1. The Economic Way of Thinking 10e ©Prentice Hall 2003 1 “The Economic Way of Thinking” 10 th Edition by Paul Heyne, Peter Boettke, and David Prychitko “Price Searching” PowerPoint Slides prepared by Assistant Professor Paul Harris Camden County College

2. The Economic Way of Thinking 10e ©Prentice Hall 2003 2 Chapter Outline I.Introduction II.The Popular Theory of Price Setting III.Introducing Ed Sike IV.The Basic Rule for Maximizing Net Revenue V.The Concept of Marginal Revenue VI.Why Marginal Revenue Is Less Than Price

3. The Economic Way of Thinking 10e ©Prentice Hall 2003 3 Chapter Outline V11.The Basic Rule for Maximizing Net Revenue VIII.The Concept of Marginal Revenue IX.Why Marginal Revenue Is Less Than Price X.Setting Marginal Revenue To Equal Marginal Cost XI.What About Those Empty Seats?

4. The Economic Way of Thinking 10e ©Prentice Hall 2003 4 Chapter Outline XII.The Price Discriminator’s Dilemma XIII.The College As Price Searcher XIV.Some Strategies For Price Discrimination XV.Ed Sike Finds a Way XVI.Resentment and Rationale

5. The Economic Way of Thinking 10e ©Prentice Hall 2003 5 Chapter Outline XVII.Lunch and Dinner Prices XVIII.Cost Plus Markup Reconsidered XIX.Once Over Lightly

6. The Economic Way of Thinking 10e ©Prentice Hall 2003 6 Introduction Firms will produce an additional product as long as its marginal revenue is greater than its marginal cost.Firms will produce an additional product as long as its marginal revenue is greater than its marginal cost. Net RevenueNet Revenue –Total revenue - total costs Firms will produce an additional product as long as its marginal revenue is greater than its marginal cost.Firms will produce an additional product as long as its marginal revenue is greater than its marginal cost. Net RevenueNet Revenue –Total revenue - total costs

7. The Economic Way of Thinking 10e ©Prentice Hall 2003 7 The Popular Theory of Price Setting A Popular BeliefA Popular Belief –Selling price is cost plus markup. QuestionsQuestions –Why choose 25 versus a 50 percent markup? –Why will a firm vary its percentage markup depending upon various factors? –Why sell below average cost?

8. The Economic Way of Thinking 10e ©Prentice Hall 2003 8 The Popular Theory of Price Setting A Popular BeliefA Popular Belief –Selling price is cost plus markup. QuestionsQuestions –Why choose 25 versus a 50 percent markup? –Why will a firm vary its percentage markup depending upon various factors? –Why sell below average cost? The cost-plus argument has numerous faults. has numerous faults.

9. The Economic Way of Thinking 10e ©Prentice Hall 2003 9 Introducing Ed Sike Scenario –Ed Sike is a college sophomore. –He sells film tickets to earn spending money. –He sets the price for his tickets.

10. The Economic Way of Thinking 10e ©Prentice Hall 2003 10 Introducing Ed Sike Ed’s Bills Per Movie Film rental$1,800 Auditorium rental250 Operator50 Ticket takers 100 Total$2,200

11. The Economic Way of Thinking 10e ©Prentice Hall 2003 11 Introducing Ed Sike Scenario –Ed receives all revenue. –Auditorium seats 700 people.

12. The Economic Way of Thinking 10e ©Prentice Hall 2003 12 Introducing Ed Sike Ed’s Demand Schedule QuantityTotalNet PriceDemandedRevenueRevenue $ 3.00700$2,100-$100 2.507501750-$450

13. The Economic Way of Thinking 10e ©Prentice Hall 2003 13 Introducing Ed Sike Price Per Ticket Number of Tickets 0100200300400500600700800900 1 2 3 4 5 6 7 D

14. The Economic Way of Thinking 10e ©Prentice Hall 2003 14 Introducing Ed Sike Scenario –The student association will subsidize the films if they lose money. –Ed is expected to earn as much net revenue as possible.

