1 C H A P T E R 13 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Using Market Power: Price Discrimination and Advertising

2 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Price Discrimination  Price discrimination is the practice of dividing consumers into two or more groups and charging different prices to each group.

3 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Price Discrimination  It is illegal for firms to practice price fixing—the coordination of pricing strategies among firms, but it is not illegal to practice price discrimination. The only legal restriction is that firms cannot use it to drive rival firms out of business.

4 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Price Discrimination  One approach is to identify a group of customers who are not willing to pay the regular price, and offer them a discount.  Examples: Airline tickets Grocery coupons Manufacturer’s rebates Senior-citizen discounts Student discounts

5 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Conditions Necessary for Price Discrimination  Market power: firms must have control over price.  Different consumer groups: consumers must differ in their willingness to pay.  Resale is not possible: unless the firm can prevent the resale of their products, price discrimination will break down.

6 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Different Groups Have Different Demands  Senior citizens have more elastic demand because they have lower income and more time to shop for substitutes.

7 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Elasticity, Revenue and Profit  If demand is inelastic, an increase in price has two advantages: it will increase total revenue and decrease quantity demanded. The firm will produce less and reduce its production costs.  If demand is elastic, a decrease in price will increase total revenue. But lower prices will increase quantity produced, thus result in higher costs. If profit is to increase, the increase in revenue must be greater than the increase in cost.

8 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Profit With a Single-price Policy  Total profit with the single price policy: $1,600

9 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Profit When Pricing in Accordance With Elasticity  Total profit with the senior discount: $1,860

10 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Advertising and the Marginal Principle  To decide how much firms should spend on advertising, firms can use the marginal principle. Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

11 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Advertising and the Marginal Principle Number of Advertisements Quantity of Detergent Sold (boxes) Marginal Benefit (assuming profit of $1 per box) Marginal Cost (each 30-second TV commercial) 0100,000$7, ,000$10,000$7, ,000 9,000$7, ,000 8,000$7, ,000 7,000$ 7, ,000 6,000$7, ,000 5,000$7,000

12 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin What Sorts of Firms Will Advertise?  For advertising to be profitable, the increase in sales must be large relative to the cost of advertising.  Advertising makes sense only if consumer choices are sensitive to advertising, and the good sold by the firm is a close but not a perfect substitute for others.

13 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Advertisers’ Dilemma  The advertisers’ dilemma states that although firms would be better off if they did not advertise, the firms advertise anyway.

14 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Advertisers’ Dilemma Neither Advertises Both Advertise Jack Advertises JackJillJackJillJackJill Net Revenue from Sales ($ million) Cost of Advertising ($ million) Net Profit Advertising ($ million)

15 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin The Advertisers’ Dilemma  Jill’s dominant strategy is to advertise.

16 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Outcome of the Advertising Game  Knowing that Jill’s dominant strategy is to advertise, Jack’s best response is to advertise too.  Each firm earns $2 million less than in the absence of advertising.

17 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Tradeoffs From Advertising  Advertising helps consumers make more informed decisions.  Information in advertising about prices helps to promote competition, thus advertising leads to lower prices. Benefits of advertising:

18 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Tradeoffs From Advertising  When firms are trapped in the advertisers’ dilemma, resources used in advertising may be wasted. Advertising results in a net decrease in industry profits.  Some advertisements give the impression that there are real differences between products when there are none. Costs of advertising: