Chapter 14 Advanced Pricing Techniques

Learning Objectives Explain why uniform pricing does not generate maximum possible total revenue and how price discrimination can generate more revenue Explain how to practice first‐degree price discrimination Explain how to practice second‐degree price discrimination Explain how to practice third‐degree price discrimination Determine profit‐maximizing prices when a firm sells multiple products related in consumption and explain how firms can profitably bundle products for a single price Understand why cost‐plus pricing usually fails to maximize profit

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 14.9)

Summary Managers wish to avoid uniform pricing because it creates too much consumer surplus Price discrimination: charging different prices for the same product for the purpose of capturing consumer surplus and turning it into economic profit Under first-degree price discrimination, the firm charges each consumer the maximum price he is willing to pay for every unit he purchases Second-degree price discrimination reduces the average price as the amount purchased increases and lets buyers self-select the price they pay by choosing how much to buy Two methods: two-part pricing and declining block pricing

Summary When a firm sells in two distinct markets, 1 & 2, it can practice third-degree price discrimination by allocating output or sales between the two markets such that MR1 = MR2 When a firm produces two products, X & Y, the firm maximizes profit by producing and selling output levels for which MRX = MCX and MRY = MCY Managers who use cost-plus pricing to set prices will fail to maximize profit because cost-plus pricing faces a number of practical and theoretical problems Cost-plus pricing is flawed because it employs average rather than marginal cost, and it does not incorporate consideration of demand conditions