Pricing
A firm has control over the prices
only if it has some market power.
Pricing decisions are simple in the
perfectly competitive markets: just
sell at the market price.
Can a firm get more than
monopoly profits?
• Monopoly profit is the maximum
profit a firm can make if it charges
the same price for all consumers
• The profits can be increased if the
firm could charge higher prices to
the consumers that are willing to
pay more.
The simplest example of why price discrimination
is profitable. Slide 1
There are three consumers in the
market willing to pay 1, 2, and 3
dollars for an apple. What price
would a monopoly seller set to
maximize profits? Imagine that the
marginal cost is zero.
P
2
1
Cindy
Andy
Bob
3
Q
The price will be set at $2 because
at this price the monopolist can sell
2 apples and make $4 in profit
which is greater than $3 that the
monopolist could make by setting
the price at $1 or $3.
The simplest example of why price discrimination
is profitable. Slide 2
What if the monopolist knew exactly
how much each consumer is willing
to pay for an apple? Then the
monopolist could charge different
prices to different consumers and
sell 3 apples.
P
2
1
Cindy
Andy
Bob
3
The profit could reach
$3+$2+$1=$6
Q
A paradox of price discrimination.
Given MC=0, what is the socially
optimal level of output?
P
Socially optimal level of output is 3.
This level would be achieved if there
was perfect competition in the
market of apples.
2
1
Cindy
Andy
Bob
3
This is also the level of output when
a single monopolist can perfectly
price-discriminate!
Q
Price discrimination is socially
optimal! But (and it is a big one) all
the surplus goes to the producer.
Three types of price
discrimination
The practice of charging different prices to
consumers for the same good or service.
1. First degree price discrimination.
2. Second degree price discrimination.
3. Third degree price discrimination.
First degree price discrimination.
The practice of charging each consumer the
maximum amount she is willing and able to pay.
Examples:
- The manager of Suez Canal charges different
prices to different ships depending on their cargo,
alternative routes, and other characteristics.
-Car dealers.
- Amazon tried to use cookies to charge different
prices
Second degree price discrimination.
The practice of posting a discrete schedule of
declining prices for different ranges of quantities.
Examples:
- Family size boxes of cereals
- Anytime minutes in wireless plans
- Volume discounts
Intertemporal price discrimination.
The first consumers to buy the product might like
the new goods or know how to use it more
efficiently.
Examples:
- First USB Flash Drives, Laptops, and Digital Cameras were
extremely expensive.
- First computer were very expensive but there were firms
and agencies who bought it because their benefits were
larger than the cost.
- Couple years ago 4Mb Flash Memory ran for $2,999 (for
comparison, 1Mb costs $399). Only professionals were
buying it (now you can compare 1Gb and 128mb)
Third degree price discrimination.
Practice of charging different prices for different
groups of consumers based on an observable
characteristic.
Example:
-Why is the ticket from Chicago to Moscow with a
change of plane in Frankfurt, Germany, cheaper than
a ticket from Chicago to Frankfurt?
-Income per capita is higher in Germany and
therefore average German is willing and able to pay
more for the air fare. This characteristic is perfectly
observable by the destination of the trip
How to identify groups?
Coupons
Office and Office-Pro
DELL Inspiron for home users and DELL Latitude
for business users.
Insurance rates vary with the number of traffic
violations.
Red cars are sometimes more expensive to insure.
Reverse auctions at www.priceline.com
Professional handbooks: none else can actually
understand them.
Firm should be able to prevent resales.
High transaction costs: far remote markets.
Services: it is very difficult to resale a haircut.
Government barriers to resale: tariffs make resale
more costly.
Students are required to show a student ID to
enter a football game with a student ticket.
It is very difficult to buy a car in Canada and bring
it into the US.
The European Honda Accord is Acura in the US.
Is third degree price discrimination bad?
Example:
Drug companies have very low marginal cost of
producing drugs. They could increase profits by
selling to developing nations at lower price if
reimportation of those drugs back to the US could be
prevented.
The drug companies and the consumers in the
developing countries would be better off.
Why does the price of brand name drugs often rise when
equivalent generic brands enter the market?
(Perloff,2004)
Grabowski and Vernon (1992):
- A study of 18 major orally administered drugs
that faced entry of generic brands
- Generic brands captured 35% of sales in the first
year after introduction.
- The price of brand name drugs increased by 7%
Is any difference in price a sign of
price discrimination?
No, only difference in prices that cannot be
explained by the difference in costs.
