Chapter 10 Market Power and Pricing Strategies

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We have examined how firms with market power can generate positive economic profit by influencing the price at which their products or services are sold.

This conclusion was based on the assumption that firms must charge the same price to all customers.

Now we explore alternative pricing strategies and show that when a firm with market power can “discriminate” among customers, additional surplus (beyond that achieved by a single-price monopolist) can be generated.

Firms with market power behave in different ways than those in perfect competition.

10.1 – The Basics of Pricing Strategy

A pricing strategy is a firm’s method of pricing its product based on market characteristics

For a perfectly competitive firm, the pricing strategy is straightforward: charge the equilibrium market price and experience zero economic profit in the long run

For firms with market power, strategies become more complex
For a single-price producer, the optimal strategy is to increase production until marginal revenue is equal to marginal cost, which yields maximum profit Some firms with market power, however, are able to charge different prices to different customers Price discrimination refers to the practice of charging different prices to different customers for the same product The ability to price-discriminate allows firms with market power to generate even more economic profit

Conditions for Price Discrimination
A firm engages in price discrimination by charging consumers different prices for the same good based on individual characteristics
belonging to an indentifiable sub-group of consumers
the quantity purchased, time, etc.

Two reasons why a firm earns a higher profit from price discrimination than uniform pricing: 1. Price-discriminating firms charge higher prices to customers who are willing to pay more than the uniform price. 2. Price-discriminating firms sell to some people who are not willing to pay as much as the uniform price.

Necessary conditions for successful price discrimination:
1. A firm must have market power (otherwise it cannot charge a price above the competitive price). Examples:monopolist, oligopolist, monopolistically competitive, cartel

2. A firm must be able to identify which consumers are willing to pay relatively more and there must be variation in consumers’ reservation price, the maximum amount someone is willing to pay.

3. A firm must be able to prevent or limit resale from customers who are charged a relatively low price to those who are charged a relatively high price.

A firm’s inability to prevent resale is often the biggest obstacle to successful price discrimination.

Resale is difficult or impossible for services and when transaction costs are high. Examples:haircuts, plumbing services, admission that requires showing an ID Not all differential pricing is price discrimination.

It is not price discrimination if the different prices simply reflect differences in costs. Example: selling magazines at a newsstand for a higher price than via direct mailing

Types of Price Discrimination
1. First-degree
Also known as perfect price discrimination
Each unit sold for each customer’s reservation price
2. Second-degree
Also known as nonlinear discrimination
Firm charges a different price for large quantities than for small quantities 3. Third-degree
Also known as group price discrimination
Firm charges different groups of customers different prices, but charges any one customer the same price for all units sold

First Degree Discrimination
Reservation price: Maximum price that a customer is willing to pay for a good First degree price discrimination: Practice of charging each customer her reservation price Variable profit: Sum of profits on each incremental unit produced by a firm.

i.e., profit ignoring fixed costs

Strategies for Customers with Different Demand Curves
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