Chapter 11 - Pricing with market power

Question 1

all pricing strategies have one thing in common. What is it?

Answer 1

We always want to capture consumer surplus and transfer it to the producer.

Question 2

Elaborate on how consumers might be able to be captured?

Answer 2

Firms want to produce at at price p* that corresponds to the point where marginal revenue is equal to marginal cost. This is fine, but we can still actually perform better.

if we consider price p: Some customers might be willing to buy at an even higher price. Others might think that p is too high a price, and would perhaps be buying if the price was lower.
Charging p* will not carry the best profits. We would have to use price discriminiation to get the best out of the situation.

Question 3

What is price discrimination?

Answer 3

Charging different prices to different customers.

Question 4

What is “reservation price”?

Answer 4

Reservation price is the highest price a customer is willing to pay for some product.

Question 5

What is (perfect) first degree price discrimination?

Answer 5

First degree price discrimination refers to charging each customer his or her own reservation price.

In the case of perfect first degree price discrimination, we could sell at the price consistent with the reservation price. In such a case, profit would be calculated as the difference between marginal revenue and marginal costs for each unit sold. However, if we know the reservation curve perfectly, we could use the price level as the marginal revenue curve is no longer relevant to use. As long as a sale makes money, we would take it. Therefore, we want to produce at the level where the demand curve intersect marginal costs.

The key here is that when we have perfect first degree price discrimination, the marginal revenue curve is no longer applicable. We want to use the demand curve.

this means, that the profit we get during perfect first degree price discrimination, is the difference between the demand curve and the marginal cost curve.

Question 6

During perfect first degree price discrimination, how much of the consumer surplus is captured by the firm?

Answer 6

100%

Question 7

Elaborate on imperfect price discrimination

Answer 7

This is the practice we use in real life. We could place customers into groups based on guesses and general facts. In a simple model, we could place consumers into:
1) Rich
2) Average
3) Poor

This would capture a larger part of the consumer surplus than if all were given the same price.

Question 8

What is second degree price discrimination?

Answer 8

Second degree price discrimination is about charging different prices for different quantities.

For instance, if a consumer has already bought 100 units of some good, and he really dont need that much more, the firm could capture this customer further by reducing the price he would have to pay for, lets say, the next 50 or 25 units.

The arch example of second degree price discrimination is quantity discounts.

Question 9

What is third degree price discrimination?

Answer 9

Third degree price discrimination is about dividing consumers into groups that have different demand curves. Then it will charge different prices for the different groups. Usually with premium and standard products etc.

Emphasis is placed on the fact that there are DIFFERENT demand curves. While first degree price discrimination would operate on the very same demand curve, trying to capture all surplus from the consumer, THIRD degree price discrimination is about charging different prices to different groups based on different demand curves.

Question 10

How should third degree price discrimination be performed in practice?

Answer 10

The group-creation requires careful consideration.

1) Total output should be divided among the groups so that each group contribute in a way where marginal revenue is the same for all of them. If this was not the case: Plant A with lower marginal revenue than B, then we would up production at plant B because there is profit to extract there. This would balance it out. Thus, we want MR1 = MR2 = MRi = MRN

2) Marginal revenue for each group must be equal to marginal costs. We need to find the production volume that satisfies this constraint.

Then we could use the simple formula MR = P(1 + 1/E_d)

P = MC / (1+ 1/E_d)

to get the price. Of course, the elasticity will be different for the groups because they have different demand curves. This is the core of the problem.

When it comes to the group creation, we typically keep it simple. Student group, senior group, regular, kid etc.h

Question 11

What is one way to collect information about specific groups of consumers? I am referring to groups in relation to price reanges

Answer 11

You could use coupons.

People who bother to use coupons are generally more sensitive to price changes. Therefore, this group of consumers will operate with a demand curve that has a higher elasticity than the “rest”. Therefore, one could probably increase the price of a product, and issue coupons to extract more of the consumer surplus, while keeping the group of customers who are likely to fuck off if prices increase.

Question 12

What is inter temporal price discrimination?

Answer 12

Intertemporal price discrimination is about separating consumers with different demand functions into groups by charging different prices at different points in time.

Question 13

What is peak-load pricing?

Answer 13

Peak load pricing is about charging higher prices during periods of higher marginal costs as a result of capacity constraints.

Question 14

Elaborate on intertemporal price discrimination

Answer 14

Intertemporal price discrimination is about charging different prices at different times so that we can split the consumers into groups based on their demand curves.

The general strategy is to separate consumers into high-demand and low-demand. We can do this by first charging a high price, and then reducing price as time pass by.

There will usually be a group of people who have a really inelastic demand curve. They buy no matter what. We can therefore capture more surplus from this group by first selling at a really high price. Then, as we observe the first group buying it, we can start lowering the price. Then we should see a sudden increase in demand.

Question 15

What is the two-part tariff?

