Chapter 11 Pricing with Market Power Topics to

Chapter 11 Pricing with Market Power

Topics to be Discussed l Capturing Consumer Surplus l Price Discrimination l Intertemporal Price Discrimination and Peak-Load Pricing l The Two-Part Tariff l Bundling l Advertising © 2005 Pearson Education, Inc. Chapter 11 2

Introduction l Pricing without market power (perfect competition) is determined by market supply and demand. l The individual producer must be able to forecast the market and then concentrate on managing production (cost) to maximize profits. © 2005 Pearson Education, Inc. Chapter 11 3

Introduction l Pricing with market power (imperfect competition) requires the individual producer to know much more about the characteristics of demand as well as manage production. © 2005 Pearson Education, Inc. Chapter 11 4

Capturing Consumer Surplus l All pricing strategies we will examine are means of capturing consumer surplus and transferring it to the producer l Profit maximizing point of P* and Q* m But some consumers will pay more that P* for a good. l Raising price will lose some consumers, leading to smaller profits l Lowering price will gains some consumers, but lower profits © 2005 Pearson Education, Inc. Chapter 11 5

Capturing Consumer Surplus $/Q Pmax The firm would like to charge higher price to those consumers willing to pay it - A A P 1 P* B Firm would also like to sell to those in area B but without lowering price to all consumers P 2 MC PC Both ways will allow the firm to capture more consumer surplus D Q* © 2005 Pearson Education, Inc. MR Chapter 11 Quantity 6

Capturing Consumer Surplus l Price discrimination is the practice of charging different prices to different consumers for similar goods. m Must be able to identify the different consumers and get them to pay different prices l Other techniques that expand the range of a firm’s market to get at more consumer surplus m Tariffs © 2005 Pearson Education, Inc. and bundling Chapter 11 7

Price Discrimination l First Degree Price Discrimination m Charge a separate price to each customer: the maximum or reservation price they are willing to pay. l How can a firm profit m m The firm produces Q* MR = MC We can see the firms variable profit – the firm’s profit ignoring fixed costs l. Area m between MR and MC Consumer surplus area between demand Price © 2005 Pearson Education, Inc. Chapter 11 8

Price Discrimination l If the firm can perfectly price discriminate, each consumer is charged exactly what they are willing to pay. m MR curve is not longer part of output decision m Incremental revenue is exactly the price at which each unit is sold – the demand curve m Additional profit from producing and selling an incremental unit is now the difference between demand marginal cost © 2005 Pearson Education, Inc. Chapter 11 9

Perfect First-Degree Price Discrimination $/Q Pmax Without price discrimination, output is Q* and price is P*. Variable profit is the area between the MC & MR (yellow). Consumer surplus is the area above P* and between 0 and Q* output. With perfect discrimination, firm will choose to produce Q** increasing variable profits to include purple area. MC P* PC D = AR MR Q* © 2005 Pearson Education, Inc. Q** Chapter 11 Quantity 10

First-Degree Price Discrimination l In practice perfect price discrimination is almost never possible 1. 2. Impractical to charge every customer a different price (unless very few customers) Firms usually does not know reservation price of each customer l Firms can discriminate imperfectly m Can charge a few different prices based on some estimates of reservation prices © 2005 Pearson Education, Inc. Chapter 11 11

First-Degree Price Discrimination l Examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product: m Lawyers, doctors, accountants m Car salesperson (15% profit margin) m Colleges and universities (differences in financial aid) © 2005 Pearson Education, Inc. Chapter 11 12

First-Degree Price Discrimination in Practice Six prices exist resulting in higher profits. With a single price P*4, there are fewer consumers. $/Q P 1 P 2 P 3 MC P*4 Discriminating up to P 6 (competitive price) will increase profits P 5 P 6 D Q* © 2005 Pearson Education, Inc. MR Chapter 11 Quantity 13

