Lecture 4.June 2008 Microeconomics Esther Kalkbrenner:

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1 Lecture 4.June 2008 Microeconomics Esther Kalkbrenner: Supply and Demand Familiar Concepts Supply and Demand (Chapter 2) Applying the Supply and Demand Model (Chapter 3) Consumers Choice Consumer Choice (Chapter 4) Applying Consumer Theory (Chapter 5) Midterm 16. April 2008 Firms Production And Costs Firms and Production (Chapter 6) Minimizing Costs (Chapter 7) Market Setting For Interaction Btw. Consumers and Firms Competitive Firms and Markets (Chapter 8) Applying the Competitive Model (Chapter 9) Midterm 28. May 2008 Market Power and Market Structure Monopoly (Chapter 11) Pricing (Chapter 12) Oligopoly (Chapter 13) Final 27.June 2008

2 Lecture 4.June 2008 Microeconomics Esther Kalkbrenner: So far: Profit Maximization under the Monopoly Model Monopoly faces a downward sloping demand Monopoly has Market Power set p such that MR=MC competitive model: demand is horizontal Starting Question today: Different Pricing Decisions Monopolies can increase profits by using non-uniform pricing = charging consumers different prices for the same product or = charging consumers differently for different quantity Examples of non-uniform pricing: - Price discrimination - Two-part tariff = pay a fee for the right to buy any number of units and a price per unit - Tie-in sale = require a customer to buy a second good along with the first purchase Topics today: 1. Why and how do firms price discriminate? 2. Perfect price discrimination 3. Quantity Price discrimination 4. Multi-market price discrimination

3 Non-uniform Pricing: Price Discrimination Why is price discrimination profitable? Firm that uses a single price for all customers faces a trade off: maximum price to consumers who really want good low enough price that less enthusiastic customers still buy as a result, single-price firm usually sets an intermediate price Price discriminate firms avoid this trade off: earns a higher profit by charging higher price to those willing to pay more than the uniform price: captures their consumer surplus lower price to those not willing to pay as much as the uniform price: extra sales Extreme Example to illustrate the benefits of price discrimination: Only movie theater in town sells tickets to wither students and/or seniors, who have different preferences : college students, $10 senior citizens, $5 Assume: theater holds all potential customers, so MC = 0 no cost to showing the movie, so π = revenue


5 Who can price discriminate? Requirements for successful price discrimination: 1. market power 2. consumers have different demand elasticities, and firm can identify how consumers differ 3. Prevent re-sale or limit resales to higher-price-paying customers by others (if re-sale can take place, firm will only make low price sales) When is it difficult to organise re-sales? transaction costs are high (e.g. product is of low value, or less widely consumed) and most services How to prevent re-sales: Increase transaction costs Vertical integration (VI) e.g. Alcoa = aluminium monopoly to sell ingots to produce wires at a low price re-sale of ingots would be possible solution: own wire production firm VI participate in more than one successive stage of the production and distribution VI into the low-price purchasers Government Intervention Regulation/Laws e.g. milk or ban Tariff

6 3 Types of price discrimination: perfect price discrimination (first-degree): sell each unit for the most each customer is willing to pay has market power can prevent resales knows how much each customer is willing to pay for each unit purchase (all knowing monopoly) firm can charge each person it s reservation price quantity discrimination (second-degree): charges a different price for larger quantities than for smaller ones multimarket price discrimination (third-degree): charge groups of customers different prices Note: Not every firm charging different prices to customers is practicing price discrimination e.g. newlyweds pay more for hotel suite justified by cost differential price discrimination e.g. newspaper students abo vs. normal abo = price discrimination

7 Perfect Price Discrimination: Graphical Approach: Monopoly sells at reservation price = height of the demand curve = max. price consumers are willing to pay for given amount of output Customer 1: rp = 6$ Customer 2: rp = 5$ Customer 3: rp = 4$ = MC Total Sales: 3 units MR=p therefore MR curve = demand curve profit maximizing: MR = MC = e Revenues:MR1+MR2+MR3=15$

8 Is price discrimination efficient? Perfect price discrimination is economically efficient = minimize cost of production & maximize profit Compare competition versus perfectly discriminating monopoly sell the same quantity maximize total welfare: W = CS + PS have no deadweight loss BUT: consumers worse off (CS = 0) than with competition Lets compare the 3 different market situations graphically (next slide) Competition Single-Price Monopoly Price discriminating Monopoly

9 , $ per unit p 1 Is price discrimination efficient? p s A e s MC Competition: Single price Monopoly: MR = p(c) = MC = e(c) MR = MC = e(s) p c = MC c B C E e c Price discriminating Monopoly: MR = p = rp = demand D MC s MC 1 Demand, MR d MR s Q Q =Q s c d Q, Units per day

