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Microeconomicsindian economy
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PRICING WITH PRICING WITH MARKET POWER-IIMARKET POWER-II
PRICING WITH PRICING WITH MARKET POWER-IIMARKET POWER-II
ME, SESSION 13ME, SESSION 13
1313thth August, 2012 August, 2012
PROF. SAMAR K. DATTAPROF. SAMAR K. DATTA
Checklist for Checklist for studentsstudents
•Two-part tariff•Advertising•Pricing of Joint Products
•Bundling & tying
Two-Part PricingTwo-Part Pricing• When it isn’t feasible to charge
different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.
• Two-part pricing consists of a fixed fee and a per unit charge.– Example: Athletic club memberships.
How Two-Part Pricing How Two-Part Pricing WorksWorks
1. Set price at marginal cost.2. Compute consumer
surplus.3. Charge a fixed-fee equal
to consumer surplus.
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC
Fixed Fee = Profits* = $16
Price
Per UnitCharge
* Assuming no fixed costs
Meaning of Two-Part Meaning of Two-Part TariffTariff
• The purchase of some products and services can be separated into two decisions, and therefore, two prices. Examples
1) Amusement Park• Pay to enter• Pay for rides and food within the park
2) Tennis Club• Pay to join• Pay to play
• Pricing decision is setting the entry fee (T) and the usage fee (P), thus choosing the trade-off between free-entry and high use prices, or high-entry and zero use prices
Usage price P* is set whereMC = D. Entry price T*
is equal to the entire consumer surplus.
T*
Two-Part Tariff with a Two-Part Tariff with a Single ConsumerSingle Consumer
Quantity
$/Q
MCP*
D
D2 = consumer 2
D1 = consumer 1
Two-Part Tariff with Two Two-Part Tariff with Two ConsumersConsumers
Quantity
$/Q
MC
Q1Q2
The price, P*, will be greater than MC. Set T* at the surplus value of D2.T*
P*
Thus there is a trade-off between high entry fee & high user price
A
C
Π=2T*+(P*-MC).(Q1+Q2)>2ΔABC
B
The Two-Part Tariff with The Two-Part Tariff with Many ConsumersMany Consumers
• No exact way to determine P* and T*.• Must consider the trade-off between the entry
fee T* and the use fee P*.– Low entry fee=> High sales and falling profit
with lower price and more entrants.
• To find optimum combination, choose several combinations of P and T
• Choose the combination that maximizes profit
• Rule of Thumb– Similar demand: Choose P close to MC and high
T– Dissimilar demand: Choose high P and low T.
Two-Part Tariff With A TwistTwo-Part Tariff With A Twist
• Suppose, entry price (T) entitles the buyer to a certain number of free units
•Gillette razors with several blades
•Amusement parks with some tokens
•On-line with free time
AdvertisingAdvertising
• Assumptions– Firm sets only one price– Firm knows Q(P,A)
• How quantity demanded depends on price and advertising
Q0
0
P0
Q1
1
P1
AR
MR
AR and MR are averageand marginal revenue whenthe firm doesn’t advertise.
MC
If the firm advertises, its average and marginalrevenue curves shift to
the right -- average costsrise, but marginal cost
does not.
AR’
MR’
AC’
Effects of AdvertisingEffects of Advertising
Quantity
$/Q
AC
AdvertisingAdvertising• Choosing Price and Advertising
Expenditure
• A Rule of Thumb for Advertising
adv. of MC full1
)(),(
A
QMC
A
QPMR
AQCAPPQ
Ads
ratio sales toAdv.
1)(
pricingfor /1/)(
PQ
A
A
Q
Q
A
P
MCP
A
QP-MC
EPMCP P
AdvertisingAdvertising• A Rule of Thumb for Advertising
• To maximize profit, the firm’s advertising-to-sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand
Thumb of Rule
demand of elasticity Adv.
P
)(
1)(
))((
PA
A
EEPQA
EPMCP
EAQQA
Advertising – An ExampleAdvertising – An Example• R(Q) = $1 million/yr• $10,000 budget for A (advertising--1% of
revenues)• EA = 0.2 (increase budget $20,000, sales
increase by 20%• EP = -4 (markup price over MC is substantial)
• Should the firm increase advertising?
• YES– A/PQ = -(0.2/-4) = 5%– Increase budget to $50,000
Meaning of Joint ProductsMeaning of Joint Products
• Goods jointly produced in fixed proportions:– Interdependence in production– Single marginal cost curve for both
products or product package; e.g., beef & hides
• However, demand curves & MR curves are independent
• Pricing decision must recognize inter-dependence in production– Marginal revenue of product package is
vertical sum of two MR curves;
Pricing of Joint Products w/o Pricing of Joint Products w/o Excess production of Hides Excess production of Hides (case 1: (case 1:
MR>0 for both products at equilibrium)MR>0 for both products at equilibrium)
PH
PB
DB
MRT
DH
MRT
MRB
MRH
MRH MRB
Prices etc.
