1. Competitive Pricing Techniques Finance 30210: Managerial Economics

2. Once production decisions have been made, a firm can be represented by it’s cost function Total costs of production are a function of quantity produced $1.50 56 MC An increase in production from 55 to 56 increased total costs by $1.50 For pricing decisions, we focus on marginal cost

3. We will be assuming that pricing decisions are being made to maximize current period profits Total Revenues equal price times quantity Total Costs (note that total costs here are economic costs. That is, we have already included a reasonable rate of return on invested capital given the risk in the industry) Profits

4. As with any economic decision, profit maximization involves evaluating every potential sale at the margin How do my profits change if I increase my sales by 1? How do my revenues change if I increase my sales by 1? (Marginal Revenues) How do my costs change if I increase my sales by 1? (Marginal Costs)

5. Q* MC As with any economic decision, profit maximization involves evaluating every potential sale at the margin MR>MC: Profits are increasing MR>MC: Profits are Decreasing MR=MC: Profits are Maximized Profit = Producer Surplus – Fixed Costs Producer Surplus MR

6. Recall that in a perfectly competitive world, price equals marginal revenue The market determines the equilibrium price Market Dollars 0 P* Demand Supply Q* Dollars 0 P* Firm Level The prevailing price (treated as a constant by each firm) becomes that firms marginal revenue MC MR Q Producer Surplus

7. Recall the characteristics we laid out for a competitive market #1: Many buyers and sellers – no individual buyer/firm has any real market power #2: Homogeneous products – no variation in product across firms #3: No barriers to entry – it’s costless for new firms to enter the marketplace #4: Perfect information – prices and quality of products are assumed to be known to all producers/consumers Can you think of situations where all these assumptions hold?

8. Market Structure Spectrum Perfect Competition Monopoly One Producer With 100% market share 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 When making pricing decisions, you need to be aware of what your market structure is

9. Measuring Market Structure – Concentration Ratios Suppose that we have the following three industries… Industry A 10 Firms in the industry, each with an equal 10% market share Industry B 22 Firms in the industry The two largest firms have 20% market share each The remaining 20 Firms have 3% market share each Industry C 8 Firms in the industry The 4 largest firms have 15% market share each The remaining 4 Firms have 10% market share each Which industry is the most competitive? Which is the least?

10. # of Firms 100 60 40 20 0 132456 0 72210 80 Cumulative Market Share 89 Let’s plot out the three industries and take a look…

11. Concentration ratios look at the cumulative market share of the N largest firms # of Firms 100 60 40 20 0 132456 0 72210 80 Cumulative Market Share 89 20 40 30 40 46 60 80 58 100 64 100

12. Concentration Ratios in US manufacturing; 1947 - 1997 Year 1947172330 1958233038 1967253342 1977243344 1987253343 1992243242 1997243240 Aggregate manufacturing in the US hasn’t really changed since WWII IndustryCR(4) Breakfast Cereals83 Automobiles80 Aircraft80 Telephone Equipment55 Women’s Footwear50 Soft Drinks47 Computers & Peripherals37 Pharmaceuticals32 Petroleum Refineries28 Textile Mills13 Concentration Ratios in US by Industry Concentration ratios vary significantly by industry!!

13. Measuring Market Structure: The Herfindahl-Hirschman Index (HHI) = Market share of firm i RankMarket Share 125625 225625 325625 4525 55 65 75 85 HHI = 2,000

14. Cumulative Market Share 100 80 40 20 0 132456 0 7 10 A B HHI = 500 HHI = 1,000 The HHI index penalizes a small number of total firms

15. Cumulative Market Share 100 80 40 20 0 132456 0 7 10 A B HHI = 500 HHI = 555 The HHI index also penalizes an unequal distribution of firms

16. # of Firms 100 60 40 20 0 132456 0 72210 80 Cumulative Market Share 89 = Market share of firm i

17. HHI Index in For Selected Industries IndustryHHI Breakfast Cereals2446 Automobiles2862 Aircraft2562 Telephone Equipment1061 Women’s Footwear795 Soft Drinks800 Computers & Peripherals464 Pharmaceuticals446 Petroleum Refineries422 Textile Mills94

