1 Welcome to EC 209: Managerial Economics- Group A By: Dr. Jacqueline Khorassani Week Twelve

2 Managerial Economics- Group A Week Twelve- Class 1 Monday, November 19 11:10-12:00 Fottrell (AM) 11:10-12:00 Fottrell (AM) Aplia Asst Due tomorrow before 5 PM Don’t forget Review Session 7PM Tonight O'Flaherty Theatre

3 Chapter 11 Pricing Strategies for Firms with Market Power

4 Standard Pricing and Profits for Firms with Market Power Price Quantity P = Q MC=AC MR = Q Profits from standard pricing = Q * (P – AC) = $8 Remember If P = 10-2Q R = PQ = 10Q -2Q 2 MR = 10-4Q If C(Q) = 2Q Then MC = 2 To max profits MC = MR 2 = 10-4Q Q = 2 Plug Q = 2 into your demand equation  P = (2)  P = 6

5 Marginal Revenue and Elasticity Recall own price elasticity of demand Recall own price elasticity of demand E = %Δ Q / %ΔP Where %Δ Q= dQ/Q %ΔP = dP/P E= dQ/Q divided by dP/P E = (dQ/dP) * P/Q

6 Also revenue is R = P.Q Where P is a function of Q Where P is a function of Q so R(Q) = P(Q).Q so R(Q) = P(Q).Q dR/dQ = dR/dP. dP/dQ + dR/dQ. dQ/dQ dR/dQ = dR/dP. dP/dQ + dR/dQ. dQ/dQ dR/dQ = Q * dP/dQ + P * 1 dR/dQ = Q * dP/dQ + P * 1 MR = P (Q/P. dP/dQ + 1) MR = P (Q/P. dP/dQ + 1) We know that (dQ/dP) * P/Q = E We know that (dQ/dP) * P/Q = E MR = P ( 1/E + 1) MR = P ( 1/E + 1) MR = P(E + 1)/E MR = P(E + 1)/E

7 MR = P(E + 1)/E If E = -1  MR = 0 If E = -1  MR = 0 If E is a smaller negative number  MR <0 If E is a smaller negative number  MR <0 If E is a bigger negative number  MR> 0 If E is a bigger negative number  MR> 0 Note: A firm will never produce a level where MR < 0. Note: A firm will never produce a level where MR < 0.

8 A Simple Markup Rule Suppose the elasticity of demand for the firm’s product is E F. Suppose the elasticity of demand for the firm’s product is E F. Since MR = P[1 + E F ]/ E F Since MR = P[1 + E F ]/ E F Setting MR = MC Setting MR = MC P[1 + E F ]/ E F = MC P[1 + E F ]/ E F = MC P = [E F /(1+ E F )]  MC P = [E F /(1+ E F )]  MC P = K x MC where K is the markup factor P = K x MC where K is the markup factor The optimal price is a simple markup over relevant costs! The optimal price is a simple markup over relevant costs!

9 Mark-up Factor= E F /(1+ E F ) If E F = -2 If E F = -2 Then Mark-up factor = -2/ -1 Then Mark-up factor = -2/ -1 –Price is 2 times MC If E F = -4 If E F = -4 Then Mark-up factor = -4/ -3 Then Mark-up factor = -4/ -3 –Price is 4/3 of MC The more elastic the demand, the lower the markup. The more elastic the demand, the lower the markup.

10 Markup Rule for Cournot Oligopoly Homogeneous product Cournot oligopoly. Homogeneous product Cournot oligopoly. N = total number of firms in the industry. N = total number of firms in the industry. Market elasticity of demand E M. Market elasticity of demand E M. Elasticity of individual firm’s demand is given by E F = N x E M. Elasticity of individual firm’s demand is given by E F = N x E M. Since P = [E F /(1+ E F )]  MC, Since P = [E F /(1+ E F )]  MC, Then, P = [NE M /(1+ NE M )]  MC. Then, P = [NE M /(1+ NE M )]  MC. The greater the number of firms  the lower the profit-maximizing markup factor. The greater the number of firms  the lower the profit-maximizing markup factor.

11 An Example Homogeneous product Cournot industry, 3 firms. Homogeneous product Cournot industry, 3 firms. MC = $10. MC = $10. Elasticity of market demand = - ½. Elasticity of market demand = - ½. Determine the profit-maximizing price? Determine the profit-maximizing price? E F = NE M = 3  (-1/2) = E F = NE M = 3  (-1/2) = P = [NE M /(1+ NE M )]  MC. P = [NE M /(1+ NE M )]  MC. P = [-1.5/(1- 1.5]  $10. P = [-1.5/(1- 1.5]  $10. P = 3  $10 = $30. P = 3  $10 = $30.

