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 2


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 3


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 4


Capturing Consumer Surplus

$/Q

Pmax

Between 0 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 5


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 6


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 7


Capturing Consumer Surplus



Price discrimination is the charging of
different prices to different consumers
for similar goods.

Chapter 11

Slide 8


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 9


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
0 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


Additional Profit From Perfect FirstDegree Price Discrimination

$/Q

Pmax

Consumer surplus when a
single price P* is charged.

With perfect discrimination
• Each customer pays their
reservation price
•Profits increase

Variable profit when a
single price P* is charged.
MC

P*

Additional profit from
perfect price discrimination


PC

D = AR

MR
Q*

Q**

Quantity

Chapter 11

Slide


Additional Profit From Perfect FirstDegree Price Discrimination


Question
 Why

would a producer have difficulty in
achieving first-degree price discrimination?



Answer
1) Too many customers (impractical)

2) Could not estimate the reservation
price for each customer
Chapter 11

Slide


Second-Degree Price Discrimination


Practice of charging different prices per
unit for different quantities of the same
good or service

Chapter 11

Slide


Second-Degree Price Discrimination
Second-degree price
discrimination is pricing
according to quantity
consumed--or in blocks.

$/Q
P1

Without discrimination: P = P0
and Q = Q0. With second-degree

discrimination there are three
prices P1, P2, and P3.
(e.g. electric utilities)

P0

P2

AC
P3

MC

D
MR
Q1

1st Block

Q0

Q2

Q3

2nd Block 3rd Block

Quantity



Second-Degree Price Discrimination
$/Q
Economies of scale permit:
•Increase consumer welfare
•Higher profits

P1
P0

P2

AC
P3

MC

D
MR
Q1

1st Block

Q0

Q2

Q3

2nd Block 3rd Block


Quantity


Price Discrimination


Third Degree Price Discrimination
1) Divides the market into two-groups.
2) Each group has its own demand
function.

Chapter 11

Slide


Third-Degree Price Discrimination
$/Q

Consumers are divided into
two groups, with separate
demand curves for each group.

MRT = MR1 + MR2

D2 = AR2
MRT
MR2
MR1


D1 = AR1
Quantity

Chapter 11

Slide


Third-Degree Price Discrimination
$/Q

MC = MR1 = MR2

P1

•QT: MC = MRT
•Group 1: P1Q1 ; more inelastic
•Group 2: P2Q2; more elastic
•MR1 = MR2 = MC

MC

P2

D2 = AR2
MRT
MR2
D1 = AR1

MR1

Q1

Q2

Chapter 11

QT

Quantity

Slide


Intertemporal Price
Discrimination and Peak-Load Pricing


Separating the Market With Time
 Initial

release of a product, the demand is
inelastic


Book



Movie




Computer

Chapter 11

Slide


Intertemporal Price
Discrimination and Peak-Load Pricing


Separating the Market With Time
 Once

this market has yielded a maximum
profit, firms lower the price to appeal to a
general market with a more elastic demand


Paper back books



Dollar Movies



Discount computers


Chapter 11

Slide


Intertemporal Price Discrimination
Consumers are divided
into groups over time.
Initially, demand is less
elastic resulting in a
price of P1 .

$/Q
P1

Over time, demand becomes
more elastic and price
is reduced to appeal to the
mass market.

P2

D2 = AR2
AC = MC

MR1

MR2


D1 = AR1

Q1

Chapter 11

Q2

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