PRICING WITH MARKET POWER II

Overview Two-part tariff Bundling Tying

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 72

Two-Part Tariff with a Single Consumer $/Q 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* D MC P* Quantity 79

Two-Part Tariff with Two Consumers Q1 Q2 The price, P*, will be greater than MC. Set T* at the surplus value of D2. T* P* $/Q D2 = consumer 2 D1 = consumer 1 Π=2T*+(P*-MC).(Q1+Q2)>ΔABC A Thus there is a trade-off between high entry fee & high user price MC C B Quantity 83

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. 84

Two-Part Tariff with Many Different Consumers (choosing T) Total profit is the sum of the profit from the entry fee and the profit from sales. Both depend on T. Profit :sales :entry fee T 87

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 ПA and ПS reaches the maximum.

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

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 90

Bundling Example With Two Consumers (theaters A-B) Reservation Price 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.

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 Gertie’s 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.

Bundling Example With Two Heterogeneous Goods and Many Consumers (reservation price Good 2) $6 $3.25 $8.25 Consumer A C 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. $10 $5 r1 (reservation price Good 1) $5 $10 98

Consumption Decisions When Products are Sold Separately II Consumers buy only good 2 P1 Consumers fall into four categories based on their reservation price. I Consumers buy both goods 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) P2 P (P1, P2) III Consumers buy neither good IV Consumers buy only Good 1 r1 100

Consumption Decisions When Products are Bundled r2 = PB - r1 I II Consumers buy bundle (r > PB) Consumers do not buy bundle (r < PB) r2 Consumers compare the sum of their reservation prices, r1 + r2, with the bundle price PB. They buy the bundle only if r1 + r2 is at least as large as PB. r1 102

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 of good 2 who now buy good 1 also Buyers who buy both the goods Buyers of good 2 lost to the firm Buyers of good 1 who now buy good 2 also Buyers who buy neither good Buyers of good 1 lost to the firm 105

Efficiency of Bundling Depends on the Degree of Negative Correlation (Spiderman) r2 Bundling pays due to negative correlation 10,000 5,000 12,000 4,000 3,000 B A r1 5,000 10,000 14,000 (Spaceballs) 106

Mixed Versus Pure Bundling C1 = MC1 = 20 With positive marginal costs, mixed bundling may be more profitable than pure bundling. r2 100 Consumer A, for example, has a reservation price for good 1 that is below marginal cost c1. With mixed bundling, consumer A is induced to buy only good 2, while consumer D is induced to buy only good 1, reducing the firm’s cost. A B D C 90 80 70 60 50 40 30 C2 = MC2 = 30 20 Is MC>0 sufficient condition for mixed bundling to dominate? 10 r1 10 20 30 40 50 60 70 80 90 100 110

Mixed Bundling with Zero Marginal Costs P1 P2 PB Profit Sell separately $80 $80 ---- $320 Pure bundling ---- ---- $100 $400 Mixed bundling $90 $90 $120 $420 Is MC>0 sufficient condition for mixed bundling to dominate? 118

Mixed Bundling with Zero Marginal Costs 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 10 90 A B D 100 80 60 40 20 r1 20 40 60 80 100 120 117

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. 121

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’?