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Chapter 9

Monopoly & Pricing with


Market Power

Topics to be Discussed
Monopoly and Monopoly Power
Sources of Monopoly Power
The Social Costs of Monopoly Power
Capturing Consumer Surplus
Price Discrimination
Two part tariff, peak load pricing,
bundling, intertemporal pricing

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Review of Perfect Competition


P = LMC = LRAC
Normal profits or zero economic profits in
the long run
Large number of buyers and sellers
Homogenous product
Perfect information
Firm is a price taker

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Review of Perfect Competition


Market

P
D

P
S

Individual Firm
LMC

P0

P0

Q0
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LRAC

D = MR = P

q0

Q
4

Monopoly
Monopoly
1.
2.
3.
4.

One seller - many buyers


One product (no good substitutes)
Barriers to entry
Price Maker

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Monopoly
The monopolist is the supply-side of the
market and has complete control over
the amount offered for sale.
Monopolist controls price but must
consider consumer demand
Profits will be maximized at the level of
output where marginal revenue equals
marginal cost.
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Average & Marginal Revenue


The monopolists average revenue, price
received per unit sold, is the market
demand curve.
Monopolist also needs to find marginal
revenue, change in revenue resulting
from a unit change in output.

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Average & Marginal Revenue


Finding Marginal Revenue
As the sole producer, the monopolist works
with the market demand to determine output
and price.
An example can be used to show the
relationship between average and marginal
revenue
Assume a monopolist with demand:

P=6-Q
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Total, Marginal, and Average


Revenue

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Total, Marginal, and Average


Revenue
Revenue is zero when price is $6
Nothing is sold

At lower prices, revenue increases as


quantity sold increases
When demand is downward sloping, the
price (average revenue) is greater than
marginal revenue
For sales to increase, price must fall

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Average and Marginal Revenue


$ per
unit of
output

7
6
5
Average Revenue (Demand)

4
3
2
1

Marginal
Revenue

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7 Output
11

Monopoly
Observations
1. To increase sales the price must fall
2. MR < P
3. Compared to perfect competition
No change in price to change sales
MR = P

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Monopolists Output Decision


1. Profits maximized at the output level
where MR = MC
2. Cost functions are the same

(Q) R(Q) C (Q)


/ Q R / Q C / Q 0 MC MR
or MC MR

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Monopolists Output Decision


At output levels below MR = MC the
decrease in revenue is greater than the
decrease in cost (MR > MC).
At output levels above MR = MC the
increase in cost is greater than the
decrease in revenue (MR < MC)

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Monopolists Output Decision


$ per
unit of
output

MC
P1
P*
AC
P2
Lost
profit

D = AR
MR
Q1
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Q*

Q2

Lost
profit

Quantity
15

Monopoly: An Example
Cost C (Q ) 50 Q 2
C
MC
2Q
Q
Demand : P (Q ) 40 Q
R(Q ) P (Q )Q 40Q Q 2
R
MR
40 2Q
Q
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Monopoly: An Example

MC MR
2Q 40 2Q
4Q 40

P (Q ) 40 Q
P (Q ) 40 10
P (Q ) 30

Q 10
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Monopoly: An Example
By setting marginal revenue equal to
marginal cost, we verified that profit is
maximized at P = $30 and Q = 10.
This can be seen graphically by plotting
cost, revenue and profit
Profit is initially negative when produce little
or no output
Profit increase and q increase, maximized at
Q*=10
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Example of Profit Maximization


C

r'

400

R
When profits are
maximized, slope of
rr and cc are equal:
MR=MC

300
c
200

r
Profits

150
100
50
0

c
5

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10

15

20 Quantity
19

Example of Profit Maximization


$/Q

40

Profit = (P - AC) x Q
= ($30 - $15)(10) =
$150

MC

P=30
AC

Profit

20
AR

AC=15
10
MR
0

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10

15

20

Quantity
20

Monopoly
Monopoly pricing compared to perfect
competition pricing:
Monopoly
P

> MC
Price is larger than MC by an amount that
depends inversely on the elasticity of demand
Perfect

