Econ 281 Chapter12.pptx summary & notes.
- 1. 1 Ch 12: Capturing Surplus •Any firm with market power (such as a monopolist) has an incentive to capture (obtain) consumer surplus in order to increase its profits •Consumer surplus can be captured though: -Price Discrimination -Tie-In’s and Bundling -Advertising -Often capturing surplus is disguised as (or intended as) a beneficial program
- 2. 2 Chapter 12: Capturing Surplus In this chapter we will cover: 12.1 Price Discrimination 12.1.1 First Degree Price Discrimination 12.1.2 Second Degree Price Discrimination 12.1.3 Third Degree Price Discrimination 12.2 Tie-In’s 12.3 Bundling 12.4 Advertising
- 3. 3 • PRICE DISCRIMINATION is the act of charging different prices to different consumers in order to capture consumer surplus. • Like burns, three basic types of price discrimination exist: First Degree Second Degree Third Degree st
- 4. 4 • In order for price discrimination to take place: 1) A firm must have market power -a PC firm that raises price will get zero sales 2) The firm must be able to distinguish between consumers -the firm must know which consumers have different demand or elasticity of demand 3) The firm must be able to prevent resale
- 5. 5 In first degree price discrimination, the monopolist charges each consumer their maximum willingness to pay (ie: each quantity is sold at its intersection on the demand curve) Examples: -Auctions (higher willingness to pays will push up price) -Sizing up customers (asking questions relating to living arrangements and work,
- 6. 6 MC=S Demand MR QM PM PC QC A B C D E DWL = C+E CS with monopoly: A PS with monopoly:B+D
- 7. 7 MC=S Demand MR QM PM PC QC A B C D E DWL = ZERO! CS with 1st Degree Price Dis.: 0 PS with 1ST Degree PD: A+B+C+D+E
- 8. 8 First Degree Price Discrimination ELIMINATES consumer surplus (each consumer pays their maximum amount) First Degree Price Discrimination ELIMINATES deadweight loss (monopolists are able to provide goods to more consumers) FDPD is hard to accomplish and VERY vulnerable to resale
- 9. 9 For the monopolist, MR=P+(ΔP/ΔQ)Q But since increased sales do not affect the price of any other goods sold, (ΔP/ΔQ)Q=0 Therefore, MR=P=D (The MR curve is the demand curve)
- 10. 10 Calculate CS,PS and DWL with and without 1st Degree Price Discrimination. Assume that: P=48-2Qd MC=4Q Without: MR=MC 48-4Q=4Q 6=Q P=48-2Q P=48-2(6)=36 MC=4Q MC=4(6)=24 With Price Discrimination: MR=D=MC 48-2Q=4Q 8=Q (PC Q) Min P=48-2Q
- 11. 11 MC=S Demand MR 6 36 24 8 A B C D E Surplus w/ monopoly = A+B+D Surplus w/ monopoly = (A+B+D+C+E) –(C+E) Surplus w/ monopoly = ½(b)(h) - ½(b)(h) = ½(48)(8) - ½(12)(2) =192-12 =180 48 32
- 12. 12 MC=S Demand MR 6 36 24 8 A B C D E Surplus w/ 1st Degree Price Discrimination = A+B+D+C+E = ½(b)(h) = ½(48)(8) =192 48 32
- 13. 13 Second degree price discrimination deals with price discounts: -Selling at a discount price after a certain number of goods are purchased Second degree price discrimination also involves offering separate membership and per unit price plans that consumers CHOOSE between -ie: Phone plans, club memberships, bus pass
