# Perfect Price Discrimination Discussion

### Description

## Topic: Perfect price discrimination

In a perfect price discrimination case what happens to consumer surplus?

**PROFESSOR’S GUIDANCE FOR THIS WEEK’S LE:**

We have talked about consumer surplus before and its importance. Also, we saw that in a monopoly consumer gets a lower share of surplus than in a competitive market. The difference is captured by the monopolist. Here we want to see what happens to consumer surplus in a perfect price discrimination scenario.

**1. Please make sure that you read the relevant chapter from the textbook**

**2. Watch the YouTube videos for this week and additional course material provide**

NOTE:

- post your 300-400 word
- Offer at least two 100-200 word comments (replies) to posts from your peers’ discussions
- you will be graded using the following rubric and standard

Explanation & Answer length: 300 Words.

CHAPTER 11 Pricing Strategies for Firms with Market Power © 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives 1. Apply simple elasticity-based markup formulas to determine profit-maximizing prices in environments where a business enjoys market power, including monopoly, monopolistic competition, and Cournot oligopoly. 2. Formulate pricing strategies that permit firms to extract additional surplus from consumers—including price discrimination, two-part pricing, block pricing, and commodity bundling—and explain the conditions needed for each of these strategies to yield higher profits than standard pricing. 3. Formulate pricing strategies that enhance profits for special cost and demand structures—such as peak-load pricing, cross-subsidies, and transfer pricing—and explain the conditions needed for each strategy to work. 4. Explain how price-matching guarantees, brand loyalty programs, and randomized pricing strategies can be used to enhance profits in markets with intense price competition.

© 2017 by McGraw-Hill Education. All Rights Reserved. 2 Basic Pricing Strategies Review of Basic Profit Maximization • Firms with market power face a downwardsloping demand. – Implication: there is a trade-off between selling many units at a low price and selling a few units at a high price. • Managers of firms with market power balance these competing forces by selecting the quantity that equates marginal revenue 𝑀𝑅 and marginal cost 𝑀𝐶 , and charging the maximum price that consumer will pay for this level of output. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-3 Basic Pricing Strategies Basic Profit Maximization In Action • Suppose the (inverse) demand for a firm’s product is given by 𝑃 = 10 − 2𝑄 and the cost function is 𝐶 𝑄 = 2𝑄. What is the profitmaximizing level of output and price for this firm?

• Answer: – The marginal revenue function is: 𝑀𝑅 = 10 − 4𝑄. – The marginal cost function is: 𝑀𝐶 = 2. – Equating these two functions yields 10 − 4𝑄 = 2, so 𝑄 = 2. The profit-maximizing price is 𝑃 = 10 − 2 2 = $6. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-4 Basic Pricing Strategies Simple Pricing Rule: Monopoly and Monopolistic Competition • What if estimates of the demand and cost functions are not available? – Managers have a “crude” estimate of • marginal cost; the price paid to a supplier. • the price elasticity of demand, since it is typically available for a representative firm in an industry. • With this information, the monopoly and monopolistically competitive firm’s profit-maximizing 1+𝐸𝐹 price (markup) is computed from: MC = 𝑃 𝐸𝐹 , where 𝑀𝑅 = 𝑃 1+𝐸𝐹 𝐸𝐹 . • So, set price such that: 𝑃 = 𝐸𝐹 1+𝐸𝐹 𝑀𝐶. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-5 Basic Pricing Strategies Simple Pricing Rule In Action: Problem • The manager of a convenience store competes in a monopolistically competitive market and buys cola from a supplier at a price of $1.25 per liter. The manager thinks that because there are several supermarkets nearby, the demand for cola sold at her store is slightly more elastic than the elasticity for the representative food store. Specifically, the elasticity of demand for cola sold by her store is −4. What price should the manager charge for a liter of cola to maximize profits? © 2017 by McGraw-Hill Education. All Rights Reserved.

11-6 Basic Pricing Strategies Simple Pricing Rule In Action: Answer • The marginal cost of cola to the firm is $1.25, or 4 5Τ per liter, and the markup factor is 4 = . 4 1−4 3 • The profit-maximizing pricing rule for a monopolistically competitive firm is: 4 5 5 𝑃= = 3 4 3 , or about $1.67 per liter. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-7 Basic Pricing Strategies Simple Pricing Rule for Cournot Oligopoly • When each of the 𝑁 firms operating in a Cournot oligopoly has identical cost structures and produces similar products, the simple profit-maximizing price (markup) in Cournot equilibrium is: 𝑁𝐸𝑀 𝑃= 𝑀𝐶 1 + 𝑁𝐸𝑀 , where 𝐸𝑀 is the market elasticity of demand. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-8 Strategies that Yield Even Greater Profits Beyond the Single-Price-Per-Unit Model • In some markets, managers can enhance profits beyond those resulting from charging all consumers a single, per-unit price. • Models that yield greater profits fall into three categories: – Pricing strategies: • that extract surplus from consumers. • for special cost and demand structures.

