Lesson-33. Pricing Strategy

Transcription

1 Pricing Strategies for the Monopolist Lesson-33 Pricing Strategy When firms can set their own price, then there are a variety of strategies that each firm may follow. Naturally, if a firm is profit maximizing, then the strategy chosen will be that which brings in the most (economic) profit. Three of these approaches, linear pricing, price discrimination and the two-part tariff, are discussed below: 1. One price for all units sold In economics circles, this approach is referred to as linear pricing and is the most commonly discussed approach in the microeconomics course. A firm will adjust the quantity of output it supplies until finding a point where the marginal revenue associated with selling that quantity is equal to the marginal cost of producing that quantity. That is, the firm will produce where MR = MC. When following this approach, the firm will then charge a specific price that applies to each unit sold. If we consider this in the context of a monopolist choosing an output level, then we have the graph below. The monopolist finds where MR = MC, which occurs at pt A. Directly below pt A, we see the monopolist s output (Q*). Going up from pt A to pt B, and then left to the Price axis, we get the monopolist s price (P*). Profit (blue area) is the difference between the price and average cost associated with supplying Q* units of this good. AC* represents the monopolist s average cost of supplying Q* units, which comes from where the dotted line (up from Q*) hits the AC curve at pt C. Just as with profits, we also see that there is some consumer surplus (orange area above the price and below demand) and deadweight loss (yellow area to the right of Q*, between demand and marginal cost). The deadweight loss arises because the firm

2 produces an inefficient amount of output. That is, the firm is not producing where P = MC, which is considered the efficient amount of output. Here, the firm charges one price (P*) for all units sold. If two consumers purchase the same item, but at a different price, then the difference in price corresponds with what must be the different cost of supplying these two consumers. For example, if consumer A buys one unit of this good at P*, and consumer B buys one unit for P** (where P* > P**), then it must be true that the price of B s unit arose from a shift in the MR or MC curve. It is also possible that there was a transportation cost (e.g., shipping and handling) tacked onto A s price that was not reflected in the graph. 2. Different Prices for Different Consumers This approach is referred to as price discrimination, and, unlike the first approach, corresponds with differences in what consumers are willing to pay, not as the result of changes in demand or differences in supply cost. For example, entertainment providers often charge different prices to students, the general public, seniors, etc., even though the cost of supplying that entertainment to each consumer is identical. Profit maximizing movie theatres, carnivals, etc., realize that some consumers are willing to pay more, or are able to pay more, for entertainment than other consumers. The problem is that demand-related consumer information is not readily available to suppliers. Ticket booth operators at the movies could try to ask consumers about their willingness to pay for tickets, but they aren t likely to get much information because consumers have no incentive to tell the truth about their preferences. As a result, movie theatres must consider other variables, variables that are easily observed like age, income or time of purchase, which are likely to be correlated with willingness to pay. Assume that there is only one form of entertainment in town, and that the movie theatre is a monopoly provider of this entertainment. Once the movie theatre manager determines what variables are correlated with willingness to pay, the manager will charge different prices to each of the different identifiable groups. The result is something like what the graph illustrates below.

3 Rather than charge just P 1 (which corresponds with P* in the one price for all units sold approach), the theatre owner can charge prices P 2 and P 3 to seniors and youth (under 18) respectively. Both of these prices will attract additional sales, which would never have occurred when the theatre charged P*. Because these groups can buy tickets at a price that is above AC, the theatre can exact additional profits (given as the pink and greenish areas to the right of the original blue profit box corresponding with P 1 ). Note that the market (if this theatre is a monopolist) generates additional consumer surplus (orange areas above each price) and dramatically decreases the deadweight loss (still dark green, to the right of Q 3 and between demand and MC) that occurred when only one price was charged for all units sold. Deadweight loss became smaller because more units were sold. Therefore, this approach accomplishes three important objectives: the firm receives additional profits, consumer surplus has increased, and the market output is closer to what we (society) consider an efficient level of output (i.e. where P = MC for the last unit sold). Only one problem remains for price discriminating firms like this theatre owner. If general admission consumers are able to buy tickets at youth prices, then the whole pricing strategy could fall apart. That is, the theatre owner could possibly become worse off by attempting price discrimination instead of charging one price for all units sold. To make price discrimination successful then, the movie theatre must prevent the resale of movie tickets between the different consumer groups. One way to do this might be to color-code the tickets, so that adults could not have their kids buy tickets for the whole family to get adults and kids in at youth prices. Price Discrimination, A Numerical Example Assume that a local concert provider has a monopoly over the provision of heavy metal rock concerts. The firm has estimated that its market demand curve can be drawn from the following equation (where P = price and Q = quantity demanded): P = 130 2Q