- 14. 14 In block pricing the first “block” of goods is sold at a given price, and the next “block” of goods is sold at a lower price A consumer pays P1 for the first Q1 good, then P2 for any goods above Q1 There can be more than 2 different blocks of prices
- 15. 15 0 P Q Demand Block Pricing 10 40 70 100 30 60 100 • Here a price of 70 applies to the first 30 goods, followed by a price of 40 for the next 30 goods • Note: P=100-Qd MC
- 16. 16 Block Pricing and Surplus 0 P Q Demand 10 40 70 100 30 60 100 450 450 450 900 900 900 • Consumer Surplus (Red) = 900 • Producer Surplus (Blue) = 2700 • Deadweight Loss (Gold) = 450 MC
- 17. 17 Normal Monopoly Surplus 0 P Q MC Demand MR 55 45 100 100 2025 1012.5 1012.5 • Consumer Surplus (Red) = 1012.5 • Producer Surplus (Blue) = 2025 • Deadweight Loss (Gold) = 1012.5
- 18. 18 In this example quantity discounts increased producer surplus Since the quantity sold on the market also increased, DWL decreased compared to the typical monopoly Note that if prices decrease due to a decreasing MC, this is not considered price discrimination
- 19. 19 Some goods (such as phone plans or clubs) carry a plan/membership fee and a cost per unit/use Often multiple plans exist, each with different fixed and variable fees Multiple plans often exist in order for the monopolist to price discriminate
- 20. 20 Membership and Per Unit Costs 0 P Q Demand .10 .40. .70 1.00 3 6 9 10 In this market for long distance, MC=$0.10, P=$0.10, and CS=$4.05. Therefore a firm could capture most consumer surplus by charging $0.10 per minute plus a plan fee of up to $4.05.
- 21. 21 Membership and Per Unit Costs 0 P Q Demand .10 .40 .70 1.00 2 6 9 10 Not all consumers are alike, so the firm offers different plans for different consumers. Here if P=$0.70, CS=$0.30. Therefore the firm could offer a price of $0.70 per minute with a plan fee of up to $0.30.
- 22. 22 Price plans are only effective price discrimination if different consumers automatically choose different plans Assume 2 customers: Customer A – makes 30 long distance calls Customer B – makes 100 long distance calls Assume 2 plans: Plan I - $1 per call, $50 plan fee
- 23. 23 Customer A -Spends $80 on plan I -Spends $60 on plan II -Picks plan II Customer B -Spends $150 on plan I -Spends $200 on plan II -Picks plan I Effective Price Discrimination
- 24. 24 Third degree price discrimination charges different prices to different consumer groups, or segments of society (each with different demand schedules) Examples: -Student and seniors movie prices -Regular and farm gasoline -Bus passes -”Customer Appreciation Days” -Tuesday deals at restaurants
- 25. 25 Third Degree Price Discrimination 0 0 100 100 20 60 80 50 20 40 Q Q P P Market 1 Market 2 Demand 1 Demand 2 MR1 MR2
- 26. 26 In order to price discriminate, the firm must separate different demand schedules SCREENING separates consumers based on characteristics that are: 1) Easily identified (age, status) 2) Strongly related to a useful consumer characteristic (willingness to pay, elasticity of demand, available income, etc.)
