Pindyck PPT CH11

MICROECONOMICS
by Robert S. Pindyck
Daniel Rubinfeld
Ninth Edition
Copyright © 2018 Pearson Education, Ltd, All Rights Reserved

Chapter 11
Pricing with Market Power
LIST OF EXAMPLES LIST OF EXAMPLES
1.1 Capturing Consumer Surplus 1.1 The Economics of Coupons and

Rebates
1.2 Price Discrimination
1.2 Airline Fares
1.3 Intertemporal Price Discrimination and
Peak-Load Pricing 1.3 How to Price a Best-Selling Novel
1.4 The Two-Part Tariff 1.4 Pricing Cellular Phone Service
1.5 Bundling 1.5 The Complete Dinner versus à la

Carte: A Restaurant’s Pricing Problem
1.6 Advertising
1.6 Advertising in Practice
Appendix: The Vertically Integrated Firm.

11.1 Capturing Consumer Surplus
FIGURE 11.1
CAPTURING CONSUMER SURPLUS
If a firm can charge only one price for all its customers,
that price will be P* and the quantity produced will be Q*.
Ideally, the firm would like to charge a higher price to

consumers willing to pay more than P*, thereby
capturing some of the consumer surplus under region A
of the demand curve.
The firm would also like to sell to consumers willing to

pay prices lower than P*, but only if doing so does not
entail lowering the price to other consumers.
In that way, the firm could also capture some of the

surplus under region B of the demand curve.

11.2 Price Discrimination (1 of 8)
price discrimination Practice of charging different prices to different consumers for similar
goods.
First-Degree Price Discrimination
reservation price Maximum price that a customer is willing to pay for a good.
first degree price discrimination Practice of charging each customer her reservation
price.
variable profit Sum of profits on each incremental unit produced by a firm; i.e., profit
ignoring fixed costs.

FIGURE 11.2
ADDITIONAL PROFIT FROM PERFECT

FIRST-DEGREE PRICE DISCRIMINATION
Because the firm charges each consumer her

reservation price, it is profitable to expand
output to Q**.
When only a single price, P*, is charged, the

firm’s variable profit is the area between the
marginal revenue and marginal cost curves.
With perfect price discrimination, this profit

expands to the area between the demand curve
and the marginal cost curve.

PERFECT PRICE DISCRIMINATION
The additional profit from producing and selling an incremental unit is the difference
between demand and marginal cost.
IMPERFECT PRICE DISCRIMINATION
FIGURE 11.3
FIRST-DEGREE PRICE DISCRIMINATION IN

PRACTICE
Firms usually don’t know the reservation price of every

consumer, but sometimes reservation prices can be
roughly identified.
Here, six different prices are charged. The firm earns

higher profits, but some consumers may also benefit.
With a single price P4, there are fewer consumers.
The consumers who now pay P5 or P6 enjoy a surplus.

Second-Degree Price Discrimination
second-degree price discrimination Practice of charging different prices per unit for
different quantities of the same good or service.
block pricing Practice of charging different prices for different quantities or “blocks” of a
good.
FIGURE 11.4
SECOND-DEGREE PRICE DISCRIMINATION
Different prices are charged for different quantities, or

“blocks,” of the same good. Here, there are three
blocks, with corresponding prices P1, P2, and P3.
There are also economies of scale, and average and

marginal costs are declining. Second-degree price
discrimination can then make consumers better off by
expanding output and lowering cost.

Third-Degree Price Discrimination
third-degree price discrimination Practice of dividing consumers into two or more groups
with separate demand curves and charging different prices to each group.
CREATING CONSUMER GROUPS
If third-degree price discrimination is feasible, how should the firm decide what price to
charge each group of consumers?
1. We know that however much is produced, total output should be divided between the
groups of customers so that marginal revenues for each group are equal.
2. We know that total output must be such that the marginal revenue for each
group of consumers is equal to the marginal cost of production.

Let P1 be the price charged to the first group of consumers, P2 the price charged to the
second group, and C(QT) the total cost of producing output QT = Q1 + Q2. Total profit is
then
Π  P1Q1  P 2Q2 C(QT )
ΔΠ  Δ(P 1Q1)  ΔC  0
ΔQ1 ΔQ1 ΔQ1
MR1  MC
MR2  MC
MR1  MR2  C (11.1)
DETERMINING RELATIVE PRICES

MR  P (11 Ed )
P 1  (1 1 E 2)
(11.2)
P 2 (1 1 E 1)
FIGURE 11.5
THIRD-DEGREE PRICE DISCRIMINATION
Consumers are divided into two groups, with

separate demand curves for each group. The
optimal prices and quantities are such that the
marginal revenue from each group is the same
and equal to marginal cost.
Here group 1, with demand curve D1, is charged

P1, and group 2, with the more elastic demand
curve D2, is charged the lower price P2.
Marginal cost depends on the total quantity

produced QT. Note that Q1 and Q2 are chosen
so that MR1 = MR2 = MC.

