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Chapter 11 Pricing with Market Power. ©2005 Pearson Education, Inc. Chapter 112 Topics to be Discussed Capturing Consumer Surplus Price Discrimination.

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Presentation on theme: "Chapter 11 Pricing with Market Power. ©2005 Pearson Education, Inc. Chapter 112 Topics to be Discussed Capturing Consumer Surplus Price Discrimination."— Presentation transcript:

1 Chapter 11 Pricing with Market Power

2 ©2005 Pearson Education, Inc. Chapter 112 Topics to be Discussed Capturing Consumer Surplus Price Discrimination Intertemporal Price Discrimination and Peak-Load Pricing The Two-Part Tariff Bundling Advertising

3 ©2005 Pearson Education, Inc. Chapter 113 Introduction Pricing without market power (perfect competition) is determined by market supply and demand The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits

4 ©2005 Pearson Education, Inc. Chapter 114 Introduction Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production

5 ©2005 Pearson Education, Inc. Chapter 115 Capturing Consumer Surplus All pricing strategies we will examine are means of capturing consumer surplus and transferring it to the producer Profit maximizing point of P* and Q* But some consumers will pay more than P* for a good Raising price will lose some consumers, leading to smaller profits Lowering price will gain some consumers, but lower profits

6 ©2005 Pearson Education, Inc. Chapter 116 Capturing Consumer Surplus Quantity $/Q D MR P max MC PCPC The firm would like to charge higher price to those consumers willing to pay it - A P* Q* A P1P1 Firm would also like to sell to those in area B but without lowering price to all consumers B P2P2 Both ways will allow the firm to capture more consumer surplus

7 ©2005 Pearson Education, Inc. Chapter 117 Capturing Consumer Surplus Price discrimination is the practice of charging different prices to different consumers for similar goods Must be able to identify the different consumers and get them to pay different prices Other techniques that expand the range of a firms market to get at more consumer surplus Tariffs and bundling

8 ©2005 Pearson Education, Inc. Chapter 118 Price Discrimination First Degree Price Discrimination Charge a separate price to each customer: the maximum or reservation price they are willing to pay How can a firm profit? The firm produces Q* MR = MC We can see the firms variable profit – the firms profit ignoring fixed costs Area between MR and MC Consumer surplus area between demand and price

9 ©2005 Pearson Education, Inc. Chapter 119 Price Discrimination If the firm can price discriminate perfectly, each consumer is charged exactly what they are willing to pay MR curve is no longer part of output decision Incremental revenue is exactly the price at which each unit is sold – the demand curve Additional profit from producing and selling an incremental unit is now the difference between demand and marginal cost

10 ©2005 Pearson Education, Inc. Chapter 1110 P* Q* Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow). Perfect First-Degree Price Discrimination Quantity $/Q With perfect discrimination, firm will choose to produce Q** increasing variable profits to include purple area. Consumer surplus is the area above P* and between 0 and Q* output. P max D = AR MR MC Q** PCPC

11 ©2005 Pearson Education, Inc. Chapter 1111 First-Degree Price Discrimination In practice, perfect price discrimination is almost never possible 1.Impractical to charge every customer a different price (unless very few customers) 2.Firms usually do not know reservation price of each customer Firms can discriminate imperfectly Can charge a few different prices based on some estimates of reservation prices

12 ©2005 Pearson Education, Inc. Chapter 1112 First-Degree Price Discrimination Examples 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: Lawyers, doctors, accountants Car salesperson (15% profit margin) Colleges and universities (differences in financial aid)

13 ©2005 Pearson Education, Inc. Chapter 1113 First-Degree Price Discrimination in Practice Quantity D MR MC $/Q P2P2 P3P3 P1P1 P5P5 P6P6 Six prices exist resulting in higher profits. With a single price P* 4, there are fewer consumers. P* 4 Q* Discriminating up to P 6 (competitive price) will increase profits.