Competition

= MC
Demand is perfectly elastic so P=MC

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Monopoly
If demand is very elastic, there is little
benefit to being a monopolist
The larger the elasticity, the closer to a
perfectly competitive market
Notice a monopolist will never produce a
quantity in the inelastic portion of
demand curve
In inelastic portion, can increase revenue by
decreasing quantity and increasing price

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Shifts in Demand
In perfect competition, the market supply
curve is determined by marginal cost.
For a monopoly, output is determined by
marginal cost and the shape of the
demand curve.
There

is no supply curve for monopolistic


market

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Shifts in Demand
Shifts in demand do not trace out price
and quantity changes corresponding to a
supply curve
Shifts in demand lead to
Changes in price with no change in output
Changes in output with no change in price
Changes in both price and quantity

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Shifts in Demand
$/Q

MC

P1
P2

Shift in
demand leads
to change in
price but same
quantity

D2
D1
MR2
MR1
Q1= Q2

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Quantity
25

Shifts in Demand
$/Q

MC

P1 = P 2

D2

Shift in
demand leads
to change in
quantity but
same price

MR2
D1
MR1
Q1
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Q2

Quantity
26

Monopoly
Shifts in demand usually cause a change
in both price and quantity.
Example show how monopolistic market
differs from perfectly competitive market
Competitive market supplies specific
quantity a every price
This relationship does not exist for a
monopolistic market

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Monopoly Power
Pure monopoly is rare.
However, a market with several firms,
each facing a downward sloping demand
curve will produce so that price exceeds
marginal cost.
Firms often product similar goods that
have some differences thereby
differentiating themselves from other
firms
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Monopoly Power: Example


Four firms with equal share a market for
20,000 toothbrushes at a price of $1.50.
Profits maximizing quantity for each from
is where MR MC
In our example that is 5000 units for Firm
A with a price of $1.50 which is greater
than marginal cost
Although Firm A is not a pure monopolist,
they have monopoly power
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The Demand for Toothbrushes


$/Q

$/Q

At a market price
of $1.50, elasticity of
demand is -1.5.

2.00

2.00

Firm A has some monopoly


power and charges a price
which exceeds MC where
MR=MC.

1.60
1.50

MCA

1.50
1.40

DA

Market
Demand

1.00

MRA

1.00
10,000

20,000

30,000

Quantity

3,000

5,000

7,000

QA

Measuring Monopoly Power


Our firm would have more monopoly power of
course if it could get rid of the other firms
But the firms monopoly power might still be
substantial

How can we measure monopoly power to


compare firms
What are the sources of monopoly power?
Why do some firms have more than others?

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Measuring Monopoly Power


Could measure monopoly power by the extent to
which price is greater than MC for each firm
Lerners Index of Monopoly Power
L = (P - MC)/P

The

larger the value of L (between 0 and


1) the greater the monopoly power.

L is expressed in terms of Ed

= (P - MC)/P = -1/Ed

Ed

is elasticity of demand for a firm, not


the market

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Monopoly Power
Monopoly power, however, does not
guarantee profits.
Profit depends on average cost relative
to price.
One firm may have more monopoly
power, but lower profits due to high
average costs

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Rule of Thumb for Pricing


Pricing for any firm with monopoly power
If Ed is large, markup is small
If Ed is small, markup is large

MC
P
1 1 Ed

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Elasticity of Demand and Price


Markup
$/Q

$/Q

The more elastic is


demand, the less the
markup.

P*

MC

MC

P*

P*-MC

P*-MC

MR
D
MR

Q*

Quantity

Q*

Quantity

Markup Pricing: Supermarkets


& Convenience Stores
Supermarkets
1. Several firms
2. Similar product
3. Ed 10 for individual stores
MC
MC
4.P

1.11( MC )
1 1 .1 0.9
5. Prices set about 10 - 11% above MC.

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Markup Pricing: Supermarkets


& Convenience Stores
Convenience Stores
1. Higher prices than supermarkets
2. Convenience differentiates them
3. Ed 5
MC
MC
4.P

1.25(MC )
1 1 5 0.8
5. Prices set about 25% above MC.

