CHAPTER 13. PRICING PRACTICES.......................................................................................

1
CHAPTER 13. PRICING PRACTICES.......................................................................................1
SECTION 1. MARKET EQUILIBRIUM, SHORTAGES AND SURPLUSES..........................1
A. The Permitted Rate of Return............................................................................................5
B. The Rate Base.......................................................................................................................6
A. Peak Load Pricing................................................................................................................8
B. Price Discrimination............................................................................................................8
1. Third Degree Price Discrimination......................................................................................9
2. Second degree price discrimination...................................................................................11
3. First Degree Price Discrimination.....................................................................................13
2. Tied Products....................................................................................................................14
SECTION 7. CONCLUSION.......................................................................................................15
SECTION 7.............................................................................................................CONCLUSION
.......................................................................................................................................................15
CHAPTER !. PR"C"#$ PRACT"CE%
The U.S. government continually rediscovers the variety and compleity o! management
techni"ues #hen it attempts to control managerial discretion. $n this chapter% #e #ill !ocus on the
last large scale U.S. government attempt to control pricing in #hich the government learned the hard
#ay a&out di!!erent pricing techni"ues. From this eercise it #ill &e possi&le to revie# various
pricing techni"ues and ho# managers optimi'e #hen using several instruments simultaneously. (ost
importantly% it #ill &e apparent that rigid pricing rules do not #or) #ell !or government or !or !irms.
SECTION 1. MARKET EQUILIBRIUM, SHORTAGES AND SURPLUSES
$n mar)ets #here money is used% &uyers and sellers provide the detailed in!ormation #ith
#hich to esta&lish prices !or the goods that are traded. This in!ormation is etremely detailed and
applies to the moment at #hich trade occurs. *ours later a ne# set o! circumstances involves a ne#
set o! in!ormation and prices can dramatically change. That+s the reason that people sit at their
computer terminals all day or stand in the pit at !utures mar)ets or hang &y the telephone #aiting !or
deals, circumstances are al#ays changing. These people are #aiting !or in!ormation a&out the supply
and demand conditions that a!!ect the price each moment and they can ma)e a lot o! money simply
&y ta)ing advantage o! the changes in prices due to the moment-to-moment changes in in!ormation
a&out supply and demand.
The demand is #hat &uyers are #illing and a&le to &uy at di!!erent prices during a given
period% ceteris pari&us .holding other !actors constant/. This demand is a!!ected &y certain
0demand determinants0 .see chapter 1/. 2n the other hand% supply indicates #hat sellers are
#illing and a&le to provide at di!!erent prices during a given time period% ceteris pari&us. The
supply is a!!ected &y supply determinants. These are the same in!luences that #ould a!!ect a
!irm+s marginal cost curve .see chapter 3/. The "uantity supplied is sensitive to price% 4ust as the
"uantity demanded is. 5hile the demand curve sho#s the "uantity demanded &ecomes larger at
lo#er prices% the supply curve sho#s that the "uantity supplied &ecomes lo#er at lo#er prices.
5here the supply and demand curves cross is the e"uili&rium. Figure 1-1 sho#s such an
e&ui'i(rium. *o#ever% #hen decision ma)ing is centrali'ed either &y giving pricing authority to
the government or &y giving price authority to higher levels o! management #ithin a !irm% there is
li)ely to &e a loss o! capa&ility to process and use the in!ormation necessary to ma)e good pricing
decisions. 6ather than choosing a price that #ill &e accepta&le to &uyers or sellers% a price may &e
pic)ed that does not 7clear the mar)et.8 9learing the mar)et means that the "uantity demanded and
the "uantity supplied o! a good or service are e"ual to each other. The economic term !or such
mar)et clearing is e"uili&rium.
$! centrali'ed pricing decisions lead to a price that is &elo# this e"uili&rium% then a
shortage results &ecause &uyers #ill #ant to &uy more than they #ould at the higher e"uili&rium
price #hile sellers #ill #ant to supply less than they #ould at the e"uili&rium price. :t any given
price a shortage is the di!!erence &et#een the "uantity demanded and the "uantity supplied as
sho#n in Figure 1-1. Such shortages are not 4ust caused &y government. The scalping that
occurs outside many private events re!lects the di!!iculty o! the private suppliers o! these events to
)no# all o! the conditions that a!!ect their customers+ #illingness and a&ility to &uy tic)ets.
Scalping is the sel!-organi'ing .and o!ten illegal/ activity that arises to eliminate a shortage.
Sometimes% shortages are simply a mar)eting ploy to call attention to a product% as in the 9a&&age
patch doll cra'e.
;ut it is not 4ust shortages that can &e created &y centrali'ed decision ma)ing. $! prices
are set a&ove an e"uili&rium price% then there #ill &e a surplus &ecause &uyers #ill #ant to &uy
less than they #ould at the lo#er e"uili&rium price #hile sellers #ill #ant to supply more than
they #ould at the lo#er e"uili&rium price. :t any given price a sur)'us is the di!!erence &et#een
the "uantity supplied and the "uantity demanded as sho#n in Figure 1-1.
Figure 13-1. <"uili&rium and Supply and Demand
Price
=uantity
Supply
Demand
Price *'oor
Price Cei'ing
%H+RTA$E
%,RPL,%
>2T<? The e"uili&rium price in a mar)et occurs #here the supply and demand curves intersect.
$! prices are &elo# the e"uili&rium level% then a shortage eists. $! prices are too high then a
surplus #ould occur.
