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Chapter 11Slide 1Topics to be DiscussednCapturing Consumer SurplusnPrice DiscriminationnIntertemporal Price Discrimination and Peak-Load PricingChapter 11Slide 2Topics to be DiscussednThe Two-Part TariffnBundlingnAdvertisingChapter 11Slide 3IntroductionnPricing without market power(perfect competition)is determined by market supply and demand.nThe individual producer must be able to forecast the market and then concentrate on managing production(cost)to maximize profits.Chapter 11Slide 4IntroductionnPricing with market power(imperfect competition)requires the individual producer to know much more about the characteristics of demand as well as manage production.Chapter 11Slide 5Capturing Consumer SurplusQuantity$/QDMRPmaxMCIf price is raised above P*,the firm will lose sales and reduce profit.PCPC is the pricethat would exist ina perfectly competitivemarket.AP*Q*P1Between 0 and Q*,consumerswill pay more than P*-consumer surplus(A).BP2Beyond Q*,price willhave to fall to create a consumer surplus(B).Chapter 11Slide 6Capturing Consumer SurplusP*Q*:single P&Q MC=MRA:consumer surplus with P*B:PMC&consumer would buy at a lower priceP1:less sales and profitsP2:increase sales&and reduce revenue and profitsPC:competitive priceQuantity$/QDMRPmaxMCPCAP*Q*P1BP2Chapter 11Slide 7Capturing Consumer SurplusQuantity$/QDMRPmaxMCPCAP*Q*P1BP2QuestionHow can the firmcapture the consumer surplusin A and sell profitably in B?AnswerPrice discriminationTwo-part tariffsBundlingChapter 11Slide 8Capturing Consumer SurplusnPrice discrimination is the charging of different prices to different consumers for similar goods.Chapter 11Slide 9Price DiscriminationnFirst Degree Price DiscriminationlCharge a separate price to each customer:the maximum or reservation price they are willing to pay.Chapter 11Slide 10P*Q*Without price discrimination,output is Q*and price is P*.Variable profit is the area between the MC&MR(yellow).Additional Profit From Perfect First-Degree Price DiscriminationQuantity$/QPmaxWith perfect discrimination,eachconsumer pays the maximumprice they are willing to pay.Consumer surplus is the area above P*and between0 and Q*output.D=ARMRMCOutput expands to Q*and pricefalls to PC where MC=MR=AR=D.Profits increase by the area above MCbetween old MR and D to outputQ*(purple)Q*PCChapter 11Slide 11P*Q*Consumer surplus when a single price P*is charged.Variable profit when a single price P*is charged.Additional profit fromperfect price discriminationQuantity$/QPmaxD=ARMRMCQ*PCWith perfect discrimination Each customer pays their reservation priceProfits increaseAdditional Profit From Perfect First-Degree Price DiscriminationChapter 11Slide 12nQuestionlWhy would a producer have difficulty in achieving first-degree price discrimination?nAnswer1)Too many customers(impractical)2)Could not estimate the reservation price for each customerAdditional Profit From Perfect First-Degree Price DiscriminationChapter 11Slide 13Price DiscriminationnFirst Degree Price DiscriminationlThe model does demonstrate the potential profit(incentive)of practicing price discrimination to some degree.Chapter 11Slide 14Price DiscriminationnFirst Degree Price DiscriminationlExamples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product:uLawyers,doctors,accountantsuCar salesperson(15%profit margin)uColleges and universitiesChapter 11Slide 15First-Degree PriceDiscrimination in PracticeQuantityDMRMC$/QP2P3P*4P5P6P1Six prices exist resultingin higher profits.With a single priceP*4,there are few consumers andthose who pay P5 or P6 may have a surplus.QSecond-Degree Price DiscriminationQuantity$/QDMRMCACP0Q0Without discrimination:P=P0 and Q=Q0.With second-degreediscrimination there are threeprices P1,P2,and P3.