• in markets with intense price competition. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-9 Strategies that Yield Even Greater Profits Models that Extract Surplus from Consumers • Strategies for surplus extraction: – Price discrimination (first, second and third degrees) – Two-part pricing – Block pricing – Commodity bundling • Each strategy is appropriate for firms with various cost structures and degrees of market interdependence. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-10 Strategies that Yield Even Greater Profits Surplus Extraction: First-Degree Price Discrimination • Price discrimination is the practice of charging different prices to consumers for the same good or service. • First-degree price discrimination is the practice of charging each consumer the maximum price he or she would be willing to pay for each unit of the good purchased. – Implication: the firm extracts all surplus from consumers and earns the highest possible profit. • Problem: managers rarely know each consumers’ maximum willingness to pay for each unit of the product. © 2017 by McGraw-Hill Education. All Rights Reserved.

11-11 Strategies that Yield Even Greater Profits First-Degree Price Discrimination Price $10 MC Firm profit under first-degree price discrimination $4 Demand 5 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 11-12 Strategies that Yield Even Greater Profits Surplus Extraction: Second-Degree Price Discrimination • Second-degree price discrimination is the practice of posting a discrete schedule of declining prices for different ranges of quantity. – Implication: firm extracts some surplus from consumers without needing to know the identity of various consumers’ demand. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-13 Strategies that Yield Even Greater Profits Second-Degree Price Discrimination Price $10 MC $7.60 Contribution to profits under second-degree price discrimination $5.20 Demand 2 4 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 11-14 Strategies that Yield Even Greater Profits Surplus Extraction: Third-Degree Price Discrimination • Third-degree price discrimination is the practice of charging different prices based on systematic differences in demand across demographic consumer groups. – Implication: marginal revenue will be different for each group. That is, if there are two groups, 𝑀𝑅1 > 𝑀𝑅2 , for example.

© 2017 by McGraw-Hill Education. All Rights Reserved. 11-15 Strategies that Yield Even Greater Profits Surplus Extraction: Third-Degree Price Discrimination Rule • To maximize profits, a firm with market power produces the output at which the marginal revenue (left-hand side of the following equations) to each group equals marginal cost. 1 + 𝐸1 𝑃1 = 𝑀𝐶 𝐸1 1 + 𝐸2 𝑃2 = 𝑀𝐶 𝐸2 © 2017 by McGraw-Hill Education. All Rights Reserved. 11-16 Strategies that Yield Even Greater Profits Third-Degree Price Discrimination Rule In Action: • You are the manager of a pizzeria that produces at a marginal cost of $6 per pizza. The pizzeria is a local monopoly near campus. During the day, only students eat at your restaurant.

In the evening, while students are studying, faculty members eat there. If students have an elasticity of demand for pizza of −4 and faculty has an elasticity of demand of −2, what should your pricing policy be to maximize profits? © 2017 by McGraw-Hill Education. All Rights Reserved. 11-17 Strategies that Yield Even Greater Profits Third-Degree Price Discrimination Rule In Action: • Assuming faculty would be unwilling to purchase cold pizzas from students, the conditions for effective third-degree price discrimination hold. It will be profitable to charge a “lunch menu” price and a “dinner menu” price. These prices are determined as follows: 1−4 𝑃𝐿 = $6 −4 1−2 𝑃𝐷 = $6 −2 • Solving these equations yield, 𝑃𝐿 = $8 and 𝑃𝐿 = $12. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-18 Strategies that Yield Even Greater Profits Surplus Extraction: Two-Part Pricing • Two-part pricing is a pricing strategy whereby a firm with market power charges a fixed fee for the right to purchase its goods, plus a per-unit charge for each unit purchased.

© 2017 by McGraw-Hill Education. All Rights Reserved. 11-19 Strategies that Yield Even Greater Profits Two-Part Pricing Price $10 Fixed fee = $32 = profits Consumer surplus = $0 Per-unit fee = $2 $2 MC = AC Demand 8 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 11-20 Strategies that Yield Even Greater Profits Surplus Extraction: Block Pricing • Block pricing is a pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-or-none decision to purchase. – The profit-maximizing price on a package is the total value the consumer receives for the package. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-21 Strategies that Yield Even Greater Profits Block Pricing Price $10 Price charged for a block of 8 units = $48 Profit with block pricing = $32 $2 MC = AC Demand 8 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 11-22 Strategies that Yield Even Greater Profits Surplus Extraction: Commodity Bundling • Commodity bundling is the practice of bundling several different products together and selling them at a single “bundle price.” – Key assumption: Consumers differ with respect to the amounts they are willing to pay for multiple products sold by a firm. – Managers cannot observe different consumers’ valuations. © 2017 by McGraw-Hill Education. All Rights Reserved.