5henever a mar)et is in dise"uili&rium there are natural mar)et !orces that #ill tend to push
prices &ac) to the e"uili&rium level. 5hen there are surpluses there are "ueues o! sellers .or their
capacity to provide service/ standing around or "ueues o! goods or services that are sitting in
inventory or on the &oo)s. Such surpluses o!ten result !rom )rice f'oors .constraints on ho# lo#
prices can &e set/. 5hen there are shortages there are "ueues o! &uyers% and such shortages o!ten
result !rom )rice cei'ings .constraints on ho# high prices can &e set/. ;oth "ueues o! people and
"ueues o! goods% services% and capacity are epensive% and the people eperience those epenses #ill
gladly ma)e a cut rate deal to lo#er those costs- even illegally.
$n traveling around the #orld% #e o!ten con!ronts situations in #hich people are adapting to
dise"uili&ria. ;y #atching #hat is happening #e can identi!y #hat mar)et is in dise"uili&rium &y the
)inds o! activities that people are engaged in. 5hen surpluses occur% the sellers are eperiencing
high costs o! holding the goods in inventory % holding onto people #ho aren+t #or)ing% and holding
ecess capacity to serve customers. The sellers #ill &egin running sales% provide discounts% and
lo#er prices in any num&er o! creative #ays. $! the price !alls too !ar they may simply thro# the
ecess item out and #rite it o!! as a total loss. There may even &e an illegal attempt to !ind a #ay to
get insurance companies to pay !or the loss. Ultimately% surpluses lead to the eit o! !irms in the
mar)et place.
5hen shortages occur% the &uyers cannot get #hat they #ant and they intensely loo) !or
people #ho have the scarce item and &id the price o! the item up#ard. $! prices cannot &e &id
up#ard% &usinesses or government must !ind a #ay to ration the scarce item. Such rationing includes
schemes li)e 7!irst come !irst served%8 lotteries% or rationing coupons. $nevita&ly people &egin to
search #idely !or alternative sources o! a commodity and to trade amongst each other. $! such trade
is legal then it is called a -hite market. $! such trading is illegal then the mar)et is called a ('ack
market. Un!ortunately% in either type o! mar)et the seller does not get the &ene!it o! the higher price
and there!ore does nothing to eliminate the shortage.
$n this chapter several :merican eperiences #ith price controls are eamined to see #hat
happens- or doesn+t happen in mar)ets #here centrali'ed control occur. The last nation#ide price
control program occurred in the 19@As. *o#ever% there have &een various )inds o! price controls in
speci!ic sectors including pu&lic utilities% health care% energy% rental properties% #age rates% interest
rates% and echange rates. These types o! controls have &een !re"uent and pervasive enough that a
great deal can &e learned !rom them a&out the di!!iculty o! centrali'ed decision ma)ing- #hether !rom
the pu&lic sector or the private sector.
<B:(PC<S? Price 9ontrols in Di!!erent Dinds o! (ar)ets
Follo#ing are some situations that appeared due to price controls that #ill test your a&ility to
detect #hat )ind o! "ueues are occurring% #hat type o! price control .ceilings or !loors/ is involved%
#hether there is a shortage or a surplus o! the di!!erent items in "uestion% and #hat )ind o! mar)et
distortions result !rom the control?
1. (inimum #age . The minimum #age is only sporadically reset &y congress to re!lect
in!lation. 5hen it is reset% o!ten the changes in #ages are very large. Small &usinesses
and !arms may suddenly !ind they cannot a!!ord to hire #or)ers at the higher #age rate.
:>S5<6? The mar)et is the la&or mar)et and in this mar)et% la&or is the seller. Since
sellers are #aiting around !or 4o&s% the minimum #age is a price !loor and has resulted in
a surplus o! la&or. So many people misclassi!y such a situation as a 7shortage o! 4o&s8
#hich #ould result in an incorrect analysis o! the supply and demand conditions in the
la&or mar)et. :n important side e!!ect #ould &e the use o! illegal immigrants in place o!
:merican la&or.
2. 2il Price 9ontrols . $n 19@3-@4 there #ere price controls on oil in the United States.
Cong lines o! people could &e seen at the service stations% #aiting !or a chance to !ill up
their cars. 2ccasionally people #ould pay to ta)e someone else+s place at the gas pump.
:>S5<6? The mar)et is the mar)et !or gasoline. $t is the &uyers #ho are standing in
line% and there!ore the government is imposing a price ceiling. The rationing scheme that
is &eing used is a !irst-come-!irst-served #hite mar)et in gasoline "ueues. 2ne o! the side
e!!ects o! long lines #as irrita&ility and even acts o! violence against service station
o#ners
3. <change 6ate !or the Dollar . :!ter 5orld 5ar $$% a !ied echange rate #as esta&lished
under the ;retton-5oods monetary system in #hich currencies #ere pegged to gold. ;y
19@1% the United States #as running large &alance o! payment de!icits #hich meant that
massive amounts o! dollars #ere leaving the country. These !lo#s o! dollars could not &e
sustained &y the gold that #e had in reserve. <ngland !inally told the United States that it
#ould no longer accept the certi!icates the U.S. used in place o! gold. 2n :ugust 11%
19@1% the >ion :dministration responded &y ta)ing the dollar o!! the gold standard and
letting it !loat against other currencies. :>S5<6? The dollar is the mar)et. Under the
;retton-5oods system% there #ere "ueues o! sellers o! dollars #ho couldn+t get !oreign
countries to accept them. *ere there is a surplus o! dollars% and !or the dollar the price
control &ecame a price !loor. 2ne o! the side e!!ects #as that :merican manu!acturers
&ecame !ar less competitive than the Eapanese or Fermans &ecause our currency #as
overvalued.
