Pricing Strategies

1. CHAPTER 8
Pricing Strategies for Firms with Market
Power

2. INTRODUCTION

3. Learning Objectives
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.
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4. Pricing Strategies
•Basic Rules of Profit Maximization:
Firms with market power face a downward-
sloping demand curve, selling a few units at
a high price.
• Profit maximizing price: Managers with
market power select the quantity that
equates marginal revenue and marginal
cost , and charging the maximum price that
consumer will pay for this level of output.
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5. A VIDEO ABOUT
“Profit Maximization”
https://www.youtube.com/watch?v=BQvtnjWZ0i
g

6. Pricing Rule for Monopoly and
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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7. Monopoly Price rule
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.
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8. A VIDEO ABOUT
“Price Discrimination”
https://www.youtube.com/watch?v=SZCV-Gm0Tf4

9. Marginal revenue and elasticity
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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.

10. 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).
Monopoly Power

11. Price strategy for Monopolistic
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
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12. Price and Output in Monopolistic
Competition
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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.

13. Price and Output in Monopolistic Competition
2-
Firms in monopolistic
competition operate with
positive markup.
Again, the downward-
sloping demand curve
for their products drives
this result.

14. CHAPTER 8
Pricing Strategies for Firms with Market
Power

15. CONSUMER SURPLUS

16. 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.
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17. A VIDEO ABOUT
“Commodity Bundling”
https://www.youtube.com/watch?v=tOk_QYAxuVw

18. 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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19. First-Degree Price Discrimination
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Price
Quantity
Demand
MC
5
$4
$10
Firm profit under first-degree
price discrimination

20. Second-Degree Price Discrimination
• 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.
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21. Second-Degree Price Discrimination
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Price
Quantity
Demand
MC
4
$5.20
$10
2
$7.60 Contribution to profits under
second-degree price discrimination

22. Third-Degree Price Discrimination
• Third-degree price discrimination, is the most common
form, where a firm divides its market into segments and
charges different prices accordingly. Markets can be
segmented in various ways for this purpose.
• marginal revenue will be different for each group, if there are two
groups, 𝑀𝑅1 > 𝑀𝑅2
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23. Price Discrimination
Consumer surplus increases and the airline’s producer
surplus increases.
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24. CHAPTER 8
Pricing Strategies for Firms with Market
Power

25. SPECIAL DEMAND AND
COSTS:

26. 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.
• 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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27. 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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28. A VIDEO ABOUT
“Transfer Pricing”
https://www.youtube.com/watch?v=8HUis_WIB_o

29. 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 .
• 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.
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30. A VIDEO ABOUT
“Double Marginalization Problem”
https://www.youtube.com/watch?v=7MPdKMeG
cv8

31. 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, , equals the net marginal revenue to the downstream division:
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32. 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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33. 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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34. 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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35. Conclusion
• 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.
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36. RECAP
On Key Terms and Concepts
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37. Key terms
• Block pricing
• Cross subsidies
• Double marginalization
• First – degree price discrimination
• Peak load pricing
• Price matching
• Price discrimination
• Transfer pricing
• Two part pricing
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