11-23 Strategies that Yield Even Greater Profits Pricing Strategies for Special Cost and Demand Structures: Peak-Load Pricing • Peak-load pricing is a pricing strategy in which higher prices are charged during peak hours than during off-peak hours. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-24 Strategies that Yield Even Greater Profits Special Demand and Costs: Peak-Load Pricing Price MC 𝑃𝐻 Demand High 𝑃𝐿 MR High MR Low 𝑄𝐿 Demand Low 𝑄𝐻 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 11-25 Strategies that Yield Even Greater Profits Special Demand and Costs: Cross-Subsidies • Cross-subsidy is a pricing strategy in which profits gained from the sale of one product are used to subsidize sales of a related product. • Cross-Subsidization Principle: – Whenever the demands for two products produced by a firm are interrelated through costs or demand, the firm may enhance profits by cross-subsidization: selling one product at or below cost and the other product above cost. © 2017 by McGraw-Hill Education. All Rights Reserved.

11-26 Strategies that Yield Even Greater Profits Special Demand and Costs: Transfer Pricing • Transfer pricing is a pricing strategy in which a firm optimally sets the internal price at which an upstream division sells an input to a downstream division. – Important since most division managers are provided an incentive to maximize their own division’s profits. – Transfer pricing aligns division manager’s incentives with that of the overall firm, and increases overall firm’s profit. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-27 Strategies that Yield Even Greater Profits Special Demand and Costs: Double Marginalization • Consider a large firm with two divisions: – upstream division is the sole provider of a key input. – downstream division uses the input produced by the upstream division to produce the final output. • Upstream division has market power and incentive to maximize divisional profits leads managers to produce where 𝑀𝑅𝑈 = 𝑀𝐶𝑈 . – Implication: 𝑃𝑈 > 𝑀𝐶𝑈 . • A similar situation exists for the downstream division; profitmaximization leads to 𝑃𝐷 > 𝑀𝐶𝐷 . • Both divisions mark price up over marginal cost resulting in a phenomenon called double marginalization.

© 2017 by McGraw-Hill Education. All Rights Reserved. 11-28 Strategies that Yield Even Greater Profits Special Demand and Costs: Transfer Pricing Rule • Transfer pricing is used to overcome double marginalization. • A transfer pricing rule sets the internal price at which an upstream division sells inputs to a downstream division in order to maximize the overall firm profits. – Require the upstream division to produce such that its marginal cost, 𝑀𝐶𝑈 , equals the net marginal revenue (𝑁𝑅𝑀𝐷 ) to the downstream division: 𝑁𝑅𝑀𝐷 = 𝑀𝑅𝐷 − 𝑀𝐶𝐷 = 𝑀𝐶𝑈 © 2017 by McGraw-Hill Education. All Rights Reserved. 11-29 Strategies that Yield Even Greater Profits Intense Price Competition: Price Matching • Price matching is a strategy in which a firm advertises a price and a promise to match any lower price offered by a competitor. – Used to mitigate the stark outcome associated with firms competing in a homogeneous-product, Bertrand oligopoly. – Outcome: If all firms in the market adopt a price matching policy, all firms can set the monopoly price and earn monopoly profits; instead of the zero profits it would earn in the usual one-shot Bertrand oligopoly.

• Potential issues: – Dealing with false consumer claims of low prices. – Competitor’s with lower cost structures. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-30 Strategies that Yield Even Greater Profits Intense Price Competition: Inducing Brand Loyalty • Brand loyal customers continue to buy a firm’s product even if another firm offers a (slightly) better price. – Strategy used to mitigate the tension of Bertrand competition. • Methods for inducing brand loyalty. – Advertising campaigns. – “Frequent-buyer” programs. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-31 Strategies that Yield Even Greater Profits Intense Price Competition: Randomized Pricing • Randomized pricing is a strategy in which a firm intentionally varies its price in an attempt to “hide” price information from consumers and rivals. • Benefits of randomized pricing to firms: – Consumers cannot learn from experience which firm charges the lowest price in the market. – Reduces the ability of rival firms to undercut a firm’s price. • Not always profitable. © 2017 by McGraw-Hill Education. All Rights Reserved. 11-32

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