CHAPTER 11 – PRICING STRATEGIES FOR FIRMS WITH MARKET POWER

Learning Objectives
1. Apply simple elasticity-based markup formulas to determine profit-maximizing prices in
environments where a business enjoys market power, including monopoly, monopolistic
competition, and Cournot oligopoly.
2. Formulate pricing strategies that permit firms to extract additional surplus from
consumers—including price discrimination, two-part pricing, block pricing, and
commodity bundling—and explain the conditions needed for each of these strategies to
yield higher profits than standard pricing.
3. Formulate pricing strategies that enhance profits for special cost and demand structures—
such as peak-load pricing, cross-subsidies, and transfer pricing—and explain the
conditions needed for each strategy to work.
4. Explain how price-matching guarantees, brand loyalty programs, and randomized pricing
strategies can be used to enhance profits in markets with intense price competition.

Review of Basic Profit Maximization

• Firms with market power face a downward-sloping demand.
– Implication: there is a trade-off between selling many units at a low price and selling a few
units at a high price.
• Managers of firms with market power balance these competing forces by selecting the quantity
that equates marginal revenue ( MR ) and marginal cost ( MC ), and charging the maximum price
that consumer will pay for this level of output.

Basic Profit Maximization In Action

• Suppose the (inverse) demand for a firm’s product is given by P=10−2 Q and the cost function
is C ( Q ) =2Q. What is the profit-maximizing level of output and price for this firm?
• Answer:
– The marginal revenue function is: MR=10−4 Q.
– The marginal cost function is: MC=2.
– Equating these two functions yields 10−4 Q=2, so Q=2.
The profit-maximizing price is P=10−2 ( 2 )=$ 6.

Simple Pricing Rule: Monopoly and Monopolistic Competition

• What if estimates of the demand and cost functions are not available?

– Managers have a “crude” estimate of

• marginal cost; the price paid to a supplier.

• the price elasticity of demand, since it is typically available for a

representative firm in an industry.

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CHAPTER 11 – PRICING STRATEGIES FOR FIRMS WITH MARKET POWER

• With this information, the monopoly and monopolistically competitive firm’s profit-
1+ E F
maximizing price (markup) is computed from: MC = P
EF [ ]
,

1+ E F
where MR=P [ ] EF
.

EF
• So, set price such that: P= [ ]
1+ E F
MC .

Simple Pricing Rule In Action: Problem

The manager of a convenience store competes in a monopolistically competitive market and

buys cola from a supplier at a price of $1.25 per liter. The manager thinks that because there
are several supermarkets nearby, the demand for cola sold at her store is slightly more elastic
than the elasticity for the representative food store. Specifically, the elasticity of demand for
cola sold by her store is −4. What price should the manager charge for a liter of cola to
maximize profits?

Simple Pricing Rule In Action: Answer

5
• The marginal cost of cola to the firm is $ 1.25, or per liter, and the markup factor is
4
4 4
[ ] = .
1−4 3

• The profit-maximizing pricing rule for a monopolistically competitive firm is:

4 5 5
P= [ ][ ]
3
= ,
4 3
or about $ 1.67 per liter.

Simple Pricing Rule for Cournot Oligopoly

• When each of the Nfirms operating in a Cournot oligopoly has identical cost structures and
produces similar products, the simple profit-maximizing price (markup) in Cournot
equilibrium is:

NE M
P=
[ ]
1+ NE M
MC , where E M is the market elasticity of demand.

Beyond the Single-Price-Per-Unit Model

• In some markets, managers can enhance profits beyond those resulting from charging all
consumers a single, per-unit price.
• Models that yield greater profits fall into three categories:

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CHAPTER 11 – PRICING STRATEGIES FOR FIRMS WITH MARKET POWER

– Pricing strategies:
• that extract surplus from consumers.
• for special cost and demand structures.
• in markets with intense price competition.
Models that Extract Surplus from Consumers
• Strategies for surplus extraction:
– Price discrimination (first, second and third degrees)
– Two-part pricing
– Block pricing
– Commodity bundling
• Each strategy is appropriate for firms with various cost structures and degrees of market
interdependence.

Surplus Extraction: First-Degree Price Discrimination

• Price discrimination is the practice of charging different prices to consumers for the same
good or service.
• First-degree price discrimination is the practice of charging each consumer the maximum
price he or she would be willing to pay for each unit of the good purchased.
– Implication: the firm extracts all surplus from consumers and earns the highest
possible profit.
• Problem: managers rarely know each consumers’ maximum willingness to pay for each
unit of the product.

First-Degree Price Discrimination

Surplus Extraction: Second-Degree Price Discrimination

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CHAPTER 11 – PRICING STRATEGIES FOR FIRMS WITH MARKET POWER

• Second-degree price discrimination is the practice of posting a discrete schedule of declining

prices for different ranges of quantity.

– Implication: firm extracts some surplus from consumers without needing to know
the identity of various consumers’ demand.

Second-Degree Price Discrimination

Surplus Extraction: Third-Degree Price Discrimination

• Third-degree price discrimination is the practice of charging different prices based on

systematic differences in demand across demographic consumer groups.

– Implication: marginal revenue will be different for each group. That is, if there are
two groups, MR 1> MR 2, for example.