Answer 15

A tariff is a duty to pay something.

two part tariff is referring to a scenario where customers pay multiple times for goods. Like, you pay once for enter and then again for a certain ride/amusement.

There are strategies involved here. you could set the first fee high, and the other ones low, or you could set the first low and the others high.

The two-part tariff applies to shit that requires you to make an initial purchase, and then follow up with other, usually smaller, purchases. It represents sort of an obligation.

Question 15

Elaborate on peak-load pricing

Answer 15

Peak-load pricing is a strategy that is very dynamic. It is about setting a price that corresponds to the current capacity conditions, rather than finding some universal price.

The point is to always be in the green. We would like to “always” have the case where MR = MC. If MC is very variable, then MR should too. This means the price must be variablel

Question 16

name some examples of two-part tariffs

Answer 16

Golf clubs, amusement parks.

Also sales of shit like razors and blades etc.

Question 17

Consider a two-part tariff. What is the problems/things we need to do as firms?

Answer 17

As firms, we need to determine 2 things:
1) The price of the initial fee.
2) The price of the recurring fee.

Question 18

When does “bundling” make sense?

Answer 18

Bundling makes sense when the customers have heterogeneous demands and when the firms cannot price discriminate.

Question 19

Elaborate on bundling

Answer 19

Bundling refer to selling multiple goods together rather than individually. This can make a lot of sense. In order for it to make sense, we need to see how different customers view the value of the products that are at sale.

Recall that bundling only make sense if we cannot price discriminate and there are heterogeneous demands.

Consider 2 movie theaters, that serve as customers. We represent a firm that has made two movies. Movie A is good, movie B is not so good.

Theater 1 rate movie A at 12 000 USD.
Theater 2 rate movie A at 10 000 USD.

Theater 1 rate movie B at 3 000 USD.
Theater 2 rate movie B at 4 000 USD.

The key is we cannot price discriminate. Therefore, if we want to keep both customers, we need to choose the price that is the lowest of the two. Following that logic, we should price movie A at 10 000 USD and movie B at 3 000 USD. This would give us 13*2 = 26 000 USD total.

However, if we bundle, we can actually achieve a better total revenue.

We therefore look at the RESERVATION PRICES IN TOTAL.
Theater 1 has a total (for those 2 movies) at 15 000 USD.
Theater 2 has a total of 14 000 USD.
Therefore, theater 2 is prepared to buy for 14 000 USD, which theater 1 would gladly accept. Therefore, we can sell the bundle at get a total of 28 000 USD.

In conclusion, bundling make use of the fact that there are relative differences in the preferences of goods among customers.
So, instead of choosing the lowest price in order to include customers, we bundle to make use of the lowest total instead.

In this case, bundling increase profits by 7.7% by enabling bundling.

Question 20

Why/when can bundling work?

Answer 20

Bundling can only work if there are RELATIVE VALUATIONS DIFFERENCES. Meaning, customer A value good 1 more than customer B, but customer B value good 2 more than customer 1.

Question 21

What is the general rule of consumption decisions when products are bundled?

Answer 21

A consumer will consider his max reservation price of the sum of the products. if this sum is smaller than, or equal to, the bundle price, then he will buy. Otherwise, he will not.

Question 22

How do we figure out if bundling is something we should do?

Answer 22

It is a statistical problem. If we find out that consumers who have a high reservation price for good A also tends to have a LOW reservation price for good B, and vice versa, then bundling makes sense. We say that the demands must be negatively correlated.

Question 23

What can we do if consumers are only a little negatively correlated in regards to demands?

Answer 23

We can use mixed bundling. Mixed bundling offer the opportunity of individual sale and as bundle. The bundle price must be below the sum of both individually.

Question 24

Define additional profit from producing and selling one more unit as a meausre of known curves

Answer 24

We can use the marginal cost curve and the demand curve. The demand curve gives us what price the differnet consumers are willing pay.

Therefore, if find the area between the demand curve and the marginal cost curve, we find ALL profit.

The key point is that with first degree price discriminaiton in the perfect case, we dont use MR = MC as the point where we’re maximizing profits. We can do a lot better. We use the demand function all the way until we reach the point where demand equals the marginal cost curve, because beyond this point, the price we get is less than the cost, which means negative revenue.

Question 25

Why is perfect first price discrimination difficult in practice?

Answer 25

It would require us to know every consumer’s RESERVATION price, which is simply not possible. It also requires us to be able to place them into the correct groups.

Question 26

Reflect on imperfect second degree price discrimination

Answer 26

It applies the same principle as perfect first degree price discrimination, but just not with every consumer. Instead, we charge a few different prices based on estimates of customer’s reservation prices.

An example of applied imperfect first degree price discrimination is car salesmen that operate with a x% profit margin. Therefore, the usually start higher than the profit maximizing price, but is able to go down, and still be higher than profit max level WHILE making it look like a good deal to the consumer.