How does the degree of competition shape a firm’s pricing power?
Perfect competition and monopoly are both extreme cases, neither of which is found in the real world in pure form.
Competitive Firm
Monopoly
The slope of the demand curve reflects a firm’s market power.
Whether a firm has relatively great market power or somewhat lesser market power can be represented by the slopes of the D and MR curves.
The competitive firm faces a horizontal D = MR: it is a price-taker.
The monopolist faces a downward-sloping D, with MR below it.
Real-world firms sit somewhere on this spectrum.
Thinking in terms of market power is important for business strategy.
Profitability depends on understanding the extent of competition in your markets.
Thinking in terms of market power is important for business strategy.
Profitability depends on understanding the extent of competition in your markets.
Can you influencehopefully decreasethe extent of that competition?
What matters is competition as perceived by your customers.
How substitutable are other goods for your own, as perceived by your customers?
Product Differentiation Strategy
Relies on differences in products or processes affecting perceived customer value.
Competing on capabilities, brand names, or product endorsements.
Convince customers there are not good substitutes.
Goal: make the demand you face less price elastic.
What can the profit-maximizing firm model teach us about real-world pricing decisions?
We know the rule: choose Q where MR = MC, then set P along D.
In the real world, firms can produce similar goods yet convince consumers that they are dealing with heterogeneous products.
Can we “push” the model to address these realities?
Price Discrimination
A firm with market power earns profits because it can set P > MC.
It captures producer surplus at the expense of consumer surplus and some deadweight loss.
But it can increase profits further if it can price discriminate:
Violate the law of one price
Charge different prices to buyers with different willingness to pay.
Can lead to increases in total surplus.
First-Order (Perfect) Price Discrimination
Charge each buyer a price equal to his/her willingness to pay.
The monopoly firm captures the entire surplus.
But there is no deadweight loss.
Intuition:
Constrained to a single price, a monopoly will not produce beyond MR = MC because additional revenue is offset by lower prices on infra-marginal units.
With perfect price discrimination, that effect vanishes.
Profits maximized by producing up to MC = D, total surplus maximized (though consumer surplus = 0).
Producers profit more, deadweight losses decrease relative to the law-of-one-price outcome.
Price Discrimination Examples
Consumer goods & services:
Senior citizen pricing, movie tickets, fast food value menus
Car sales (negotiations from a list price)
Discount coupons
“Personalized” pricing:
Amazon, Home Depot, restaurant ordering apps
Travel:
Airlines — the leading real-world example.
Segmented Market, Differential Pricing
Motivating example: an airline with business and non-business travelers.
Buying essentially the same product.
Value different aspects (schedule conformance vs. comfort).
Different price elasticities for each segment.
The airline must determine:
How many tickets to sell in total.
How to allocate them across the two customer types.
What price to charge each customer type.
Each segment has its own demand curve and marginal revenue curve.
Business Travelers
Non-Business Travelers
Total to produce: sum up the MR curves, equate to MC.
At MR = 130, total Q = 170, corresponding to QBUS = 63 and QNONBUS = 107.
Key rule: In a segmented market, equate MR across customer typesand in both cases to MC. This allocation is profit-maximizing. Shifting a unit from non-business to business (or vice versa) while holding total output fixed would lower profit.
Why must MR be equal across segments?
Suppose QBUS = 62 and QNONBUS = 108 (still total = 170).
Then MRBUS > 130 > MRNONBUS.
While still producing 170, the firm could gain MRBUS > 130 at the expense of MRNONBUS < 130 by selling one more (less) business (non-business) ticket.
Profit is maximized only when MRBUS = MRNONBUS = MC.
Airline Segmented Market: Optimal Prices
Segment
Elasticity
Q* (tickets)
Optimal Price
Business travelers
Less elastic
63
$261
Non-business travelers
More elastic
107
$188
Total tickets sold
170
MR = $130 = MC
Given MRBUS = MRNONBUS = 130 = MC, each segment’s price is read off its own demand curve at the optimal quantity.
The price charged is higher for the customers with less elastic demand.
PBUS = $261 PNONBUS = $188
Business travelers are less willing to substitute away from this flight, they have less elastic demand. So they pay more.
General rule: Charge the higher price to the segment with the less elastic (more inelastic) demand. Charge the lower price to the segment with the more elastic demand.
Segmented Market, Differential Pricing
Airline example revisited: first class & coach tickets.
Buying essentially the same transport, valuing different features (schedule conformance vs. comfortable seats).
Different price elasticities for each segment.
Whether your business deals with segmented markets by customer-type or by product, the logic of differential pricing is the same.
Differential pricing is greatif you can get away with it.
When you exploit market segmentation, consumers may try to benefit by integrating the market (buying at the lower price and reselling), or react negatively to the price discrimination.
A business can achieve higher profits by putting up “fences” between markets.
Fence: Intertemporal Pricing
Pricing by time of day, day of week, season, etc.
Road tolls differentiated by time of day.
Parking meter rates differentiated by time of day.
Matinee movie pricing.
Early-bird dinner specials.
The “fence”: willingness to consume at a particular time.
Business travelers fly on Tuesday morning, leisure travelers can wait for Sunday.
Other Fences Between Markets
Varying price by delivery location.
Brand-name clothing at resort shops versus off-highway outlets.
“Versioning”
MS Office: Home, Personal, Business, and Business Premium.
Software tiers, streaming plan levels.
Two-Part Tariffs
Pay a cover charge at a club, then also pay by the drink.
Costco membership + per-unit prices.
Coupons
Different consumers receive them, different consumers make the effort to use them.
Fences work by making it difficult for lower-price consumers to “pretend” to be higher-price consumers, and vice versa.
The fence is the mechanism that preserves market segmentation.
Time of purchase (intertemporal pricing) or location (geographic versioning).
Product version or quality level (versioning).
Entry fee plus per-unit usage fee (two-part tariffs).
Putting It Together: Market Power Strategy
Build market power through product differentiation.
Make your product perceived as unique, reduce price elasticity of demand.
Identify segments with different elasticities.
Equate MR across segments and to MC to determine optimal quantities.