Chapter 11
Pricing with
Market Power
Topics to be Discussed

Capturing Consumer Surplus

Price Discrimination

Intertemporal Price Discrimination and
Peak-Load Pricing
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
PC is the price
that would exist in
a perfectly competitive
market.
P2
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
Price Discrimination

First Degree Price Discrimination

Chapter 11
Charge a separate price to each customer:
the maximum or reservation price they are
willing to pay.
Slide 6
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 7
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 8
Price Discrimination

First Degree Price Discrimination

Chapter 11
Examples of imperfect price discrimination
where the seller has the ability to
segregate the market to some extent and
charge different prices for the same
product:
 Lawyers, doctors, accountants

Car salesperson (15% profit margin)

Colleges and universities
Slide 9
First-Degree Price
Discrimination in Practice
Six prices exist resulting
in higher profits. With a single price
P*4, there are fewer consumers and
those who now pay P5 or P6 may have a surplus.
$/Q
P1
P2
P3
MC
P*4
P5
P6
D
MR
Q
Chapter 11
Quantity
Slide 10
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 13
Price Discrimination

Third Degree Price Discrimination
3) Most common type of price
discrimination.

Chapter 11
Examples: airlines, liquor, vegetables,
discounts to students and senior
citizens.
Slide 14
Price Discrimination

Third Degree Price Discrimination
4) Third-degree price discrimination is
feasible when the seller can
separate his/her market into groups
who have different price elasticities
of demand (e.g. business air
travelers versus vacation air
travelers)
Chapter 11
Slide 15
Price Discrimination

Third Degree Price Discrimination

Chapter 11
Objectives

MR1 = MR2

MR1 = MR2 = MC
Slide 16
Price Discrimination

Third Degree Price Discrimination

Determining relative prices
Recall : MR  P1  1 Ed 
Then : MR1  P1 (1  1 E1 )  MR2  P2 (1  1 E2 )
P1 (1  1 E2 )
And :

P2 (1  1 E1 )
Chapter 11
Slide 17
Price Discrimination

Third Degree Price Discrimination

Chapter 11
Pricing: Charge higher price to group with
a low demand elasticity
Slide 18
Price Discrimination

Third Degree Price Discrimination

Example: E1 = -2 & E2 = -4
3
P1 (1  1 4)

 4  1.5
P2 (1  1 2) 1
2

Chapter 11
P1 should be 1.5 times as high as P2
Slide 19
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 20
Third-Degree Price Discrimination
$/Q
•QT: MC = MRT
•Group 1: P1Q1 ; more inelastic
•Group 2: P2Q2; more elastic
•MR1 = MR2 = MC
•MC depends on QT
P1
MC
P2
D2 = AR2
MRT
MR2
D1 = AR1
MR1
Q1
Chapter 11
Q2
QT
Quantity
Slide 21
The Economics of Coupons and Rebates
Price Discrimination

Those consumers who are more price
elastic will tend to use the
coupon/rebate more often when they
purchase the product than those
consumers with a less elastic demand.

Coupons and rebate programs allow
firms to price discriminate.
Chapter 11
Slide 22
Price Elasticities of Demand for Users
Versus Nonusers of Coupons
Price Elasticity
Product
Nonusers
Users
Toilet tissue
-0.60
-0.66
Stuffing/dressing
-0.71
-0.96
Shampoo
-0.84
-1.04
Cooking/salad oil
-1.22
-1.32
Dry mix dinner
-0.88
-1.09
Cake mix
-0.21
-0.43
Chapter 11
Slide 23
Price Elasticities of Demand for Users
Versus Nonusers of Coupons
Price Elasticity
Product
Nonusers
Users
Cat food
-0.49
-1.13
Frozen entrée
-0.60
-0.95
Gelatin
-0.97
-1.25
Spaghetti sauce
-1.65
-1.81
Crème rinse/conditioner
-0.82
-1.12
Soup
-1.05
-1.22
Hot dogs
-0.59
-0.77
Chapter 11
Slide 24
The Economics of Coupons and Rebates

Cake Mix
 Nonusers
 Users:
Chapter 11
of coupons: PE = -0.21
PE = -0.43
Slide 25
The Economics of Coupons and Rebates

Cake Mix Brand (Pillsbury)


PE Pillsbury 8 to 10 times PE all cake mix
Example: elasticity of demand for Pillsbury
cake mix

PE Users of coupons: -4
(-0.43 all cake mix)

PE Nonusers: -2
(-0.21 all cake mix)
Chapter 11
Slide 26
The Economics of Coupons and Rebates
P1 (1  1 E2 )

P2 (1  1 E1 )

Using:

Price of nonusers should be 1.5 times
users
 Or,
if cake mix sells for $1.50, coupons
should be 50 cents
Chapter 11
Slide 27