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Economics of the Firm

Competitive Pricing
Techniques

When making pricing decisions, you need to be aware of what your market
structure is
Market Structure Spectrum

Perfect Competition

The market is supplied by many


producers each with zero market
share
Firm Level Demand DOES
NOT equal industry demand

Monopoly

One Producer With 100%


market share
Firm Level Demand
EQUALS industry
demand

Recall the characteristics we laid out for a competitive market

#1: Many buyers and sellers


no individual buyer/firm has
any real market power

#2: Homogeneous products


no variation in product
across firms

#3: No barriers to entry its


costless for new firms to
enter the marketplace

#4: Perfect information


prices and quality of products
are assumed to be known to
all producers/consumers

#5: No Externalities ALL


costs/benefits of the product
are absorbed by the
consumer

#6: Transactions are costless


buyers and sellers incur no
costs in an exchange

Can you think of situations where all these assumptions hold?

Measuring Market Structure Concentration Ratios


Suppose that we take all the firms in an industry and ranked them by
size. Then calculate the cumulative market share of the n largest firms.

Cumulative Market
Share
100

A
C

80

40
20
0

01

10

20

# of
Firms

Measuring Market Structure Concentration Ratios


Cumulative Market
Share
100

A
C

80

B
40
20
0

01

10

20

CR4 Measures the cumulative market share of the top four


firms

# of
Firms

Concentration Ratios in US manufacturing; 1947 - 1997

Year

CR50

CR100

CR200

1947

17

23

30

1958

23

30

38

1967

25

33

42

1977

24

33

44

1987

25

33

43

1992

24

32

42

1997

24

32

40

Aggregate manufacturing in the US hasnt really changed since WWII

Measuring Market Structure: The Herfindahl-Hirschman


Index (HHI)
N

HHI s
i 1

2
i

si = Market share of firm i


s 2i

Rank

Market Share

25

625

25

625

25

625

25

25

25

25

25

HHI = 2,000

The HHI index penalizes a small number of total firms

Cumulative Market
Share
100

A
HHI = 500

80

B
HHI = 1,000

40
20
0

01

10

20

The HHI index also penalizes an unequal distribution of firms

Cumulative Market
Share
100
80

HHI = 500
HHI = 555

40

B
20
0

01

10

20

Concentration Ratios in For Selected Industries


Industry

CR(4)

HHI

Breakfast Cereals

83

2446

Automobiles

80

2862

Aircraft

80

2562

Telephone Equipment

55

1061

Womens Footwear

50

795

Soft Drinks

47

800

Computers & Peripherals 37

464

Pharmaceuticals

32

446

Petroleum Refineries

28

422

Textile Mills

13

94

Recall that in a perfectly competitive world, price equals marginal


revenue
Individual

Market
Dollars

Dollars

Supply

MC

MR

1.44*

$1.44*

Demand

400

400,000*

The market determines the


equilibrium price of $1.44 and
400,000 fish sold by the 1,000
fishermen

At the prevailing market price of


$1.44, each fisherman supplies 400
fish

In a monopolized market, the single firm in the market faces the industry
demand curve
Individual

Market
Dollars

Dollars

MC

1.44*

$1.44*

Demand

Demand

400,000

400,000*

400,000 fish are sold at a market


price of $1.44

The single firm in the market has


chosen that price of $1.44 based off
of industry demand

We will be assuming that pricing decisions are being made to maximize


current period profits

Total Costs (note that total costs


here are economic costs. That is,
we have already included a
reasonable rate of return on
invested capital given the risk in
the industry)
Profits

PQ TC
Total Revenues
equal price times
quantity

As with any economic decision, profit maximization involves evaluating every


potential sale at the margin

PQ TC

How do my profits
change if I
increase my sales
by 1?

