A pricing strategy is a firm’s plan for setting the price of its product given the market conditions it faces and its desire to maximize profit. The pricing strategy for a perfectly competitive firm is that it charges the equilibrium market price for its product and earns no economic profit. The pricing strategy for firms with market power is more complex. A firm with monopoly power that charges one price to all its customers sets the market price according to the quantity of output it chooses to produce to maximize its profit. (Remember that firms operating in markets with barriers to entry can earn economic profits even in the long run.) Some firms with market power, however, can charge different prices to different customers for the same product using a pricing strategy called price discrimination. If a firm with market power can price-discriminate, it can earn greater economic profit than a single-price monopoly.

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It is important to understand that price discrimination is not necessarily the same phenomenon as the existence of different prices for different goods. Price differences can occur across similar products even in a competitive market if the marginal costs of producing the products are different. For example, if the marginal cost of washing SUVs at the car wash is higher than that of washing Mini Coopers because SUVs are bigger, car washes might charge more to wash SUVs. Price discrimination is something different. It implies the use of market power to charge higher prices for the same product to those consumers who are willing to pay more for it. Price variations due to price discrimination do not reflect differences in marginal costs; they exist only because a firm with market power has the ability to charge different prices for the same product.

There are several pricing strategies a company with market power can use depending on its circumstances. These range from direct price discrimination to indirect price discrimination to bundling to two-part tariffs and beyond. The motivation for these strategies is straightforward: A company with market power charges a higher price for the units of output that provide consumers with greater consumer surplus. By adjusting the price, a firm extracts more producer surplus from each transaction.

All firms—from perfectly competitive to monopolistic and everything in between—have a pricing strategy. In this chapter, we discuss pricing strategies that can only be pursued by firms meeting two key requirements:

Requirement 1: The firm must have market power. A company must have market power to price-discriminate. It’s that simple. If the firm you have in mind does not have market power, you are in the wrong chapter of the book. You should be in Chapter 8 on perfect competition. Without market power, a firm can’t choose its price at all, much less choose to charge different prices to different consumers or use more advanced pricing strategies.

Requirement 2: The firm must prevent resale and arbitrage. To take advantage of advanced pricing strategies, a firm must be able to prevent its customers from reselling its product among themselves. Otherwise, the customers able to buy the product at a low price could purchase a large number and resell them to other customers who would otherwise have had to buy the product from the firm at a higher price. The practice of taking advantage of price differences for a product by buying at a lower price and reselling at a higher price is called arbitrage.

The ability to engage in arbitrage makes all customers better off. The low-price customers make a profit on resale, and the high-price consumers can buy the product at a lower price than the firm would charge. The firm isn’t better off, though. It is effectively shut out from directly selling to any consumers except those who want to buy at the lowest price. Because it would then be selling at only one price, however, the firm would be back in the traditional situation for a firm with market power described in Chapter 9: It should produce the quantity at which marginal revenue equals marginal cost and charge the price at which buyers would consume that quantity (and therefore not worry about resellers).

If a firm meets the two requirements above, it can attempt to implement more profitable pricing strategies than can a single-price monopoly. Figure 10.1 provides an overview of these strategies.

Strategies for Customers with Different Demands The first pricing strategies we look at involve price discrimination. For price discrimination to be an option, a firm needs to have different types of customers with different price sensitivities of demand. The exact kind of price discrimination the firm should use depends on the kind of information the firm has.

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Do a Firm’s Customers Have the Same Demand Curves? There is still another set of pricing strategies that a firm can use even if its consumers have the same demand curves. These strategies involve offering different unit prices to the same customer for different quantities purchased or charging lump-sum fees on top of per-unit prices.

We explore all these strategies in the remainder of this chapter. To help clarify a firm’s decision, each pricing strategy section has a When to Use It feature that explains what a firm needs to know about its market and customers to use a given pricing strategy most effectively. By using the best strategy, the firm can extract the most producer surplus from the market.