CHAPTER 11

Pricing Strategies for Firms with Market Power

© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 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.
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 Basic Pricing Strategies
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.

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 Basic Pricing Strategies
Basic Profit Maximization In Action
• Suppose the (inverse) demand for a firm’s
product is given by 𝑃 = 10 − 2𝑄 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 − 4𝑄.
– The marginal cost function is: 𝑀𝐶 = 2.
– Equating these two functions yields 10 − 4𝑄 = 2,
so 𝑄 = 2. The profit-maximizing price is 𝑃 = 10 −
2 2 = $6.

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 Basic Pricing Strategies

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.
• With this information, the monopoly and
monopolistically competitive firm’s profit-maximizing
1+𝐸𝐹
price (markup) is computed from: MC = 𝑃
𝐸𝐹
1+𝐸𝐹
, where 𝑀𝑅 = 𝑃 .
𝐸𝐹
𝐸𝐹
• So, set price such that: 𝑃 = 𝑀𝐶.
1+𝐸𝐹
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 Basic Pricing Strategies
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?
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 Basic Pricing Strategies
Simple Pricing Rule In Action:
Answer
• The marginal cost of cola to the firm is $1.25, or
5 4 4
4 per liter, and the markup factor is = .
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.

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 Basic Pricing Strategies
Simple Pricing Rule for Cournot
Oligopoly
• When each of the 𝑁 firms operating in a
Cournot oligopoly has identical cost structures
and produces similar products, the simple
profit-maximizing price (markup) in Cournot
equilibrium is:
𝑁𝐸𝑀
𝑃= 𝑀𝐶
1 + 𝑁𝐸𝑀
, where 𝐸𝑀 is the market elasticity of demand.

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 Strategies that Yield Even Greater Profits

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:
– Pricing strategies:
• that extract surplus from consumers.
• for special cost and demand structures.
• in markets with intense price competition.

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 Strategies that Yield Even Greater Profits

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.

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 Strategies that Yield Even Greater Profits

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.
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 Strategies that Yield Even Greater Profits

First-Degree Price Discrimination

Price
$10 MC

Firm profit under first-degree

price discrimination
$4

Demand

5 Quantity

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 Strategies that Yield Even Greater Profits

Surplus Extraction:
Second-Degree Price Discrimination
• 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.

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 Strategies that Yield Even Greater Profits

Second-Degree Price Discrimination

Price
$10 MC

$7.60 Contribution to profits under

second-degree price discrimination
$5.20

Demand

2 4 Quantity

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 Strategies that Yield Even Greater Profits

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,
𝑀𝑅1 > 𝑀𝑅2 , for example.

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 Strategies that Yield Even Greater Profits

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 + 𝐸1
𝑃1 = 𝑀𝐶
𝐸1
1 + 𝐸2
𝑃2 = 𝑀𝐶
𝐸2

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 Strategies that Yield Even Greater Profits

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 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?
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 Strategies that Yield Even Greater 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 = $6
−4
1−2
𝑃𝐷 = $6
−2
• Solving these equations yield, 𝑃𝐿 = $8 and
𝑃𝐿 = $12.
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 Strategies that Yield Even Greater Profits

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.

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 Strategies that Yield Even Greater Profits

Two-Part Pricing
Price
$10

Fixed fee = $32 = profits

Consumer surplus = $0

Per-unit fee = $2

$2 MC = AC

Demand

8 Quantity

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 Strategies that Yield Even Greater Profits

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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 Strategies that Yield Even Greater Profits

Block Pricing
Price
$10
Price charged for a block of 8 units = $48

Profit with block pricing = $32

$2 MC = AC

Demand

8 Quantity

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 Strategies that Yield Even Greater Profits

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.

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 Strategies that Yield Even Greater Profits

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.

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 Strategies that Yield Even Greater Profits
Special Demand and Costs:
Peak-Load Pricing
Price MC

𝑃𝐻
Demand High

𝑃𝐿
MR High

MR Low Demand Low

𝑄𝐿 𝑄𝐻 Quantity

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 Strategies that Yield Even Greater Profits

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.

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 Strategies that Yield Even Greater Profits

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.
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 Strategies that Yield Even Greater Profits

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 𝑀𝑅𝑈 = 𝑀𝐶𝑈 .
– Implication: 𝑃𝑈 > 𝑀𝐶𝑈 .
• A similar situation exists for the downstream division; profit-
maximization leads to 𝑃𝐷 > 𝑀𝐶𝐷 .
• Both divisions mark price up over marginal cost resulting
in a phenomenon called double marginalization.
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 Strategies that Yield Even Greater Profits

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, 𝑀𝐶𝑈 , equals the net marginal
revenue (𝑁𝑅𝑀𝐷 ) to the downstream division:
𝑁𝑅𝑀𝐷 = 𝑀𝑅𝐷 − 𝑀𝐶𝐷 = 𝑀𝐶𝑈
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 Strategies that Yield Even Greater Profits

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.
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 Strategies that Yield Even Greater Profits

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.

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 Strategies that Yield Even Greater Profits

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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