Second-Degree Price Discrimination l In some markets, consumers purchase many units of a good over time m Demand for that good declines with increased consumption l Electricity, water, heating fuel m Firms can engage in second degree price discrimination l Practice of charging different prices per unit for different quantities of the same good or service © 2005 Pearson Education, Inc. Chapter 11 14

Second-Degree Price Discrimination l Quantity discounts are an example of second-degree price discrimination m Ex: Buying in bulk like at Sam’s Club l Block pricing – the practice of charging different prices for different quantities of “blocks” of a good m Ex: electric power companies charge different prices for a consumer purchasing a set block of electricity © 2005 Pearson Education, Inc. Chapter 11 15

Second-Degree Price Discrimination $/Q Without discrimination: P = P 0 and Q = Q 0. With second-degree discrimination there are three blocks with prices P 1, P 2, & P 3. Different prices are charged for different quantities or “blocks” of same good P 1 P 0 P 2 AC MC P 3 D MR Q 1 1 st Block © 2005 Pearson Education, Inc. Q 0 2 nd Block Q 2 Q 3 Quantity 3 rd Block Chapter 11 16

Third-Degree Price Discrimination l Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group 1. 2. Divides the market into two-groups. Each group has its own demand function. © 2005 Pearson Education, Inc. Chapter 11 17

Price Discrimination l Third Degree Price Discrimination l Most common type of price discrimination. m Examples: airlines, premium v. non-premium liquor, discounts to students and senior citizens, frozen v. canned vegetables. © 2005 Pearson Education, Inc. Chapter 11 18

Third-Degree Price Discrimination l Some characteristic is used to divide the consumer groups l Typically elasticities of demand differ for the groups m College students and senior citizens are not usually willing to pay as much as others because of lower incomes m These groups are easily distinguishable with ID’s © 2005 Pearson Education, Inc. Chapter 11 19

Creating Consumer Groups l If third degree price-discrimination is feasible, how can the firm decide what to charge each group of consumers? 1. 2. Total output should be divided between groups so that MR for each group are equal. Total output is chosen so that MR for each group of consumers is equal to the MC of production © 2005 Pearson Education, Inc. Chapter 11 20

Third-Degree Price Discrimination l Algebraically m P 1: price first group m P 2: price second group m C(QT) = total cost of producing output QT = Q 1 + Q 2 m Profit: © 2005 Pearson Education, Inc. = P 1 Q 1 + P 2 Q 2 - C(QT) Chapter 11 21

Third-Degree Price Discrimination l Firm should increase sales to each group until incremental profit from last unit sold is zero l Set incremental for sales to group 1 = 0 © 2005 Pearson Education, Inc. Chapter 11 22

Third-Degree Price Discrimination l First group of consumers: m MR 1= MC l Can do the same thing for the second group of consumers l Second group of customers: m MR 2 = MC l Combining these conclusions gives m MR 1 = MR 2 = MC © 2005 Pearson Education, Inc. Chapter 11 23

Third-Degree Price Discrimination l Determining relative prices m Thinking of relative prices that should be charged to each group of consumers and relating them to price elasticities of demand may be easier. © 2005 Pearson Education, Inc. Chapter 11 24

Third-Degree Price Discrimination l Determining relative prices m Equating MR 1 and MR 2 gives the following relationship that must hold for prices m The higher price will be charged to consumer with the lower demand elasticity © 2005 Pearson Education, Inc. Chapter 11 25

Third-Degree Price Discrimination l Example m E 1 = -2 & E 2 = -4 m P 1 should be 1. 5 times as high as P 2 © 2005 Pearson Education, Inc. Chapter 11 26

Third-Degree Price Discrimination $/Q Consumers are divided into two groups, with separate demand curves for each group. MRT = MR 1 + MR 2 D 2 = AR 2 MRT MR 2 MR 1 © 2005 Pearson Education, Inc. D 1 = AR 1 Chapter 11 Quantity 27

