1. Chapter 12 Pricing and Advertising Everything is worth what its purchaser will pay for it. Publilius Syrus (first century BC)

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-2 Chapter 12 Outline Challenge: Sale Price 12.1Conditions for Price Discrimination 12.2Perfect Price Discrimination 12.3Group Price Discrimination 12.4Nonlinear Pricing 12.5Two-Part Pricing 12.6Tie-In Sales 12.7Advertising Challenge Solution α

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-3 Challenge: Sale Price Background: Because many firms use sales—temporarily setting the price below the usual price—some customers pay lower prices than others over time. When Heinz ketchup goes on sale, switchers — ketchup customers who normally buy whichever brand is least expensive—purchase Heinz rather than the low price generic ketchup. Questions: How can Heinz’s managers design a pattern of sales that maximizes Heinz’s profit by obtaining extra sales from switchers without losing substantial sums by selling to its loyal customers at a discount price? Under what conditions does it pay for Heinz to have a policy of periodic sales?

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-4 12.0 Price vs. Quantity Decision Monopoly’s quantity decision: Price decision: (Note Q’(P)=1/P’(Q)) Quantity and price decision yield the same outcome for the monopoly, but not for the oligopoly.

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-5 12.1 Conditions for Price Discrimination Why does Disneyworld charge local residents $369 for an annual pass and out-of-towners $489? Why are airline fares less if you book in advance? Why are computers and software bundled and sold at a single price? Firms sometimes use nonuniform pricing, where prices vary across customers, to earn a higher profit.

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-6 12.1 Conditions for Price Discrimination A firm engages in price discrimination by charging consumers different prices for the same good based on individual characteristics belonging to an indentifiable sub-group of consumers the quantity purchased Two reasons why a firm earns a higher profit from price discrimination than uniform pricing: 1.Price-discriminating firms charge higher prices to customers who are willing to pay more than the uniform price. 2.Price-discriminating firms sell to some people who are not willing to pay as much as the uniform price.

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-7 12.1 Conditions for Price Discrimination Necessary conditions for successful price discrimination: 1.A firm must have market power (otherwise it cannot charge a price above the competitive price). Examples: monopolist, oligopolist, monopolistically competitive, cartel 2.A firm must be able to identify which consumers are willing to pay relatively more and there must be variation in consumers’ reservation price, the maximum amount someone is willing to pay. 3.A firm must be able to prevent or limit resale from customers who are charged a relatively low price to those who are charged a relatively high price.

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-8 12.1 Conditions for Price Discrimination A firm’s inability to prevent resale is often the biggest obstacle to successful price discrimination. Resale is difficult or impossible for services and when transaction costs are high. Examples: haircuts, plumbing services, admission that requires showing an ID Not all differential pricing is price discrimination. It is not price discrimination if the different prices simply reflect differences in costs. Example: selling magazines at a newsstand for a higher price than via direct mailing

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-9 12.1 Types of Price Discrimination 1. First-degree Also known as perfect price discrimination Each unit sold for each customer’s reservation price 2. Second-degree Also known as nonlinear discrimination Firm charges a different price for large quantities than for small quantities 3. Third-degree Also known as group price discrimination Firm charges different groups of customers different prices, but charges any one customer the same price for all units sold

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-10 12.2 Perfect Price Discrimination Under perfect price discrimination, the firm charges each consumer a price that is exactly equal to the maximum he/she is willing to pay. Thus, each consumer gets zero consumer surplus. Firm profit is increased by the amount of consumer surplus that would exist in a competitive market; all CS is transferred to the firm.

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-11 12.2 Perfect Price Discrimination All consumer surplus is transformed into firm profit.

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-12 12.2 Perfect Price Discrimination If D(Q) is the inverse demand function for total output, Q, and p = D(Q) is the reservation price charged of each customer, the discriminating monopoly’s revenue is: This is equal to the area under the demand curve up to Q. Maximizing profit by choosing output: FOC: Result: produce where D(Q) equals MC.

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-13 12.2 Perfect Price Discrimination Producing where Demand = MC, all consumer surplus (A+B+C) is transformed into firm profit.

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-14 12.2 Perfect Price Discrimination The perfect price discrimination result of producing where demand equals MC means that the competitive quantity of output gets produced. This outcome is efficient: it maximizes total welfare no deadweight loss is generated But the outcome is harmful to consumers because all surplus is producer surplus!