18. In a monopolized market, the single firm in the market faces the industry demand curve Given the chosen quantity, industry demand determines price Market Dollars 0 P Demand Q Dollars 0 Individual The single firm in the market has profit maximized based off of where MR = MC MC Q MR Producer Surplus

19. In a world where firms have market power, they control their level of sales by setting their price. Suppose that you have the following demand curve (A relationship between price and quantity ): Total Sales Your listed price For example: If you were to set a price of $20, you can expect 60 sales

20. We could also talk about inverse demand (a relationship between quantity and price): For example: If you wanted to make 40 sales, you could set a $30 price A price that will hit that target Your target for sales

21. Either way, if we know price and total sales, we can calculate revenues Total Revenues =($30)(40) = $1200 Total Revenues = Price*Quantity Can we increase revenues past $1200 and, if so, how?

22. Either way, if we know price and total sales, we can calculate revenues Turns out lowering price was the right thing to do to raise revenues. Total Revenues =($35)(30) = $1050 Total Revenues =($25)(50) = $1250

23. 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?

24. D Your demand curve will tell you how much you need to lower your price to reach one more customer 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

25. D Your demand curve will tell you how much you need to lower your price to reach one more customer Revenues =($30)(40) = $1200 ($.50)(40) =$20 ($29.50)(1) =$29.50 $29.50 From additional sale -$20 loss from lowering price $9.50 increase in revenues Revenues =($29.50)(41) = $1209.50

26. An elasticity of demand that is greater than 1 in absolute value indicates that lowering price will increase revenues Total Revenues =($29.50)(41) = $1209.5 Total Revenues =($30)(40) = $1200 % Change in revenues =.80%.80%-1.70%2.5%

27. An elasticity of demand that is less than 1 in absolute value indicates that raising price will increase revenues Total Revenues =($10)(80) = $800 Total Revenues =($10.50)(79) = $829.50 % Change in revenues = 3.75% 3.75%5.00%-1.25%

28. Revenues are maximized when the elasticity of demand equals -1 Max Revenues Quantity = 50 Price =$25 Revenues = $1,250 Quantity = 50 Price =$25 Elasticity = -1 Elasticity is less than -1: raise price Elasticity is greater than -1: lower price

29. P = $30 MR = $9.50 Q = 40 P = $30 Revenues = ($30)(40) = $1200 Q = 41 P = $29.50 Revenues = ($29.50)(41) = $1209.50 Marginal Revenues = $9.50 Because you must lower your price to existing customers to attract new customers, marginal revenue will always be less than price

30. P MR P = $25 MR = MC = $0 Note that because we have ignored the cost side, we are assuming marginal costs are equal to zero! Revenues = $1250

31. Now, let’s bring in the cost side. For simplicity, lets assume that you face a constant marginal cost equal to $20 per unit. QuantityPriceTotal Revenue Marginal Revenue Total Cost Marginal Cost Profit 1$49.50 $20 $29.50 2$49$98$48.50$40$20$58 3$48.50$145.50$47.50$60$20$85.50 4$48$192$46.50$80$20$112 5$47.50$237.50$45.50$100$20$137.50 6$47$282$44.50$120$20$162 7$46.50$325.50$43.50$140$20$185.50 Continuing on down… 29$35.50$1029.50$21.50$580$20$449.50 30$35$1050$20.50$600$20$450 31$34.50$1069.50$19.50$620$20$449.50

32. Slope = 20 Profits = $450 A profit maximizing price sets marginal revenue equal to marginal cost. Marginal revenue is the change in total revenue (i.e. the slope)

33. P = $35 Profit = ($35-$20)*30 = $450 Price = $35 Quantity = 30 Elasticity = -2.36 A profit maximizing price sets marginal revenue equal to marginal cost

34. D A profit maximizing strategy equates marginal revenues with marginal costs… Marginal Revenue Firm’s will be charging a markup over marginal cost where the markup is related to the elasticity of demand

35. P = $35 Profit = ($35-$20)*30 = $450 Price = $35 Quantity = 30 Elasticity = -2.36 A profit maximizing price sets marginal revenue equal to marginal cost This is not a coincidence. A monopoly sets a markup that is inversely proportional to the elasticity of demand!

