Chapter
Twelve
Pricing
Pricing
• Monopolies (and other noncompetitive
firms) can use information about
individual consumer’s demand curve to
increase their profits.
• Instead of setting a single price, such
firms use nonuniform pricing.
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12–2
Pricing
• Nonuniform Pricing
– Charging consumers different prices for the
same product or charging a single
customer a price that depends on the
number of units the customer buys
• Price Discrimination
– Practice in which a firm charges
consumers different prices for the same
good
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12–3
Pricing
• In this chapter, we examine six main
topics
– Why and how firms price discriminate
– Perfect price discrimination
– Quantity discrimination
– Multimarket price discrimination
– Two-part tariffs
– Tie-in sales
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12–4
Why and How Firms Price
Discrimination
• Why Price Discrimination Pays
– For almost any good or service, some
consumers are willing to pay more than
others.
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12–5
Why Price Discrimination Pays
• A firm earns a higher profit from price
discrimination than from uniform pricing
for two reasons.
• First, a price-discrimination firm charges
a higher price to customers who are
willing to pay more than the uniform
price, capturing some or all of their
consumer surplus.
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12–6
Why Price Discrimination Pays
• Second, a price-discrimination firm sells
to some people who were not willing to
pay as much as the uniform price.
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12–7
Table 12.1 A Theater’s Profit Based
on the Pricing Method Used
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12–8
Who Can Price Discriminate
• For a firm to price discriminate
successfully, three conditions must be
met.
• First, a firm must have market power.
• Second, consumers must differ in their
sensitivity to price (demand elasticities),
and a firm must be able to identify how
consumers differ in this sensitivity.
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12–9
Who Can Price Discriminate
• Third, a firm must be able to prevent or
limit resales to higher-price-paying
customers by customers whom the firm
charges relatively low prices.
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12–10
Preventing Resales
• Resales are difficult or impossible for
most services and when transaction
costs are high.
• Some firms act to raise transaction
costs or otherwise make resales difficult.
• A firm can prevent resales by vertically
integrating: participating in more than
one successive stage of the production
and distribution chain for a good or
service.
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12–11
Types of Price Discrimination
• Perfect price discrimination (first-degree
price discrimination)
• Quantity discrimination (second-degree
price discrimination)
• Multimarket price discrimination (thirddegree price discrimination)
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12–12
Perfect Price Discrimination
• A situation in which a firm sells each
unit at the maximum amount any
customer is willing to pay for it, so
prices differ across customers and a
given customers may pay more for
some units than for others.
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12–13
Perfect Price Discrimination
• If a firm with market power knows
exactly how much each customer is
willing to pay for each unit of its good
and it can prevent resales, the firm
charges each person his or her
reservation price: the maximum
amount a person would be willing to pay
for a unit of output.
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12–14
Figure 12.1 Perfect Price
Discrimination
6
5
e
MC
4
3
MR = $6 MR = $5 MR = $4
1
2
3
Demand, Marginal revenue
2
1
0
1
2
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3
4
5
6
Q, Units per day
12–15
Perfect Price Discrimination
• A perfectly price-discriminating
monopoly’s marginal revenue is the
same as its price.
• As the figure shows, the firm’s marginal
revenue is MR1  $6 on the first unit,
MR2  $5 on the second unit, and MR3  $4
on the third unit.
• As a result, the firm’s marginal revenue
curve is its demand curve.
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12–16
Perfect Price Discrimination: Efficient
but Hurts Consumers
• A perfect price discrimination
equilibrium is efficient and maximizes
total welfare, where welfare is defined
as the sum of consumer surplus and
producer surplus.
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12–17
Perfect Price Discrimination: Efficient
but Hurts Consumers
• As such, this equilibrium has more in
common with a competitive equilibrium
than with a single-price-monopoly
equilibrium.
