and Mixed Bundling

Blank	Word Processor	Spreadsheet	Bundle
Aaron	$120	$30	$150
Brigitte	$110	$90	$200
Charles	$90	$110	$200
Dorothy	$30	$120	$150

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.

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.

10.7 Peak-Load Pricing (1 of 3)

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 M C = 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.

Figure 10.7 Peak-Load Pricing

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.

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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