Chapter Twelve Pricing and Advertising Topics Why and

Chapter Twelve Pricing and Advertising

Topics § Why and How Firms Price Discriminate. § Perfect Price Discrimination. § Quantity Discrimination. § Multimarket Price Discrimination. § Two-Part Tariffs. § Tie-In Sales. § Advertising. © 2009 Pearson Addison-Wesley. All rights reserved. 2

Nonuniform pricing § nonuniform 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 © 2009 Pearson Addison-Wesley. All rights reserved. 3

Price discrimination § Price discrimination - practice in which a firm charges consumers different prices for the same good © 2009 Pearson Addison-Wesley. All rights reserved. 4

Why Price Discrimination Pays § A price-discriminating firm earns a higher profit from price discrimination because: w 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 w it sells to some people who were not willing to pay as much as the uniform price. © 2009 Pearson Addison-Wesley. All rights reserved. 5

Table 12. 1 A Theater’s Profit Based on the Pricing Method Used © 2009 Pearson Addison-Wesley. All rights reserved. 6

Who Can Price Discriminate § Three conditions: w a firm must have market power. w consumers must differ in their sensitivity to price, and a firm must be able to identify how consumers differ in this sensitivity. w a firm must be able to prevent or limit resales © 2009 Pearson Addison-Wesley. All rights reserved. 7

Not All Price Differences Are Price Discrimination § Not every seller who charges consumers different prices is price discriminating. © 2009 Pearson Addison-Wesley. All rights reserved. 8

Types of Price Discrimination § perfect price discrimination (firstdegree 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 © 2009 Pearson Addison-Wesley. All rights reserved. 9

Types of Price Discrimination (cont). § quantity discrimination (seconddegree 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 © 2009 Pearson Addison-Wesley. All rights reserved. 10

Perfect Price Discrimination § multimarket 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 © 2009 Pearson Addison-Wesley. All rights reserved. 11

Perfect Price Discrimination (cont). § reservation price - the maximum amount a person would be willing to pay for a unit of output © 2009 Pearson Addison-Wesley. All rights reserved. 12

Figure 12. 1 Perfect Price Discrimination © 2009 Pearson Addison-Wesley. All rights reserved. 13

Perfect Price Discrimination: Efficient But Hurts Consumers § A perfect price discrimination equilibrium is efficient and maximizes total welfare. § Perfect price discrimination equilibrium differs from the competitive equilibrium in two ways: w perfect price discrimination equilibrium, only the last unit is sold at that price. w perfectly price-discriminating monopoly captures all the welfare. © 2009 Pearson Addison-Wesley. All rights reserved. 14

p, $ per unit Figure 12. 2 Competitive, Single-Price, and Perfect Discrimination Equilibria p 1 A ps MC es B C pc = MCc ec E D MCs Demand, MRd MC 1 MRs Qs © 2009 Pearson Addison-Wesley. All rights reserved. Qc = Qd Q, Units per day 15

Figure 12. 2 Competitive, Single-Price, and Perfect Discrimination Equilibria (cont. ) © 2009 Pearson Addison-Wesley. All rights reserved. 16

Application Botox Revisited © 2009 Pearson Addison-Wesley. All rights reserved. 17

Solved Problem 12. 1 § How does welfare change if the movie theater described in Table 12. 1 goes from charging a single price to perfectly price discriminating? © 2009 Pearson Addison-Wesley. All rights reserved. 18

Solved Problem 12. 2 § Competitive firms are the customers of a union, which is the monopoly supplier of labor services. Show the union’s “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. © 2009 Pearson Addison-Wesley. All rights reserved. 19

Solved Problem 12. 2 © 2009 Pearson Addison-Wesley. All rights reserved. 20

Quantity Discrimination § Most customers are willing to pay more for the first unit than for successive units: w the typical customer’s 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. © 2009 Pearson Addison-Wesley. All rights reserved. 21

(a) Quantity Discrimination (b) Single-Price Monopoly p 1, $ per unit p 2, $ per unit Figure 12. 3 Quantity Discrimination 90 70 A= $200 90 E = $450 60 C= $200 50 B= $1, 200 F = $900 D= $200 30 G = $450 m m 30 Demand MR 0 20 40 90 Q, Units per day © 2009 Pearson Addison-Wesley. All rights reserved. 0 30 90 Q, Units per day 22

