Chapter 7: Pricing with Market Power

Brickley, Smith, and Zimmerman, Managerial Economics and

Organizational Architecture, 4th ed.

Pricing with market power learning objectives

• Students should be able to• Explain the role of elasticity in optimal

pricing• Identify circumstances appropriate for

price discrimination• Apply selected pricing techniques

consistent with maximum profit

Pricing objective

A firm has market power if…it faces a downsloping demand curve.

The firm’s pricing objective is…to maximize shareholder value.

The demand curve reflects…consumer willingness and ability to buy.

Pricing with market power(Figure 7.1)

Single price per unitFigure 7.2

Other single pricing issues• Relevant costs

– sunk costs are irrelevant– current opportunity costs are relevant

• Price sensitivity– price elasticity, , is a measure of price

sensitivity– Optimal price is P*=MC*/[1-1/ *]– A firm with market power should never

operate on the inelastic portion of the demand curve

Price sensitivity and optimal markup

(Figure 7.3)

Estimating profit-maximizing price

• In theory, MC=MR, but in practice, manager may not know demand curve and therefore MR.

• Cost-plus or mark-up pricing may be useful approximations.

• But they must reflect awareness of price sensitivity!

Cost-plus pricing• Add a markup to average total cost to yield

target return• Does this ignore incremental costs and price

sensitivity?– not if managers have a fundamental

understanding of their markets– consistently bad pricing policies are not good

for the firm’s long-term fiscal health

Mark-up pricing

• Optimal mark-up rule of thumb:P*=MC*/(1-1/*)

where * indicates estimated value• Requires some knowledge or

awareness of both marginal costs and elasticity

Potential for higher profits(Figure 7.4)

Homogenous consumer demand

• Block pricing– declining price on subsequent blocks of product– product packaging

• Two-part tariffs– up-front fee for the right to purchase– additional fee per unit purchased– best when customers have relatively homogenous

demand for product

Two-part tariffcapturing consumer surplus

Price discriminationheterogeneous consumer demands

• Price discrimination occurs when firm charges different prices to different groups of customers for the same product– not related to cost differences

• Necessary conditions– different price elasticities of demand– no transfers across submarkets

Using information about individuals

• Personalized pricing– “first degree” price discrimination– possible only with small number of buyers

• Group pricing– “third degree” price discrimination– very common (utilities, theaters, airlines…)

Optimal pricing at Snowfishdifferent demand elasticities

Using information about the distribution of demands

• Menu pricing– “second degree” price discrimination– consumers select preferred package

• Coupons and rebates– users likely more price sensitive– users who are new customers may stick

with product

Bundling and other concerns• Bundling may yield a higher price than if

each component is sold separately– theater season tickets– restaurant fixed price meals

• Multiperiod pricing– low initial price can “lock-in” customers

• Strategic considerations– low price may be barrier to entry