BEC 30325
Managerial Economics
Advanced Pricing Techniques
Advanced Pricing Techniques
• Price discrimination
• Multiple products
• Cost-plus pricing
2
Capturing Consumer Surplus
• Uniform pricing
– Charging the same price for every unit of the
product
• Price discrimination
– More profitable alternative to uniform pricing
– Market conditions must allow this practice to be
profitably executed
– Technique of charging different prices for the same
product
– Used to capture consumer surplus (turning
consumer surplus into profit)
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The Trouble with Uniform Pricing
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Price Discrimination
• Exists when the price-to-marginal cost ratio
differs between two products:
PA
PB

MC A MC B
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Price Discrimination
Three conditions necessary to practice
price discrimination profitably:
1) Firm must possess some degree of market power
2) A cost-effective means of preventing resale
between lower- and higher-price buyers
(consumer arbitrage) must be implemented
3) Price elasticities must differ between individual
buyers or groups of buyers
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First-Degree (Perfect) Price Discrimination
• Every unit is sold for the maximum price each
consumer is willing to pay
– Allows the firm to capture entire consumer surplus
• Difficulties
– Requires precise knowledge about every buyer’s
demand for the good
– Seller must negotiate a different price for every
unit sold to every buyer
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First-Degree (Perfect) Price Discrimination
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Second-Degree Price Discrimination
• Lower prices are offered for larger
quantities and buyers can self-select the
price by choosing how much to buy
• When the same consumer buys more than
one unit of a good or service at a time, the
marginal value placed on additional units
declines as more units are consumed
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Second-Degree Price Discrimination
• Two-part pricing
– Charges buyers a fixed access charge (A) to purchase as
many units as they wish for a constant fee (f) per unit
– Total expenditure (TE) for q units is:
TE  A  fq
Average price ( p ) is:
TE A  fq
p

q
q
A
 f
q
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Second-Degree Price Discrimination
• When consumers have identical demands,
entire consumer surplus can be captured
by:
– Setting f = MC
– Setting A = consumer surplus (CS)
• Optimal usage fee when two groups of
buyers have identical demands is the level
for which MRf = MCf
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Inverse Demand Curve for Each of 100 Identical
Senior Golfers
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Demand at Northvale Golf Club
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Second-Degree Price Discrimination
• Declining block pricing
– Offers quantity discounts over successive
discrete blocks of quantities purchased
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Block Pricing with Five Blocks
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Third-Degree Price Discrimination
• If a firm sells in two markets, 1 & 2
– Allocate output (sales) so MR1 = MR2
– Optimal total output is that for which MRT =
MC
• For profit-maximization, allocate sales of
total output so that
MRT = MC = MR1 = MR2
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Third-Degree Price Discrimination
• Equal-marginal-revenue principle
– Allocating output (sales) so MR1 = MR2 which
will maximize total revenue for the firm
(TR1 + TR2)
– More elastic market gets lower price
– Less elastic market gets higher price
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Allocating Sales Between Markets
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Constructing the Marginal Revenue Curve
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Profit-Maximization Under Third-Degree Price
Discrimination
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Multiple Products
• Related in consumption
– For two products, X & Y, produce & sell levels
of output for which
MRX = MCX and MRY = MCY
– MRX is a function not only of QX but also of
QY (as is MRY) -- conditions must be satisfied
simultaneously
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Multiple Products
• Related in production as substitutes
– For two products, X & Y, allocate production
facility so that
MRPX = MRPY
– Optimal level of facility usage in the long run is
where MRPT = MC
– For profit-maximization:
MRPT = MC = MRPX = MRPY
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Multiple Products
• Related in production as complements
– To maximize profit, set joint marginal revenue
equal to marginal cost:
MRJ = MC
– If profit-maximizing level of joint production
exceeds output where MRJ kinks, units beyond
zero MR are disposed of rather than sold
– Profit-maximizing prices are found using demand
functions for the two goods
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Profit-Maximizing Allocation of Production
Facilities
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Profit-Maximization with Joint Products
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Cost-Plus Pricing
• Common technique for pricing when firms do
not wish to estimate demand & cost
conditions to apply the MR = MC rule for
profit-maximization
• Price charged represents a markup (margin)
over average cost:
P = (1 + m)ATC
Where m is the markup on unit cost
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Cost-Plus Pricing
• Does not generally produce profitmaximizing price
– Fails to incorporate information on demand &
marginal revenue
– Uses average, not marginal, cost
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Practical Problems with Cost-Plus Pricing
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