1、CHAPTER 11PRICING WITH MARKET POWERTEACHING NOTESThe chapter begins with a more traditional discussion of price discrimination and then applies the analysis of third-degree price discrimination to intertemporal price discrimination and peak-load pricing. The chapter continues with discussions of two
2、-part tariffs, bundling, and the distinction between bundling and tying. Although two-part tariffs and bundling are usually not covered at this level, this text stresses an intuitive understanding of how consumer surplus is converted to producer surplus. The chapter concludes with an introduction to
3、 optimal advertising.Since this chapter is unique in its coverage, there is an extensive set of exercises. Exercises (1), (3)-(6), (8), and (9) focus on price discrimination. Exercises (2), (7), (10), and (13) apply the two-part tariff model. All others, except for Exercise (17), require an understa
4、nding of bundling; Exercise (17) is a mathematical treatment of advertising. Many exercises require some algebraic or numeric manipulation. The Appendix to the chapter can be difficult for most students and should not be covered in class unless you are teaching a mathematical or business-oriented co
5、urse. Should you choose to include the Appendix, make sure students have an intuitive feel for the model before presenting the algebra or geometry.When introducing this chapter, highlight the requirements for profitable price discrimination: (1) supply-side market power, (2) the ability to separate
6、customers, and (3) differing demand elasticities for different classes of customers. The discussion of first-degree price discrimination begins with the concept of a reservation price. The text uses reservation prices throughout the chapter. Since the discussion of Figure 11.2 may be confusing to st
7、udents, an alternative presentation could begin with a diagram similar to Figure 9.1, with the addition of information from Figure 10.9. Show that with first-degree price discrimination the monopolist captures deadweight loss and all consumer surplus. Also, stress that with perfect discrimination th
8、e marginal revenue curve coincides with the demand curve.First-degree price discrimination is best followed by the discussion on third-degree, rather than second-degree, price discrimination. When you do cover second-degree price discrimination, note that many utilities now charge higher prices for
9、larger blocks. (Use your own electricity bill as an example.) The geometry of third-degree price discrimination is too difficult for most students; therefore, they need a careful explanation of the intuition behind the model. Slowly introduce the algebra so that students can see that the profit-maxi
10、mizing quantities in each market are those where marginal revenue equals marginal cost. If students understand this basic concept, they will be able to do Exercise (8). This section concludes with Examples 11.1 and 11.2. Because of the prevalence of coupons, rebates, and airline travel, all students
11、 will be able to relate to these examples.When presenting intertemporal price discrimination and peak-load pricing, begin by comparing the similarities in the analysis with third-degree price discrimination. Discuss the difference between these forms of exploiting monopoly power and third-degree pri
12、ce discrimination. Here, marginal revenue and cost are equal within customer class but need not be equal across classes.Students easily grasp the case of a two-part tariff with a single customer. Fewer will understand the case for two customers. Fewer still will understand the case of many different
13、 customers. Instead of moving directly into a discussion of more than one customer, you could introduce Example 11.4 to give concrete meaning to entry and usage fees. Then return to the cases dealing with more than one customer.When discussing bundling, point out that in Figure 11.12 prices are on b
14、oth axes. To introduce bundling, consider starting with Example 11.5 and a menu from a local restaurant. Make sure students understand when bundling is profitable (when demands are negatively correlated) and that mixed bundling can be more profitable than either selling separately or pure bundling (
15、demands are only somewhat negatively correlated and/or when marginal production costs are significant). To distinguish tying, from bundling, point out that with tying the first product is useless without the second product.REVIEW QUESTIONS1. Suppose a firm can practice perfect, first-degree price di
16、scrimination. What is the lowest price it will charge, and what will its total output be?When the firm is able to practice perfect first-degree price discrimination, each unit is sold at the reservation price of each consumer, assuming each consumer purchases one unit. Because each unit is sold at t
17、he consumers reservation price, marginal revenue is simply the price of the last unit. We know that firms maximize profits by producing an output such that marginal revenue is equal to marginal cost. For the perfect price discriminator, that point is where the marginal cost curve intersects the dema
18、nd curve. Increasing output beyond that point would imply that MR MC, and the firm should increase its output.2. How does a car salesperson practice price discrimination? How does the ability to discriminate correctly affect his or her earnings?The relevant range of the demand curve facing the car s
19、alesperson is bounded above by the manufacturers suggested retail price plus the dealers markup and bounded below by the dealers price plus administrative and inventory overhead. By sizing up the customer, the salesperson determines the customers reservation price. Through a process of bargaining, a
20、 sales price is determined. If the salesperson has misjudged the reservation price of the customer, either the sale is lost because the customers reservation price is lower than the salespersons guess or profit is lost because the customers reservation price is higher than the salespersons guess. Th
21、us, the salespersons commission is positively correlated to his or her ability to determine the reservation price of each customer.3. Electric utilities often practice second-degree price discrimination. Why might this improve consumer welfare?Consumer surplus is higher under block pricing than unde
22、r monopoly pricing because more output is produced. For example, assume there are two prices P1 and P2, with P1 greater than P2. Customers with reservation prices above P1 pay P1, capturing surplus equal to the area bounded by the demand curve and P1. This also would occur with monopoly pricing. Und
23、er block pricing, customers with reservation prices between P1 and P2 capture surplus equal to the area bounded by the demand curve, the difference between P1 and P2, and the difference between Q1 and Q2. This quantity is greater than the surplus captured under monopoly, hence block pricing, under t
24、hese assumptions, improves consumer welfare.Figure 11.34. Give some examples of third-degree price discrimination. Can third-degree price discrimination be effective if the different groups of consumers have different levels of demand but the same price elasticities?To engage in third-degree price d
25、iscrimination, the producer must separate customers into distinct markets (sorting) and prevent the reselling of the product from customers in one market to customers in another market (arbitrage). While examples in this chapter stress the techniques for separating customers, there are also techniqu