36. Markups 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 Suppose that we assumed the automobile industry were monopolized… So, a 1% increase in automobile prices will lower sales by 2.3%

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

38. 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? You need to be able to identify customer types and prevent resale!!

39. Dollars 0 $40 40,000 Let’s suppose that Notre dame has identified three different consumer types for Notre Dame football tickets. Further, assume that Notre Dame has a marginal cost of $20 per ticket. $120 $80 70,00080,000 Alumni Faculty Students If Notre Dame had to set one uniform price to everybody, what price would it set?

40. Dollars 0 $40 40,000 Let’s suppose that Notre dame has identified three different consumer types for Notre Dame football tickets. Further, assume that Notre Dame has a marginal cost of $20 per ticket. $120 $80 70,00080,000 Alumni Faculty Students PriceQuantityTotal RevenueTotal CostProfit $12040,000$4.8M$800,000$4.0M $8070,000$5.6M$1.4M$4.2M $4080,000$3.2M$1.6M $20MC

41. Dollars 0 $40 40,000 Now, suppose that Notre Dame can set up differential pricing. $120 $80 70,00080,000 Alumni Faculty Students PriceQuantityTotal Revenue Total CostProfit $12040,000$4.8M$400,000$4.4M $8030,000$2.4M$300,000$2.1M $4010,000$400,000$200,000 Total80,000$7.6M$900,000$6.7M $20MC Pricing Schedule Regular Price: $120 Faculty/Staff: $80 Student: $40 What would Notre Dame need to do to accomplish this?

42. Example: DVD codes are a digital rights management technique that allows film distributors to control content, release date, and price according to region. DVD coding allows for distributors to price discriminate by region.

43. Suppose that you are the pricing for the DVD release of Avatar Your marginal costs are constant at $4 and you have the following demand curves: US Sales European Sales + Total Sales

44. Here is what our aggregate demand looks like Quantity Price $24 $36 At a price above $24, Europeans aren’t buying. You only have the American market At a price below $24, we now have both markets. + 3

45. Option #1: We could charge a common price to everyone… Quantity Price $24 $36 3 Solve for inverse demand Calculate total revenues Equate marginal revenues to marginal costs $17 $4 6.5

46. Option #2: Why don’t we just charge them different prices? Quantity Price $20 4 Quantity Price $14 2.5 AmericaEurope $36 $24$80,000 $4

47. Why is movie theatre popcorn so expensive? Dollars 0200 $15 300 General Public Senior Citizens $8 This would be an easy price discrimination problem… Pricing Schedule Regular Price: $15 Senior Citizens: $8

48. Now, suppose that the identities are unknown? How can the theatre extract more money out of the avid moviegoer? Dollars 0200 $15 300 Avid Moviegoer Occasional Moviegoer $8 Ticket PricePopcorn PriceTotal Option #1$14$1$15 Option #2$8$7$15 Option #3$2$13$15 As long as the total price (popcorn + ticket) is $15 or less, avid moviegoers will still go Which pricing option would you choose?

49. Suppose that Disneyworld knows something about the average consumer’s demand for amusement park rides. Disneyworld has a constant marginal cost of $.02 per ride Dollars 0.50 Demand 50 Price (per ride)Quantity (rides) $10 $.991 $.982 $0100

50. As a first pass, we could solve for a profit maximizing price per ride Dollars 0.51 Demand 49 Price (per ride) Quantity (rides) Total Revenues Marginal Revenues Marginal Cost $10$0 $.991 $.02 $.982$1.96$.97$.02 $.5248$24.96$.05$.02 $.5149$24.99$.03$.02 $.5050$25$.01$.02 MC MR.02 Profit = $24.01

51. If all Disney does is charge a price per ride, they are leaving some money on the table Dollars 0.51 Demand 49 MC MR.02 Profit = $24.01 $1 CS = (1/2)($1-.51)*49 = $12.00 We are charging this person $24.01 for 49 rides when they would’ve $36.01!

