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PRICING WITH MARKET POWER II. Overview Two-part tariff Bundling Tying.

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Presentation on theme: "PRICING WITH MARKET POWER II. Overview Two-part tariff Bundling Tying."— Presentation transcript:

1 PRICING WITH MARKET POWER II

2 Overview Two-part tariff Bundling Tying

3 Meaning of Two-Part Tariff The purchase of some products and services can be separated into two decisions, and therefore, two prices. Examples 1)Amusement Park Pay to enter Pay for rides and food within the park 2)Tennis Club Pay to join Pay to play Pricing decision is setting the entry fee (T) and the usage fee (P), thus choosing the trade-off between free-entry and high use prices, or high-entry and zero use prices

4 Usage price P* is set where MC = D. Entry price T* is equal to the entire consumer surplus. How do you find out T* ? T* Two-Part Tariff with a Single Consumer Quantity $/Q MC P* D

5 D 2 = consumer 2 D 1 = consumer 1 Two-Part Tariff with Two Consumers Quantity $/Q MC Q1Q1 Q2Q2 The price, P*, will be greater than MC. Set T* at the surplus value of D 2. T* P* Thus there is a trade-off between high entry fee & high user price A C Π=2T*+(P*-MC).(Q1+Q2)>ΔABC B

6 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=> High sales revenue, but less entry, –Low price=> More use, but falling profit with lower price. To find optimum combination, choose several combinations of P and T Choose the combination that maximizes profit Rule of Thumb –Similar demand: Choose P close to MC and high T –Dissimilar demand: Choose high P and low T.

7 Two-Part Tariff with Many Different Consumers (choosing T) 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.

8 Two-Part Tariff with many different Consumers (choosing n, alternatively) Optimum two-part tariff that globally maximizes profits is attained at The optimum is achieved where the vertical sum (curve not shown) of П A and П S reaches the maximum.

9 Two-Part Tariff With A Twist Suppose, entry price (T) entitles the buyer to a certain number of free units Gillette razors with several blades Amusement parks with some tokens On-line with free time

10 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

11 Bundling Example With Two Consumers (theaters A-B) Spiderman Spaceballs Theater A$12,000$3,000 Theater B$10,000$4,000 Renting the movies separately would result in each theater paying the lowest reservation price for each movie –Total Revenue = $26,000 If the movies are bundled and if each were charged the lower of the two prices –Total revenue will be $28,000. Reservation Price

12 Bundling Example With Two Consumers – Importance of Negative Correlation of Demands 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 If the movies are bundled and if each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films, separately.

13 Bundling Example With Two Heterogeneous Goods and Many Consumers r 2 (reservation price Good 2) r 1 (reservation price Good 1) $5 $10 $5$10 $6 $3.25$8.25 $3.25 Consumer A Consumer C Consumer B Each consumer represented by a dot – A, B, C. Consumer A is willing to pay up to $3.25 for good 1 and up to $6 for good 2.

14 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 P (P 1, P 2 ) Two sets of choice involved: (i) Whether to choose P further up inside I or further down inside III – i.e., choice of intercept of intercept of a straight line; (ii) Whether to swing the line to capture more customers from one quadrant or the other – i.e., from II and IV (thus involving choice of slope of the line)

15 Consumption Decisions When Products are Bundled r2r2 r1r1 r 2 = P B - r 1 I II Consumers buy bundle (r > P B ) Consumers do not buy bundle (r < P B ) Consumers compare the sum of their reservation prices, r 1 + r 2, with the bundle price P B. They buy the bundle only if r 1 + r 2 is at least as large as P B.

16 Consumption Decisions When Products are Bundled Depending on the prices, some of the consumers in regions II and IV might have bought one of the goods if they were sold separately. These customers are lost to the firm. However, the other customers in regions II and IV now buy both goods where they formerly bought only one. The firm then, must decide whether it can do better by bundling. Buyers who buy neither good Buyers of good 1 lost to the firm Buyers of good 1 who now buy good 2 also Buyers of good 2 lost to the firm Buyers of good 2 who now buy good 1 also Buyers who buy both the goods

17 Efficiency of Bundling Depends on the Degree of Negative Correlation r2r2 r1r1 Bundling pays due to negative correlation (Spaceballs) (Spiderman) 5,000 14,000 10,000 5,000 10,000 12,000 4,000 3,000 B A

18 Mixed Versus Pure Bundling r2r2 r1r1 102030405060708090100 10 20 30 40 50 60 70 80 90 100 C 2 = MC 2 = 30 Consumer A, for example, has a reservation price for good 1 that is below marginal cost c 1. With mixed bundling, consumer A is induced to buy only good 2, while consumer D is induced to buy only good 1, reducing the firms cost. A B D C C 1 = MC 1 = 20 With positive marginal costs, mixed bundling may be more profitable than pure bundling. Is MC>0 sufficient condition for mixed bundling to dominate?

19 Sell separately$80$80----$320 Pure bundling--------$100$400 Mixed bundling$90$90$120$420 P1P1 P2P2 PBPB Profit Mixed Bundling with Zero Marginal Costs Is MC>0 sufficient condition for mixed bundling to dominate?

20 Mixed Bundling with Zero Marginal Costs r2r2 r1r1 20406080100 20 40 60 80 100 120 In this example, consumers B and C are willing to pay $20 more for the bundle than are consumers A and D. With mixed bundling, the price of the Bundle can be increased to $120. A & D can be charged $90 for a single good. C 1090 10 90 A B D

21 Mixed Bundling in Practice Use of market surveys to determine reservation prices Design a pricing strategy from the survey results Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.

22 Tying Practice of requiring a customer to purchase one good in order to purchase another. Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy user Examples: –Xerox machines and the paper –IBM mainframe and computer cards –Renting out tractor along with driver –Rural moneylenders providing credit against sale of output and/or input purchase (even land leasing-in) contract Is tying necessarily exploitative?


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