Surplus Extraction: Third-Degree Price Discrimination Rule

• To maximize profits, a firm with market power produces the output at which the marginal
revenue (left-hand side of the following equations) to each group equals marginal cost.

1+ E 1
P1
[ ]
E1
=M C

1+ E 2
P2
[ ]
E2
=M C

Third-Degree Price Discrimination Rule In Action:

• You are the manager of a pizzeria that produces at a marginal cost of $6 per pizza. The
pizzeria is a local monopoly near campus. During the day, only students eat at your

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CHAPTER 11 – PRICING STRATEGIES FOR FIRMS WITH MARKET POWER

restaurant. In the evening, while students are studying, faculty members eat there. If
students have an elasticity of demand for pizza of −4 and faculty has an elasticity of
demand of −2, what should your pricing policy be to maximize profits?

Third-Degree
Price Discrimination Rule In Action:
• Assuming faculty would be unwilling to purchase cold pizzas from students, the conditions
for effective third-degree price discrimination hold. It will be profitable to charge a “lunch
menu” price and a “dinner menu” price. These prices are determined as follows:
1−4
PL [ ]
−4
=$ 6

1−2
PD [ ]
−2
=$ 6

• Solving these equations yield, P L=$ 8 and P L=$ 12.

Surplus Extraction: Two-Part Pricing

• Two-part pricing is a pricing strategy whereby a firm with market power charges a fixed fee
for the right to purchase its goods, plus a per-unit charge for each unit purchased.

Two-Part Pricing

Surplus Extraction: Block Pricing

• Block pricing is a pricing strategy in which identical products are packaged together in
order to enhance profits by forcing customers to make an all-or-none decision to purchase.
– The profit-maximizing price on a package is the total value the consumer receives
for the package.

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CHAPTER 11 – PRICING STRATEGIES FOR FIRMS WITH MARKET POWER

Block Pricing

Surplus Extraction: Commodity Bundling

• Commodity bundling is the practice of bundling several different products together and
selling them at a single “bundle price.”
– Key assumption: Consumers differ with respect to the amounts they are willing to
pay for multiple products sold by a firm.
– Managers cannot observe different consumers’ valuations.

Pricing Strategies for Special Cost and Demand Structures: Peak-Load Pricing
• Peak-load pricing is a pricing strategy in which higher prices are charged during peak
hours than during off-peak hours.

Special Demand and Costs: Peak-Load Pricing

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Special Demand and Costs: Cross-Subsidies

• Cross-subsidy is a pricing strategy in which profits gained from the sale of one product are
used to subsidize sales of a related product.
• Cross-Subsidization Principle:
– Whenever the demands for two products produced by a firm are interrelated
through costs or demand, the firm may enhance profits by cross-subsidization:
selling one product at or below cost and the other product above cost.

Special Demand and Costs: Transfer Pricing

• Transfer pricing is a pricing strategy in which a firm optimally sets the internal price at
which an upstream division sells an input to a downstream division.
– Important since most division managers are provided an incentive to maximize their
own division’s profits.
– Transfer pricing aligns division manager’s incentives with that of the overall firm,
and increases overall firm’s profit.

Special Demand and Costs: Double Marginalization

• Consider a large firm with two divisions:
– upstream division is the sole provider of a key input.
– downstream division uses the input produced by the upstream division to produce
the final output.
• Upstream division has market power and incentive to maximize divisional profits leads
managers to produce where MR U =MC U .
– Implication: PU > MC U .
– A similar situation exists for the downstream division; profit-maximization leads to
P D > MC D .
• Both divisions mark price up over marginal cost resulting in a phenomenon called double
marginalization.

Special Demand and Costs: Transfer Pricing Rule

• Transfer pricing is used to overcome double marginalization.
• A transfer pricing rule sets the internal price at which an upstream division sells inputs to a
downstream division in order to maximize the overall firm profits.
– Require the upstream division to produce such that its marginal cost, MC U , equals
the net marginal revenue ( NRM ¿¿ D)¿ to the downstream division:
NRM D=MR D −MC D=MC U

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Intense Price Competition: Price Matching

• Price matching is a strategy in which a firm advertises a price and a promise to match any
lower price offered by a competitor.
– Used to mitigate the stark outcome associated with firms competing in a
homogeneous-product, Bertrand oligopoly.
– Outcome: If all firms in the market adopt a price matching policy, all firms can set
the monopoly price and earn monopoly profits; instead of the zero profits it would
earn in the usual one-shot Bertrand oligopoly.
• Potential issues:
– Dealing with false consumer claims of low prices.
– Competitor’s with lower cost structures.

Intense Price Competition: Inducing Brand Loyalty

• Brand loyal customers continue to buy a firm’s product even if another firm offers a
(slightly) better price.
– Strategy used to mitigate the tension of Bertrand competition.
• Methods for inducing brand loyalty.
– Advertising campaigns.
– “Frequent-buyer” programs.

Intense Price Competition: Randomized Pricing

• Randomized pricing is a strategy in which a firm intentionally varies its price in an attempt
to “hide” price information from consumers and rivals.
• Benefits of randomized pricing to firms:
– Consumers cannot learn from experience which firm charges the lowest price in the
market.
– Reduces the ability of rival firms to undercut a firm’s price.
• Not always profitable.

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