52. Like the movie theatre, Disney has two prices to play with. We have a price per ride as well as an entry fee. For any price per ride, we can set the entry fee equal to the consumer surplus generated. Dollars 0 $P Demand Q MC.02 Profit = (P-.02)*Q $1 Fee = (1/2)($1-P)*Q Price (per ride) Quantity (rides) Ride Revenue Fee Revenue Total Revenues Marginal Revenues Marginal Cost $10$0 --- $.991 $.005$.995 $.02 $.982$1.96$.02$1.98$.985$.02 $.0397$2.91$47.05$49.96$.03$.02 98$1.96$48.02$49.98$.02 $.0199$.99$49$49.99$.01$.02 Total Profit = $48.02 We are still looking to where marginal revenues equal marginal costs.

53. The optimal pricing scheme here is to set a price per ride equal to marginal cost. We then set the entry fee equal to the consumer surplus generated. Dollars 0 Demand 98 MC.02 $1 Fee = (1/2)($1-.02)*98 = $48.02 Total Profit = $48.02 Pricing Schedule Entry Fee: $48.02 Price Per Ride: $.02 Or, we could combine the two Entry Fee: $48.02 + Ride Charges: $1.96 98 Ride Package = $49.98 Ride Revenue =.02*98 = $1.96

54. Dollars 0.51 Demand 49 MC MR.02 Profit = $24.01 $1 Now, suppose that we introduced two different clientele. Say, senior citizens and Non-seniors. We could discriminate based on price per ride (assume there is one of each type) Non-Seniors Dollars 0.41 Demand 39 MC MR.02 Profit = $15.21 $.80 Seniors Total Profit = $24.01 + $15.21 = $39.22

55. Alternatively, you set the cost of the rides at their marginal cost ($.02) for everybody and discriminate on the entry fee. Entry Fee = $48.02 Young $30.42 Old P = $.02/Ride Dollars 0 Demand 98 MC.02 $1 0 Demand 78 MC.02 $.80 Total Profit = $48.02 + $30.42 = $78.44 Fee = (1/2)($1-.02)*98 = $48.02 Fee = (1/2)($.80-.02)*78 = $30.42 Ride Revenue =.02*98 = $1.96Ride Revenue =.02*78 = $1.56 SeniorsNon-Seniors

56. Or, you could establish different package prices. Pricing Schedule= Regular Admission (98 rides): $49.98 Senior Citizen Special (78 Rides): $31.98 Dollars 0 Demand 98 MC.02 $1 0 Demand 78 MC.02 $.80 Total Price = $48.02 + $1.96 = $49.98 Fee = (1/2)($1-.02)*98 = $48.02 Fee = (1/2)($.80-.02)*78 = $30.42 Ride Revenue =.02*98 = $1.96Ride Revenue =.02*78 = $1.56 Total Price = $30.42 + $1.56 = $31.98 SeniorsNon-Seniors

57. Suppose that you couldn’t distinguish High value customers from low value customers: Would this work? Dollars 0 Demand 98 MC.02 $1 0 Demand 78 MC.02 $.80 Fee = (1/2)($1-.02)*98 = $48.02 Fee = (1/2)($.80-.02)*78 = $30.42 Ride Revenue =.02*98 = $1.96Ride Revenue =.02*78 = $1.56 Pricing Schedule= Regular Admission (98 rides): $49.98 “Early Bird” Special (78 Rides): $31.98

58. 78.22 $1 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? $30.42 $17.16 If the high value customer buys the 78 ride package, she keeps $15.60 of her surplus! 78 Ride Coupons: $31.98 Total Willingness to pay for 78 Rides: $47.58 $15.60 -

59. D 98 $.02 $1.00 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 $15.60 of surplus) $1.96 $48.02 Total Willingness = $49.98 - Required Surplus = $15.60 Package Price = $34.38 78 Ride Coupons: $31.98 98 Ride Coupons: $34.38