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12–18
Figure 12.2 Competitive, Single-Price,
and Perfect Discrimination Equilibria
p
1
MC
A
es
ps
B
C
ec
pc = MCc
E
D
MC
MCs
Demand, MRd
1
MRs
Qs
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Qc = Qd
Q, Units per day
12–19
Figure 12.2 Competitive, Single-Price,
and Perfect Discrimination Equilibria
• In the competitive market equilibrium, ec ,
price is pc , quantity is Qc , consumer
surplus is A  B  C , producer surplus
is D  E , and there is no deadweight
loss.
• In the single-price monopoly equilibrium,
es , price is ps , quantity is Qs , consumer
surplus falls to A , producer surplus
is B  D, and deadweight loss is C  E.
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12–20
Figure 12.2 Competitive, Single-Price,
and Perfect Discrimination Equilibria
• In the perfect discrimination equilibrium,
the monopoly sells each unit at the
customer’s reservation price on the
demand curve.
• It sells Qd ( Qc ) units, where the last unit
is sold at its marginal cost.
• Customers have no consumer surplus,
but there is no deadweight loss.
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12–21
Transaction Costs and Perfect Price
Discrimination
• Transaction costs are a major reason
why these firms do not perfectly price
discriminate: It is too difficult or costly to
gather information about each
customer’s price sensitivity.
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12–22
Transaction Costs and Perfect Price
Discrimination
• Many other firms believe that, taking the
transaction costs into account, it pays to
use quantity discrimination, multimarket
price discrimination, or other nonlinear
pricing methods rather than try to
perfectly price discriminate.
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12–23
Quantity Discrimination
• A situation in which a firm charges a
different price for large quantities than
for small quantities but all customers
who buy a given quantity pay the same
price.
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12–24
Quantity Discrimination
• Most customers are willing to pay more
for the first unit than for successive units:
The typical customer’s demand curve is
downward sloping.
• The price varies only with quantity: All
customers pay the same price for a
given quantity.
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12–25
Figure 12.3 Quantity Discrimination
(a) Quantity Discrimination
(b) Single-Price Monopoly
90
70
90
A=
$200
E = $450
60
C=
$200
50
B=
$1,200
F = $900
D=
$200
m
30
G = $450
m
30
Demand
Demand
MR
0
20
40
90
Q, Units per day
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0
30
90
Q, Units per day
12–26
Figure 12.3 Quantity Discrimination
•
If this monopoly engages in quantity
discounting, it makes a larger profit
(producer surplus) than it does if it
sets a single price, and welfare is
greater.
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12–27
Figure 12.3 Quantity Discrimination
a) With quantity discounting, profit is
B  $1, 200 and welfare is
A  B  C  $1, 600.
b) If it sets a single price (so that its
marginal revenue equals its marginal
cost), the monopoly’s profit is F  $900,
and welfare is E  F  $1,350.
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12–28
Multimarket Price Discrimination
• A situation in which a firm charges
different groups of customers different
prices but charges a given customer the
same price for every unit of output sold.
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12–29
Multimarket Price Discrimination with
Two Groups
• How does a monopoly set its prices if it
sells to two (or more) groups of
consumers with different demand
curves and if resales between the two
groups are impossible?
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12–30
Multimarket Price Discrimination with
Two Groups
• Because the monopoly equates the
marginal revenue for each group to its
common marginal cost, MC  m , the
marginal revenues for the two countries
are equal:
MRA  m  MRB
(12.1)
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12–31
Multimarket Price Discrimination with
Two Groups
• Rewriting Equation 12.1 using these
expressions for marginal revenue, we
find that


1 
1 
MRA  pA 1    m  pB 1    MRB(12.2)
 A 
 B 
• The ratio of prices in the two countries
depends only on demand elasticities in
those countries:
PC 1  1/  US
(12.3)

pUS 1  1/  C
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12–32
Figure 12.4 Multimarket Pricing of
Harry Potter DVD
(a) United States
(b) United Kingdom
35
29
D
A
D
B
CS
B
p = 18
B
CS
p = 15
A
1
MR
A
MR
pA
pB
DWL
m
9.4
19.47
Q , Million sets per year
A
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DWL
B
A
1
B
m
1
2.2
4.53
Q , Million sets per year
B
12–33
Identifying Groups
• Firms use two approaches to divide
customers into groups.