4. 6ent 9ontrols. (any communities in the United States have rent controls. $n places
li)e >e# Gor)% the controls have held rents do#n !or so long% that landlords have not
)ept up their properties and renters cannot !ind apartments to rent. :>S5<6? The
mar)et is rental apartments% and there are "ueues o! &uyers. This means there are
shortages o! apartments and rent controls ta)e the !orm o! price ceilings. 2ne o! the side
e!!ects is dilapidated rental housing.
1. D6Fs. Diagnostic 6elated Froupings .D6F/ are classi!ications that allo# the
government to determine the rate at #hich di!!erent )inds o! medical procedures #ill &e
reim&ursed. Since many people depend upon (edicare% (edicaid and other government
programs the D6Fs e!!ectively set the price that can &e charged. *o#ever% many *(2s
#ithdre# !rom the (edicare program &ecause government reim&ursement rates #ere too
lo#. This le!t many people #ithout access to their doctors or #ithout medical care.
:>S5<6? The mar)et is the health care mar)et% and there are "ueues o! &uyers #ho
are not &eing served. This means there are shortages and the D6Fs must &e #or)ing as
a price ceiling. The side e!!ect is poor access and "uality o! care.
<ach o! the cases in #hich shortages occurred #ere accompanied &y mar)et pressures to
raise prices. People dealt in a &lac) mar)et% #aited in a line% paid !or someone elseHs place in line%
sold ration tic)ets% or undertoo) a host o! other costly techni"ues !or counteracting the shortage.
The e!!ect o! all o! these activities #as to raise the costs o! &uying the commodity. ;ut #hile prices
#ent up to ration &uyers they did not &ene!it the sellers to eliminate the shortage.
<ach o! the cases in #hich the surpluses occurred #ere accompanied &y mar)et pressures to
lo#er prices. ;usinesses #anted to o!!er sales% sought alternative mar)ets in #hich to sell the
product% donated it !or humanitarian purposes% or simply dumped it. ;uyers% sensing their mar)et
po#er% &ecame harder negotiators. :gain &lac) mar)ets !or the product appeared% &ut the &lac)
mar)et price #as under the list price or support price. The e!!ect o! all o! these activities #as to
lo#er the price o! the commodity. Prices generally #ent do#n to provide more product to &uyers
and lo#er incentives to suppliers% &ut i! prices #ere not allo#ed to change the ill e!!ects o! the
surplus persisted and intensi!ied.
The governmentHs eperience serves as a lesson !or managers o! private !irms. (anagers o!
private !irms can ma)e the same mista)e as the government &y imposing rigid !ormulas on pricing.
They can induce shortages 4ust as easily as the government can !rom rigid pricing. 5e continually
see evidence o! these private mar)et shortages including the scalping that goes on at ma4or playo!!
games% the crushing lines at ma4or sports events and concerts% the long #ait !or the popular doctor%
the nursing shortage% unavaila&ility o! household help and &a&ysitters% the lines at &an) teller and
restaurant carry out #indo#s% the cro#ding o! high#ays% the over utili'ation o! recreation !acilities
or par)s% the over&oo)ing o! hotels% etc.
SECTION 4. RETURN ON INVESTMENT
$n long run decisions a&out a ne# product or the continuation o! an old product% managers
o!ten #ant to see ho# the return on investment on one product compares #ith the return on others.
$n doing so% the manager is assessing the opportunity cost o! an investment. Suppose a 2AI return
can &e earned on investments #ith similar ris)s else#here, then the manager might set a target rate
of return .J/ o! 2AI. The price% determined on the &asis o! the target rate o! return% depends upon
the amount o! invested capital .D/ needed to produce the standardi'ed volume .=K/ as !ollo#s?
.4-1/ P L UM N UF N JKDO=K
2nce again eplicit costs are included in the standardi'ed unit cost .UMNUF/, implicit costs are
covered &y the satis!actory pro!it .JKDO =K/. $! 1A units o! a ne# product had a unit cost o! P3% &ut
P3A had to &e invested to produce the item% then a pro!it o! PQ .L2AIKP3A/ #ould &e needed to
reach a 2AI target rate o! return. This #ould translate into a price o! P3.QA per unit .LP3N.PQO1A
units//.
There is one type o! industry in #hich return on investment has &een used etensively as a
means to control prices, utilities% particularly electric utilities. From this industry #e can learn a great
deal a&out the di!!iculties price control and pricing using a target return on investment criterion.
A. The Permitted Rate of Return
: stateHs right to regulate utility rates #as a!!irmed in 13@@ &y the Supreme 9ourt in the case
(unn vs. $llinois .94 U.S. 113 .13@@//. ;ut that decision also ushered in a century o! s"ua&&les
a&out ho# to measure the return on investment.
: utility regulator typically set a given 0!air rate o! return0 !or a utility. This !air rate o!
return% r% multiplied &y the utilityHs investment .D/ determined its maimum allo#a&le pro!it?
.4-2/ allo#a&le pro!it L rKD
Fenerally% there #as little pro&lem determining the fair rate of return% r. The !air rate o! return
#as o!ten computed &ased on the return !rom mar)et opportunities that #ere most similar in ris) and
value to those o! the utility. : utility commission could choose a mar)et rate o! return !or similar
investments #ith similar degrees o! ris).
B. The Rate Base
*o#ever% the level o! investment% D% #as the su&4ect o! etensive de&ate and legal #rangling.
