ECONOMICS FOR MANAGEMENT

LECTURE 14 & 15 - PRODUCER THEORY (PRICING)

Prof. THIAGU RANGANATHAN

AGENDA

• SIMPLE PRICING RULE

• PRICE DISCRIMINATION
• FIRST-DEGREE
• SECOND-DEGREE
• THIRD-DEGREE

• TWO-PART TARRIFF

• PACKAGE DEALS
Review

Market Structure Short Run Long Run

   
MR=MC MR=MC
P = MR P=MR
COMPETITION

P=MC P=MC=min(ATC)
PERFECT

Profit/Loss= (P-ATC) *Q Profit/Loss=0

 

Shut Down Rule: Shutdown if

P<AVC
 

   
MR=MC MR=MC
MONOPOLY

P>MR P>MR
P>MC P>MC
Profit/Loss= (P-ATC) *Q P>ATC
Shut Down Rule: Shutdown if Profit = (P-ATC)*Q
P<AVC
 
 
 

 
   
MR=MC MR=MC
P>MR P>MR
P>MC P>MC
Profit/Loss= (P-ATC) *Q P=ATC>min(ATC)
Shut Down Rule: Shutdown if Profit/Loss=0
P<AVC
IC
Simple Pricing Rule: Monopoly and Monopolistic
Competition
 In situation where managers only 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

R (q )  p (q )q
dR dp
 The monopoly and monopolistically competitive firm’s profit-maximizing
 q p
price (markup) is computed from: dq dq
dR dp q
 p[  1]
, where dq dq p
dR 1 
 p   1
dq E 
 So, set price such that: .
1  E 
MR  p 
 E 
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 . What
price should the manager charge for a liter of cola to maximize profits?
Simple Pricing Rule In Action: Answer
 The marginal cost of cola to the firm is , or per liter, and the markup
factor is .
 The profit-maximizing pricing rule for a monopolistically competitive
firm is:

, or about per liter.

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.

 The basic conditions for price discrimination to exist are:

 Firms should have some degree of market power. A perfectly competitive firm can
never discriminate
 A firm should be able to separate consumers into two or more groups
 The firm must be able to prevent arbitrage by buyers
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.
Surplus Extraction:
First-Degree Price Discrimination In Action
Price
$ 10 MC

Firm profit under first-degree

price discrimination
$4

Demand

5 Quantity
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.
Surplus Extraction: Second-Degree
Price Discrimination In Action
Price
$ 10 MC

$ 7.60 Contribution to profits under

second-degree price
$ 5.20 discrimination

Demand

2 4 Quantity
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: If one price was charged to both groups, such that the marginal revenue
to group 1 equals marginal cost:

 Then,

Assuming
 And profits would not be maximized
Surplus Extraction: Third-Degree
Price Discrimination Rule
 To maximize profits, a firm with market power produces the output at
which the marginal revenue to each group equals marginal cost.
Surplus Extraction: Third-Degree
Price Discrimination Rule
 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 and faculty has an elasticity of demand of ,
what should your pricing policy be to maximize profits?
 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:

 Solving these equations yield, and .

Surplus Extraction:
Two-Part Pricing
Price
$ 10

Fixed fee = $32 = profits

Consumer surplus = $0

Per-unit fee = $2

$2 MC = AC

Demand

8 Quantity
Surplus Extraction:
Package Deal
Price
$ 10
Price charged for a block of 8 units = $48

Profit with block pricing = $32

$2 MC = AC

Demand

8 Quantity
Surplus Extraction:
Commodity Bundling In Action
Valuation of Valuation of
Consumer
Computer Monitor
1 $2,000 $200
2 $1,500 $300

 How does the manager price a computer and

monitor?
 Price separately:
 Charge for computer and for monitors.
 Profit (assuming zero cost) is: .
 Commodity bundling:
 Charge for a bundle consisting of a computer and monitor.
 Profit (assuming zero cost) is: .