Chapter 11: Pricing with Market Power – Study Notes

Chapter 11: Pricing with Market Power

11.1 Capturing Consumer Surplus

Firms with market power can increase profits by capturing consumer surplus—the difference between what consumers are willing to pay and what they actually pay. This section explores how firms can set prices to extract more surplus from consumers.

• Consumer Surplus: The area under the demand curve and above the price line, representing the net benefit to consumers.

• Single Price Limitation: If a firm charges only one price, it cannot capture all consumer surplus. Some consumers would pay more, but are charged less, while others would pay less, but are excluded.

• Goal: Firms aim to set prices to capture as much surplus as possible, sometimes by charging different prices to different consumers.

• Graphical Representation: The surplus captured is shown as the area between the demand curve and the price line up to the quantity sold.

11.2 Price Discrimination

Price discrimination is the practice of charging different prices to different consumers for similar goods. It allows firms to increase profits by capturing more consumer surplus.

• First-Degree Price Discrimination (Perfect Price Discrimination): Each consumer is charged their reservation price (the maximum they are willing to pay). This allows the firm to capture all consumer surplus.

• Variable Profit: The sum of profits on each incremental unit produced, ignoring fixed costs.

• Imperfect Price Discrimination: In practice, firms may not know each consumer's reservation price, so they charge a limited number of different prices.

• Second-Degree Price Discrimination: Different prices are charged for different quantities or 'blocks' of the same good (block pricing). This can encourage consumers to buy more and lower average costs.

• Third-Degree Price Discrimination: Consumers are divided into groups with separate demand curves, and different prices are charged to each group. The firm maximizes profit by equating marginal revenue for each group to marginal cost.

Key Equations:

• Total profit: $\Pi = P_1 Q_1 + P_2 Q_2 - C(Q_T)$, where $Q_T = Q_1 + Q_2$

• Marginal revenue equals marginal cost for each group: $MR_1 = MR_2 = MC$

• Relative prices: $\frac{P_1}{P_2} = \frac{1 + 1/E_2}{1 + 1/E_1}$

Example: Coupons and rebates are forms of price discrimination, allowing firms to charge lower prices to more price-sensitive consumers.

Table: Price Elasticities of Demand for Users vs. Nonusers of Coupons

Product	Nonusers	Users
Toilet tissue	-0.50	-0.66
Shampoo	-0.84	-1.04
Dry mix dinners	-0.49	-1.15
Hot dogs	-0.55	-0.71

Table: Elasticities of Demand for Air Travel

Elasticity	First Class	Unrestricted Coach	Discounted
Price	-1.2	-0.9	-1.8
Income	1.2	1.2	1.8

11.3 Intertemporal Price Discrimination and Peak-Load Pricing

Firms can separate consumers by charging different prices at different times or during periods of high demand.

• Intertemporal Price Discrimination: Charging higher prices initially to consumers with high willingness to pay, then lowering prices later for the mass market.

• Peak-Load Pricing: Charging higher prices during peak periods when demand and marginal cost are high (e.g., electricity during hot summer days).

Example: Hardcover books are released at a high price for eager readers, then paperback editions are sold later at a lower price.

11.4 The Two-Part Tariff

A two-part tariff is a pricing strategy where consumers pay both an entry fee and a usage fee. This allows firms to extract more consumer surplus, especially when consumers have different demand levels.

• Single Consumer: The firm sets the usage fee equal to marginal cost and the entry fee equal to the entire consumer surplus.

• Multiple Consumers: The entry fee is set based on the consumer with the smaller demand, and the usage fee may exceed marginal cost.

• Many Consumers: The firm maximizes profit by adjusting both the entry and usage fees, considering the number of entrants and their surplus.

Example: Cellular phone plans often use a two-part tariff: a monthly access fee plus per-minute charges.

Table: Cellular Data Plans (2016)

Provider	Data Usage	Monthly Price	Access Charge	Overage Fee
Verizon	1GB	$30	$15	$15/GB
Sprint	2GB	$45	$45	None

11.5 Bundling

Bundling is the practice of selling two or more products as a package. It can increase profits when consumers' reservation prices for the goods are negatively correlated.

• Pure Bundling: Goods are only sold as a package.

• Mixed Bundling: Goods are sold both as a package and separately.

• Profitability: Bundling is most profitable when consumers value the goods differently (negative correlation in reservation prices).

• Graphical Analysis: Consumers buy the bundle only if the sum of their reservation prices exceeds the bundle price.

Example: Movie theaters may pay more for a bundle of films than for each film separately if their valuations are negatively correlated.

Table: Reservation Prices for Two Theaters

	Gone with the Wind	Getting Gertie's Garter
Theater A	$12,000	$3,000
Theater B	$10,000	$4,000

11.6 Advertising

Advertising can shift the demand curve to the right, increasing both price and quantity sold. Firms must balance the cost of advertising with the additional profit generated.

• Profit Maximization with Advertising: The firm should advertise up to the point where the marginal revenue from advertising equals the marginal cost.

• Advertising-to-Sales Ratio: The ratio of advertising expenditure to sales revenue is related to the advertising elasticity of demand.

Key Equations:

• Profit function with advertising: $\Pi = PQ(P, A) - C(Q) - A$

• Advertising rule: $\frac{A}{PQ} = \frac{e_A}{|e_p|}$ where $e_A$ is the advertising elasticity of demand and $e_p$ is the price elasticity of demand.

Appendix: The Vertically Integrated Firm

Vertical integration occurs when a firm controls multiple stages of production, such as both manufacturing components and assembling final products. This can help eliminate double marginalization and improve efficiency.

• Double Marginalization: Occurs when both upstream and downstream firms have market power, leading to higher prices and lower output than if the firms were integrated.

• Transfer Pricing: The price at which divisions of a vertically integrated firm transact with each other. Optimal transfer prices are typically set equal to marginal cost to maximize overall profit.

• Tax Considerations: Transfer prices may be adjusted to shift profits to divisions in lower-tax jurisdictions.

Example: An automobile manufacturer with an engine division and an assembly division can increase total profit by setting the transfer price for engines at marginal cost, rather than the monopoly price.

Additional info: These notes expand on the provided slides by including definitions, formulas, and examples for clarity and completeness.