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Markup Pricing: Supermarkets


& Convenience Stores
Convenience stores have more
monopoly power.
Convenience stores do have higher
profits than supermarkets however.
Volume is far smaller and average fixed
costs are larger

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Sources of Monopoly Power


Why do some firms have considerable
monopoly power, and others have little or
none?
Monopoly power is determined by ability
to set price higher than marginal cost
A firms monopoly power, therefore, is
determined by the firms elasticity of
demand.
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Sources of Monopoly Power


The less elastic the demand curve, the
more monopoly power a firm has.
The firms elasticity of demand is
determined by:
1) Elasticity of market demand
2) Number of firms in market
3) The interaction among firms

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Elasticity of Market Demand


With one firm their demand curve is
market demand curve
Degree of monopoly power determined
completely by elasticity of market demand

With more firms, individual demand may


differ from market demand
Demand for a firms product is more elastic
than the market elasticity

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Number of Firms
The monopoly power of a firm falls as the
number of firms increases all else equal
More important are the number of firms with
significant market share
Market is highly concentrated if only a few
firms account for most of the sales

Firms would like to create barriers to


entry to keep new firms out of market
Patent, copyrights, licenses, economies of
scale
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Interaction Among Firms


If firms are aggressive in gaining market
share by, for example, undercutting the
other firms, prices may reach close to
competitive levels.
If firms collude (violation of antitrust
rules), could generate substantial
monopoly power
Markets are dynamic and therefore, so is
the concept of monopoly power
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The Social Costs of Monopoly


Power
Monopoly power results in higher prices
and lower quantities.
However, does monopoly power make
consumers and producers in the
aggregate better or worse off?
We can compare producer and
consumer surplus when in a competitive
market and in a monopolistic market
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The Social Costs of Monopoly


Perfectly competitive firm will produce where
MC = D PC and QC
Monopoly produces where MR = MC, getting
their price from the demand curve PM and
QM
There is a loss in consumer surplus when going
from perfect competition to monopoly
A deadweight loss is also created with
monopoly

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Deadweight Loss from


Monopoly Power
$/Q
Lost Consumer Surplus
Deadweight
Loss

Pm
A

MC

Because of the
higher price,
consumers lose
A+B and
producer gains
A-C.

PC

AR=D
MR

Qm
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QC

Quantity
46

Externality
When one
persons actions
imposes a cost or
benefit on the
well-being of a
bystander.
Externalities
usually result in
market failure.
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Externalities can be:


1) Positive: an external
benefit is imposed on
someone. (examples: gardens,

restored historic buildings, research)

2) Negative: an external
cost is imposed on
someone. (examples: exhaust
from autos, barking dogs, noise
from airplanes)

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Externalities
Externalities cause markets to
allocate resources inefficiently.
This happens through:
1) CONSUMPTION: consuming a good
results in externality.
2) PRODUCTION: producing a good
results in externality.
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Externalities

In general, an external cost means the


market overproduces the good (ie,
paint). An external benefit means the
market underproduces the good (ie,
gardens)

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Pricing with Market Power

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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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.

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Chapter 11

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Capturing Consumer Surplus


All pricing strategies we will examine are
means of capturing consumer surplus
and transferring it to the producer
Profit maximizing point of P* and Q*
But some consumers will pay more that P*
for a good.
Raising

price will lose some consumers, leading


to smaller profits
Lowering price will gains some consumers, but
lower profits

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Chapter 11

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Capturing Consumer Surplus


$/Q
Pmax

The firm would like to


charge higher price to
those consumers
willing to pay it - A

P1
P*

Firm would also like to


sell to those in area B but
without lowering price to
all consumers

P2
MC
PC

Both ways will allow


the firm to capture
more consumer
surplus

Q*
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MR
Chapter 11

Quantity
55

Capturing Consumer Surplus


Price discrimination is the practice of
charging different prices to different
consumers for similar goods.
Must be able to identify the different
consumers and get them to pay different
prices

Other techniques that expand the range


of a firms market to get at more
consumer surplus
Tariffs and bundling
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Price Discrimination
First Degree Price Discrimination
Charge a separate price to each customer: the
maximum or reservation price they are willing to pay.