How do my
revenues change if
I increase my sales
by 1? (Marginal
Revenues)

How do my costs
change if I
increase my sales
by 1? (Marginal
Costs)

In a world where firms have market power, they control their level of sales by setting their price.
Suppose that you have the following demand curve (A relationship between price and quantity):

Q 100 2 P
Your listed price

Total
Sales

P
For example: If you were to set a
price of $20, you can expect 60
sales

P $20

Q 100 2 20 60

D
Q 60

We could also talk about inverse demand (a relationship between quantity and price):

Q 100 2 P

P 50 .5Q
A price
that will hit
that target

Your target for sales

P
For example: If you wanted to
make 40 sales, you could set a $30
price

40 100 2 P
60 2 P
P $30

P 30

D
Q 40

Either way, if we know price and total sales, we can calculate revenues

P 50 .5Q
P
Total Revenues = Price*Quantity

P $30
Total Revenues
=($30)(40)
= $1200

Q 40

Q
Can we increase revenues past
$1200 and, if so, how?

Either way, if we know price and total sales, we can calculate revenues

P 50 .5Q
P
Total Revenues =($35)(30) = $1050

P $35
Total Revenues =($25)(50) = $1250

P $30
P $25

D
Q 30 Q 40 Q 50

Q
Turns out lowering price was the right
thing to do to raise revenues.

Initially, you have chosen a price (P)


to charge and are making Q sales.

p
Total Revenues = PQ

Q
Suppose that you want to increase your sales.
What do you need to do?

Your demand curve will tell you how much you need to lower your price to reach
one more customer
This area represents the revenues
that you lose because you have to
lower your price to existing customers

This area represents


the revenues that you
gain from attracting a
new customer

Q
Q

Your demand curve will tell you how much you need to lower your price to reach
one more customer

P 50 .5Q

Revenues =($30)(40) = $1200

$29.50 From additional sale


- $20 loss from lowering price
$9.50 increase in revenues

p $30
p $29.50

($.50)(40) =$20

Revenues =($29.50)(41) = $1209.50


($29.50)(1)
=$29.50

D
Q 40

Q 41

Demand curves slope downwards this reflects the negative


relationship between price and quantity. Elasticity of Demand measures
this effect quantitatively

Pric
e

2.75 2.50

*100 10%
2.50

%QD 20
D

2
% P
10

$2.7
5
$2.5
0

D I $50,000
4

45

*100 20%
5

Quantit
y

Note that elasticities vary along a linear demand curve D 2.3


Pric
e

D .61
$35

Q 100 2 P
P

$35

30

$34

32

$20

60

$19

62

$10

80

% Change
in Q

%
Change
in P

Elastici
ty

6.7

-2.9

-2.3

3.3

-5

-.61

$20

D
0
-1
-2

$9

82

2.5

-10

-.255

-3
-4
-5
-6
-7
-8
-9
-10

30

60

Quantit

80 y

Lets calculate the elasticity of demand at a quantity of 40 (a.k.a. a price of $30)

P 50 .5Q
P

%P 1.7

% Q
2.5

1.47
% P 1.7

At a quantity of 40, the


elasticity of demand is
bigger that 1 in absolute
value

P $30
P $29.50

D
Q 40 Q 41

%Q 2.5

Lets calculate the elasticity of demand at a quantity of 40 (a.k.a. a price of $30)

P 50 .5Q
TR PQ
P
Total Revenues =($30)
(40) = $1200

If I want to increase my sales


target, I need to lower my price
to all my existing customers

1.47

P $30

Total Revenues =($29.50)


(41) = $1209.5

P $29.50

D
Q 40 Q 41

% Change in revenues = .
80%

An elasticity of demand that is greater


than 1 in absolute value indicates that
lowering price will increase revenues

TR PQ
%TR % P %Q
.80%

-1.70%

% Q
2.5

1.47
% P 1.7

Total Revenues =($30)(40) = $1200

1.47

%P 1.7

P $30

Total Revenues =($29.50)


