Chapter 10 - Market power and pricing

Question 1

What is a pricing strategy?

Answer 1

A firm’s method of pricing its product based on market characteristics

Question 2

1. Define price discrimination. What are the two requirements of price discrimination?

Answer 2

Price discrimination is the practice of charging different prices to different customers for the same product.
In order for a firm to price-discriminate, it must have market power and be able to prevent resale or arbitrage of its product. Arbitrage is the practice of reselling a product at a price higher than its original selling price.

Question 3

2. Why is producer surplus maximized under perfect price discrimination and is there deadweight loss?

Answer 3

Under perfect price discrimination, the producer charges each individual customer the price equal to his willingness to pay for the product. As a result, the producer captures all available surplus of the market (the area below demand and above marginal cost), maximizing his producer surplus. There is no deadweight loss when a firm practices perfect price discrimination.

Question 4

3. What are the two types of direct price discrimination?

Answer 4

Direct price discrimination encompasses two types of price discrimination. We discussed the first-perfect or first-degree price discrimination-in our answer to Question 2 above. The second, segmenting or third-degree price discrimination, is the practice of charging different prices to different groups of customers based on identifiable group characteristics.

Question 5

When can a firm use perfect/first-degree price discrimination?

Answer 5

1. When the firm has market power and can prevent resale
2. The firm’s customers have different demand curves
3. The firm has complete information about every customer and can identify each one’s demand before purchase

Question 6

Where will a firm produce if it practices perfect price discrimination and what is the consumer and producer surplus?

Answer 6

The firm will produce where P = MC. Consumer surplus will be 0 because every consumer will be charged a price equal to his willingness to pay.
The producer surplus will be the difference between the price and the marginal cost.

Question 7

When can a firm use segmenting/third degree price discrimination?

Answer 7

1. When the firm has market power and can prevent resale.
2. The firm’s customers have different demand curves.
3. The firm can directly identify specific groups of customers with different price sensitivities (but not the demand of every individual customer) before purchase.

Question 8

What is segmenting/third degree price discrimination?

Answer 8

A type of direct price discrimination in which a firm charges different price to different groups of customers.

Question 9

4. What are some ways that a firm can segment its customers?

Answer 9

Segmenting may be based on one of a variety of characteristics, including customer characteristics such as age or gender, past purchasing behaviour, location, and over time (only if the seller directly assigns customers to a given time period. The more forward-looking consumers are, the more segmenting across time actually becomes indirect price discrimination).

Question 10

If a firm is able to engage in segmenting, how should they treat the different groups?

Answer 10

The fundamental economic idea of segmenting is simple. If a firm can directly identify groups that have different demand and charge different prices to each, it can essentially treat each groups as a separate market. The firm then sets its profit-maximizing quantity for each one of these “markets” where MR=MC and sets the corresponding single-price profit-maximizing price according to each market’s demand curve.

Question 11

How much should each segment be charged?

Answer 11

Because the standard market power pricing rule applies in each segment, it also means that the Lerner index applies in each market. If the firm sells the same good to both segments of the market, the marginal cost of producing for each segment is the same. In this case, the only reason to charge different prices to customers in different segments is because they have different demand elasticities. The ratio of these prices is:
P_1/P_2 =[(E_1^D)/(1+E_1^D )]/[(E_2^D)/(1+E_2^D )]
As the demand in segment 1 becomes less elastic relative to segment 2 (i.e. E_1^D becomes smaller than E_2^D in absolute vale), the ratio P_1/P_2 will rise. To find the optimal mark-up for each segment, just use the Lerner index.

Question 12

When should a firm use indirect/second-degree price discrimination?

Answer 12

1. The firm has market power and can prevent resale
2. The firm’s customers have different demand curves
3. The firm cannot directly identify which customers have which type of demand before purchase

Question 13

5. Contrast direct price discrimination and indirect price discrimination.

Answer 13

Direct price discrimination hinges on the firm’s ability to distinguish customers’ demand for the product before purchase. In indirect price discrimination, the firm doesn’t have this knowledge; instead, it allows customers to choose among a variety of offered prices, effectively having customers sort themselves into groups based on their demand for the product.

Question 14

What are the requirements for quantity discounting to work in terms of indirect price discrimination?

Answer 14

Customers who purchase larger quantities of a product need to have relatively more elastic demands than consumers who buy smaller quantities. If the consumers in the market do not have these elasticity characteristics, the firm would be trying to find a way to raise prices on the people who buy greater quantities, the opposite of a quantity discount.

Question 15

6. What is incentive compatibility? Why is it necessary for an indirect price discrimination strategy to be incentive compatible?

Answer 15

Incentive compatibility dictates that the price offered to each consumer group must be chosen by that group. Without incentive compatibility, the firm using indirect price discrimination will not be maximizing its producer surplus.

Question 16

7. Provide an example of product versioning.

Answer 16

A firm that offers different product options designed to attract different types of customers is using yet another pricing strategy-versioning. An airline that offers business class and coach tickets, for example, is betting on versioning to maximize its producer surplus. This way companies can get its customers to self-select into groups based on their price sensitivities.

Question 17

How does incentive compatibility apply to versioning?

Answer 17

For versioning to work, mark-up must be higher for segment with less elastic demand, though not too much to maintain incentive compatibility.
The version for the less price sensitive consumers needs to give them a higher consumer surplus than the version for the more price sensitive consumers. The version for the more price sensitive consumers needs to give them a higher consumer surplus than the version for the less price sensitive consumers. Each group chooses the version designed to take advantage of the nature of their demand curves. That means these prices are incentive-compatible.

Question 18

What is necessary for versioning to work?

Answer 18

With versioning, the different versions’ marginal costs do not need to be the same. All that is necessary for versioning to work is for the mark-up of price over marginal cost to be bigger for the versions bought by customers with less elastic demand.

Question 19

How can firms use coupons for indirect price discrimination?

Answer 19

Retailers would like to charge shoppers who have less elastic demands more for products while setting a lower price for consumers who are more sensitive to price. Again, however, they have no way of directly identifying and separating these different groups when they buy, so they have to get the groups to do it themselves. Coupons are a device they use to do so.
The key to the way coupons work is that the people who go to the trouble of using coupons-who search for the right site or deal online, comb through junk mail, or search through newspaper inserts-are more likely to have more elastic demand. Because both the willingness to do the work clipping the coupons and the willingness to shop around for cheaper groceries are determined by the consumers’ perceived value of time, coupon clipping, and the price elasticity of demand are likely to be correlated. That way, the people who actually end up getting a price discount from a coupon are those consumers with more elastic demand-exactly the group to whom the retailers would like to offer lower prices. The shoppers who are less sensitive to price end up paying the higher, undiscounted price.

Question 20

8. What are the differences between segmenting, and quantity discounts?

Answer 20

When segmenting, the firm uses its knowledge of characteristics of specific groups of customers to charge different prices to the groups. Quantity discounting is a form of indirect price discrimination in which firms charge a lower per-unit price to customers who buy larger quantities.

Question 21

What is the profit if of the segments (segmenting/third-degree price discrimination)?

Answer 21

The total producer surplus the producers earn is the difference between the price and the marginal cost for each segment times the number of units sold to that segment.