3. Learning Objectives
2-3
After studying this chapter, you will be able to:
• Explain the basic rule of profit maximization and apply it
to determine profit maximizing price for monopoly,
monopolistic competition, and oligopoly market.
Explain pricing strategies of monopoly and how monopoly
enhance profit through price discrimination
Explain the price rules for monopoly and monopolistic
competition
Explain how cost pricing rules influence firms to decide
their production.
4. Pricing Rule for Monopolyand
Monopolistic Competition
• Price elasticity and pricing strategy
• A particular firm’s elasticity depends on how the firms
compete with one another, and the elasticity of market
demand limits the potential monopoly power of individual
producers.
• the monopoly and monopolistically competitive firm’s
profit-maximizing price (markup)
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5. Monopoly Price rule
2-6
To sell a larger output, a monopoly must set a lower price
There are two types of monopoly price-setting strategies:
A single-price monopoly is a firm that must sell each unit
of its output for the same price to all its customers.
Price discrimination is the practice of selling different
units of a good or service for different prices. Many firms
do discriminate price, but not all of them are monopoly
firms.
For more information on “Price Discrimination”
https://www.youtube.com/watch?v=SZCV-Gm0Tf4
6. Marginal revenue andelasticity
If demand is inelastic, a
fall in price brings a
decrease in total revenue
(P↓,TR ↓ ).
The rise in revenue from
the increase in quantity
sold is outweighed by the
fall in revenue from the
lower price per unit, and
MR is negative.
2-7
7. Monopoly Power
Elasticity Of Demand And Price Markup
The markup (P − MC)/P is equal to the negative inverse of the price elasticity of
demand, P-MC/P = - 1/ED
If the firm’s demand is elastic, as in (a), the markup is small and the firm has
little monopoly power.
The opposite is true if demand is relatively inelastic, as in (b).
8. Price strategy forMonopolistic
Competition
Price is determined from the demand for the firm’s product and
is the highest price that the firm can charge for the profit-
maximizing quantity.
•The firm in monopolistic competition operates like
a single-price monopoly.
•The firm produces the quantity at which MR equals MC and
sells that quantity for the highest possible price.
•It makes an economic profit (as in this example) when P >
ATC.
A firm has excess capacity if it produces less than the quantity
at which ATC is a minimum.
A firm’s markup is the amount by which its price exceeds its
marginal cost
2-9
9. Price and Output inMonopolistic
Competition
The firm in monopolistic
competition operates like
a single-price monopoly.
The firm produces the
quantity at which MR
equals MC and sells that
quantity for the highest
possible price.
It makes an economic
profit (as in this example)
when P > ATC.
2-
10. Price and Output in Monopolistic Competition
Firms in monopolistic
competition operate with
positive markup.
Again, the downward-
sloping demand curve
for their products drives
this result.
2-
13. Consumer Surplus
• Extract surplus from consumers through:
• 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.
• For more information about “Commodity Bundling”
• https://www.youtube.com/watch?v=tOk_QYAxuVw
11-13
14. 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. So 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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16. Second-Degree PriceDiscrimination
11-16
• Second-degree price discrimination: a firm may charge
different prices for different levels of consumption.
• This type of strategy may be used in the selling of a
product like electricity.
22. Special Demand andCosts:
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.
• 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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23. Special Demand andCosts:
Transfer Pricing
11-23
• 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.
• For more information on “Transfer Pricing”
• https://www.youtube.com/watch?v=8HUis_WIB_o
24. Special Demand andCosts:
Double Marginalization
11-24
• 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 .
• Implication: .
• A similar situation exists for the downstream division; profit-
maximization leads to .
• Both divisions mark price up over marginal cost resulting in a
phenomenon called double marginalization.
• For more information on “Double Marginalization Problem”
• https://www.youtube.com/watch?v=7MPdKMeGcv8
26. Intense PriceCompetition:
Price Matching
11-26
• 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.
27. Intense PriceCompetition:
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.
11-27
28. Intense PriceCompetition:
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 chargesthe
lowest price in the market.
• Reduces the ability of rival firms to undercut a firm’s price.
• Not always profitable.
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29. Conclusion
11-29
• First degree price discrimination, block pricing,
and two part pricing permit a firm to extract all
consumer surplus.
• Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
• Simple markup rules are the easiest to
implement, but leave consumers with the most
surplus and may result in double-marginalization.
• Different strategies require different information.
