Pricing with Market Power

Asmita Verma
IIM Visakhapatnam
1st September 2022
Introduction
• In most cases, the companies have to take a decision of how efficiently
they can use their market power.

• There are different pricing strategies to capture consumer surplus and

converting it to additional profit for the firm.
Price Discrimination
Charging different prices for a product when the price differences are
not justified by cost differences.
• Objective of the Firm
To attain higher profits than would be available otherwise.
• Conditions to Practice Price Discrimination:
• Firm must be an imperfect competitor (a price maker)
• Price elasticity must differ for units of the product sold at different prices
• Firm must be able to segment the market and prevent resale of unit across markets (markets
must be separated).
First-Degree Price Discrimination
• Each unit is sold at the highest possible price
• Firm extracts all of the consumers’ surplus
• Firm maximizes total revenue and profit from any quantity sold
• Seldom encountered in real world
Example:
Colleges and universities adjust the amount of financial aid based
on detailed data on family income, mortgage payments etc and
charge the highest possible price.
Second-Degree Price Discrimination
• Charging a uniform price per unit for a specific quantity, a lower
price per unit for an additional quantity, and so on.
• Extracting part, but not all, of the consumers’ surplus.
• More common than first degree price discrimination, but limited
to cases where products and services are easily metered for
example,
Pricing of electricity: kilowatt hours
Pricing of gas: cubic feet
First- and Second-Degree Price Discrimination

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Third-Degree Price Discrimination
• Charging different prices for the same product sold in different
markets.
• Firm maximizes profits by selling a quantity on each market such
that the marginal revenue on each market is equal to the marginal
cost of production.
Third-Degree Price Discrimination Graphically

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Example: Electricity Rates for Different
Customers

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Intertemporal Price Discrimination
• Practice of separating consumers with different demand functions into
different groups by charging different prices at different points in time.
• The strategy is to sell at a higher price to low elasticity consumers and
then sell at a lower price to the mass market.
• Example,
(1) If high performance digital cameras are launched at a higher price, the
photographers will buy it. After some time, the company will lower the
price of the product and another group of consumers will buy it.
(2) The hardcover edition in the first year and paperback edition in the
second year.
(3) Movie released in the first year and release of the same movie in later
years.
Example: Peak- Loading Pricing
• It refers to the charging of a higher price for a good or service during
peak times than off-peak times.

• Example, Electricity is a non-storable service (it must be generated

when it is needed). In order to satisfy peak demand, electric power
companies must bring into operation older and less efficient equipment
and thus incur higher marginal costs and charge higher prices.

• The demand for electricity is higher during some periods (summer

afternoon) than other times (spring or winter afternoon).
Rates for Peak and Off-Peak Hours
 Two-part Tariff
• Form of pricing in which consumers are charged both at an entry and
usage fee.

• Example, in amusement park, the consumers are charged at the entry

and also charged for each ride.

• In tennis or golf club, annual member fee is paid along with fee
for each use of the court or round of golf.
 The Two-Part Tariff

For a Single Consumer:

The consumer has demand curve D.
The firm maximizes profit by
setting usage fee P equal to
marginal cost and entry fee T* equal
to the entire surplus of the
consumer.
Example: Pricing Cellular Phone Service
• Cellular phone service has traditionally been priced using a
two-part tariff: a monthly access fee, which includes some
amount of free “anytime” minutes, plus a per-minute charge
for additional minutes.​
• Offering different plans allowed companies to combine third-
degree price discrimination with the two-part tariff.​
• Today, most consumers use their phone not just to make or
receive calls but also to surf the Web, read email, and so on.
They separate themselves into groups based on their
expected data usage, with each group choosing a different
plan.​
• Cellular providers have learned that the most profitable way
to price their service is to combine price discrimination with
a two-part tariff.​
Pop quiz
When a firm charges each customer the maximum price that the
customer is willing to pay, the firm:
A) engages in a discrete pricing strategy.
B) charges the average reservation price.
C) engages in second-degree price discrimination.
D) engages in first-degree price discrimination.
International Price Discrimination and Dumping
• International price discrimination is called dumping.

• This refers to the charging of a lower price abroad than at home for
same commodity because of the greater price elasticity of demand in
the foreign market.

• The firm can earn higher profit by doing so.

Types of Dumping
• Predatory Dumping: It is temporary sale of a commodity at lower price 
abroad in order to drive out the domestic producers and after which  price
is increased to take advantage of newly acquired monopoly, e.g.  Zenith in
USA accused Japanese television manufacturers of using  predatory
dumping.