FIGURE 11.6
NO SALES TO SMALLER MARKETS
Even if third-degree price discrimination is feasible,

it may not pay to sell to both groups of consumers if
marginal cost is rising.
Here the first group of consumers, with demand D1,

are not willing to pay much for the product.
It is unprofitable to sell to them because the price

would have to be too low to compensate for the
resulting increase in marginal cost.

EXAMPLE 11.1
THE ECONOMICS OF COUPONS AND REBATES
Coupons provide a means of price discrimination.
TABLE 11.1: PRICE ELASTICITIES OF DEMAND FOR USERS
VERSUS NONUSERS OF COUPONS
Blank Cell PRICE ELASTICITY PRICE ELASTICITY
PRODUCT NONUSERS USERS
Toilet tissue – 0.60 –0.66
Stuffing/dressing –0.71 –0.96
Shampoo –0.84 –1.04
Cooking/salad oil –1.22 –1.32
Dry mix dinners –0.88 –1.09
Cake mix –0.21 –0.43
Cat food –0.49 –1.13
Frozen entrees –0.60 –0.95
Gelatin –0.97 –1.25
Spaghetti sauce –1.65 –1.81
Crème rinse/conditioner –0.82 –1.12
Soups –1.05 –1.22
Hot dogs –0.59 –0.77

EXAMPLE 11.2
AIRLINE FARES
Travelers are often amazed at the variety of fares available for round-trip flights from New York to
Los Angeles.
Recently, for example, the first-class fare was above $2000; the regular (unrestricted) economy
fare was about $1000, and special discount fares (often requiring the purchase of a ticket two
weeks in advance and/or a Saturday night stayover) could be bought for as little as $200. These
fares provide a profitable form of price discrimination. The gains from discriminating are large
because different types of customers, with very different elasticities of demand, purchase these
different types of tickets.
Airline price discrimination has become increasingly sophisticated. A wide variety of fares is
available.
TABLE 11.2 ELASTICTIES OF DEMAND FOR AIR TRAVEL
Blank Cell FARE CATEGORY FARE CATEGORY FARE CATEGORY
ELASTICITY FIRST CLASS UNRESTRICTED COACH DISCOUNTED
Price –0.3 –0.4 –0.9
Income 1.2 1.2 1.8

Peak-Load Pricing (1 of 3)
intertemporal price discrimination Practice of separating consumers with different
demand functions into different groups by charging different prices at different points in
time.
peak-load pricing Practice of charging higher prices during peak periods when capacity
constraints cause marginal costs to be high.

Intertemporal Price Discrimination
FIGURE 11.7
INTERTEMPORAL PRICE
DISCRIMINATION
Consumers are divided into groups by

changing the price over time.
Initially, the price is high. The firm captures

surplus from consumers who have a high
demand for the good and who are unwilling to
wait to buy it.
Later the price is reduced to appeal to the

mass market.

Peak-Load Pricing
FIGURE 11.8
PEAK-LOAD PRICING
Demands for some goods and services

increase sharply during particular times of
the day or year.
Charging a higher price P1 during the peak

periods is more profitable for the firm than
charging a single price at all times.
It is also more efficient because marginal

cost is higher during peak periods.

EXAMPLE 11.3
HOW TO PRICE A BEST-SELLING NOVEL
Publishing both hardbound and paperback editions of a

book allows publishers to price discriminate.
Some consumers want to buy a new bestseller as soon
as it is released, even if the price is $25. Other
consumers, however, will wait a year until the book is
available in paperback for $10.
The key is to divide consumers into two groups, so that
those who are willing to pay a high price do so and only
those unwilling to pay a high price wait and buy the
paperback.
It is clear, however, that those consumers willing to wait
for the paperback edition have demands that are far
more elastic than those of bibliophiles.
It is not surprising, then, that paperback editions sell for
so much less than hardbacks.

11.4 The Two-Part Tariff (1 of 3)
two-part tariff Form of pricing in which consumers
are charged both an entry and a usage fee.
SINGLE CONSUMER
FIGURE 11.9
TWO-PART TARIFF WITH A SINGLE

CONSUMER
The consumer has demand curve D.
The firm maximizes profit by setting usage fee P

equal to marginal cost and entry fee T* equal to
the entire surplus of the consumer.

TWO CONSUMERS
FIGURE 11.10
TWO-PART TARIFF WITH TWO CONSUMERS
The profit-maximizing usage fee P* will exceed marginal

cost.
The entry fee T* is equal to the surplus of the consumer

with the smaller demand.
The resulting profit is 2T* + (P* − MC)(Q1 + Q2). Note that

this profit is larger than twice the area of triangle ABC.