How can a firm profit


The firm produces Q* MR = MC
We can see the firms variable profit the firms profit
ignoring fixed costs

Area

between MR and MC

Consumer surplus area between demand and Price

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Price Discrimination
If the firm can perfectly price
discriminate, each consumer is charged
exactly what they are willing to pay.
MR curve is not longer part of output
decision
Incremental revenue is exactly the price at
which each unit is sold the demand curve
Additional profit from producing and selling
an incremental unit is now the difference
between demand and marginal cost
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Perfect First-Degree Price


Discrimination
$/Q
Pmax

Without price discrimination,


output is Q* and price is P*.
Variable profit is the area
between the MC & MR (yellow).

Consumer surplus is the area


above P* and between
0 and Q* output.

With perfect discrimination, firm


will choose to produce Q**
increasing variable profits to
include purple area.

MC
P*
PC

D = AR

MR
Q*
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Q**
Chapter 11

Quantity
59

First-Degree Price Discrimination


In practice perfect price discrimination is
almost never possible
1. Impractical to charge every customer a
different price (unless very few customers)
2. Firms usually does not know reservation
price of each customer

Firms can discriminate imperfectly


Can charge a few different prices based on
some estimates of reservation prices
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First-Degree Price Discrimination


Examples of imperfect price
discrimination where the seller has the
ability to segregate the market to some
extent and charge different prices for the
same product:
Lawyers, doctors, accountants
Car salesperson (15% profit margin)
Colleges and universities (differences in
financial aid)
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First-Degree Price
Discrimination in Practice
Six prices exist resulting
in higher profits. With a single price
P*4, there are fewer consumers.

$/Q
P1
P2
P3

MC

P*4

Discriminating up to
P6 (competitive price)
will increase profits

P5
P6

Q*
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MR
Chapter 11

Quantity
62

Second-Degree Price
Discrimination
In some markets, consumers purchase
many units of a good over time
Demand for that good declines with
increased consumption
Electricity,

water, heating fuel

Firms can engage in second degree price


discrimination
Practice

of charging different prices per unit for


different quantities of the same good or service

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Second-Degree Price
Discrimination
Quantity discounts are an example of
second-degree price discrimination
Ex: Buying in bulk like at Sams Club

Block pricing the practice of charging


different prices for different quantities of
blocks of a good
Ex: electric power companies charge
different prices for a consumer purchasing a
set block of electricity
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Second-Degree Price Discrimination


$/Q

Without discrimination: P
= P0 and Q = Q0. With
second-degree
discrimination there are
three blocks with prices
P1, P2, & P3.

Different prices are


charged for
different quantities
or blocks of same
good

P1
P0
P2

AC
MC

P3

D
MR
Q1
1st Block
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Q0
2nd Block

Q2

Q3

Quantity

3rd Block
65

Third-Degree Price Discrimination


Practice of dividing consumers into two
or more groups with separate demand
curves and charging different prices to
each group
1. Divides the market into two-groups.
2. Each group has its own demand function.

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Price Discrimination
Third Degree Price Discrimination
Most common type of price
discrimination.
Examples: airlines, premium v. non-premium
liquor, discounts to students and senior
citizens, frozen v. canned vegetables.

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Third-Degree Price Discrimination


Some characteristic is used to divide the
consumer groups
Typically elasticities of demand differ for
the groups
College students and senior citizens are not
usually willing to pay as much as others
because of lower incomes
These groups are easily distinguishable with
IDs
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Creating Consumer Groups


If third degree price-discrimination is
feasible, how can the firm decide what
to charge each group of consumers?
1. Total output should be divided between
groups so that MR for each group are
equal.
2. Total output is chosen so that MR for each
group of consumers is equal to the MC of
production

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Third-Degree Price
Discrimination
Algebraically
P1: price first group
P2: price second group
C(QT) = total cost of producing output
Q T = Q1 + Q 2
Profit: = P1Q1 + P2Q2 - C(QT)

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Third-Degree Price
Discrimination
First group of consumers:
MR1= MC

Can do the same thing for the second


group of consumers
Second group of customers:
MR2 = MC

Combining these conclusions gives


MR1 = MR2 = MC
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Third-Degree Price
Discrimination
Determining relative prices
Thinking of relative prices that should be
charged to each group of consumers and
relating them to price elasticities of demand
may be easier.

