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Finance 30210: Managerial Economics Competitive Pricing Techniques

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Once production decisions have been made, a firm can be represented by its cost function Total costs of production are a function of quantity produced $ MC An increase in production increased total costs by $1.50 For pricing decisions, we focus on marginal cost

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Next, we need to know something about the demand the firm faces. Demand refers to quantity as a function of price Inverse demand refers to price as a function of quantity

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Now, the firm takes its costs and consumer as given and chooses a quantity (or price) to maximize profits Your price will be influenced by your sales target Your costs will be influenced by your production levels Total Revenues equal price times quantity Total Costs Profits

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First Order Necessary Conditions Marginal Cost (MC) Firms are choosing a sales target to maximize profits Marginal Revenue (MR)

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D Initially, you have chosen a price (P) to charge and are making Q sales. Total Revenues = PQ Suppose that you want to increase your sales. What do you need to do?

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D Your demand curve will tell you how much you need to lower your price to reach one more customer 1 This area represents the revenues that you lose because you have to lower your price to existing customers This area represents the revenues that you gain from attracting a new customer

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If we are maximizing profits, we want marginal revenues to equal marginal costs: Firms will be charging a markup over marginal cost where the markup is related to the elasticity of demand

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Market Structure Spectrum Perfect Competition Monopoly One Producer Supplies the entire Market The market is supplied by many producers – each with zero market share Firm Level Demand DOES NOT equal industry demand Firm Level Demand EQUALS industry demand

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Suppose there is a monopolist that faces the following demand Further, the monopoly has a linear cost function D $40 20 Can this firm do better?

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First, to increase sales by one, by how much does this firm have to lower its price? D $40 20 A $0.50 price drop would increase sales by one 21 $ $.50*20 = -$10 Again, this is a loss because we lowered our price to our existing customers! (1)($39.50) The additional sale! MR = $29.50 MC = $10 We should lower price!

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Suppose there is a monopolist that faces the following demand Further, this monopolist has a cost function given by Marginal Cost

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D MR = 50-Q MC=$

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D MR MC The markup formula works!

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Now, suppose this market is serviced by a large number of identical firms – each with marginal costs equal to $10 D D Industry Firm Level Lowest price among firm is competitors

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Is it possible for D D IndustryFirm Level $10 Profit > 0 As long as price is above marginal cost, there is an incentive for each firm to undercut its rivals. This incentive disappears when price equals marginal cost.

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Competitive Market equilibrium D D IndustryFirm Level Profit = 0 As long as price is above marginal cost, there is an incentive for each firm to undercut its rivals. This incentive disappears when price equals marginal cost. S$10

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Perfectly competitive firms face demand curves that are perfectly elastic (infinite elasticity. Hence, the markup (and profits) are zero) D Firm Level D MC Industry Note: Industry elasticities in competitive industries are always less than 1 (industry profits could be increased by raising price!)

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Measuring Market Structure – Concentration Ratios Suppose that we take all the firms in an industry and ranked them by size. Then calculate the cumulative market share of the n largest firms. Size Rank Cumulative Market Share A B C

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Measuring Market Structure – Concentration Ratios Size Rank Cumulative Market Share A B C Measures the cumulative market share of the top four firms

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Concentration Ratios in US manufacturing; Year Aggregate manufacturing in the US hasnt really changed since WWII

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Measuring Market Structure: The Herfindahl-Hirschman Index (HHI) = Market share of firm i RankMarket Share HHI = 2,000

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Cumulative Market Share A B HHI = 500 HHI = 1,000 The HHI index penalizes a small number of total firms

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Cumulative Market Share A B HHI = 500 HHI = 555 The HHI index also penalizes an unequal distribution of firms

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Concentration Ratios in For Selected Industries IndustryCR(4)HHI Breakfast Cereals Automobiles Aircraft Telephone Equipment Womens Footwear50795 Soft Drinks47800 Computers & Peripherals37464 Pharmaceuticals32446 Petroleum Refineries28422 Textile Mills1394

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Another way to measure competition is by the outcome. The Lerner index measures the percentage of a products price that is due to the markup Perfect CompetitionMonopoly

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Lerner index in For Selected Industries IndustryLI Communication.972 Paper & Allied Products.930 Electric, Gas & Sanitary Services.921 Food Products.880 General Manufacturing.777 Furniture.731 Tobacco.638 Apparel.444 Motor Vehicles.433 Machinery.300

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Consider the Following Two Industries Canned Fruits/Vegetables (SIC 2033) $15B in Annual Sales 500 Firms CR4 = 27, CR8 = 42 HHI = 300 LI =.243 Canned Specialty Foods (SIC 2032) $6B in Annual Sales 200 Firms CR4 = 69, CR8 = 84 HHI = 2000 LI =.446

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Market Size and Market Structure Costs MC AC If market size is small, this industry experiences decreasing costs (big firms have an advantage over small firms) However, if the industry gets big enough, costs start to increase and the size advantage becomes a disadvantage!