MANY CONSUMERS
FIGURE 11.11
TWO-PART TARIFF WITH MANY DIFFERENT CONSUMERS
Total profit π is the sum of the profit from the entry fee πa and
the profit from sales πs. Both πa and πs depend on T, the entry
fee. Therefore
π = πa + πs = n(T)T + (P − MC)Q(n)
where n is the number of entrants, which depends on the entry

fee T, and Q is the rate of sales, which is greater the larger is
n.
Here T* is the profit-maximizing entry fee, given P. To calculate

optimum values for P and T, we can start with a number for P,
find the optimum T, and then estimate the resulting profit.
P is then changed and the corresponding T recalculated, along

with the new profit level.

EXAMPLE 11.4 (1 of 4)
PRICING CELLULAR PHONE SERVICE
Cellular phone service has traditionally been priced

using a two-part tariff: a monthly access fee, which
includes some amount of free “anytime” minutes, plus a
per-minute charge for additional minutes.
Offering different plans allowed companies to combine

third-degree price discrimination with the two-part tariff.
Today, most consumers use their phone not just to make

or receive calls but also to surf the Web, read email, and
so on. They separate themselves into groups based on
their expected data usage, with each group choosing a
different plan.
Cellular providers have learned that the most profitable

way to price their service is to combine price
discrimination with a two-part tariff.

TABLE 11.3: CELLULAR DATA PLANS (2016)
MONTHLY ACCESS
DATA USAGE MONTHLY PRICE CHARGE OVERAGE FEE
A. VERIZON A. VERIZON A. VERIZON A. VERIZON
1GB $30 $20 $15/GB
3GB $45 $20 $15/GB
6GB $60 $20 $15/GB
12GB $80 $20 $15/GB
18GB $100 $20 $15/GB
B. SPRINT B. SPRINT B. SPRINT B. SPRINT
1GB $20 $45 None1
3GB $30 $45 None
6GB $45 $45 None
12GB $60 $45 None
24GB $80 $45 None
1 All plans include 2GB unlimited data

MONTHLY ACCESS
C. AT&T C. AT&T C. AT&T C. AT&T
2GB $30 $25 $15/GB
5GB $50 $25 $15/GB
15GB $100 $15 $15/GB
20GB $140 $15 $15/GB
25GB $175 $15 $15/GB
30GB $225 $15 $15/GB
D. VODAPHONE (U.K)2 D. VODAPHONE (U.K)2 D. VODAPHONE (U.K)2 D. VODAPHONE (U.K)2
3GB £37 None £6.50/250MB
6GB £42 None £6.50/250MB
12GB £47 None £6.50/250MB
24GB £52 None £6.50/250MB
30GB £58 None £6.50/250MB
2£1 = $1.29 (as of July 2016

MONTHLY ACCESS
E. VODAPHONE E. VODAPHONE E. VODAPHONE E. VODAPHONE
(AUSTRALIA) (AUSTRALIA) (AUSTRALIA) (AUSTRALIA)
4GB $60 None $10/GB
7GB $70 None $10/GB
8GB $80 None $10/GB
11GB $100 None $10/GB
16GB $130 None $10/GB
F. CHINA UNICOM F. CHINA UNICOM F. CHINA UNICOM F. CHINA UNICOM
1GB $25 None $.03/MB

11.5 Bundling (1 of 12)
Bundling Practice of selling two or more products as a package.
To see how a film company can use customer heterogeneity to its advantage, suppose that
there are two movie theaters and that their reservation prices for our two films are as
follows:
Blank Cell GONE WITH THE WIND GETTING GERTIE’S GARTER

Theater A $12,000 $3000
Theater B $10,000 $4000
If the films are rented separately, the maximum price that could be charged for Wind is
$10,000 because charging more would exclude Theater B. Similarly, the maximum price
that could be charged for Gertie is $3000.
But suppose the films are bundled. Theater A values the pair of films at $15,000 ($12,000 +
$3000), and Theater B values the pair at $14,000 ($10,000 + $4000). Therefore, we can
charge each theater $14,000 for the pair of films and earn a total revenue of $28,000.

Relative Valuations
Why is bundling more profitable than selling the films separately? Because the relative
valuations of the two films are reversed.
The demands are negatively correlated—the customer willing to pay the most for Wind is
willing to pay the least for Gertie.
Suppose demands were positively correlated—that is, Theater A would pay more for both
films:
Blank Cell GONE WITH THE WIND GETTING GERTIE’S GARTER

Theater A $12,000 $4000
Theater B $10,000 $3000
If we bundled the films, the maximum price that could be charged for the package is
$13,000, yielding a total revenue of $26,000, the same as by renting the films separately.

FIGURE 11.12
RESERVATION PRICES
Reservation prices r1 and r2 for two goods are

shown for three consumers, labeled A, B, and C.
Consumer A is willing to pay up to $3.25 for good

1 and up to $6 for good 2.

FIGURE 11.13
CONSUMPTION DECISIONS WHEN

PRODUCTS ARE SOLD SEPARATELY
The reservation prices of consumers in

region I exceed the prices P1 and P2 for the
two goods, so these consumers buy both
goods.
Consumers in regions II and IV buy only one

of the goods, and consumers in region III buy
neither good.