(e.g.electric utilities)P1Q11st BlockP2Q2P3Q32nd Block 3rd BlockSecond-degree pricediscrimination is pricingaccording to quantityconsumed-or in blocks.Second-Degree Price DiscriminationQuantity$/QDMRMCACP0Q0P1Q11st BlockP2Q2P3Q32nd Block 3rd BlockEconomies of scale permit:Increase consumer welfareHigher profitsChapter 11Slide 18Price DiscriminationnThird Degree Price Discrimination1)Divides the market into two-groups.2)Each group has its own demand function.Chapter 11Slide 19Price DiscriminationnThird Degree Price Discrimination3)Most common type of pricediscrimination.uExamples:airlines,liquor,vegetables,discounts to students and senior citizens.Chapter 11Slide 20Price DiscriminationnThird Degree Price Discrimination4)Third-degree price discrimination is feasible when the seller can separate his/her market into groups who have different price elasticities of demand(e.g.business air travelers versus vacation air travelers)Chapter 11Slide 21Price DiscriminationnThird Degree Price DiscriminationlObjectivesuMR1=MR2uMC1=MR1 and MC2=MR2uMR1=MR2=MCChapter 11Slide 22Price DiscriminationnThird Degree Price DiscriminationlP1:price first grouplP2:price second grouplC(Qr)=total cost of QT=Q1+Q2lProfit()=P1Q1+P2Q2-C(Qr)Chapter 11Slide 23Price DiscriminationnThird Degree Price DiscriminationlSet incremental for sales to group 1=0l l Chapter 11Slide 24Price DiscriminationnThird Degree Price DiscriminationlSecond group of customers:MR2=MClMR1=MR2=MC Chapter 11Slide 25Price DiscriminationnThird Degree Price DiscriminationlDetermining relative pricesl Chapter 11Slide 26Price DiscriminationnThird Degree Price DiscriminationlDetermining relative pricesl lPricing:Charge higher price to group with a low demand elasticity Chapter 11Slide 27Price DiscriminationnThird Degree Price DiscriminationlExample:E1=-2&E2=-4 l lP1 should be 1.5 times as high as P2Chapter 11Slide 28Third-Degree Price DiscriminationQuantityD2=AR2MR2$/QD1=AR1MR1Consumers are divided intotwo groups,with separatedemand curves for each group.MRTMRT=MR1+MR2Chapter 11Slide 29Third-Degree Price DiscriminationQuantityD2=AR2MR2$/QD1=AR1MR1MRTMCQ2P2QTQT:MC=MRTGroup 1:P1Q1;more elasticGroup 2:P2Q2;more inelasticMR1=MR2=MCQT control MCQ1P1MC=MR1 at Q1 and P1Chapter 11Slide 30No Sales to Smaller MarketEven if third-degree pricediscrimination is feasible,it doesntalways pay to sell to both groupsof consumers if marginal cost is rising.Chapter 11Slide 31No Sales to Smaller MarketQuantityD2MR2$/QMCD1MR1Q*P*Group one,with demand D1,are not willing to pay enoughfor the good tomake pricediscrimination profitable.Chapter 11Slide 32The Economics of Coupons and RebatesnThose consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand.nCoupons and rebate programs allow firms to price discriminate.Price DiscriminationChapter 11Slide 33Price Elasticities of Demand for Users Versus Nonusers of CouponsToilet tissue-0.60-0.66Stuffing/dressing-0.71-0.96Shampoo-0.84-1.04Cooking/salad oil-1.22-1.32Dry mix dinner-0.88-1.09Cake mix-0.21-0.43Price ElasticityProductNonusersUsersChapter 11Slide 34Cat food-0.49-1.13Frozen entre-0.60-0.95Gelatin-0.97-1.25Spaghetti sauce-1.65-1.81Crme rinse/conditioner-0.82-1.12Soup-1.05-1.22Hot dogs-0.59-0.77Price ElasticityProductNonusersUsersPrice Elasticities of Demand for Users Versus Nonusers of CouponsChapter 11Slide 35The Economics of Coupons and RebatesnCake MixlNonusers of coupons:PE=-0.21lUsers:PE=-0.43Chapter 11Slide 36The Economics of Coupons and RebatesnCake Mix Brand(Pillsbury)lPE:8 to 10 times cake mix PEnExamplelPE Users:-4lPE Nonusers:-2Chapter 11Slide 37The Economics of Coupons and RebatesnUsing:nPrice of nonusers should be 1.5 times userslOr,if cake mix sells for$1.50,coupons should be 50 cents Chapter 11Slide 38Airline FaresnDifferences in elasticities imply that some customers will pay a higher fare than others.nBusiness travelers have few choices and their demand is less elastic.nCasual travelers have choices and are more price sensitive.Chapter 11Slide 39Elasticities of Demand for Air Travel Price-0.3-0.4-0.9 Income1.21.21.8Fare CategoryElasticityFirst-ClassUnrestricted CoachDiscountChapter 11Slide 40Airline