Scores Total Econ Math Econ Math
A. Methods of Procuring Inputs:
VIII. Chapter 11. Pricing Strategies
A. Basic Pricing Strategies for Firms with Market Power
1. Optimal Pricing for a monopolist or monopolistic competitor
a. Basic Case
b. Imperfect Demand Information
P = MC/[1+1/η].
Preview__________________________________________________________
B. Strategies that yield higher profits 1. Price Discrimination
a. Perfect (1st degree) price discrimination i. Calculating gains
ii. Necessary conditions
b. Price List (2nd degree) price discrimination c. Group Division (3rd degree price discrimination.
2. Two part pricing.
.
Lecture____________________________________________________________
A. Basic Pricing Strategies for Firms with Market Power.
1. Optimal Pricing for a monopolist or monopolistic competitor. Generally speaking, firms with downsloping demand can raise prices above the competitive level. This applies both to monopolistic competitors as well as to monopolists.
a. Basic Case. With perfect demand information, the firm can maximize profits by setting MR equal to MC to find the optimal quantity.
Then the firm inserts Q into the price function to find the optimal price.
We just reviewed this above. One important problem with this approach is that firms rarely have complete demand information.
b.. Optimization without a demand curve. As we noted earlier in the semester, often times we don’t have a good estimate of the demand curve.
Rather, we must rely elasticity information to draw inference about optimal outcomes. Fortunately, this is not too difficult. Recall, a monopolist optimizes where MR = MC. MC should be known. Let’s consider MR.
TR = P(Q)Q. Taking the derivative w.r.t. Q yields P
P = MC/(1+1/η)
This is a useful expression, since it allows us to determine the optimal markup with only information regarding price elasticity of demand.
B. Strategies that Yield Greater Profits. However, if firms with downsloping demand are not constrained to charge the same price to all consumers, even higher profits are
available. We start with price discrimination,
1. Price Discrimination: The practice of charging different prices to consumers for the same good. The below figures illustrate maximum profits available from posting a uniform price:
P MC
D
Qm Q
MR
Now, if the firm is restricted to posting a single price, then the Qm will be produced, and the maximum profits than can be realized is the area in the shaded box. However, more surplus is available: Consumers take home the triangle above the shaded box at the top of the figure. Also, due to the inefficiently high price, fewer units are sold than would have been sold at the competitive price, causing an additional welfare loss.
a. First-degree price discrimination: The practice of charging different prices to consumers for the same good.
Suppose that the firm could successfully size up every consumer that came into their shop, size them up, and charge them their limit price for the good. The, the efficient quantity would be produced, and the firm would enjoy the entire surplus.
P MC
D
Qe Q MR
Perfect price discrimination requires satisfaction of two conditions
a. The firm must be able to assess accurately the maximum willingness to pay of each consumer
b. The firm must be able to prevent arbitrage, or the resale of units from low value consumers to high value consumers.
In practice, the first of these conditios is difficult to satisfy with any precision However, first degree price discrimination is often attempted in markets where the resale is
impossible, and where the item exchanged is very costly (e.g. real estate or automobiles) or where the consumer knows little about the cost of the service (automobile repairs)
Lecture 37
REVIEW___________________________________________________:
VIII. Chapter 11. Pricing Strategies.
A. Basic Pricing Strategies for Firms with Market Power
1. Optimal Pricing for a monopolist or monopolistic competitor a. Basic Case
b. Imperfect Demand Information
P = MC/[1+1/η].
Preview__________________________________________________________
B. Strategies that yield higher profits 1. Price Discrimination
a. Perfect (1st degree) price discrimination i. Calculating gains
ii. Necessary conditions
b. Price List (2nd degree) price discrimination c. Group Division (3rd degree price discrimination.
2. Two part pricing.
3.
Lecture____________________________________________________________
B. Strategies that Yield Greater Profits.
The second of these conditions can be problematic, but ini practice, the first is typically a condemning problem. However, it is fairly conventional in a number of markets,
including mechanical repairs, automobiles, and real estate to make an effort at first degree price discrimination.
Other methods of price discrimination are more typical.
2. Second Degree Price Discrimination: One standard alternative is to offer all consumers a schedule that decreases with quantities purchased. This is second degree price
discrimination: The practice of posting a discrete schedule of declining prices for different ranges of quantities.
Example: Suppose Best Buy sells a first CD for $15, and then additional CD’s for $10.