(41) = $1209.5

P $29.50

D
Q 40 Q 41

%Q 2.5

% Change in revenues = .
80%

2.5%

An elasticity of demand that is less than


1 in absolute value indicates that raising
price will increase revenues

TR PQ
%TR % P %Q
3.75%

5.00%

% Q 1.25

.25
% P
5.0

% Change in revenues = 3 .75%


Total Revenues =($10.50)(79) = $829.50

% P 5

P $10.50

Total Revenues =($10)(80)


= $800

P $10.00

.25

D
Q 79 Q 80

% Q 1.25

-1.25%

Revenues are maximized when the elasticity of demand equals -1

Total Revenues

Elasticity

1400

1200

-1
-2

1000

-3

800

-4

600

-5
-6

400

Elasticity is less
than -1: raise price

Elasticity is greater
than -1: lower price

-7

200

-8

-9
-10

Max Revenues
Quantity = 50
Price =$25
Revenues = $1,250

Quantity = 50
Price =$25
Elasticity = -1

Because you must lower your price to existing customers to attract new
customers, marginal revenue will always be less than price
Q = 40
P = $30
Revenues = ($30)(40) = $1200
60
Q = 41
P = $29.50
Revenues = ($29.50)(41) = $1209.50

40
P = $30
20

Marginal Revenues = $9.50

MR = $9.50
0

-20

-40

MR
-60

Note that because we have ignored the cost side, we are assuming marginal
costs are equal to zero!

1400

60

Revenues = $1250
1200

40

1000

P = $25
20
P

800
MR = MC = $0

600
-20
400
-40

200
MR

-60

Now, lets bring in the cost side. For simplicity, lets assume that you face a
constant marginal cost equal to $20 per unit.
Quanti
ty

Price

Total
Reven
ue

Margi
nal
Reven
ue

Total
Cost

Margi
nal
Cost

Profit

$49.50

$49.50

$49.50

$20

$20

$29.50

$49

$98

$48.50

$40

$20

$58

$48.50

$145.5
0

$47.50

$60

$20

$85.50

$48

$192

$46.50

$80

$20

$112

$47.50

$237.5
0

$45.50

$100

$20

$137.5
0

$47

$282

$44.50

$120

$20

$162

$46.50

$325.5
0

$43.50

$140

$20

29

$35.50

$1029.
50

$21.50

$580

$20

$449.5
0

30

$35

$1050

$20.50

$600

$20

$450

31

$34.50

$1069.
50

$19.50

$620

$20

$449.5
0

Continuing on

$185.5
0
down

A profit maximizing price sets marginal revenue equal to marginal cost. Marginal
revenue is the change in total revenue (i.e. the slope)
1500
Slope = 20

1000

500

Profits = $450

-500

Total Revenue
Profit

Total Cost

A profit maximizing price sets


marginal revenue equal to marginal
cost

Price = $35
Quantity = 30
Elasticity = -2.36

60
50

P MC $35 $20

.42
P
$35

40
P = $35
30
20

Profit = ($35-$20)*30
= $450

1
1

.42
2.36

10
0

This is not a coincidence. A


monopoly sets a markup
that is inversely proportional
to the elasticity of demand!

-10
-20
-30

Price
Marginal Revenue

Marginal Cost

Markups for Selected Industries


Industry

LI

Communication

.972

Paper & Allied Products

.930

Electric, Gas & Sanitary Services

.921

Food Products

.880

General Manufacturing

.777

Furniture

.731

Tobacco

.638

Apparel

.444

Motor Vehicles

.433

Machinery

.300

Suppose that we
assumed the
automobile
industry were
monopolized
P MC
.433
P

So, a 1% increase in automobile prices will lower sales by 2.3%

1
2 .3
.433

Is it possible to attract new customers without lowering your price to


everybody?

p
Loss from charging
existing customers a
lower price

Gain from attracting new


customers

Lets suppose that Notre dame has identified three different


consumer types for Notre Dame football tickets. Further,
assume that Notre Dame has a marginal cost of $20 per ticket.

