Like firms in a competitive market, a firm with market power maximises its profits choosing the quantity of goods (or services) at which marginal revenues equal the marginal cost.
However, unlike firms in a competitive market, a firm with market power (whose excess is represented by a monopolist) faces a downward sloping demand curve and therefore is able, to some extent, to choose the price at which it is selling its products. Thus, the price of a firm with market power is greater than MC (P>MC=MR).In particular, a firm with market power that sets a single price should base this price on the consumer response/sensibility to the price. This follows from a mark- up rule which states that a firm with market power with a single price should set its price such that: In other words, the firm should take into consideration the elasticity of the demand. The more the demand is inelastic the more the firm can raise its price, without losing substantial demand.If a firm is able to identify different segments of customers and their willingness to pay, this firm can maximise its profits and avoid deadweight losses by setting different prices for each segment.
In the case of direct segmentation, the firm should consider the following factors to set the price in each market segment: 1)The price sensitivity of the consumer in the segment 2)Whether the marginal cost of serving a segment is lower than the marginal cost of serving another segment.Examples of factors correlated to price sensitivity are the age of the consumers, their income, and the country where they live. In the context of market segmentation, a firm must be careful and prevent arbitrage: the possibility that a customer buy a product in a segment with lower price and resell the same product to a slightly higher price but lower than the price of the product in another segment of the firm. Providing a personal warranty that is not assignable to a second customer is a first way to limit arbitrage. Second is using contract/agreements which forbid to a customer to resell the product.Third is using a system to match the ID of the student with the School where he is enrolled if a firm provides a lower price for students. If the firm is not able to prevent arbitrage and it cannot sell the same product at different prices, then it could change its strategy and try to sell different (slightly) product to different segments of customers.
This generally involves placing restrictions or lower value aspects on the lower priced version, so as to make the product less appealing to the segment of the market with higher willingness to pay.The differences in the products will probably result in a diminished demand for the low quality version (as compared to what would be if the seller could directly identify the low willingness to pay group and simply offer the “high quality” version to them at a low price); but the diminished demand by the low willingness to pay group is compensated by the ability of the firm of deter the high end segment from buying the lower product. An example of a firm with market power could be Philipp Morris International, one of the world largest producers of cigarettes.The market power of Philipp Morris is due to: -the relatively small number of players in the tobacco industry, -the kind of product Philip Morris sells: cigarettes. Smokers are relatively low price sensitive if compared to consumers of other products, -the huge margins that Philipp Morris has on the cigarettes. Philipp Morris has a portfolio of cigarettes which comprises more than 150 brands in 1900 variants. All these brands and variants are part of a strategy of market segmentation.
Philipp Morris pricing strategy’ factors include: )Regional factors: each country have different prices 2)Age groups: the brands of cigarettes are targeted to different age groups. In particular, cheaper cigarettes are targeted to very young smokers. More expensive class cigarettes are targeted to higher income people. An alternative pricing scheme that Philipp Morris could implement would be to create a brand whose difference is not in the blend of the cigarettes but on the appeal and design of the packs and charge a higher price for these “fashionable” packs.Lots of consumer would be willing to pay a higher price to have different “product” and identify themselves as “different” smokers. This new brand would increase Philipp Morris’ profits for two reasons: 1)It would increase the number of consumers who are identified as “social smokers”, therefore increasing the quantity supplied.
2)The higher price will not be affected by higher cost of production, since the cost of producing a different pack would be substantially the same.