4 Marginal revenue (MR), in this case, would be MR = 130-4Q. The firm s average and marginal costs are constant, in that the AC and MC equations are both always equal to $40. These equations appear as follows: AC = 10 MC = 10 If the firm was to charge one price for every ticket it sells, the demand, MR, MC and AC curves inform us that the firm will sell 30 tickets at a price of $70 per unit and make economics profits of $1800 (you may want to verify this on your own). Let's assume that the firm has enough information on its market to utilize a price discrimination pricing strategy. To be a price discriminating monopolist, this firm must do two things: 1. Separate consumers into different groups, based on differences in their maximum willingness to pay for the firm s product 2. Prevent the resale of the firm s product between these different groups Let's further assume then, that the firm has determined that younger consumers (under 50) are willing to pay up to $80 per ticket for an upcoming heavy metal band concert and that older consumers (50 or older) are willing to pay up to $30 per ticket to rock on at this concert. If the firm uses price discrimination, based on age differences, how do we measure the effects of this pricing strategy on profits? If the monopolist sets a price of $80, then we calculate the number sold by plugging P = 80 into the market demand equation and solving for Q. P = 130 2Q 80 = 130 2Q Q = 25 If the firm sets a price of $30, then we can similarly calculate the number that would be sold at P = = 130 2Q Q = 50 Of course, if there are two prices charged, we want to consider the additional sales that occur because of the lower price - which is the difference between the two quantities (25 and 50). Therefore, as the graph shows below, the $80 price will result in 25 tickets being sold to the younger group whereas charging the older consumers a price of $30 will cause the overall sales to increase to 50 tickets (i.e. an 25 additional tickets are sold).

5 Profits (p) are measured as the net revenue generated from the sales of this good at the two prices given above (where the "1" subscript denotes the younger group, and the "2" subscript corresponds with the older group). The pink area corresponds with the profits derived from sales to group 1, and the green area corresponds with the profits derived from sales to group 2. p = "Pink Area" + "Green Area" p = (P 1 AC 1 )Q 1 + (P 2 AC 2 )(Q 2 - Q 1 ) p = (80 10)25 + (30 10)(50-25) p = 2250 The firm can obviously make more profits now than what would have been attained in the pre-price discrimination system. Note that we could have chosen a different pair of prices to work with, and that our profits from price discrimination could go up or down, depending on which prices we chose. For example, prices of $90 and $10 would yield total profits of $1600; whereas prices of $75 and $30 would yield total profits of $ Set up a "club" and charge one price for all units This approach is referred to as the two-part tariff. Consumers first pay a flat (fixed) fee which effectively gives them the "right" to buy as many units of a good as they want at a given price. The flat fee has many names. Sometimes it s called a membership fee, at other times it s a hookup fee, and in some situations the fee is called an entry fee. In each case, however, all consumers will pay the same fee regardless of whether they end up buying anything (thereafter) or not. Once the fee is paid and the consumer is effectively inside the store, each consumer can purchase varying amounts of whatever is being sold.