Dollars

$120

$80

Alumni

Faculty

Students

$40

40,000

70,000

80,000

If Notre Dame had to


set one uniform price to
everybody, what price
would it set?

Lets suppose that Notre dame has identified three different


consumer types for Notre Dame football tickets. Further,
assume that Notre Dame has a marginal cost of $20 per ticket.

Dollars

$120

$80

Alumni

Price

Quantity

Total
Revenue

Total Cost

Profit

$120

40,000

$4.8M

$800,000

$4.0M

$80

70,000

$5.6M

$1.4M

$4.2M

$40

80,000

$3.2M

$1.6M

$1.6M

Faculty

Students

$40
$20
0

MC
40,000

70,000

80,000

Now, suppose that Notre Dame can set up differential pricing.


Pricing Schedule
Regular Price: $120
Faculty/Staff: $80
Student: $40

Dollars

$120

$80

Alumni

Price

Quantit
y

Total
Revenu
e

Total
Cost

Profit

$120

40,000

$4.8M

$400,00
0

$4.4M

$80

30,000

$2.4M

$300,00
0

$2.1M

$40

10,000

$400,00
0

$200,00
0

$200,00
0

Total

80,000

$7.6M

$900,00
0

$6.7M

Faculty

Students

$40
$20
0

MC
40,000

70,000

80,000

What would Notre Dame


need to do to accomplish
this?

Example: DVD codes are a digital rights management technique that allows film
distributors to control content, release date, and price according to region.

DVD coding allows for distributors to price discriminate by region.

Why is movie theatre popcorn so expensive?

Dollars

$15

General
Public

This would be an easy price


discrimination problem
Senior
Citizens

$8

Pricing Schedule
Regular Price: $15
Senior Citizens: $8
0

200

300

Now, suppose that the identities are unknown? How


can the theatre extract more money out of the avid
moviegoer?

Ticket
Price

Popcorn
Price

Total

Option #1

$14

$1

$15

Option #2

$8

$7

$15

Option #3

$2

$13

$15

Dollars

$15

Avid
Moviegoer

Occasional
Moviegoer

$8

200

As long as the total


price (popcorn +
ticket) is $15 or less,
avid moviegoers will
still go
300

Which pricing option would you choose?

Suppose that Disneyworld knows something about the average


consumers demand for amusement park rides. Disneyworld has
a constant marginal cost of $.02 per ride

Q 100 100 P
Dollars

.50

Price (per ride)

Quantity (rides)

$1

$.99

$.98

$0

100

Demand

50

As a first pass, we could solve for a profit maximizing price per


ride

Q 100 100 P
Dollars

.51

Profit = $24.01
MC
Demand

.02
0

49
MR

Price
(per
ride)

Quanti
ty
(rides)

Total
Reven
ues

Margin
al
Reven
ues

Margin
al Cost

$1

$0

$.99

$.99

$.99

$.02

$.98

$1.96

$.97

$.02

$.52

48

$24.96

$.05

$.02

$.51

49

$24.99

$.03

$.02

$.50

50

$25

$.01

$.02

If all Disney does is charge a price per ride, they are leaving
some money on the table

Q 100 100 P
Dollars

$1

CS = (1/2)($1-.51)*49 = $12.00

.51

Profit = $24.01
MC
Demand

.02
0

49
MR

We are charging this person


$24.01 for 49 rides when they
wouldve $36.01!

Like the movie theatre, Disney has two prices to play with. We have a
price per ride as well as an entry fee. For any price per ride, we can set
the entry fee equal to the consumer surplus generated.

Q 100 100 P
Dollars
Fee = (1/2)($1-P)*Q

$1

$P
Profit = (P-.02)*Q

Price
(per
ride)

Quantity
(rides)

Ride
Revenu
e

Fee
Revenu
e

Total
Revenu
es

Margin
al
Revenu
es

Margin
al Cost

$1

$0

$0

$0

---

---

$.99

$.99

$.005

$.995

$.995

$.02

$.98

$1.96

$.02

$1.98

$.985

$.02

$.03

97

$2.91

$47.0
5

$49.9
6

$.03

$.02

$.0
2

98

$1.96

$48.0
2

$49.9
8

$.02

$.02

$.01

99

$.99

$49

$49.9
9

$.01

$.02

MC
Demand

.02
0

Total Profit = $48.02

We are still looking to where


marginal revenues equal
marginal costs.

