14-1 Learning Objectives  Explain why uniform pricing does not generate maximum possible total revenue and how price discrimination can generate more revenue  Explain how to practice first ‐ degree price discrimination  Explain how to practice second ‐ degree price discrimination  Explain how to practice third ‐ degree price discrimination  Determine profit ‐ maximizing prices when a firm sells multiple products related in consumption and explain how firms can profitably bundle products for a single price  Understand why cost ‐ plus pricing usually fails to maximize profit

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

14-3 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)

14-4 The Trouble with Uniform Pricing (Figure 14.1)

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

14-6 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 Price Discrimination

14-7 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

14-8 First-Degree (Perfect) Price Discrimination (Figure 14.2)

14-9 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

14-10 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:

14-11  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 MR f = MC f Second-Degree Price Discrimination

14-12 Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14.3)

14-13 Demand at Northvale Golf Club (Figure 14.4)

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

14-15 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. ~ Coupons ~ Airline Tickets ~ Reverse Auction ~ Rebates

14-16 Block Pricing with Five Blocks (Figure 14.5)

14-17 Block Pricing

14-18 Block Pricing (cont.) Consumer pays 70* *20. Monopolist charges single price and sells 30 units at $60.

14-19 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 MR T = MC  For profit-maximization, allocate sales of total output so that MR T = MC = MR 1 = MR 2

14-20  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 Third-Degree Price Discrimination

14-21 Allocating Sales Between Markets (Figure 14.6)

14-22 Constructing the Marginal Revenue Curve (Figure 14.7)

14-23 Profit-Maximization Under Third-Degree Price Discrimination (Figure 14.8)

14-24 Multiple Products  Related in consumption ~For two products, X & Y, produce & sell levels of output for which MR X = MC X and MR Y = MC Y ~ MR X is a function not only of Q X but also of Q Y (as is MR Y ) – conditions must be satisfied simultaneously

14-25  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 Bundling Multiple Products

14-26 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

14-27  Does not generally produce profit- maximizing price ~Fails to incorporate information on demand & marginal revenue ~Uses average, not marginal, cost Cost-Plus Pricing

14-28 Practical Problems with Cost-Plus Pricing (Figure 14.9)

14-29 Summary  Managers wish to avoid uniform pricing because it creates too much consumer surplus ~Price discrimination: charging different prices for the same product for the purpose of capturing consumer surplus and turning it into economic profit  Under first-degree price discrimination, the firm charges each consumer the maximum price he is willing to pay for every unit he purchases  Second-degree price discrimination reduces the average price as the amount purchased increases and lets buyers self-select the price they pay by choosing how much to buy ~Two methods: two-part pricing and declining block pricing

14-30 Summary  When a firm sells in two distinct markets, 1 & 2, it can practice third-degree price discrimination by allocating output or sales between the two markets such that MR 1 = MR 2  When a firm produces two products, X & Y, the firm maximizes profit by producing and selling output levels for which MR X = MC X and MR Y = MC Y  Managers who use cost-plus pricing to set prices will fail to maximize profit because cost-plus pricing faces a number of practical and theoretical problems ~Cost-plus pricing is flawed because it employs average rather than marginal cost, and it does not incorporate consideration of demand conditions