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Consider the Following Two Industries Pharmaceutical Preparations (SIC 2834) $50B in Annual Sales 583 Firms CR4 = 26, CR8 = 42 HHI = 341 Aircraft (SIC 3721) $65B in Annual Sales 151 Firms CR4 = 79, CR8 = 93 HHI = 2717

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Globally scale economies Costs MC AC Costs MC AC Industries with globally scale economies tend to develop as natural monopolies (the market should – and will – be serviced by one producer). This can happen if production exhibits increasing marginal productivity, or if there are large fixed costs.

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Monopoly Market Characteristics Small market size Scale economies (Network Externalities, Learning by Doing, Large Fixed Costs) Government Policy (Protected Monopolies) Any one of these characteristics suggest that the market structure could be monopolistic.

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Long Run Industry Dynamics As an industry ages, three things happen…. D Short Run D Long Run As more alternatives become available, consumer demand becomes much more price responsive

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Long Run Industry Dynamics As an industry ages, three things happen…. MC Short Run MC Long Run As production techniques become more flexible, marginal costs drop and become much less sensitive to input prices

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Long Run Industry Dynamics As an industry ages, three things happen…. Market Structure Spectrum Perfect Competition (Long Run) Monopoly (Short Run) As new firms enter the industry (i.e. no artificial or natural barriers), the industry becomes more competitive and markups fall

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Most firms face the a downward sloping market demand and therefore must lower its price to increase sales. D Loss from charging existing customers a lower price Gain from attracting new customers Is it possible to attract new customers without lowering your price to everybody?

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Price Discrimination D $15 $ If this monopolist could lower its price to the 21 st customer while continuing to charge the 20 th customer $15, it could increase profits. Requirements: Identification No Arbitrage

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Price Discrimination (Group Pricing) Suppose that you are the publisher for JK Rowlings newest book Harry Potter and the Deathly Hallows Your marginal costs are constant at $4 per book and you have the following demand curves: US Sales European Sales

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D $36 9 D $24 6 D $36 15 $24 3 European Market US Market Worldwide $24 3 If you dont have the ability to sell at different prices to the two markets, then we need to aggregate these demands into a world demand.

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$36 15 $24 3 $12 $18 DMR

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$ DMR MC 6.5 $17 $4

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If you can distinguish between the two markets (and resale is not a problem), then you can treat them separately. D 9 US Market MC MR 4 $20

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If you can distinguish between the two markets (and resale is not a problem), then you can treat them separately. D 6 European Market MC MR 2.5 $14

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D 9 MC MR 4 D 6 MC MR 2.5 $14 European Market US Market Price Discrimination (Group Pricing) $20

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Suppose you operate an amusement park. You know that you face two types of customers (Young and Old). You have estimated their demands as follows: Old Young You have a a constant marginal cost of $2 per ride Can you distinguish low demanders from high demanders? Can you prevent resale?

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D 49 D 39 $41 Old Young $51 $100 $80 If you could distinguish each group and prevent resale, you could charge different prices

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$ $80 20 $60 $70 DMR First, lets calculate a uniform price for both consumers 90 Two Part Pricing

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$ DMR MC 88 $46 $2

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D 54 D 34 $46 Old Young First, you set a price for everyone equal to $46. Young people choose 54 rides while old people choose 34 rides. $46 $100 $80 Can we do better than this?

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D Note that the young consumer pays $46 for the 54 th ride. However, she was willing to pay more than $46 for all the previous rides. We call this consumer surplus. $46 54 $55 45 This consumer would have paid up to $55 for the 45 th ride. If the going market price was $46, consumer surplus for the 45 th ride would have been $9.

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D 54 $46 $100 The young person paid a total of $2,484 for the 54 rides. However, this consumer was willing to pay $3942. $2,484 $1,458 How can we extract this extra money?

