Revenue

Introduction to
Microeconomics y Defining
D fi i total,
t t l average and
d marginal
i l revenue
1
y Revenue curves when firms are price takers
LECTURE 5 (SESSION 2) (horizontal demand curve)
MARKET STRUCTURE
{ average revenue (AR)
DR NICHOLAS VASILAKOS { marginal
g revenue ((MR))

Deriving a firm’s AR and MR: price-taking firm

Revenue
£)

£)

y Defining
D fi i total,
t t l average and
d marginal
i l revenue
Price (£

R, MR (£

S
y Revenue curves when firms are price takers
AR

D = AR
(horizontal demand curve)
Pe
= MR
{ average revenue (AR)

{ marginal
g revenue ((MR))
D
O { total revenue (TR)
O
Q (millions) Q (hundreds)

((a)) The market ((b)) The firm

 Total revenue for a price-taking firm AR and MR curves for a firm facing a downward-sloping D curve

TR 8 Q P =AR TR MR
6000 Quantity
Q tit P
Price
i = AR TR
(units) (£) (£) (£)
(units) = MR (£) (£)
1 8 8
6
0 5 0 2 7 14
5000 6 6 4
200 5 1000 3 18
5 2
400 5 2000 4 20
4 0
600 5 3000 5 20
4000 -2
2

AR, MR (£)
TR (£)

800 5 4000 4 6 3 18
2 -4
1000 5 5000 7 14
1200 5 6000
3000
2 AR
2000
0
1 2 3 4 5 6 7 Quantity
1000
-2
0
0 200 400 600 800 1000 1200 MR
-4
Quantity

TR curve for a firm facing a downward-sloping D curve Finding maximum profit using total curves

24 TC
20
20 d
16 16

Ȇ (£)
TR, TC, TȆ
TR e TR
Quantity P = AR TR 12
12
(units) (£) (£)
£)
TR (£

1 8 8 8
8 2 7 14
f
3 6 18 4
4 5 20
4 5 4 20 0
6 3 18 1 2 3 4 5 6 7 Quantity
7 2 14
-4
0
0 1 2 3 4 5 6 7 -8 TȆ
Quantity
 Profit maximisation Profit maximisation

y Using
U i ttotal
t l curves y Using
U i ttotal
t l curves
{ maximising difference between TR and TC { maximising difference between TR and TC
{ the total profit curve { the total profit curve

y Using
g marginal
g and average
g curves
y Using marginal and average curves { Stage 1:
{ Stage 1: profit maximised where MR = MC
p
profit maximised where MR = MC
{ Stage 2:
using AR and AC curves to measure maximum
profit

Measuring maximum profit using average curves

16 MC
Total profit =
£1.50 x 3 = £4.50
Perfect Competition and
12
Profits maximised at the Monopoly
e (£)

output where MC = MR
Costs and revenue

8 AC
ALTERNATIVE MARKET STRUCTURES & THE
a CONCEPT OF MARKET POWER
6.00
TOTAL PROFIT b
4.50
4

AR
0
1 2 3 4 5 6 7
Quantity

-44 MR
 Features of the four market structures Characteristics of perfect competition:
Detail
14
Implications for
Number Freedom of
Type
yp of market Nature of p
product Examples
p demand curve
of firms entry
faced by firm y L
Large numbersb off buyers
b andd sellers.
ll
Perfect Very Homogeneous Cabbages, carrots Horizontal: { No individual firm can influence price (i.e. no individual firm has
competition many Unrestricted (undifferentiated) (approximately) firm is a price taker “market power”).
{ All firms are price takers. Individual firms don’t set prices;
Monopolistic Many / Plumbers, Downward sloping, rather prices are determined by the interaction of supply and
Unrestricted Differentiated
competition several restaurants but relatively elastic demand in the market as a whole.
y All firms
fi produce
d the
th same (h
(homogeneous)) product. d t
Undifferentiated Petrol Downward sloping.
Oligopoly Few Restricted Relatively inelastic y All buyers and sellers possess complete information
or differentiated cars, electrical
appliances
(shape depends on
reactions
i off rivals)
i l )
(quality,
(q y, price,
p , etc).
)
{ Ensures no buyer purchases at price different from other buyers , no
Many prescription Downward sloping: seller sells at different price from other suppliers.
Monopoly One Restricted or Unique drugs, local water more inelastic than
oligopoly. Firm has
y Free entry and exit to industry
industry.
completely company
blocked considerable control
over price