14 ©2005 Pearson Education, Inc. Chapter 1114 Second-Degree Price Discrimination In some markets, consumers purchase many units of a good over time Demand for that good declines with increased consumption Electricity, water, heating fuel Firms can engage in second-degree price discrimination Practice of charging different prices per unit for different quantities of the same good or service

15 ©2005 Pearson Education, Inc. Chapter 1115 Second-Degree Price Discrimination Quantity discounts are an example of second-degree price discrimination Ex: Buying in bulk at Sams Club Block pricing – the practice of charging different prices for different quantities of blocks of a good Ex: electric power companies charge different prices for a consumer purchasing a set block of electricity

16 ©2005 Pearson Education, Inc. Chapter 1116 Second-Degree Price Discrimination $/Q Without discrimination: P = P 0 and Q = Q 0. With second-degree discrimination there are three blocks with prices P 1, P 2, & P 3. Quantity D MR MC AC P0P0 Q0Q0 Q1Q1 P1P1 1st Block P2P2 Q2Q2 2nd Block P3P3 Q3Q3 3rd Block Different prices are charged for different quantities or blocks of same good.

17 ©2005 Pearson Education, Inc. Chapter 1117 Third-Degree Price Discrimination Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group 1.Divides the market into two groups 2.Each group has its own demand function

18 ©2005 Pearson Education, Inc. Chapter 1118 Price Discrimination Third Degree Price Discrimination Most common type of price discrimination Examples: airlines, premium vs. non- premium liquor, discounts to students and senior citizens, frozen vs. canned vegetables

19 ©2005 Pearson Education, Inc. Chapter 1119 Third-Degree Price Discrimination Same characteristic is used to divide the consumer groups Typically, elasticities of demand differ for the groups College students and senior citizens are not usually willing to pay as much as others because of lower incomes These groups are easily distinguishable with IDs

20 ©2005 Pearson Education, Inc. Chapter 1120 Creating Consumer Groups If third-degree price discrimination is feasible, how can the firm decide what to charge each group of consumers? 1.Total output should be divided between groups so that MR for each group is equal 2.Total output is chosen so that MR for each group of consumers is equal to the MC of production

21 ©2005 Pearson Education, Inc. Chapter 1121 Third-Degree Price Discrimination Algebraically P 1 : price first group P 2 : price second group C(Q T ) = total cost of producing output Q T = Q 1 + Q 2 Profit: = P 1 Q 1 + P 2 Q 2 - C(Q T )

22 ©2005 Pearson Education, Inc. Chapter 1122 Third-Degree Price Discrimination Firm should increase sales to each group until incremental profit from last unit sold is zero Set incremental for sales to group 1 = 0

23 ©2005 Pearson Education, Inc. Chapter 1123 Third-Degree Price Discrimination First group of consumers: MR 1 = MC Can do the same thing for the second group of consumers Second group of customers: MR 2 = MC Combining these conclusions gives MR 1 = MR 2 = MC

24 ©2005 Pearson Education, Inc. Chapter 1124 Third-Degree Price Discrimination Determining relative prices Thinking of relative prices that should be charged to each group of consumers and relating them to price elasticities of demand may be easier

25 ©2005 Pearson Education, Inc. Chapter 1125 Third-Degree Price Discrimination Determining relative prices Equating MR 1 and MR 2 gives the following relationship that must hold for prices The higher price will be charged to consumer with the lower demand elasticity

26 ©2005 Pearson Education, Inc. Chapter 1126 Third-Degree Price Discrimination Example E 1 = -2 and E 2 = -4 P 1 should be 1.5 times as high as P 2

27 ©2005 Pearson Education, Inc. Chapter 1127 Third-Degree Price Discrimination Quantity D 2 = AR 2 MR 2 $/Q D 1 = AR 1 MR 1 Consumers are divided into two groups, with separate demand curves for each group. MR T MR T = MR 1 + MR 2