Third-Degree Price Discrimination $/Q MC = MR 1 at Q 1 and P 1 • QT: MC = MRT • Group 1: more inelastic • Group 2: more elastic • MR 1 = MR 2 = MCT • QT control MC MC P 2 D 2 = AR 2 MCT MR 2 D 1 = AR 1 MR 1 Q 1 © 2005 Pearson Education, Inc. Q 2 Chapter 11 QT Quantity 28

No Sales to Smaller Market l Even if third-degree price discrimination is possible, it may not be feasible to try and sell to both groups m It is possible that the demand for one group is so low, it would not be profitable to lower price enough to sell to that group. © 2005 Pearson Education, Inc. Chapter 11 29

No Sales to Smaller Market Group one, with demand D 1, are not willing to pay enough for the good to make price discrimination profitable. $/Q MC P* D 2 MC=MR 1 =MR 2 MR 1 D 1 Q* © 2005 Pearson Education, Inc. Chapter 11 Quantity 30

The Economics of Coupons and Rebates l Those consumers who are more price elastic will tend to use the coupon/rebate more often when they purchase the product than those consumers with a less elastic demand. l Coupons and rebate programs allow firms to price discriminate. © 2005 Pearson Education, Inc. Chapter 11 31

The Economics of Coupons and Rebates l About 20 – 30% of consumers use coupons or rebates l Firms can get those with higher elasticities of demand to purchase the good who would not normally buy it. l Table 11. 1 shows how elasticities of demand vary for coupon/rebate users and non users © 2005 Pearson Education, Inc. Chapter 11 32

Price Elasticities of Demand: Users v. Nonusers of Coupons © 2005 Pearson Education, Inc. Chapter 11 33

Airline Fares l Differences in elasticities imply that some customers will pay a higher fare than others. l Business travelers have few choices and their demand is less elastic. l Casual travelers and families are more price sensitive and will therefore be choosier. © 2005 Pearson Education, Inc. Chapter 11 34

Elasticities of Demand for Air Travel © 2005 Pearson Education, Inc. Chapter 11 35

Airline Fares l There are multiple fares for every route flown by airlines l They separate the market by setting various restrictions on the tickets. m Must stay over a Saturday night m 21 -day advance, 14 -day advance m Basic restrictions – can change ticket to only certain days m Most expensive: no restrictions – first class © 2005 Pearson Education, Inc. Chapter 11 36

Other Types of Price Discrimination l Intertemporal Price Discrimination m Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time m Initial release of a product, the demand is inelastic l Hard back v. paperback book l New release movie l Technology © 2005 Pearson Education, Inc. Chapter 11 37

Intertemporal Price Discrimination l Once this market has yielded a maximum profit, firms lower the price to appeal to a general market with a more elastic demand. l This can be seen graphically looking at two different groups of consumers – one willing to buy right now and one willing to wait. © 2005 Pearson Education, Inc. Chapter 11 38

Intertemporal Price Discrimination $/Q Initially, demand is less elastic resulting in a price of P 1 Over time, demand becomes more elastic and price is reduced to appeal to the mass market. P 2 D 2 = AR 2 AC = MC MR 1 Q 1 © 2005 Pearson Education, Inc. MR 2 D 1 = AR 1 Q 2 Chapter 11 Quantity 39

Other Types of Price Discrimination l Peak-Load Pricing m Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be higher. l Demand for some products may peak at particular times. m Rush hour traffic m Electricity - late summer afternoons m Ski resorts on weekends © 2005 Pearson Education, Inc. Chapter 11 40

Peak-Load Pricing l Objective is to increase efficiency by charging customers close to marginal cost m Increased MR and MC would indicate a higher price. m Total surplus is higher because charging close to MC m Can measure efficiency gain from peak-load pricing © 2005 Pearson Education, Inc. Chapter 11 41

Peak-Load Pricing l With third-degree price discrimination, the MR for all markets was equal l MR is not equal for each market because one market does not impact the other market with peak-load pricing. m Price and sales in each market are independent m Ex: electricity, movie theaters © 2005 Pearson Education, Inc. Chapter 11 42