26、es for preventing resale. For example, airlines restrict the use of their tickets by printing the name of the passenger on the ticket. Other examples include dividing markets by age and gender, e.g., charging different prices for movie tickets to different age groups. If customers in the separate ma
27、rkets have the same price elasticities, then from equation 11.2 we know that the prices are the same in all markets. While the producer can effectively separate the markets, there is little profit incentive to do so.5. Show why optimal, third-degree price discrimination requires that marginal revenu
28、e for each group of consumers equals marginal cost. Use this condition to explain how a firm should change its prices and total output if the demand curve for one group of consumers shifted outward, so that marginal revenue for that group increased. We know that firms maximize profits by choosing ou
29、tput so marginal revenue is equal to marginal cost. If MR for one market is greater than MC, then the firm should increase sales to maximize profit, thus lowering the price on the last unit and raising the cost of producing the last unit. Similarly, if MR for one market is less than MC, the firm sho
30、uld decrease sales to maximize profit, thereby raising the price on the last unit and lowering the cost of producing the last unit. By equating MR and MC in each market, marginal revenue is equal in all markets.If the quantity demanded increased, the marginal revenue at each price would also increas
31、e. If MR = MC before the demand shift, MR would be greater than MC after the demand shift. To lower MR and raise MC, the producer should increase sales to this market by lowering price, thus increasing output. This increase in output would increase MC of the last unit sold. To maximize profit, the p
32、roducer must increase the MR on units sold in other markets, i.e., increase price in these other markets. The firm shifts sales to the market experiencing the increase in demand and away from other markets.6. When pricing automobiles, American car companies typically charge a much higher percentage
33、markup over cost for “luxury option” items (such as leather trim, etc.) than for the car itself or for more “basic” options such as power steering and automatic transmission. Explain why.This can be explained as an instance of third-degree price discrimination. In order to use the model of third-deg
34、ree price discrimination presented in the text, we need to assume that the costs of producing car options is a function of the total number of options produced and the production of each type of options affects costs in the same way. For simplicity, we can assume that there are two types of option p
35、ackages, “luxury” and “basic,” and that these two types of packages are purchased by two different types of consumers. In this case, the relationship across product types MR1 = MR2 must hold, which implies that:P1 /P2 = (1+1/E2) / (1+1/E1)where 1 and 2 denote the luxury and basic products types.This
36、 means that the higher price is charged for the package with the lower elasticity of demand. Thus the pricing of automobiles can be explained if the “luxury” options are purchased by consumers with low elasticities of demand relative to consumers of more “basic” packages.7. How is peak-load pricing
37、a form of price discrimination? Can it make consumers better off? Give an example.Price discrimination involves separating customers into distinct markets. There are several ways of segmenting markets: by customer characteristics, by geography, and by time. In peak-load pricing, sellers charge diffe
38、rent prices to customers at different times. When there is a higher quantity demanded at each price, a higher price is charged. Peak-load pricing can increase total consumer surplus by charging a lower price to customers with elasticities greater than the average elasticity of the market as a whole.
39、 Most telephone companies charge a different price during normal business hours, evening hours, and night and weekend hours. Callers with more elastic demand wait until the period when the charge is closest to their reservation price.8. How can a firm determine an optimal two-part tariff if it has t
40、wo customers with different demand curves? (Assume that it knows the demand curves.)If all customers had the same demand curve, the firm would set a price equal to marginal cost and a fee equal to each consumers consumer surplus. With consumers with different demand curves and, therefore, different
41、levels of consumer surplus, the firm is faced with the following problem. If it sets the user fee equal to the larger consumer surplus, the firm will earn profits only from the consumers with the larger consumer surplus because the second group of consumers will not purchase any of the good. On the
42、other hand, if the firm sets the fee equal to the smaller surplus of the second consumer, the firm will earn revenues from both types of consumers.9. Why is the pricing of a Gillette safety razor a form of a two-part tariff? Must Gillette be a monopoly producer of its blades as well as its razors? S
43、uppose you were advising Gillette on how to determine the two parts of the tariff. What procedure would you suggest?By selling the razor and the blades separately, the pricing of a Gillette safety razor can involve a two-part tariff. If Gillette has no monopoly power in the blade market, the price o
44、f blades is driven to marginal cost; the price of the blade could not be used to capture consumer surplus. If Gillette has monopoly power in the blade market, it should determine the optimal price of the razor and resulting profit for each price for blades. It should choose the blade price that maxi
45、mizes profit, a strategy that would involve estimating the demand function for shaving.10. Why did Loews bundle Gone with the Wind and Getting Gerties Garter? What characteristic of demands is needed for bundling to increase profits?Loews bundled its film Gone with the Wind and Getting Gerties Garte
46、r to maximize revenues. Because Loews could not price discriminate by charging a different price to each customer according to the customers price elasticity, it chose to bundle the two films and charge theaters for showing both films. The price would have been the combined reservation prices of the
47、 last theater that Loews wanted to attract. Of course, this tactic would only maximize revenues if demands for the two films were negatively correlated.11. How does mixed bundling differ from pure bundling? Under what conditions is mixed bundling preferred to pure bundling? Why do many restaurants p
48、ractice mixed bundling (by offering a complete dinner as well as an la carte menu) instead of pure bundling?Pure bundling involves selling products only as a package. Mixed bundling allows the consumer to purchase the products either separately or together. Mixed bundling yields higher profits than
49、pure bundling when either demands for the individual products do not have a strong negative correlation, or marginal costs are high, or both. Restaurants can maximize profits with mixed bundling by offering both la carte and full dinners by charging higher prices for individual items to capture the consumers willin