Perfect competition
p is a benchmark Demand and revenue under perfect competition
15 16

y Profit
P fit = T
Total
t l revenue – Total
T t l costt ((Ⱥ=TR-TC).
TR TC)
y These assumptions not, in general, descriptively
realistic (may be some markets that come close). y Smallness of firm/price-taking assumption means
that for each firm the demand curve is horizontal
y Many interesting real world problems (we will look
at the market price.
at some) involve violation of these assumptions:
{ Pricing with market power. y i.e.
i e for the firm (not industry/market) demand is
{ Incomplete or asymmetric information. perfectly elastic; firm can sell as much as it wants
at market price.
y However,
H these
th cases are better
b tt understood
d t db by fi
firstt
analysing the benchmark case and then relaxing y Industry/market demand curve is downward
the assumptions sloping.
p g
 Perfect competition;
p the firm and the industryy Total,
o , average,
g , marginal
g revenue for
o a competitive
o p firm
17 18

P P
Industry Firm
S
TR PQ (remember: P is a given constant for the firm)
TR PQ
AR P
Q Q
PM D
PM 'TR P'Q
MR P
'Q 'Q

D
So we have AR MR P
Q
Q

Total, average and marginal revenue for a competitive firm— A closer look at MC=MR
diagrammatic version
19 20

MC
TR P MC, MR ʌ=TR-TC
TR
Moving in this di-
MR rection adds more to
cost than to revenue
D=AR=MR=P ( C
(MC>MR) ) so ʌ de-
d
Moving in this direction creasing
adds more to revenue than
to cost (MR>MC) so
Slope=AR=MR=P ʌ increasing
Q
Q Q
Q3
 MC=MR mathematicallyy Profit maximisation
21

S TR (Q)  TC (Q ) y What
Wh t if a loss
l iis made?
d ?
'S 'TR 'TC { loss minimising:
 MR  MC still produce where MR = MC
'Q 'Q 'Q Ù

{ Short run Vs Long run

When this is zero profits are at a maximum (ignoring the
possibility of a solution at Q1in our diagrams). Thus:
'S
MR  MC 0
'Q
MR MC

Loss-minimising output

Short run: decision to shut down MC

23
AC
y Fixed costs are unavoidable even if nothing produced
produced.

nue (£)
y This not so for variable costs, so these should never be
incurred if revenue doesn’t at least cover them.
y But
B t if variable
i bl costs
t can be
b more th
than covered,
d any

Costs and reven

AC
surplus will contribute to covering the fixed costs.
y So, as long as variable costs are covered, the firm should LOSS
produce even if it is making a short
short-term
term loss.
loss AR

y Ⱥ=TR-TC=P.Q-FC-VC=PQ-FC-AVC.Q C
= -FC+Q(P-AVC)

-FC
FC is unavoidable in short run
run. But if second term
negative, firms can avoid this negative effect on Ⱥ by
setting Q=0. Firm should not produce, even in the short- AR
run.
O Q
Quantity
MR
 The short-run shut-down point

Profit maximisation The firm will shut down in

the short run if it cannot
cover variable costs.
y What
Wh t if a loss
l iis made?
d ? If AVC is higher or AR

ue (£)
{ loss minimising: lower than that shown,
still
till produce
d where
h MR = MC the firm will shut down
down.

d revenu
{ short-run shut-down point: P= AC
P = AVC AVC
AVC

osts and
Co
AR
O Q
Quantity

Profit maximisation
Perfect Competition and
y Wh
Whatt if a lloss
ss is made?
d ? Monopoly
{ loss minimising:
still produce where MR = MC
{ short-run shut-down point: SUPPLY CURVES REVISITED
P = AVC
{ long-run shut-down point:
P = LRAC
 Supplyy cu
Supp curves:
ves: S
Short
o t run
u Vs Long
o g run
u Supply
pp y curves: Short run Vs Long
g run
29

y Analysis
A l i off th
the profit-maximising
fit i i i level
l l off output
t t y Short-run
Sh t supply
l curve off iindustry:
d t S = MC
under perfect competition enables us to see how
supply curves arise
arise. y Long
Long-run
run equilibrium of the firm
y We have to be clear about two dimensions of the { all supernormal profits competed away
problem:
bl
{ The level of aggregation
Ù Fi
Firm versus iindustry.
d t
{ The time period
Ù Short-run
Short run versus long
long-run
run.

