Managerial Economics & Business
Strategy
Chapter 11
Pricing Strategies for
Firms with Market
Power
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Overview
I. Basic Pricing Strategies
– Monopoly & Monopolistic Competition
– Cournot Oligopoly
II. Extracting Consumer Surplus
– Price Discrimination
– Block Pricing
Two-Part Pricing
Commodity Bundling
III. Pricing for Special Cost and Demand
Structures
– Peak-Load Pricing
– Cross Subsidies
Transfer Pricing
IV. Pricing in Markets with Intense Price
Competition
– Price Matching
– Brand Loyalty
Randomized Pricing
11-2
Pricing Strategies
 Firms with market power have some
influence over the prices they charge.
 Optimal pricing strategies vary depending
on the underlying market structure and the
instruments available to influence demand
(advertising).
11-3
Standard Pricing and Profits for Firms
with Market Power
Price
Profits from standard pricing
= $8
10
8
6
4
MC
2
P = 10 - 2Q
1
2
3
4
5
MR = 10 - 4Q
Quantity
11-4
Profit Max
 Firms with market power face downward
sloping demand curves for their product.
 Profit maximizing price is the maximum
price that consumers will pay for this level
of output.
11-5
An Algebraic Example
 P = 10 - 2Q
 C(Q) = 2Q
 If the firm must charge a single price to all
consumers, the profit-maximizing price is
obtained by setting MR = MC.
 10 - 4Q = 2, so Q* = 2.
 P* = 10 - 2(2) = 6.
 Profits = (6)(2) - 2(2) = $8.
11-6
Using Demand and Elasticity in Pricing
Decisions
 For small producers that lack detailed
information about demand publically
available information must suffice.
 General information about demand and
elasticities can be used to effect pricing
decisions.
 A simple markup rule follows:
11-7
A Simple Markup Rule
 Suppose the elasticity of demand for the
firm’s product is EF.
 Since MR = P[1 + EF]/ EF.
 Setting MR = MC and simplifying, yields
this simple pricing formula:
P = [EF/(1+ EF)]  MC.
 The optimal price is a simple markup
over relevant costs!
– More elastic the demand, lower markup.
– Less elastic the demand, higher markup.
11-8
An Example






Elasticity of demand for Kodak film is -2.
P = [EF/(1+ EF)]  MC
P = [-2/(1 - 2)]  MC
P = 2  MC
Price is twice marginal cost.
Fifty percent of Kodak’s price is margin
above manufacturing costs.
11-9
Mark Up
 Important points:
 The more elastic the demand for the
firm’s product the lower the profit
maximizing markup.
 The higher the MC the higher the price.
11-10
Cournot Oligopoly
 Each firm believes that its rivals will hold their
output constant if it changes its own output.
 The ultimate solution relies on the intersection of
reaction functions.
 If there are N identical firms in a Cournot
oligopoly, the profit maximizing price for a firm is:
 P = [NEM/1+ NEM] MC
 Where N is the number of firms in the industry,
EM is the market elasticity of demand, and MC is
marginal cost.
11-11
Markup Rule for Cournot Oligopoly




Homogeneous product Cournot oligopoly.
N = total number of firms in the industry.
Market elasticity of demand EM .
Elasticity of individual firm’s demand is
given by EF = N x EM.
 Since P = [EF/(1+ EF)]  MC,
 Then, P = [NEM/(1+ NEM)]  MC.
 The greater the number of firms, the
lower the profit-maximizing markup
factor.
11-12
An Example
 Homogeneous product Cournot industry, 3
firms.
 MC = $10.
 Elasticity of market demand = - ½.
 Determine the profit-maximizing price?
 EF = N EM = 3  (-1/2) = -1.5.
 P = [EF/(1+ EF)]  MC.
 P = [-1.5/(1- 1.5]  $10.
 P = 3  $10 = $30.
11-13
Another Example
 Homogeneous product Cournot industry, 10
firms.
 MC = $10.
 Elasticity of market demand = - ½.
 Determine the profit-maximizing price?
 EF = N EM = 10  (-1/2) = -5.0
 P = [EF/(1+ EF)]  MC.
 P = [-5.0/(1- 5.0]  $10.
 P = 1.25  $10 = $12.50.
11-14
Extracting Consumer Surplus:
Moving From Single Price Markets
 Most models examined to this point involve a
“single” equilibrium price.