28 ©2005 Pearson Education, Inc. Chapter 1128 Third-Degree Price Discrimination Quantity D 2 = AR 2 MR 2 $/Q D 1 = AR 1 MR 1 MR T MC Q2Q2 P2P2 Q T : MC = MR T Group 1: more inelastic Group 2: more elastic MR 1 = MR 2 = MC T Q T control MC Q1Q1 P1P1 MC = MR 1 at Q 1 and P 1 QTQT MC T

29 ©2005 Pearson Education, Inc. Chapter 1129 No Sales to Smaller Market Even if third-degree price discrimination is possible, it may not be feasible to try to sell to both groups It is possible that the demand for one group is so low that it would not be profitable to lower price enough to sell to that group

30 ©2005 Pearson Education, Inc. Chapter 1130 No Sales to Smaller Market Quantity D2D2 MR 2 $/Q MC D1D1 MR 1 Group one, with demand D 1, is not willing to pay enough for the good to make price discrimination profitable. Q*Q* P*P* MC=MR 1 =MR 2

31 ©2005 Pearson Education, Inc. Chapter 1131 The Economics of Coupons and Rebates Those 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 Coupons and rebate programs allow firms to price discriminate

32 ©2005 Pearson Education, Inc. Chapter 1132 The Economics of Coupons and Rebates About 20 – 30% of consumers use coupons or rebates Firms can get those with higher elasticities of demand to purchase the good who would not normally buy it Table 11.1 shows how elasticities of demand vary for coupon/rebate users and non-users

33 ©2005 Pearson Education, Inc. Chapter 1133 Price Elasticities of Demand: Users vs. Nonusers of Coupons

34 ©2005 Pearson Education, Inc. Chapter 1134 Airline Fares Differences in elasticities imply that some customers will pay a higher fare than others Business travelers have few choices and their demand is less elastic Casual travelers and families are more price-sensitive and will therefore be choosier

35 ©2005 Pearson Education, Inc. Chapter 1135 Elasticities of Demand for Air Travel

36 ©2005 Pearson Education, Inc. Chapter 1136 Airline Fares There are multiple fares for every route flown by airlines They separate the market by setting various restrictions on the tickets Must stay over a Saturday night 21-day advance, 14-day advance Basic restrictions – can change ticket to only certain days Most expensive: no restrictions – first class

37 ©2005 Pearson Education, Inc. Chapter 1137 Other Types of Price Discrimination Intertemporal Price Discrimination Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time Initial release of a product, the demand is inelastic Hard back vs. paperback book New release movie Technology

38 ©2005 Pearson Education, Inc. Chapter 1138 Intertemporal Price Discrimination Once this market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand This can be seen graphically looking at two different groups of consumers – one willing to buy right now and one willing to wait

39 ©2005 Pearson Education, Inc. Chapter 1139 Intertemporal Price Discrimination Quantity AC = MC $/Q Over time, demand becomes more elastic and price is reduced to appeal to the mass market. MR 2 D 2 = AR 2 Q2Q2 P2P2 D 1 = AR 1 MR 1 P1P1 Q1Q1 Initially, demand is less elastic, resulting in a price of P 1.

40 ©2005 Pearson Education, Inc. Chapter 1140 Other Types of Price Discrimination Peak-Load Pricing Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be higher Demand for some products may peak at particular times Rush hour traffic Electricity - late summer afternoons Ski resorts on weekends

41 ©2005 Pearson Education, Inc. Chapter 1141 Peak-Load Pricing Objective is to increase efficiency by charging customers close to marginal cost Increased MR and MC would indicate a higher price Total surplus is higher because charging close to MC Can measure efficiency gain from peak-load pricing

42 ©2005 Pearson Education, Inc. Chapter 1142 Peak-Load Pricing With third-degree price discrimination, the MR for all markets was equal MR is not equal for each market because one market does not impact the other market with peak-load pricing Price and sales in each market are independent Ex: electricity, movie theaters

43 ©2005 Pearson Education, Inc. Chapter 1143 MR 1 D 1 = AR 1 MC Peak-Load Pricing P1P1 Q1Q1 Quantity $/Q MR 2 D 2 = AR 2 Q2Q2 P2P2 MR=MC for each group. Group 1 has higher demand during peak times.