Short-run supply
pp y curve for firm Short-run
Short run supply curve for industry
31 32
P Firm’s SRMC is its supply
pp y curve
P
P3
S1
P2 S2 S3 S=ȈSi
SRAVC
P1
P1
P0

SRMC P0

Q
Q0 Q1 Q2 Q3 Q
Q1 Q2 Q3 Q=Q1+Q2+Q3
 The long-run
g in a competitive
p industryy Long-run
g supply
pp y curve for a firm
33 34

y In the long run if firms are making profits that more than P costt
P, Long run supply
cover opportunity costs (“abnormal” profits) new firms will
enter the industry.
y This will increase aggregate supply and drive down the LRATC
price.
y New
N entry t and d th
the d
downward d pressure on price
i ththatt it
generates will continue until abnormal profits are P*
eliminated;; firms are just
j covering
g opportunity
pp y costs.
{ Remember that opportunity costs include the best alternative return LRMC
that could be made in other industries.
y Conversely,
Conversely if opportunity costs are not covered firms will Q
leave the industry.
y This
s will raise
a se p
price,
ce, u
until
t oppo
opportunity
tu ty costs for
o tthee
remaining firms are covered.

Long-run
g supply
pp y curve for industryy Long
g run supply
pp y curve for industryy II
35 36

If
P, cost Long-run supply curve for
y We assume that all firms are identical, in particular have P
an individual firm
identical costs
costs.
And P1
LRATC P1
y We assume also that input prices do not vary with industry
P* P* LR industry (market) supply
output.
Then: LRMC
D2
D1
y The long run supply curve for the industry is horizontal at a
price equal to firms
firms’ minimum long
long- run average cost.
Q Q
Could long run industry supply slope upwards? Perfect competition:
p concluding
g thoughts
g
37
YES, if:
{ Firms differed in their cost structure, some with lower y Advantages of perfect competition
minimum LRAC than others, and there was not an infinite { P = MC >> no market power!
number of each type (if there was
was, the low cost firms would
drive the higher cost firms out of the market). { production at minimum AC
And/or
/ { only normal profits in long run
{ As an industry expanded the costs of its inputs increased; in
this case as industry output increased firms’ LRAC curves { responsive to consumer wishes: consumer sovereignty
would shift upwards
upwards, generating an upward sloping industry { competition Ÿ efficiency
supply curve.
And/or { no point in advertising
{ If entry were limited.

Perfect competition:
p concluding
g thoughts
g
Perfect Competition and
y Disadvantages of perfect competition Monopoly
{ insufficient profits for investment
MONOPOLY
{ lack of product variety

{ lack of competition over product design and specification

 Introduction Barriers to entryy
41 42

y Monopolist is single seller in market and earns “abnormal”

abnormal profits,
profits as
y In
I perfect
f t competition
titi each
h fi
firm was iinsignificantly
i ifi tl small
ll we shall see.
in relation to size of market. y How can this state of affairs be maintained?
y This meant each firm had no market power and was a y Due to “barriers
barriers to entry”;
entry ; in their absence,
absence competitors would enter
price taker. the industry and bid away the monopoly profits.
y Two classes of barriers to entry:
y Now consider opposite extreme of market structure. { Natural
y The firm is the market; no competitors. Ù Unique skills (labour market).
Ù Increasing returns to scale/lumpy investments mean low unit costs for incumbent,
{ Monopoly– one seller in market (many buyers). high unit costs for new entrant which must incur high set-up costs. This is often
called “natural
natural monopoly”
monopoly .
{ Monopsony – one buyer
b i market
in k (many
( sellers).
ll ) { Artificial (can, in principle, be removed)
y These are again benchmark cases to help us understand Ù Licensing
Patents
how firms with market power behave
behave. Ù
Ù Discrimination
y Both types of market structure are relatively rare in their Ù Tariffs/import controls
pure forms.
p