15. The Economic Way of Thinking 10e ©Prentice Hall 2003 15 The Basic Rule for Maximizing Net Revenue Set the Price so that only those units whose marginal revenue is greater than marginal Costs. Marginal costs is the addition to total cost from selling an additional unit. Marginal revenue is the addition to total revenue from selling one more unit.

16. The Economic Way of Thinking 10e ©Prentice Hall 2003 16 $7300$2,100-$100 64002,400200 55002,500300 46002,400200 $3700$2,100-100 The Concept of Marginal Revenue Ed’s Demand Schedule QuantityTotalNet PriceDemandedRevenueRevenue

17. The Economic Way of Thinking 10e ©Prentice Hall 2003 17 The Concept of Marginal Revenue Marginal Revenue The additional revenue expected from an action under consideration. Ed’s marginal revenue is zero.

18. The Economic Way of Thinking 10e ©Prentice Hall 2003 18 The Concept of Marginal Revenue Ed’s Demand Schedule QuantityTotalNet PriceDemandedRevenueRevenue $7300$2,100-$100 64002,400200 55002,500300 46002,400200 $3700$2,100-100

19. The Economic Way of Thinking 10e ©Prentice Hall 2003 19 The Concept of Marginal Revenue Question –Why is profit maximized where marginal revenue equals marginal cost?

20. The Economic Way of Thinking 10e ©Prentice Hall 2003 20 Why Marginal Revenue Is Less Than Price Marginal revenue < Price Why? In order to increase sales, Ed must lower the price on the additional ticket and the ones that would have been sold at a higher price.

21. The Economic Way of Thinking 10e ©Prentice Hall 2003 21 Why Marginal Revenue Is Less Than Price Marginal revenue The difference between the revenue gained from additional quantity and the revenue lost from lowering price on the previous quantity

22. The Economic Way of Thinking 10e ©Prentice Hall 2003 22 Gained Lost Why Marginal Revenue Is Less Than Price P Q D A B

23. The Economic Way of Thinking 10e ©Prentice Hall 2003 23 Additions to net revenue Subtractions from net revenue Why Marginal Revenue Is Less Than Price P Q MR MC

24. The Economic Way of Thinking 10e ©Prentice Hall 2003 24 Why Marginal Revenue Is Less Than Price QuestionsQuestions –What would Ed have to do to sell 550 tickets instead of 500? –How would this impact his marginal revenue? –Is it a correct pricing decision?

25. The Economic Way of Thinking 10e ©Prentice Hall 2003 25 Why Marginal Revenue Is Less Than Price P Q 0900800600500300100400200700 MR

26. The Economic Way of Thinking 10e ©Prentice Hall 2003 26 Setting Marginal Revenue To Equal Marginal Cost  Question  What would happen if the distributor changed the rental fee to $800 + $2/ticket sold?

27. The Economic Way of Thinking 10e ©Prentice Hall 2003 27 Setting Marginal Revenue To Equal Marginal Cost P Q MR 0900800600500300100400200700 1 3 4 5 6 7 2 D Marginal cost What is Ed’s net revenue now?

28. The Economic Way of Thinking 10e ©Prentice Hall 2003 28 What About Those Empty Seats? QuestionsQuestions –Aren’t seats going to waste? –Why doesn’t Ed lower the price on the empty seats?

29. The Economic Way of Thinking 10e ©Prentice Hall 2003 29 The Price Discriminator’s Dilemma QuestionQuestion –When should Ed leave seats empty? AnswerAnswer –If the cost of discriminating among potential ticket buyers is greater than the additional revenue gained through discrimination

30. The Economic Way of Thinking 10e ©Prentice Hall 2003 30 The Price Discriminator’s Dilemma Question What if Ed offered to sell the empty seats for $3 to anyone unwilling to pay more?

31. The Economic Way of Thinking 10e ©Prentice Hall 2003 31 The College As a Price Searcher QuestionsQuestions –Why do colleges continually ask for donations to cover costs not paid for by tuition? –Why do these colleges give scholarships to needy students?