FaresnThe airlines separate the market by setting various restrictions on the tickets.lLess expensive:notice,stay over the weekend,no refundlMost expensive:no restrictionsChapter 11Slide 41Intertemporal PriceDiscrimination and Peak-Load PricingnSeparating the Market With TimelInitial release of a product,the demand is inelasticuBookuMovieuComputerChapter 11Slide 42nSeparating the Market With TimelOnce this market has yielded a maximum profit,firms lower the price to appeal to a general market with a more elastic demand uPaper back booksuDollar MoviesuDiscount computersIntertemporal PriceDiscrimination and Peak-Load PricingChapter 11Slide 43Intertemporal Price DiscriminationQuantityAC=MC$/QOver time,demand becomesmore elastic and price is reduced to appeal to the mass market.Q2MR2D2=AR2P2D1=AR1MR1P1Q1Consumers are dividedinto groups over time.Initially,demand is lesselastic resulting in a price of P1.Chapter 11Slide 44nDemand for some products may peak at particular times.lRush hour trafficlElectricity-late summer afternoonslSki resorts on weekendsIntertemporal PriceDiscrimination and Peak-Load PricingPeak-Load PricingChapter 11Slide 45nCapacity restraints will also increase MC.nIncreased MR and MC would indicate a higher price.Peak-Load PricingIntertemporal PriceDiscrimination and Peak-Load PricingChapter 11Slide 46nMR is not equal for each market because one market does not impact the other market.Peak-Load PricingIntertemporal PriceDiscrimination and Peak-Load PricingChapter 11Slide 47MR1D1=AR1MCP1Q1Peak-load price=P1.Peak-Load PricingQuantity$/QMR2D2=AR2Off-load price=P2.Q2P2Chapter 11Slide 48How to Price a Best Selling NovelnWhat Do You Think?1)How would you arrive at the price for the initial release of the hardbound edition of a book?Chapter 11Slide 49How to Price a Best Selling NovelnWhat Do You Think?2)How long do you wait to release the paperback edition?Could the popularity of the book impact your decision?Chapter 11Slide 50nWhat Do You Think?3)How do you determine the price for the paperback edition?How to Price a Best Selling NovelChapter 11Slide 51The Two-Part TariffnThe purchase of some products and services can be separated into two decisions,and therefore,two prices.Chapter 11Slide 52The Two-Part TariffnExamples1)Amusement ParkuPay to enteruPay for rides and food within the park2)Tennis ClubuPay to joinuPay to playChapter 11Slide 53The Two-Part TariffnExamples3)Rental of Mainframe ComputersuFlat FeeuProcessing Time4)Safety RazoruPay for razoruPay for bladesChapter 11Slide 54The Two-Part TariffnExamples5)Polaroid FilmuPay for the camerauPay for the filmChapter 11Slide 55The Two-Part TariffnPricing decision is setting the entry fee(T)and the usage fee(P).nChoosing the trade-off between free-entry and high use prices or high-entry and zero use prices.Chapter 11Slide 56Usage price P*is set whereMC=D.Entry price T*is equal to the entire consumer surplus.T*Two-Part Tariff with a Single ConsumerQuantity$/QMCP*DChapter 11Slide 57D2=consumer 2D1=consumer 1Q1Q2The price,P*,will be greater than MC.Set T*at the surplus value of D2.T*Two-Part Tariff with Two ConsumersQuantity$/QMCABCChapter 11Slide 58The Two-Part TariffnThe Two-Part Tariff With Many Different ConsumerslNo exact way to determine P*and T*.lMust consider the trade-off between the entry fee T*and the use fee P*.uLow entry fee:High sales and falling profit with lower price and more entrants.Chapter 11Slide 59The Two-Part TariffnThe Two-Part Tariff With Many Different ConsumerslTo find optimum combination,choose several combinations of P,T.lChoose the combination that maximizes profit.Chapter 11Slide 60Two-Part Tariff withMany Different ConsumersTProfit:entry fee:salesT*Total profit is the sum of the profit from the entry fee andthe profit from sales.Both depend on T.Chapter 11Slide 61The Two-Part TariffnRule of ThumblSimilar demand:Choose P close to MC and high TlDissimilar demand:Choose high P and low T.Chapter 11Slide 