Economics of Management Strategy BEE3027

1. Economics of Management StrategyBEE3027 Lecture 4

2. Non-linear Pricing • In this section we will deal with ways how a monopoly (or a firm with market power) can capture surplus from consumers. • These are more sophisticated approaches to pricing than the standard models of industrial organisation, which assume firms charge a single price for each unit sold.

3. Monopoly problem • Standard monopolist sets MR = MC to determine optimal output and price. • Typical consequence of that is that there are consumers who would be served in a perfectly competitive market but are not: • Deadweight loss. • How can the problem be overcome?

4. 1st Degree Price discrimination • In this (rather unrealistic) case, the monopolist can determine each consumer’s reservation price and charge that price. • As a result, the monopolist will extract the whole consumer surplus. • It is economically efficient, but it is debatable whether this is desirable.

5. 3rd Degree Price discrimination • Here, the monopolist is not able to perfectly distinguish each consumer’s reservation price. • However it can screen consumers into types: • E.g. Students, OAPs. • As such, it can charge different prices to different types of consumers.

6. 3rd Degree Price discrimination • 3rd Degree Price Discrimination can be beneficial to consumers. • A key factor is the relative size of the two groups and their demand elasticities. • Often, one group will “subsidise” the other. • Students pay cheaper prices for cinema tickets

7. 2nd Degree Price discrimination • Another alternative for a monopolist is to give quantity discounts: • It can charge different prices for different blocks of units a consumer purchases. • This type of pricing scheme is used quite commonly by utility companies. • EDF Energy charges a price for the first block of Kwatts and a lower one for the second block.

8. 2nd Degree Price discrimination • P = 10 - q • Monopolist now chooses two blocks of units to sell at different prices: • q1 at p1 • (q2 – q1) at p2. • Profits are given by: • Monopolist takes q1as given and maximises profit. • MR2 = MC =>

9. 2nd Degree Price discrimination • Plug the optimal q2 into the original profit function to obtain: • Which when simplified gives:

10. 2nd Degree Price discrimination • Calculating the profit maximising condition: • Plugging the value of q1 back into q2 gives:

11. 2nd Degree Price discrimination • So, if c=0: • So, the first block of units is more expensive than the second block of units! • This allows the monopolist to extract extra consumer surplus away from the DWL area: • More efficient!

12. Two-Part Tariff • Many services that we purchase charge consumers with annual membership charges rather than a per-unit fee. • Gym; • Sports clubs; • Theatres; • Amusement parks. • The logic is that even a monopolist cannot usually extract all consumer surplus. • By adding an extra pricing instrument, the monopolist is able to extract all CS.

13. Two-Part Tariff • The logic behind two-part tariff is that the monopolist will set P=MC to determine optimal output and set F = CS to extract full surplus. • However, there are several problems: • Monopolist does not necessarily know individual demand schedules perfectly; • Consumers will have different demand schedules, hence if it sets F too high, it may lose some (or all) customers! • Still, two-part tariffs are quite common