Commonlyy mentioned entryy barriers Monopolist constrained by market demand

44
{ economies of scale
{ product differentiation and brand loyalty y Although monopolist doesn’t have to worry about
{ lower costs for an established firm competitors -- there are none– this does not mean
{ ownership
hi or controll over k
key factors
f monopolist
li iis unconstrained.
i d
{ ownership or control over outlets y The monopolist is constrained by the demand curve
{ legal restrictions (d
(downward d sloping)
l i ) ffor it
its product.
d t
{ mergers and takeovers
y This means the monopolistic firm can choose either the
{ aggressive
gg tactics
level of output or the price of output
output, but not both
{ intimidation
independently:
{ If it chooses p
price then q
quantityy is determined by demand curve.
{ If it chooses quantity then price is determined by demand curve.
 Marginal revenue for a monopolist Marginal revenue for a monopolist II
45 46

y Fact that monopolist faces downward sloping P

TR (Q
(Q=11)=9.5q11=104.5
11) 9.5q11 104.5
TR (Q=10)=10q10=100
demand curve means MRP (Remember that for a MR=¨TR=4.5
competitive firm (MR=P).
(MR P). Revenue loss due to reduction in
y For a monopolist to sell more it must lower the price. price on 10 units previously sold
ut the
But t e lower
o e pprice
ce app
applies
es to all o
of its
ts sales,
sa es, not
ot just 10
0
R
Revenue gain
i due
d tto
the marginal unit. 9.5 Increase in quantity sold
y Thus,, marginal
g revenue is the price
p the monopolist
p
receives for the marginal unit less the price reduction
it must accept on all the units it was previously D

selling
lli at a hi
higher
h price.
i
Q
10 11

Marginal
g Revenue and Price ((cont).
) Average
g and Marginal
g Revenue
(a) Competitive Firm (b) Monopoly

y The
Th marginal
i l revenue off a monopoly
l diff
differs ffrom

Price, p, $ per unitt

Price, p, $ per unitt
that of a competitive firm because the monopoly
faces a downward
downward-sloping
sloping demand curve unlike the
competitive firm. p1
Demand curve
p1
{ Thus, the monopoly
Thus monopoly’ss marginal revenue curve lies below the p2
C

demand curve at every positive quantity Demand curve

A B
A B

q q + 1 Quantity, q, Units per year Q Q+1

Quantity, Q, Units per year
 Profit maximising under monopoly

Profit maximisation for a monopolist I £ MC

49

TR TC
TR, Total profit AC
TC

P*
TR
ʌ
AC

D
Q
Q* MR
O Qm Q

Profit maximisation for a monopolist

p II Notice that…
51

y So
S logic
l i off MC
MC=MR
MR carries
i through
th h tto monopolist.
li t y Because
B a linear
li d
demand
d curve iis more elastic
l ti att
y However, unlike the perfect competition case, MR smaller quantities,
not equall to price
i b because monopolist
li not a price
i { monopoly
l profit
fit iis maximized
i i d iin th
the elastic
l ti portion
ti off th
the
demand curve.
taker.
y As in perfect competition variable costs must be
{ Equivalently, a monopoly never operates in the inelastic
covered to make it worthwhile to produce any portion of its demand curve.
output. So if P< AVC theh monopolist
li should
h ld set Q=0.
y The concept of market power
 Example
p Example
p

y Assume
A demand
d d curve ffaced
dbby monopolist:
li t p=24 – Q y The
Th average variable i bl costt iis:
y The monopoly faces a short-run cost function of: AVC = Q2/Q = Q,
{ so it is
i a straight
t i ht li
line th
through
h th
the origin
i i with
ith a slope
l off 1.
C(Q) = Q2 + 12

{ where Q2 is the monopoly’s variable cost as a function of

output and $12 is its fixed cost.

{ Given this cost function the monopoly’s marginal cost function

is
MC = 2Q.