The optimal pricing scheme here is to set a price per ride equal
to marginal cost. We then set the entry fee equal to the
consumer surplus generated.

Q 100 100 P
Pricing Schedule
Entry Fee: $48.02
Price Per Ride: $.02

Dollars
Fee = (1/2)($1-.02)*98 = $48.02

$1

Or, we could
combine the two

.02

MC
Demand

Ride Revenue = .02*98 = $1.96


0

Total Profit = $48.02

98

Entry Fee: $48.02


+ Ride Charges: $1.96
98 Ride Package = $49.98

Now, suppose that we introduced two different clientele. Say, senior citizens and
Non-seniors. We could discriminate based on price per ride (assume there is one
of each type)

Non-Seniors

Seniors

Q 100 100 P

Q 80 100 P

Dollars

Dollars

$1

$.80

.51

.41

Profit = $24.01

Profit = $15.21
MC
Demand

.02
0

49

MC
Demand

.02
0

39

MR

Total Profit = $24.01 + $15.21 = $39.22

MR

Alternatively, you set the cost of the rides at their marginal cost ($.02) for
everybody and discriminate on the entry fee.
P = $.02/Ride

Dollars

$1

Entry Fee =

Seniors
Q 80 100 P

MC
Demand

Ride Revenue = .02*98 = $1.96


0

$30.42 Old

Non-Seniors
Q 100 100 P

Fee = (1/2)($1-.02)*98 = $48.02

.02

$48.02 Young

98

$.80

Fee = (1/2)($.80-.02)*78 = $30.42

.02

Ride Revenue = .02*78 = $1.56


0

Total Profit = $48.02 + $30.42 = $78.44

78

MC
Demand

Or, you could establish different package prices.


Pricing Schedule=

Dollars

$1

Regular Admission (98 rides): $49.98


Senior Citizen Special (78 Rides): $31.98

Non-Seniors
Q 100 100 P

Seniors
Q 80 100 P

Fee = (1/2)($1-.02)*98 = $48.02

.02

MC
Demand

Ride Revenue = .02*98 = $1.96


0

98

Total Price = $48.02 + $1.96 = $49.98

$.80

Fee = (1/2)($.80-.02)*78 = $30.42

.02

Ride Revenue = .02*78 = $1.56


0

MC
Demand

78

Total Price = $30.42 + $1.56 = $31.98

Suppose that you couldnt distinguish High value customers from low value
customers: Would this work?

Dollars

$1

Q 80 100 P

Q 100 100 P

Fee = (1/2)($1-.02)*98 = $48.02

.02

MC
Demand

Ride Revenue = .02*98 = $1.96


0

98

Pricing Schedule=

$.80

Fee = (1/2)($.80-.02)*78 = $30.42

.02

Ride Revenue = .02*78 = $1.56


0

Regular Admission (98 rides): $49.98


Early Bird Special (78 Rides): $31.98

78

MC
Demand

We know that is the high value consumer buys 98 ticket package, all her surplus
is extracted by the amusement park. How about if she buys the 78 Ride
package?

Total Willingness to pay for 78 Rides: $47.58

- 78 Ride Coupons: $31.98

$100

$15.60

$30.42

If the high value customer buys


the 78 ride package, she keeps
$15.60 of her surplus!