FIGURE 11.14
CONSUMPTION DECISIONS WHEN

PRODUCTS ARE BUNDLED
Consumers compare the sum of their

reservation prices r1 + r2, with the price of the
bundle PB.
They buy the bundle only if r1 + r2 is at least

as large as PB.

FIGURE 11.15
RESERVATION PRICES
In (a), because demands are perfectly

positively correlated, the firm does not gain
by bundling: It would earn the same profit by
selling the goods separately.
In (b), demands are perfectly negatively

correlated. Bundling is the ideal strategy—all
the consumer surplus can be extracted.

FIGURE 11.16
MOVIE EXAMPLE
Consumers A and B are two movie theaters.

The diagram shows their reservation prices
for the films Gone with the Wind and Getting
Gertie’s Garter.
Because the demands are negatively

correlated, bundling pays.

Mixed Bundling
mixed bundling Selling two or more goods both as a package and individually.
pure bundling Selling products only as a package.
FIGURE 11.17
MIXED VERSUS PURE BUNDLING
With positive marginal costs, mixed bundling may be

more profitable than pure bundling.
Consumer A has a reservation price for good 1 that is

below marginal cost c1,
and consumer D has a reservation price for good 2

that is below marginal cost c2.
With mixed bundling, consumer A is induced to buy

only good 2, and consumer D is induced to buy only
good 1, thus reducing the firm’s cost.

Let’s compare three strategies:
1. Selling the goods separately at prices P1 = $50 and P2 = $90.
2. Selling the goods only as a bundle at a price of $100.
3. Mixed bundling, whereby the goods are offered separately at prices P1 = P2 = $89.95, or
as a bundle at a price of $100.
TABLE 11.4: BUNDLING EXAMPLE
Blank cell P1 P2 P3 PROFIT
Sold separately $50 $90 — $150
Pure bundling — — $100 $200
Mixed bundling $89.95 $89.95 $100 $229.90
As we should expect, pure bundling is better than selling the goods separately because
consumers’ demands are negatively correlated. But what about mixed bundling?

FIGURE 11.18
MIXED BUNDLING WITH ZERO MARGINAL COSTS
If marginal costs are zero, and if consumers’ demands are not

perfectly negatively correlated, mixed bundling is still more
profitable than pure bundling.
In this example, consumers B and C are willing to pay $20

more for the bundle than are consumers A and D.
With pure bundling, the price of the bundle is $100. With mixed
bundling, the price of the bundle can be increased to $120 and
consumers A and D can still be charged $90 for a single good.
TABLE 11.5: MIXED BUNDLING WITH ZERO MARGINAL COSTS
Blank Cell P1 P2 P3 PROFIT
Sold separately $80 $80 — $320
Pure bundling — — $100 $400
Mixed bundling $90 $90 $120 $420

Bundling in Practice
FIGURE 11.19
MIXED BUNDLING IN PRACTICE
The dots in this figure are estimates of reservation prices for

a representative sample of consumers.
A company could first choose a price for the bundle, PB,

such that a diagonal line connecting these prices passes
roughly midway through the dots.
The company could then try individual prices P1 and P2.
Given P1, P2, and PB, profits can be calculated for this
sample of consumers. Managers can then raise or lower P1,
P2 , and PB and see whether the new pricing leads to higher
profits. This procedure is repeated until total profit is roughly
maximized.

EXAMPLE 11.5
THE COMPLETE DINNER VERSUS À LA CARTE: A RESTAURANT PRICING
PROBLEM
For a restaurant, mixed bundling means offering both

complete dinners (the appetizer, main course, and dessert
come as a package) and an à la carte menu (the
customer buys the appetizer, main course, and dessert
separately).
This strategy allows the à la carte menu to be priced to

capture consumer surplus from customers who value
some dishes much more highly than others.
At the same time, the complete dinner retains those

customers who have lower variations in their reservation
prices for different dishes (e.g., customers who attach
moderate values to both appetizers and desserts).
Successful restaurateurs know their customers’ demand

characteristics and use that knowledge to design a pricing
strategy that extracts as much consumer surplus as
possible.