44 ©2005 Pearson Education, Inc. Chapter 1144 How to Price a Best-Selling Novel How would you arrive at the price forthe initial release of the hardbound edition of a book? Hardback and paperback books are ways for the company to price discriminate How does the company determine what price to sell the hardback and paperback books for? How does the company determine when to release the paperback?

45 ©2005 Pearson Education, Inc. Chapter 1145 How to Price a Best-Selling Novel Company must divide consumers into two groups: Those willing to buy the more expensive hardback Those willing to wait for the paperback Have to be strategic about when to release paperback after hardback Publishers typically wait 12 to 18 months

46 ©2005 Pearson Education, Inc. Chapter 1146 How to Price a Best-Selling Novel Publishers must use estimates of past books to determine how much to sell a new book for Hard to determine the demand for a NEW book New books are typically sold for about the same price, to take this into account Demand for paperbacks is more elastic so we should expect it to be priced lower

47 ©2005 Pearson Education, Inc. Chapter 1147 The Two-Part Tariff Form of pricing in which consumers are charged both an entry and usage fee Ex: amusement park, golf course, telephone service A fee is charged upfront for right to use/buy the product An additional fee is charged for each unit the consumer wishes to consume Pay a fee to play golf and then pay another fee for each game you play

48 ©2005 Pearson Education, Inc. Chapter 1148 The Two-Part Tariff Pricing decision is setting the entry fee (T) and the usage fee (P) Choosing the trade-off between free- entry and high-use prices or high-entry and zero-use prices Single Consumer Assume firm knows consumer demand Firm wants to capture as much consumer surplus as possible

49 ©2005 Pearson Education, Inc. Chapter 1149 Usage price P* is set equal to MC. Entry price T* is equal to the entire consumer surplus. Firm captures all consumer surplus as profit. T* Two-Part Tariff with a Single Consumer Quantity $/Q MC P* D

50 ©2005 Pearson Education, Inc. Chapter 1150 Two-Part Tariff with Two Consumers Two consumers, but firm can only set one entry fee and one usage fee Will no longer set usage fee equal to MC Could make entry fee no larger than CS of consumer with smallest demand Firm should set usage fee above MC Set entry fee equal to remaining consumer surplus of consumer with smaller demand Firm needs to know demand curves

51 ©2005 Pearson Education, Inc. Chapter 1151 D 2 = consumer 2 D 1 = consumer 1 Q1Q1 Q2Q2 The price, P*, will be greater than MC. Set T* at the surplus value of D 2. Two-Part Tariff with Two Consumers Quantity $/Q MC B C A T*

52 ©2005 Pearson Education, Inc. Chapter 1152 The Two-Part Tariff with Many Consumers No exact way to determine P* and T* Must consider the trade-off between the entry fee T* and the use fee P* Low entry fee: more entrants and more profit from sales of item As entry fee becomes smaller, number of entrants is larger and profit from entry fee will fall

53 ©2005 Pearson Education, Inc. Chapter 1153 The Two-Part Tariff with Many Consumers To find optimum combination, choose several combinations of P and T Find combination that maximizes profit Firms profit is divided into two components Each is a function of entry fee, T assuming a fixed sales price, P

54 ©2005 Pearson Education, Inc. Chapter 1154 Two-Part Tariff with Many Different Consumers T Profit :entry fee :sales T* Total profit is the sum of the profit from the entry fee and the profit from sales. Both depend on T.