Peak-Load Pricing $/Q MC MR=MC for each group. Group 1 has higher demand during peak times P 1 D 1 = AR 1 P 2 MR 1 D 2 = AR 2 MR 2 Q 2 © 2005 Pearson Education, Inc. Q 1 Chapter 11 Quantity 43

How to Price a Best Selling Novel l How would you arrive at the price for the initial release of the hardbound edition of a book? m Hard-back and paperback books are ways for the company to price discriminate. m How does the company determine what price to sell the hard-back and paperback books for? m How doe the company determine when to release the paperback? © 2005 Pearson Education, Inc. Chapter 11 44

How to Price a Best Selling Novel l Company must divide consumers into two groups: m Those willing to buy more expensive hard back m Those willing to wait for paperback l Have to be strategic abut when to release paperback after hardback m Publishers © 2005 Pearson Education, Inc. typically wait 12 to 18 months Chapter 11 45

How to Price a Best Selling Novel l Publishers must use estimates of past books to determine how much to sell a new book. l Hard to determine the demand for a NEW book. l New books are typically sold for about the same price to take this into account. l Demand for paperbacks is more elastic so we should expect it to be priced lower. © 2005 Pearson Education, Inc. Chapter 11 46

The Two-Part Tariff l Form of pricing in which consumers are charged both an entry and usage fee. m EX: amusement park, golf course, telephone service l A fee is charged upfront for right to use/buy the product l An additional fee is charged for each unit the consumer wishes to consume m Pay a fee to to play golf and then pay another fee for each game you play. © 2005 Pearson Education, Inc. Chapter 11 47

The Two-Part Tariff l Pricing decision is setting the entry fee (T) and the usage fee (P). l Choosing the trade-off between free-entry and high-use prices or high-entry and zero-use prices. l Single Consumer m Assume firm knows consumer demand m Firm wants to capture as much consumer surplus as possible © 2005 Pearson Education, Inc. Chapter 11 48

Two-Part Tariff with a Single Consumer $/Q Usage price P* is set equal to MC. Entry price T* is equal to the entire consumer surplus. Firm captures all consumer surplus as profit T* MC P* D Quantity © 2005 Pearson Education, Inc. Chapter 11 49

Two-Part Tariff with Two Consumers l Two consumers, but firm can only set one entry fee and one usage fee. l Will no longer set usage fee equal to MC. m Could make entry fee no larger than CS of consumer with smallest demand l Firm should set usage fee above MC l Set entry fee equal to remaining consumer surplus of consumer with smaller demand l Firm needs to know demand curves © 2005 Pearson Education, Inc. Chapter 11 50

Two-Part Tariff with Two Consumers $/Q The price, P*, will be greater than MC. Set T* at the surplus value of D 2. T* A MC B C D 1 = consumer 1 D 2 = consumer 2 Q 2 © 2005 Pearson Education, Inc. Q 1 Chapter 11 Quantity 51

The Two-Part Tariff with Many Consumers l No exact way to determine P* and T*. l Must consider the trade-off between the entry fee T* and the use fee P*. m Low entry fee: more entrants and more profit form sales of item m As entry fee becomes smaller, number of entrants is larger and profit from entry fee will fall © 2005 Pearson Education, Inc. Chapter 11 52

The Two-Part Tariff with Many Consumers l To find optimum combination, choose several combinations of P, T. l Find combination that maximizes profit. l Firm’s profit is divided into two components m Each is a function of entry fee, T assuming a fixed sales price, P © 2005 Pearson Education, Inc. Chapter 11 53

Two-Part Tariff with Many Different Consumers Profit Total profit is the sum of the profit from the entry fee and the profit from sales. Both depend on T. : entry fee : sales T T* © 2005 Pearson Education, Inc. Chapter 11 54

The Two-Part Tariff l Rule of Thumb m Similar demand: Choose P close to MC and high T m Dissimilar demand: Choose high P and low T. m Ex: Disneyland in California and Disney world in Florida have a strategy of high entry fee and charge nothing for ride. © 2005 Pearson Education, Inc. Chapter 11 55