The pro&lem #as to determine ho# to measure a utilityHs investment% #hich #as called its rate (ase.
There are three theoretical approaches !or measuring the rate &ase?
.a/ 2riginal or 0*istorical0 Malue. :s its name implies% a !irm can value its capital &ased on the
actual dollar cost- origina' cost- at #hich it #as purchased. *o#ever% #ith in!lation such a
valuation understates the current value o! the capital.
.&/ 6eproduction Malue. $! a utility #ished to &uy or sell its identical !acilities on the mar)et at
current prices% it could compute the total current value or re)roduction .a'ue o! its
!acilities. This is the )ind o! value estimation that &ecomes important #hen a company is
li"uidated. *o#ever% since a utility is o&ligated to provide service% it does not accurately
represent the cost o! providing that service. $ts current !acilities are li)ely to &e out-o!-date.
9ompara&le !acilities may not &e !ound on the mar)et% and that ma)es valuation di!!icult.
The !irm #ould not attempt to &uy the same !acilities even i! they #ere availa&le% pre!erring
instead to adopt the latest technology.
.c/ 6eplacement Malue. $deally a !irm #ould replace depreciated !acilities #ith the latest
technology. The re)'acement .a'ue is the current mar)et value o! the !irmHs capacity% &ased
on the latest technology that #ould achieve the !irmHs current production capacity.
$! a utility commission #ere to restrict the !irms under its 4urisdiction to a method #hich resulted in
too small a valuation o! a !irmHs investment% pro!its and services #ould &e s"uee'ed% ma)ing !urther
investment capital hard to raise. 2n the other hand% i! the valuation #ere too high% the !irm #ould
ma)e such high pro!its that its stoc) #ould &e &id up and the utility #ould tend to overepand.
The Supreme 9ourt tried to resolve the valuation pro&lem &e!ore the turn o! the century. $n
Smyth vs. :mes .1Q9 U.S. 4QQ .1393//% it created the concept o! 0!air value0 #hich !ailed to &e
speci!ic and also provided a misleading suggestion a&out ho# !air value might &e determined. The
ne# 0!air value0 criterion #as commonly interpreted as an average o! the original and reproduction
valuation methods% &ut it provided the &asis !or massive litigation. Finally% in Federal Po#er
9ommission et. al. M. *ope >atural Fas 9o. .32A U.S. 191 .1944//% the Supreme 9ourt got a#ay
!rom de!ining !air value. $t le!t that up to the regulators as long as the regulatory decision process
#as 04ust and reasona&le.0 (any o! the regulators then adopted the !la#ed% &ut relatively simple
original cost method o! valuation o! the rate &ase. ;ut there #as no common procedure amongst the
regulators.
<ven i! an ade"uate rate &ase is esta&lished% a rate o! return control provides undesira&le
incentives !or a utility. 2nce a commission has determined ho# it #ill measure the rate &ase% the
utility has an incentive to spend as much money as possi&le to ma)e the rate &ase larger.
<penditures on inputs such as la&or #hich do not raise the rate &ase are li)ely to &e held do#n.
*o#ever ependitures on plant and e"uipment #hich are included in the rate &ase are li)ely to &e
!avored. <conomists have measured a &ias to#ard ecessive capital ependiture relative to
ependitures on other !actors. This &ias is called the A.erch/0ohnson effect.
1
;ut the e!!ect is
more easily remem&ered as 7gold-plating.8
SECTION 5. PRICE DISCRIMINATION AND PEAK LOAD PRICING
The pro&lem #ith using any pricing !ormula as a rigid guideline is that the !ormula can
inter!ere #ith the rationing !unction that prices should per!orm in a mar)et economy. Prices serve as
a mar)et signal to &uyers and sellers. 6ising prices constrain &uyers #illingness and a&ility to &uy
and can there!ore alleviate shortages. Falling prices ena&le sellers to clear out un#anted inventories
that result !rom surpluses. $! a !irm is rigid in its pricing it may not &e a&le to ad4ust its prices
appropriately to eliminate surpluses or shortages.
To &e !lei&le enough to avoid shortages and surpluses% a !irm may have to &e s)illed in
ad4usting prices rapidly. <ven #ithin the period o! a single day% demand may !luctuate &et#een
pea)s and valleys and a single price #ould eacer&ate such !luctuations. $n such circumstances a
!irm should &e s)illed at )eak 'oad )ricing in #hich it charges higher prices !or customers &uying
#hen demand is greatest. Di!!erent customers may have di!!erent capa&ilities to pay. : !irm
charging di!!erent prices &ased on customer a&ility to pay is using )rice discrimination to ration
goods and services. ;ecause governments have learned so much a&out these t#o pricing techni"ues
!rom closely regulating utilities% #e also #ill use utilities to learn a&out the conditions under #hich
di!!erent prices should &e charged #ithin a single mar)et.
Figure 1-1. Pea) Coad Pricing
1
*arvey :verch and Celand C. Eohnson% 0;ehavior o! the Firm under 6egulatory 9onstraint%0
:merican <conomic 6evie# 12 .Decem&er 19Q2/? 1A12-Q9. : good% though dated survey
concerning this e!!ect can &e !ound in <li'a&eth ;ailey% Theory o! 6egulatory 9onstraint .Ceington%
(ass.? Ceington% 19@3/
P
r
i
c
e

.
P
O
A
A
A

D
#
h
/
=uantity .AAAs D#h/ 1 6 2
Pea)
Demand
E3)anded
Ca)acit4
2!!
