Managerial Economics Eighth Edition Truett + Truett Chapter 11: Topics in Pricing and Profit Analysis John Wiley & Sons, Inc. 12/2/2018 Slides by Jim Witsmeer

Discussion Topics Markup Pricing Multiple Products Price Discrimination Access Fees Bundling Alternatives to Profit Maximization 12/2/2018

Merchandise Markup What does it mean? Where is it used? Why? Markup on price or cost? Should it be a constant? How does markup relate to profit maximization? 12/2/2018

Profit Maximization & Markup Profit is maximum when: From our earlier studies of price elasticity (ch 2) we know. If AVC is a constant and equals MC, then profit maximizing markup is inversely related to price elasticity as follows: 12/2/2018

Multiple Product Firms Joint Products Products that are interdependent in that producing one necessarily results in the production of the other (byproduct). Transfer Products Products that one portion of the company produces that are inputs for another product’s production. 12/2/2018

Fixed Ratio of Products Product A and B are joint products with demand and MR curves as shown. Adding only the positive portion of the marginal revenues we get the bent curve, MRJ + MRA. If the marginal cost is SMC, then Qe of each product should be produced. If the marginal cost is reduced to SMC’, then Qe’ of both A and B are produced but (Qe’-Q*) of B will not be sold. 12/2/2018

Variable Ratio of Products The curved lines represent amounts of A & B produced for the same total cost. The straight lines are isorevenue lines given fixed prices for A & B. Point D is the maximum profit point in the upper graph. The three curves in the lower graph reflect three possible levels of production (shifts). Point E is the maximum profit point in the lower graph. 12/2/2018

Transfer Products Transfer products exist when a firm produces a product that it also uses in another of its products. Prices are set either by a perfectly competitive market, if applicable, otherwise by the firm in which case the external price will differ. 12/2/2018

Transfer Product Pricing Marginal cost is the total of the transfer and final products. Marginal revenue includes only the final product. This fixes the quantity of both products. The firm can then fix the price of the transfer product at its marginal cost for that quantity. This ensures that the supplying division is operating at it’s maximum profit point. 12/2/2018

Transfer Product Pricing Under perfectly competitive market for transfer product. The marginal revenue curve of the transfer product is flat in this case. At the maximum profit point for the transfer product an excess or shortage exists depending upon the marginal cost curve of it’s supplying division. In this case the firm should sell excess or buy shortage of the transfer product. 12/2/2018

Price Discrimination Price discrimination occurs when the same product is sold for different prices. First degree price discrimination offers a different price for each additional item purchased. Second degree price discrimination offers block discounts for additional items purchased. Third degree price discrimination involves the separation of markets into segments with different demand curves and prices. 12/2/2018

Second Degree Price Discrimination ZERO COST EXAMPLE DX MRX For no cost case with single price set at $5 for maximum profit of $15. With a discount of $2 for all additional purchases beyond 5 units, consumer will purchase 7 units and profit will increase by $6. PM QM QD PD 12/2/2018

First Degree Price Discrimination Each time the consumer purchases an item you lower the price on the next item the exact amount required to match the demand curve. NO COST EXAMPLE By doing this you take advantage of the consumer surplus and fill the space under the demand curve to maximize profit. DX Do you see any problems with this approach? 12/2/2018

Third Degree Price Discrimination TWO REQUIREMENTS The market segments must be separated The market segments must have different price elasticities of demand LEGALITY – In the U.S. under some circumstances price discrimination can be illegal. The elasticity of demand can be matched to the price by raising the price where the elasticity of demand is lower. 12/2/2018

Third Degree Price Discrimination HOTEL ROOM RATE EXAMPLE FOR CONVENTIONS AND THE GENERAL MARKET TC = 18200 + 30 Rg + 30Rc so that MC = $30 for both markets Profit is maximum at MR =MC for both markets. Profit without price discrimination $51,879 per day Profit with price discrimination $52,550 per day 12/2/2018

Two-Part Pricing Using this pricing strategy, to raise profits the seller simply divides the price into two or more parts. Why do you think this would increase profits? Can you think of some examples where this is done? 12/2/2018

Access Fee Pricing In the single customer situation the seller can charge the buyer an access fee equal to the consumer surplus without losing the sale. With multiple customers the seller is constrained to the access fee acceptable to the lowest demand buyer. The access fee must be considerably higher than the cost of collection. 12/2/2018

Bundling Bundling involves offering a single package price for multiple products. This strategy can be advantageous to the buyer as well. Bundling works well if there are groups of consumers with inversely related preferences. Total revenue is increased when both groups by a package at a higher price than required to entice them individually to purchase both items separately. 12/2/2018

Alternatives to Profit Maximization Under what conditions might a firm operate with goals other than maximum profit? Can this strategy benefit the company in the long run? What does “benefit the company” mean other than profit? 12/2/2018

End of Chapter 11 Copyright © 2004 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the United States copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for resale. The publisher assumes no responsibilities for errors, omissions, or damages, caused by the use of the information contained herein. 12/2/2018