1. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko “The Economic Way of Thinking” 11 th Edition Chapter 9: Price Searching

2. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 43 Chapter 9 Outline Introduction The Popular Theory of Price Setting Introducing Ed Sike The Basic Rule for Maximizing Net Revenue The Concept of Marginal Revenue Why Marginal Revenue is Less Than Price

3. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 43 Chapter 9 Outline Setting Marginal Revenue to Equal Marginal Cost What About Those Empty Seats? The Price Discriminator’s Dilemma The College as Price Searcher Some Strategies for Price Discrimination Ed Sike Finds a Way

4. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 43 Chapter 9 Outline Resentment and Rationale Lunch and Dinner Prices Cost-Plus-Markup Reconsidered

5. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 43 Introduction Firms will produce an additional product as long as its marginal revenue is expected to be greater than its marginal cost. Net Revenue = TR - TC

6. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 43 The Popular Theory of Price Setting A Popular Belief –Selling price is cost plus markup. Questions –Why choose 25 versus a 50 percent markup? –Why will a firm vary its percentage markup depending upon various factors? –Why sell below average cost?

7. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 43 The Popular Theory of Price Setting Cost-Plus-Markup Theory is obviously inadequate.

8. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 43 Introducing Ed Sike Scenario –Ed Sike is a college sophomore –He sells film tickets to earn spending money –He sets the price for his tickets

9. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 43 Introducing Ed Sike Ed’s Costs Per Movie Film rental$1,800 Auditorium rental250 Operator50 Ticket takers 100 Total$2,200

10. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 43 Introducing Ed Sike Scenario –Ed receives all revenue –Auditorium seats 700 people

11. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 43 Introducing Ed Sike Price Per Ticket Number of Tickets 0100200300400500600700800900 1 2 3 4 5 6 7 D

12. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 43 Introducing Ed Sike Scenario –The student association will subsidize the films if they lose money –Ed is expected to earn as much net revenue as possible

13. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 43 The Basic Rule for Maximizing Net Revenue Set the price to sell only those units whose marginal revenue is expected to be greater than marginal costs. Marginal cost is the addition to total cost from selling an additional unit. Marginal revenue is the addition of total revenue from selling one more unit.

14. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 43 The Concept of Marginal Revenue Marginal Revenue –The additional revenue expected from an action under consideration –Ed’s marginal revenue is zero

15. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 43 The Concept of Marginal Revenue Ed’s Demand Schedule QuantityTotalNet PriceDemandedRevenueRevenue $7300$2,100-$100 64002,400200 55002,500300 46002,400200 $3700$2,100-100

16. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 43 The Concept of Marginal Revenue Question –Why is profit maximized where marginal revenue equals marginal cost?

17. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 43 Why Marginal Revenue is Less Than Price Marginal Revenue < Price –Why? In order to increase sales, Ed must lower the price on the additional ticket and the ones that would have been sold at a higher price.

18. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 43 Why Marginal Revenue is Less Than Price Marginal Revenue –The difference between the revenue gained from additional quantity and the revenue lost from lowering price on the previous quantity

19. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 43 Why Marginal Revenue is Less Than Price Gained Lost P Q D A B

20. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 43 Why Marginal Revenue is Less Than Price Additions to net revenue Subtractions from net revenue P Q MR MC

21. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 43 Why Marginal Revenue is Less Than Price Questions –What would Ed have to do to sell 550 tickets instead of 500? –How would this impact his marginal revenue? –Is it a correct pricing decision?

22. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 43 Why Marginal Revenue is Less Than Price P Q 0900800600500300100400200700 MR

23. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 43 Setting Marginal Revenue to Equal Marginal Cost Question –What would happen if the distributor changed the rental fee from a flat $1,800 to $800.00 + $2/ticket sold?

24. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 43 Setting Marginal Revenue to Equal Marginal Cost P Q MR 0900800600500300100400200700 1 3 4 5 6 7 2 D Marginal cost What is Ed’s net revenue now?

25. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 43 What About Those Empty Seats? Questions –Are seats going to waste? –Why doesn’t Ed lower the price on the empty seats?

26. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 43 The Price Discriminator’s Dilemma Question –When should Ed leave seats empty? Answer –If the cost of discriminating among potential ticket buyers is greater than the additional revenue gained through discrimination.

27. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 43 The Price Discriminator’s Dilemma Question –What if Ed offered to sell the empty seats for $3 to anyone willing to pay more?

28. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 28 of 43 The College as a Price Searcher Questions –Why do colleges continually ask for donations to cover costs not paid for by tuition? –Why do these colleges give scholarships to needy students?

29. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 29 of 43 The College as a Price Searcher Questions –How could Ivy charge $6,000 and give each student a scholarship equal to the difference between $6,000 and what the student is willing to pay? –How does the school determine what each student is willing to pay?

30. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 30 of 43 The College as a Price Searcher Solutions –Willingness to pay is correlated with wealth –Scholarships are available to those who fill out some forms –Ivy could discriminate based on wealth to increase revenue

31. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 31 of 43 The College as a Price Searcher Scholarships enrolled Tuition Paid Revenue has increased from $9m to $18m. P Q 6,000 D

32. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 32 of 43 Some Strategies for Price Discrimination Grocery coupons Discounts for: –Children –Students –Senior Citizens Airfare Prices for: –Business traveler –Vacationer

33. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 33 of 43 Some Strategies for Price Discrimination P Q Business Traveler P Q D D Vacation Traveler

34. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 34 of 43 Ed Sike Finds a Way Questions –Could Ed increase revenue by charging different groups of customers different prices? –Should students or teachers pay the higher price?

35. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 35 of 43 Ed Sike Finds a Way Price Per Ticket Number of Tickets 0100200300400500600700800900 1 2 3 4 5 6 7 D faculty MR faculty DsDs MR s

36. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 36 of 43 Resentment and Rationale Firms must justify price discrimination Conditions necessary for price discrimination: –Distinguish buyers from different price elasticities –Prevent low-price buyers from reselling to high-price buyers –Control resentment

37. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 37 of 43 Resentment and Rationale Question –Why would a ticket from New York to Chicago cost more than a ticket from New York to Los Angeles? Answer –Competition!

38. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 38 of 43 Lunch and Dinner Prices Why are dinner prices more expensive than lunch prices?

39. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 39 of 43 Lunch and Dinner Prices Answer –Lunch customers are more responsive to prices. They eat out more often The meal makes up a large share of the event’s cost (no sitter, movie, etc.)

40. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 40 of 43 Cost-Plus-Markup Reconsidered Price searchers: –Estimate marginal cost and marginal revenue –Determine the appropriate level of output –Set their prices so that they can just manage to sell the output produced.

41. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 41 of 43 Cost-Plus-Markup Reconsidered Cost-Plus-Markup –A good place to start –A search technique

42. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 42 of 43 Once Over Lightly Price searchers are looking for pricing structures that will enable them to sell all units for which MR>MC. A crucial factor for a price searcher is the ability or inability to discriminate. The crucial rule for price searching is to set MR = MC.

43. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 43 of 43 End of Chapter 9