Chapter Twelve

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

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

3. 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 © 2008 Pearson Addison Wesley. All rights reserved.

4. 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 Pricing © 2008 Pearson Addison Wesley. All rights reserved.

5. Why Price Discrimination Pays For almost any good or service, some consumers are willing to pay more than others. Why and How Firms Price Discriminate © 2008 Pearson Addison Wesley. All rights reserved.

6. 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 © 2008 Pearson Addison Wesley. All rights reserved.

7. Second, a price-discrimination firm sells to some people who were not willing to pay as much as the uniform price. Why Price Discrimination Pays © 2008 Pearson Addison Wesley. All rights reserved.

8. 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 © 2008 Pearson Addison Wesley. All rights reserved.

9. 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. Who Can Price Discriminate © 2008 Pearson Addison Wesley. All rights reserved.

10. Resales are difficult or impossible for most services and when transactioncosts 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. Preventing Resales © 2008 Pearson Addison Wesley. All rights reserved.

11. Perfect price discrimination (first-degree price discrimination) Quantity discrimination (second-degree price discrimination) Multimarket price discrimination (third-degree price discrimination) Types of Price Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

12. 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. Perfect Price Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

13. 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. Perfect Price Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

14. Figure 12.1Perfect Price Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

15. 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. Perfect Price Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

16. 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. Perfect Price Discrimination: Efficient but Harmful to Consumers © 2008 Pearson Addison Wesley. All rights reserved.

17. Figure 12.2Competitive, Single-Price, and Perfect Discrimination Equilibria © 2008 Pearson Addison Wesley. All rights reserved.

18. 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 . Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria © 2008 Pearson Addison Wesley. All rights reserved.

19. 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. Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria © 2008 Pearson Addison Wesley. All rights reserved.

20. Equation 12.1 © 2008 Pearson Addison Wesley. All rights reserved.

21. Equation 12.2 © 2008 Pearson Addison Wesley. All rights reserved.

22. Equation 12.3 © 2008 Pearson Addison Wesley. All rights reserved.

23. 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 © 2008 Pearson Addison Wesley. All rights reserved.

24. 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. Transaction Costs and Perfect Price Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

25. 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 © 2008 Pearson Addison Wesley. All rights reserved.

26. 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. Quantity Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

27. Figure 12.3Quantity Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

28. 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 © 2008 Pearson Addison Wesley. All rights reserved.

29. With quantity discounting, profit is and welfare is . If it sets a single price (so that its marginal revenue equals its marginal cost), the monopoly’s profit is , and welfare is . Figure 12.3 Quantity Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

30. 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 © 2008 Pearson Addison Wesley. All rights reserved.

31. 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 © 2008 Pearson Addison Wesley. All rights reserved.

32. Because the monopoly equates the marginal revenue for each group to its common marginal cost, , the marginal revenues for the two countries are equal: Multimarket Price Discrimination with Two Groups © 2008 Pearson Addison Wesley. All rights reserved.

33. 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) Multimarket Price Discrimination with Two Groups © 2008 Pearson Addison Wesley. All rights reserved.

34. Equation 12.4 © 2008 Pearson Addison Wesley. All rights reserved.

35. Equation 12.5 © 2008 Pearson Addison Wesley. All rights reserved.

36. Equation 12.6 © 2008 Pearson Addison Wesley. All rights reserved.

37. Equation 12.7 © 2008 Pearson Addison Wesley. All rights reserved.

38. Figure 12.4Multimarket Pricing of Harry Potter DVD © 2008 Pearson Addison Wesley. All rights reserved.

39. 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 © 2008 Pearson Addison Wesley. All rights reserved.

40. 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. Identifying Groups © 2008 Pearson Addison Wesley. All rights reserved.

41. 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. Welfare Effects of Multimarket Price Discrimination © 2008 Pearson Addison Wesley. All rights reserved.

42. Consumer surplus is greater and more output is produced with competition (or perfect price discrimination) than with multimarket price discrimination. Multimarket Price Discrimination Versus Competition © 2008 Pearson Addison Wesley. All rights reserved.

43. 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 © 2008 Pearson Addison Wesley. All rights reserved.

44. 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. Multimarket Price Discrimination Versus Single-Price Monopoly © 2008 Pearson Addison Wesley. All rights reserved.

45. 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). Two-Part Tariffs © 2008 Pearson Addison Wesley. All rights reserved.

46. 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 © 2008 Pearson Addison Wesley. All rights reserved.

47. 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. A Two-Part Tariff with Identical Consumers © 2008 Pearson Addison Wesley. All rights reserved.

48. Figure 12.5Two-Part Tariff © 2008 Pearson Addison Wesley. All rights reserved.

49. 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 . Figure 12.5 Two-Part Tariff © 2008 Pearson Addison Wesley. All rights reserved.

50. 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. A Two-Part Tariff with Nonidentical Consumers © 2008 Pearson Addison Wesley. All rights reserved.