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Pricing

Pricing. ECG 507 Professor Allen Fall 2005. 1. Introduction. Pricing without market power (perfect competition) is determined by market supply and demand. The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits.

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Pricing

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  1. Pricing ECG 507 Professor Allen Fall 2005

  2. 1. Introduction • Pricing without market power (perfect competition) is determined by market supply and demand. • The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits.

  3. 2. Introduction • Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production.

  4. 3. Capturing Consumer Surplus $/Q Pmax If price is raised above P*, the firm will lose sales and reduce profit. A P1 P* B P2 MC PC D MR Quantity Q*

  5. 4. Capturing Consumer Surplus $/Q Pmax If price is lowered the firm gains sales, but loses revenue on previous sales and lowers profits. A P1 P* B P2 MC PC D MR Quantity Q*

  6. 5. Capturing Consumer Surplus $/Q Pmax How can the firm capture the consumer surplus in A and B? A P1 P* B P2 MC PC D MR Quantity Q*

  7. 6. Capturing Consumer Surplus • Price discrimination is the charging of different prices to different consumers. • Major types • Same good, different prices (cars, cosmetics) • Price diff > cost diff (club floors in hotels) • Price varies with consumption (pizza) • Price varies by location (cement)

  8. 7. Firms price discriminate when • Monopoly power in each market • Able to identify each group • No chance for arbitrage

  9. 8. Principles of price discrimination • MR has to be the same in each market • If not, you could increase TR by shifting output from one market to another • MR in each market = MC • If not, you could increase profits by cutting back output if MC > MR (or increasing output if MR > MC)

  10. 9. Price Discrimination • Using Elasticity to Set Price in Third Degree Discrimination

  11. 10. Price Discrimination • Using Elasticity to Set Price in Third Degree Discrimination

  12. 11. Third-Degree Price Discrimination $/Q Consumers are divided into two groups, with separate demand curves for each group. D2 = AR2 MR2 D1 = AR1 MR1 Quantity

  13. 12. Third-Degree Price Discrimination $/Q MRT = MR1 + MR2 D2 = AR2 MRT MR2 MR1 D1 = AR1 Quantity

  14. 13. Third-Degree Price Discrimination $/Q P1 MC = MR1 at Q1 and P1 MC D2 = AR2 MRT MR2 D1 = AR1 MR1 Q1 QT Quantity

  15. 14. Third-Degree Price Discrimination $/Q MC = MR2 at Q2 and P2 The more inelastic the demand, the higher the price. P1 MC P2 D2 = AR2 MRT MR2 D1 = AR1 MR1 Q1 Q2 QT Quantity

  16. MC D MR 15. Second-Degree Price Discrimination $/Q Second-degree price discrimination is pricing according to quantity consumed--or in blocks. P1 P0 P2 P3 Q1 Q0 Q2 Q3 Quantity 1st Block 2nd Block 3rd Block

  17. 16. Price Discrimination • First Degree Price Discrimination • Charge a separate price to each customer: the maximum or reservation price they are willing to pay. • Examples: Professions, car dealers, private universities

  18. 17. Perfect First-Degree Price Discrimination $/Q Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow). Pmax MC P* D MR Quantity Q*

  19. 18. Perfect First-Degree Price Discrimination $/Q Consumer surplus is the area above P* and between 0 and Q* output. Pmax MC P* D = AR MR Quantity Q*

  20. 19. Perfect First-Degree Price Discrimination Output expands to Q** and price falls to PC where MC = MR = AR = D. Profits increase by the area above MC between old MR and D to output Q** (purple)--no consumer surplus. $/Q Pmax MC P* PC D = AR MR Quantity Q* Q**

  21. 20. Perfect First-Degree Price Discrimination Consumer surplus when a single price P* is charged. $/Q Pmax Variable profit when a single price P* is charged. MC P* Additional profit from perfect price discrimination PC D = AR MR Quantity Q* Q**

  22. 21. Intertemporal Price Discrimination • Separating the Market With Time • Initial release of a product, the demand is inelastic • Hard cover books • New release movies • Latest fashions

  23. 22. Intertemporal Price Discrimination • Separating the Market With Time • Once this market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand • Paper back books • Dollar Movies • Discount rack

  24. 23. Peak-Load Pricing • Demand for some products may peak at particular times. • Rush hour traffic • Electricity - late summer afternoons • Ski resorts on weekends

  25. 24. Peak-Load Pricing • Capacity restraints will also increase MC. • Increased MR and MC would indicate a higher price. • MR is not equal for each market because one market does not impact the other market.

  26. 25. Peak-Load Pricing $/Q MC D1 = AR2 MR1 Quantity

  27. 26. Peak-Load Pricing MC $/Q Peak-load price = P1 . P1 D1 = AR2 MR1 Quantity Q1

  28. 27. Peak-Load Pricing Off- load price = P2 . $/Q MC P1 D1 = AR2 P2 MR1 D2 = AR2 MR2 Quantity Q2 Q1

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