© 2008 Pearson Addison Wesley. All rights reserved Chapter Twelve Pricing and Advertising

© 2008 Pearson Addison Wesley. All rights reserved

Chapter Twelve

Pricing and Advertising

© 2008 Pearson Addison Wesley. All rights reserved. 12-2

Pricing

• Monopolies (and other noncompetitive firms) can use information about individual consumer’s demand curve to increase their profits.

• Instead of setting a single price, such firms use nonuniform pricing.


Pricing

• Nonuniform Pricing– Charging consumers different prices for

the same product or charging a single customer a price that depends on the number of units the customer buys

• Price Discrimination– Practice in which a firm charges

consumers different prices for the same good


Pricing

• In this chapter, we examine seven main topics– Why and How Firms Price Discriminate– Perfect Price Discrimination– Quantity Discrimination– Multimarket Price Discrimination– Two-Part Tariffs– Tie-In Sales– Advertising


Why and How Firms Price Discriminate

• Why Price Discrimination Pays– For almost any good or service, some

consumers are willing to pay more than others.


Why Price Discrimination Pays

• A firm earns a higher profit from price discrimination than from uniform pricing for two reasons.

• First, a price-discrimination firm charges a higher price to customers who are willing to pay more than the uniform price, capturing some or all of their consumer surplus.


Why Price Discrimination Pays

• Second, a price-discrimination firm sells to some people who were not willing to pay as much as the uniform price.


Who Can Price Discriminate

• For a firm to price discriminate successfully, three conditions must be met.

• First, a firm must have market power.• Second, consumers must differ in their

sensitivity to price (demand elasticities), and a firm must be able to identify how consumers differ in this sensitivity.


Who Can Price Discriminate

• Third, a firm must be able to prevent or limit resales to higher-price-paying customers by customers whom the firm charges relatively low prices.


Preventing Resales

• Resales are difficult or impossible for most services and when transaction costs are high.

• Some firms act to raise transaction costs or otherwise make resales difficult.

• A firm can prevent resales by vertically integrating: participating in more than one successive stage of the production and distribution chain for a good or service.


Types of Price Discrimination

• Perfect price discrimination (first-degree price discrimination)

• Quantity discrimination (second-degree price discrimination)

• Multimarket price discrimination (third-degree price discrimination)


Perfect Price Discrimination

• A situation in which a firm sells each unit at the maximum amount any customer is willing to pay for it, so prices differ across customers and a given customers may pay more for some units than for others.



• If a firm with market power knows exactly how much each customer is willing to pay for each unit of its good and it can prevent resales, the firm charges each person his or her reservation price: the maximum amount a person would be willing to pay for a unit of output.


Figure 12.1Perfect Price Discrimination



• A perfectly price-discriminating monopoly’s marginal revenue is the same as its price.

• As the figure shows, the firm’s marginal revenue is on the first unit,

on the second unit, and on the third unit.

• As a result, the firm’s marginal revenue curve is its demand curve.

1 $6MR

3 $4MR2 $5MR


Perfect Price Discrimination: Efficient but Harmful to Consumers

• A perfect price discrimination equilibrium is efficient and maximizes total welfare, where welfare is defined as the sum of consumer surplus and producer surplus.

• As such, this equilibrium has more in common with a competitive equilibrium than with a single-price-monopoly equilibrium.


Figure 12.2Competitive, Single-Price, and Perfect Discrimination Equilibria


Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria

• In the competitive market equilibrium, , price is , quantity is , consumer surplus is , producer surplus is , and there is no deadweight loss.

• In the single-price monopoly equilibrium,

, price is , quantity is , consumer surplus falls to , producer surplus is , and deadweight loss is .

cecQcp

A B C

se sQ

D E

spA

B D C E


Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria

• In the perfect discrimination equilibrium, the monopoly sells each unit at the customer’s reservation price on the demand curve.

• It sells units, where the last unit is sold at its marginal cost.

• Customers have no consumer surplus, but there is no deadweight loss.

( )d cQ Q


Equation 12.1


Equation 12.2


Equation 12.3


Transaction Costs and Perfect Price Discrimination

• Transaction costs are a major reason why these firms do not perfectly price discriminate: It is too difficult or costly to gather information about each customer’s price sensitivity.


Transaction Costs and Perfect Price Discrimination

• Many other firms believe that, taking the transaction costs into account, it pays to use quantity discrimination, multimarket price discrimination, or other nonlinear pricing methods rather than try to perfectly price discriminate.


Quantity Discrimination

• A situation in which a firm charges a different price for large quantities than for small quantities but all customers who buy a given quantity pay the same price.


Quantity Discrimination

• Most customers are willing to pay more for the first unit than for successive units: The typical customer’s demand curve is downward sloping.

• The price varies only with quantity: All customers pay the same price for a given quantity.


Figure 12.3Quantity Discrimination


Figure 12.3 Quantity Discrimination

• If this monopoly engages in quantity discounting, it makes a larger profit (producer surplus) than it does if it sets a single price, and welfare is greater.


Figure 12.3 Quantity Discrimination

a) With quantity discounting, profit is

and welfare is .

b) If it sets a single price (so that its marginal revenue equals its marginal cost), the monopoly’s profit is , and welfare is .

$1,200B $1,600 A B C

$1,350 E F$900F


Multimarket Price Discrimination

• A situation in which a firm charges different groups of customers different prices but charges a given customer the same price for every unit of output sold.


Multimarket Price Discrimination with Two Groups

• How does a monopoly set its prices if it sells to two (or more) groups of consumers with different demand curves and if resales between the two groups are impossible?


Multimarket Price Discrimination with Two Groups

• Because the monopoly equates the marginal revenue for each group to its common marginal cost, , the marginal revenues for the two countries are equal:

A BMR m MR

MC m


Multimarket Price Discrimination with Two Groups• Rewriting Equation 12.1 using these

expressions for marginal revenue, we find that

(12.8)

• The ratio of prices in the two countries depends only on demand elasticities in those countries:

(12.9)1 1/

1 1/

C US

US C

P

p

1 11 1

A A B BA B

MR p m p MR


Equation 12.4


Equation 12.5


Equation 12.6


Equation 12.7


Figure 12.4Multimarket Pricing of Harry Potter DVD


Identifying Groups

• Firms use two approaches to divide customers into groups.

• One method is to divide buyers into groups based on observable characteristics of consumers that the firm believes are associated with unusually high or low price elasticities.


Identifying Groups

• Another approach is to identify and divide consumers on the basis of their actions: The firm allows consumers to self-select the group to which they belong.


Welfare Effects of Multimarket Price Discrimination

• Multimarket price discrimination results in inefficient production and consumption.

• As a result, welfare under multimarket price discrimination is lower than that under competition or perfect price discrimination.


Multimarket Price Discrimination Versus Competition

• Consumer surplus is greater and more output is produced with competition (or perfect price discrimination) than with multimarket price discrimination.


Multimarket Price Discrimination Versus Single-Price Monopoly

• From theory alone, we can’t tell whether welfare is higher if the monopoly uses multimarket price discrimination or if it sets a single price.

• Both types of monopolies set price above marginal cost, so too little is produced relative to competition.


Multimarket Price Discrimination Versus Single-Price Monopoly

• The closer the multimarket-price-discriminating monopoly comes to perfectly price discrimination (say, by dividing its customers into many groups rather than just two), the more output it produces, so the less the production inefficiency there is.


Two-Part Tariffs

• Two-part tariff– A pricing system in which the firm charges

a customer a lump-sum fee (the first tariff or price) for the right to buy as many units of the good as the consumer wants at a specified price (the second tariff).


A Two-Part Tariff with Identical Consumers

• If all the monopoly’s customers are identical, a monopoly that knows its customers’ demand curve can set a two-part tariff that has the same two properties as the perfect price discrimination equilibrium.


A Two-Part Tariff with Identical Consumers

• First, the efficient quantity, , is sold because the price of the last unit equals marginal cost.

• Second, all consumer surplus is transferred from consumers to the firm.

1Q


Figure 12.5Two-Part Tariff


Figure 12.5 Two-Part Tariff

• Two-part tariff– If all consumers have the demand curve in

panel a, a monopoly can capture all the consumer surplus with a two-part tariff by which it charges a price, , equal to the marginal cost, , for each item and a lump-sum membership fee of .

1 1 1 $2,450 L A B C

p$10m


A Two-Part Tariff with Nonidentical Consumers

• If the monopoly can treat its customers differently, it maximizes its profit by setting

and charging Consumer 1 a fee equal to its potential consumer surplus, , and Consumer 2 a fee of , for a total profit of $6,500.2 2 2 $4,050 A B C

$10 p m

1 1 1 $2,450 A B C


A Two-Part Tariff with Nonidentical Consumers

• If the monopoly must charge all consumers the same price, it maximizes its profit at $5,000 by setting and charging both customers a lump-sum fee equal to the potential consumer surplus of Consumer 1, .

$20p

1 $1,800 L A


Tie-In Sales

• Tie-in sale– A type of nonlinear pricing in which

customers can buy one product only if they agree to buy another product as well.


Tie-In Sales

• Requirement tie-in sale

Consumers who buy one product from a firm are required to make all their purchases of another product from that firm.

• Bundling (package tie-in sale)– A type of tie-in sale in which two goods are

combined so that customers cannot buy either good separately.


Advertising

• One of the most important decision that a monopoly has to make is how much to advertise.

• A successful promotional campaign shifts the monopoly’s demand curve by changing consumers’ tastes or informing consumers about new products.


The Decision Whether to Advertise

• If advertising shifts demand outward or makes it less elastic, the firm’s gross profit, which ignores the cost of advertising, must rise.

• The firm undertakes this advertising campaign, however, only if it expects its net profit (gross profit minus the cost of advertising) to increase.


Figure 12.6Advertising


How Much to Advertise

• How much should a monopoly advertise to maximize its net profit?

• A monopoly sets its quantity, Q, and level of advertising, A to maximize its profit as shown in equation (12-10).


Equation 12.10


Equation 12.11


Equation 12.12

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© 2008 Pearson Addison Wesley. All rights reserved Chapter Twelve Pricing and Advertising