60. 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

61. 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

62. 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

63. 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

64. 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

65. ConsumerProduct 1Product 2Sum A$300$200$500 B$300$200$500 C$300$200$500 D$300$200$500 Product 1 (MC = $100) Product 2 (MC = $150) Bundling is only Useful When there is variation over individual consumers with respect to the individual goods, but little variation with respect to the sum!? Individually Priced: P1 = $300, P2 = $200, Profit = $1,000 Pure Bundling: PB = $500, Profit = $1,000 Mixed Bundling: P1 = $300, P2 = $200, PB = $500, Profit = $1,000

66. Suppose that you sell laser printers. To create printed pages, you need both a printer and an ink cartridge. For now, assume that the toner cartridges are sold in a competitive market and sell for $2 each. An ink cartridge is good for 1,000 printed pages. Dollars 0 $2 Demand 14 $16 Quantity of printed pages (000s) Toner cartridge price You can set the price of the printer equal to the customer’s consumer surplus ? CS = ½*($16 - $2)(14) = $98

67. Now, suppose that you design a printer that requires a special cartridge that only you produce. What would you do if you could choose a printer price and a cartridge price? Dollars 0 $9 Demand 7 $16 Quantity of printed pages (000s) Toner cartridge price CS = ½*($9 - $2)(7) = $24.50 MR MC $2 QPTRTCMRMCProfit 1$15 $2$15$2$13 2$14$28$4$13$2$24 3$13$39$6$11$2$33 4$12$48$8$9$2$40 5$11$55$10$7$2$45 6$10$60$12$5$2$48 7$9$63$14$3$2$49 8$8$64$16$1$2$48 We could make our money on the cartridges and sell the printers cheap… Profit = $49 + $24.50 = $73.50 $49

68. Alternatively, we could do something like the amusement park. We maximize profits combining cartridge revenue AND printer revenue Dollars 0 Demand 14 $16 Quantity of printed pages (000s) Toner cartridge price CS = ½*($16 - $2)(14) = $98 MR MC $2 QPTRCSTotalTCMRMCProfit 1$15 $.5$15.5$2$15.5$2$13.5 2$14$28$2$30$4$14.5$2$26 3$13$39$4.5$43.5$6$13.5$2$37.5 4$12$48$8$56$8$12.5$2$48 5$11$55$12.5$67.5$10$11.5$2$57.5 13$3$39$84.5$123.5$26$3.5$2$97.5 14$2$28$98$126$28$2.5$2$98 15$1$15$112.5$127.5$30$1.50$2$97.5 We are back to a low cartridge price and a high printer price

69. Now, suppose that you have two customers. Call them high value and low value. Suppose that you can easily identify them and prevent resale. We could discriminate on both the printer price and the cartridge price. Dollars 0 $9 Demand 7 $16 CS = ½*($16 - $9)(7) = $24.50 MR MC $2 Dollars 0 $7 Demand 5 $12 CS = ½*($12 - $2)(5) = $12.50 MR MC $2 Profit = ($9-$2)7 +$24.50 = $73.50Profit = ($7-$2)5 +$12.50 = $37.50 Total Profit = $111

70. Alternatively, we could essentially give the cartridges away and discriminate on the printer (like Disneyworld). Dollars 0 Demand 14 $16 CS = ½*($16 - $2)(14) = $98 MC $2 Dollars 0 Demand 10 $12 CS = ½*($12 - $2)(10) = $50 MC $2 Profit = $98 Profit $50 Total Profit = $148

71. Suppose that you couldn’t explicitly price discriminate. Let’s say that you know you have a high value and low value demander, but you don’t know who is who. Let’s first try and do this like the amusement park Dollars 0 Demand 14 $16 CS = ½*($16 - $2)(14) = $98 MC $2 Dollars 0 Demand 10 $12 CS = ½*($12 - $2)(10) = $50 MC $2 14 Cartridge Package = $98 + $2*14 = $12610 Cartridge Package = $50 + $2*10 = $70