 In reality, there are many different prices being
charged in the market.
 Managers can price discriminate given some
basic assumptions.
11-15
Extracting Consumer Surplus:
Moving From Single Price Markets
 Price discrimination is the practice of charging
different prices to consumer for the same good to
achieve higher profits.
 The three basic forms of price discrimination are:
– First-degree (or perfect) price discrimination.
– Second-degree price discrimination.
– Third-degree price discrimination.
11-16
First-Degree or Perfect
Price Discrimination
 Practice of charging each consumer the
maximum amount he or she will pay for
each incremental unit.
 Permits a firm to extract all surplus from
consumers by charging exactly each
potential consumer’s WTP.
11-17
Perfect Price Discrimination
Price
10
Profits*:
.5(4-0)(10 - 2)
= $16
8
6
4
Total Cost* = $8
2
MC
D
* Assuming no fixed costs
1
2
3
4
5
Quantity
11-18
Caveats:
 In practice, transactions costs and
information constraints make this difficult
to implement perfectly (but car dealers and
some professionals come close).
 Price discrimination won’t work if
consumers can resell the good.
11-19
Second-Degree
Price Discrimination
 The practice of posting
a discrete schedule of
declining prices for
different quantities.
 Eliminates the
information constraint
present in first-degree
price discrimination.
 Example: Electric
utilities
Price
MC
$10
$8
$5
D
2
4
Quantity
11-20
Third-Degree Price Discrimination
 The practice of charging different groups
of consumers different prices for the
same product.
 Group must have observable
characteristics for third-degree price
discrimination to work.
 Examples include student discounts,
senior citizen’s discounts, regional &
international pricing.
11-21
Implementing Third-Degree
Price Discrimination
 Suppose the total demand for a product is
comprised of two groups with different
elasticities, E1 < E2.
 Notice that group 1 is more price sensitive
than group 2.
 Profit-maximizing prices?
 P1 = [E1/(1+ E1)]  MC
 P2 = [E2/(1+ E2)]  MC
11-22
Implementing Third-Degree
Price Discrimination
 For profit max firms should equate the MR
from selling to each group to MC.
 Output should be allocated so that MR1 =
MR2.
 If MR1 > MR2 then the firm could allocate
more output to market 1 and less to 2 until
the MR for the two markets are equal.
11-23




Implementing Third-Degree
Price Discrimination
For TDPD to enhance profits differences
must exist in the elasticity of demand of
various consumers.
The firm must be able to determine the
elasticity differences.
Retired individuals, students, business
versus leisure travelers.
See demonstration problem 11-4 page
407.
11-24
Another Example
 Suppose the elasticity of demand for Kodak film
in the US is EU = -1.5, and the elasticity of
demand in Japan is EJ = -2.5.
 Marginal cost of manufacturing film is $3.
 PU = [EU/(1+ EU)]  MC = [-1.5/(1 - 1.5)]  $3 =
$9
 PJ = [EJ/(1+ EJ)]  MC = [-2.5/(1 - 2.5)]  $3 =
$5
 Kodak’s optimal third-degree pricing strategy is
to charge a higher price in the US, where
demand is less elastic.
11-25
Two-Part Pricing
 When it isn’t feasible to charge different
prices for different units sold, but demand
information is known, two-part pricing may
permit you to extract all surplus from
consumers.
 Two-part pricing consists of a fixed fee and a
per unit charge.
– Example: Athletic club memberships.
11-26
How Two-Part Pricing Works
1. Set price at marginal cost.
Price
2. Compute consumer surplus.
3. Charge a fixed-fee equal to
consumer surplus.
4. All profits are derived from
the fixed fee.
10
8
6
Per Unit
Charge
Fixed Fee = Profits* = $16
* Assuming no fixed costs
4
MC
2
D
1
2
3
4
5
Quantity
11-27
Charging a Monopoly Price
 From the previous example:
 If the firm charged one price rather than
a two-part pricing scheme:
 Inverse D curve is P = 10 - 2Q
 MR = 10-4Q; MC = 2
 Setting MR = MC yields an optimal Q = 2
and P = $6.
 Therefore TR = $12 and profits = $12-4 =
$8
11-28
Block Pricing
 The practice of packaging multiple units
of an identical product together and
selling them as one package.