Pea)
Demand
Marg!a" C#$%
5 +ff Peak Price
Marg!a"
C#$%
B&'#r&
&()a!$#!
Marg!a"
C#$%
A'%&r
&()a!$#!
Peak Price Before e3)ansion
Peak Price
After e3)ansion
6.5
5.7
>2T<? 5ith pea) load pricing a !irm can !inance epansion to the point #here pea) and o!!-pea)
pricing #ill &e the same.
A. Peak Load Pricing
;ecause o! regulatory lag in granting price increases% in!lation% or restrictions &y regulators a
utility company may !ind that there is a greater "uantity demanded than it has the capacity to provide.
This capacity shortage is li)ely to occur only at certain pea) periods. Figure 1-1 sho#s the short run
marginal cost curve o! a utility #hich has the capacity to produce QAAA )ilo#att hours o! electricity.
>otice that demand during pea) periods o! time is to the right o! the demand at non-pea) periods.
To ration the electricity e!!iciently% the utility should raise the price it charges to pea) users to the
point #here demand intersects price .at a&out P@.1A per thousand D5h in the Figure/. *o#ever% i!
such a price #ere charged !or o!! pea) users% the utility #ould drop its revenues as o!! pea) sales
drop !rom Q to 4 D5h. The solution is to charge o!!-pea) users the marginal cost o! providing the
electricity .at P1.AA per thousand D5h/ and charge the cost o! epansion to the pea) users .at
P@.1A/. Such a multiple price approach is called )eak 'oad )ricing.
The additional revenues !rom pea) load pricing can &e reinvested to epand capacity. 5hen
capacity is epanded enough to cover pea) and o!!-pea) demand% the price !or the t#o services #ill
converge. $n Figure 1-1% the utility could epand to 9 D5h in order to eliminate the price
di!!erential. $! a price regulator ignores pea) load pricing% it can cause shortages resulting in
&ro#nouts or &lac)outs, &e!ore the utility epansion in Figure 1-1 such shortages #ould have
occurred at any price &elo# P@.1A !or pea) demand.
B. Price Discrimination
Pea) load pricing is not the only rationale !or charging di!!erent rates !or di!!erent customers.
Price discrimination occurs #hen customers are charged di!!erent prices !or the same good or
service% and #hen the di!!erence in price is not related to di!!erences in the cost o! providing service.
Three types o! price discrimination are de!ined in economics?
.1/ Third degree )rice discrimination occurs #hen a !irm can identi!y groups o! &uyers #ho
can &e charged di!!erent prices !or the same product.
.2/ %econd degree )rice discrimination occurs #hen a !irm can charge di!!erent prices !or
additional increments o! one product to a single customer .or single customer group/.
.3/ *irst degree )rice discrimination occurs #hen a !irm can charge di!!erent prices !or each
additional unit o! output according to #hat each customer is #illing and a&le to pay.
: separate analysis is re"uired !or each o! these three types o! discrimination.
1. Third Degree Price Discrimination
: utility can o!ten segment its mar)ets &ased on characteristics o! its customers. The )ey to
success!ul segmentation is the a&ility to prevent customers #ho are charged higher prices !rom
disguising themselves to "uali!y !or lo#er rates and to prevent them !rom &uying !rom the customers
#ho "uality !or lo#er prices. :irlines can success!ully segment &y giving lo#er rates to customers
#ho can plan in advance. Utilities are a&le to di!!erentiate &et#een residential% commercial% and
industrial users.
2nce an e!!ective &asis !or mar)et segmentation and the demand !or each mar)et segment
has &een !ound% the pro!it maimi'ation rule can &e applied. $t re"uires the hori'ontal summation o!
marginal revenue curves o! the separate mar)ets to derive the marginal revenue curve !or the
com&ined mar)ets. Figure 1-2 sho#s the hypothetical demand and marginal revenue !or industrial
.center/ and residential .le!t/ users. :ssuming there are no commercial customers% #e can derive the
marginal revenue curve !or o!!ering service to &oth mar)ets .right hand diagram/. For each level o!
marginal revenue% the corresponding "uantities in the residential and industrial mar)et are added
together to !ind the com&ined marginal revenue curve.
The pro!it maimi'ation condition re"uires that marginal revenue o! the com&ined mar)ets
e"uals marginal cost. *o#ever% the pricing in the t#o mar)ets must &e separate. Theoretically to
)eep trac) o! ho# to determine optimal production levels !or t#o mar)ets% a manager can !ollo# the
!ollo#ing !our steps% as illustrated in Figure 1-2?
Step 1. *ind the com(ined out)ut for each )ossi('e margina' re.enue 'e.e'.. For
eample% one mar)et produces a marginal revenue o! P3.AA per D#h #hen 13AA D#h is sold
#hile in the other mar)et only that marginal revenue occurs a!ter only @AA D#h is achieved.
$n the com&ined mar)et the P3.AA marginal revenue is achieved #ith production o! 21AA
D#h. $! any more #ere produced marginal revenue #ould !all in &oth mar)ets.
Step 2. $ra)h the cumu'ati.e 8R cur.e. :t each marginal revenue level a graph o! the
cumulative marginal revenue curve can &e constructed as sho#n on the right hand side o!
Figure Q-2. This graph is simply the hori'ontal sum o! the outputs cumulated at each level o!
marginal revenue in the t#o mar)ets separately. These individual mar)ets are depicted in the
le!t hand and center graphs.
