Chapter 8 Pricing Strategies
- 1. CHAPTER 8 Pricing Strategies for Firms with Market Power
- 2. INTRODUCTION
- 3. Learning Objectives After studying this chapter, you will be able to: • Explain the basic rule of profit maximization and apply it to determine profit maximizing price for monopoly, monopolistic competition, and oligopoly market. Explain pricing strategies of monopoly and how monopoly enhance profit through price discrimination Explain the price rules for monopoly and monopolistic competition Explain how cost pricing rules influence firms to decide their production. 2-3
- 4. Pricing Strategies •Basic Rules of Profit Maximization: Firms with market power face a downward- sloping demand curve, selling a few units at a high price. • Profit maximizing price: Managers with market power select the quantity that equates marginal revenue and marginal cost , and charging the maximum price that consumer will pay for this level of output. 11-4
- 5. A VIDEO ABOUT “Profit Maximization” https://www.youtube.com/watch?v=BQvtnjWZ0i g
- 6. Pricing Rule for Monopoly and Monopolistic Competition • Price elasticity and pricing strategy • A particular firm’s elasticity depends on how the firms compete with one another, and the elasticity of market demand limits the potential monopoly power of individual producers. • the monopoly and monopolistically competitive firm’s profit-maximizing price (markup) 11-6
- 7. Monopoly Price rule To sell a larger output, a monopoly must set a lower price There are two types of monopoly price-setting strategies: • A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers. • Price discrimination is the practice of selling different units of a good or service for different prices. Many firms do discriminate price, but not all of them are monopoly firms. 2-7
- 8. A VIDEO ABOUT “Price Discrimination” https://www.youtube.com/watch?v=SZCV-Gm0Tf4
- 9. Marginal revenue and elasticity 2-9 If demand is inelastic, a fall in price brings a decrease in total revenue (P↓,TR ↓ ). The rise in revenue from the increase in quantity sold is outweighed by the fall in revenue from the lower price per unit, and MR is negative.
- 10. Elasticity Of Demand And Price Markup The markup (P − MC)/P is equal to the negative inverse of the price elasticity of demand, P-MC/P = - 1/ED If the firm’s demand is elastic, as in (a), the markup is small and the firm has little monopoly power. The opposite is true if demand is relatively inelastic, as in (b). Monopoly Power
- 11. Price strategy for Monopolistic Competition Price is determined from the demand for the firm’s product and is the highest price that the firm can charge for the profit- maximizing quantity. •The firm in monopolistic competition operates like a single-price monopoly. •The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price. •It makes an economic profit (as in this example) when P > ATC. A firm has excess capacity if it produces less than the quantity at which ATC is a minimum. A firm’s markup is the amount by which its price exceeds its marginal cost 2-
- 12. Price and Output in Monopolistic Competition 2- The firm in monopolistic competition operates like a single-price monopoly. The firm produces the quantity at which MR equals MC and sells that quantity for the highest possible price. It makes an economic profit (as in this example) when P > ATC.
- 13. Price and Output in Monopolistic Competition 2- Firms in monopolistic competition operate with positive markup. Again, the downward- sloping demand curve for their products drives this result.
- 14. CHAPTER 8 Pricing Strategies for Firms with Market Power
- 15. CONSUMER SURPLUS
- 16. Consumer Surplus • Extract surplus from consumers through: • 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. 11-16
- 17. A VIDEO ABOUT “Commodity Bundling” https://www.youtube.com/watch?v=tOk_QYAxuVw
- 18. 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. So 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. 11-18
- 19. First-Degree Price Discrimination 11-19 Price Quantity Demand MC 5 $4 $10 Firm profit under first-degree price discrimination
- 20. Second-Degree Price Discrimination • Second-degree price discrimination: a firm may charge different prices for different levels of consumption. • This type of strategy may be used in the selling of a product like electricity. 11-20
- 21. Second-Degree Price Discrimination 11-21 Price Quantity Demand MC 4 $5.20 $10 2 $7.60 Contribution to profits under second-degree price discrimination
- 22. Third-Degree Price Discrimination • Third-degree price discrimination, is the most common form, where a firm divides its market into segments and charges different prices accordingly. Markets can be segmented in various ways for this purpose. • marginal revenue will be different for each group, if there are two groups, 𝑀𝑅1 > 𝑀𝑅2 11-22
- 23. Price Discrimination Consumer surplus increases and the airline’s producer surplus increases. 2-
- 24. CHAPTER 8 Pricing Strategies for Firms with Market Power
- 26. 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. 11-26
- 27. 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. 11-27
- 28. A VIDEO ABOUT “Transfer Pricing” https://www.youtube.com/watch?v=8HUis_WIB_o
- 29. 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 . • Implication: . • A similar situation exists for the downstream division; profit- maximization leads to . • Both divisions mark price up over marginal cost resulting in a phenomenon called double marginalization. 11-29
- 30. A VIDEO ABOUT “Double Marginalization Problem” https://www.youtube.com/watch?v=7MPdKMeG cv8
- 31. 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, , equals the net marginal revenue to the downstream division: 11-31
- 32. 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
- 33. 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. 11-33
- 34. 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. 11-34
- 35. 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
- 36. RECAP On Key Terms and Concepts 2-36
- 37. Key terms • Block pricing • Cross subsidies • Double marginalization • First – degree price discrimination • Peak load pricing • Price matching • Price discrimination • Transfer pricing • Two part pricing 2-