PROBLEM
TABLE 11.6: MIXED BUNDLING AT MCDONALD’S—U.S. ANND CHINA (2016)
UNITED STATES (MASSACHUSETTS)

MEAL (INCLUDES SODA UNBUNDLED PRICE OF
INDIVIDUAL ITEM PRICE AND FRIES) PRICE BUNDLE SAVINGS
Premium McWrap Premium McWrap

$5.36 $9.49 $7.80 $1.69
Chicken & Bacon Chicken & Bacon
Filet-O-Fish $4.62 Filet-O-Fish $8.75 $7.06 $1.69

Big Mac $4.87 Big Mac $9.00 $7.31 $1.69
Quarter Pounder $4.62 Quarter Pounder $8.75 $7.06 $1.69
Double Quarter
$5.84 Double Quarter Pounder $9.97 $8.16 $1.81
Pounder
10-piece Chicken 10-piece Chicken

$5.48 $9.61 $7.92 $1.69
McNuggets McNuggets
Large French Fries $2.31 Blank Cell Blank Cell Blank Cell Blank Cell
Large Soda $1.82 Blank Cell Blank Cell Blank Cell Blank Cell

PROBLEM
TABLE 11.6: MIXED BUNDLING AT MCDONALD’S—U.S. ANND CHINA (2016)

CHINA (BEIJING)
MEAL (INCLUDES UNBUNDLED PRICE OF
INDIVIDUAL ITEM PRICE* SODA AND FRIES) PRICE BUNDLE SAVINGS
Big Mac 17 RMB Big Mac 33 RMB 20 RMB 13 RMB
German Sausage Double German Sausage

20 RMB 36 RMB 32 RMB 4 RMB
Beef Burger Double Beef Burger
Duck Burger 23 RMB Duck Burger 39 RMB 31 RMB 8 RMB
French Fries 7 RMB Blank Cell Blank Cell Blank Cell Blank Cell
Drink 9 RMB Blank Cell Blank Cell Blank Cell Blank Cell
*1 RMB = $0.15

Tying
Tying Practice of requiring a customer to purchase one good in order to purchase another.
Why might firms use this kind of pricing practice?
One of the main benefits of tying is that it often allows a firm to meter demand and thereby
practice price discrimination more effectively.
Tying can also be used to extend a firm’s market power.
Tying can have other uses. An important one is to protect customer goodwill connected with
a brand name.
This is why franchises are often required to purchase inputs from the franchiser.

11.6 Advertising (1 of 3)
FIGURE 11.20
EFFECTS OF ADVERTISING
AR and MR are average and marginal revenue when the firm

doesn’t advertise, and AC and MC are average and marginal
cost.
The firm produces Q0 and receives a price P0..
Its total profit π0 is given by the gray-shaded rectangle.
If the firm advertises, its average and marginal revenue curves

shift to the right.
Average cost rises (to AC′) but marginal cost remains the
same.
The firm now produces Q1 (where MR′ = MC), and receives a

price P1.
Its total profit , π1, is now larger.

The price P and advertising expenditure A to maximize profit, is given by:
Π  PQ (P, A) C(Q)  A
In figure 11.20 we saw that advertising leads to increased output.
But increased output in turn means increased production costs, and this must be taken into
account when comparing the costs and benefits of an extra dollar of advertising.
The firm should advertise up to the point that
MRAds  P ΔQ  1 MC ΔQ = full marginal cost of advertising (11.3)

ΔA ΔA

A Rule of Thumb for Advertising
First, rewrite equation (11.3) as follows:

(P  MC) ΔQ  1
ΔA
Now multiply both sides of this equation by A/PQ, the advertising-to-sales ratio.
advertising-to-sales ratio Ratio of a firm’s advertising expenditures to its sales.
P  MC  A ΔQ   A
P Q ΔA  PQ
advertising elasticity of demand Percentage change in quantity demanded resulting from

a 1-percent increase in advertising expenditures.
A PQ  (EA EP ) (11.4)

ADVERTISING IN PRACTICE
A supermarket with a price elasticity of demand equal to -10, and
advertising elasticity of demand between 0.1 and 0.3, should
have an advertising budget of around 1 to 3 percent of sales.
Convenience stores have lower price elasticities of demand

(around −5), but their advertising-to-sales ratios are usually less
than those for supermarkets (and are often zero). Why?
Because convenience stores mostly serve customers who live

nearby; they may need a few items late at night or may simply not
want to drive to the supermarket.
On the other hand, advertising is quite important for makers of

designer jeans, who will have advertising-to-sales ratios as high
as 10 or 20 percent.
Laundry detergents have among the highest advertising-to-sales

ratios of all products, sometimes exceeding 30 percent, even
though demand for any one brand is at least as price elastic as it
is for designer jeans. What justifies all the advertising? A very
large advertising elasticity.

TABLE 11.7: SALES AND ADVERTISING EXPENDITURES FOR LEADING BRANDS

OF OVER-THE-COUNTER DRUGS (IN MILLIONS OF DOLLARS)
Blank Cell SALES ADVERTISING RATIO (%)
Pain Medications Blank Cell Blank Cell Blank Cell
Tylenol 855 143.8 17
Advil 360 91.7 26
Bayer 170 43.8 26
Excedrin 130 26.7 21
Antacids Blank Cell Blank Cell Blank Cell
Alka-Seltzer 160 52.2 33
Mylanta 135 32.8 24
Tums 135 27.6 20