Step 3. 8C5 Cumu'ati.e 8R. Using the ne# marginal revenue curve in the right hand
graph% !ind #here marginal revenue and marginal cost o! the 4oint products are e"ual. This
mar)s on the B-ais the pro!it maimi'ing output !or the t#o goods.
Step 4. Read the )rice off the demand cur.es in the indi.idua' markets. For the
marginal revenue .P9.1A/ #here (9Lcumulative (6% go &ac) to the individual mar)ets and
!ind the associated outputs and prices. >otice that the prices in the t#o mar)ets are di!!erent.
$n one mar)et% the demand curve associated #ith a marginal revenue o! P3.AA corresponds to
a price o! P21.AA% &ut in the other mar)et the demand curve sho#s that the price #ould only
&e P2A.AA. The di!!erences &et#een the t#o mar)ets re!lect the di!!erences in the elasticities
o! demand in the t#o separate mar)ets.
Figure 1-2
Hori9onta' Addition of 8argina' Re.enue
9.50
3.00
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A
A
A

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1.3 .@ 2.1
6esidential .D#h/ N $ndustrial .D#h/ L Total (arginal 6evenue
P
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P
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A
A
A

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6esidential
Demand
$ndustrial
Demand
R&$*&!%a"
Marg!a"
r&+&!,&
I!*,$%ra"
Marg!a"
r&+&!,&
H#r-#!%a"
S,. #'
Marg!a"
r&+&!,&
(arginal cost
8C58R
Residentia'
Price
"ndustria'
Price
3
1& 1a
4a
4&
2
:5.77
:7.77
>2T<? (arginal revenue curves in the t#o mar)et segments are added hori'ontally to arrive at the
marginal revenue curve !or the com&ined mar)et.
5hile a manager is not generally going to graph the marginal revenue and marginal cost
curves 4ointly !or 4oint products% the manager must &e a#are o! the comple #ays that the mar)ets
!or 4oint products interact #ith each other and must reali'e ho# the price sensitivity .in other #ords%
the elasticity/ in the di!!erent mar)ets re"uires di!!erent prices. ;y )no#ing the reasoning implicit in
Figure 1-2% a manager is not em&arrassed a&out charging di!!erent prices in di!!erent mar)ets% &ut
)no#s ho# to 4usti!y and eplain #hy it is necessary to charge di!!erent prices i! ade"uate rationing
and optimal pro!it are to &e achieved.
5ith in!ormation a&out demand in each o! its mar)et segments a utility could determine #hat
price to charge in each mar)et. Fiven the price elasticity o! demand%
i
% !or each group% i% the pro!it
maimi'ing output #ould &e esta&lished &y the !ollo#ing !ormula?

.1-1/ P L (9 O .1 N 1O
i
/
$t applies to each group .residential commercial/ separately% rather than to a #hole mar)et. $!
allo#ed to discriminate in prices% a utility #ould need to )no# the price elasticity o! demand !or each
o! its groups in order to determine the appropriate price.
Success!ul 3rd degree price discrimination can only &e practiced in mar)ets #here a !irm has
the discretion to charge di!!erent prices and #here it is possi&le to group customers into separate
mar)ets. $n other #ords% a utility #ould not #ant to see residential users &uying electricity indirectly
!rom industrial users. Such secondary mar)ets prevent success!ul mar)et segmentation. Finally% the
elasticities o! demand must &e di!!erent !or each group. $! the resources associated #ith price
discrimination and the cost o! mar)et segmentation is greater than the revenue generated !rom price
discrimination% then 3rd degree price discrimination may not &e #orth#hile. 5hen ne# technologies
such as micro-tur&ines allo# customers to sell to other customers% a utility may lose pro!it potential
&y not )no#ing ho# to discriminate &et#een di!!erent mar)ets.
2. Second degree price discrimination
$n order to provide the amount o! service re"uired &y customers% utilities may have to
discriminate in prices in order to &e pro!ita&le. Figure 1-3 sho#s a utility #ith a do#n#ard sloping
long run average cost curve. <ven i! the average costs #ere not every#here a&ove demand%
economies o! scale #ould mean that the utility #ould !ace losses i! it tried to price at marginal cost.
.$n chapter 3 #ith economies o! scale #e sa# that marginal cost #ould &e &elo# average costs and
price #ould there!ore &e &elo# average cost/.
:llo#ing a !irm to provide discounts !or large "uantity purchases can provide additional
revenues #ithout any increase in cost. Such "uantity discounts appear every#here !rom the !actory
to the grocery store. ;ecause the prices vary #ith &loc)s o! output :nd degree )rice
discrimination is o!ten called ('ock )rice discrimination. $n dec'ining ('ock )rice
discrimination the prices are lo#er !or larger purchases. *o#ever% #ith environmentalist pressures
and the ina&ility to epand% utilities have sometimes &een !orced to eliminate such discrimination. $n
!act% i! a utility could not epand even though demand #ere epanding it could eventually &e !orced
to increasing ('ock )rice discrimination.
Figure 1-3. ;loc) Price Discrimination
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=uantity .D#h/ 6 2
Demand
L#!g R,! Marg!a" C#$%
L#!g
R,!
Marg!a"
C#$%
6.5
6.7
5.7
L#!g
R,!
A+&rag&
C#$%
Re.enue added -;
Discrimination5
5<6.5/5.7=>65 5
Tota' Re.enue5 <5.7>2=515
Tota' Cost 5 <6>2=551
>2T<? $! the !irm #ere only to charge one price o! P1.AA per D#h and #ere to produce 9AAA D#h%
there #ould only &e P41%AAA o! revenue #hich #ould &e less than the costs .P14%AAA/ o! providing
the electricity. ;ut #ith second degree price discrimination% P11%AAA more can &e added. The !irst
&loc) o! revenue consists o! Q D5h at a price o! P@.1A !or a revenue contri&ution o! P41.AA. The
second &loc) o! revenue consists o! 3 D5* at a price o! P1.AA #hich contri&utes P11.AA o! etra
revenue.
