ECON214 (Fall 2010)
24. 11. 2010 (Tutorial 10)
Chapter 11 Pricing Strategies for Firms with Market Power
Basic pricing strategies
 Firms maximizes profits by equating MR and MC
 Firms can use information about elasticities to determine the profit-maximizing markup
used to set product prices
 Relation between MR and elasticity of demand

firm s revenue





where
(1) Pricing rule for Monopoly and Monopolistic Competition

 The optimal price is a simple markup over MC
 The more elastic the demand, the lower markup. The less elastic the demand, the higher
the markup
 A firm with higher MC will charge a higher profit-maximizing price
Example:
A convenient store competes in a monopolistically competitive market and buys soft drinks
from a supplier a price of $1.25. The elasticity of demand for the store is 4. What is the
profit maximizing price of soft drinks? What is the profit-maximizing price if the store
competes in a perfectly competitive market?
If the store competes in a monopolistically competitive market, then,
If the store competes in a perfectly competitive market,
. The markup factor
approaches 1, and P = MC = 1.25
Note: the Markup factor in a monopolistically competitive market is larger (which is 4/3 > 1)
(2)
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

Pricing rule for Cournot Oligopoly
Assume there are N identical firms in a Cournot oligopoly selling homogeneous product
EF = NEM (elasticity of demand for a firm is N times of the market elasticity of demand)
Profit maximizing price for a firm is
 The more elastic the market demand, the closer the profit-maximizing price to MC
(smaller markup factor)
 The larger the number of firms, the closer the profit-maximizing price to MC (smaller
markup factor)
 The higher the MC, the higher the profit-maximizing price
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Example:
Suppose 3 firms compete in a homogeneous-product Cournot industry. The market elasticity
of demand for the product is 2, and each firm’s MC is $50. What is the profit-maximizing
equilibrium price?
The profit-maximizing price:
Pricing strategies for greater profits (by extracting surplus from consumers)
(1) Price discrimination
 The practice of charging different prices to consumers for the same good or service
 Price discrimination works only if there is no resell in the market and firms have perfect/
some information about the consumers depending on the type of price discrimination it
implements
(a) First degree (Perfect) price discrimination
 The practice of charging each consumer the maximum amount he would be willing to pay
for each unit of good purchased
 Firms extract all surplus from consumers and earn the highest possible profits.
 It works if firms have perfect information on consumers’ willingness to pay
(b) Second degree price discrimination
 The practice of posting a discrete schedule of declining prices for different ranges of
quantities
 Consumers sort themselves accordingly to their willingness to pay for alternative
quantities of the good
 Firms cannot extract all surplus from consumers and profits are lower than in the case of
1st degree price discrimination
(c) Third degree price discrimination
 The practice of charging different groups of consumers different prices for the same
product
 To maximize profits, a firm with market power produces the output at which MR to each
group equals MC. That is
 Differences must exist in the elasticity of various consumers and firms have some means
of identifying the elasticity of demand by different groups of consumers
(2) Two-part pricing
 A firm can enhance profits by engaging in two-part pricing by charging a per-unit price
that equals MC, plus a fixed fee equal to the consumer surplus each consumer receives at
this per-unit price
 All profits are derived from the fixed fee
 It does not require that consumers have different elasticities of demand. The consumers
can vary the amounts they purchase according to their individual demands for the product
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(3) Block pricing
 By packaging units of a product and selling them as one package, the firm earns more
than by posting a simple per-unit price. The profit maximizing price on a package is the
total value the consumer receives for the package, including consumer surplus
 It enhances profits by forcing consumers to make an all-or-nothing decision to purchase
units of good
 Firms could enhance profits even consumers have identical demands
Example:
Suppose consumer’s demand function for gum produced by a firm with market power is
given by P = 0.2 – 0.04Q, and MC is 0. What price should be the firm charge for a package
containing 5 pieces of gum?
The total value to the consumer of 5 pieces of gum is 0.5[(0.2 – 0) 5] = 0.5
(4) Commodity bundling
 The practice of bundling several different products together and selling them at a single
“bundle price”
 Firms could enhance profits when consumers differ with respect to the amounts they are
willing to pay for multiple products sold by a firm
 Commodity bundling can enhance profit even when the firm cannot distinguish among
the amounts different consumers are willing to pay
Example:
Suppose three consumers of new car have the following valuations for options:
Consumer
Air Condition
Power Brakes
Total valuation
1
1000
500
1500
2
800
300
1100
3
100
800
900
The firm’s costs are zero.
(a) If the firm knows the valuations and identity of each consumer, what is the optimal
pricing strategy?
Firm will maximize profits by perfect price discrimination and earns a profit of $3500.
(b) Suppose the firm does not know the identities of the buyers. How much will the firm
make if the firm sells brakes and air conditioners for $800 each but offers a special
options package for $1100?
Only consumer 1 and 2 will buy the package if the price of it is 1100. Consumer 3 will
buy the power brakes only. Total profit for the firm is 3000
Other pricing strategies
(1) Cross-subsidies (products with special cost and demand structures)
 Pricing strategy in which profits gained from the sale of one product are used to subsidize
sales of a related product
 Whenever the demands for two products produced by a firm are interrelated through costs
and demand, the firm may enhance profits by selling one product at or below cost and the
other product above cost
 Network effect may exist, by offering one product at a lower price, it may stimulate the
demand for its complementary product
 Example: Adobe Reader (free) and Adobe Acrobat
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(2) Price matching
 A strategy in which a firm advertises a price and a promise to match any lower price
offered by a competitor