6 This pricing strategy has many examples. The State Fair charges an entry fee, and then specific prices for each ride. Some discount stores (e.g. Sam s Club) ask shoppers to first pay a membership fee, before going inside the store to purchase various products at their discounted prices. If the individual prices of each good exceed the good s average cost, the firm will make profit. Additional profits can also be brought in, however, with the fixed fee. The amount of fixed fee revenue collected depends on the available consumer surplus. As the firm sets a lower price for the units supplied, the consumer surplus becomes larger. Larger consumer surplus makes it possible for the firm to collect more revenue by either charging a larger membership fee or by adding members. How might this approach work if the theatre manager decided to use this pricing approach instead of either of the previous two approaches? Again, we can see this with the use of another graph. The manager could charge an entry fee, something that allows moviegoers to enter the theatre and buy their tickets. Because consumers are willing to pay an entry fee that is no greater than their potential consumer surplus, the movie theatre realizes that it is possible to collect up to the amount of the aggregate consumer surplus from this market (the dark green area above the price P 1 ). The lower the price, the greater the market consumer surplus and the higher the (potential) entry fee revenues. Therefore, we should expect the movie theatre to set low ticket prices as an inducement to get consumers to pay the entry fee. While lower prices would not bring monopoly-like profits, the entry fee revenues could potentially raise profits above those attained by the other monopoly s one price for all units sold strategy. In the graph, the movie theatre sets a price that is equal to marginal cost (to do so requires setting the price where MC cross the demand curve at pt. A). This price brings forth profits that are represented by the blue profit box. If the entry fee is set high enough, the movie theatre can add the entire green consumer surplus area to total profits also.

7 Similar to the price discrimination approach, we see that the two-part tariff pricing strategy may lead to a big reduction in deadweight loss and concurrent increase in output. Consequently, we can see that the monopolist may not be as inefficient as first believed with the one price for all units sold approach. We should concede as well, however, that consumer surplus may potentially disappear with the deadweight loss if the firm can successfully set prices that are equal to each consumer s maximum willingness to pay (in the case of price discrimination) or set a fixed fee that allows the firm to secure all of each consumer s consumer surplus. Two-Part Tariff, A Numerical Example Suppose the campus bookstore has a monopoly over the supply of textbooks. The bookstore hires someone to estimate their (market) demand curve and receives the following information (where P = price and Q = quantity demanded): P = Q Marginal revenue (MR), in this case, would be MR = 100-3Q. The firm buys all of its books from a book publisher at $40 per book, making the bookstore s average and marginal cost (AC and MC, respectively) always equal to $40. The bookstore s AC and MC equations would be: AC = 40 MC = 40 If the firm was to charge one price for book it sells, the demand, MR, MC and AC curves help us in determining that the bookstore will sell 20 books at a price of $70 per book. Economic profits would be $600 (you may want to verify this on your own). Let s assume that the bookstore owner hears about two-part tariffs and would like to implement this pricing strategy. Students are asked to pay a cover charge, just to enter the store, and may then buy all the textbooks they want at some pre-determined price. The lower the textbook price, the more consumers save. More specifically, the lower the price, the greater the consumer surplus. The bookstore knows that the two-part tariff pricing approach allows them to recover any lost profits (from lower prices) by raising the cover charge, so the firm will adjust the cover charge and textbook price to a point where profits are as high as possible. Given the demand for economics textbooks, the bookstore decides on a price of $40 per book. That is, the bookstore decides to sell the textbooks at cost. To determine how many books are sold at this price, we take the demand curve and plug the price of $40 in for P before solving for the quantity sold (Q). P = Q 40 = Q

8 Q = 40 In the absence of any cover charge, this would allow consumers to obtain (overall) consumer surplus of $1200. This is illustrated in the graph below, where the blue area represents consumer surplus. Because consumer surplus is the area of the triangle bordered by the demand curve, price and vertical axis, we can calculate the area of this triangle as: CS = 0.5("base" x "height") CS = 0.5(Q* x ["y-intercept" - P*]) CS = 0.5(40 x [100 40]) CS = 1200 Because we don't have enough specific information about the various consumers making up this market, including how many consumers there will be, we can only make guesses at the cover charge. For example, suppose there are 30 students who think they can save money by paying the cover charge to enter the bookstore. If the bookstore sets the cover charge at $25 per person and there are 30 students willing to enter, then the firm can earn total profits (i.e. profits from book sales + revenues from the cover charge) of $750. Price Discrimination: A Summary Discussions of firm pricing behavior often assume that a firm will charge the same price to all consumers. In reality, we find examples like theatres who charge different prices to students, the general public, seniors, etc. - even though the cost of supplying "entertainment" to each of these consumer types is the same. This corresponds with a practice known as price discrimination.

