26April, 2006

Reading: Chapter 11

HW 15 Due Monday

Return Hw 14

Lecture 37

REVIEW______:

VIII. Chapter 11.Pricing Strategies.

A. Basic Pricing Strategies for Firms with Market Power

1. Optimal Pricing for a monopolist or monopolistic competitor

a. Basic Case

b. Imperfect Demand Information

P=MC/[1+1/].

Preview______

B. Strategies that yield higher profits

1. Price Discrimination

a. Perfect (1st degree) price discrimination

i. Calculating gains

ii. Necessary conditions

b. Price List (2nd degree) price discrimination

c. Group Division (3rd degree price discrimination.

2. Two part pricing.

.

Lecture______

A. Basic Pricing Strategies for Firms with Market Power.

1. Optimal Pricing for a monopolist or monopolistic competitor. Generally speaking, firms with downsloping demand can raise prices above the competitive level. This applies both to monopolistic competitors as well as to monopolists.

a. Basic Case. With perfect demand information, the firm can maximize profits by setting MR equal to MC to find the optimal quantity. Then the firm inserts Q into the price function to find the optimal price. We just reviewed this above. One important problem with this approach is that firms rarely have complete demand information.

b.. Optimization without a demand curve. As we noted earlier in the semester, often times we don’t have a good estimate of the demand curve. Rather, we must rely elasticity information to draw inference about optimal outcomes. Fortunately, this is not too difficult. Recall, a monopolist optimizes where MR = MC. MC should be known. Let’s consider MR.

TR = P(Q)Q. Taking the derivative w.r.t. Q yields

Pull out P from the RHS and we have

Now in an optimum MR = MC, thus

MC=P(1/ + 1)

Or

P=MC/(1+1/)

This is a useful expression, since it allows us to determine the optimal markup with only information regarding price elasticity of demand.

B. Strategies that Yield Greater Profits. However, if firms with downsloping demand are not constrained to charge the same price to all consumers, even higher profits are available. We start with price discrimination,

1. Price Discrimination: The practice of charging different prices to consumers for the same good. The below figures illustrate maximum profits available from posting a uniform price:

PMC

D

QmQ

MR

Now, if the firm is restricted to posting a single price, then the Qm will be produced, and the maximum profits than can be realized is the area in the shaded box. However, more surplus is available: Consumers take home the triangle above the shaded box at the top of the figure. Also, due to the inefficiently high price, fewer units are sold than would have been sold at the competitive price, causing an additional welfare loss.

a. First-degree price discrimination: The practice of charging different prices to consumers for the same good.

Suppose that the firm could successfully size up every consumer that came into their shop, size them up, and charge them their limit price for the good. The, the efficient quantity would be produced, and the firm would enjoy the entire surplus.

PMC

D

QeQ

MR

Perfect price discrimination requires satisfaction of two conditions

  1. The firm must be able to assess accurately the maximum willingness to pay of each consumer
  2. The firm must be able to prevent arbitrage, or the resale of units from low value consumers to high value consumers.

In practice, the first of these conditios is difficult to satisfy with any precision However, first degree price discrimination is often attempted in markets where the resale is impossible, and where the item exchanged is very costly (e.g. real estate or automobiles) or where the consumer knows little about the cost of the service (automobile repairs)

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