MR P 1 1 Ed
Then : MR1 P1 (1 1 E1 ) MR2 P2 (1 1 E2 )
E1 and E2 elasticites of demand for each group
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Third-Degree Price Discrimination


$/Q

Consumers are divided into


two groups, with separate
demand curves for each group.

MRT = MR1 + MR2

D2 = AR2
MRT
MR2
MR1
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D1 = AR1
Quantity

73

Third-Degree Price Discrimination


$/Q

MC = MR1 at Q1 and P1

P1

QT: MC = MRT
Group 1: more inelastic
Group 2: more elastic
MR1 = MR2 = MCT
QT control MC

MC

P2

D2 = AR2

MCT

MRT
MR2
D1 = AR1

MR1
Q1

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Q2

Chapter 11

QT

Quantity

74

No Sales to Smaller Market


Even if third-degree price discrimination
is possible, it may not be feasible to try
and sell to both groups
It is possible that the demand for one group
is so low, it would not be profitable to lower
price enough to sell to that group .

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No Sales to Smaller Market


Group one, with
demand D1, are not
willing to pay enough
for the good to make
price discrimination
profitable.

$/Q
MC
P*
D2
MC=MR1
=MR2
MR2

MR1

D1
Q*

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Quantity
76

Other Types of Price


Discrimination
Intertemporal Price Discrimination
Practice of separating consumers with
different demand functions into different
groups by charging different prices at
different points in time
Initial release of a product, the demand is
inelastic
Hard

back v. paperback book


New release movie
Technology

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Intertemporal Price
Discrimination
Once this market has yielded a
maximum profit, firms lower the price to
appeal to a general market with a more
elastic demand.
This can be seen graphically looking at
two different groups of consumers one
willing to buy right now and one willing to
wait.

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Intertemporal Price
Discrimination
$/Q

Initially, demand is less


elastic resulting in a
price of P1 .

P1

Over time, demand becomes


more elastic and price
is reduced to appeal to the
mass market.

P2

D2 = AR2
AC = MC

MR1
Q1
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MR2

D1 = AR1
Q2

Quantity
79

Other Types of Price


Discrimination
Peak-Load Pricing
Practice of charging higher prices during
peak periods when capacity constraints
cause marginal costs to be higher.

Demand for some products may peak at


particular times.
Rush hour traffic
Electricity - late summer afternoons
Ski resorts on weekends
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Peak-Load Pricing
Objective is to increase efficiency by
charging customers close to marginal
cost
Increased MR and MC would indicate a
higher price.
Total surplus is higher because charging
close to MC
Can measure efficiency gain from peak-load
pricing
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Peak-Load Pricing
With third-degree price discrimination,
the MR for all markets was equal
MR is not equal for each market because
one market does not impact the other
market with peak-load pricing.
Price and sales in each market are
independent
Ex: electricity, movie theaters

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Peak-Load Pricing
$/Q

MC

MR=MC for each


group. Group 1
has higher
demand during
peak times

P1

D1 = AR1
P2
MR1
D2 = AR2

MR2
Q2
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Q1

Quantity
83

Bundling
When film company leased Gone with
the Wind it required theaters to also
lease Getting Gerties Garter.
Why would a company do this?
Company must be able to increase revenue.
We can see the reservation prices for each
theater and movie.

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The Two-Part Tariff


Form of pricing in which consumers are charged
both an entry and usage fee.
EX: amusement park, golf course, telephone service

A fee is charged upfront for right to use/buy the


product
An additional fee is charged for each unit the
consumer wishes to consume
Pay a fee to to play golf and then pay another fee for
each game you play.

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The Two-Part Tariff


Pricing decision is setting the entry fee
(T) and the usage fee (P).
Choosing the trade-off between freeentry and high-use prices or high-entry
and zero-use prices.
Single Consumer
Assume firm knows consumer demand
Firm wants to capture as much consumer
surplus as possible
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Two-Part Tariff with a Single


Consumer
$/Q
T*

P*

Usage price P* is set equal to MC.


Entry price T* is equal to the entire
consumer surplus.
Firm captures all consumer
surplus as profit

MC
D

Quantity
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