ECO 610-401

1. ECO 610-401 • Monday, September 22 • Topics • Price Discrimination • Non-linear Pricing • Joint Product Pricing • Readings • Costs & Decision Making: Level of Production & Mix of Resources • Readings: • Brickley et. al, Chapters 5,7; • Hoyt, Lectures 2-3:103-115 • Homework due (Assignment 1)

2. Assignment for Monday, September 29th • Topics: • Costs & Decision Making: Level of Production & Mix of Resources • Decision Making: Make or Buy and Transfer Pricing • Double Marginalization and Vertical Integration • Relevant Costs • Readings: • Brickley et. al, Chapters 5,7; Chapter 19:562-574 • Hoyt, Lecture 3:103-126

3. Questions to Consider for today • How can price discrimination reduce the extent of this tradeoff? • What is the tradeoff a monopolist faces when making pricing decisions? • Think about some examples in which different consumers (or firms) face different prices for the same, or almost same, product. What might account for these differences in prices? Specifically are they motivated by differences in the cost of serving or selling to customers or differences in the customer’s willingness to pay? • Frequently, goods and services are “packaged” or “bundled”. Occasionally firms will only sell these goods as a bundle (pure bundle) though often they will sell the items separately and as a bundle (mixed bundling). Think of some examples. Why and when might firms want to offer items as a bundle? • Why do clubs (tennis, golf) frequently charge both a membership fee and a use fee?

8. Price Elasticity and Revenue • MR = 0 when Ed = -1 (Revenue Maximization) • Relationship between MR and Elasticity: • MR > 0 when Ed < -1(Elastic) • Increases in Q increase revenue in elastic region • MR < 0 when Ed < -1(Inelastic) • Increases in Q decrease revenue in inelastic region

9. Markup Pricing and Elasticity of Demand • We often hear of markup pricing or “cost-plus” pricing but how much should the markup be? • Should all products sold be marked up the same amount? • What should the base (for costs) be? The Markup Rule • Elasticities provided an answer to what the profit-maximizing markup should be.

11. Forms of Price Discrimination • How is it that firms can price discriminate? • Different prices for different categories of customers. • Declining block pricing: • The per unit price decreases the more you buy. • Tie-in Sales: • Require the purchase of another service (repair services, parts) when purchasing a good; • Bundling and Quality Differences: • Make quality differences or provide an additional services for services. • Declining Prices over time

12. Rationale and General Rules for Successful Price Discrimination • Recall the monopolist’s problem: • To gain more sales, must lower price to everyone – including those willing to pay high price • Price discrimination allows you to continue to charge the higher price to customers willing to pay more. • To successfully price discriminate: • It is necessary to have some monopoly power. • No resale -- the two groups can not trade between each other.

13. Rule for Price Discrimination • In the example, no marginal cost • But is an opportunity cost – a seat sold to 1 group can’t be sold to other group • What is profit-maximizing? • Revenue from additional sale to group A (MRA) = Foregone revenue from sale to group S (MRS) • With MC > 0 then: • MRA = MC = MRS

14. Price discrimination will increase profits when: • different groups of customers have different price elasticities of demand; • it is possible to distinguish between the two groups and set prices accordingly. • Consumers with the most inelastic demand should face the highest price. • For groups, A and B, the price set to each group should follow:

16. Forms of Price Discrimination • First Degree Price Discrimination. • The firm extracts the maximum amount the consumer is willing to pay --the height of the demand curve. • Requires information about the willingness to pay of the consumers. • Examples: Large ticket items: appliances, automobiles, houses, when there is often no fixed price.

17. Second Degree Price Discrimination. • The price decreases as the quantity purchased increases. • Demand curve for users who do not demand a great deal of the product are more inelastic -- set high price to them. • Demand for consumers of large quantities, for whom search is more profitable, is likely to be more elastic --a lower price to them is more profitable. • Examples include: bulk rates for food and residential versus commercial pricing of utilities. • Another example, block pricing at the wholesale level is an antitrust violation if not justified by differences in costs of providing services.

18. Strategies for Segmenting the Market • Theoretically advantageous to segment the market and charge different prices according to customer’s willingness to pay. • How do we know who is willing to pay a high price and who is only willing to pay a little above cost? • We can rely on characteristics of the customers (young versus old, students, geographic location) but sometimes this is not what determines the price elasticity or willingness to pay. • How can we obtain this information?

19. Third Degree Price Discrimination • Most common form. • The market is segmented into two (or more) categories according to the characteristics of the purchasers.

20. Tie-in Sales (requirements tie-in) • The classic (illegal) cases of a tie-in sale: • Xerox requiring the paper and repair services only to be obtained from them • IBM requiring the purchase of computer cards from them. Why would they want to do this?

21. Another Example: Copiers

22. Example 1: Restaurants • Why do restaurants sometimes only offer meals that include salad, entree, beverage, and dessert rather than only service a la carte? • In this way they don’t have to lower the price of the entree to get the dessert lover to buy it or lower the price of the dessert to get the entree lover to buy it.

23. Example: Automobiles

24. Example 2: Season Tickets • Why only sell season tickets and not tickets to individual performances? • Some people are willing to pay a high price to see Miss Saigon but not to see Sunset Boulevard • Others would pay a high price for Sunset Boulevard tickets but not Miss Saigon. • By bundling the tickets: • we don’t have to lower Miss Saigon ticket prices to sell to Sunset Boulevard lovers and vice-versa. • Bundling doesn’t make sense if everyone values Miss Saigon more than Sunset Boulevard

27. Example 3: Cable Television • Why is it often the case that premium channels such as HBO, The Learning Channel, Bravo, The Sports Channel, Discovery, and The History Channel sold as a package and not separately? • Again, this is a way of making those who value sports a higher effective price by also purchasing arts programming and vice-versa.

