6 minute read
Predatory pricing: Get out
Chapter 14: Increasing Revenue with Advanced Pricing Strategies
attached to whether or not price discrimination is of the first degree or third degree — one isn’t more important than the other. (See the upcoming section “Identifying Who Wants to Pay More: Types of Price Discrimination” for details on the different degrees of price discrimination.)
Advertisement
Recognizing the conditions necessary for price discrimination
Price discrimination requires the following conditions
✓ You can segment the market into customers who have different price elasticities of demand. ✓ The firm possesses some degree of monopoly power and can set price. ✓ Finally, customers can’t resell the good. If customers are able to resell the good, those who pay a lower price can buy the good and sell it for a higher price, but not as high as the firm charges, to customers willing to pay the high price. This process is called arbitrage, and it limits the firm’s ability to benefit from price discrimination.
241
Assessing price discrimination’s impact
Firms that engage in price discrimination generally
✓ Produce a greater quantity of output. Because the firm is able to charge different prices to different groups of consumers, it can attract more buyers who are willing to pay a low price without sacrificing revenue from buyers willing to pay a higher price. By selling to both groups at different prices the firm increases the quantity of the good it sells. ✓ Increase their profit. By charging different prices, the firm is able to capture more consumer surplus — the difference between the price a consumer is willing to pay and the price the consumer actually pays.
This additional consumer surplus adds to the firm’s producer surplus.
As a business owner, you want customers to pay higher prices. Obviously those same customers want to pay lower prices. But as a demand curve
illustrates, the prices some customers are willing and able to pay are much higher than the prices others are willing and able to pay. You can increase your profit if you’re able to separate customers who are willing to pay higher prices from those willing to pay lower prices.
You should charge customers who have a less elastic demand a higher price, because a less elastic demand means the customer is less responsive to price changes. Customers whose demand is more elastic are more responsive to price changes. These customers should be charged a lower price in order to get them to buy a lot more.
Wishing for first-degree price discrimination
First-degree price discrimination, sometimes referred to as perfect price discrimination, exists when a firm charges a different price for each unit of the good sold — every customer pays a different price for the good. This degree is the ultimate extreme in price discrimination — hence, its designation as “perfect.”
When first-degree price discrimination exists, the firm’s marginal revenue curve corresponds to its demand curve. Because a different price — the maximum price each customer is willing and able to pay — is set for each unit of the good, each unit adds its price to total revenue. So, marginal revenue, the change in total revenue, equals the price determined from the demand curve.
Figure 14-1 illustrates a monopoly that’s using first-degree price discrimination. In the graph, marginal cost, MC, and average total cost, ATC, have the usual shapes with marginal cost passing through the minimum point on the average-total-cost curve. The firm faces a downward-sloping market demand curve that’s the same as the firm’s demand curve, D = d, given that it’s a monopoly. Because the firm charges every consumer the maximum price he or she is willing to pay, marginal revenue corresponds to the firm’s demand curve, d = MR.
Profit maximization occurs at the output level corresponding to marginal revenue equals marginal cost, q0 in Figure 14-1. Each unit of output has a unique price, so Plast is the price only for the last unit sold. Every other unit has a higher price. The resulting profit for the firm equals the revenue it receives for each unit minus the average total cost per unit, ATC0. Because the price for each unit is the maximum price as determined from the demand curve, the shaded area labeled π in Figure 14-1 represents the firm’s total profit.
Chapter 14: Increasing Revenue with Advanced Pricing Strategies
243
Figure 14-1:
First-degree price discrimination.
First-degree price discrimination is virtually impossible to implement. First, the firm must know exactly the maximum price each consumer will pay for each unit of the good purchased, which isn’t likely. In addition, the firm must negotiate separately with each individual consumer, and be able to prevent resale between consumers. The cost of these negotiations is likely to far outweigh the benefits to the firm of first-degree price discrimination. Nevertheless, the closer your firm gets to first-degree price discrimination, the greater the benefits.
Using second-degree price discrimination
Charging different prices for different ranges or blocks of output results in second-degree price discrimination or declining block pricing. Typically, consumers pay one price for the first, small block of output, and lower prices for additional ranges or blocks of output. Electric companies frequently use this type of price discrimination. For example, an electric company charges 9 cents per kilowatt hour for the first 300 kilowatt hours of electricity used in a month, 5 cents per kilowatt hour for the block 301 to 1,000 kilowatt hours, and 4 cents for each kilowatt hour over 1,000. A consumer using 1,200 kilowatt hours pays $70.00 = $0.09 × 300 + $0.05 × 700 + $0.04 × 200.
A firm engaging in second-degree price discrimination faces a marginal revenue curve that appears as a series of steps. The marginal revenue curve is a horizontal line corresponding to the price for that block of output. Figure 14-2 illustrates second-degree price discrimination.
Figure 14-2:
Seconddegree price discrimination.
The marginal-cost, MC, and average-total-cost, ATC, curves in Figure 14-2 have the typical shape. The firm in Figure 14-2 represents a monopoly so the downward-sloping market demand corresponds to the firm’s demand curve, D = d.
To derive the marginal-revenue curve, note for the block of output from 0 to qA, you charge PA for each unit of output. Thus, each unit adds PA to your total revenue and PA is your marginal revenue. For the block of output from qA to qB, you charge the lower PB and your marginal revenue “steps down” to correspond to PB. For the block of output from qB to q0, you again lower price, this time to P0, and marginal revenue takes another step down to P0. To sell more units of output beyond q0, you have to further lower price, so marginal revenue continues to take steps down. Marginal revenue, MR, in Figure 14-2 reflects this series of steps.
The profit-maximizing firm always produces the output level corresponding to marginal revenue equals marginal cost. This is the output level q0 in Figure 14-2. The firm doesn’t charge a single price. Instead, the firm charges the price PA for the block of output from 0 to qA, P to qB, and P0 for the remaining output. B for the block of output from qA
The amount of profit the firm receives for each unit is the difference between price and average total cost, so the shaded area labeled with the symbol π in Figure 14-2 represents the firm’s total profit. Note that the profit area in second-degree price discrimination is smaller than the profit area illustrated in Figure 14-1 for first-degree price discrimination.
