Chapter Twelve

Pricing and Advertising

TopicsWhy and How Firms Price Discriminate. Perfect Price Discrimination. Quantity Discrimination. Multimarket Price Discrimination. Two-Part Tariffs. Tie-In Sales. Advertising.

Nonuniform pricingnonuniform pricing - charging consumers different prices for the same product or charging a single customer a price that depends on the number of units the customer buys

Price discriminationPrice discrimination - practice in which a firm charges consumers different prices for the same good

Why Price Discrimination PaysA price-discriminating firm earns a higher profit from price discrimination because:it charges a higher price to customers who are willing to pay more than the uniform price, capturing some or all of their consumer surplus it sells to some people who were not willing to pay as much as the uniform price.

Table 12.1 A Theaters Profit Based on the Pricing Method Used

Who Can Price DiscriminateThree conditions:a firm must have market power.consumers must differ in their sensitivity to price, and a firm must be able to identify how consumers differ in this sensitivity.a firm must be able to prevent or limit resales

Not All Price Differences Are Price DiscriminationNot every seller who charges consumers different prices is price discriminating.

Types of Price Discriminationperfect price discrimination (first-degree price discrimination) - situation in which a firm sells each unit at the maximum amount any customer is willing to pay for it, so prices differ across customers and a given customer may pay more for some units than for others

Types of Price Discrimination (cont).quantity discrimination (second-degree price discrimination) - situation in which a firm charges a different price for large quantities than for small quantities but all customers who buy a given quantity pay the same price

Perfect Price Discriminationmultimarket price discrimination (thirddegree price discrimination) - a situation in which a firm charges different groups of customers different prices but charges a given customer the same price for every unit of output sold

Perfect Price Discrimination (cont).reservation price - the maximum amount a person would be willing to pay for a unit of output

Figure 12.1 Perfect Price Discrimination

Perfect Price Discrimination: Efficient But Hurts ConsumersA perfect price discrimination equilibrium is efficient and maximizes total welfare.

Perfect price discrimination equilibrium differs from the competitive equilibrium in two ways:perfect price discrimination equilibrium, only the last unit is sold at that price.perfectly price-discriminating monopoly captures all the welfare.

Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibriap, $ per unitEDCBAQ, Units per dayMCsDemand,MRdpc =MCcecp1MC1MC

Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria (cont.)

Application Botox Revisited

Solved Problem 12.1How does welfare change if the movie theater described in Table 12.1 goes from charging a single price to perfectly price discriminating?

Solved Problem 12.2Competitive firms are the customers of a union, which is the monopoly supplier of labor services. Show the unions producer surplus if it perfectly price discriminates. Then suppose that the union makes the firms a take-it-or-leave-it offer: They must guarantee to hire a minimum of H* hours of work at a wage of w*, or they can hire no one. Show that by setting w* and H* appropriately, the union can achieve the same outcome as if it could perfectly price discriminate.

Solved Problem 12.2

Quantity DiscriminationMost customers are willing to pay more for the first unit than for successive units: the typical customers demand curve is downward sloping.

block-pricing schedules - charge one price for the first few units (a block) of usage and a different price for subsequent blocks.

Figure 12.3 Quantity Discriminationp1, $ per unit30507090Q, Units per day2040900m(a) Quantity DiscriminationDemandp2, $ per unit306090Q, Units per day30900m(b) Single-Price MonopolyDemandMR

Figure 12.3 Quantity Discrimination (cont.)

Multimarket Price DiscriminationThe most common method of multimarket price discrimination is to divide potential customers into two or more groups and set a different price for each group.

Multimarket Price Discrimination with Two GroupsA copyright gives Warner Home Entertainment the legal monopoly to produce and sell the Harry Potter and the Prisoner of Azkaban two-DVD movie set, which it released in November 2004. Warner engages in multimarket price discrimination by charging different prices in various countries because it believes that the elasticities of demand differ compared to the U.S. price

Multimarket Price Discrimination with Two Groups (cont). = A + B = [pAQA mQA] + [pBQB mQB]

pAQA = revenue from American customerspBQB = revenue from British customers = American and British profits

Warner sets its quantities so that the marginal revenue for each group equals the common marginal cost, m, which is about $1 per unit.

Multimarket Price Discrimination with Two Groups (cont).Because the monopoly equates the marginal revenue for each group to its common marginal cost, :MRA = m = MRB.

Therefore, using price elasticities:

Multimarket Price Discrimination with Two Groups (cont).From previous slide:

and rearranging,

Figure 12.4 Multimarket Pricing of Harry Potter DVD

Solved Problem 12.3A monopoly drug producer with a constant marginal cost of m = 1 sells in only two countries and faces a linear demand curve of Q1 = 12 2p1 in Country 1 and Q2 = 9 p2 in Country 2. What price does the monopoly charge in each country, how much does it sell in each, and what profit does it earn in each with and without a ban against shipments between the countries?

Solved Problem 12.3

Solved Problem 12.3 (contd)

Identifying GroupsTwo approaches to divide customers into groups:divide buyers into groups based on observable characteristics of consumers.identify and divide consumers on the basis of their actions

Welfare Effects of Multimarket Price DiscriminationMultimarket price discrimination results in inefficient production and consumption.As a result, welfare under multimarket price discrimination is lower than that under competition or perfect price discrimination.

Two-Part Tariffstwo-part tariff - a pricing system in which the firm charges a customer a lump-sum fee (the first tariff or price) for the right to buy as many units of the good as the consumer wants at a specified price (the second tariff)

A Two-Part Tariff with Identical ConsumersA monopoly that knows its customers demand curve can set a two-part tariff that has the same two properties as the perfect price discrimination equilibrium.the efficient quantity, Q1, is sold because the price of the last unit equals marginal cost. all consumer surplus is transferred from consumers to the firm.

Figure 12.5 Two-Part Tariff

Tie-In Salestie-in sale- a type of nonlinear pricing in which customers can buy one product only if they agree to buy another product as well.

requirement tie - in sale a tie-in sale in which customers who buy one product from a firm are required to make all their purchases of another product from that firm

Tie-In Sales (cont).bundling (package tie-in sale) - a type of tie-in sale in which two goods are combined so that customers cannot buy either good separately.bundling a pair of goods pays only if their demands are negatively correlated:

Table 12.2 Bundling of Tickets to Football Game

AdvertisingA monopoly advertises to raise its profit.A successful advertising campaign shifts the market demand curve by changing consumers tastes or informing them about new products.

The Decision Whether to AdvertiseEven if advertising succeeds in shifting demand, it may not pay for the firm to advertise. If advertising shifts demand outward, the firms gross profit must rise. The firm undertakes this advertising campaign only if it expects its net profit (gross profit minus the cost of advertising) to increase.

Figure 12.6 Advertising

Figure 12.7 Shift in the Marginal Benefit of Advertising

Cross-Chapter Analysis: Magazine Subscriptions