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.
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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
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Price discrimination Price discrimination - practice in which a firm charges consumers different prices for the same good
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Why Price Discrimination Pays A 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.
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Table 12.1 A Theater’s Profit Based on the Pricing Method Used
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Who Can Price Discriminate Three 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
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Not All Price Differences Are Price Discrimination Not every seller who charges consumers different prices is price discriminating.
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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
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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
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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
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Perfect Price Discrimination (cont). reservation price - the maximum amount a person would be willing to pay for a unit of output
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Figure 12.1 Perfect Price Discrimination
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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: perfect price discrimination equilibrium, only the last unit is sold at that price. perfectly price-discriminating monopoly captures all the welfare. 12-14
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p, $ per unit
Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria p1
A ps
MC
es
B
C
pc = MCc
ec
E D
MCs
Demand, MRd
MC1 MRs Qs © 2009 Pearson Addison-Wesley. All rights reserved.
Qc = Qd
Q, Units per day 12-15
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Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria (cont.)
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Application Botox Revisited
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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?
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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.
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Solved Problem 12.2
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Quantity Discrimination Most customers are willing to pay more for the first unit than for successive units: 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.
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(a) Quantity Discrimination
(b) Single-Price Monopoly
p1, $ per unit
p2, $ 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
Demand MR
0
20
40
90 Q, Units per day
0
30
90 Q, Units per day
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Figure 12.3 Quantity Discrimination (cont.)
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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.
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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. 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.
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Multimarket Price Discrimination with Two Groups (cont). π = πA + πB = [pAQA − mQA] + [pBQB − mQB] pAQA = revenue from American customers pBQB = 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.
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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:
⎛ ⎛ 1⎞ 1⎞ MRA = pA ⎜⎜1 + ⎟⎟ = m = pB ⎜⎜1 + ⎟⎟ = MRB ⎝ εB ⎠ ⎝ εA ⎠ © 2009 Pearson Addison-Wesley. All rights reserved.
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Multimarket Price Discrimination with Two Groups (cont). From previous slide: ⎛ ⎛ 1⎞ 1⎞ MR A = p A ⎜⎜1 + ⎟⎟ = m = pB ⎜⎜1 + ⎟⎟ = MRB ε ε A ⎠ B ⎠ ⎝ ⎝ and rearranging,
1 1+ εA pA = pB 1 + 1
εB
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Figure 12.4 Multimarket Pricing of Harry Potter DVD
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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 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? © 2009 Pearson Addison-Wesley. All rights reserved.
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Solved Problem 12.3
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Solved Problem 12.3 (cont’d)
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Identifying Groups Two 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
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Welfare Effects of Multimarket Price Discrimination Multimarket 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.
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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)
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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. 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.
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Figure 12.5 Two-Part Tariff
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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.
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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:
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Table 12.2 Bundling of Tickets to Football Game
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Advertising A 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.
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The Decision Whether to Advertise Even if advertising succeeds in shifting demand, it may not pay for the firm to advertise. If advertising shifts demand outward, the firm’s 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.
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Price of Co ke, p c , $ per unit
Figure 12.6 Advertising 19 17
p2 = 12 p1 = 11
e2 B e1 π1
MC = AC
5
MR 1 Q1 = 24 Q2 = 28
0
MR 2
D1
D2
68
76
Qc , Units of Co ke per year 12-43
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Marginal benefit, marginal cost, $ per unit
Figure 12.7 Shift in the Marginal Benefit of Advertising MB 2
MB 1
MC
A2 A1 Minutes of advertising time purchased per day © 2009 Pearson Addison-Wesley. All rights reserved.
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Cross-Chapter Analysis: Magazine Subscriptions
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