1. PRICING WITH MARKET POWER II

2. Overview
Two-part tariff
Bundling
Tying

3. Meaning of Two-Part Tariff
The purchase of some products and services can be separated into two decisions, and therefore, two prices. Examples
1) Amusement Park
Pay to enter
Pay for rides and food within the park
2) Tennis Club
Pay to join
Pay to play
Pricing decision is setting the entry fee (T) and the usage fee (P), thus choosing the trade-off between free-entry and high use prices, or high-entry and zero use prices 72

4. Two-Part Tariff with a Single Consumer
$/Q
Usage price P* is set where MC = D.
Entry price T* is equal to the entire
consumer surplus. How do you find
out T* ? T* D MC P*
Quantity 79

5. Two-Part Tariff with Two ConsumersQ1 Q2
The price, P*, will be
greater than MC. Set T*
at the surplus value of D2. T* P*
$/Q
D2 = consumer 2
D1 = consumer 1
Π=2T*+(P*-MC).(Q1+Q2)>ΔABC A
Thus there is a trade-off
between high entry fee &
high user price MC C B
Quantity 83

6. The Two-Part Tariff with Many Consumers
No exact way to determine P* and T*.
Must consider the trade-off between the entry fee T* and the use fee P*.
Low entry fee=> High sales revenue, but less entry,
Low price=> More use, but falling profit with lower price.
To find optimum combination, choose several combinations of P and T
Choose the combination that maximizes profit
Rule of Thumb
Similar demand: Choose P close to MC and high T
Dissimilar demand: Choose high P and low T. 84

7. Two-Part Tariff with Many Different Consumers (choosing T)
Total profit is the sum of the
profit from the entry fee and
the profit from sales. Both
depend on T.
Profit
:sales
:entry fee T 87

8. Two-Part Tariff with many different Consumers (choosing n, alternatively)
Optimum two-part tariff that globally maximizes profits is attained at
The optimum is achieved where the vertical sum (curve not shown) of ПA and ПS reaches the maximum.

9. Two-Part Tariff With A Twist
Suppose, entry price (T) entitles the buyer to a certain number of free units
Gillette razors with several blades
Amusement parks with some tokens
On-line with free time

10. Bundling
Bundling is packaging two or more products to gain a pricing advantage.
Conditions necessary for bundling
Heterogeneous customers
Price discrimination is not possible
Demands must be negatively correlated 90

11. Bundling Example With Two Consumers (theaters A-B)
Reservation Price
Spiderman Spaceballs
Theater A $12,000 $3,000
Theater B $10,000 $4,000
Renting the movies separately would result in each theater paying the lowest reservation price for each movie
Total Revenue = $26,000
If the movies are bundled and if each were charged the lower of the two prices
Total revenue will be $28,000.

12. Bundling Example With Two Consumers – Importance of Negative Correlation of Demands
If the demands were positively correlated (Theater A would pay more for both films as shown), bundling would not result in an increase in revenue.
Gone with the Wind Getting Gertie’s Garter
Theater A $12,000 $4,000
Theater B $10,000 $3,000
If the movies are bundled and if each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films, separately.

13. Bundling Example With Two Heterogeneous Goods and Many Consumers
(reservation
price Good 2) $6
$3.25
$8.25
Consumer A C B
Each consumer
represented by a
dot – A, B, C.
Consumer A is
willing to pay up to
$3.25 for good 1 and
up to $6 for good 2.
$10 $5
r1 (reservation
price Good 1) $5
$10 98

14. Consumption Decisions When Products are Sold SeparatelyII
Consumers buy
only good 2 P1
Consumers fall into
four categories based
on their reservation
price. I
Consumers buy
both goods
Two sets of choice involved:
(i) Whether to choose P
further up inside I or
further down inside III –
i.e., choice of intercept of
intercept of a straight line;
(ii) Whether to swing the line
to capture more customers
from one quadrant or the
other – i.e., from II and IV
(thus involving choice of
slope of the line) P2
P (P1, P2)
III
Consumers buy
neither good IV
Consumers buy
only Good 1 r1
100

15. Consumption Decisions When Products are Bundled
r2 = PB - r1 I II
Consumers
buy bundle
(r > PB)
Consumers do
not buy bundle
(r < PB) r2
Consumers compare the sum of their reservation prices, r1 + r2, with the bundle price PB. They buy the bundle only if r1 + r2 is at least as large as PB. r1
102

16. Consumption Decisions When Products are Bundled
Depending on the prices, some of the consumers in regions II and IV might have bought one of the goods if they were sold separately. These customers are lost to the firm.
However, the other customers in regions II and IV now buy both goods where they formerly bought only one.
The firm then, must decide whether it can do better by bundling.
Buyers of good 2 who now buy good 1 also
Buyers who buy both the goods
Buyers of good 2 lost to the firm
Buyers of good 1 who now buy good 2 also
Buyers who buy neither good
Buyers of good 1 lost to the firm
105

17. Efficiency of Bundling Depends on the Degree of Negative Correlation
(Spiderman) r2
Bundling pays due to
negative correlation
10,000
5,000
12,000
4,000
3,000 B A r1
5,000
10,000
14,000
(Spaceballs)
106

18. Mixed Versus Pure Bundling
C1 = MC1 = 20
With positive marginal
costs, mixed bundling
may be more profitable
than pure bundling. r2
100
Consumer A, for example, has a reservation
price for good 1 that is below marginal cost c1.
With mixed bundling, consumer A is induced
to buy only good 2, while consumer D is
induced to buy only good 1, reducing the
firm’s cost. A B D C 90 80 70 60 50 40 30
C2 = MC2 = 30 20
Is MC>0 sufficient
condition for mixed
bundling to dominate? 10 r1 10 20 30 40 50 60 70 80 90
100
110

19. Mixed Bundling with Zero Marginal CostsP1 P2 PB
Profit
Sell separately $80 $ $320
Pure bundling $100 $400
Mixed bundling $90 $90 $120 $420
Is MC>0 sufficient condition for mixed bundling to dominate?
118

20. Mixed Bundling with Zero Marginal Costs
120
In this example, consumers B and C are willing to
pay $20 more for the bundle than are consumers
A and D. With mixed bundling, the price of the
Bundle can be increased to $120. A & D can be
charged $90 for a single good. C 10 90 A B D
100 80 60 40 20 r1 20 40 60 80
100
120
117

21. Mixed Bundling in Practice
Use of market surveys to determine reservation prices
Design a pricing strategy from the survey results
Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.
121

22. Tying
Practice of requiring a customer to purchase one good in order to purchase another.
Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy user
Examples:
Xerox machines and the paper
IBM mainframe and computer cards
Renting out tractor along with driver
Rural moneylenders providing credit against sale of output and/or input purchase (even land leasing-in) contract
Is tying necessarily ‘exploitative’?