 In the Bertrand oligopoly model, a collusion works only if the game is an infinitely
repeated one and they are able to monitor their rivals
 With price matching strategy, no firm has an incentive to lower their prices as it will
trigger a price war and there is no need to monitor the prices charged by its rivals.
 Each firm charges the monopoly price and shares the market
 Moreover, the consumers are not able to find a better price in the market. Even if some
other firms charge low price, a firm using price matching strategy can price discriminate
between those who find such a lower price and those who do not
 Price matching works if a firm has a mechanism that precludes consumers from claiming
to have found a lower price when in fact they have not.
 A firm using pricing matching will suffer loss if its cost is higher than its rivals
(3) Randomized pricing
 Pricing strategy in which a firm intentionally varies its price in an attempt to “hide” price
information from consumers and rivals
 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
 It is not always profitable to engage in randomized pricing strategies
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Problems and Examples:
Question 14 (Baye, P.428)
ccording to the Cahner’s In-Stat Group, the number of worldwide wireless phone will soon
reach the 1 billion mark. In the US alone, the number of wireless subscribers is projected to
grow by almost 17 million subscribers per year for the next 5 years. Contributing to the
extensive growth are lower prices, larger geographic coverage, prepaid services, and Internet
enabled phones. While the actual cost of a wireless phone is about $75, most wireless carriers
offer their customers a “free” phone with a one-year wireless service agreement. Is this
pricing strategy rational? Explain.
Yes. It is consistent with cross subsidization. Phones and services are complements in
demand.
In addition, there may be cost complementarities and economies of scope since it is cheaper
for providers to train employees to activate in-house phones rather than other brands
purchased elsewhere.
This strategy is also consistent with bundling. In this case, the company may say that the
phone is “free,” but in actuality it is part of a bundle that cannot be broken apart. Both cross
subsidization and bundling can be used to enhance profits.
Question 15 (Baye, P.429)
The merican Baker’s ssociation reports that annual sales of bakery goods last year rose
15%, driven by a 50% increase in the demand for bran muffins. Most of the increase was
attributed to a report that diets rich in bran help prevent certain types of cancer. You are the
manager of a bakery that produces and packages gourmet bran muffins, and you currently sell
bran muffins in packages of 3. However, as a result of this new report, a typical consumer’s
inverse demand for your bran muffins is now P = 3 – 0.5Q. If your cost of producing bran
muffins is C(Q) = Q, determine the optimal number of bran muffins to sell in a single
package and the optimal package price.
Set P = MC to obtain 3 – 0.5Q = 1 and solve to obtain the optimal package size, Q = 4 units.
The total value to a consumer of package of 4 muffins is $8 ( (0.5)($3 – $1)(4) + ($1)(4) =
$8). (Please try to show it in a diagram)
Question 18 (Baye, P.429)
As a manager of a chain of movie theaters that are monopolies in their respective markets,
you have noticed much higher demand on weekends than during the week. You therefore
conducted a study that has revealed two different demand curves at your movie theaters. On
weekends, the inverse demand function is P = 15 – 0.001Q; on weekdays, it is P = 10 –
0.001Q. You acquire legal rights from movie producers to show their films at a cost of
$20000 per movie, plus a $2 “royalty” for each moviegoer entering your theaters (the average
moviegoer in your market watches a movie only once). Devise a pricing strategy to maximize
your firm’s profits
Probably the best you can do in this instance is charge different per-unit prices on weekends
and weekdays.
The optimal decision on weekends is determined by 15 – 0.002Q = 2 (MR = MC). Solving
yields Q = 6500. The optimal price on weekends is thus P = 15 – 0.001(6500) = $8.50.
The optimal decision for weekdays is determined by 10 – 0.002Q = 2. Solving yields Q =
4000. The optimal weekday price is thus P = 10 –0.001(4000) = $6.
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Question 21 (Baye, P.430)
Suppose the European Union (EU) is investigating a proposed merger between two of the
largest distillers of premium Scotch liquor. Based on some economists’ definition of the
relevant market, the two firms proposing to merge enjoyed combined market share of about
two-thirds, while another firm essentially controlled the remaining share of the market.
Additionally, suppose that the (wholesale) market elasticity of demand for Scotch liquor is
1.2 and that its costs $15.4 to produce and distribute each liter of Scotch. Based only on
these date, provide quantitative estimates of the likely pre-and post-merger prices in the
wholesale market for premium Scotch liquor. In light of your estimates, are you surprised that
the EU might raise concerns about potential anticompetitive effects of the proposed merger?
Explain.
3 1.2
15.40  $21.32
The profit-maximizing price when three firms compete is P 
1  3 1.2
per liter.
If two of the three firms were unconditionally permitted to merge, then the profit-maximizing
2 1.2
15.40  $26.40 per liter.
price is P 
1  2 1.2
Given the circumstances, it is not surprising that the EU raised concerns about a proposed
merger since price in the market for premium Scotch liquor would increase by almost 24%.
Question 23 (Baye, P.431)
You manage a company that competes in an industry that is comprised of five equal-sized
firms that produce similar products. A recent industry report indicates that the market is fairly
saturated, in that a 10% industry-wide price increase would lead to a 22 % decline in units
sold by all firms in the industry. Currently, Congress is considering legislation that would
impose a tariff on a key input used by the industry. Your best estimate is that, if the legislation
passes, your marginal cost will increase by $1. Based on this information, what price increase
would you recommend if the tariff legislation is passed by Congress? Explain.
%Q d 22

 2.2 .
%P 10
Since there are five firms in the industry, the individual firm’s elasticity of demand is
  11 
E f  5 2.2  11. The profit-maximizing price is, therefore, P  
 MC  1.10MC .
 1  11 
Thus, a 100 cent increase in marginal cost would lead to a $1.10 increase in the optimal price.
The market elasticity of demand is E M  
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