 Examples
– Paper towels
– Six-packs of soda.
11-29
An Algebraic Example




Typical consumer’s demand is P = 10 - 2Q
C(Q) = 2Q
Optimal number of units in a package?
Optimal package price?
11-30
Optimal Quantity To
Package: 4 Units
Price
10
8
6
4
MC = AC
2
D
1
2
3
4
5
Quantity
11-31
Optimal Price for
the Package: $24
Consumer’s valuation of 4
units = .5(8)(4) + (2)(4) = $24
Therefore, set P = $24!
Price
10
8
6
4
MC = AC
2
D
1
2
3
4
5
Quantity
11-32
Costs and Profits with
Block Pricing
Price
10
Profits* = [.5(8)(4) + (2)(4)] – (2)(4)
= $16
8
6
4
Costs = (2)(4) = $8
2
D
* Assuming no fixed costs
1
2
3
4
5
MC = AC
Quantity
11-33
Profitable Block Pricing
 By charging a block price for a package
and not allowing the consumer to buy
single units the firm earns greater profits.
 The firm is expropriating the consumer
surplus that would have been earned at
a lower per unit price.
 Forces consumers to make an all or
nothing choice.
11-34
Commodity Bundling
 The practice of bundling two or more
products together and charging one
price for the bundle.
 Examples
– Vacation packages.
– Computers and software.
– Automobile companies offering “packages”
– Film and developing.
11-35
An Example that Illustrates
Kodak’s Moment
 Total market size for film and developing is 4
million consumers.
 Four types of consumers
– 25% will use only Kodak film (F).
– 25% will use only Kodak developing (D).
– 25% will use only Kodak film and use only Kodak
developing (FD).
– 25% have no preference (N).
 Zero costs (for simplicity).
 Maximum price each type of consumer will pay is
as follows:
11-36
Reservation Prices for Kodak Film
and Developing by Type of
Consumer
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
11-37
Optimal Film Price?
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Optimal Price is $8; only types F and FD buy resulting in profits
of $8 x 2 million = $16 Million.
At a price of $4, only types F, FD, and D will buy
(profits of $12 Million).
At a price of $3, all will types will buy (profits of $12 Million).
11-38
Optimal Price for Developing?
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
At a price of $6, only “D” type buys (profits of $6 Million).
At a price of $4, only “D” and “FD” types buy (profits of $8
Million).
At a price of $2, all types buy (profits of $8 Million).
Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million.
11-39
Total Profits by Pricing Each
Item Separately?
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Total Profit = Film Profits + Development Profits
= $16 Million + $9 Million = $25 Million
Surprisingly, the firm can earn even greater profits by bundling!
11-40
Pricing a “Bundle” of Film and
Developing
11-41
Consumer Valuations of a Bundle
Type
F
FD
D
N
Film
$8
$8
$4
$3
Developing Value of Bundle
$3
$11
$4
$12
$6
$10
$2
$5
11-42
What’s the Optimal Price for a
Bundle?
Type
F
FD
D
N
Film
$8
$8
$4
$3
Developing Value of Bundle
$3
$11
$4
$12
$6
$10
$2
$5
Optimal Bundle Price = $10 (for profits of $30 million)
11-43
Peak Load and Cross Subsidy Pricing
 Appropriate for firms with special cost and
demand structures.
 Peak load pricing – when demand is so high
that capacity cannot serve all customers at the
same price.
 Different groups of demanders are those that
purchase at different times of the day.
 Firm discriminates by charging different
prices at different times of day.
11-44
Peak-Load Pricing
Price
 When demand during
peak times is higher than
the capacity of the firm,
the firm should engage in
PH
peak-load pricing.
 Charge a higher price
PL
(PH) during peak times
(DH).
 Charge a lower price (PL)
during off-peak times
(DL).
MC
DH
MRH
MRL
QL
DL
QH Quantity
11-45
Cross-Subsidies
 Relevant when a firm has cost complementarities and
demand for a group of products is interdependent
 The profits earned from the sales of one product
subsidize the sale of another product.
 May be profitable when there are significant demand
complementarities.
 Examples
– Browser and server software.
– Drinks and meals at restaurants.
– Adobe Acrobat and Reader.
11-46
Double Marginalization leading to Transfer
Pricing
 Consider a large firm with two divisions:
– the upstream division is the sole
provider of a key input.