QuantityX*
MC
As MR for B<0 at Q1, (Q1-Q0) amount of product B ought to be kept off the
market for maximization of profit
Tangency of iso-product curves to the highest possible iso-revenue curves
provides the optimal points in figure
Case 3: Unlike in the two earlierCases, outputs A & B are nowproduced under flexible proportions,giving rise to concave to origin product transformation curves at constant costs.
BundlingBundling
• Bundling is packaging two or more products to gain a pricing advantage.
• Conditions necessary for bundling– Heterogeneous customers– Price discrimination is not possible– Demands must be negatively correlated
Bundling Example With Bundling Example With Two ConsumersTwo Consumers
Spiderman Spaceballs
Theater A $12,000 $3,000
Theater B $10,000 $4,000
• Renting the movies separately would result in each theater paying the lowest reservation price for each movie
– Total Revenue = $26,000
• If the movies are bundled and if each were charged the lower of the two prices
– Total revenue will be $28,000.
Reservation Price
Bundling Example With Two Bundling Example With Two Consumers – Importance of Negative Consumers – Importance of Negative
Correlation of DemandsCorrelation of Demands• If the demands were positively correlated
(Theater A would pay more for both films as shown), bundling would not result in an increase in revenue.
Gone with the Wind Getting Gertie’s Garter
Theater A $12,000 $4,000
Theater B $10,000 $3,000
If the movies are bundled and if each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films, separately.
Bundling Example With Two Bundling Example With Two Heterogeneous Goods and Many Heterogeneous Goods and Many
ConsumersConsumersr2
(reservationprice Good 2)
r1 (reservation price Good 1)
$5
$10
$5 $10
$6
$3.25 $8.25
$3.25
ConsumerA
ConsumerC
ConsumerB
Consumer A is willing to pay up to
$3.25 for good 1 andup to $6 for good 2.
Consumption Decisions Consumption Decisions WhenWhen
Products are Sold Products are Sold SeparatelySeparately
r2
r1
P2
II
Consumers buyonly good 2
22
11
Pr
Pr
P1
Consumers fall intofour categories basedon their reservation
price.I
Consumers buyboth goods
22
11
Pr
Pr
III
Consumers buyneither good
22
11
Pr
Pr
IV
Consumers buyonly Good 1
22
11
Pr
Pr
Consumption DecisionsConsumption DecisionsWhen Products are When Products are
BundledBundledr2
r1
r2 = PB - r1
I
II
Consumersbuy bundle
(r > PB)
Consumers donot buy bundle
(r < PB)
Consumers compare the sum of their reservation prices, r1 + r2, with the bundle price PB. They buy the bundle only if r1 + r2 is at least as large as PB.
Consumption DecisionsConsumption DecisionsWhen Products are BundledWhen Products are Bundled
Depending on the prices, some of the consumers in regions II and IV might have bought one of the goods if they were sold separately. These customers are lost to the firm.
However, the other customers in regions II and IV now buy both goods where they formerly bought only one.
The firm then, must decide whether it can do better by bundling.
Buyers who buy neither good
Buyers of good 1 lost to the firm
Buyers of good 1 who now buy good 2 also
Buyers of good 2 lost to the firm
Buyers of good 2 who now buy good 1 also
Buyers who buy both the goods
Efficiency of Bundling Depends Efficiency of Bundling Depends on the Degree of Negative on the Degree of Negative
CorrelationCorrelation
r2
r1
Bundling pays due to negative correlation
(Spaceballs)
(Spiderman)
5,000 14,00010,000
5,000
10,000
12,000
4,000
3,000
B
A
Mixed Versus Pure BundlingMixed Versus Pure Bundling
r2
r110 20 30 40 50 60 70 80 90 100
10
20
30
40
50
60
70
80
90
100
C2 = MC2 = 30
Consumer A, for example, has a reservation price for good 1 that is below marginal cost c1.
With mixed bundling, consumer A is induced to buy only good 2, while
consumer D is induced to buy only good 1,reducing the firm’s cost.
A
B
D
C
C1 = MC1 = 20With positive marginalcosts, mixed bundling may be more profitable
than pure bundling.
Sell separately $80 $80 ----$320
Pure bundling ---- ---- $100 $400
Mixed bundling $90 $90 $120$420
P1 P2 PB Profit
Mixed BundlingMixed Bundlingwith Zero Marginal Costswith Zero Marginal Costs
Mixed BundlingMixed Bundlingwith Zero Marginal Costswith Zero Marginal Costs
r2
r120 40 60 80 100
20
40
60
80
100
120
120
In this example, consumers B and C are willing to pay $20 more for the bundle
than are consumers A and D. With mixed bundling, the price of the bundle
can be increased to $120.A & D can be charged $90 for a single good.
C
10 90
10
90A
B
D
Mixed Bundling in PracticeMixed Bundling in Practice
• Use of market surveys to determine reservation prices
• Design a pricing strategy from the survey results
• Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.
TyingTying• Practice of requiring a customer to
purchase one good in order to purchase another.
• Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy user
• Examples– Xerox machines and the paper
– IBM mainframe and computer cards
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