TABLE 11.7: SALES AND ADVERTISING EXPENDITURES

FOR LEADING BRANDS OF OVER-THE-COUNTER DRUGS
(IN MILLIONS OF DOLLARS) (continued)
Blank Cell SALES ADVERTISING RATIO (%)

Cold Remedies
Blank Cell Blank Cell Blank Cell
(decongestants)
Benadryl 130 30.9 24
Sudafed 115 28.6 25
Cough Medicine Blank Cell Blank Cell Blank Cell
Vicks 350 26.6 8
Robitussin 205 37.7 19
Halls 130 17.4 13

Appendix to Chapter 11
The Vertically Integrated Firm
horizontal integration Organizational form in which several plants produce the same or
related products for a firm.
vertical integration Organizational form in which a firm contains several divisions, with
some producing parts and components that others use to produce finished products.
transfer prices Internal prices at which parts and components from upstream divisions are
“sold” to downstream divisions within a firm.

Why Vertically Integrate? (1 of 8)
Market Power and Double Marginalization
How do firms along a vertical chain exercise such monopoly power, and how are prices and
output affected? Would the firms benefit from a vertical merger that integrates an upstream
and a related downstream business? Would consumers?
Suppose an engine manufacturer has monopoly power in the market for engines, and an
automobile manufacturer that buys these engines has monopoly power in the market for its
cars. Would this market power cause these two firms to benefit in any way if they were to
merge? Would consumers of the final product—automobiles—be better or worse off if the
two companies merged?
When there is market power of this sort, a vertical merger can be beneficial to the two
firms, and also beneficial to consumers.

SEPARATE FIRMS
Suppose a monopolist producer of specialty engines produces those engines at a constant

marginal cost cE, and sells the engines at a price PE. The engines are bought by a
monopolist producer of sports cars, which sells the cars at the price P. Demand for the cars
is given by
Q  AP (A11.1)
with the constant A > cE.
If the two companies are independent of each other, the automobile manufacturer will take
the price of engines as given, and choose a price for its cars to maximize its profits:
ΠA  (P  PE ) ( A  P ) (A11.2)
You can check that given PE, the profit maximizing price of cars is:
P *  1 ( A  PE ) (A11.3)
2

SEPARATE FIRMS
Then the number of cars sold and the automobile company’s profit are:
Q  1 ( A  PE ) (A11.4)
2
and
ΠA  1 ( A  PE )2 (A11.5)
4
What about the engine manufacturer? It chooses the price of engines, PE, to maximize its
profit:
(A11.6)
ΠE  (PE  CE ) Q (PE )  (PE  CE ) 1 ( A  PE )
2

You can confirm that the profit-maximizing price of engines is:
P*  1( A  CE )
E
(A11.7)
2
The profit to the engine manufacturer is then equal to:
ΠE*  1 ( A  CE )2 (A11.8)
8

In Equation (A11.5), substitute for the price of engines from equation (A11.7). You will see
that the automobile company’s profit is then:
Π*A  1 ( A  CE )2 (A11.9)
16
Hence the total profit for the two companies is:
Π*  Π*  Π*  3 ( A  CE )2 (A11.10)
TOT A E 16
Also, the price paid by consumers is:
P *  1 (3 A  CE ) (A11.11)
4

VERTICAL INTEGRATION
Now suppose that the engine company and the automobile company merge to form a vertically
integrated firm. The management of this firm would choose a price of automobiles to maximize the firm’s
profit:
Π  (P CE ) ( A  P ) (A11.12)
The profit-maximizing price of cars is now:
P*  ( A CE ) 2 (A11.13)
which yields a profit of:

Π*  1 ( A  CE )2 (A11.14)
4
Observe that the profit for the integrated firm is greater than the total profit for the two
individual firms that operate independently. Furthermore, the price to consumers for
automobiles is lower.
DOUBLE MARGINALIZATION
double marginalization When each firm in a vertical chain marks up its price above its
marginal cost, thereby increasing the price of the final product.
FIGURE A11.1 (1 of 2)
EXAMPLE OF DOUBLE MARGINALIZATION
For the automobile company, the marginal revenue

curve for cars is the demand curve for engines (the
net marginal revenue for engines).
Corresponding to that demand curve is the engine

company’s marginal revenue curve, MRE..
If the engine company and automobile company

are separate entities, the engine company will
produce a quantity of engines Q ′E at the point
where its marginal revenue curve intersects its
marginal cost curve.
The automobile maker will buy those engines and

produce an equal number of cars. Hence, the price
of cars will be P ′A.

FIGURE A11.1 (2 of 2)
EXAMPLE OF DOUBLE MARGINALIZATION
But if the firms merge, the integrated company will have

the demand curve ARCARS and marginal revenue curve
MRCARS.
It produces a number of engines and equal number of

cars at the point where MRCARS equals the marginal
cost of producing cars, which is MCE. Thus more
engines and cars are produced, and the price of cars is
lower.
ALTERNATIVES TO VERTICAL INTEGRATION
quantity forcing Use of a sales quota or other incentives to make downstream firms sell
as much as possible.

