Chapter 14: Advanced Pricing Techniques McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Advanced Pricing Techniques Price discrimination Multiple products Cost-plus pricing

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)

The Trouble with Uniform Pricing (Figure 14.1)

Price Discrimination Exists when the price-to-marginal cost ratio differs between two products:

Price Discrimination Three conditions necessary to practice price discrimination profitably: Firm must possess some degree of market power A cost-effective means of preventing resale between lower- and higher-price buyers (consumer arbitrage) must be implemented Price elasticities must differ between individual buyers or groups of buyers

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

First-Degree (Perfect) Price Discrimination (Figure 14.2)

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

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:

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

Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14.3)

Demand at Northvale Golf Club (Figure 14.4)

Second-Degree Price Discrimination Declining block pricing Offers quantity discounts over successive discrete blocks of quantities purchased

Block Pricing with Five Blocks (Figure 14.5)

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

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

Allocating Sales Between Markets (Figure 14.6)

Constructing the Marginal Revenue Curve (Figure 14.7)

Profit-Maximization Under Third-Degree Price Discrimination (Figure 14

Multiple Products Related in consumption MRX = MCX and MRY = MCY 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

Bundling Multiple Products When price discrimination is not possible, bundling multiple goods and charging a single price can be more profitable than charging individual prices for multiple goods Two conditions for profitable bundling Consumers must have different demand prices for each good in the bundle Demand prices must be negatively correlated across consumer types

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

Cost-Plus Pricing Does not generally produce profit-maximizing price Fails to incorporate information on demand & marginal revenue Uses average, not marginal, cost

Practical Problems with Cost-Plus Pricing (Figure 14.13)