62The Two-Part TariffnTwo-Part Tariff With A TwistlEntry price(T)entitles the buyer to a certain number of free unitsuGillette razors with several bladesuAmusement parks with some tokensuOn-line with free timeChapter 11Slide 63Polaroid Camerasn1971 Polaroid introduced the SX-70 cameranWhat Do You Think?lHow would you price the camera and film?Chapter 11Slide 64Polaroid CamerasnHintChapter 11Slide 65Pricing Cellular Phone ServicenQuestionlWhy do cellular phone providers offer several different plans instead of a single two-part tariff with an access fee and per-unit charge?Chapter 11Slide 66BundlingnBundling is packaging two or more products to gain a pricing advantage.nConditions necessary for bundlinglHeterogeneous customerslPrice discrimination is not possiblelDemands must be negatively correlatedChapter 11Slide 67BundlingnAn example:Leasing“Gone with the Wind”&“Getting Gerties Garter.”lThe reservation prices for each theater and movie are:Gone with the Wind Getting Gerties GarterTheater A$12,000$3,000Theater B$10,000$4,000Chapter 11Slide 68BundlingnRenting the movies separately would result in each theater paying the lowest reservation price for each movie:lMaximum price Wind=$10,000lMaximum price Gertie=$3,000nTotal Revenue=$26,000Chapter 11Slide 69BundlingnIf the movies are bundled:lTheater A will pay$15,000 for bothlTheater B will pay$14,000 for bothnIf each were charged the lower of the two prices,total revenue will be$28,000.Chapter 11Slide 70BundlingnNegative Correlated:Profitable to BundlelA pays more for Wind($12,000)than B($10,000).lB pays more for Gertie($4,000)than A($3,000).Relative ValuationsChapter 11Slide 71BundlingnIf the demands were positively correlated(Theater A would pay more for both films as shown)bundling would not result in an increase in revenue.Gone with the Wind Getting Gerties GarterTheater A$12,000$4,000Theater B$10,000$3,000Relative ValuationsChapter 11Slide 72BundlingnIf the movies are bundled:lTheater A will pay$16,000 for bothlTheater B will pay$13,000 for bothnIf each were charged the lower of the two prices,total revenue will be$26,000,the same as by selling the films separately.Chapter 11Slide 73BundlingnBundling Scenario:Two different goods and many consumerslMany consumers with different reservation price combinations for two goodsChapter 11Slide 74Reservation Pricesr2(reservationprice Good 2)r1(reservation priceGood 1)$5$10$5$10$6$3.25$8.25$3.25ConsumerAConsumerCConsumerBConsumer A is willing to pay up to$3.25 for good 1 andup to$6 for good 2.Chapter 11Slide 75Consumption Decisions WhenProducts are Sold Separatelyr2r1P2IIConsumers buyonly good 2P1Consumers fall intofour categories basedon their reservationprice.IConsumers buyboth goodsIIIConsumers buyneither goodIVConsumers buyonly Good 1Chapter 11Slide 76Consumption DecisionsWhen Products are Bundledr2r1Consumers buy the bundlewhen r1+r2 PB(PB=bundle price).PB=r1+r2 or r2=PB-r1Region 1:r PBRegion 2:r PB)Consumers donot buy bundle(r PB)Chapter 11Slide 77nThe effectiveness of bundling depends upon the degree of negative correlation between the two demands.Consumption DecisionsWhen Products are BundledChapter 11Slide 78Reservation Pricesr2r1P2P1If the demands are perfectly positivelycorrelated,the firmwill not gain by bundling.It would earn the sameprofit by selling the goods separately.Chapter 11Slide 79Reservation Pricesr2r1If the demands are perfectly negativelycorrelated bundling is the ideal strategy-all theconsumer surplus canbe extracted and a higherprofit results.Chapter 11Slide 80Movie Exampler2r1Bundling pays due to negative correlation(Wind)(Gertie)5,00014,00010,0005,00010,00012,0004,0003,000BAChapter 11Slide 81BundlingnMixed BundlinglSelling both as a bundle and separatelynPure BundlinglSelling only a packageChapter 11Slide 82Mixed Versus Pure Bundlingr2r1102030405060708090100102030405060708090100C2=MC2C2=30Consumer A,for example,has a reservation price for good 1 that is below marginal