The utility in Figure 1-3 can increase its revenues &y simply lo#ering its price !or additional
increments o! output. $n ma)ing a &id to install electric service% a utility might o!!er P@.1A !or the
!irst si thousand D5h and then o!!er P1.AA !or the net three thousand D5h% as sho#n in Figure 1-
3. CetHs see ho# this pricing scheme #ould a!!ect the utilityHs pro!its.
Table 5-1. Revenue effects of Price Discrimination
============================================================
Block Discrimination No Discrimination
(000/s !/"#$ !(000s !/"#$ ! (000s
%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%
1st & "#$ !'.50 !(5.00 !5.00 !)0.00
*n+ ) "#$ !5.00 ,!15.00 !5.00 ,!15.00
Total Revenue !&0.00 !(5.00
Total -ost !&.00 -!5(.00 !&.00 -!5(.00
Profit (.oss !&.00 -!/.00
0ain from Discrimination=-!&.00- (-/.00= !15.00
============================================================
N1T23 T$e 4rice an+ revenue +iffer onl5 for t$e first block of
out4ut. 6o7ever8 t$e e9tra revenue8 !15.008 from +iscrimination
allo7s t$e utilit5 to take a 4rofit rat$er t$an a loss.
6aising the price P2.1A on the !irst QAAA D5h &loc) generates another P11%AAA .LQAAAKP2.1A/ o!
revenue as sho#n &y the shaded area in Figure 1-3. 5ith this etra discrimination% the utility can
ma)e a positive pro!it% rather than a loss.
3. First Degree Price Discrimination
$! the utility #as allo#ed to charge every customer #hat each customer #ere #illing and a&le
to pay% then the utility #ould &e using first degree )rice discrimination. Figure 1-4 sho#s that a
utility #hich can use 1st degree price discrimination can capture the #hole area- called consumer
sur)'us- under the demand curve. $n Figure 1-4% the consumer surplus is given &y the triangle
located &et#een the demand curve and the price charged &y the utility. This consumer surplus
measures the potential revenue !rom charging all customers the maimum that each is #illing and
a&le to pay !or each unit.
Figure 1-4. First Degree Price Discrimination
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=uantity .AAAs D#h/ 6 2
Demand
L#!g R,! Marg!a" C#$%
L#!g
R,!
Marg!a"
C#$%
6.7
5.7
L#!g
R,!
A+&rag&
C#$%
7
Re.enue Added
5Consumer %ur)'us
5.5 <7/5=>25 ::.5
Tota' Re.enue5 <5.7>2=515
Tota' Cost 5 <6>2=551
>2T<? The shaded triangle is the consumer surplus. Since the demand curve is linear% the area is
given &y the !ormula? consumer surplus L 1O2 K output K price di!!erence
L 1O2 K 9AAA D5h K .P1A.AA-P1.AA/ L P22.1A
5ith per!ect in!ormation a&out consumer demand a utility could determine precisely #hat
price to charge each customer !or each unit o! output. Fiven the price elasticity o! demand%
4
% !or
each customer% 4% the pro!it maimi'ing condition #ould &e?
.1-2/ P L (9 O .1 N 1O
4
/
;y no# this condition should &e !amiliar. *o#ever% no# it applies to each individual separately%
rather than to a #hole mar)et or mar)et segment. :llo#ed to discriminate in prices% a utility #ould
#ant to )no# the price elasticity o! demand o! each o! its customers in order to determine the
appropriate price.
5ith the a&ility to discriminate in price on every unit #ith respect to every customer% the
utility in Figure 1-4 #ould &e a&le to ma)e a pro!it. :t an output o! 9AAA D5h% total cost is P14AA.
6evenue #ithout price discrimination #ould &e only P41AA .L9AAAD#h K P1.AA/. *o#ever% #ith
!irst degree price discrimination% the utility can turn the !ull consumer surplus o! P221A .L.1O2/K 9AAA
D#hK .P1A.AA-P1.AA// into additional revenue. Total revenue is there!ore% PQ@1A .LP41AANP221A/
and total pro!it is P131A .LPQ@1A-P14AA/. The utility is pro!ita&le #ith !irst degree price
discrimination. 2! course% the utility #ould have to prevent the consumers !rom getting together in
any #ay to &uy !rom each other% #ould have to !ind precise in!ormation on consumer demand% and
#ould have to gain permission !rom regulators. These conditions are all violated !or most utilities.
SECTION /. MULTIPLE PRODUCT PRICING0 T&* Pr#*,1%$
2!ten &usinesses !ind that they can ma)e a great deal o! revenue &y o!!ering additional
products% particularly i! they have mar)et po#er in one mar)et. :ll they need to do is to re"uire
people #ho #ant the one .t4ing= product in #hich the company has mar)et po#er to &uy the other
.tied/ good o!! o! #hich the company #ishes to ma)e additional revenue. Such a re"uirement #as
once illegal per se under the antitrust la#s.
*o#ever% !or decades <conomists "uestioned #hether tying o! goods could have any
redeeming value. Firms have goods or services tied together !or many reasons?
