TSN 10
Monday, April 25, 2022
8:36 AM
Outline
- Basic pricing strategies
○ Review of the basic rule for profit maximization
○ A simple pricing rule for monopoly and monopolistic competition
○ A simple pricing rule for Cournot oligopoly
- Strategies that yield even greater profits
○ Extracting surplus from consumers
○ Pricing strategies for special cost and demand structures
○ Pricing strategies in markets with intense price competition
Introduction
- Focus on pricing strategies in environments where firms have some market power
- Many of these strategies permit firms to earn profits that are greater than those of a single-price
monopolist
○ Price discrimination
○ Two-part pricing
○ Block pricing
○ Commodity bundling
○ Peak-load pricing
Review of Basic Profit Maximization
- Firms with market power face a downward- sloping demand
○ There is a tradeoff b/w selling many units at a low price and selling few units at a high price
- Managers of firms with market power balance these competing forces by selecting the quantity
that equates MR and MC, and charging the max price that consumer will pay for this level of
output
- 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 profit-maximizing level of output and price for this firm?
○ R=P*C
○ MR= 10-4Q
○ MC= 2
○ 10 - 4Q = 2
○ 4Q=8
○ Q=2
○ P= $6
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 the 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
price (markup) is computed from
○
○ Where
○
○ So set price such that

○ Suppose, 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?
 (-4/1-4)* 5/4
 4/3 * 5/4=5/3
 P= $1.67
Simple Pricing Rule: 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
○
○ Where E is the market elasticity of demand
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 3 categories
○ Pricing strategies
 That extract surplus from consumers
□ Price discrimination, two part, block, commodity bundling
 For special cost and demand structures
□ Peak load, cross subsidy, transfer
 In markets with intense price competition
□ Price matching, randomized
Models that Extract Surplus from Consumers
- Covers
○ Price discrimination (first, second, and third degrees)
○ Two-part pricing
○ Block pricing
○ Commodity pricing
- Each strategy is appropriate for firms with various cost structures and degrees of market
interdependence
Surplus Extraction: 1st Degree Price Discrimination
- Price discrimination is the practice of charging different prices to consumers for the same good or
service
- 1st degree price discrimination is the practice of charging each consumer the maximum price they
would be willing to pay for each unit of the good purchased
○ Implies 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
-
Surplus Extraction: 2nd Degree Price Discrimination
- Second degree price discrimination is the practice of posting a discrete schedule of declining
prices for different ranges of quantity
○ Implies firm extracts some surplus from consumers without needing to know the identity of
various consumers' demand
-
○ First charge 7.6 for the first units then charge 5.2 for the next few units
 Don’t need to know how much consumer is willing to pay for a unit
 Can still extract some surplus
Surplus Extraction: 3rd Degree Price Discrimination
- Third degree price discrimination is the practice of charging different prices based on systematic
differences in demand across demographic consumer groups
○ Implies marginal revenue will be different for each group. That is if there are two groups,
MR1 > MR2 for example
- To maximize profits, a firm with market power produces the output at which the marginal revenue
(left) to each group equals marginal cost
-
- Suppose, 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?
○ 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.
○ PL= (-4/1-4)*6=$8
○ PD= (-2/1-2)*6=$12
Surplus Extraction: Two-Part Pricing
- 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
-
○ Total revenue is the are of the triangle and the rectangle under the triangle
 32+16=48
○ Total cost is the rectangle
 16
○ Total profit is the triangle
 32
 Entire consumer surplus is extracted as profit
Surplus Extraction: Block Pricing
- 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
one package
-
Surplus Extraction: Commodity Bundling
- 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
- How does the manager price a computer and monitor?
○ Price separately
 Charge 1500 for the computer and 200 for monitors
 Profit (assuming zero cost) is 2*1500 + 2*200=3400
○ Commodity bundling
 Charge 1800 for a bundle of computer and monitor
 Profit is 2*1800=3600
Special Demand and Costs: Peak-Load Pricing
- Higher prices are charged during peak hours than during off-peak hours
-
Special Demand and Costs: Cross-Subsidies
- Profits gained from the sale of one product are used to subsidize sales of a related product
- Principle
○ Whenever demands for 2 products produced by a firm are interrelated thru costs or
demand, the firm may enhance profits by cross-subsidization: selling one product at or
below cost and the other above cost
Intense Price Competition: Price Matching
- 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 homogeneousproduct, 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 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
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
Intense Price Competition: Randomized Pricing
- A firm intentionally varies its price in an attempt to "hide" price information from consumers and
rivals
- Benefits 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
Conclusion
- 1st degree price discrimination, block pricing, and two-part pricing permit the firm to extract all
consumer surplus
- Commodity bundling, 2nd and 3rd degree price discrimination permit a firm to extract some (but
not all) consumer surplus
- Different strategies require different information