$22
$17.16

Q 100 100 P
78

You need to set a price for the 98 ride package that is incentive compatible. That
is, you need to set a price that the high value customer will self select. (i.e., a
package that generates $15.60 of surplus)

p
Total Willingness = $49.98

$1.00

- Required Surplus = $15.60


Package Price

78 Ride Coupons: $31.98


98 Ride Coupons: $34.38

= $34.38

$48.02

$.02
$1.96

98

$31.98 $34.38 $.02176 $62.84

Bundling
Suppose that you are selling two products. Marginal costs for these products
are $100 (Product 1) and $150 (Product 2). You have 4 potential consumers
that will either buy one unit or none of each product (they buy if the price is
below their reservation value)

Consumer Product 1 Product 2

Sum

$50

$450

$500

$250

$275

$525

$300

$220

$520

$450

$50

$500

If you sold each of these products separately, you would choose prices
as follows

Product 1 (MC = $100)

Product 2 (MC = $150)

TR

Profit

TR

Profit

$450

$450

$350

$450

$450

$300

$300

$600

$400

$275

$550

$250

$250

$750

$450

$220

$660

$210

$50

$200

-$200

$50

$200

-$400

Profits = $450 + $300 = $750

Pure Bundling does not allow the products to be sold separately


Product 1 (MC = $100)
Product 2 (MC = $150)

Consumer Product 1 Product 2

Sum

$50

$450

$500

$250

$275

$525

$300

$220

$520

$450

$50

$500

With a bundled price of $500, all four consumers buy


both goods:
Profits = 4($500 -$100 - $150) = $1,000

Mixed Bundling allows the products to be sold separately


Product 1 (MC = $100)
Product 2 (MC = $150)

Consumer Product 1 Product 2 Sum


A

$50

$450

$500

$250

$275

$525

$300

$220

$520

$450

$50

$500

Price 1 = $250
Price 2 = $450
Bundle = $500

Consumer A: Buys Product 2 (Profit = $300) or Bundle


(Profit = $250)
Consumer B: Buys Bundle (Profit = $250)
Consumer C: Buys Product 1 (Profit = $150)
Consumer D: Buys Only Product 1 (Profit = $150)

Profit = $850
or $800

Mixed Bundling allows the products to be sold separately


Product 1 (MC = $100)
Product 2 (MC = $150)

Consumer Product 1 Product 2 Sum


A

$50

$450

$500

$250

$275

$525

$300

$220

$520

$450

$50

$500

Price 1 = $450
Price 2 = $450
Bundle = $520

Consumer A: Buys Only Product 2 (Profit = $300)


Consumer B: Buys Bundle (Profit = $270)
Consumer C: Buys Bundle (Profit = $270)
Consumer D: Buys Only Product 1 (Profit = $350)

Profit = $1,190

Bundling is only Useful When there is variation over individual consumers


with respect to the individual goods, but little variation with respect to the
sum!?

Consumer Product 1 Product 2 Sum


A

$300

$200

$500

$300

$200

$500

$300

$200

$500

$300

$200

$500

Product 1 (MC = $100)


Product 2 (MC = $150)

Individually Priced: P1 = $300, P2 = $200, Profit = $1,000


Pure Bundling: PB = $500, Profit = $1,000
Mixed Bundling: P1 = $300, P2 = $200, PB = $500, Profit = $1,000

Suppose that you sell laser printers. To create printed pages, you need both a printer
and an ink cartridge. For now, assume that the toner cartridges are sold in a
competitive market and sell for $2 each. An ink cartridge is good for 1,000 printed
pages.

Q 16 P
Dollars

CS = *($16 - $2)(14) = $98


$16

Quantity of
printed pages
(000s)

Toner cartridge
price

$2

Demand

14

What price would you


sell the printer for?

Now, suppose that you design a printer that requires a special cartridge that
only you produce. What would you do if you could choose a printer price
and a cartridge price?