.a/ 5hen a !irm has mar)et po#er in one mar)et or has a commodity in short supply .tying
good/% it may &e a&le to rid itsel! o! a surplus or a commodity in #hich it has no mar)et
po#er .tied good/. $n airline travel% !or eample !ree upgrades to !irst class seats .tying
good/ is tied to the num&er o! miles traveled through normally paid !lights on an airline .tied
good/.
.&/ 5hen a !irm introduces a ne# product% it may #ish to ensure "uality service so that the ne#
product #ill &uild good#ill more "uic)ly. 5hile tying is o!ten illegal%
2
the Supreme 9ourt
3
recogni'ed in a case involving an electronics company that tying service to a ne# product
provided a reasona&le use o! tying.
.c/ : !irm can o!ten use tying !or the purpose o! 1st degree price discrimination. Success!ul
discrimination re"uires that the tied good must &e used in proportion to a customerHs need !or
the tying good .eg. a camera or copying machine/. $n chapter 1A #e sa# that photographic
and copying companies li)e Bero could gauge the needs o! customers &y the num&er o!
copies or photographs customers made. ;y ta)ing revenues !rom the num&er o! copies made
or the num&er o! photographs ta)en .tied good/% the companies could set prices &ased on
relative needs !or copying services. This is a !orm o! price discrimination.
;ecause the demand !or the tying good a!!ects the demand !or the tied good% they must &e priced in
tandem.
*
Section 3 o! the 9layton :ct ma)es such sales illegal i! they su&stantially lessen competition.
)
United States v. Eerrold <lectronics 9orporation% 3Q1 U.S. 1Q@ .19Q1/
<B:(PC<? Tying *ome *ealth 9are to *ospital Services
Suppose the hospital o!!ering home health care services &egan to !ind that there #as sti!!
competition !rom other home health care agencies. They might decide to re"uire anyone #ho is a
mem&er o! the hospital+s net#or) to use home health services provided &y the hospital. Pu&licly they
might claim that this #ould &e the only #ay that they could ensure "uality service.
;y ma)ing such a re"uirement% the hospital+s net#or) &ecomes the tied good and the home
health care &ecomes the tying good. Such a tying arrangement may !orce the hospital to supply the
&urden o! proo! in an antitrust case to sho# ho# their home health care #ould maintain "uality #hile
other home health services #ould not. $n addition they #ould have the &urden to sho# that the tying
arrangement involves the least restrictiveness necessary to maintain "uality.
%ECT"+# 6. C+#CL,%"+#
Price controls and ine!!icient pricing continue to characteri'e many mar)ets. Private !irms
can &e 4ust as ine!!icient #ith centrali'ed pricing as governments can &e #ith price controls.
5henever a rigid !ormula or rule-o!-thum& is applied to pricing it inevita&ly ignores the changes
in underlying mar)et conditions #hich can lead to shortages or surpluses. For eample% the Post-
o!!ice uses one price !or a !irst class stamp% regardless o! #here a piece o! mail is sent in the
United States. 5hile it might &e more e!!icient to charge on the &asis o! the distance that a letter
is sent% such a rigid !ormula might itsel! prove ine!!icient. For eample% !or decades the steel
industry priced steel on the &asis o! the distance !rom certain )ey steel centers. >othing points
more clearly to the ine!!iciencies o! such pricing schemes than the competitors li)e Fede and
UPS #ho come into a mar)et and survive pro!ita&ly under more !lei&le pricing schemes.
5hile the last general price control program ended in the decade o! the 19@As% price
controls are gro#ing in several industries. (ost prominently they are appearing in the *ealth
9are industry. $ronically it #as during a conservative 6epu&lican administration #hen the !irst
steps to#ard price controls #ere underta)en in the health mar)et. 6esearchers at Gale University
categori'ed diseases #ith a system called Diagnostic 6elated Froups .D6Fs/ #hich #ere applied
to hospitals. These categories allo#ed the !ederal government to set limitations on
reim&ursements through (edicare !or patients #ith di!!erent diseases. Then in 1939 *arvard
researchers esta&lished a similar system% the 6esource ;ased 6elative Malue System .6;6MS/%
!or physician reim&ursement. Still more recently researchers designed an 7:PF8 system to
control reim&ursements !or am&ulatory% home health% occupational therapy% and physical therapy
care.
Such categori'ation systems allo# the government to control health care reim&ursement.
*o#ever% as in any price control% inade"uate reim&ursement leads to shortages o! services.
$ncreasingly% large groups o! the population are !inding shortages in health care coverage or
"uality o! health care as a result. :s such symptoms o! dise"uili&rium #orsen% the government
#ill again need to step in to re!orm the health care mar)et. 5hile it is easy to start a price control
program% past eperiences have sho#n that it &ecomes very di!!icult to end such programs. ;ut i!
private mar)et pricing is also ine!!icient% there may &e little choice &ut to rely upon government
involvement.
$>D<B
:verch-Eohnson e!!ect..................................@
&lac) mar)et.................................................3
&loc) price discrimination...........................11
consumer surplus........................................13
dise"uili&rium...............................................3
e"uili&rium....................................................2
!air rate o! return..........................................Q
First degree price discrimination..................9
original cost..................................................Q
pea) load pricing..........................................@
price ceilings.................................................3
price discrimination......................................@
price !loors....................................................3
rate &ase........................................................Q
replacement value.........................................Q
reproduction value........................................Q
Second degree price discrimination..............9
shortage........................................................2
surplus..........................................................2
target rate o! return......................................1
Third degree price discrimination.................9
tying/ product.............................................14
#hite mar)et.................................................3
.tied/ good..................................................14