The Optimal Mark-Up and Price Discrimination Outline The optimal mark-up over cost What is price discrimination? Examples of price discrimination When is price discrimination feasible? First, second, and third degree price discrimination Multinational pricing of autos Interdependent demand

Price as the decision variable Thus far we have assumed that quantity was the relevant decision-variable. In reality, most firms establish a price for their product and then try to satisfy demand for their product at that price. The price established by management is generally based on costs plus a mark-up.

The trade-off between price and profit The firm’s contribution can be written as: Contribution = (P – MC)Q We assume that marginal cost (MC) is constant. Issue: How far above MC should the firm raise P to maximize its contribution (and hence profits)?

It depends on elasticity (E P ) We can show that the optimal mark-up over MC is inversely proportional to elasticity of demand (E P )

The markup rule The size of the firm’s mark-up (above marginal cost expressed as a percentage of price) depends inversely on the price elasticity of demand for a good or service. That is, the optimal markup is given by: [3.12] Rearranging [3.1] we obtain: [3.13]

Elasticities and optimal prices ElasticityMCPrice ---

Students at Sherwood High in Sandy Springs, Maryland talk about things that bother them

What is price discrimination? Price discrimination is the practice of selling the same product to different buyers (or groups of buyers) at different prices.

Examples of price discrimination Airlines charge full fares to business travelers, whereas they offer discount fares to vacationers. “Sizing up their income” pricing by dentists, plumbers, and auto mechanics. Publishers of academic journals charge higher prices for library as compared to individual subscriptions. Senior citizen discounts. Discounts for new buyers—e.g., magazine subscriptions. Theater ticket pricing

When is price discrimination feasible? 1.The seller must be capable of identifying market segments that differ based on willingness to pay, or elasticity of demand. 2.The seller must be capable of “enforcing” the different prices charged to different market segments—that is, the seller must be able to prevent “arbitrage.”

1 st degree price discrimination Sometimes called “perfect” price discrimination, the seller charges each buyer their “reservation price” for every unit purchased. Reservation price is the maximum price a buyer is willing to pay rather than go without the last unit of the good.

Auctions Auctions are designed to force buyers nearer to their reservations prices.

3 rd degree price discrimination This is the practice of charging different prices in different market segments

Examples of market “segments” Business travelers versus tourists. Kids versus adults Those covered by health insurance and those not covered. Senior citizens versus everyone else. Mercedes Benz owners versus Chevrolet owners. Domestic versus foreign buyers

Multinational pricing of autos The problem for a car manufacturer is to establish profit-maximizing prices on cars sold domestically and in the foreign market segment

The Demand Functions The inverse demand equation for the home (H) market is given by: Where P H is the price charge in the home market and H is the quantity sold in the home market The inverse demand equation for the foreign (F) market is given by:

30, Quantity Price 25,000 Home Foreign 35.7 The demand for cars

30, Quantity (000s) Price DHDH 30 Profit maximization in the Home segment MR H MC H 10,000 20, To maximize profits in the Home segment, set MR H = MC H

18, Quantity (000s) Price 25,000 DFDF 35.7 Profit-maximization in the foreign market segment MR F MC F 11, To maximize profits in the Foreign segment, set MR F = MC F

Summary Notice that the price is higher in the Home market where the manufacturer faces a less elastic demand curve

Interdependent demand Consider a microbrewery that brews lager and pilsner. The price of the lager will likely affect the demand for pilsner.

Example Let A denote lager and B is pilsner. Let the profit function be given by: Note: We assume that there are no interdependencies or complementarities in production

Determining the optimal quantity Produce up to the point in which the extra total revenue (MTR) from the sale of product A is equal to the marginal cost of A, and similarly for B. That is: And:

Numerical example Let MC A = $80; MC B = $40 P A = 280 – 2Q A P B = 180 – Q B – 2Q A Notice that increased sales of A adversely affect sales of B, but not vice versa.

TR = R A + R B = (280Q A – 2Q A 2 ) + (180Q B – Q B 2 -2Q A Q B ) Thus we have: Therefore: MTR A = 280 – 4Q A – 2Q B And: MTR B = 180 – 2Q B – 2Q A So set MTR A = MC A and MTR B = MC B and solve for Q A and Q B 280 – 4Q A – 2Q B = – 2Q B – 2Q A = 40 The result is a linear equation system with two equations and two unknowns

The solutions Solving the equation system yields: Q A = 30 and Q B = 40 Substituting into the price (or inverse demand) equations yields: P A = $220 and P B = $80 Contrast this outcome to the case where the brewery ignored the cross effect of A and B and simply tried to maximize profits from A.

Information Goods Examples: Databases, video games, word processing applications, sheet music, news articles. Properties of information goods: High fixed costs Zero or negligible marginal cost. Network externalities. Information is costly to produce but cheap (often costless) to reproduce.

Network Effects Network externality is defined as a change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes. Autarky value: Value generated by the product even if there are no other users. Synchronization value: additional value derived from being able to interact with other users of the product, and it is this latter value that is the essence of network effects.

Phones and fax machines have zero autarchy value; whereas computers do have some.

The development of bandwidth has greatly increased the synchronization value of PCs.

Path Dependence and Lock-In Effects Network industries may exhibit path dependence, so that the behavior of early adopters may have a disproportionate influence on the equilibrium outcome. Lock-in may occur on the “wrong” technology because if, for whatever reason, the wrong technology is chosen, it may be difficult to achieve the coordinated movement of large numbers of users required for the “right” technology to become the standard.

QWERTY: Example of an Unfortunate Lock-in effect RTY