Q 16 P

Dollars

CS = *($9 - $2)(7) = $24.50

$16

Quantity of
printed pages
(000s)

Toner cartridge
price

$9

MC

$2

Demand

7
MR

We could make our money on the


cartridges and sell the printers
cheap

TR

TC

MR

MC

Pro
fit

$15

$15

$2

$15

$2

$13

$14

$28

$4

$13

$2

$24

$13

$39

$6

$11

$2

$33

$12

$48

$8

$9

$2

$40

$11

$55

$10

$7

$2

$45

$10

$60

$12

$5

$2

$48

$9

$63

$14

$3

$2

$49

$8

$64

$16

$1

$2

$48

Alternatively, we could do something like the amusement park. We


maximize profits combining cartridge revenue AND printer revenue

Q 16 P

Dollars

CS = *($16 - $2)(14) = $98

$16

Quantity of
printed pages
(000s)

MC

$2

TR

CS

Tota
l

TC

MR

MC

Pro
fit

$15

$15

$.5

$15.
5

$2

$15.
5

$2

$13.5

$14

$28

$2

$30

$4

$14.
5

$2

$26

$13

$39

$4.5

$43.
5

$6

$13.
5

$2

$37.5

$12

$48

$8

$56

$8

$12.
5

$2

$48

$11

$55

$12.5

$67.
5

$1
0

$11.
5

$2

$57.5

13

$3

$39

$84.5

$123
.5

$2
6

$3.5

$2

$97.5

Demand

14
MR

We are back to a low


cartridge price and a high
printer price

Toner cartridge
price

Now, suppose that you have two customers. Call them high value and low value.
Suppose that you can easily identify them and prevent resale. We could
discriminate on both the printer price and the cartridge price.

Q 12 P

Q 16 P

Dollars

Dollars

CS = *($16 - $9)(7) = $24.50

$16

$9

CS = *($12 - $2)(5) = $12.50

$12

$7

MC

$2

MC

$2

Demand

Demand

0
MR

5
MR

Profit = ($9-$2)7 +$24.50 = $73.50

Total Profit = $111

Profit = ($7-$2)5 +$12.50 = $37.50

Alternatively, we could essentially give the cartridges away and discriminate on


the printer (like Disneyworld).

Dollars

Q 12 P

Q 16 P

Dollars

CS = *($16 - $2)(14) = $98

$16

MC

$2

CS = *($12 - $2)(10) = $50

$12

MC

$2

Demand

14

Demand

Profit = $98

10

Profit $50

Total Profit = $148

Suppose that you couldnt explicitly price discriminate. Lets say that you know
you have a high value and low value demander, but you dont know who is who.
Lets first try and do this like the amusement park

Dollars

Q 12 P

Q 16 P

Dollars

CS = *($16 - $2)(14) = $98

$16

MC

$2

CS = *($12 - $2)(10) = $50

$12

MC

$2

Demand

14

14 Cartridge Package = $98 + $2*14 = $126

Demand

10

10 Cartridge Package = $50 + $2*10 = $70

Suppose that you couldnt explicitly price discriminate. Lets say that you know
you have a high value and low value demander, but you dont know who is who.
Lets first try and do this like the amusement park

Q 16 P

Dollars

14 Cartridge Package = $126

CS = *($16 - $9)(10) = $50

$16

- required consumer surplus = $40


Discounted Price = $86

14 Cartridge Package = $86


10 Cartridge Package = $70

$6
$60
Demand

10
Total Willingness to Pay = $110
- 10 Cartridge Package = $70
Consumer Surplus = $40

Profit = $86 + $70 - $2*24 = $108

Lets try a different strategy. Suppose that you charge a markup on the cartridges
and then charge a common price for the printer to each. We would set the price
of the printer equal to the consumer surplus of the lower value demander of insure
that both groups buy the printer.