55 ©2005 Pearson Education, Inc. Chapter 1155 The Two-Part Tariff Rule of Thumb Similar demand: Choose P close to MC and high T Dissimilar demand: Choose high P and low T Ex: Disneyland in California and Disney world in Florida have a strategy of high entry fee and charge nothing for ride

56 ©2005 Pearson Education, Inc. Chapter 1156 The Two-Part Tariff With a Twist Entry price (T) entitles the buyer to a certain number of free units Gillette razors sold with several blades Amusement park admission comes with some tokens On-line fees with free time Can set higher entry fee without losing many consumers Higher entry fee captures either surplus without driving them out of the market Captures more surplus of large customers

57 ©2005 Pearson Education, Inc. Chapter 1157 Polaroid Cameras In 1971, Polaroid introduced the SX-70 camera Polaroid was able to use two-part tariff for pricing of camera/film Allowed them greater profits than would have been possible if camera used ordinary film Polaroid had a monopoly on cameras and film

58 ©2005 Pearson Education, Inc. Chapter 1158 Polaroid Cameras Buying camera is like entry fee Unlike an amusement park, for example, the marginal cost of providing an additional camera is significantly greater than zero It was necessary for Polaroid to have monopoly If ordinary film could be used, the price of film would be close to MC Polaroid needed to gain most of its profits from sale of film

59 ©2005 Pearson Education, Inc. Chapter 1159 Polaroid Cameras Analytical framework:

60 ©2005 Pearson Education, Inc. Chapter 1160 Polaroid Cameras In the end, the film prices were significantly above marginal cost There was considerable heterogeneity of consumer demands

61 ©2005 Pearson Education, Inc. Chapter 1161 Cellular Rate Plans In most areas in US, consumers can choose cellular providers: Verizon, Cingular, AT&T and Sprint Market power exists because consumers face switching costs When they sign up with a firm, they must sign a contract with high costs to break Plans often exist of monthly cost plus fee extra minutes Companies can combine third-degree price discrimination with two-part tariff

62 ©2005 Pearson Education, Inc. Chapter 1162 Cellular Rate Plans

63 ©2005 Pearson Education, Inc. Chapter 1163 Cellular Rate Plans

64 ©2005 Pearson Education, Inc. Chapter 1164 Bundling Bundling is packaging two or more products to gain a pricing advantage Conditions necessary for bundling Heterogeneous customers Price discrimination is not possible Demands must be negatively correlated

65 ©2005 Pearson Education, Inc. Chapter 1165 Bundling When film company leased Gone with the Wind, it required theaters to also lease Getting Gerties Garter Why would a company do this? Company must be able to increase revenue We can see the reservation prices for each theater and movie

66 ©2005 Pearson Education, Inc. Chapter 1166 Bundling Renting the movies separately would result in each theater paying the lowest reservation price for each movie: Maximum price Wind = $10,000 Maximum price Gertie = $3,000 Total Revenue = $26,000 Gone with the Wind Getting Gerties Garter Theater A$12,000$3,000 Theater B$10,000$4,000

67 ©2005 Pearson Education, Inc. Chapter 1167 Bundling If the movies are bundled: Theater A will pay $15,000 for both Theater B will pay $14,000 for both If each were charged the lower of the two prices, total revenue will be $28,000 The movie company will gain more revenue ($2000) by bundling the movie

68 ©2005 Pearson Education, Inc. Chapter 1168 Relative Valuations More profitable to bundle because relative valuation of two films are reversed Demands are negatively correlated A pays more for Wind ($12,000) than B ($10,000) B pays more for Gertie ($4,000) than A ($3,000)

69 ©2005 Pearson Education, Inc. Chapter 1169 Relative Valuations If 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 Garter Theater A$12,000$4,000 Theater B$10,000$3,000

70 ©2005 Pearson Education, Inc. Chapter 1170 Bundling If the movies are bundled: Theater A will pay $16,000 for both Theater B will pay $13,000 for both If each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films separately