• One method is to divide buyers into
groups based on observable
characteristics of consumers that the
firm believes are associated with
unusually high or low price elasticities.
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12–34
Identifying Groups
• Another approach is to identify and
divide consumers on the basis of their
actions: The firm allows consumers to
self-select the group to which they
belong.
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12–35
Welfare Effects of Multimarket Price
Discrimination
• Multimarket price discrimination results
in inefficient production and
consumption.
• As a result, welfare under multimarket
price discrimination is lower than that
under competition or perfect price
discrimination.
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12–36
Multimarket Price Discrimination
Versus Competition
• Consumer surplus is greater and more
output is produced with competition (or
perfect price discrimination) than with
multimarket price discrimination.
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12–37
Multimarket Price Discrimination
Versus Single-Price Monopoly
• From theory alone, we can’t tell whether
welfare is higher if the monopoly uses
multimarket price discrimination or if it
sets a single price.
• Both types of monopolies set price
above marginal cost, so too little is
produced relative to competition.
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12–38
Multimarket Price Discrimination
Versus Single-Price Monopoly
• The closer the multimarket-pricediscriminating monopoly comes to
perfectly price discrimination (say, by
dividing its customers into many groups
rather than just two), the more output it
produces, so the less the production
inefficiency there is.
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12–39
Two-Part Tariffs
• Two-part tariff
– A pricing system in which the firm
charges a customer a lump-sum fee (the
first tariff or price) for the right to buy as
many units of the good as the consumer
wants at a specified price (the second
tariff).
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12–40
A Two-Part Tariff with Identical
Consumers
• If all the monopoly’s customers are
identical, a monopoly that knows its
customers’ demand curve can set a
two-part tariff that has the same two
properties as the perfect price
discrimination equilibrium.
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12–41
A Two-Part Tariff with Identical
Consumers
• First, the efficient quantity, Q1, is sold
because the price of the last unit equals
marginal cost.
• Second, all consumer surplus is
transferred from consumers to the firm.
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12–42
Figure 12.5 Two-Part Tariff
(a) Consumer 1
(b) Consumer 2
100
80
D2
D1
A = $3,200
2
A = $1,800
1
20
10
0
B = $600
1
C = $50
1
20
m
60 70 80
q , Units per day
1
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10
0
C = $50
2
B = $800
2
m
80 90 100
q , Units per day
2
12–43
Figure 12.5 Two-Part Tariff
• Two-part tariff
– If all consumers have the demand curve
in panel a, a monopoly can capture all
the consumer surplus with a two-part
tariff by which it charges a price, p ,
equal to the marginal cost, m  $10, for
each item and a lump-sum membership
fee of L  A1  B1  C1  $2, 450 .
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12–44
A Two-Part Tariff with Nonidentical
Consumers
• Suppose that the monopoly has two
customers, Consumer 1 in panel a and
Consumer 2 in panel b.
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12–45
A Two-Part Tariff with Nonidentical
Consumers
• If the monopoly can treat its customers
differently, it maximizes its profit by
setting p  m  $10 and charging
Consumer 1 a fee equal to its potential
consumer surplus, A1  B1  C1  $2, 450,
and Consumer 2 a fee
of A2  B2  C2  $4,050, for a total profit
of $6,500.
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12–46
A Two-Part Tariff with Nonidentical
Consumers
• If the monopoly must charge all
consumers the same price, it maximizes
its profit at $5,000 by setting p  $20 and
charging both customers a lump-sum
fee equal to the potential consumer
surplus of Consumer 1, L  A1  $1,800.
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12–47
Tie-In Sales
• Tie-in sale
– A type of nonlinear pricing in which
customers can buy one product only if
they agree to buy another product as
well.
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12–48
Tie-In Sales
• Requirement tie-in sale
– A tie-in sale in which customers who buy
one product from a firm are required to
make all their purchases of another
product from that firm.
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12–49
Tie-In Sales
• Bundling (package tie-in sale)
– A type of tie-in sale in which two goods
are combined so that customers cannot
buy either good separately.
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12–50