Example
p Example
p

y We determine the profit-maximizing

profit maximizing output by: y At th
thatt quantity,
tit
MR = 24 í 2Q = 2Q = MC. Ù AVC = $6,
{ Solving for Q, we find that Q = 6.
| which is less than the price
price, so the firm does not shut down
down.
{ Substituting Q = 6 into the inverse demand function:
| The average cost is AC = $(6 + 12/6) = $8, which is less than the
p = 24 í Q = 24 í 6 = $18. price, so the firm makes a profit.
{ At that
th t quantity,
tit
Ù AVC = $6,
| which is less than the price, so the firm does not shut
down.
| The average cost is AC = $(6 + 12/6) = $8, which is less
than the price, so the firm makes a profit.
 Effects of a Shift of the Demand Curve Effects of a Shift of the Demand Curve

y Unlike
U lik a competitive
titi fifirm, a monopoly
l ddoes nott h
have
a supply curve.

y A given quantity can correspond to more than one

monopoly-optimal price.
{ A shift in the demand curve may cause the monopoly optimal
price
i to stay constant andd the
h quantity
i to change
h or b
both
h price
i
and quantity to change.

Table 11.2 Elasticity of Demand, Price, and

Market Power Marginal Cost

y market power - the ability of a firm to charge a price

above marginal cost and earn a positive profit.
§ 1·
MR p¨1  ¸ MC
© H¹
{ and rearranging
g g the terms:

p 1
MC 1  (1 / H )
{ so the ratio of the price to marginal cost depends only on the
elasticity of demand at the profit-maximizing
profit maximizing quantity.
quantity

© 2009 Pearson Addison-Wesley. All rights reserved. 11-59

 Lerner Index Exercise

y Lerner Index - the ratio of the difference y Apple

Apple’ss constant marginal cost of producing its
between price and marginal cost to the price: (p top-of-the-line iPod is $200, its fixed cost is $736
í MC)/p.
)p million and its inverse demand function is p = 600
million,
í 25Q, where Q is units measured in millions.
{ In terms of the elasticity of demand: What is Apple’s
pp average
g cost function? Assuming g
that Apple is maximizing short-run monopoly
p  MC 1 profit, what is its marginal revenue function? What
p H are its profit-maximizing price and quantity, profit,
and Lerner Index? Show Apple’s profit-maximizing
solution
l ti iin a fifigure.

© 2009 Pearson Addison-Wesley. All rights reserved. 11-61

Solution to exercise Does monopoly

p y matter? Is it a bad thing?
g
64

y One objection to monopoly is the fact that monopolists can

earn abnormal profits (and keep doing so).
y Monopoly
p yp profits can finance R&D,, so mayy not always
y be a
bad thing.
y But if monopoly profits are a bad thing they can always be
taxed.
d
y If tax is either a lump-sum or a percentage of profits the
output of monopolist will not be affected (neither MR nor
MC affected).
{ Unless set so high as to cause losses.
 Cost of monopoly
p y is lower output
p and higher
g p
price Advantages and disadvantages of monopoly
65 66

y Deadweight
D d i ht cost/deadweight
t/d d i ht lloss off monopoly
l iin llastt slide
lid
b+d=deadweight loss
MC (=supply in the has to be set against possible advantages:
competitive case)
e { Possibility of reaping economies of scale not available to competitive
PM firms.
a b { Possibility that monopoly profits used for R&D.
PC
y However monopoly may have other disadvantages apart
d
c from the deadweight loss:
{ May waste resources on maintaining
M i i i iits monopolyl position.
ii
f MR D=AR { May, in fact, do less R&D because monopoly profits reduce incentive
to innovate.
Q
QM QC
MR