Q 12 P

Example:
Cartridge Price: $3
Consumer Surplus = *($12 - $3)(9) = $40.50

Dollars

CS = *($12 - $P)(12-P)

$12

Charge $40.50 for the printer


(Both customers will buy)
Low value customers buy 9
cartridges
High Value customers buy 13
cartridges

$P

$60
Demand

12-P

Profit = 2*$40.50 + ($3-$2)(21) = $103

We need to find the best cartridge price

P Q1 Q2

Q 16 P

.512 P Q2

Q 12 P

$2 Q1 Q2

2 * CS

Price

Quantity
1

Quanti
ty 2

Total
Reven
ue

Consumer
Surplus

Printer
Revenue

Total
Revenue

Total
Cost

Profit

$0

16

12

$0

$72

$144

$144

$56

$88

$.25

15.75

11.75

$6.875

$69.03

$138.06

$144.93

$55

$89.93

$.50

15.5

11.5

$13.50

$66.135

$132.25

$145.75

$54

$91.75

$3

13

$66

$40.5

$81

$147

$44

$103

$4

12

$80

$32

$64

$144

$40

$104

$4.25

11.75

7.75

$82.87
5

$30.03

$60.06

$142.93

$39

$103.93

Lets try a different strategy. Suppose that you charge a market on the cartridges
and then charge a common price for the printer to each. We would set the price
of the printer equal to the consumer surplus of the lower value demander of insure
that both groups buy the printer.

Q 12 P

Best Choice:

Dollars

CS = *($12 - $4)(8) = $32

$12

$4

Charge $32 for the printer


(Both customers will buy)
Charge $4 for cartridges
Low value customers buy 8
cartridges
High Value customers buy 12
cartridges

$60
Demand

Profit = 2*$32 + ($4-$2)(20) = $104

One last example. Consider the market for hot dogs.


Most people require a bun for each hot dog they eat
(with the exception of the Atkins diet people!)

Q 12 PH PB
Price of a Hot Dog

Price of a Hot Dog Bun

Hot Dogs and Buns are made by separate companies each


has a monopoly in its own industry. For simplicity, assume
that the marginal cost of production for each equals zero.

For simplicity I will assume that marginal costs are zero


(i.e. we are maximizing revenues)
Suppose that you knew that the buns were selling for $2,
what should you charge?

Q 12 PH $2 10 P

You
charge $5

Quantity

Price

Total
Revenue

Marginal
Revenue

$9

$9

$9

$8

$16

$7

$7

$21

$5

$6

$24

$3

$5

$25

$1

$4

$24

-$1

But, if the bun guy sees you charging $5, he needs to


react to that

Q 12 PB $5 7 P

Bun Guy
charge $4

Quantity

Price

Total
Revenue

Marginal
Revenue

$6

$6

$6

$5

$10

$4

$4

$12

$2

$3

$12

$0

$2

$10

-$2

$1

$6

-$4

But, if the bun guy is charging $4, you need to react to that

Q 12 PB $4 8 P

You
charge $4

Quantity

Price

Total
Revenue

Marginal
Revenue

$7

$7

$7

$6

$12

$5

$5

$15

$3

$4

$16

$1

$3

$15

-$1

$2

$12

-$3

Now, suppose that these companies merged into


one monopoly

Q 12 PB PH 8 P

You
charge $6
for hot
dog/bun

Quantity

Combined
Price

Total
Revenue

Marginal
Revenue

$11

$11

$11

$10

$20

$9

$9

$27

$7

$8

$32

$5

$7

$35

-$3

$6

$36

-$1

$5

$35

-$1

$4

$32

-$3

$3

$27

-$5

Look at what happened here

Q 12 PB PH

Separate Hot Dog/Bun Suppliers

PH $4
PB $4
Consumer Pays $8 for a
hot dog/bun pair

Single Hot Dog/Bun Suppliers

PH PB $6

Consumer Pays $6 for a


hot dog/bun pair

Eliminating a company benefits consumers!!!

Example: Microsoft vs. Netscape


The argument against Microsoft was using its monopoly power in
the operating system market to force its way into the browser
market by bundling Internet Explorer with Windows 95.
To prove its claim, the government needed to show:
Microsoft did, in fact, possess monopoly power
The browser and the operating system were, in fact, two distinct
products that did not need to be integrated
Microsofts behavior was an abuse of power that hurt
consumers
What should Microsofts defense be?

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