71 ©2005 Pearson Education, Inc. Chapter 1171 Bundling Bundling Scenario: Two different goods and many consumers Many consumers with different reservation price combinations for two goods Can show graphically the preferences of consumers in terms of reservation prices and consumption decisions given prices charged r 1 is reservation price of consumer for good 1 r 2 is reservation price of consumer for good 2

72 ©2005 Pearson Education, Inc. Chapter 1172 Reservation Prices r2r2 r1r1 $6 $3.25 Consumer A $10 Consumer C $8.25 $3.25 Consumer B For example, Consumer A is willing to pay up to $3.25 for good 1 and up to $6 for good 2.

73 ©2005 Pearson Education, Inc. Chapter 1173 Consumption Decisions When Products are Sold Separately r2r2 r1r1 P2P2 II Consumers buy only Good 2 P1P1 Consumers fall into four categories based on their reservation price. I Consumers buy both goods III Consumers buy neither good IV Consumers buy only Good 1

74 ©2005 Pearson Education, Inc. Chapter 1174 Consumption Decisions When Products are Bundled r2r2 r1r1 Consumers buy the bundle when r 1 + r 2 > P B (P B = bundle price). P B = r 1 + r 2 or r 2 = P B - r 1 Region 1: r > P B Region 2: r < P B r 2 = P B - r 1 I Consumers buy bundle (r > P B ) II Consumers do not buy bundle (r < P B )

75 ©2005 Pearson Education, Inc. Chapter 1175 Consumption Decisions When Products are Bundled The effectiveness of bundling depends upon the degree of negative correlation between the two demands Best when consumers who have high reservation price for Good 1 have a low reservation price for Good 2 and vice versa Can see graphically looking at positively and negatively correlated prices

76 ©2005 Pearson Education, Inc. Chapter 1176 Reservation Prices r2r2 r1r1 P2P2 P1P1 If the demands are perfectly positively correlated, the firm will not gain by bundling. It would earn the same profit by selling the goods separately.

77 ©2005 Pearson Education, Inc. Chapter 1177 Reservation Prices r2r2 r1r1 If the demands are perfectly negatively correlated, bundling is the ideal strategy – all the consumer surplus can be extracted and a higher profit results.

78 ©2005 Pearson Education, Inc. Chapter 1178 Movie Example r2r2 r1r1 Bundling pays due to negative correlation. ( Wind ) (Gertie) 5,000 14,000 10,000 5,000 10,000 12,000 4,000 3,000 B A

79 ©2005 Pearson Education, Inc. Chapter 1179 Mixed Bundling Practice of selling two or more goods both as a package and individually This differs from pure bundling when products are sold only as a package Mixed bundling is good strategy when Demands are somewhat negatively correlated Marginal production costs are significant

80 ©2005 Pearson Education, Inc. Chapter 1180 Mixed Bundling – Example Demands are perfectly negatively correlated but significant marginal costs Four customers under three different strategies Selling good separately, P 1 = $50, P 2 = $90 Selling goods only as a bundle, P B = $100 Mixed bundling: Sold individually with P 1 = P 2 = $89.95 Sold as a bundle with P B = $100

81 ©2005 Pearson Education, Inc. Chapter 1181 Mixed Bundling – Example We can see the effects under different scenarios in the following table:

82 ©2005 Pearson Education, Inc. Chapter 1182 Mixed Versus Pure Bundling r1r1 102030405060708090100 r2r2 10 20 30 40 50 60 70 80 90 100 C 2 = MC 2 C 2 = 30 For each good, marginal production cost exceeds reservation price of one consumer. A and D will buy individually B and C will buy bundle A B D C C 1 = MC 1 C 1 = 20 With positive marginal costs, mixed bundling may be more profitable than pure bundling.