cost c1.With mixed bundling,consumer A is induced to buy only good 2,whileconsumer D is induced to buy only good 1,reducing the firms cost.ABDCC1=MC1C1=20With positive marginalcosts,mixed bundling may be more profitablethan pure bundling.Chapter 11Slide 83BundlingnScenariolPerfect negative correlationlSignificant marginal costMixed vs.Pure BundlingChapter 11Slide 84BundlingnObservationslReservation price is below MC for some consumerslMixed bundling induces the consumers to buy only goods for which their reservation price is greater than MCMixed vs.Pure BundlingChapter 11Slide 85Bundling ExamplenSell SeparatelylConsumers B,C,and D buy 1 and A buys 2nPure BundlinglConsumers A,B,C,and D buy the bundlenMixed BundlinglConsumer D buys 1,A buys 2,and B&C buys the bundleChapter 11Slide 86Bundling ExampleSell separately$50$90-$150Pure bundling-$100$200Mixed bundling$89.95$89.95$100$229.90 C1=$20 C2=$30P1P2PBProfitChapter 11Slide 87BundlingnSell Separatelyl3($50-$20)+1($90-$30)=$150nPure Bundlingl4($100-$20-$30)=$200nMixed Bundlingl($89.95-$20)+($89.95-$30)-2($100-$20-$30)=$229.90lC1=$20 C2=$30Chapter 11Slide 88BundlingnQuestionlIf MC=0,would mixed bundling still be the most profitable strategy with perfect negative correlation?Chapter 11Slide 89Mixed Bundlingwith Zero Marginal Costsr2r12040608010020406080100120120In this example,consumers B and C are willing to pay$20 more for the bundle than are consumers A and D.With mixed bundling,the price of the bundlecan be increased to$120.A&D can be charged$90 for a single good.C10901090ABDChapter 11Slide 90Sell separately$80$80-$320Pure bundling-$100$400Mixed bundling$90$90$120$420P1P2PBProfitMixed Bundlingwith Zero Marginal CostsChapter 11Slide 91BundlingnQuestionlWhy is mixed bundling more profitable with MC=0?Chapter 11Slide 92BundlingnBundling in PracticelAutomobile option packageslVacation travellCable televisionChapter 11Slide 93BundlingnMixed Bundling in PracticelUse of market surveys to determine reservation priceslDesign a pricing strategy from the survey resultsChapter 11Slide 94Mixed Bundling in Practicer2r1The firm can first choose a pricefor the bundle and then try individualprices P1 and P2 until total profitis roughly maximized.P2PBPBP1The dots are estimates of reservation prices for a representative sample of consumers.Chapter 11Slide 95The Complete Dinner Versus a la Carte:A Restaurants Pricing ProblemnPricing to match consumer preferences for various selectionsnMixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.Chapter 11Slide 96BundlingnTyinglPractice of requiring a customer to purchase one good in order to purchase another.lExamplesuXerox machines and the paperuIBM mainframe and computer cardsChapter 11Slide 97BundlingnTyinglAllows the seller to meter the customer and use a two-part tariff to discriminate against the heavy userlMcDonaldsuAllows them to protect their brand name.Chapter 11Slide 98AdvertisingnAssumptionslFirm sets only one pricelFirm knows Q(P,A)uHow quantity demanded depends on price and advertisingChapter 11Slide 99Q0P0Q1P1ARMRAR and MR are averageand marginal revenue whenthe firm doesnt advertise.MCIf the firm advertises,its average and marginalrevenue curves shift tothe right-average costsrise,but marginal costdoes not.ARMRACEffects of AdvertisingQuantity$/QACChapter 11Slide 100AdvertisingnChoosing Price and Advertising ExpenditureChapter 11Slide 101AdvertisingnA Rule of Thumb for AdvertisingChapter 11Slide 102AdvertisingnA Rule of Thumb for AdvertisingChapter 11Slide 103AdvertisingnA Rule of Thumb for AdvertisinglTo maximize profit,the firms advertising-to-sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand.Chapter 11Slide 104AdvertisingnAn ExamplelR(Q)=$1 million/yrl$10,000 budget for A(advertising-1%of revenues)lEA=.2(increase budget$20,000,sales increase by 20%lEP=-4(markup price over MC is substantial)Chapter 11Slide 105AdvertisingnQuestionlSho
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