12 First-Degree or Perfect Price Discrimination First-Degree or Perfect Price Discrimination Practice of charging each consumer the maximum amount he or she will pay for each incremental unit. Practice of charging each consumer the maximum amount he or she will pay for each incremental unit. Permits a firm to extract all surplus from consumers. Permits a firm to extract all surplus from consumers.

13 Perfect Price Discrimination Price Quantity D Profits*:.5(4-0)(10 - 2) = $16 Total Cost* = $8 MC = AC In practice, transactions costs and information constraints make this difficult to implement perfectly. Price discrimination won’t work if consumers can resell the good.

14 Second-Degree Price Discrimination The practice of posting a discrete schedule of declining prices for different quantities. The practice of posting a discrete schedule of declining prices for different quantities. Eliminates the information constraint present in first-degree price discrimination. Eliminates the information constraint present in first-degree price discrimination. Example: Electric utilities Example: Electric utilities Price MC D $5 $10 4 Quantity $8 2 The first 2 units are sold at $8/unit The second 2 units are sold at $5/unit Part of Consumer surplus is captured by the firm

15 Managerial Economics- Group A Week Twelve- Class 2 Week Twelve- Class 2 –Tuesday, November 20 –Cairnes –15:10-16:00 Aplia assignment is due before 5PM today Aplia assignment is due before 5PM today Send me questions on the entire course material Send me questions on the entire course material

16 Last Class we talked about two types of price discrimination 1. First-Degree or Perfect Price Discrimination charging each consumer the maximum amount he or she will pay for each incremental unit. charging each consumer the maximum amount he or she will pay for each incremental unit. Firm captures the entire Consumer Surplus Firm captures the entire Consumer Surplus Hard to implement Hard to implement 2. Second-Degree Price Discrimination posting a discrete schedule of declining prices for different quantities. posting a discrete schedule of declining prices for different quantities. Does not capture the entire Consumer Surplus Does not capture the entire Consumer Surplus Easier to implement Easier to implement

17 Third-Degree Price Discrimination charging different groups of consumers different prices for the same product. charging different groups of consumers different prices for the same product. Group must have observable characteristics for third-degree price discrimination to work. Group must have observable characteristics for third-degree price discrimination to work. Examples Examples –student discounts, –senior citizen’s discounts, –regional & international pricing.

18 Implementing Third- Degree Price Discrimination Demands by two groups have different elasticities, E 1 < E 2. Demands by two groups have different elasticities, E 1 < E 2. Notice that group 2 is more price sensitive than group 1. Notice that group 2 is more price sensitive than group 1. –Who should be paying a lower price? –Group 2 Profit-maximizing prices? Profit-maximizing prices? P 1 = [E 1 /(1+ E 1 )]  MC P 1 = [E 1 /(1+ E 1 )]  MC P 2 = [E 2 /(1+ E 2 )]  MC P 2 = [E 2 /(1+ E 2 )]  MC

19 An Example Suppose the elasticity of demand for Kodak film in the US is E U = -1.5, and the elasticity of demand in Japan is E J = Suppose the elasticity of demand for Kodak film in the US is E U = -1.5, and the elasticity of demand in Japan is E J = Marginal cost of manufacturing film is $3. Marginal cost of manufacturing film is $3. P U = [E U /(1+ E U )]  MC = [-1.5/( )]  $3 = $9 P U = [E U /(1+ E U )]  MC = [-1.5/( )]  $3 = $9 P J = [E J /(1+ E J )]  MC = [-2.5/( )]  $3 = $5 P J = [E J /(1+ E J )]  MC = [-2.5/( )]  $3 = $5 Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic. Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic.

20 Two-Part Pricing If it isn’t feasible to charge different prices for different units sold, If it isn’t feasible to charge different prices for different units sold, but demand information is known, but demand information is known, two-part pricing may permit you to extract all surplus from consumers. two-part pricing may permit you to extract all surplus from consumers. Two-part pricing consists of a fixed fee and a per unit charge. Two-part pricing consists of a fixed fee and a per unit charge. Example: Example: –Athletic club memberships. You may pay a monthly membership fee You may pay a monthly membership fee Plus a small fee for each visit Plus a small fee for each visit

21 Example An average (typical) consumer’s demand is An average (typical) consumer’s demand is P = 10 – 2Q & MC = 2 1. Set P = MC = 2 2. Find Q Q = 2  Q = Q = 2  Q = 4 Find Consumer surplus Find Consumer surplus

22 To find Consumer Surplus 1. Draw the demand curve P = Q 2. Draw the MC curve 3. Intersection gives you the price Quantity D MC Fixed Fee = consumer surplus = Profits = €16 Price Per Unit Charge

23 Block Pricing packaging multiple units of an identical product together and selling them as one package. packaging multiple units of an identical product together and selling them as one package. Examples Examples –Paper towels. –Six-packs of soda.