83 ©2005 Pearson Education, Inc. Chapter 1183 Bundling If MC is zero, mixed bundling can still be more profitable if consumer demands are not perfectly negatively correlated Example: Reservation prices for consumers B and C are higher Compare the same three strategies Mixed bundling is the more profitable option since everyone will end up buying

84 ©2005 Pearson Education, Inc. 84 Mixed Bundling with Zero Marginal Costs A and D purchase individually. B and C purchase bundled. Profits are highest with mixed bundling. r1r1 204060801001201090 r2r2 20 40 60 80 100 120 10 90 C A D B

85 ©2005 Pearson Education, Inc. Chapter 1185 Bundling in Practice Car purchasing Bundles of options such as electric locks with air conditioning Vacation Travel Bundling hotel with air fare Cable television Premium channels bundled together

86 ©2005 Pearson Education, Inc. Chapter 1186 Bundling Mixed Bundling in Practice Use of market surveys to determine reservation prices Design a pricing strategy from the survey results Can show graphically using information collected from consumers Consumers are separated into four regions Can change prices to find max profits

87 ©2005 Pearson Education, Inc. Chapter 1187 Mixed Bundling in Practice r2r2 r1r1 The firm can first choose a price for the bundle and then try individual prices P 1 and P 2 until total profit is roughly maximized. P2P2 PBPB PBPB P1P1

88 ©2005 Pearson Education, Inc. Chapter 1188 A Restaurants Pricing Problem

89 ©2005 Pearson Education, Inc. Chapter 1189 Tying The practice of requiring a customer to purchase one good in order to purchase another Xerox machines and the paper IBM mainframe and computer cards Allows firm to meter demand and practice price discrimination more effectively

90 ©2005 Pearson Education, Inc. Chapter 1190 Tying Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy user McDonalds Allows them to protect their brand name Microsoft Uses to extend market power

91 ©2005 Pearson Education, Inc. Chapter 1191 Advertising Firms with market power have to decide how much to advertise We can show how firms choose profit maximizing advertising Decision depends on characteristics of demand for firms product

92 ©2005 Pearson Education, Inc. Chapter 1192 Advertising Assumptions Firm sets only one price for product Firm knows quantity demanded depends on price and advertising expenditure dollars, A Q(P,A) We can show the firms cost curves, revenue curves, and profits under advertising and no advertising

93 ©2005 Pearson Education, Inc. Chapter 1193 AR and MR are average and marginal revenue when the firm doesnt advertise. If the firm advertises, its average and marginal revenue curves shift to the right -- average costs rise, but marginal cost does not. Effects of Advertising Quantity $/Q Q1Q1 P1P1 AC Q0Q0 P0P0 AR MR AC MR MC AR

94 ©2005 Pearson Education, Inc. Chapter 1194 Advertising Choosing Price and Advertising Expenditure

95 ©2005 Pearson Education, Inc. Chapter 1195 Advertising A Rule of Thumb for Advertising

96 ©2005 Pearson Education, Inc. Chapter 1196 Advertising A Rule of Thumb for Advertising

97 ©2005 Pearson Education, Inc. Chapter 1197 Advertising A Rule of Thumb for Advertising To maximize profit, the firms advertising-to- sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand

98 ©2005 Pearson Education, Inc. Chapter 1198 Advertising An Example R(Q) = $1 million/yr $10,000 budget for A (advertising--1% of revenues) E A =.2 (increase budget $20,000, sales increase by 20%) E P = -4 (markup price over MC is substantial)

99 ©2005 Pearson Education, Inc. Chapter 1199 Advertising The firm in our example should increase advertising A/PQ = -(2/-.4) = 5% Increase budget to $50,000

100 ©2005 Pearson Education, Inc. Chapter 11100 Advertising – In Practice Estimate the level of advertising for each of the firms Supermarkets E P = -10; E A = 0.1 to 0.3 Convenience stores E P = -5; E A very small Designer jeans E P = -3 to –4; E A = 0.3 to 1 Laundry detergents E P = -3 to –4; E A very large

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