9 What is price discrimination? The standard discussion of price discrimination centers on the following brief definition: "Price discrimination is the sale (or purchase) of different units of a good or service at price differentials not directly corresponding to differences in supply cost." (Scherer and Ross, 1990) How do firms conduct price discrimination? Price discrimination is founded on a firm's ability to distinguish amongst buyers, based on their varying demand characteristics for a particular product. The more a firm is able to do so, the more perfect the degree of price discrimination. Three conditions must exist to enable a firm to profitably price discriminate: (a) The firm must have market power, (b) The firm must be able to distinguish among buyers on the basis of their demandrelated characteristics (e.g. demand elasticity or reservation price), and (c) The firm must be able to constrain resale between buyers with high and low reservation prices (or demand elasticity s). There are three degrees of price discrimination (illustrated below): (a) First degree (perfect), where firms charge each consumer their reservation price for the good; (b) Second degree, where firms charge "blocks" of consumers their reservation price for the good; and (c) Third degree, where firms divide consumers into two or more sub markets, each with its own demand curve, and independently maximizes profits in each sub market.

10 What types of price discrimination are found in practice? There are three main classes, each with differing intra-type examples: personal discrimination, which is based on differences among individual consumers; group discrimination, where inter-group differences are the distinguishing factor; and product discrimination, where different products are priced in a discriminating manner. Here are some examples of each type of price discrimination (from Scherer and Ross, 1990) Personal Discrimination 1. Haggle-every-time: each transaction is a separately negotiated bargain. Examples: Middle Eastern bazaars, and new/used car sales. 2. Size-up-their-income: wealthier (individual) customers are expected to possess more inelastic demand and are charged more than less affluent consumers. Examples: legal and medical services. 3. Measure-the-use: customers who use a product more are charged a higher price that is not proportional to any difference in costs. Example: Xerox machine rental charges. Group Discrimination 1. Dump-the-surplus: goods in excess supply are exported at reduced prices, to prevent depressing domestic monopoly prices. Example: export market dumping (e.g. televisions, computer chips, etc.) 2. Promote-new-customers: new customers are offered lower prices than existing customers to develop new brand loyalty. Examples: newspapers and magazines. 3. Keep-them-loyal: special discounts are given to high volume buyers or prized customers. Example: frequent flier programs. 4. Sort-them-by-time-value: coupons, which involve a time commitment for redemption, are given to customers. Those who redeem these coupons are presumed to have a lower opportunity cost of time, which corresponds with a lower reservation price. Examples: mail-in rebates, and newspaper coupons. 5. Divide-them-by-elasticity: separating customers on the basis of belonging to a particular group, when there is an expectation that the demand elasticity or reservation price will vary among each group. Examples: business vs. tourist rates on travel, and student vs. general admission prices for entertainment.

11 Product Discrimination 1. Appeal-to-the-classes: pricing higher quality products to achieve larger markups than with lower quality products. Examples: cloth vs. paperbound books, and luxury vs. midsize economy cars. 2. Make-them-pay-for-the-label: charging higher prices for (homogeneous) goods, based on name recognition. Examples: Name brand vs. generic aspirin, salt, etc. 3. Clear-the-stock: clearance sale prices are charged on certain items when inventories need to be reduced, with the hope that these lower prices will induce purchases by customers with tight budgets. Example: Macy's, or other high-end store clearance sales. 4. Switch-them-to-off-peak-times: for goods and services with varying timeconsumption patterns, lower prices are charged during off-peak periods. Examples: hotel and motel rates, and long distance telephone rates. 5. Skimming: setting high introductory prices that are designed to exploit customers eager to buy a new product. Example: introductory automobile prices.