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Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 14: Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved. Chapter 14: Advanced Pricing Techniques Mc. Graw-Hill/Irwin

Advanced Pricing Techniques • Price discrimination • Multiple products • Cost-plus pricing 14 -2 Advanced Pricing Techniques • Price discrimination • Multiple products • Cost-plus pricing 14 -2

Capturing Consumer Surplus • Uniform pricing • Charging the same price for every unit Capturing Consumer Surplus • Uniform pricing • Charging the same price for every unit of the product • Price discrimination • More profitable alternative to uniform pricing • Market conditions must allow this practice to be profitably executed • Technique of charging different prices for the same product • Used to capture consumer surplus (turning consumer surplus into profit) 14 -3

The Trouble with Uniform Pricing (Figure 14. 1) 14 -4 The Trouble with Uniform Pricing (Figure 14. 1) 14 -4

Price Discrimination • Exists when the price-to-marginal cost ratio differs between two products: 14 Price Discrimination • Exists when the price-to-marginal cost ratio differs between two products: 14 -5

Price Discrimination Three conditions necessary to practice price discrimination profitably: 1) Firm must possess Price Discrimination Three conditions necessary to practice price discrimination profitably: 1) Firm must possess some degree of market power 2) A cost-effective means of preventing resale between lower- and higher-price buyers (consumer arbitrage) must be implemented 3) Price elasticities must differ between individual buyers or groups of buyers 14 -6

First-Degree (Perfect) Price Discrimination • Every unit is sold for the maximum price each First-Degree (Perfect) Price Discrimination • Every unit is sold for the maximum price each consumer is willing to pay • Allows the firm to capture entire consumer surplus • Difficulties • Requires precise knowledge about every buyer’s demand for the good • Seller must negotiate a different price for every unit sold to every buyer 14 -7

First-Degree (Perfect) Price Discrimination (Figure 14. 2) 14 -8 First-Degree (Perfect) Price Discrimination (Figure 14. 2) 14 -8

Second-Degree Price Discrimination • Lower prices are offered for larger quantities and buyers can Second-Degree Price Discrimination • Lower prices are offered for larger quantities and buyers can self-select the price by choosing how much to buy • When the same consumer buys more than one unit of a good or service at a time, the marginal value placed on additional units declines as more units are consumed 14 -9

Second-Degree Price Discrimination • Two-part pricing • Charges buyers a fixed access charge (A) Second-Degree Price Discrimination • Two-part pricing • Charges buyers a fixed access charge (A) to purchase as many units as they wish for a constant fee (f) per unit • Total expenditure (TE) for q units is: 14 -10

Second-Degree Price Discrimination • When consumers have identical demands, entire consumer surplus can be Second-Degree Price Discrimination • When consumers have identical demands, entire consumer surplus can be captured by: • Setting f *= MC • Setting A* = consumer surplus (CS) • Optimal usage fee when two groups of buyers have identical demands is the level for which MRf = MCf 14 -11

Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14. 3) 14 Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14. 3) 14 -12

Demand at Northvale Golf Club (Figure 14. 4) 14 -13 Demand at Northvale Golf Club (Figure 14. 4) 14 -13

Second-Degree Price Discrimination • Declining block pricing • Offers quantity discounts over successive discrete Second-Degree Price Discrimination • Declining block pricing • Offers quantity discounts over successive discrete blocks of quantities purchased 14 -14

Block Pricing with Five Blocks (Figure 14. 5) 14 -15 Block Pricing with Five Blocks (Figure 14. 5) 14 -15

Third-Degree Price Discrimination • If a firm sells in two markets, 1 & 2 Third-Degree Price Discrimination • If a firm sells in two markets, 1 & 2 • Allocate output (sales) so MR 1 = MR 2 • Optimal total output is that for which MRT = MC • For profit-maximization, allocate sales of total output so that MRT = MC = MR 1 = MR 2 14 -16

Third-Degree Price Discrimination • Equal-marginal-revenue principle • Allocating output (sales) so MR 1 = Third-Degree Price Discrimination • Equal-marginal-revenue principle • Allocating output (sales) so MR 1 = MR 2 which will maximize total revenue for the firm (TR 1 + TR 2) • More elastic market gets lower price • Less elastic market gets higher price 14 -17

Allocating Sales Between Markets (Figure 14. 6) 14 -18 Allocating Sales Between Markets (Figure 14. 6) 14 -18

Constructing the Marginal Revenue Curve (Figure 14. 7) 14 -19 Constructing the Marginal Revenue Curve (Figure 14. 7) 14 -19

Profit-Maximization Under Third-Degree Price Discrimination (Figure 14. 8) 14 -20 Profit-Maximization Under Third-Degree Price Discrimination (Figure 14. 8) 14 -20

Multiple Products • Related in consumption • For two products, X & Y, produce Multiple Products • Related in consumption • For two products, X & Y, produce & sell levels of output for which MRX = MCX and MRY = MCY • MRX is a function not only of QX but also of QY (as is MRY) – conditions must be satisfied simultaneously 14 -21

Bundling Multiple Products • When price discrimination is not possible, bundling multiple goods and Bundling Multiple Products • When price discrimination is not possible, bundling multiple goods and charging a single price can be more profitable than charging individual prices for multiple goods • Two conditions for profitable bundling • Consumers must have different demand prices for each good in the bundle • Demand prices must be negatively correlated across consumer types 14 -22

Cost-Plus Pricing • Common technique for pricing when firms do not wish to estimate Cost-Plus Pricing • Common technique for pricing when firms do not wish to estimate demand & cost conditions to apply the MR = MC rule for profit-maximization • Price charged represents a markup (margin) over average cost: P = (1 + m) ATC Where m is the markup on unit cost 14 -23

Cost-Plus Pricing • Does not generally produce profitmaximizing price • Fails to incorporate information Cost-Plus Pricing • Does not generally produce profitmaximizing price • Fails to incorporate information on demand & marginal revenue • Uses average, not marginal, cost 14 -24

Practical Problems with Cost-Plus Pricing (Figure 14. 13) 14 -25 Practical Problems with Cost-Plus Pricing (Figure 14. 13) 14 -25