1. 1 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy

2. 2 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy

3. 3 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy CHAPTER 15 Pricing Strategy Fernando Quijano Prepared by: Why does Disney charge so many different prices for the same product?

4. 4 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy CHAPTER 15 Pricing Strategy 15.1Pricing Strategy, the Law of One Price, and Arbitrage Define the law of one price and explain the role of arbitrage. 15.2Price Discrimination: Charging Different Prices for the Same Product Explain how a firm can increase its profits through price discrimination. 15.3Other Pricing Strategies Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. Chapter Outline and Learning Objectives

5. 5 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. Pricing Strategy, The Law of One Price, and Arbitrage Arbitrage Define the law of one price and explain the role of arbitrage. 15.1 LEARNING OBJECTIVE

6. 6 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Solved Problem 15-1 Is Arbitrage Just a Rip-off? Does eBay serve a useful economic purpose? Economists would say that it does. It is easy to sell goods on eBay, so over time, competition should cause the difference between the prices on eBay and the prices charged elsewhere to shrink. Define the law of one price and explain the role of arbitrage. 15.1 LEARNING OBJECTIVE YOUR TURN: For more practice, do related problems 1.5 and 1.6 at the end of this chapter.

7. 7 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Pricing Strategy, The Law of One Price, and Arbitrage PRODUCT: DAN BROWN’S THE LOST SYMBOL COMPANYPRICE Amazon.com$14.83 BarnesandNoble.com14.83 WaitForeverForYourOrder.com 13.50 JustStartedinBusinessLastWednesday.com 13.25 Why Don’t All Firms Charge the Same Price? Table 15-1 Which Internet Bookseller Would You Buy From? Define the law of one price and explain the role of arbitrage. 15.1 LEARNING OBJECTIVE

8. 8 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Price discrimination Charging different prices to different customers for the same product when the price differences are not due to differences in cost. Price Discrimination: Charging Different Prices for the Same Product Don’t Let This Happen to YOU! Don’t Confuse Price Discrimination with Other Types of Discrimination Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE YOUR TURN: Test your understanding by doing related problem 2.18 at the end of this chapter.

9. 9 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy 1.A firm must possess market power. 2.Some consumers must have a greater willingness to pay for the product than other consumers, and the firm must be able to know what prices customers are willing to pay. 3.The firm must be able to divide up—or segment—the market for the product so that consumers who buy the product at a low price are not able to resell it at a high price. In other words, price discrimination will not work if arbitrage is possible. The Requirements for Successful Price Discrimination A successful strategy of price discrimination has three requirements: Price Discrimination: Charging Different Prices for the Same Product Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

10. 10 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy The Requirements for Successful Price Discrimination FIGURE 15-1 Price Discrimination by a Movie Theater Price Discrimination: Charging Different Prices for the Same Product Fewer people want to go to the movies in the afternoon than in the evening. In panel (a), the profit-maximizing price for a ticket to an afternoon showing is $7.25. Charging this same price for evening showings would not be profit maximizing, as panel (b) shows. At a price of $7.25, 850 tickets would be sold to evening showings, which is more than the profit-maximizing number of 625 tickets. To maximize profits, the theater should charge $9.75 for tickets to evening showings. Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

11. 11 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Solved Problem 15-2 How Apple Uses Price Discrimination to Increase Profits if Apple charges $1,399 in the general public segment of the market, shown in panel (b), it would sell 32,500 computers, which is more than the profit-maximizing quantity. By charging $1,499 to the general public, Apple will sell 30,500 computers, the profit-maximizing quantity. YOUR TURN: For more practice, do related problem 2.12 at the end of this chapter. Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

12. 12 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy FIGURE 15-2 33 Customers and 27 Different Prices Price Discrimination: Charging Different Prices for the Same Product Airlines: The Kings of Price Discrimination To fill as many seats on a flight as possible, airlines charge many different ticket prices. The 33 passengers on this United Airlines flight from Chicago to Los Angeles paid 27 different prices for their tickets, including one passenger who used frequent flyer miles to obtain a free ticket. The first number in the figure is the price paid for the ticket; the second number is the number of days in advance that the ticket was purchased. Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

13. 13 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy How Colleges Use Yield Management Making the Connection Some colleges use yield management techniques to determine financial aid. YOUR TURN: Test your understanding by doing related problem 2.14 at the end of this chapter. When colleges use yield management techniques, they increase financial aid offers to students who are likely to be more price sensitive, and they reduce financial aid offers to students who are likely to be less price sensitive. Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

14. 14 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy FIGURE 15-3 Perfect Price Discrimination Price Discrimination: Charging Different Prices for the Same Product Perfect Price Discrimination Panel (a) shows the case of a monopolist who cannot practice price discrimination and, therefore, can charge only a single price for its product. Because the monopolist stops production at a level of output where price is above marginal cost, there is a deadweight loss. In panel (b), the monopolist is able to practice perfect price discrimination by charging a different price to each consumer. The result is to convert both the consumer surplus and the deadweight loss from panel (a) into profit. Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

15. 15 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy FIGURE 15-4 Price Discrimination across Time Price Discrimination: Charging Different Prices for the Same Product Price Discrimination across Time In panel (a), with a marginal cost of $1.50 per copy for a hardcover, the profit-maximizing level of output is 500,000 copies, which can be sold at a price of $27.95. In panel (b), the more elastic demand of casual readers and the slightly lower marginal cost result in a profit-maximizing output of 1,000,000 for the paperback edition, which can be sold at a price of $9.99. Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

16. 16 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy In 1936, Congress passed the Robinson– Patman Act, which outlawed price discrimination that reduced competition and which also contained language that could be interpreted as making illegal all price discrimination not based on differences in cost. Price Discrimination: Charging Different Prices for the Same Product Can Price Discrimination Be Illegal? Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

17. 17 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Price Discrimination with a Twist at Netflix Making the Connection Why does renting only a few movies get you better service with Netflix? Price discrimination can also involve charging the same price for goods or services of different quality. Netflix subscribers who rent the fewest movies per month have the best chance of receiving the latest releases. YOUR TURN: Test your understanding by doing related problem 2.17 at the end of this chapter. Explain how a firm can increase its profits through price discrimination. 15.2 LEARNING OBJECTIVE

18. 18 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Many firms use what is called odd pricing—for example, charging $4.95 instead of $5.00, or $199 instead of $200. Other Pricing Strategies Odd Pricing: Why Is the Price $2.99 Instead of $3.00? Do consumers have an illusion that a price of $9.99 is significantly cheaper than $10.00? There is some evidence that using odd prices makes economic sense. Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. 15.3 LEARNING OBJECTIVE

19. 19 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy 1.When marginal cost and average cost are roughly equal 2.When the firm has difficulty estimating its demand curve Other Pricing Strategies Why Do Some Firms Use Cost-Plus Pricing? Economists conclude that using cost-plus pricing may be the best way to determine the optimal price in two situations: Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. 15.3 LEARNING OBJECTIVE

20. 20 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Cost-Plus Pricing in the Publishing Industry PLANT COSTS Typesetting$3,500 Other plant costs 2,000 MANUFACTURING COSTS Printing$5,750 Paper 6,250 Binding 5,000 TOTAL PRODUCTION COST $22,500 Making the Connection Most publishers arrive at a price for a book by applying a markup to their production costs, which are usually divided into plant costs and manufacturing costs. YOUR TURN: Test your understanding by doing related problem 3.8 at the end of this chapter. Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. 15.3 LEARNING OBJECTIVE

21. 21 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Two-part tariff A situation in which consumers pay one price (or tariff) for the right to buy as much of a related good as they want at a second price. Other Pricing Strategies Why Do Some Firms Use Two-Part Tariffs? Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. 15.3 LEARNING OBJECTIVE

22. 22 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy FIGURE 15-5 A Two-Part Tariff at Disney World Other Pricing Strategies Why Do Some Firms Use Two-Part Tariffs? In panel (a), Disney charges the monopoly price of $26 per ride ticket and sells 20,000 ride tickets. Its profit from ride tickets is shown by the area of the light-green rectangle, B, $480,000. In panel (b), Disney charges the perfectly competitive price of $2, which results in a quantity of 40,000 ride tickets sold. At the lower ride ticket price, Disney can charge a higher price for admission tickets, which will increase its total profits. Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. 15.3 LEARNING OBJECTIVE

23. 23 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Table 15-2 Disney’s Profits per Day from Different Pricing Strategies MONOPOLY PRICE FOR RIDES COMPETITIVE PRICE FOR RIDES PROFITS FROM ADMISSION TICKETS$240,000$960,000 PROFITS FROM RIDE TICKETS 480,000 0 TOTAL PROFIT720,000960,000 Other Pricing Strategies Why Do Some Firms Use Two-Part Tariffs? Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. 15.3 LEARNING OBJECTIVE

24. 24 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy 1.Because price equals marginal cost at the level of output supplied, the outcome is economically efficient. 2.All consumer surplus is transformed into profit. Other Pricing Strategies Why Do Some Firms Use Two-Part Tariffs? It is important to note the following about the outcome of a firm using an optimal two-part tariff: Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. 15.3 LEARNING OBJECTIVE

25. 25 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Paying for the Right to Pay to See “America’s Team” AN INSIDE LOOK >> An NFL team owner can use a two-part tariff to increase profits. The profit-maximizing monopoly price for a season ticket is $2,000. This assumes that tickets to individual games are sold for $200 each. If the team owner knew the maximum each season ticket buyer was willing to pay, he could charge a PSL fee that would result in a total amount paid by all season ticket buyers equal to area A—the total consumer surplus.

26. 26 of 26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 15: Pricing Strategy Price discrimination Transactions costs Two-part tariff KEY TERMS