Transfer Pricing in the Integrated Firm
(1 of 12)
Transfer Pricing When There Is No Outside Market
Suppose the downstream automobile division had to “pay” the upstream engine division a
transfer price for each engine it used. What should that transfer price be? It should equal
the marginal cost of producing engines, i.e., MCE. Why? Because then the automobile
division will have a marginal cost of producing cars equal to MCE, so that even if it is left to
maximize its own divisional profit, it will produce the correct number of cars.
Another way to see this is in terms of opportunity cost. The opportunity cost to the
integrated firm of utilizing one more engine is the marginal cost of engines. Thus we have a
simple rule: Set the transfer price of any upstream parts and components equal to the
marginal cost of producing those parts and components.
Now consider a firm with three divisions: Two upstream divisions produce inputs to a
downstream processing division. The two upstream divisions produce quantities Q1 and Q2
and have total costs C1(Q1) and C2(Q2). The downstream division produces a quantity Q
using the production function
𝑄 = 𝑓 𝐾, 𝐿, 𝑄1 , 𝑄2

Transfer Pricing in the Integrated Firm (2 of 12)
We assume there are no outside markets for the intermediate inputs Q1 and Q2; they can
be used only by the downstream division. Then the firm has two problems:
1. What quantities Q1 , Q2, and Q will maximize its profit?
2. Is there an incentive scheme that will decentralize the firm’s management?
In particular, is there a set of transfer prices P1 and P2, so that if each division maximizes its
own divisional profit, the profit of the overall firm will also be maximized?
To solve these problems, we note that the firm’s total profit is
Π (Q) R (Q)Cd (Q)C1 (Q1)C2 (Q2) (A11.15)

The net marginal revenue NMR1 that the firm earns from an extra unit of Q1 is (MR − MCd)
MP1. Setting this equal to the marginal cost of the unit, we obtain the following rule for profit
maximization
NMR 1  (MRMCd )MP1  MC1 (A11.16)
Going through the same steps for the second intermediate input gives
NMR 2  (MRMCd )MP2  MC2 (A11.17)

If each of the three divisions uses these transfer prices to maximize its own divisional profit,
the profit of the overall firm should be maximized. The two upstream divisions will maximize
their divisional profits, π1 and π2, which are given by
Π1  P1Q1 C1 (Q1)
and
Π2  P 2Q2 C2 (Q2)

Because the upstream divisions take P1 and P2 as given, they will choose Q1 and Q2 so that
P1 = MC1 and P2 = MC2. Similarly, the downstream division will maximize
Π(Q)  R(Q) Cd(Q)  P1(Q1)  P 2(Q2)
Because the downstream division also takes P1 and P2 as given, it will choose Q1 and Q2 so
that
(MRMCd)MP1  NMR1  P1 (A11.18)
and
(MRMCd)MP2  NMR 2  P 2 (A11.19)
A simple solution to the transfer pricing problem is as follows: Set each transfer price equal
to the marginal cost of the respective upstream division.

FIGURE A11.2
RACE CAR MOTORS, INC.
The firm’s upstream division should produce a

quantity of engines QE that equates its marginal
cost of engine production MCE with the
downstream division’s net marginal revenue of
engines NMRE.
Because the firm uses one engine in every car,

NMRE. is the difference between the marginal
revenue from selling cars and the marginal cost of
assembling them, i.e., MR – MCA. .
The optimal transfer price for engines PE equals

the marginal cost of producing them.
Finished cars are sold at price PA.

NMRE  (MRMCA) MPE  MRMCA

Transfer Pricing with a Competitive Outside Market
FIGURE A11.3
BUYING ENGINES IN A COMPETITIVE

OUTSIDE MARKET
Race Car Motors’ marginal cost of engines

MCE* is the upstream division’s marginal cost
for quantities up to QE,1 and the market price
PE,M for quantities above QE,1.
The downstream division should use a total of

QE,2 engines to produce an equal number of
cars; in that case, the marginal cost of
engines equals net marginal revenue.
QE,2 − QE,1 of these engines are bought in the

outside market. The downstream division
“pays” the upstream division the transfer price
PE,M for the remaining QE,1 engines.

FIGURE A11.4
SELLING ENGINES IN A COMPETITIVE OUTSIDE

MARKET
The optimal transfer price for Race Car Motors is

again the market price PE,M. This price is above the
point at which MCE intersects NMRE, so the
upstream division sells some of its engines in the
outside market.
The upstream division produces QE,1 engines, the
quantity at which MCE equals PE,M.
The downstream division uses only QE,2 of these
engines, the quantity at which NMRE equals PE,M.
Compared with Figure A11.2, in which there is no
outside market, more engines but fewer cars are
produced.

