PRICING STRATEGIES

Limit Pricing.

Predatory Pricing.

Cost-plus Pricing.

Price Discrimination.

These are discussed in the following sections.

 PRICING STRATEGIES
In imperfect market such as monopoly or oligopoly firms
use various pricing strategies to compete with the rival
firms.
The Neo-Classical Theory of the firm is not relevant in
analyzing these behavior of the firm.
Some of the strategies are:
Limit Pricing,
Predatory Pricing,
Cost-Plus Pricing, and
Price Discrimination.
The following slides deal with them in details.
 Limit Pricing in Monopoly and Oligopoly

LIMIT PRICING
To deter potential rivals the monopolist may limit
its supernormal profit [not profit maximise].

In the slide below the monopolist limits its price

to PL which makes it impossible for a new entrant
to make a profit.

PL may be below the monopolists short-run profit

maximising price but may be a means of
protecting long-run profits.
 Limit pricing

AC new entrant

PL
AC monopolist

Provided price is kept below

the limit price (PL), new firms
cannot make a profit.

O Q
As shown here the monopolist has a lower AC due to a large-scale production.
 LIMIT PRICING
As shown in the previous slide the monopolist
sacrifices short-run profit by lowering the price of its
product or service to the limit so that the potential
entry is blocked.
The price set by the firm is too low and it makes
impossible for a potential firm to sustain itself. Thus it
deters the firm from entering the market.
Thus the firm aims for the long-run profit
maximization.
This phenomenon is observed when the market
becomes Contestable [barriers to entry becomes
highly insignificant].
 PREDATORY PRICING IN OLIGOPOLY
Predatory pricing strategy is pursued by firms
operating in an oligopoly market.
Firms are interdependent and therefore this strategy
is pursued to drive the actual competition from the
market.
Under this policy measure the firm lowers the price
of its good or service or provides other benefits so
that its service becomes distinctively different from
the services of the rival firms.
The successful firm would be able to increase the
market share by taking some buyers away from the
rival firms.
 COST-PLUS PRICING
This is the Neo-Keynesian Theory developed by R.
Hall and C. Hitch.

It has been developed to overcome the drawbacks

associated with the Neo-Classical Theory of the Firm.
The drawback of the theory was that firms in the real
world did not equate MC and MR to determine the
equilibrium quantity and price. It was difficult to
calculate MR and MC.

Thus the firms used cost-plus pricing method rather

than using MC and MR approach.
 COST-PLUS PRICING
Under this the firm uses the following rule:
P = ATC + Mark-Up [ % of ATC ].
Here P is price per unit of the good, ATC is the total
cost per unit of the output, and mark-up is the profit
margin. It is set as a certain percentage of ATC.
Here ATC = AFC + AVC.
The firm estimates these costs for generating a
standard volume of output. The output may be 80
percent of the optimum output. After estimation of the
ATC the profit margin is added to determine the price
of the good.
This pricing strategy is more realistic in comparison to
the MC and MR approach.
Price Discrimination
 PRICE DISCRIMINATION
Price discrimination is the practice of charging different
price for the same good or service to different groups of
consumers to maximize profit.

The different prices are charged not because of cost

differences.

Firms operating in Oligopoly and Monopoly markets

practice it.

There are both merits and demerits of pursuing such a

policy.
 PRICE DISCRIMINATION: CONDITIONS
The following are the conditions needed for the
successful implementation of price discrimination.
They are:
Market must be imperfect- in perfect competition it
cannot be pursued.
Market must be segregated into two or more groups
under various criterion and seepage among the
markets must not occur.
The cost of separation of markets into various
groups must be highly insignificant to the produces.
The degree of responsiveness of demand must be
different in markets.
PRICE DISCRIMINATION: METHODS
Firms use different methods to price discriminate.
The following are some of the methods pursued by
the firms. They are:
Income- lower income groups are charged lower
price in comparison to the rich.
Time- during busy hours prices are higher in
comparison to the slack hours.
Place- in a foreign market price charged is lower in
comparison to the domestic market. Likewise high
price is charged in a posh area in comparison to a
commoner area.
Quantity-lower price for larger quantities bought
than for lower quantity.
 DEGREE OF PRICE DISCRIMINATION
The degree measures the intensity of price
discrimination. The intensity is measured or assessed
by taking into account its impact on the consumers’
surplus.
Thus there are four degrees of price discrimination.
They are:
Price Discrimination of the First Degree.
Price Discrimination of the Second Degree.
Price Discrimination of the Third Degree, and
Price Discrimination of the Fourth Degree.
The following sections discuss them in details.
 PRICE DISCRIMINATION OF THE FIRST DEGREE

This is a perfect or an absolute form of price

discrimination.

Under this form the monopolist sells each unit of the

good at a price consumers are willing and able to pay
for the good rather than going without it.