– the downstream division uses the input
produced by the upstream division to
produce the final output.
 Incentives to maximize divisional profits leads
the upstream manager to produce where
MRU = MCU.
– Implication: PU > MCU.
11-47
Double Marginalization
 Similarly, when the downstream division has
market power and has an incentive to maximize
divisional profits, the manager will produce
where MRD = MCD.
– Implication: PD > MCD.
 Thus, both divisions mark up price over
marginal cost resulting in in a phenomenon
called double marginalization.
– Result: less than optimal overall profits for the
firm.
11-48
Transfer Pricing
 To overcome double marginalization, the
internal price at which an upstream division
sells inputs to a downstream division should
be set in order to maximize the overall firm
profits.
 To achieve this goal, the upstream division
produces such that its marginal cost, MCu
equals the net marginal revenue to the
downstream division (NMRd):
NMRd = MRd - PMCd = MCu
11-49
Upstream Division’s Problem
 Demand for the final product P = 10 - 2Q.
 C(Q) = 2Q.
 Suppose the upstream manager sets MR
= MC to maximize profits.
 10 - 4Q = 2, so Q* = 2.
 P* = 10 - 2(2) = $6, so upstream manager
charges the downstream division $6 per
unit.
11-50
Downstream Division’s Problem
 Demand for the final product P = 10 - 2Q.
 Downstream division’s marginal cost is the $6
charged by the upstream division.
 Downstream division sets MR = MC to
maximize profits.
 10 - 4Q = 6, so Q* = 1.
 P* = 10 - 2(1) = $8, so downstream division
charges $8 per unit.
11-51
Analysis
 This pricing strategy by the upstream division
results in less than optimal profits!
 The upstream division needs the price to be $6
and the quantity sold to be 2 units in order to
maximize profits. Unfortunately,
 The downstream division sets price at $8, which is
too high; only 1 unit is sold at that price.
– Downstream division profits are $8  1 – 6(1) = $2.
 The upstream division’s profits are $6  1 - 2(1) =
$4 instead of the monopoly profits of $6  2 - 2(2)
= $8.
 Overall firm profit is $4 + $2 = $6.
11-52
Upstream Division’s
“Monopoly Profits”
Price
Profit = $8
10
8
6
4
2
MC = AC
P = 10 - 2Q
1
2
3
4
5
Quantity
MR = 10 - 4Q
11-53
Upstream Firm’s Profits when
Downstream Marks Price Up to $8
Price
Downstream
Price
Profit = $4
10
8
6
4
2
MC = AC
P = 10 - 2Q
1
2
3
4
5
MR = 10 - 4Q
Quantity
11-54
Solutions for the Overall Firm?
 Provide upstream manager with an
incentive to set the optimal transfer price of
$2 (upstream division’s marginal cost).
 Overall profit with optimal transfer price:
  $6  2  $2  2  $8
11-55
Pricing in Markets with Intense Price
Competition (Bertrand Oligopoly)
 Price Matching
– Advertising a price and a promise to match any lower
price offered by a competitor.
– No firm has an incentive to lower their prices.
– Each firm charges the monopoly price and shares the
market.
– No need for the firm to monitor competitors
– Consumers are required to demonstrate a lower price.
– Firm can price discriminate between those who
found a lower price and those that did not.
11-56
Pricing in Markets with Intense Price Competition
(Bertrand Oligopoly)
 Induce brand loyalty
– Some consumers will remain “loyal” to a
firm; even in the face of price cuts.
– Advertising campaigns and “frequentuser” style programs can help firms
induce loyalty among consumers.
11-57
Pricing in Markets with Intense Price
Competition (Bertrand Oligopoly)
 Randomized Pricing
– A strategy of constantly changing prices.
– Decreases consumers’ incentive to shop
around as they cannot learn from
experience which firm charges the
lowest price.
– Reduces the ability of rival firms to
undercut a firm’s prices.
11-58
Conclusion
 First degree price discrimination, block pricing, and
two part pricing permit a firm to extract all consumer
surplus.
 Commodity bundling, second-degree and third
degree price discrimination permit a firm to extract
some (but not all) consumer surplus.
 Simple markup rules are the easiest to implement,
but leave consumers with the most surplus and may
result in double-marginalization.
 Different strategies require different information.
11-59