Transfer Pricing with a Noncompetitive Outside Market
Now suppose there is an outside market for the output of the upstream division, but that
market is not competitive. Suppose that Race Car Motors can be a monopoly supplier to
that outside market while also producing engines for its own use.
In this case, the transfer price paid to the Engine Division will be below the price at which
engines are bought in the outside market. The reason is that the opportunity cost of utilizing
an engine internally is just the marginal cost of producing the engine, whereas the
opportunity cost of selling it outside is higher, because it includes a monopoly markup.

Transfer Pricing with a Noncompetitive Outside Market
Sometimes a vertically integrated firm can buy components in an outside market in which it
has monopsony power.
Suppose that Race Car Motors can obtain its engines from its upstream Engine Division, or
can purchase them as a monopsonist in the outside market. In this case, the transfer price
paid to the Engine Division will be above the price at which engines are bought in the
outside market. The reason is that, with monopsony power, purchasing one additional
engine in the outside market incurs a marginal expenditure that is greater than the actual
price paid in that market.

Taxes and Transfer Pricing
Taxes can play an important role in determining transfer prices when the objective is to
maximize the after-tax profits of the integrated firm.
This is especially the case when the upstream and downstream divisions of the firm
operate in different countries.
To see this, suppose that the upstream Engine Division of Race Car Motors happens to be
located in an Asian country with a low corporate profits tax rate, while the downstream
Assembly Division is located in the United States, with a higher tax rate. Suppose that in
the absence of taxes, the marginal cost and thus the optimal transfer price for an engine is
$5000. How would this transfer price be affected by taxes?

Taxes and Transfer Pricing
In our example, the difference in tax rates will cause the opportunity cost of using an engine
downstream to exceed $5000. Why? Because the downstream profit generated by the use
of the engine will be taxed at a relatively high rate.
Thus, taking taxes into account, the firm will want to set a higher transfer price, perhaps
$7000. This will reduce the downstream profits in the United States (so that the firm will pay
less in taxes) and increase the profits of the upstream division, which faces a lower tax
rate.

A Numerical Example (1 of 3)
Suppose Race Car Motors has the following demand for its automobiles:
P  20,000  Q
Its marginal revenue is thus
MR  20,000  2Q
The downstream division’s cost of assembling cars is
CA(Q)  8000Q
so that the division’s marginal cost is MCA = 8000. The upstream division’s cost of
producing engines is
CE (QE )  2QE2
The division’s marginal cost is thus MCE (QE )  4QE

First, suppose there is no outside market for the engines. How many engines and cars
should the firm produce? What should be the transfer price for engines?
To solve this problem, we set the net marginal revenue for engines equal to the marginal
cost of producing engines. Because each car has one engine, QE = Q. The net marginal
revenue of engines is thus
NMR E  MR  MCA  12,000  2QE
Now set NMRE equal to MCE:

12,000  2QE  4QE
Thus 6QE = 12,000 and QE = 2000. The firm should therefore produce 2000 engines and
2000 cars. The optimal transfer price is the marginal cost of these 2000 engines:
PE  4QE  $8000

Second, suppose that engines can be bought or sold for $6000 in an outside competitive
market. This is below the $8000 transfer price that is optimal when there is no outside
market, so the firm should buy some engines outside. Its marginal cost of engines, and the
optimal transfer price, is now $6000. Set this $6000 marginal cost equal to the net marginal
revenue of engines:
6000  NMR E  12,000  2QE
Thus the total quantity of engines and cars is now 3000. The company now produces more
cars (and sells them at a lower price) because its cost of engines is lower. Also, since the
transfer price for the engines is now $6000, the upstream Engine Division supplies only
1500 engines (because MCE(1500) = $6000). The remaining 1500 engines are bought in
the outside market.

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What is price discrimination and what are its different forms?

What is price discrimination and what are its different forms?

What factors allow firms to practice price discrimination?

What factors allow firms to practice price discrimination?

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1.5 Bundling 1.5 The Complete Dinner versus à la

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Ideally, the firm would like to charge a higher price to

The firm would also like to sell to consumers willing to

In that way, the firm could also capture some of the

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Because the firm charges each consumer her

When only a single price, P*, is charged, the

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FIRST-DEGREE PRICE DISCRIMINATION IN

Firms usually don’t know the reservation price of every

Here, six different prices are charged. The firm earns

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Different prices are charged for different quantities, or

There are also economies of scale, and average and

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CREATING CONSUMER GROUPS

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MR1  MR2  C (11.1)

DETERMINING RELATIVE PRICES

THIRD-DEGREE PRICE DISCRIMINATION

Consumers are divided into two groups, with

Here group 1, with demand curve D1, is charged

Marginal cost depends on the total quantity

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NO SALES TO SMALLER MARKETS

Even if third-degree price discrimination is feasible,

Here the first group of consumers, with demand D1,

It is unprofitable to sell to them because the price

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Initially, the price is high. The firm captures

Later the price is reduced to appeal to the

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Demands for some goods and services

Charging a higher price P1 during the peak

It is also more efficient because marginal