The Two-Part Tariff With a Twist l Entry price (T) entitles the buyer to a certain number of free units m m m Gillette razors sold with several blades Amusement park admission comes with some tokens On-line fees with free time l Can set higher entry fee without losing many consumers m m Higher entry fee captures either surplus without driving them out of the market Captures more surplus of large customers © 2005 Pearson Education, Inc. Chapter 11 56

Polaroid Cameras l 1971 Polaroid introduced the SX-70 camera l Polaroid was able to use two part tariff to pricing of camera/film m Allowed them greater profits than would have been possible if camera used ordinary film l Polaroid had a monopoly on cameras and film © 2005 Pearson Education, Inc. Chapter 11 57

Polaroid Cameras l Buying camera is like entry fee l Unlike an amusement park, for example, the marginal cost of providing an additional camera is significantly greater than zero. l It was necessary for Polaroid to have monopoly. m m If ordinary film could be used, they price of film would be close to MC Polaroid needed to gain most of its profits from sale of firm © 2005 Pearson Education, Inc. Chapter 11 58

Polaroid Cameras l Analytical framework: © 2005 Pearson Education, Inc. Chapter 11 59

Polaroid Cameras l In the end, the film prices were significantly above marginal cost. l There was considerable heterogeneity of consumer demands. © 2005 Pearson Education, Inc. Chapter 11 60

Cellular Rate Plans l In most areas in US, consumers can choose cellular providers: Verizon, Cingular, ATT and Sprint l Market power exists because consumers face switching costs m When sign up with a firm, must sign a contract with high costs to break l Plans often exists of monthly cost plus free for extra minutes l Companies can combine third-degree price discrimination with two-part tariff © 2005 Pearson Education, Inc. Chapter 11 61

Cellular Rate Plans © 2005 Pearson Education, Inc. Chapter 11 62

Cellular Rate Plans © 2005 Pearson Education, Inc. Chapter 11 63

Bundling l Bundling is packaging two or more products to gain a pricing advantage. l Conditions necessary for bundling m Heterogeneous customers m Price discrimination is not possible m Demands must be negatively correlated © 2005 Pearson Education, Inc. Chapter 11 64

Bundling l When film company leased “Gone with the Wind” it required theaters to also lease “Getting Gertie’s Garter. ” l Why would a company do this? m Company must be able to increase revenue. m We can see the reservation prices for each theater and movie. © 2005 Pearson Education, Inc. Chapter 11 65

Bundling Gone with the Wind Getting Gertie’s Garter Theater A $12, 000 $3, 000 Theater B $10, 000 $4, 000 l Renting the movies separately would result in each theater paying the lowest reservation price for each movie: Maximum price Wind = $10, 000 m Maximum price Gertie = $3, 000 m l Total Revenue = $26, 000 © 2005 Pearson Education, Inc. Chapter 11 66

Bundling l If the movies are bundled: m Theater A will pay $15, 000 for both m Theater B will pay $14, 000 for both l If each were charged the lower of the two prices, total revenue will be $28, 000. l The movie company will gain more revenue ($2000) by bundling the movie © 2005 Pearson Education, Inc. Chapter 11 67

Relative Valuations l More profitable to bundle because relative valuation of two films are reversed l Demands are negatively correlated m. A pays more for Wind ($12, 000) than B ($10, 000). m B pays more for Gertie ($4, 000) than A ($3, 000). © 2005 Pearson Education, Inc. Chapter 11 68

Relative Valuations l 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 © 2005 Pearson Education, Inc. Chapter 11 69

Bundling l If the movies are bundled: m Theater A will pay $16, 000 for both m Theater B will pay $13, 000 for both l If each were charged the lower of the two prices, total revenue will be $26, 000, the same as by selling the films separately. © 2005 Pearson Education, Inc. Chapter 11 70

