Pricing Strategies

Sessions 14, 15
 Capturing Consumer Surplus
• Firms’ (monopolists’) profit would be larger if he
could solve two problems
• Consumers who buy some of the product receive some
consumer surplus
– Firm could increase profit if he could charge them a higher
price
• Consumers aren’t buying some units that they value
less than the monopoly price but more than marginal
cost
– Monopolist could increase profit if he could charge these
buyers less for those units of the good
 Price Discrimination
• Monopolist might be able to do better by price
discriminating: charging different prices for
different units of the same good

• Price discrimination:
different buyers are charged different unit prices
for similar goods, and the prices are in different
ratios to marginal costs.
 Examples
• Pricing of cinema hall tickets by time of day, day of
the week
• Pricing of transport services by age
• Pricing of professional services by income categories
• Pricing of goods by different degrees of recognition
or frequency of purchase
• Pricing of books by different editions
• Pricing by region
 Conditions for Successful Price Discrimination

• The firm must have some degree of market power,

i.e., the ability to set prices

• The firm must be able to separate customers into two

or more groups

• The firm must be able to prevent arbitrage by buyers,

i.e., resale by buyers
 When resale is not possible

• Services
• Warranties – The firm can void a warranty if the
object is resold
• Transaction cost
• Contractual remedies
• Vertical integration
• Government intervention
 Three degrees of price discrimination

• First-degree or perfect price discrimination

• Second-degree or nonlinear pricing

• Third-degree price discrimination

 Why three degrees?

• How much information does the seller have about

buyers?

1. Perfect information – seller knows the type of each

and every buyer

2. Seller knows the distribution of buyer types, not

individual buyers

3. Seller can identify buyer types by categories

 First-degree or perfect price discrimination

• The seller has perfect information about the demand

curves of buyers.

• For each unit sold, the seller charges the buyer an

amount equal to the maximum willingness to pay for
that unit.
 Example

Buyer Reservation Price Total Demand

• A 10 1
• B 9 2
• C 8 3
• D 7 4
• E 6 5

• MC = 6
 Perfect price discrimination

• Next, suppose that each consumer wants one unit of a

product, but consumers are willing to pay different
amounts.
• By ranking the consumers according to their
maximum willingness to pay and plotting the
aggregate demands, we get a downward sloping
aggregate demand curve.
• The firm then charges each consumer the maximum
that the person is willing to pay and sells to any
customer whose maximum willingness to pay
exceeds or is equal to the marginal cost.
 Perfect price discrimination: Results

• From the efficiency standpoint, perfect price

discrimination gives the same result as perfect
competition – no deadweight loss

• Distributional implications are totally different: CS =

0 and Seller captures all consumer surplus
 Two-part Tariff

• Use of two-part tariffs to achieve perfect price

discrimination
• A two-part tariff consists of:
– a fixed fee that buyers have to pay to be allowed to
purchase the commodity
(sometimes called the access fee)
– and a fixed per unit charge thereafter
• Two-part tariffs fall under the category of non-linear
pricing
 Examples of two-part tariffs

1. Membership fees for clubs plus the price of drinks

and meals

2. The entrance fee to the zoo together with separate

fees for entering other exhibits

3. Monthly rentals for telephones plus payment for

calls etc.
Two-Part Tariff with a Single Consumer
Second-degree price discrimination or nonlinear pricing

• We assume that the monopolist will not be able to

identify the type of a particular buyer, though she
may have a good idea about the distribution of buyer
types

• The monopolist then constructs a price schedule in

such a way that buyers reveal their types by choosing
points on the schedule – “self-selection”
Second-degree price discrimination or nonlinear pricing

• Customers may be identified by their willingness to

spend time to buy a good at a lower price or to order
goods and services in advance of delivery

• Firms use differences in the value customers place on

their time to discriminate by using queues
 Getting customers to identify themselves

• Coupons
• People who use coupons are more price sensitive on
average than those who don’t

• Airline tickets
• Choice between high-price tickets with no strings
attached and low-price fares with various kinds of
restrictions
 Non-linear pricing

• Buyers face nonlinear price schedules, i.e., the price

paid depends on the quantity or quality bought

• Sometimes differences in quality, too, get reflected in

a nonlinear manner in prices
 A damaged good pricing strategy

• If price = $100, total revenue = $10,000

• If price = $40, total revenue = $8,000
 A damaged good pricing strategy

• Introduce a “damaged” version at the price of $29.99;

price the full version at $89.98.
• Then B-types will choose the damaged version
because they will get a surplus of 1 cent
• A-types will buy the full version because it gives
them a surplus of $10.02, while the damaged version
gives a surplus of $10.01
• Total revenue = $8998 + $2999 = $11,997
 Quantity discounts

• Most customers are willing to pay more for the first

units than for the successive units

• Firm can price-discriminate by letting the price each

customer pays vary with the number of units the
customer buys

• Use of a price-schedule implies quantity discounts

 Non-linear pricing

Incentive compatibility constraint

• The seller must make sure that the offer aimed at a
type A is not found attractive by a type B

Individual rationality (participation) constraint

• Each buyer of a certain type must find the appropriate
price sufficiently attractive to buy the product
 Durable Good Monopolies

• Durable goods do not perish even after repeated

usage

• Monopolist is then tempted to charge a lower price in

the future – temporal price discrimination

• But buyers should be able to anticipate this and

postpone their purchase
 Durable Good Monopolies

• Coase (1972) had conjectured that

• if the time periods are short enough and the

consumers can rationally anticipate buyer’s actions,

• then the price might immediately drop down to the

level of marginal cost and the monopolist forfeit all
market power
 Bundling

• Two or more commodities are sold only in fixed

proportions

• Pure vs. mixed bundling

 Bundling

• Pure Bundling
• 100 buyers of each type
• Zero costs
Pencil Box Sharpener Total

Type 1 24 2 26
Type 2 22 3 25

Total revenue (no bundling) = 4400+400 = 4800

Total revenue (bundling) = 25 x 200 = 5000
 Bundling

• Reservation prices are positively correlated

Pencil Box Sharpener Total

Type 1 24 3 27
Type 2 22 2 24

Total revenue (no bundling) = 4400 + 400 = 4800

Total revenue (bundling) = 24 x 200 = 4800