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D 54 D 34 $46 Old Young Two Part pricing involves setting an entry fee as well as a per unit price. In this case, you could set a common per ride fee of $46, but then extract any remaining surplus from the consumers by setting the following entry fees. $46 $100 $80 $1458 $578 Entry Fee = $1458 Young $578 Old Could you do better than this? P = $46/Ride $2484 $1564

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D 98 D 78 $2 Old Young Suppose that you set the cost of the rides at their marginal cost ($2). Both old and young people would use more rides and, hence, have even more surplus to extract via the fee. $2 $100 $80 $4802 $3042 Entry Fee = $4802 Young $3042 Old P = $2/Ride

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D 98 D 78 $2 OldYoung $2 $100 $80 $4802 $3042 Block Pricing involves offering packages. For example: Geezer Pleaser: Entry + 78 Ride Coupons (1 coupon per ride): $3198 Standard Admission: Entry + 98 Ride Coupons (1 coupon per ride): $4998 $2(98) = $196$2(78) = $156 ($4802 +$196) ($3042 +$156)

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Suppose that you couldnt distinguish High value customers from low value customers: Would this work? 1 Ticket Per Ride 78 Ride Coupons: $ Ride Coupons: $4998 D 98 D 78 $2 OldYoung $2 $100 $80 $4802 $3042 $2(98) = $196$2(78) = $156

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78 $22 $100 We know that is the high value consumer buys 98 ticket package, all her surplus is extracted by the amusement park. How about if she buys the 78 Ride package? $3042 $1716 If the high value customer buys the 78 ride package, she keeps $1560 of her surplus! 78 Ride Coupons: $3198 Total Willingness to pay for 78 Rides: $4758 $1560 -

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D 98 $2 $100 You need to set a price for the 98 ride package that is incentive compatible. That is, you need to set a price that the high value customer will self select. (i.e., a package that generates $1560 of surplus) $196 $4802 Total Willingness = $4,998 - Required Surplus = $1,560 Package Price = $3,438 This is known as Menu Pricing

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1 Ticket Per Ride 78 Ride: $3198 ($41/Ride) 98 Rides: $3438 ($35/Ride) Menu Pricing: You cant distinguish high demand from low demand (2 nd Degree Price Discrimination) Block Pricing: You can distinguish high demand and low demand (1 st Degree Price Discrimination) 1 Ticket Per Ride 78 Ride: $3198 ( $41/Ride) 98 Rides: $4998 ( $51/Ride) Group Pricing: You can distinguish high demand from low demand (3 rd Degree Price Discrimination) No Entry Fee Low Demanders: $41/Ride High Demanders: $51/Ride

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Bundling Suppose that you are selling two products. Marginal costs for these products are $100 (Product 1) and $150 (Product 2). You have 4 potential consumers that will either buy one unit or none of each product (they buy if the price is below their reservation value) ConsumerProduct 1Product 2Sum A$50$450$500 B$250$275$525 C$300$220$520 D$450$50$500

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If you sold each of these products separately, you would choose prices as follows PQTRProfit $4501 $350 $3002$600$400 $2503$750$450 $504$200-$200 PQTRProfit $4501 $300 $2752$550$250 $2203$660$210 $504$200-$400 Product 1 (MC = $100)Product 2 (MC = $150) Profits = $450 + $300 = $750

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ConsumerProduct 1Product 2Sum A$50$450$500 B$250$275$525 C$300$220$520 D$450$50$500 Pure Bundling does not allow the products to be sold separately Product 2 (MC = $150) Product 1 (MC = $100) With a bundled price of $500, all four consumers buy both goods: Profits = 4($500 -$100 - $150) = $1,000

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ConsumerProduct 1Product 2Sum A$50$450$500 B$250$275$525 C$300$220$520 D$450$50$500 Mixed Bundling allows the products to be sold separately Product 1 (MC = $100) Product 2 (MC = $150) Price 1 = $250 Price 2 = $450 Bundle = $500 Consumer A: Buys Product 2 (Profit = $300) or Bundle (Profit = $250) Consumer B: Buys Bundle (Profit = $250) Consumer C: Buys Product 1 (Profit = $150) Consumer D: Buys Only Product 1 (Profit = $150) Profit = $850 or $800

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ConsumerProduct 1Product 2Sum A$50$450$500 B$250$275$525 C$300$220$520 D$450$50$500 Mixed Bundling allows the products to be sold separately Product 1 (MC = $100) Product 2 (MC = $150) Price 1 = $450 Price 2 = $450 Bundle = $520 Consumer A: Buys Only Product 2 (Profit = $300) Consumer B: Buys Bundle (Profit = $270) Consumer C: Buys Bundle (Profit = $270) Consumer D: Buys Only Product 1 (Profit = $350) Profit = $1,190

