Capturing Consumer Surplus

All the pricing strategies that we will examine have one thing in common: They are means of capturing consumer surplus and transferring it to the producer. You can see this more clearly in Figure 11.1. Suppose the firm sold all its output at a single price. To maximize profit, it would pick a price P* and corresponding output Q* at the intersection of its marginal cost and marginal revenue curves. Although the firm would then be profitable, its managers might still wonder if they could make it even more profitable.

They know that some customers (in region A of the demand curve) would pay more than P*. But raising the price would mean losing some customers, sell- ing less, and earning smaller profits. Similarly, other potential customers are not buying the firm’s product because they will not pay a price as high as P*. Many of them, however, would pay prices higher than the firm’s marginal cost. (These customers are in region B of the demand curve.) By lowering its price, the firm could sell to some of these customers. Unfortunately, it would then earn less revenue from its existing customers, and again profits would shrink.

How can the firm capture the consumer surplus (or at least part of it) from its customers in region A, and perhaps also sell profitably to some of its potential cus- tomers in region B? Charging a single price clearly will not do the trick. However, the firm might charge different prices to different customers, according to where the customers are along the demand curve. For example, some customers in the upper end of region A would be charged the higher price P1, some in region B would be charged the lower price P2, and some in between would be charged P*. This is the basis of price discrimination: charging different prices to different cus-tomers. The problem, of course, is to identify the different customers, and to get them to pay different prices. We will see how this can be done in the next section.

The other pricing techniques that we will discuss in this chapter—two-part tariffs and bundling—also expand the range of a firm’s market to include more customers and to capture more consumer surplus. In each case, we will examine both the amount by which the firm’s profit can be increased and the effect on consumer welfare. (As we will see, when there is a high degree of monopoly power, these pricing techniques can sometimes make both consumers and the producer better off.) We turn first to price discrimination.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.

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