Peak-load pricing

Peak-load pricing also involves charging different prices at different points in time. Rather than capturing consumer surplus, however, the objective is to increase economic efficiency by charging consumers prices that are close to marginal cost.

For some goods and services, demand peaks at particular times—for roads and tunnels during commuter rush hours, for electricity during late summer afternoons, and for ski resorts and amusement parks on weekends. Marginal cost is also high during these peak periods because of capacity constraints. Prices should thus be higher during peak periods.

This is illustrated in above Figure, where D1 is the demand curve for the peak period and D2 the demand curve for the nonpeak period. The firm sets marginal revenue equal to marginal cost for each period, obtaining the high price P1 for the peak period and the lower price P2 for the nonpeak period, selling corresponding quantities Q1 and Q2. This strategy increases the firm’s profit above what it would be if it charged one price for all periods. It is also more efficient: The sum of producer and consumer surplus is greater because prices are closer to marginal cost.

The efficiency gain from peak-load pricing is important. If the firms were a regulated monopolist (e.g., an electric utility), the regulatory agency should set the prices P1 and P2 at the points where the demand curves, D1 and D2, intersect the marginal cost curve, rather than where the marginal revenue curves intersect marginal cost. In that case, consumers realize the entire efficiency gain.

Note that peak-load pricing is different from third-degree price discrimination. With third-degree price discrimination, marginal revenue must be equal for each group of consumers and equal to marginal cost. Why? Because the costs of serving the different groups are not independent. For example, with unrestricted versus discounted air fares, increasing the number of seats sold at discounted fares affects the cost of selling unrestricted tickets—marginal cost rises rapidly as the airplane fills up. But this is not so with peak-load pricing (or for that matter, with most instances of intertemporal price discrimination). Selling more tickets for ski lifts or amusement parks on a weekday does not significantly raise the cost of selling tickets on the weekend. Similarly, selling more electricity during off-peak periods will not significantly increase the cost of selling electricity during peak periods. As a result, price and sales in each period can be determined independently by setting marginal cost equal to marginal revenue for each period.

Movie theaters, which charge more for evening shows than for matinees, are another example. For most movie theaters, the marginal cost of serving customers during the matinee is independent of marginal cost during the evening. The owner of a movie theater can determine the optimal prices for the evening and matinee shows independently, using estimates of demand and marginal cost in each period.