Bundling l Bundling Scenario: Two different goods and many consumers m Many consumers with different reservation price combinations for two goods m Can show graphically the preferences of consumers in terms of reservation prices and consumption decisions given prices charged m r 1 is reservation price of consumer for good 1 m r 2 is reservation price of consumer for good 2 © 2005 Pearson Education, Inc. Chapter 11 71

Reservation Prices r 2 For example, Consumer A is willing to pay up to $3. 25 for good 1 and up to $6 for good 2. Consumer C $10 Consumer A $6 Consumer B $3. 25 © 2005 Pearson Education, Inc. $8. 25 Chapter 11 $10 r 1 72

Consumption Decisions When Products are Sold Separately r 2 II Consumers fall into four categories based on their reservation price. I Consumers buy only good 2 Consumers buy both goods P 2 III IV Consumers buy neither good Consumers buy only Good 1 r 1 P 1 © 2005 Pearson Education, Inc. Chapter 11 73

Consumption Decisions When Products are Bundled r 2 Consumers buy the bundle when r 1 + r 2 > PB (PB = bundle price). PB = r 1 + r 2 or r 2 = PB - r 1 Region 1: r > PB Region 2: r < PB I Consumers buy bundle (r > PB) r 2 = P B - r 1 II Consumers do not buy bundle (r < PB) r 1 © 2005 Pearson Education, Inc. Chapter 11 74

Consumption Decisions When Products are Bundled l The effectiveness of bundling depends upon the degree of negative correlation between the two demands. m Best when consumers who have high reservation price for good 1 have a low reservation price for good 2 and vice versa m Can see graphically looking at positively and negatively correlated prices © 2005 Pearson Education, Inc. Chapter 11 75

Reservation Prices r 2 If the demands are perfectly positively correlated, the firm will not gain by bundling. It would earn the same profit by selling the goods separately. P 2 r 1 P 1 © 2005 Pearson Education, Inc. Chapter 11 76

Reservation Prices r 2 If the demands are perfectly negatively correlated bundling is the ideal strategy – all the consumer surplus can be extracted and a higher profit results. r 1 © 2005 Pearson Education, Inc. Chapter 11 77

Movie Example (Gertie) r 2 10, 000 Bundling pays due to negative correlation 5, 000 4, 000 3, 000 B A 5, 000 © 2005 Pearson Education, Inc. 10, 000 12, 000 14, 000 Chapter 11 r 1 (Wind) 78

Mixed Bundling l Practice of selling tow or more goods both as a package and individually. l This differs from pure bundling when sell products only as a package. l Mixed bundling is good strategy when m Demands are somewhat negatively correlated m Marginal production costs are significant © 2005 Pearson Education, Inc. Chapter 11 79

Mixed Bundling – Example l Demands are perfectly negatively correlated but significant marginal costs l Four customers under three different strategies m Selling good separately, P 1 = $50, P 2 = $90 m Selling goods only as a bundle, PB = $100 m Mixed bundling: l Sold individually with P 1 = P 2 = $89. 95 l Sold as a bundle with PB = $100 © 2005 Pearson Education, Inc. Chapter 11 80

Mixed Bundling – Example l Can see effects under different scenarios in following table © 2005 Pearson Education, Inc. Chapter 11 81

Mixed Versus Pure Bundling r 2 100 C 1 = MC 1 = 20 With positive marginal costs, mixed bundling may be more profitable than pure bundling. A 90 80 For each good, marginal production cost exceeds reservation price of one consumer. • A and D will buy individually • B and C will buy bundle 70 60 B 50 C 40 C 2 = MC 2 = 30 30 20 D 10 10 20 30 40 50 60 70 80 90 100 © 2005 Pearson Education, Inc. Chapter 11 r 1 82

Bundling l If MC are zero, mixed bundling can still be more profitable if consumer demands are not perfectly negatively correlated. l Example: m Reservation prices for consumers B and C are higher m Compare the same three strategies m Mixed bundling is more profitable option since everyone will end up buying © 2005 Pearson Education, Inc. Chapter 11 83