Examples:
-Hardcover vs. paperback books
-International edition of M.Baye “Managerial Economics”
-Business class travel. The difference in prices can be larger than the
difference in costs
-PC with 128Mb of RAM and 512Mb of RAM. The price often differs
by more than the difference in component price.
-Optional umbrellas in the trunk of a Bentley will cost you $450
apiece.
-Volume discounts that do not reflect economies of scale
-Why restaurants can sell large drinks when refills are free?
Additional pricing strategies.
1.Two part pricing:
2. Block pricing:
Six flag pricing.
6-packs.
3. Commodity bundling:
4. Peak-load pricing:
PC and a monitor.
anytime/weekend minutes in cell phone plans
5. Randomized pricing:
weekly sales.
6. Inducing brand loyalty:
7. Cross-subsidization:
8. Price matching:
coupons for first time users of spin-brush
free wireless in coffee shops
Best buy vs. Circuit City
1.Two part pricing.
Examples:
- Disney Land
- Sam’s Club
- Coffee mugs with
discounted refills
1.Why two part pricing is profitable?
If Six Flags can charge $8 to enter the park and
then let the visitors ride for free, the profits will be
$8 instead of $4 if Six Flags charged monopoly price
$2 of per ride.
4
2
2
4
2. Block pricing.
Examples:
- 6-packs
- 12-24 rolls of toilet tissues
in one package
2. Why block pricing works?
What the firm sold in
packs of 2 only? You
can’t buy one unit.
4
2
2
4
3. Commodity bundling.
Examples:
- Microsoft Office
- Dell’s PC with a monitor
- Amazon’s free shipping
3. The rationale behind commodity bundling.
There are two consumers with the following
reservation prices for Word and Excel.
Their reservation prices for Office is the sum of the
two reservation prices.
Word
Excel
Ann
$100
$60
$160
Joe
$70
$80
$150
$70
$60
$150
$140
$120
$300
To maximize profits
monopolist will charge
Maximum
Profits
Office
3. Is commodity bundling always optimal?
Similarly the reservation price of the two consumers for
a flash-light and for batteries are in the table below.
However, in this case profits from a bundle are smaller.
Flash light
2 batteries
Ann
$5
$2
$7
Joe
$4
$0.5
$4.5
$4
$2
$4.5
$8
$2
$9
To maximize profits
monopolist will charge
Maximum
Profits
Bundle
3. A more general case of commodity bundling.
There are two goods: word processor and spreadsheet.
You are considering whether your firms should bundle
them and sell as office.
Their demands are given by the two curves below.
P
P
5
5
Q
Q
3. A more general case of commodity bundling.
The combined demand curve will show how much
consumers are willing to pay for a unit of “word processor
+spreadsheet”. Therefore the two curves have to be
added up vertically to get the demand curve for the
“office”.
P
10
5
Q
4. Peak-load pricing.
Examples:
-Airlines charge holiday premiums on airline travel
-Hotels are more expensive in the summer
-Roses around Valentines
Peak-load pricing is widely used because
the demand of all consumers increases at
the same time. The firm does not have
to be able to single out consumes with
different demands.
4. Peak-load pricing.
Why we do not see peak-load pricing during
Christmas sales?
- Higher prices can be hidden behind lowpriced door busters
- At Christmas there are more people willing to
buy the good who are not necessarily willing to
pay more
- Most of the goods are durables and can be
purchased in advance
5. Randomized pricing.
Randomized pricing allows for the firms to make
producer’s “shop” for the better price.
One store has a sale this week while the other one
a sale next week. This way the consumers are
encouraged to check out the sales.
Example:
Best Buy vs. Circuit City
Pay Less vs. Marsh
6. Inducing brand loyalty.
(Experience goods)
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SpinBrush®.
7. Cross-subsidization.
Examples:
- free wireless in coffee shops
- Adobe’s free Acrobat Reader
- P&G and Black&Decker combine to
provide low cost coffee makers in order to
boost sales of ground coffee
8. Price matching.
Examples:
- BestBuy matches the price of any
competitor
- Meijer’s price matching policy
8. Price matching.
How do we know if the firms are engaging a fierce
price competition or they are just watching each
other?
- It is difficult because both involve price
matching.
- Some times the price matching includes a
clause about identical product. If Best Buy
carries Centon brand memory and Circuit City
carries PNY memory they do not have to price
match.
So. Why is popcorn more
expensive in the movie theaters?