• Kodak filed dumping charges against Fuji in 1993 for predatory

dumping.

• Sporadic Dumping: It is occasional sale of commodity at a lower price 

abroad than domestically in order to unload surplus without lowering 
domestic price.
Transfer Pricing
• Transfer pricing is the price which is paid to subsidiary company by
its parent company after selling product to the parent company.
• It is a pricing of intermediate products sold by one division of a firm
and purchased by another division of the same firm.

• For example, if a thermal power plant owned its own coal mine,
the
questions would arise as to how much coal the coal mine should sell to
the parent power plant and how much to outsiders and at what prices.

• Similarly, the thermal power plant must determine how much coal
to
purchase from its own coal mine and how much from outsiders, and at
what prices.
Prestige Pricing
• It refers to deliberately settling high prices to attract prestige-oriented
consumers.

• For example, there are more people buying furs costing INR 10,000
than similar furs costing INR 4,000 because they often equate price
with quality.

• Recognising this fact, producers sometimes package same basic

product differently, one to appear of higher quality than another and
sell the first at a much higher price.

• Example: Mercedes Benz, costly furs, watches and perfumes.

Penetration/predatory Pricing
• Penetration pricing is a business strategy where low price is offered
for a new product or service during its initial offering to attract
customers.

• The lower price helps to attract customers towards new product and
stay away from existing products and to create loyalty towards specific
product.

• Example: Netflix prices rise after a period of lower price.

Bundling Price
• Bundling is a practice of selling two or more products as a package.
Bundling is useful when the customers have heterogenous demand and
the firms cannot discriminate prices.

• Example, MGM company who distributed first film (Gone with the
Wind) also distributes a second film (Getting Gertie’s Garter).

• Mixed bundling is selling two or more goods both as a package or

individually.
• Pure bundling is selling the products only as a package.
 Tying
• In tying, a consumer who buys or leases a product also purchases
another product needed in the use of the first.

• Tying refers to the requirement that the products have to be bought or

sold at some combination. Pure bundling is a common form of tying,
but tying can also take other forms.

• For example, when the Xerox Corporation was the only producer of
photocopiers in the 1950s, it required companies leasing its machines
to also purchase paper from Xerox.

• Similarly, IBM required customers who leased its mainframe

computers also had to use computer cards used by IBM.
Difference between mixed bundling and tying

In case of mixed bundling the consumer may be happy to buy one of

the products, but in case of tying, the first product becomes useless
without access to second product.
Example: The Complete Dinner Versus À La
Carte: A Restaurant Pricing Problem​
• For a restaurant, mixed bundling means offering both complete
dinners (the appetizer, main course, and dessert come as a
package) and an à la carte menu (the customer buys the appetizer,
main course, and dessert separately). ​
• This strategy allows the à la carte menu to be priced to capture
consumer surplus from customers who value some dishes much
more highly than others.​
• At the same time, the complete dinner retains those  customers
who have lower variations in their reservation prices for different
dishes (e.g., customers who attach moderate values to both
appetizers and desserts).​
• Successful restaurateurs know their customers’
demand characteristics and use that knowledge to design a
pricing strategy that extracts as much consumer surplus
as possible.​
Multiple choice questions
1. A doctor charges two different prices for medical services, and the
price level depends on the patients' income such that wealthy patients
are charged more than poorer ones. This pricing scheme represents a
form of:
A) first-degree price discrimination.
B) second-degree price discrimination.
C) third-degree price discrimination.
D) Two-part pricing
2. A local theatre charges $5.00 for every matinee (daytime) ticket, but
the ticket prices are much higher during the evening. This is an example
of:
A) peak-load pricing.
B) second-degree price discrimination.
C) a two-part tariff.
D) bundling.
E) none of the above
3. A local restaurant sells strawberry pie for $3.00 per slice. However, if
you order the prime rib dinner, you can get a slice of pie for only a
dollar. This is an example of:
A) bundling.
B) second-degree price discrimination.
C) a two-part tariff.
D) none of the above
Exercise
Assume there a two separate markets for good X with the given
demand curves. If the marginal cost of producing this good X is $2,
what are the optimal quantities and prices in each of the two markets?
Solution
First, we find the marginal revenue for each of the markets and set it to equal
marginal cost. Then we compute the optimal quantities and prices for each
market.

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