28. When is bundling successful? • When consumers have very different tastes between the bundled goods. • By bundling a good the consumer values highly with one she does not, it is possible for her to get her to pay more for the bundle.

29. Forms of Bundling • Pure Bundling • Cannot buy separately • Mixed Bundling • Can buy separately or as a bundle • Pure Components • Do not sell as a bundle • When would you use these strategies?

30. Bundling and Profit Maximization • Whatstrategy should the monopolist undertake? • Consider the ideal strategy • 1st degree price discrimination in which the monopolist charges each individual exactly the amount she is willing to pay. • 3 conditions are satisfied in this case: • Complete Extraction Consumers are charged exactly what their reservation price. • Exclusion. No individual consumes a good if the cost that good exceeds her reservation price. • Inclusion. Any individual whose reservation price exceeds the cost of the good consumes it.

31. Pure bundling • More effective than pure components because it increases the number of consumers -- that is it is successful at inclusion. • Mixed bundling is profitable because • Does not force someone to purchase a good for whom her value is less than the cost of the good (exclusion) • Mixed bundling is more effective than simply selling separately: • It allows the price to be raised to the consumers who value only one of the two goods while still charging a premium for those who value both through bundle pricing.

32. A Model of Conditions for Bundling • Assumptions • A firm produces 2 goods (1 and 2) both with constant marginal cost (c1,c2) • Each consumer is only interested in consuming at the most 1 unit of either or both goods. • The goods are neither complements or substitutes. Let r1 represent the most an individual is willing to pay for good 1 (reservation price) and r2 the most for good 2. Then an individual will never purchase the bundle if the bundle price, rB =r1 + r2.

33. Pricing Options • Sell the goods only individually at the prices and given by MR =MC (pure components strategy). • Sell the goods only in a package with one of each good at a price of PB (pure bundling strategy).

34. General Implications • Bundling will increase profitability by increasing the number of consumers. • In most cases mixed bundling will generally dominate pure bundling as it allows for a higher component price while still having as larger or a larger base of consumers than occurs with pure bundling.

35. Examples of Bundling • A major automobile manufacturer is considering producing a base model and offering a luxury model. • Cost of producing the base model is $21,000. • Cost of the accessories added to the base model to make it a luxury model is $3,000. • 3 consumers groups who differ with respect to how much they are willing to pay for the base model and for the luxury accessories.

36. There are two distinct pricing strategies: • Sell both a base (B) model and a luxury (L) model (mixed bundling); • Sell only the luxury model (pure bundling).

37. Sell both models. • Base at $25,000 • Luxury at $29,000 or $32,000 •  with B=$25 and L=$29 = (25-21)30 + (29-21-3)80=$520 A buys Base and B and C buy Luxury) •  with B=$25 and L=$32 = (25-21)60+(32-21-3)50 = $640 (A and B buy Base and C buys Luxury) • If sell both, shouldhave B=$25 and L=$32.

38. Sell only Luxury. • Consider L=$37. =(37-21-3)50 = $650 (Group C buys Luxury). • By selling only the Luxury model the firm can exploit the fact that the consumers who value the accessories the most also value the base the most.

40. Nonlinear Pricing • If the spending on a good is not proportional to volume purchased of the good, we have nonlinear pricing. • Spending is not proportional to purchases generally because price decreases as purchases increase or there is an initial payment or fee paid regardless of how much they purchase. • 2 alternative explanations. • Both explanations suggest that often this nonlinear pricing strategy is a form of price discrimination.

41. Examples • Why do we observe golf clubs charging both a membership fee and greens fees? • Why do large purchases of products, for example, commercial users of utilities receive lower (per unit) rates than small residential users? • 1st practice, the charging of both a membership fee and a usage fee, is a form of first-degree price discrimination. • 2nd practice, a quantity discount, is a form of second-degree price discrimination.

42. An Example: The Golf Club • 2 components to demand for Golf Club: • Member of Club (play high amount to play some) • Playing golf (declining willingness to pay) as number of rounds increase

43. An Example:The Golf Club PD M

44. Single-Price Monopolist fails on 2 accounts: • Does not extract full consumer surplus (extraction) • Does not sell all rounds with Willingness to Pay > 10

45. Two Part Pricing for the Club • Two-Part Pricing will: • Extract Consumer Surplus (CS) • Include all rounds with MB > 10 • How? • Set Green Fee (price per round) = MC =10 • Set Membership Fee=CS= .5x(50-10)40 = $800 • This strategy extracts all CS and includes all units with MB >MC

46. An Example: Membership Fees PD M

47. Two-Part Pricing and Second-Degree Price Discrimination • Suppose instead, there were 3 types of golfers: • Once a month • weekend • diehard

48. Fees with Different Tastes

49. The club has extracted all the CS from the weekend golfer, this strategy is probably not the best one. • The price of $10 and a membership fee of $800 will discourage any of the monthly golfers from joining • The die-hard golfers still have positive CS meaning that there is the potential for more profits from them.

50. An Example: Fees with Different Tastes CSA = 612.5 CSB = 937.5 DB DA