© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/eO’Sullivan/Sheffrin Prepared by: Fernando Quijano and Yvonn Quijano CHAPTERCHAPTER 13 Using Market Power: Price Discrimination and Advertising

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Discrimination Price discrimination is the process under which a firm divides consumers into two or more groups and picks a different price for each group.Price discrimination is the process under which a firm divides consumers into two or more groups and picks a different price for each group. The only legal restriction on price discrimination is that a firm cannot use it to drive rival firms out of business.The only legal restriction on price discrimination is that a firm cannot use it to drive rival firms out of business.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Price Discrimination A firm has an opportunity for price discrimination if three conditions are met:A firm has an opportunity for price discrimination if three conditions are met: Market power.Market power. Resale is not possible.Resale is not possible. Different consumer groups.Different consumer groups.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Senior Discounts in Restaurants A firm that picks a single price of $5 (for both seniors and nonseniors) reaches point n on the nonsenior demand curve (300 customers) and point s on the senior demand curve (100 customers).A firm that picks a single price of $5 (for both seniors and nonseniors) reaches point n on the nonsenior demand curve (300 customers) and point s on the senior demand curve (100 customers).

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Senior Discounts in Restaurants Under a price discrimination scheme, the price for nonseniors is $6 (point f ), and the price for the seniors is $3 (point d ).Under a price discrimination scheme, the price for nonseniors is $6 (point f ), and the price for the seniors is $3 (point d ).

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin A Senior Discount Increases Total Profit Single Price Policy Senior Discount SeniorsNonseniorsSeniorsNonseniors Price$5$5$3$6 Average cost per meal $1$1$1$1 Profit per meal $4$4$2$5 Number of meals 100 meals 300 meals 280 meals 260 meals Profit$400$1,200$560$1,300 Total profit $1,600$1,860

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin A Senior Discount Increases Total Profit Total profit with the single price policy: $1,600Total profit with the single price policy: $1,600

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin A Senior Discount Increases Total Profit Total profit with the senior discount: $1,860Total profit with the senior discount: $1,860

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Advertising and the Marginal Principle Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost; reduce the level of an activity if its marginal cost exceeds its marginal benefit. If possible, pick the level at which the activity’s marginal benefit equals its marginal cost.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Advertising and the Marginal Principle Number of Advertisements Quantity of Detergent Sold (Boxes) Marginal Benefit (Assuming Net Revenue of $1 per Box) Marginal Cost 0100, ,000$10,000$7, ,000$9,000$7, ,000$8,000$7, ,000$7,000$7, ,000$6,000$7, ,000$5,000$7,000

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin The Advertisers’ Dilemma The advertisers’ dilemma states that although each firm would be better off if neither advertised, both firms advertise.The advertisers’ dilemma states that although each firm would be better off if neither advertised, both firms advertise. Neither Advertises Both Advertise Jack Advertises JackJillJackJillJackJill Net revenue from sales ($ million) Cost of advertising ($ million) Profit ($ million)

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Game Tree for Advertisers’ Dilemma Jack moves first, choosing to advertise or not.Jack moves first, choosing to advertise or not.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Game Tree for Advertisers’ Dilemma Jill’s best response is to advertise no matter what Jack does.Jill’s best response is to advertise no matter what Jack does.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Game Tree for Advertisers’ Dilemma Knowing this, Jack realizes that the only possible outcomes are shown by rectangles 1 and 3.Knowing this, Jack realizes that the only possible outcomes are shown by rectangles 1 and 3.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Game Tree for Advertisers’ Dilemma From Jack’s perspective, rectangle 1 ($6 million) is better than rectangle 3 ($5 million), so his best response is to advertise too.From Jack’s perspective, rectangle 1 ($6 million) is better than rectangle 3 ($5 million), so his best response is to advertise too.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Game Tree for Advertisers’ Dilemma Both Jack and Jill advertise, and each earns a profit of $6 million.Both Jack and Jill advertise, and each earns a profit of $6 million.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Trade-Offs from Advertising Advertising helps consumers make more informed decisions.Advertising helps consumers make more informed decisions. Benefits of advertising: Advertising provides consumers with information on the prices and promotes competition.Advertising provides consumers with information on the prices and promotes competition.

© 2003 Prentice Hall Business PublishingEconomics: Principles and Tools, 3/e O’Sullivan/Sheffrin Trade-Offs from Advertising When firms are trapped in the advertisers’ dilemma, resources used in advertising may be wasted. Advertising results in a net decrease in industry profits.When firms are trapped in the advertisers’ dilemma, resources used in advertising may be wasted. Advertising results in a net decrease in industry profits. Costs of advertising: Some advertisements give the impression that there are real differences between products when there are none.Some advertisements give the impression that there are real differences between products when there are none.