Chapter 14 Firms Must Have Market Power Practice Any

Chapter 14:

ADVANCED PRICING TECHNIQUES

Essential Concepts

PRICE DISCRIMINATION: CAPTURING CONSUMER SURPLUS

1. Uniform pricing occurs when businesses charge the same rice for every unit of the product they sell.

Price discrimination is a more profitable alternative to uniform pricing, if market conditions allow this

practice to be profitably executed.

of capturing consumer surplus, turning consumer surplus into economic profit.

3. Price discrimination between two products A and B exists when the price-to– marginal cost ratio

differs between products:

FIRST-DEGREE (OR PERFECT) PRICE DISCRIMINATION

1. Under first-degree price discrimination, the discriminating firm examines each individual’s demand

separately, and charges each consumer the maximum price he or she is willing to pay for every unit.

2. Since every unit is sold for its demand price, first-degree price discrimination allows the firm to

SECOND-DEGREE PRICE DISCRIMINATION

1. When the same consumer buys more than one unit of a good or service at a time, the marginal value

2. There are many ways to design pricing plans that offer reduced average prices as quantity purchased

increases. We look at two of these: (i) two-part pricing, and (ii) declining block pricing.

3. Two-Part Pricing Under two-part pricing, the firm charges buyers a fixed access charge (A) to

purchase as many units as they wish for a constant usage fee (f) per unit. The total expenditure for a

Chapter 14: Advanced Pricing Techniques

which shows that p falls as q rises (i.e., quantity discount).

4. Determining the optimal values for A and f is a complex task, but we can give solutions for two

simplified situations. By showing you how this works for two rather simple situations, we can show

you the basic way in which two-part pricing increases revenue and profit:

5. Declining Block Pricing Declining block pricing is a common form of second-degree price

discrimination that offers quantity discounts over successive discrete blocks of quantities purchased.

THIRD-DEGREE PRICE DISCRIMINATION

1. If a firm sells in two distinct markets (1 and 2) –that is, practices third-degree price discrimination–

then it should allocate output (sales) between the two markets such that

MR1=MR2

, which will

maximize the total revenue (TR1 + TR2) for the firm. This is known as the equal-marginal-revenue

principle.

2. When setting prices in multiple markets, the application of the equal-marginal-revenue principle

3. The optimal level of total output for a third-degree price discriminating firm is the level for which

PRICING PRACTICES FOR MULTIPRODUCT FIRMS

1. Pricing Multiple Products Related in Consumption If a firm produces two products, X and Y, the firm

maximizes profit by producing and selling output levels for which

2. Bundling Multiple Products When price discrimination is not possible and if two conditions are met,

bundling multiple goods and charging a single price for the bundle can be more profitable than

COST-PLUS PRICING (DON’T DO IT)

1. Cost-plus pricing is a common technique for pricing when firms cannot or do not wish to estimate

2. The price charged represents a markup (margin) over average cost:

cost to compute price.

Answers to Applied Problems

1. STIHL may be practicing second-degree price discrimination by offering different qualities at

different prices, where the price-to-marginal cost ratios differ across quality lines. STIHL knows that

most buyers are only going to buy one chain saw, so quantity discounts are not useful. By letting

2. Low income people may benefit from price discrimination, because they are likely to be more price

sensitive buyers and thus be on the receiving end of lower prices. Price discrimination may make it

3. Before airlines began requiring photo IDs, there was an active market in newspapers for cheap airline

tickets. If you wanted to fly to New York unexpectedly, you would not likely qualify for supersaver

4. Firms must have market power to practice any one of the forms of price discrimination. Since global

competition reduces market power, firms facing global competition will find it more difficult to raise

prices much above marginal cost. This reduces the benefit of undertaking price discrimination

methods, making uniform pricing attractive.

5. If the number of blocks equals the number of units where P = MC, then all consumer surplus is

extracted and declining block pricing results in the same profit as first-degree (or perfect) price

discrimination. When multiple units are sold for the same price within pricing blocks, uniform pricing

Chapter 14: Advanced Pricing Techniques

information about consumer demand in order to implement declining block pricing compared with

perfect or precise demand information needed to practice first-degree price discrimination.

6. a.

MRT=MC ÞQT

*=40

c. From their respective demand curves, PS = $0.70 and PB = $0.90.

7. a.

and

c. Using the procedure set forth in footnote 9 in the textbook:

MRC=136 –0.032QC–0.016QS

e. Substituting the above quantities into the inverse demand functions provides the profit-

maximizing prices:

8. Price discrimination could explain price differentials not based on cost differences. Hardcover books

sell for more than paperbacks, implying that the purchasers of hardcover books are relatively less

responsive to price changes (have a less elastic demand) than the purchasers of paperbacks.

9. The fee differences could indicate price discrimination by the dating service. If men tend to have a

10. a. To maximize revenue, which is equivalent to maximizing profit in this example, Berkely Golf &

Tennis Club should charge $250 for golf memberships and $100 for tennis memberships, which

will generate monthly revenue of $170,000 = ($250  400 + $100  700). To find this pair of

11. a. Business travelers tend to pay the higher price because they qualify for discounts less frequently

than do leisure travelers.

b. Business travelers have fewer substitutes for air travel than do leisure travelers. Business

travelers must reach destinations in a timely fashion. Driving or taking the bus is not a good

higher price to the less elastic market.

c. (1) Business people must often travel on short notice, leisure travelers usually can plan 14

days in advance.

12. a. If the shirts are truly the same (only the size differs), then costs are the same and the laundry is

practicing price discrimination.

(1) Compared to men, women can more easily substitute home laundering and ironing for

professional laundry service. Thus women have a readily available (and close) substitute for

professional laundering.

(2) Compared to the average man, women have lower incomes on average, so the fraction of

c. Abby’s advice to bundle all shirts together is a clever way to make it difficult (and costly) for a

laundry to separate markets. While women’s blouses often have some differences (buttons are on

the opposite side of a blouse), it will be costly, perhaps too costly, for laundries to profitably

separate markets for the purpose of price discrimination. Some women are now buying small

sized men’s shirts for themselves to avoid price discrimination.

13. a. The bar is not maximizing profit. At the current prices, the last male customer added more to

total revenue ($1.50) than the last female customer ($.50). By selling more drinks to male

customers and fewer drinks to female customers, the bar can increase total revenue and profit.