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
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...
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