Thus all of the consumers’ surplus is appropriated by

the monopolists and maximizes its overall profit.
This occurs because the price of the good is set at the
price consumers’ are willing to pay.
 PRICE DISCRIMINATION OF THE FIRST DEGREE
Q MU Pw Pa Cs
0 - - - -
1 10 10 10 0
2 9 9 9 0
3 8 8 8 0
4 7 7 7 0
5 6 6 6 0
Total EMU=40 Epw=40 Epa=40 Cs=EPw-Epa=0

As shown above the table illustrates the operation of price discrimination of the
first degree. Marginal utility [MU] indicates the price consumer is willing to pay
for the good and this is price at which each unit of the good is sold. So the
monopolist appropriates all of the consumer’s surplus.
Thus this is an absolute form of price discrimination.
However to operationalize it the monopolist has to assess MU cardinally.
Is it possible to measure MU cardinally?
 FIRST DEGREE
The following diagram shows the price
discrimination of the first degree.

As shown in the adjoining

figure the monopolist sells
each unit of the good at a
different price.
Thus for OQ* units of the
good the buyer is willing to
pay ODEQ* and the actual
payment is also ODEQ* and
therefore no consumer
surplus is left. If OMC were
the price for all units upto
OQ* then the consumer
would have paid OMCEQ*
and the consumer’s surplus
would have been MCDE.
 PRICE DISCRIMINATION OF THE SECOND DEGREE

In this form of price discrimination the monopolist

splits market into two or more blocs on the basis of
quantity of the good bought by each buyer. The
following table illustrates it.
Q MU Pw Blocs Pa Cs
0 - - -
1 10 10 8 2
2 9 9 A 8 1
3 8 8 8 0
4 7 7 5 2
5 6 6 B 5 1
6 5 5 5 0
Total EMU=45 EPw=45 EPa=39 Cs=EPw-EPa=6
 SECOND DEGREE
As shown in the previous table the monopolist has
split the market into two blocs and actual price is
charged on the basis of the quantities bought. Price in
market A is set at the lowest willingness to pay and
price in market B is also set accordingly.

Thus under this form of price discrimination some

consumer’s surplus is left into the hands of consumer’s
in both the markets.

So it is not as exploitative as we saw in the case of the

price discrimination of the first degree.
 SECOND DEGREE
The following diagram shows price discrimination of
the second degree.
As shown in the adjacent figure the
monopolist has split the market into six
blocs and has charged different price in
each market. Actual payments made are
represented by the shaded rectangles and
the unshaded triangles at the top of each
rectangle represent consumer’s surplus.
So the total amount of money willing to be
paid for quantities OQ1 is the summation
of the triangle and the rectangle at the
quantity.
Similarly for other blocs such as Q1Q2 may
also be derived in the same manner.

The above analysis shows that the total amount of consumer’s surplus is the
summation of the each of the consumer’s surplus of the respective blocs.
 PRICE DISCRIMINATION OF THE THIRD
DEGREE
In this of price discrimination the monopolist
segregates the market into two or more groups on the
basis of the differences of the price elasticity of
demand.

Then a high price is charged for the good in the

market where the demand for the good is relatively
inelastic and a low price is charged in the market in
which price elasticity of demand for the good is
relatively elastic.

The diagram in the next slide shows it.

 THIRD DEGREE
Here market has been separated into two groups.
As shown here MC is made
equal to MR1 and MR2 by
the profit maximizing
monopolist.
So quantity OQ*1 is sold in
market 1 at a price of OP1
whereas OQ*2 is the
quantity of the good is sold
in market 2 at a price of
OP2.
It is observed thus that
price in market 1 is high
because demand for the
good is relatively inelastic.
In market 2 price is low
because demand for the
good is relatively elastic.
 MERITS AND DEMERITS OF PRICE
DISCRIMINATION

As shown in the diagram if firm were

to charge a single price then it would
make a loss.
Price discrimination would permit
the firm to sustain itself.
 MERITS AND DEMERITS OF PRICE DISCRIMINATION

Similarly by charging different price for the good or service

during peak and off peak hours the demand for the good is
managed. This happens in the case of goods such as electricity
which cannot be stored once it is generated. So by charging high
price during peak time and by charging low during off peak time
an efficient use of the resource is made.
Price discrimination also allows consumer’s having lower ability
to pay for it to consume the good because high payers for the
good subsidize the good for them.
However dead-weight loss and productive and allocative
inefficiencies occur in a monopoly and therefore it may not be
socially desirable.
However if it attains dynamic efficiency in the long run and
provides benefits to consumers then the net social benefit may be
maximized.
 OTHER PRICING STRATEGIES
The other pricing strategies are:
Incremental Pricing.
Peak-load Pricing.
Transfer Pricing.
Joint-product Pricing.
Export Pricing, etc,.

Interested students may explore these alternative

pricing strategies.