Natural Monopoly
p y A case of Natural Monopoly
p y

y natural
t l monopoly
l - situation
it ti iin which
hi h one fi
firm
can produce the total output of the market at lower
costt th
than severall fi
firms could.
ld

y Believing that they are natural monopolies,

g
governments frequently
q yg
grant monopolyp y rights
g to
public utilities to provide essential goods or
services such as water, ggas, electric p
power, or mail
delivery
 Regulating a monopoly Government Actions That Create Monopolies
p
69

y Most
M t governments
t attempt
tt t tto preventt th
the emergence off yG
Governments t createt many monopolies. li
monopolies. { Sometimes governments own and manage monopolies.
{ Mergers that generate firms controlling large share of market may be { In
I th
the U
United
it d States,
St t as iin mostt countries,
t i th the postal
t l service
i iis
banned unless shown to be in public interest.
a government monopoly.
y Or attempt to break them up (Microsoft).
y Or regulate them:
y Frequently, however, governments create
{ Setting a maximum price below PM will increase output and reduce
d d i h lloss.
deadweight monopolies by preventing competing firms from
{ Setting a price =MC should eliminate deadweight entirely. entering a market.

Government and Barriers to Entryy Patents

y Governments
G t create
t monopolies
li iin one off th
three y Patent - an exclusive right granted to the inventor
ways: to sell a new and useful product, process, substance,
1. by making
b ki it diffi
difficult
lt ffor new fi
firms tto obtain
bt i a li
license tto or design for a fixed period of time.
operate, { The length of a patent varies across countries.
2
2. by granting a firm the rights to be a monopoly
monopoly, or
3. by auctioning the rights to be monopoly. y Question: If a firm with a patent monopoly sets a
high price that results in deadweight loss then why
d governments grant patent monopolies?
do li
 Optimal
p Price Regulation
g Optimal Price Regulation

y In
I some markets,
k t the
th governmentt can eliminate
li i t ththe
deadweight loss of monopoly by requiring that a
monopoly charge no more than the competitive
price.

Exercise Regulation
g of Monopolies
p

y Suppose
S that
th t th
the governmentt sets
t a price,
i p2, that
th t iis y Problems
P bl th
thatt governments
t fface iin regulating
l ti
below the socially optimal level, p1, but above the monopolies:
monopoly’ss minimum average cost.
monopoly cost How do the { because they
b h d do not k
know the
h actuall ddemandd andd
price, the quantity sold, the quantity demanded, and marginal cost curves, governments may set the price at
welfare under this regulation compare to those under the wrong level
level.
optimal regulation? { Second, many governments use regulations that are less
efficient than price regulation
regulation.
{ Third, regulated firms may bribe or otherwise influence
government regulators
g g to help
p the firms rather than
society as a whole.
 Increasing
g Competition
p Network Externalities

y Encouraging
E i competition
titi iis an alternative
lt ti tto y network
t k externality
t lit - the
th situation
it ti where
h one
regulation as a means of reducing the harms of person’s demand for a good depends on the
monopoly.
monopoly consumption of the good by others

Direct Size Effect.

Perfect Competition and
y Many
M iindustries
d t i exhibit
hibit positive
iti network
t k Monopoly
externalities where the customer gets a direct benefit
from a larger network
network.
{ Example: the larger an ATM network such as the Plus network MONOPOLY: PRICE DISCRIMINATION
 Price Discrimination byy a Monopolist
p Definition of p
price discrimination
81 82

y Up to this point we have assumed that there will yP

Price
i discrimination
di i i ti occurs when: h
always be a single market price for a given product. { a firm charges different prices to different customers for the
y Easyy to see that this must b
be the case in a same good
good.
competitive setting. { or different prices to the same customer for different types of
y This doesn’t have to be the case with monopolies. p
purchase.
M
Monopoliesli can price
i di
discriminate
i i t
y And
y Why do they do this? To increase their profits;
essentially they capture for themselves some of the { These differences are not related to cost differences.

consumer surplus that arises when a single price is

charged.