Mixed Bundling with Zero Marginal Costs r 2 120 A and D purchase individually. B and C purchase bundled. Profits are highest with mixed bundling. 100 90 A B 80 60 C 40 20 D 10 10 20 Inc. © 2005 Pearson Education, 40 60 80 90 100 120 r 1 84

Bundling in Practice l Car purchasing m Bundles of options such as electric locks with air conditioning l Vacation Travel m Bundling hotel with air fare l Cable television m Premium © 2005 Pearson Education, Inc. channels bundled together Chapter 11 85

Bundling l Mixed Bundling in Practice m Use of market surveys to determine reservation prices m Design a pricing strategy from the survey results l Can show graphically using information collected from consumers m Consumers are separated into four regions m Can change prices to find max profits © 2005 Pearson Education, Inc. Chapter 11 86

Mixed Bundling in Practice r 2 The firm can first choose a price for the bundle and then try individual prices P 1 and P 2 until total profit is roughly maximized. PB P 2 P 1 © 2005 Pearson Education, Inc. Chapter 11 PB r 1 87

A Restaurant’s Pricing Problem © 2005 Pearson Education, Inc. Chapter 11 88

Tying l Practice of requiring a customer to purchase one good in order to purchase another. m Xerox machines and the paper m IBM mainframe and computer cards l Allows firm to meter demand practice price discrimination more effectively. © 2005 Pearson Education, Inc. Chapter 11 89

Tying l Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy user m Mc. Donald’s l Allows them to protect their brand name. m Microsoft l An © 2005 Pearson Education, Inc. be used to extend market power Chapter 11 90

Advertising l Firms with market power have to decide how much to advertise l We can show firms choose profit maximizing advertising m Decision depends on characteristics of demand for firm’s product © 2005 Pearson Education, Inc. Chapter 11 91

Advertising l Assumptions m Firm sets only one price for product m Firm knows quantity demanded depends on price and advertising expenditure dollars, A Q(P, A) m We can show the firm’s cost curves, revenue curves, and profits under advertising and no advertising © 2005 Pearson Education, Inc. Chapter 11 92

Effects of Advertising $/Q MC P 1 AR andfirm MRadvertises, are average If the and revenue when its marginal average and marginal the firm doesn’t revenue curvesadvertise. shift to the right -- average costs rise, but marginal cost does not. AC’ P 0 AR’ AC MR’ AR MR © 2005 Pearson Education, Inc. Q 0 Q 1 Chapter 11 Quantity 93

Advertising l Choosing Price and Advertising Expenditure © 2005 Pearson Education, Inc. Chapter 11 94

Advertising l A Rule of Thumb for Advertising © 2005 Pearson Education, Inc. Chapter 11 95

Advertising l A Rule of Thumb for Advertising © 2005 Pearson Education, Inc. Chapter 11 96

Advertising l A Rule of Thumb for Advertising m To maximize profit, the firm’s advertising-tosales ratio should be equal to minus the ratio of the advertising and price elasticities of demand. © 2005 Pearson Education, Inc. Chapter 11 97

Advertising l An Example m R(Q) = $1 million/yr m $10, 000 budget for A (advertising--1% of revenues) m EA =. 2 (increase budget $20, 000, sales increase by 20% m EP = -4 (markup price over MC is substantial) © 2005 Pearson Education, Inc. Chapter 11 98

Advertising l The firm in our example should increase advertising m A/PQ = -(2/-. 4) = 5% m Increase budget to $50, 000 © 2005 Pearson Education, Inc. Chapter 11 99

Advertising – In Practice l Estimate the level of advertising for each of the firms m Supermarkets l EP = -10; EA = 0. 1 to 0. 3 m Convenience l EP = -5; EA very small m Designer l EP © 2005 Pearson Education, Inc. jeans = -3 to – 4; EA = 0. 3 to 1 m Laundry l EP stores detergents = -3 to – 4; EA very large Chapter 11 100