Figure 12. 3 Quantity Discrimination (cont. ) © 2009 Pearson Addison-Wesley. All rights reserved. 23

Multimarket Price Discrimination § The 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. © 2009 Pearson Addison-Wesley. All rights reserved. 24

Multimarket Price Discrimination with Two Groups § A 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. w 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 © 2009 Pearson Addison-Wesley. All rights reserved. 25

Multimarket Price Discrimination with Two Groups (cont). π = πA + πB = [p. AQA − m. QA] + [p. BQB − m. QB] § p. AQA = revenue from American customers § p. BQB = revenue from British customers § π = 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. © 2009 Pearson Addison-Wesley. All rights reserved. 26

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. w Therefore, using price elasticities: © 2009 Pearson Addison-Wesley. All rights reserved. 27

Multimarket Price Discrimination with Two Groups (cont). § From previous slide: w and rearranging, © 2009 Pearson Addison-Wesley. All rights reserved. 28

Figure 12. 4 Multimarket Pricing of Harry Potter DVD © 2009 Pearson Addison-Wesley. All rights reserved. 29

Solved Problem 12. 3 § A monopoly drug producer with a constant marginal cost of m = 1 sells in only two countries and faces a linear demand curve of Q 1 = 12 − 2 p 1 in Country 1 and Q 2 = 9 − p 2 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? © 2009 Pearson Addison-Wesley. All rights reserved. 30

Solved Problem 12. 3 © 2009 Pearson Addison-Wesley. All rights reserved. 31

Solved Problem 12. 3 (cont’d) © 2009 Pearson Addison-Wesley. All rights reserved. 32

Identifying Groups § Two approaches to divide customers into groups: w divide buyers into groups based on observable characteristics of consumers. w identify and divide consumers on the basis of their actions © 2009 Pearson Addison-Wesley. All rights reserved. 33

Welfare Effects of Multimarket Price Discrimination § Multimarket price discrimination results in inefficient production and consumption. w As a result, welfare under multimarket price discrimination is lower than that under competition or perfect price discrimination. © 2009 Pearson Addison-Wesley. All rights reserved. 34

Two-Part Tariffs § two-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) © 2009 Pearson Addison-Wesley. All rights reserved. 35

A Two-Part Tariff with Identical Consumers § A 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. w the efficient quantity, Q 1, is sold because the price of the last unit equals marginal cost. w all consumer surplus is transferred from consumers to the firm. © 2009 Pearson Addison-Wesley. All rights reserved. 36

Figure 12. 5 Two-Part Tariff © 2009 Pearson Addison-Wesley. All rights reserved. 37

Tie-In Sales § tie-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 © 2009 Pearson Addison-Wesley. All rights reserved. 38

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. w bundling a pair of goods pays only if their demands are negatively correlated: © 2009 Pearson Addison-Wesley. All rights reserved. 39

Table 12. 2 Bundling of Tickets to Football Game © 2009 Pearson Addison-Wesley. All rights reserved. 40

Advertising § A monopoly advertises to raise its profit. w A successful advertising campaign shifts the market demand curve by changing consumers’ tastes or informing them about new products. © 2009 Pearson Addison-Wesley. All rights reserved. 41

The Decision Whether to Advertise § Even if advertising succeeds in shifting demand, it may not pay for the firm to advertise. w If advertising shifts demand outward, the firm’s gross profit must rise. w The firm undertakes this advertising campaign only if it expects its net profit (gross profit minus the cost of advertising) to increase. © 2009 Pearson Addison-Wesley. All rights reserved. 42

Figure 12. 6 Advertising © 2009 Pearson Addison-Wesley. All rights reserved. 43

Figure 12. 7 Shift in the Marginal Benefit of Advertising © 2009 Pearson Addison-Wesley. All rights reserved. 44

Cross-Chapter Analysis: Magazine Subscriptions © 2009 Pearson Addison-Wesley. All rights reserved. 45