CHAPTER 11
Pricing Strategies for
Firms with Market
Power
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
Chapter Overview
• Basic pricing strategies
– Review of the basic rule of profit maximization
– A simple pricing rule for monopoly and monopolistic
competition
– A simple pricing rule for Cournot oligopoly
• Strategies that yield even greater profits
– Exacting surplus from consumers
– Pricing strategies for special cost and demand
structures
– Pricing strategies in markets with intense price
competition
11-2
Introduction
Chapter Overview
• In Chapter 10 a general set of tools was developed to
examine situations where economic agents’ decisions
impacted rivals’ payoffs. The concept of a dominant
strategies, Nash equilibria and subgame perfect equilibria
were explored.
• In this chapter, we 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
11-3
Basic Pricing Strategies
Review of Basic Profit Maximization
• Firms with market power face a downwardsloping demand.
– Implication: there is a trade-off between selling
many units at a low price and selling a few units at a
high price.
• Managers of firms with market power balance
these competing forces by selecting the
quantity that equates marginal revenue 𝑀𝑅
and marginal cost 𝑀𝐶 , and charging the
maximum price that consumer will pay for this
level of output.
11-4
Basic Pricing Strategies
Basic Profit Maximization In Action
• 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 profitmaximizing level of output and price for this
firm?
• Answer:
– The marginal revenue function is: 𝑀𝑅 = 10 − 4𝑄.
– The marginal cost function is: 𝑀𝐶 = 2.
– Equating these two functions yields 10 − 4𝑄 = 2,
so 𝑄 = 2. The profit-maximizing price is 𝑃 = 10 −
2 2 = $6.
11-5
Basic Pricing Strategies
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 a 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
1+𝐸𝐹
price (markup) is computed from: 𝑃
= 𝑀𝐶
𝐸𝐹
, where 𝑀𝑅 = 𝑃
1+𝐸𝐹
𝐸𝐹
.
• So, set price such that: 𝑃 =
𝐸𝐹
1+𝐸𝐹
𝑀𝐶.
11-6
Basic Pricing Strategies
Simple Pricing Rule In Action: Problem
• 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?
11-7
Basic Pricing Strategies
Simple Pricing Rule In Action: Answer
• The marginal cost of cola to the firm is $1.25, or
5
4
per liter, and the markup factor is
4
1−4
=
4
.
3
• The profit-maximizing pricing rule for a
monopolistically competitive firm is:
4 5
5
𝑃=
=
3 4
3
, or about $1.67 per liter.
11-8
Basic Pricing Strategies
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 is:
𝑁𝐸𝑀
𝑃=
𝑀𝐶
1 + 𝑁𝐸𝑀
, where 𝐸𝑀 is the market elasticity of demand.
11-9
Strategies that Yield Even Greater Profits
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 three
categories:
– Pricing strategies:
• that extract surplus from consumers.
• for special cost and demand structures.
• in markets with intense price competition.
11-10
Strategies that Yield Even Greater Profits
Models that Extract Surplus from Consumers
• This section covers the following models of
surplus extraction:
– Price discrimination (first, second and third degrees)
– Two-part pricing
– Block pricing
– Commodity bundling
• Each strategy is appropriate for firms with
various cost structures and degrees of market
interdependence.
11-11
Strategies that Yield Even Greater Profits
Surplus Extraction:
First-Degree Price Discrimination
• Price discrimination is the practice of charging
different prices to consumers for the same good or
service.
• First-degree price discrimination is the practice of
charging each consumer the maximum price he or
she would be willing to pay for each unit of the
good purchased.
– Implication: 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.
11-12
Strategies that Yield Even Greater Profits
Surplus Extraction:
First-Degree Price Discrimination In Action
Price
$10
MC
Firm profit under first-degree
price discrimination
$4
Demand
5
Quantity
11-13
Strategies that Yield Even Greater Profits
Surplus Extraction:
Second-Degree Price Discrimination
• Second-degree price discrimination is the
practice of posting a discrete schedule of
declining prices for different ranges of quantity.
– Implication: firm extracts some surplus from
consumers without needing to know the identity of
various consumers’ demand.
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Strategies that Yield Even Greater Profits
Surplus Extraction: Second-Degree
Price Discrimination In Action
Price
$10
MC
$7.60
Contribution to profits under
second-degree price discrimination
$5.20
Demand
2
4
Quantity
11-15
Strategies that Yield Even Greater Profits
Surplus Extraction:
Third-Degree Price Discrimination
• Third-degree price discrimination is the practice
of charging different prices based on systematic
differences in demand across demographic
consumer groups.
– Implication: marginal revenue will be different for
each group. That is, if there are two groups, 𝑀𝑅1 >
𝑀𝑅2 , for example.
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Strategies that Yield Even Greater Profits
Surplus Extraction: Third-Degree
Price Discrimination Rule
• To maximize profits, a firm with market power
produces the output at which the marginal
revenue (left-hand side of the following
equations) to each group equals marginal cost.
1 + 𝐸1
𝑃1
= 𝑀𝐶
𝐸1
1 + 𝐸2
𝑃2
= 𝑀𝐶
𝐸2
11-17
Strategies that Yield Even Greater Profits
Surplus Extraction: Third-Degree
Price Discrimination Rule In Action: Problem
• 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?