First requirement for price discrimination to be feasible

Examples of goods where arbitrage difficult
83 84

y There must be no secondary markets in the product y Cinemas

Ci charges
h diff
differentt prices
i ffor children
hild and
d
in question. adults and colour code the tickets.
y If there were,
were the customers buying at a lower price y Doctors (or
( other
h professionals)
f i l ) may charge
h diff
different
could resell at higher price to customers being prices to rich and poor patients.
ccharged
a ged a higher
g e p price,
ce, but st
still u
undercut
de cut tthee p
primary
a y
seller. y British universities charge different prices to home
y Both g groups
p of customers would benefit. and overseas students.
y This process, known as arbitrage, would continue y Electricity suppliers charge different prices to
g p
until a single price p
prevailed in the market (arbitrage g domestic and industrial customers.
opportunities exhausted).
 “Third degree”
g p
price discrimination How does firm decide to charge in each market?
85 86

y Most
M t common fform off price
i didiscrimination
i i ti iis y Firm
Fi chooses
h t t l amountt tto produce
total d b
by MC
MC=MR,
MR
where the seller divides consumers into two or as usual.
more sub-groups
sub groups for which there are separate
y Then
h it i equates the
h MR iit gets iin each
h market
k
demand curves.
{ If it didn’t it could increase TR by moving sales from market
y Many criteria could be used to separate the with lower MR to market with higher MR MR.
markets:
y Then the firm “reads off” the price in each market
{ Age (senior citizen and child discounts)
{ Geographical location (zoned bus or tube fares) from the demand cur
curve.
e
{ Purpose for which product used (business and economy
fares).
fares)
{ Income (doctor, lawyers, etc as mentioned)

Price discrimination diagrammatically Price discrimination and elasticityy

87 88

P, MC P, MC
1. P i discrimination
Price di i i ti will ill only
l occur where
h
elasticities of demand differ in the sub-markets.
2. The
h market k withi h the
h more iinelastic
l i d demandd will
ill
have the higher price.
P1
3. The more different are the elasticities the greater
P2 are the gains from price discrimination.
MC
D2
D1 MR2
MR1

Q1 Q2 Q
Market
a et 1 Market
a et 2
 Airline fares Hardback and p
paperback
p books
89 90

y The wide variation in airline fares is a good example of price y Many assume that the reason hardbacks cost so much more
differences reflecting different elasticities of demand. than paperbacks is because they cost a lot more to produce.

y Business travellers may have to be at their destination rapidly y Not generally the case
case. The main costs are editing and
to deal with a problem or clinch a deal; the costs of the ticket typesetting; once these incurred the MC is low, both for
may be insignificant compared with the costs of not being in hardback and paperback.
the right place at the right time; demand will be inelastic
inelastic.
y But publishing the hardback first enables the publisher to
y For a student booking a flight to visit family or go on holiday set a high price for customers with inelastic demand; fans
the price is likely to be a much more important factor
factor, so of the author,
author libraries
libraries, etc
etc.
demand much more elastic.
y Once this inelastic demand has been “mopped up”, the
y The
h airline
l would
ld obviously
b l prefer
f to ffill
ll plane
l with
hbbusiness lower price paperback can be released to capture the more
class passengers, but if demand insufficient it is better to fill price-sensitive portion of the market.
seats at lower prices than leave those seats empty.

Peak load pricing

p g A two-part
p tariff
91 92

y This
Thi is
i a form
f off price
i didiscrimination
i i ti which
hi h iis efficient
ffi i t y Sometimes
S ti k
known as non-linear
li pricing.
i i
when demand fluctuates: y It is yet another way of extracting consumer surplus.
{ Electricity demand
demand.
y There
Th is
i an “entry
“ t ffee”” which
hi h consumers pay iin order
d b be
{ Demand for public transport.
able to purchase the product.
y Charging
g g a higher
g p
price during
gppeak demand mayy be y Then there is an additional fee per unit consumed
consumed.
appropriate in the public sector, even where profit
y Many real world examples:
maximisation is not the objective
{ It charges a higher price to those who value the output or service { Telephone services: annual rental plus charge per call
call.
most highly. { Amusement park: entry fee and charge per ride.
{ It may even out demand by encouraging some consumers to shift { Tennis club: annual subscription and hourly charge for courts
courts.
their demand from peak to off-peak periods.
 Bundling
gI

y Bundling is another way for firms with market power to

increase their profits by capturing consumer surplus.
y Bundling is selling two or more goods together as
combinations or packages, but not separately (although
mixed strategies possible).
y Many real world examples:
{ Magazine available by subscription but not single issues.
{ Cinema double bills.
{ Fixed price menu in restaurant.
{ Computer operating systems and software
software.

93