PRICING POLICY

AIMS & OBJECTIVES

After studying this lesson, you will be able to understand: Pricing in Competitive Markets Pricing in Imperfectly Competitive Markets Idea of dead weigh loss Types of pricing in imperfect competitive market

Price Discrimination Two-Part Pricing Bundle Pricing Peak Load Pricing

PRICING IN COMPETITIVE MARKETS

In perfect competition, sellers are price takers. The rule of thumb for pricing in this market is to set a price P= MC

PRICING IN IMPERFECTLY COMPETITIVE MARKETS

In imperfect competition, sellers have monopoly power meaning power to make a price greater than MC. Price greater than MC could be decided either by markup on price {(PMC)/P} or by markup on cost i.e. {(P- MC)/MC} Thus, monopoly power is measured by Lerner index = {(P-MC)/P} Now, in Monopoly, profit max requires MR = MC & MR = P{1-(1/e)}

Thus, MC = P{1-(1/e)}. Using this in Lerner index we get

Lerner index = {(P-MC)/P} = 1/e. The above implies in imperfect competition sellers enjoy monopoly power i.e. power to make price greater than MC but the power to make price is limited by the elasticity of demand of the consumers that the sellers face.
4

ECONOMIC COST OF IMPERFECT

COMPETITION

In perfect competition P= MC and also P= min AC ideal capacity or the most efficient capacity/output In imperfect competition P > MC and P > min AC output is less than efficient capacity/output Thus, there is loss of efficiency if there is imperfect competition For each unit that the monopolist reduces output below E, efficiency loss is the vertical distance between the demand curve & the MC curve The total deadweight loss from the monopolists output restriction is the sum of all such loses represented by the triangle ABE

B E A Competitive equilibrium

QM

Qpc

Ideal output

WHAT IS DEAD WEIGHT LOSS THEN?

The inefficiency loss to the society from sellers exercising their monopoly power to set price P >MC is sometimes called deadweight loss This refers to the loss of economic welfare arising from distortions in prices and output (distortions or differences from competitive price & output). If price= MC, consumers enjoy substantial surplus. If now monopolist comes in to charge P>MC, consumers will lose more surplus than the monopolist will gain. This is because as price rises consumers surplus falls and producers gain this surplus. Besides as price rises quantity bought and sold in the market falls leading to exit of some consumers from the market. The surplus that they were enjoying is lost forever. This represents a net loss of welfare in the economy . This net loss in economic welfare (measured as sum of consumers plus producers surpluses) is called deadweight loss

PRICING IN MARKETS WITH MONOPOLY

POWER

In markets with monopoly power, a seller can practice different pricing strategies. Some of them are: Price discrimination Two-part pricing Bundle pricing Peak Load pricing

PRICE DISCRIMINATION

Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same.

PRICE DISCRIMINATION

Two important effects of price discrimination: It can increase the monopolists profits. It can reduce deadweight loss. But in order to price discriminate, the firm must Be able to separate the customers on the basis of willingness to pay. Prevent the customers from reselling the product.

TYPES OF PRICE DISCRIMINATION

First degree- the practice of charging maximum possible price that the consumers are willing to pay for each of the successive units of the product. Example: applies to any market where discounts from posted prices are normal like professional services, homes. Second Degree- this occurs if the monopolist can divide the buyers of his product into different groups each having a different range of demand prices and charge from each group a price that equals the minimum demand price of that group. Example: electric companies charging block rates Third Degree- here the monopolist divides his market into different sub markets and charges for the product in different sub markets different prices. Example: charging of different rates for an insured patient and uninsured patient

10

PROFIT MAXIMIZING CONDITION UNDER THIRD

DEGREE PRICE DISCRIMINATION

Let the seller divide his market into two markets: Market 1 & Market 2 while he produces the product under same cost conditions Profit max for the seller implies profit maximization in each of the two markets, i.e, MR1 = MC & MR2 = MC MR1= MR2 = MC Now MR = d/dq (TR) = d/dq (pq) = p+qdp/dq = p (1-1/e) Thus, MR1 = p1(1-1/e1) & MR2 = p2(1-1/e2) Now MR1= MR2 for profit maximization p1(1-1/e1) = p2(1-1/e2) p1 p2 when e1 e2. In particular p1> p2 when e1< e2 Thus, for price discrimination to be successful, the monopolist must be able to separate the customers on the basis of price elasticities of demand

11