Chapter 11: Pricing with Market Power – Practice Problems and Study Guide

Pricing with Market Power

First-Degree Price Discrimination

First-degree price discrimination, also known as perfect price discrimination, occurs when a firm charges each consumer the maximum price they are willing to pay for each unit of a good or service. This strategy allows the firm to capture the entire consumer surplus, converting it into additional profit.

• Definition: The practice of charging each consumer their exact willingness to pay.

• Key Point: No consumer surplus remains; all surplus is transferred to the producer.

• Example: Personalized negotiation in car sales or auction pricing.

Second-Degree Price Discrimination

Second-degree price discrimination involves charging different prices based on the quantity consumed or the version of the product purchased, rather than consumer identity.

• Definition: Price varies according to the quantity bought or product version (e.g., bulk discounts, versioning).

• Example: Electricity pricing tiers, quantity discounts at wholesale stores.

Third-Degree Price Discrimination

Third-degree price discrimination occurs when a firm segments the market into distinct groups based on observable characteristics and charges each group a different price.

• Conditions Required:

  • Ability to segment markets (e.g., by age, location, time of use).

  • No resale between groups (arbitrage prevention).

  • Different price elasticities of demand across groups.

• Example: Student and senior discounts, geographic pricing.

Profit Maximization with Multiple Markets

When a firm can segment markets, it can set different prices in each market to maximize profit. The optimal price in each market depends on the elasticity of demand and the marginal cost of production.

• Marginal Revenue (MR): The additional revenue from selling one more unit.

• Marginal Cost (MC): The additional cost of producing one more unit.

• Profit Maximization Rule: Set MR = MC in each market.

Example Calculation:

• Suppose two markets with demand curves: Market 1: $Q_1 = 50 - P_1$ Market 2: $Q_2 = 100 - 2P_2$ Marginal cost: $MC = 10$ Find MR for each market and set $MR_1 = MC$ and $MR_2 = MC$ to solve for optimal prices and quantities.

Comparing Single vs. Separate Pricing

Firms must decide whether to set a single price for all consumers or to price discriminate. Separate pricing is more profitable when consumer groups have different elasticities of demand and resale is not possible.

• Single Price: One price for all consumers; may leave consumer surplus unexploited.

• Separate Pricing: Different prices for different groups; increases profit if conditions for price discrimination are met.

Two-Part Pricing

Two-part pricing involves charging a fixed fee plus a per-unit price. This strategy can increase profits when consumers have different demand curves.

• Definition: A pricing method with an entry fee (fixed fee) and a usage fee (per-unit price).

• Application: Membership clubs, amusement parks (entry fee plus per-ride cost).

• Profit Maximization: Set the per-unit price equal to marginal cost and the fixed fee equal to the consumer surplus.

Table: Types of Price Discrimination

Type	Basis for Pricing	Example
First-degree	Individual willingness to pay	Personalized negotiation
Second-degree	Quantity or version purchased	Bulk discounts
Third-degree	Consumer group characteristics	Student discounts

Key Equations

• Marginal Revenue for linear demand: $MR = a - 2bQ$ (if $P = a - bQ$)

• Profit Maximization: $MR = MC$

Additional info:

• Price discrimination increases firm profit but may reduce consumer surplus and overall welfare, depending on market structure and elasticity differences.

• Regulatory and ethical considerations may limit the use of price discrimination in some markets.