Chapter 12

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.
12 - 2
Copyright 2012 Pearson Education. All rights reserved.

Nonuniform Pricing and Price Discrimination

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

12 - 3

Copyright 2012 Pearson Education. All rights reserved.

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.

12 - 4

Copyright 2012 Pearson Education. All rights reserved.

Table 12.1 A Theaters Profit Based on the Pricing Method Used

12 - 5

Copyright 2012 Pearson Education. All rights reserved.

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.

12 - 6

Copyright 2012 Pearson Education. All rights reserved.

Preventing Resale
Resale is difficult or impossible for most services and when transaction costs are high. Some firms act to raise transaction costs or otherwise make resale difficult. A firm can prevent resale by vertically integrating: participating in more than one successive stage of the production and distribution chain for a good or service. Governments frequently aid price discrimination by preventing resale.
12 - 7
Copyright 2012 Pearson Education. All rights reserved.

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

12 - 8

Copyright 2012 Pearson Education. All rights reserved.

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.

12 - 9

Copyright 2012 Pearson Education. All rights reserved.

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.

12 - 10

Copyright 2012 Pearson Education. All rights reserved.

Types of Price Discrimination (cont.) 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.

12 - 11

Copyright 2012 Pearson Education. All rights reserved.

Perfect Price Discrimination

If a firm with market power knows exactly how much each customer is willing to pay for each unit of its good and it can prevent resale, the firm charges each person his or her reservation price. Reservation price - the maximum amount a person would be willing to pay for a unit of output.

12 - 12

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.1 Perfect Price Discrimination

12 - 13

Copyright 2012 Pearson Education. All rights reserved.

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

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.2 Competitive, Single-Price, and Perfect Discrimination Equilibria

p, $ per unit p1

A ps B pc = MCc D

es C E MCs

MC

ec

MC1 MRs Qs
12 - 15

Demand,MRd

Qc = Qd

Q, Units per day

Copyright 2012 Pearson Education. All rights reserved.

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

12 - 16

Copyright 2012 Pearson Education. All rights reserved.

Application: Botox Revisited

12 - 17

Copyright 2012 Pearson Education. All rights reserved.

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? Answer
Calculate welfare for panel a (a) if the theater sets a single price and (b) if it perfectly price discriminates, and then (c) compare them. Calculate welfare for panel b (a) if the theater sets a single price and (b) if it perfectly price discriminates, and then (c) compare them.

12 - 18

Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 12.2

Competitive 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-orleave-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.
12 - 19
Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 12.2

12 - 20

Copyright 2012 Pearson Education. All rights reserved.

Transaction Costs and Perfect Price Discrimination

Although some firms come close to perfect price discrimination, many more firms set a single price or use another nonlinear pricing method. Transaction costs are a major reason why these firms do not perfectly price discriminate:
It is too difficult or costly to gather information about each customers price sensitivity.
12 - 21
Copyright 2012 Pearson Education. All rights reserved.

Quantity Discrimination
Most 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.

12 - 22

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.3 Quantity Discrimination

(a) Quantity Disc rimination p1, $ per unit 90 A= $200 (b) Single-Price Monopoly p2, $ per unit 90

70

E = $450 C= $200 B= $1,200 30 60

50

D= $200 m Demand 30

F = $900 G = $450 m Demand MR

20

40

90 Q, Units per day

30

90 Q, Units per day

12 - 23

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.3 Quantity Discrimination (cont.)

12 - 24

Copyright 2012 Pearson Education. All rights reserved.

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.

12 - 25

Copyright 2012 Pearson Education. All rights reserved.

Multimarket Price Discrimination with Two Groups A copyright gives Universal Studios the legal monopoly to produce and sell the Mama Mia! DVD.
Universal 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.

12 - 26

Copyright 2012 Pearson Education. All rights reserved.

Multimarket Price Discrimination with Two Groups (cont.)

= A + B = [pAQA mQA] + [pBQB mQB] pAQA = revenue from American customers pBQB = 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.
12 - 27
Copyright 2012 Pearson Education. All rights reserved.

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:

MR A

pA 1

1
A

pB 1

1
B

MR B

12 - 28

Copyright 2012 Pearson Education. All rights reserved.

Multimarket Price Discrimination with Two Groups (cont.)