11-18
Strategies that Yield Even Greater Profits
Surplus Extraction: Third-Degree
Price Discrimination Rule In Action: Answer
• 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. These prices are
determined as follows:
1−4
𝑃𝐿
= $6
−4
1−2
𝑃𝐷
= $6
−2
• Solving these equations yield, 𝑃𝐿 = $8 and 𝑃𝐿 =
$12.
11-19
Strategies that Yield Even Greater Profits
Surplus Extraction: Two-Part Pricing
• Two-part pricing is a pricing strategy whereby 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.
11-20
Strategies that Yield Even Greater Profits
Surplus Extraction:
Two-Part Pricing In Action
Price
$10
Fixed fee = $32 = profits
Consumer surplus = $0
Per-unit fee = $2
$2
MC = AC
Demand
8
Quantity
11-21
Strategies that Yield Even Greater Profits
Surplus Extraction: Block Pricing
• Block pricing is a pricing strategy in which
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 package.
11-22
Strategies that Yield Even Greater Profits
Surplus Extraction:
Block Pricing In Action
Price
$10
Price charged for a block of 8 units = $48
Profit with block pricing = $32
$2
MC = AC
Demand
8
Quantity
11-23
Strategies that Yield Even Greater Profits
Surplus Extraction: Commodity Bundling
• Commodity bundling is the practice of 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.
11-24
Strategies that Yield Even Greater Profits
Surplus Extraction:
Commodity Bundling In Action
Consumer
Valuation of
Computer
Valuation of
Monitor
1
$2,000
$200
2
$1,500
$300
• How does the manager price a computer and monitor?
– Price separately:
•
•
Charge $1,500 for computer and $200 for monitors.
Profit (assuming zero cost) is: 2 × $1,500 + 2 × $200 =
$3,400.
– Commodity bundling:
•
•
Charge $1,800 for a bundle consisting of a computer and
monitor.
Profit (assuming zero cost) is: 2 × $1,800 = $3,600.
11-25
Strategies that Yield Even Greater Profits
Special Demand and Costs:
Peak-Load Pricing
• Peak-load pricing is a pricing strategy in which
higher prices are charged during peak hours
than during off-peak hours.
11-26
Strategies that Yield Even Greater Profits
Special Demand and Costs:
Peak-Load Pricing In Action
Price
MC
𝑃𝐻
Demand High
𝑃𝐿
MR High
MR Low
𝑄𝐿
Demand Low
𝑄𝐻
Quantity
11-27
Strategies that Yield Even Greater Profits
Special Demand and Costs:
Cross-Subsidies
• Cross-subsidy is a pricing strategy in which
profits gained from the sale of one product are
used to subsidize sales of a related product.
• Principle:
– Whenever the demands for two products produced
by a firm are interrelated through costs or demand,
the firm may enhance profits by cross-subsidization:
selling one product at or below cost and the other
product above cost.
11-28
Strategies that Yield Even Greater Profits
Special Demand and Costs:
Transfer Pricing
• Transfer pricing is a pricing strategy in which a
firm optimally sets the internal price at which an
upstream division sells an input to a
downstream division.
– Important since most division managers are
provided an incentive to maximize their own
division’s profits.
– Transfer pricing aligns division manager’s incentives
with that of the overall firm, and increases overall
firm’s profit.
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Strategies that Yield Even Greater Profits
Special Demand and Costs:
Double Marginalization
• Consider a large firm with two divisions:
– upstream division is the sole provider of a key input.
– downstream division uses the input produced by the
upstream division to produce the final output.
• Upstream division has market power and incentive to
maximize divisional profits leads managers to produce
where 𝑀𝑅𝑈 = 𝑀𝐶𝑈 .
– Implication: 𝑃𝑈 > 𝑀𝐶𝑈 .
• A similar situation exists for the downstream division; profitmaximization leads to 𝑃𝐷 > 𝑀𝐶𝐷 .
• Both divisions mark price up over marginal cost resulting
in a phenomenon called double marginalization.
11-30
Strategies that Yield Even Greater Profits
Special Demand and Costs:
Transfer Pricing Rule
• Transfer pricing is used to overcome double
marginalization.
• A transfer pricing rule sets the internal price at
which an upstream division sells inputs to a
downstream division in order to maximize the
overall firm profits.
– Require the upstream division to produce such that
its marginal cost, 𝑀𝐶𝑈 , equals the net marginal
revenue (𝑁𝑅𝑀𝐷 ) to the downstream division:
𝑁𝑅𝑀𝐷 = 𝑀𝑅𝐷 − 𝑀𝐶𝐷 = 𝑀𝐶𝑈
11-31
Strategies that Yield Even Greater Profits
Intense Price Competition:
Price Matching
• Price matching is a strategy in which 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 homogeneous-product, 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 the 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.
11-32
Strategies that Yield Even Greater Profits
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.
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Strategies that Yield Even Greater Profits
Intense Price Competition:
Randomized Pricing
• Randomized pricing is a strategy in which a firm
intentionally varies its price in an attempt to
“hide” price information from consumers and
rivals.
• Benefits of randomized pricing 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.
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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.
11-35