32. The Economic Way of Thinking 10e ©Prentice Hall 2003 32 Demand Curve for Enrollment at Ivy College Q MR 0 5,0003,0001,0004,0002,000 1,000 3,000 4,000 5,000 6,000 2,000 D Assume MC = 0 Students enrolling (per year) 6,000 Annual Tuition/Student 0

33. The Economic Way of Thinking 10e ©Prentice Hall 2003 33 The College As a Price Searcher Questions How could Ivy charge $6,000 and give each student a scholarship equal to the difference between $6,000 and what the student is willing to pay? How does the school determine what each student is willing to pay?

34. The Economic Way of Thinking 10e ©Prentice Hall 2003 34 The College As a Price Searcher Solutions Willingness to pay is correlated with wealth. Scholarships are available to those who fill out some forms. Ivy could discriminate based on wealth to increase revenue.

35. The Economic Way of Thinking 10e ©Prentice Hall 2003 35 Scholarships enrolled Tuition Paid Revenue has increased from $9m to $18m. The College As a Price Searcher P Q 6,000 D

36. The Economic Way of Thinking 10e ©Prentice Hall 2003 36 Some Strategies for Price Discrimination Grocery Coupons Discounts for: ChildrenStudents Senior citizens Airfare Prices Business traveler Vacationer

37. The Economic Way of Thinking 10e ©Prentice Hall 2003 37 Some Strategies for Price Discrimination P Q Business Traveler P Q D D Vacation Traveler

38. The Economic Way of Thinking 10e ©Prentice Hall 2003 38 Ed Sike Finds A Way Questions Could Ed increase revenue by charging different groups of customers different prices? Should students or teachers pay the higher price?

39. The Economic Way of Thinking 10e ©Prentice Hall 2003 39 Ed Sike Finds A Way Price Per Ticket Number of Tickets 0100200300400500600700800900 1 2 3 4 5 6 7 D faculty MR faculty DsDs MR s

40. The Economic Way of Thinking 10e ©Prentice Hall 2003 40 Resentment and Rationale Firms must justify price discrimination. Conditions Necessary for Price Discrimination Distinguish buyers with different price elasticities Prevent low-price buyers from reselling to high-price buyers Control resentment

41. The Economic Way of Thinking 10e ©Prentice Hall 2003 41 Resentment and Rationale QuestionQuestion –Why would a ticket from New York to Chicago cost more than a ticket from New York to Los Angeles? QuestionQuestion –Why would a ticket from New York to Chicago cost more than a ticket from New York to Los Angeles?

42. The Economic Way of Thinking 10e ©Prentice Hall 2003 42 Resentment and Rationale P Q D Chicago D LA

43. The Economic Way of Thinking 10e ©Prentice Hall 2003 43 Lunch and Dinner Prices QuestionQuestion –Why are lunch prices more expensive than dinner prices?

44. The Economic Way of Thinking 10e ©Prentice Hall 2003 44 Lunch and Dinner Prices AnswerAnswer –Lunch customers are more responsive to prices. They eat out more.They eat out more. The meal makes up a large share of the event’s cost (no sitter, movie, etc.).The meal makes up a large share of the event’s cost (no sitter, movie, etc.).

45. The Economic Way of Thinking 10e ©Prentice Hall 2003 45 Cost Plus Markup Reconsidered Price Searchers:Price Searchers: 1)Estimate marginal cost and marginal revenue. 2) Determine the appropriate level of output. 3) Set their prices so that they can just manage to sell the output produced. `

46. The Economic Way of Thinking 10e ©Prentice Hall 2003 46 Cost Plus Markup Reconsidered Cost-Plus MarkupCost-Plus Markup –A good place to start Cost-Plus MarkupCost-Plus Markup –A good place to start

47. The Economic Way of Thinking 10e ©Prentice Hall 2003 47 Once Over Lightly Price searchers are looking for pricing structures that will enable them to sell all units for which MR>MC. A crucial factor for a price searcher is the ability or inability to discriminate. The crucial rule for price searching is to set MR= to MC.

48. The Economic Way of Thinking 10e ©Prentice Hall 2003 48 End of Chapter 10 Next. Chapter 11, “ Competition and Government Policy”