1. Chapter 14 Advanced Pricing Techniques
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2. 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

3. Advanced Pricing Techniques
Price discrimination
Multiple products
Cost-plus pricing

4. 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)

5. The Trouble with Uniform Pricing (Figure 14.1)

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

7. 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

8. 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

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

10. 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

11. 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:

12. 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

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

14. Demand at Northvale Golf Club (Figure 14.4)

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

16. Block Pricing with Five Blocks (Figure 14.5)

17. 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

18. 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

19. Allocating Sales Between Markets (Figure 14.6)

20. Constructing the Marginal Revenue Curve (Figure 14.7)

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

22. 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

23. 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

24. 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

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

26. Practical Problems with Cost-Plus Pricing (Figure 14.9)

27. 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

28. 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