From previous slide:
MR A pA 1 1
A

pB 1

1
B

MR B

and rearranging,

pA pB

1 1

1
A

1
B

12 - 29

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.4 Multimarket Pricing of Mama Mia! DVD

12 - 30

Copyright 2012 Pearson Education. All rights reserved.

10

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?
12 - 31
Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 12.3

12 - 32

Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 12.3

12 - 33

Copyright 2012 Pearson Education. All rights reserved.

11

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.

12 - 34

Copyright 2012 Pearson Education. All rights reserved.

Application Buying Discounts

Firms use various approaches to induce consumers to indicate whether they have relatively high or low elasticities of demand. By spending extra time to obtain a discount, price-sensitive consumers are able to differentiate themselves.

12 - 35

Coupons Airline Tickets Reverse Auction Rebates

Copyright 2012 Pearson Education. All rights reserved.

Welfare Effects of Multimarket Price Discrimination

Multimarket price discrimination results in inefficient production and consumption. Welfare under multimarket price discrimination is lower than that under competition or perfect price discrimination. Welfare may be lower or higher with multimarket price discrimination than with a single-price monopoly, however.

12 - 36

Copyright 2012 Pearson Education. All rights reserved.

12

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).

12 - 37

Copyright 2012 Pearson Education. All rights reserved.

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 is sold because the price of the last unit equals marginal cost. All consumer surplus is transferred from consumers to the firm.
12 - 38

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.5 Two-Part Tariff with Identical Consumers

12 - 39

Copyright 2012 Pearson Education. All rights reserved.

13

A Two-Part Tariff with Nonidentical Consumers The monopoly charge a price above marginal cost. By raising its price, the monopoly earns more per unit from both types of customers but lowers its customers potential consumer surplus.

12 - 40

Copyright 2012 Pearson Education. All rights reserved.

A Two-Part Tariff with Nonidentical Consumers (cont.) Thus, if the monopoly can capture each customers potential surplus by charging different lump-sum fees, it sets its price equal to marginal cost. However, if the monopoly must charge everyone the same lump-sum fee, the increase in profit from Customer 2 from the higher price more than offsets the reduction in the lump-sum fee.
12 - 41
Copyright 2012 Pearson Education. All rights reserved.

Figure 12.6 Two-Part Tariff with Nonidentical Consumers

12 - 42

Copyright 2012 Pearson Education. All rights reserved.

14

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

12 - 43

Copyright 2012 Pearson Education. All rights reserved.

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.

12 - 44

Copyright 2012 Pearson Education. All rights reserved.

Table 12.2 Determining Whether to Bundle Services

12 - 45

Copyright 2012 Pearson Education. All rights reserved.

15

Solved Problem 12.4

The same cable company, with zero marginal and average costs, now has two more customers in addition to the pair in panel b of Table 12.2. The following table shows each customers willingness to pay for each service and for a bundle. Show that the firm can earn more by using mixed bundling than by using pure bundling or charging separate prices for each service.
12 - 46
Copyright 2012 Pearson Education. All rights reserved.

Solved Problem 12.4

12 - 47

Copyright 2012 Pearson Education. All rights reserved.

Application Available for a Song

In 2010 Apples iTunes online music store switched to nonuniform pricing. Did Apples one-price-for-all-songs policy cost it substantial potential profit? Shiller and Waldfogel (2009) surveyed nearly 1,000 students and determined each persons willingness to pay for each of 50 popular songs. Then they used this information to calculate a firms optimal pricing under various pricing schemes.
12 - 48
Copyright 2012 Pearson Education. All rights reserved.

16

Application Available for a Song (cont.)

12 - 49

Copyright 2012 Pearson Education. All rights reserved.

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.

12 - 50

Copyright 2012 Pearson Education. All rights reserved.

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 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.
12 - 51
Copyright 2012 Pearson Education. All rights reserved.

17

Figure 12.7 Advertising

12 - 52

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.8 Shift in the Marginal Benefit of Advertising

Marginal benefit, marginal cost, $ per unit MB 2 MB 1

MC

A2 A1 Minutes of ad vertising time purchased per day 12 - 53

Copyright 2012 Pearson Education. All rights reserved.

Figure 12.9 Effects of Advertising Sales on a Magazines Price

12 - 54

Copyright 2012 Pearson Education. All rights reserved.

18