Suppose that the MC of selling the CD’s was $5 each. Suppose that your demand is such that you would pay up to $15 for a first CD and $10 for a second CD.
If they charged $10 each they would earn $10, and if they charged $15 each they would earn $10.
P MC
$15
$10
$5
Qe Q
MR
c. Third Degree Price Discrimination: The practice of identifying different types of consumers, and charging different prices to each group.
This is a very standard practice in entertainment goods (such as food, movies and sporting events): “Senior citizen’s discounts,” “Student’s discounts”, etc. appear to be a way for the firm to help out particular groups of people. In fact, it is also a way to increase profits. By separating low-value buyers from the high value buyers, and charging different prices, the firm makes sales it would otherwise forego.
Successful third degree price discrimination requires two things
1. High and low value groups must be separable. (This is often pretty easy.
Senior citizens can be required to show a driver’s license, etc.)
2. There must be a way to prevent one group from reselling to the other. (If this is not prohibited, then arbitrage will eliminate sales in the high-value market).
Optimal pricing under third degree price discrimination is easily motivated graphically.
Just identify the demand curves for the separate groups, and optimize with respect to each group.
P P
MC MC
D D
Q Q
MR1 MR2
Manipulating the elasticity formula presented earlier for the case of a monopolist, this can be algebraically expressed as
MC = MR1 = MR2
= P1[(η1+1)/η1] = P2[(η2+1)/η2]
Solving for prices
P1 = MC/[1+1/η1]
P2 = MC/[1+1/η2] = 1P
Example: Suppose you are selling popcorn in a movie theatre. Theatre-goers are prohibited from bringing in food from home, so you have some market power. Suppose that the price elasticity of demand for students is -2, while the price elasticity of demand for the general public is -1.5. If popcorn costs $.25 per box to prepare, box and sell, what price should be charged to each group?
Answer: Let group 1 be the general public, and let group 2 be students. Then
P1 = .25/[1+1/-2] = .50
P2 = MC/[1+1/-1.5] = .75
= .50
2. Two Part Pricing: The practice of charging a per unit cost that equals marginal cost, plus a fixed fee equal to the consumer surplus each consumer receives at the MC price.
This is a second scheme that allows firms with some market power to increase profits. It is typically employed by athletic clubs and discount centers (buying clubs),where an initiation fee is charged, along with some (possible zero) usage fee. The profitability of two part pricing is easily seen in an illustration
P P
MC MC
D D
Q Q
MR1 MR2
Single Price Monopolist Two part pricing
If a firm charges P=MC in the second case, but an initiation fee equal to the entire consumer surplus triangle, profits are higher than they would be as a single price monopolist.
Example: What would be the optimal initiation fee in the above example if the demand curve was 10 - P, and the marginal cost of a “visit was $1?
Answer: The optimal quantity is 10 - 1 = 9. Thus the consumer surplus realized from marginal cost pricing is (1/2)[10-1]9 = $40.50.
Lecture 38
REVIEW___________________________________________________:
VIII. Chapter 11. Pricing Strategies.
B. Strategies that yield higher profits 1. Price Discrimination
a. Perfect (1st degree) price discrimination i. Calculating gains
ii. Necessary conditions
b. Price List (2nd degree) price discrimination c. Group Division (3rd degree price discrimination.
2. Two part pricing.
3. Commodity Bundling The practice of bundling several different products together and selling them at a single “bundle price.” This is final scheme for increasing profits that we will discuss. The potential profitability of bundling can be seen in the following
example.
Suppose a firm sells computers and monitors, but that different consumers value the different products differently.
Consumer Valuation of computer Valuation of Monitor 1
Suppose, for simplicity that MC equals zero. If demand consisted of only these two consumers, then the best the firm could do with single product, nondiscriminatory price is 1500 for the computers, and 200 for the monitors.
However, if the firm charged $1800 for the computer/monitor combination, it could earn 100 more per sale.
Observe that effective first-degree price discrimination would be more profitable.
However, when it is impossible to distinguish consumers before the fact, this is a profit-improving option relative to single-product pricing. Commodity pricing is a very standard feature of big-ticket items, such as automobiles and new houses.
TEST
Test 1 Review
I. Chapter 1. The Fundamentals of Managerial Economics A. Definition of Topic.
1. Economics
2. Managerial Decisions
B. Components of Effective Decision Making