72. We need to choose packages so that each demander chooses the “correct” package Dollars 0 Demand 10 $16 CS = ½*($16 - $9)(10) = $50 $60 $6 - 10 Cartridge Package = $70 Total Willingness to Pay = $110 Consumer Surplus = $40 14 Cartridge Package = $126 - required consumer surplus = $40 “Discounted Price” = $86 14 Cartridge Package = $86 10 Cartridge Package = $70 Profit = $86 + $70 - $2*24 = $108

73. Let’s try a different strategy. Suppose that you charge a markup on the cartridges and then charge a common price for the printer to each. We would set the price of the printer equal to the consumer surplus of the lower value demander of insure that both groups buy the printer. Dollars 0 Demand 12-P $12 CS = ½*($12 - $P)(12-P) $P Example: Cartridge Price: $3 Consumer Surplus = ½*($12 - $3)(9) = $40.50  Charge $40.50 for the printer (Both customers will buy)  Low value customers buy 9 cartridges  High Value customers buy 13 cartridges Profit = 2*$40.50 + ($3-$2)(21) = $103

74. We need to find the best cartridge price… PriceQuantity 1Quantity 2Total Revenue Consumer Surplus Printer Revenue Total RevenueTotal CostProfit $01612$0$72$144 $56$88 $.2515.7511.75$6.875$69.03$138.06$144.93$55$89.93 $.5015.511.5$13.50$66.135$132.25$145.75$54$91.75 $3139$66$40.5$81$147$44$103 $4128$80$32$64$144$40$104 $4.2511.757.75$82.875$30.03$60.06$142.93$39$103.93

75. Let’s try a different strategy. Suppose that you charge a market on the cartridges and then charge a common price for the printer to each. We would set the price of the printer equal to the consumer surplus of the lower value demander of insure that both groups buy the printer. Dollars 0 Demand 8 $12 CS = ½*($12 - $4)(8) = $32 $60 $4 Best Choice:  Charge $32 for the printer (Both customers will buy)  Charge $4 for cartridges  Low value customers buy 8 cartridges (Pay $64 total)  High Value customers buy 12 cartridges (Pay $80 total) Profit = 2*$32 + ($4-$2)(20) = $104

76. One last example. Consider the market for hot dogs. Most people require a bun for each hot dog they eat (with the exception of the Atkins diet people!) 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.

77. For simplicity I will assume that marginal costs are zero (i.e. we are maximizing revenues) Suppose that you knew that the buns were selling for $2, what should you charge? QuantityPriceTotal RevenueMarginal Revenue 1$9 2$8$16$7 3 $21$5 4$6$24$3 5$5$25$1 6$4$24-$1 You charge $5

78. But, if the bun guy sees you charging $5, he needs to react to that… QuantityPriceTotal RevenueMarginal Revenue 1$6 2$5$10$4 3 $12$2 4$3$12$0 5$2$10-$2 6$1$6-$4 Bun Guy charge $4

79. But, if the bun guy is charging $4, you need to react to that… QuantityPriceTotal RevenueMarginal Revenue 1$7 2$6$12$5 3 $15$3 4$4$16$1 5$3$15-$1 6$2$12-$3 You charge $4

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

81. 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 firm’s reaction function. Complementary Goods

82. 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

83. Now, suppose that these companies merged into one monopoly QuantityCombined Price Total RevenueMarginal Revenue 1$11 2$10$20$9 3 $27$7 4$8$32$5 5$7$35-$3 6$6$36$1 7$5$35-$1 8$4$32-$3 9$3$27-$5 You charge $6 for hot dog/bun

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

85. Look at what happened here… Separate Hot Dog/Bun Suppliers Consumer Pays $8 for a hot dog/bun pair Single Hot Dog/Bun Suppliers Consumer Pays $6 for a hot dog/bun pair Eliminating a company benefits consumers!!!

86. Example: 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 Microsoft’s behavior was an abuse of power that hurt consumers What should Microsoft’s defense be?

87. 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.

88. Spatial Competition – Location Preferences Starbucks currently has 12,937 locations in the US Gucci currently has 31 locations in the US How can we explain this difference?

89. 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 can’t distinguish consumers and, hence, can’t price discriminate. Dollar Price Distance to Store Travel Costs

90. 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

91. 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

92. 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??

93. 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

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

95. 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