24 An Algebraic Example Typical consumer’s demand is Typical consumer’s demand is P = Q C(Q) = 2Q C(Q) = 2Q Optimal number of units in a package? Optimal number of units in a package? Optimal package price? Optimal package price?

25 To determine the optimal quantity per package Price Quantity D MC = AC Find Q from P = MC MC = 2 P= Q 2= 10-2Q Q = 4

26 To find the optimal price for the Package Price Quantity D MC = AC Consumer’s valuation of 4 units =.5(8)(4) + (2)(4) = $24 Therefore, set P = $24! Find out the value of 4 units to consumer & set a price equal to that The value to consumer is the area under the demand curve

27 Costs and Profits with Block Pricing Price Quantity D MC = AC Profits = [.5(8)(4) + (2)(4)] – (2)(4) = $16 Costs = (2)(4) = $8

28 Commodity Bundling The practice of bundling two or more products together and charging one price for the bundle. The practice of bundling two or more products together and charging one price for the bundle. Examples Examples –Holiday packages. –Computers and software. –Film and developing.

29 Peak-Load Pricing demand during peak times is higher than the capacity of the firm demand during peak times is higher than the capacity of the firm the firm engages in peak-load pricing. the firm engages in peak-load pricing. Charge a higher price (P H ) during peak times (D H ). Charge a higher price (P H ) during peak times (D H ). Charge a lower price (P L ) during off-peak times (D L ). Charge a lower price (P L ) during off-peak times (D L ). Quantity Price MC MR L PLPL QLQL QHQH DHDH MR H DLDL PHPH

30 Cross-Subsidies Prices charged for one product are subsidized by the sale of another product. Prices charged for one product are subsidized by the sale of another product. May be profitable when there are significant demand complementarities effects. May be profitable when there are significant demand complementarities effects. Examples Examples –Browser and server software. –Drinks and meals at restaurants.

31 Double Marginalization Example Example –A large firm has division the upstream division is the sole provider of a key input. the upstream division is the sole provider of a key input. the downstream division uses the input produced by the upstream division to produce the final output. the downstream division uses the input produced by the upstream division to produce the final output. –Incentives to maximize divisional profits leads the upstream manager to produce where MR U = MC U. Implication: P U > MC U. Implication: P U > MC U.

32 Double Marginalization Similarly the downstream division has market power and has an incentive to maximize divisional profits, the manager will produce where MR D = MC D. Similarly the downstream division has market power and has an incentive to maximize divisional profits, the manager will produce where MR D = MC D. –Implication: P D > MC D. Thus, both divisions mark price up over marginal cost resulting in a phenomenon called double marginalization. Thus, both divisions mark price up over marginal cost resulting in a phenomenon called double marginalization. –Result: less than optimal overall profits for the firm.

33 Managerial Economics- Group A Week Twelve- Class 3 Week Twelve- Class 3 –Thursday, November 22 –15:10-16:00 –Tyndall Next Aplia Assignment is due before 5 PM on Tuesday, November 27 Next Aplia Assignment is due before 5 PM on Tuesday, November 27

34 Last time we talked about Double marginalization Double marginalization What doe it mean? What doe it mean? –The manager of the pasta factory that belongs to the restaurant and only provides pastas to the restaurant –And the manager of the restaurant –Maximizing their profits separately Not the best strategy Not the best strategy

35 Instead the firm should maximize the overall profits of selling the final good (product of the restaurant) This is called “Transfer Pricing” This is called “Transfer Pricing” That is That is MR r = MC r + MC p where MR r is marginal revenue of restaurant MC r is marginal cost of restaurant MC p is marginal cost of pasta factory MR r - MC r = MC p NMR r = MC p –The pasta factory produces such that its marginal cost equals the net marginal revenue of restaurant (NMR r )

36 Pricing in Markets with Intense Price Competition Price Matching Price Matching –Advertising a price and a promise to match any lower price offered by a competitor. –No firm has an incentive to lower their prices. –Each firm charges the monopoly price and shares the market.

37 Pricing in Markets with Intense Price Competition Randomized Pricing Randomized Pricing –A strategy of constantly changing prices. –Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price. –Reduces the ability of rival firms to undercut a firm’s prices

38 Other information 1. Posted three sample MCQ on my website & on blackboard as well 2. Also, remember to check blackboard for sample of previous years’ exams 3. There is going to be another Review Session on Wednesday, November 28 at 7-9 pm in IT250 1st floor 4. Send me your questions I will post the answers on my website. I will post the answers on my website.