10 Revisit Example 12.1 Theater Visitors: How does welfare change with price discrimination? Pricing Profit 10 Students Profit 20 Seniors Total Profit Welfare Uniform, $5 $50 $100 $150 CS=50$ = optimal choice PS=150$ If uniform pricing W=200$ Uniform, $10 $100 $0 $100 Price discriminate CS=0$ Output uniform pricing 5$ = $100 $100 $200 PS=200$ Output price discrimination W=200$ Pricing Profit 10 Students Profit 5 Seniors Total Profit Welfare Uniform, $5 $50 $25 $75 Uniform, $10 = optimal choice If uniform pricing $100 $0 $100 CS=0$ PS=100$ W=100$ Price discriminate If output From uniform pricing to price discrimination, then W $100 $100 $200 CS=0$ PS=200$ W=200$

11 Alternative non-linear pricing methods: Quantity discrimination: Problem with price discrimination: firm does not know which customers have highest reservation prices transaction costs to gather the information about reservation prices is costly (sales/negotiators) Quantity discrimination: firm might know most customers are willing to pay more for first unit (demand slopes down) firm varies price each customer pays with number of units customer buys price varies only with quantity: all customers pay the same price for a given quantity However note: If quantity discount is due to cost differential price discrimination Examples: public utility (electricity, water, gas ) charges one price for the first few units (a block) of usage different price for subsequent blocks both declining-block and increasing-block pricing are common

12 Quantity Discrimination Graphical Approach: (a) Quantity Discrimination p 1, $ per unit 90 (b) Single-Price Monopoly p 2, $ per unit A = $200 C = $200 B = $1,200 D = $200 m E = $450 F = $900 G = $450 m Demand Demand MR Q, Units per day Q, Units per day

13 Alternative non-linear pricing methods: Multi-market price discrimination: Multi-market price discrimination: firms know only which groups of customers are likely to have higher reservation prices than others firms are able to identify groups of customers to set different prices for each group firms set a different price for each group Re-sales are impossible Example: Multi-market price discrimination with 2 groups Japanses robot dog Aibo US customer charged P=2,500$ Japanese customer charged P=2,000$ marginal cost = m 2 different demand curves: D(USA) and D(JAPAN) monopoly charges Group i members p i for Q i units profit from Group i is π i = p i Q i mq i monopoly sets its quantities so that marginal revenue for each group i, MR i, equals common marginal cost, m: MR USA = m = MR Japan

14 Example: Multi-market Pricing of Aibo maximize combined profits: (a) Japan p J, $ per unit (b) United States p US, $ per unit 4,500 3,500 CS US CS J p US = 2,500 p J = 2,000 D J D US π J π US DWL J 500 MC 500 DWL US MC MR J MR US 0 Q J = 3,000 7,000 0 Q US = 2,000 4,500 Q J, Units per year Q US, Units per year

15 Example Aibo Multi-market price discrimination: Can the firm increase profits by lowering the price in Japan and sell more units? R = P( Q) Q i i i i dp i dpi Q i 1 MRi = Q + Pi = Pi 1+ = Pi 1+ dqi dqi Pi εi We know that: MR USA = m = MR Japan 1 1 MR = P 1+ = P 1+ = MR ε Japan εusa P Japan P USA Japan Japan USA USA ε USA = ε Japan Ratio of prices depend only on demand elasticities:: If: m=500$ p(japan)=2000$ p(usa)=2,500$ Then: ε (Japan) = and ε (USA) = Demand is believed to be more elastic in Japan than in USA

16 Example to set prices if demand elasticities are known: Example: monopoly sells in two markets: e.g. US market and Japanese market constant elasticity of demand is ε 1 = -2 in first market MC = $1 ε 2 = -4 in second market Re-sales are impossible What prices should monopoly charge? 1 1 pi 1+ = MC = 1 pi = 1/ 1+ εi εi Use the information about elasticity to calculate the prices in the 2 markets p 1 = 1/(1 ½) = 2 p 2 = 1/(1 ¼) = 4/3 Therefore: p 1 /p 2 = 2/(4/3) = 1.5

17 Group Identification and Welfare Effects: Multi-market Price Discrimination How to identify which customers belong to a group? Observable Consumer Characteristics of consumers that firms believe are associated with unusually high or low price elasticities e.g. movie theaters differentiate according to age country differences in selling the same product which can not be explained by transportation cost differentials e.g. coca cola bottles Consumer Self-Selection: customers with low willingness to spend on food self-select themselves e.g. by cutting coupons (value of time differentially appreciated) each price discrimination method requires that, to receive a discount, consumers incur some cost, such as their time; otherwise, all consumers would get a discount; by spending extra time to obtain a discount, price-sensitive consumers differentiate themselves from others e.g. airline tickets - cheaper = have certain requirements e.g. stay over weekend, advance purchase, no changing possible or more expensive = business travelers, little time, higher willingness to spend, relatively inelastic demand Welfare Effects of Multi-market price discrimination: Multi-market price discrimination results in inefficient production and consumption (DWL) welfare in multi-market price discrimination < competition or perfect price discrimination welfare either > or < with multi-market price discrimination than with a single-price monopoly