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-15 12.3 Group Price Discrimination

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-16 12.3 Group Price Discrimination The first-order conditions imply that marginal revenue from each group should be the same and equal to marginal cost: Because marginal revenue is a function of elasticity, we can write: Thus, the higher price will be charged in the less elastic market segment.

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-17 12.3 Group Price Discrimination A higher price will be charged in the market with the more price-inelastic demand.

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-18 12.4 Multimarket Price Discrimination

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-19 Solved Problem 12.2 A monopoly drug producer with a constant marginal cost of m = 1 sells in only two countries and faces a linear demand curve of –Q 1 = 12 − 2p 1 in Country 1 and –Q 2 = 9 − p 2 in Country 2. A price-discriminating monopoly? What price does the monopoly charge in each country with a ban against shipments between the countries? –MR 1 =6-Q 1 =MC=1  Q 1 =5; P 1 =3.5; π 1 =12.5; CS 1 =6.25. –MR 2 =9-2Q 2 =MC=1  Q 2 =4; P 2 =5; π 1 =16; CS 2 =8

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-20 Solved Problem 12.2

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-21 Solved Problem 12.2 A single-price monopoly? What price does the monopoly charge in both countries without a ban against shipments between the countries? –Q(p)=Q 1 (p)+Q 2 (p)= 21 − 3p ;p=7-Q/3 –MR=7-2Q/3=MC=1  Q=9; P=4; π=27<28.5 –Q 1 =12−2p=4  π 1 =12<12.5; CS 1 =4<6.25; π 1 +CS 1 =16<18.75 –Q 2 =9−p=5  π 2 =15 8; π 2 +CS 2 =27.5>24 –π 1 +CS 1 =16 24; π+CS=43.5>42.75

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-22 Solved Problem 12.2

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-23 12.3 Group Price Discrimination Welfare under multimarket price discrimination is lower than it is under either competition or perfect price discrimination. Under competition, more output is produced and CS is greater The welfare effects relative to uniform price monopoly are indeterminate. Both types of monopolies set price above marginal cost, so output is lower than in competition. Welfare is likely to be lower with discrimination due to consumption inefficiency and time wasted shopping.

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-24 12.4 Nonlinear Price Discrimination Price varies only with the quantity purchased, but each customer faces the same nonlinear pricing schedule. Not all quantity discounts are price discrimination; some reflect reductions in firm costs associated with large-quantity sales. Many utilities use block-pricing schedules, by which they charge one price for the first few units of usage (block) and then a different price for subsequent blocks. Example: increasing-block pricing associated with electricity; per KWH charge increases the more you use

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-25 12.4 Nonlinear Price Discrimination Consider a firm that uses declining-block prices to maximize profit. $70 is charged for 1 ≤ Q ≤ 20 $50 is charged for Q > 20 Thus, a consumer who buys 30 units pays $70 20 = $1400 for the first block and $50 10 = $500 for the second block, for a total of $1900. By contrast, under a non-discriminating monopoly, this consumer would be charged a uniform price of $60 and pay a total of $1,800 for 30 units.

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-26 12.4 Nonlinear Price Discrimination

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-27 12.4 Nonlinear Price Discrimination Designing block prices with p(Q)=90-Q and MC=30. $p 1 is charged for 1 ≤ Q ≤ Q 1 $p 2 is charged for Q > Q 1 p 1 =p(Q 1 ); p 2 =p(Q 2 ) π=p(Q 1 )Q 1 +p(Q 2 )(Q 2 -Q 1 )-30Q 2 =(90-Q 1 )Q 1 +(90- Q 2 )(Q 2 -Q 1 )-30Q 2 dπ/dQ 1 =90-2Q 1 -(90-Q 2 )=0  Q 2 =2Q 1; dπ/dQ 2 =90-2Q 2 +Q 1 -30=0  Q 1 =20; Q 2 =40 ; p 1 =p(Q 1 )=70; p 2 =p(Q 2 )=50; The more block prices the monopoly can set, the closer the monopoly can get to perfect price discrimination.

28. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-28 12.5 Two-Part Pricing Another form of nonlinear pricing, a two-part tariff, is when the firm charges a consumer a lump-sum fee for the right to purchase (first tariff) and a per unit fee for each unit actually purchased (second tariff). Think of the first tariff as an “access fee” and the second as a “usage fee”. Examples: A country club charges a membership fee and greens fees to play a round of golf The state fair charges an entrance fee and a per ticket fee for rides Cell phone service providers charge a monthly service fee and a fee per text message

29. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-29 12.5 Two-Part Tariffs If all consumers are identically competitive buyers, the firm can capture all CS by setting charging a lump-sum “access fee” equal to CS (A 1 +B 1 +C 1 ) and a “usage fee” equal to marginal cost (m).

30. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-30 12.5 Two-Part Tariffs Now assume that the monopoly has two customers. If the firm can treat customers differently, it can still capture all consumer surplus as in the previous graph. If the firm has to charge all customers the same price, it maximizes profit by: Setting the lump-sum “access fee” equal to the potential CS of the consumer with the smaller demand and a price that is above marginal cost.

31. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-31 12.5 Two-Part Tariffs With different customers, firm charges lump- sum fee of A 1 and per unit fee of $20.

32. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-32 12.5 Two-Part Tariffs If the firm charges both customers T=A+pq, and each consumer determines his/her own q i : The lump-sum fee, A, depends on p. The lump-sum fee, A, will be the lower total CS of the two consumers, CS 1 in the example. CS 1 (p)=(80-p) 2 /2; CS 2 (p)=(100-p) 2 /2 π=2CS 1 +(p-m)[q 1 (p)+q 2 (p)] =(80-p) 2 +(p-10)[80-p+100-p] dπ/dp=-2(80-p)+(180-2p)-2(p-10)=0  p=20>10 A=CS 1 (p)=1,800; q 1 (p)=60; q 2 (p)=80; π=5,000;

33. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-33 12.5 Two-Part Tariffs If the firm charges both customers only the same uniform price p. π=(p-m)[q 1 (p)+q 2 (p)] =(p-10)[80-p+100-p] dπ/dp=(180-2p)-2(p-10)=0  p=50>20 q 1 (p)=30; q 2 (p)=50; π=3,200<5,000;

34. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-34 12.6 Tie-In Sales Another type of nonuniform pricing is a tie-in sale, in which customers can buy one product only if they agree to purchase another product as well. Requirement tie-in sale: customers who buy one product from a firm are required to make all purchases of related products from that firm Example: photocopying machine buyers must buy services and supplies from same company Bundling: two goods are combined so that customers cannot buy either good separately Example: Refrigerators are sold with shelves

35. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-35 12.6 Tie-In Sales (Pure Bundling) Negatively correlated Word Proce ssor Sprea dshee t Bundl e Alisha12050170 Bob9070160 P*9050160 Q*222 Positively correlated Word Proce ssor Sprea dshee t Bundl e Carol10090190 Dmitri9040130 P*90 130 Q*212

36. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-36 12.6 Tie-In Sales(Mixed Bundling) Word Proce ssor Sprea dshee t Bundl e Aaron12030150 Brigitte11090200 Charle s 90110200 Doroth y 30120150 Negatively correlated reservation prices –Separate prices 540 max –Pure bundling 600 max –Mixed bundling 640 max

37. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-37 12.7 Advertising Monopoly firms don’t just decide on price and quantity, they also make important decisions about how much to advertise their products. Advertising may positively influence consumers’ preferences and thereby increase demand for the product. Although higher demand increases gross profit, if the cost of advertising is substantial, net profit may or may not increase.

38. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-38 12.7 Deciding Whether to Advertise Advertise if cost is less than additional gross profit, area B.

39. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-39 12.7 How Much to Advertise If a monopoly raises advertising expenditures by $1, how much does its gross profit rise? Additional advertising pays when gross profit rises by more than $1 following an additional dollar spent on advertising. Thus, the profit-maximizing amount of advertising equates the marginal benefit and marginal cost of advertising. Mathematically: where R is revenue and is a function of output and advertising cost

40. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-40 12.7 How Much to Advertise Given the maximization problem: The profit-maximizing output and advertising levels are the Q * and A * that simultaneously satisfy the FOCs: The monopoly advertises until the marginal benefit from the last unit of advertising equals $1, the marginal cost.

41. Copyright ©2014 Pearson Education, Inc. All rights reserved.12-41 12.7 How Much to Advertise