- 27. 27 Youth often have more time to shop around and lower disposable income -Different demand = different price Seniors are often more sensitive to price -Different demand = different price Identity cards can verify age and prevent arbitrage (reselling of goods)
- 28. 28 Products are more expensive when first released; those who MUST have a new good (ie: Iphone 36) have different demands than those who can wait Phone plans are cheaper (sometimes free) at night, due to different types of consumers -Business calls during day -Personal calls at night Different consumer groups visit restaurants Fridays compared to Tuesdays ->Tuesday
- 29. 29 Coupons and Rebates take time to collect or redeem Consumers willing to use coupons and rebates are more price sensitive Different price elasticities = different prices In general, rebates and discounts are offered to consumers who are more price sensitive (elastic demands) Loyalty apps or cards also fall into this category
- 30. 30 Another way companies can offer essentially the same product is through quality and convenience differences. Higher willingness to pay will want to buy higher quality Higher willingness to pay will want higher convenience
- 31. 31 Quality Examples: Cars (luxury and base), Laptops (with or without a dedicated graphics card), Software (Windows X, Windows X.1, Windows X Pro, Windows X Student Edition) Convenience Examples: Last minute ticket sales, customer support, cancellation ability (ie: airplane tickets)
- 32. 32 First Degree -Each consumer pays their maximum willingness to pay Second Degree -Consumers sort themselves into different price categories (quantity discounts or plans) Third Degree -Firms sort consumers into different price categories
- 33. 33 A firm can capture consumer surplus by allowing consumers to purchase one good (tying product) only if it agrees to buy another (tied product ie: Buy an hp printer, and be forced to buy hp ink ie: Buy an iPhone and being forced to use iTunes ie: Buy an Android phone and being forced to use Android apps
- 34. 34 Tie in sales extends market power from the TYING product (ie: iPhone) to the TIED product (ie: iTunes) ie: iTunes can have higher prices than it could if the market was competitive -another way of using tie-in sales is by making guarantees invalid if non-brand parts or components are used
- 35. 35 Bundling is a type of tie in where a consumer can only buy good A if it also buys good B simultaneously. TV channel packages Furnaces and Furnace installation Cars with passenger air bags Laptop with webcam Bundling forces consumers to buy all goods when they may not buy them individually:
- 36. 36 Two people are looking to replace their furnace. The handyman realizes the value of a new furnace, and would pay up to $4000 for one, but is only willing to pay $1000 for installation. A typical homeowner doesn’t realize all the benefits of a new furnace, so would pay $3000 for one, but has no installation experience and would pay $2000 for installation. A firm’s costs are $2000 for the furnace and $500 for installation
- 37. 37 At individual prices: (f=furnace, i=installation) Pf=$3000, sells two furnaces for $2000 profit Pf=$4000, sells one furnace for $2000 profit Pi=$1000, sells two installs for $1000 profit Pi=$2000, sells one install for $1500 profit At a bundled price: Pb=$5000, sells two bundles for $5000 profit Which is why it is hard to buy a furnace without a furnace install bundled in.
- 38. 38 Bundling is only possible if customers’ demands are negatively correlated. That is, if consumers are willing to pay more for different goods. (Note that in the above example, both people may be technically indifferent between buying and not buying the various goods at listed prices. To ensure the consumer buys, the goods need to be priced slightly below their willingness to pay, ie: Bundle price of $4999.)
- 39. 39 Sometimes a firm can increase profits by offering a bundle AND individual items. This can attract customers who are uninterested in the bundle. Consider customer C who would pay $4500 for a furnace, but only $250 for installation. He wouldn’t buy the bundle, but he would buy a furnace for $4499, giving the firm $2499 profit. Note that neither other consumer would want the furnace for that price; they’d prefer the bundle.
- 40. 40 Advertising is an example of a NONPRICE strategy a firm can use to increase profits. Advertising carries a cost, but also shifts out the demand curve, allowing for greater sales at a higher price:
- 41. 41 Price Quantity D2 MR2 MC D1 MR1 AC2 AC1 AC increases due to advertising costs, but profit may also increase
- 42. 42 How much should a firm advertise? A firm should advertise until MRadvertising=MCadvertising Note that not all firms benefit from advertising (ie: electricity monopoly can’t really increase electricity demand through advertising)
- 43. 43 Chapter 12 Summary Price Discrimination can occur when a firm Has Market Power Can distinguish between consumers Can prevent resale First Degree Price Discrimination charges the maximum to everyone Second Degree Price Discrimination allows consumers to sort themselves into different prices
- 44. 44 Chapter 12 Summary Third Degree Price Discrimination allows the firm to sort consumers into different prices Price discrimination DECREASES deadweight loss Tie-in sales and bundling increases the demand for individual goods that are grouped together, thus increasing profits Advertising increases costs and demand And may increase profits
- 45. 45 Chapter 12 Summary Your professor very much enjoyed teaching you this term, and wishes you all the best in your future