1. PowerPoint Slides © Michael R. Ward, UTA 2014

2. Tool Merger Black & Decker, a power tool company, and Stanley, a maker of hand tools, have recently merged. How is this likely to affect tool prices? Are power tools and hand tools complements or substitutes? Both! Depending on the uses. Ex Screwdrivers and power screwdrivers likely are substitutes Ex Measuring tapes and power drills likely are complements Econ 5313

3. Multi-Product Firms Why does it matter if the products are complements or substitutes? Now you are maximizing the sum of profits from two related products Moving away from MB=MC will decrease profits in a single market but it will also affect profits in the other, related market Econ 5313

4. Increase in Demand Take your typical stand alone product You have maximized profits by setting MR = MC D P* Q P MC MR Econ 5313

5. Increase in Demand Suppose “something” caused the demand to shift out Now it is profitable to increase price P* MR D Q P MC Econ 5313

6. Increase in Demand Now profits are higher due to: 1.Higher Price 2.Higher quantity P* MR D Q P MC Econ 5313

7. How to Increase Demand How can a multi-product firm shift the demand out? With substitutes, you increase price With complements, you decrease price For small price changes, the lost profits from MR≠MC is trivial and the profit gain in the other market can be big For bigger price changes, the lost profits are no longer trivial Trick is to raise price just enough so that the loss on this product is made up for with the gain on the other related product. Econ 5313

8. How to Increase Demand Also, the effects are usually reciprocal If you raise the price of A to increase demand on substitute B, you probably also want to raise the price of B to increase the demand on A Limited by substitution to products C, D, & E Do you raise price the same amount on both? If you lower the price of A to increase demand on complement B, you probably want to lower the price of B to increase the demand on A Usually limited by prices being above MC Not always (e.g., loss leaders) Econ 5313

9. Post-Merger Strategy With substitutes, this comes into play when you acquire a new product Ex Black and Decker/Stanley merger Ex AmAir/USAir merger This is precisely why mergers between competitors get antitrust scrutiny Higher prices typically harm consumers Substitutes also can come into play when you develop a new product Ex Release of iPad mini Ex Opening a new store in a restaurant chain Econ 5313

10. Intra-firm Competition Substitutes can lead to ‘cannibalization’ Since two of your products compete, buyers can try to play one off the other Ex Chevy and Pontiac versions of same car Ex Bank merger has branches competing for customers One strategy is to try to differentiate these more Often see product repositioning after new substitute is introduced or acquired Econ 5313

11. Non-Compete Clauses Branded drugs face generic entry by rival drugs that typically take 80% of sales away from the branded drug within three years Generic drugs are much cheaper than branded drugs, and most insurance companies encourage generics Often, the branded-drug maker sues the generic entrant for violating its patent In the patent dispute settlement negotiations, the branded-drug maker offered to pay the generic entrant $10 million to stay out of the industry Why would the branded drug offer to pay the generic drug to stay out of the industry? Econ 5313

12. Platforms Again Complementary products are the heart of the platform strategy Easier to implement because, often, everyone wins Typically, prices end up lower but quantity is much bigger making profits rise Lower prices typically make consumers better off If we look, we can see it in many places: Ex iPod and iTunes Ex Baseball gloves and baseballs Ex Microsoft Windows and Expedia Ex Bookstores selling the Harry Potter book below cost Econ 5313

13. Loss Leaders When do you want to lose money on a complementary product? We can see this in many places too: Ex Retailer and “free” parking, “free” grocery cart Ex Free samples at Costco Ex Turkeys at Thanksgiving Ex Casinos and “comps” Ex Microsoft Windows and Microsoft Internet Explorer Chris Anderson’s recent “Free! Why $0.00 Is the Future of Business” Essentially argues this platform strategy of complements is becoming more important Econ 5313

14. Yield Management Should cruise ships sail with every room sold? Exact number of tickets sold is uncertain What are the lost profits from an empty room? P-MC for the room Since MC small, probably P What are lost profits from a full boat? Possibly would have sold out at a price just a smidgeon higher Lose Q×smidgeon Have to balance these to eventualities Econ 5313

15. Yield Management Difficulty comes from capacity constraints Cruise ships Airlines Stadium seating Hotels rooms Hospital rooms When deciding size, capacity is a marginal cost Equate LRMC with LRMR LRMC includes the cost of capacity LRMR is PV of expected MRs After built, capacity costs are fixed and sunk MC is much lower than LRMC until you hit the capacity Econ 5313

16. Yield Management During low demand MR = MC somewhere less than capacity Set prices as before (simple pricing) During high demand MR > MC at capacity You would like to sell another unit (hotel room, airline seat) but there are no more In this case, just set price to fill all of capacity Ex Selling parking spaces downtown Econ 5313

17. Yield Management When capacity is binding Cost of overpricing is unsold capacity (P-MC) for the unsold units Cost of underpricing is possible foregone price premiums (P’-P) for all units Must balance the two Observational problem Easier to observe the first than the second Too cautious as with decision errors? Can exploit how quickly you sell out Econ 5313

18. Same Asset – Different Demand Suppose your parking lot has two different consumer types who use it at two different times. Daily commuters use it during the daytime, and sports fans use it at different times to park at sporting events. Daily commuter demand is variable, yet stable and known. Demand for sporting events is uncertain, and depends on the quality of the match, as well as on unpredictable events, like the weather. How would you price these two events differently? For commuter demand, experiment to see when it fills up. If it fills up before 9am, raise price; otherwise reduce price. For sporting event parking, too idiosyncratic to experiment. Must set a price such that balances the cost of over-pricing and with the cost of under-pricing. Experience is likely to be your best guide. Econ 5313

19. Promotion and Pricing Combines two of the “Four P’s of marketing” Product, Placement, Pricing and Promotion Promotional spending can affect demand in different ways Common dichotomy is: pricing-related product-related Econ 5313

20. Promotion and Pricing Price-related promotions (coupons, end-of-aisle displays, etc.) increase demand but tend to make it more elastic Tend to compare your product to another product but yours is cheaper Attracts “value” customers who are more elastic With more elastic demand, it makes sense to reduce price concurrently Profitable if increase in quantity is big enough Caveat: Prices can affect customer perception of quality – i.e. consumers may infer lower quality from lower price Econ 5313

21. Promotion and Pricing Product-related promotions (quality advertising, celebrity endorsements, etc.) tend to make demand less elastic Tend to highlight why your product is better than others Attracts the quality conscious consumer willing to pay for premium brands If promotions make demand less elastic, it makes sense to raise price concurrently Econ 5313

22. From the Blog Chapter 12 Turkeys are cheaper at Thanksgiving Video Game Consoles and Content Hospital Yield Management Smart Parking Meters Price Effects from Beer Mergers Econ 5313

23. Main Points After acquiring a substitute: Raise price on both to eliminate competition between the two Raise price more on the lower margin (more elastic) product Reposition so as to lessen cannibalization After acquiring a complement, reduce prices on both Yield Management is an issue when capacity costs are large, fixed, and sunk In this case, SRMC << LRMC and you should price to fill capacity If demand is difficult to forecast, weigh costs of overpricing (unsold capacity) against underpricing (lost margin) Promotional focus affects pricing strategy Price focus makes demand elastic => lower price Product focus makes demand inelastic => raise price Econ 5313