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Tie-in Sales Suppose that you are the producer of laser printers. You face two types of demanders (high and low). You cant distinguish high from low. D 12 D 16 $12 $16 You have a monopoly in the printer market, but the toner cartridge market is perfectly competitive. The price of cartridges is $2 (equal to MC) – a toner cartridge is good for 1,000 printed pages. Quantity of printed pages (in thousands) Price for 1,000 printed pages

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Tie-in Sales You have already built 1,000 printers (the production cost is sunk and can be ignored). You are planning on leasing the printers. What price should you charge? D 12 D 16 $12 $16 10 $2 14 $50 $98 A monthly fee of $50 will allow you to sell to both consumers. Can you do better than this? Profit = $50*1000 = $50,000

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Tie-in Sales Suppose that you started producing toner cartridges and insisted that your lessees used your cartridges. Your marginal cost for the cartridges is also $2. How would you set up your pricing schedule? D $12 (Aggregate Demand)

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Tie-in Sales D 12 D 16 $12 $16 8 $4 12 $32 $72 By forcing tie-in sales. You can charge $4 per cartridge and then a monthly fee of $32. Profit = ($4 - $2)*(8 + 12) + 2($32) = $104*500 = $52,000

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Complementary Goods Suppose that the demand for Hot Dogs is given as follows: Price of a Hot Dog Price of a Hot Dog Bun Hot Dogs and Buns are made by separate companies – each has a monopoly in its own industry. For simplicity, assume that the marginal cost of production for each equals zero.

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Each firm must price their own product based on their expectation of the other firm Bun CompanyHot Dog Company Complementary Goods

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Each firm must price their own product based on their expectation of the other firm Bun CompanyHot Dog Company Substitute these quantities back into the demand curve to get the associated prices. This gives us each firms reaction function. Complementary Goods

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Any equilibrium with the two firms must have each of them acting optimally in response to the other. $4 $12 $6 $12 $6 Bun Company Hot Dog Company

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Now, suppose that these companies merged into one monopoly Complementary Goods

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Case Study: Microsoft vs. Netscape The argument against Microsoft was using its monopoly power in the operating system market to force its way into the browser market by bundling Internet Explorer with Windows 95. To prove its claim, the government needed to show: Microsoft did, in fact, possess monopoly power The browser and the operating system were, in fact, two distinct products that did not need to be integrated Microsofts behavior was an abuse of power that hurt consumers What should Microsofts defense be?

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Case Study: Microsoft vs. Netscape Suppose that the demand for browsers/operating systems is as follows (look familiar?). Again, Assume MC=0 Case #1: Suppose that Microsoft never entered the browser market – leaving Netscape as a monopolist.

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Case Study: Microsoft vs. Netscape Case #2: Now, suppose that Microsoft competes in the Browser market With competition (and no collusion) in the browser market, Microsoft and Netscape continue to undercut one another until the price of the browser equals MC ( =$0) Given the browsers price of zero, Microsoft will sell its operating system for $6

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Spatial Competition – Location Preferences When you purchase a product, you pay more than just the dollar cost. The total purchase cost is called your opportunity cost Consider two customers shopping for wine. One lives close to the store while the other lives far away. 20 miles 2 miles The opportunity cost is higher for the consumer that is further away. Therefore, if both customers have the same demand for wine, the distant customer would require a lower price.

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Spatial Competition – Location Preferences Starbucks currently has 5,200 locations in the US Gucci currently has 31 locations in the US How can we explain this difference?

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Consider a market with N identical consumers. Each has a demand given by We must include their travel time in the total price they pay for the product. The firm cant distinguish consumers and, hence, cant price discriminate. Dollar Price Distance to Store Travel Costs

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There is one street of length one. Suppose that you build one store in the middle. For simplicity, assume that MC = 0 X = 1 X = 1/2 With a price This is the marginal customer What fraction of the market will you capture? To capture the whole market, set x = 1/2

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Now, suppose you build two stores… X = 1 X = 1/4 With a priceWhat fraction of the market will you capture? To capture the whole market, set x = 1/4 X = 1/4

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Now, suppose you build three stores… X = 1 X = 1/6 With a priceWhat fraction of the market will you capture? To capture the whole market, set x = 1/6 X = 1/6 Do you see the pattern??

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With n stores, the price you can charge is As n gets arbitrarily large, p approaches V Further, profits are equal to Total SalesPrice Total Costs

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Maximizing Profits Number of locations is based on: Size of the market (N) Fixed costs of establishing a new location (F) Moving Costs (t)

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Horizontal Differentiation Baskin Robbins has 31 Flavors…how did they decide on 31? t = Consumer Pickiness N = Market size F = R&D costs of finding a new flavor

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