Chapter 11

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Managerial Economics &
Business Strategy
Chapter 11
Pricing Strategies for Firms with
Market Power
Standard Pricing and Profits
Price
Profits from standard pricing
= $8
10
8
6
4
MC=AC
2
P = 10 - 2Q
1
2
3
4
5
MR = 10 - 4Q
Quantity
Price Discrimination
• Defined as:
n
the practice of charging different prices to consumers
for the same good or service
• Purpose:
n
to extract consumer surplus and increase firm profits.
• Caveat:
n
in order for price discrimination to work consumers
who pay a lower price are not able to resell the good to
consumers willing to pay a higher price (i.e., no
arbitrage possibilities)
First-Degree or Perfect
Price Discrimination
• Practice of charging each consumer their
maximum willlingness-to-pay
n
n
n
Permits a firm to extract all surplus from consumers
Nearly impossible
Examples: car salesman who is able to “perfectly size
up” his customers
Perfect Price Discrimination
Price
Profits:
.5(4)(10 - 2)
= $16
10
8
6
4
Total Cost
2
MC
D
1
2
3
4
5
Quantity
Second Degree
Price Discrimination
Price
• The practice of charging
$10
different prices for
different quantities of the $8
same good.
• Examples: soup,
$5
electricity, items sold in
$3
bulk, and block pricing
which is encouraged
when scale economies
exist
D
AC
MC
2
4
MR
Quantity
Third Degree Price Discrimination
• The practice of charging different groups
of consumers different prices for the same
product
n
Based on Time, Consumer Characteristics, or
geographic location
• Examples include student discounts, senior
citizen’s discounts, coupons, rebates,
matinees, long-distance telephone service,
best-selling novels (hard vs. soft), new
technologies (e.g., DVD players)
Third Degree PD
• To maximize profits, the firm should equate
MR from selling Q to each group to MC
n
MR1=MC and MR2=MC; thus firm should allocate Q
among the 2 groups such that MR1=MR2=MC.
• Suppose E1 < E2
• Thus, group 1 will be charged a lower price
than group 2.
n
n
n
Senior citizen or student discounts
Those who clip coupons
Matinees
An Example
BMW can produce any quantity of cars at a
constant MC equal to $15,000, and a FC of $20
million. You are asked to advise the CEO as to
what prices and quantities BMW should set for
sales in Europe and in the US. The demand for
BMW’s in each market is given by
QE=18,000 – 400PE
QU=5500 – 100PU
Assume that BMW can restrict US sales to
authorized dealers only.
Two-Part Pricing
• Two-part pricing consists of a fixed fee and a per
unit charge.
• Works well when consumer demands are
relatively homogeneous.
n
Examples: golf club memberships, Costco, cell phone
services, Gillette razors.
How Two-Part Pricing Works
Price
1. Set price at marginal cost.
2. Compute consumer surplus.
3. Charge a fixed-fee equal to
consumer surplus.
10
8
6
Per Unit
Charge
Fixed Fee = Profits = $16
4
MC
2
D
1
2
3
4
5
Quantity
An Example
As the owner of the only tennis club in an isolated wealthy
community, you must decide on membership dues and fees for
court time. There are 2 types of tennis players (serious and
occasional) with the following demands
QS = 6 – PS
QO = 3 – 0.5PO
where Q is court hours per week, and P is the fee per hour for
each individual player. Assume that there are 1000 players of
each type, the MC of court time is zero, FC are $5000 per week,
and serious and occasional players look alike so you must
charge the same price.
You only want S players. What should you charge for annual
dues and court fees? Could you increase profits by selling to
both types?
Commodity Bundling
• The practice of bundling two or more products
together and charging one price for the bundle.
Mixed Bundling the practice of selling goods
separately or as a bundle
• Good when:
n
n
n
Heterogeneous consumer demands
Can’t PD
Consumer demands are negatively correlated
• Examples
n
n
n
n
Vacation packages
Computers and software
Film and developing
McDonald’s
An Example that Illustrates
Kodak’s Moment
• Total market size is 4 million consumers
• Four types of consumers
n
n
n
n
25% will use only Kodak film
25% will use only Kodak developing
25% will use only Kodak film and use only Kodak
developing
25% have no preference
• Zero costs (for simplicity)
• Maximum price each type of consumer will
pay is as follows:
Reservation Prices for Kodak Film
and Developing by Type of
Consumer
Type
F
FD
B
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Optimal Film Price?
Type
F
FD
B
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Optimal Price is $8, to earn profits of $8 x 2 million = $16 Million
At a price of $4, only first three types will buy (profits of $12 Million)
At a price of $3, all will types will buy (profits of $12 Million)
Optimal Price for Developing?
Type
F
FD
B
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
At a price of $6, only “B” type buys (profits of $6 Million)
At a price of $4, only “B” and “FD” types buy (profits of $8 Million)
At a price of $2, all types buy (profits of $8 Million)
Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million
Total Profits by Pricing Each Item
Separately?
Type
F
FD
B
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
$16 Million Film Profits + $9 Million Development Profits =$25 Million
Let’s see if the firm can earn even greater profits by bundling
Consumer Valuations of a Bundle
Type
F
FD
D
N
Film Developing Value of Bundle
$8
$3
$11
$8
$4
$12
$4
$6
$10
$3
$2
$5
What’s the Optimal Price for a
Bundle?
Type
F
FD
D
N
Film Developing Value of Bundle
$8
$3
$11
$8
$4
$12
$4
$6
$10
$3
$2
$5
Optimal Bundle Price = $10 (for profits of $30 million)
Cross-Subsidies
• Prices charged for one product are subsidized
by the sale of another product
• May be profitable when there are significant
demand complementarities
• Example
n
Adobe Reader and Adobe Acrobat
Pricing in Markets with Intense
Price Competition
• Price Matching
n
n
n
Advertising a price and a promise to match any lower price offered
by a competitor.
Such strategies weaken the incentives for rivals to undercut any
given store’s price, thus
Each firm charges the monopoly price and shares the market.
• Randomized Pricing
n
n
n
A strategy of constantly changing prices.
Decreases consumers’ incentive to shop around as they cannot
learn from experience which firm charges the lowest price.
Reduces the ability of rival firms to undercut a firm’s prices.
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