Transcript Week 12

Welcome to
EC 209: Managerial
Economics- Group A
By: Dr. Jacqueline Khorassani
Week Twelve
1
Managerial EconomicsGroup A
Week Twelve- Class 1
Monday, November 19
11:10-12:00
Fottrell (AM)
Aplia Asst
Due tomorrow before 5 PM
Don’t forget
Review Session
7PM Tonight
O'Flaherty Theatre
2
Chapter 11
Pricing Strategies for Firms
with Market Power
3
Standard Pricing and Profits
for Firms with Market Power
Price
Profits from standard pricing
= Q * (P – AC) = $8
10
If
C(Q) = 2Q
Then
MC = 2
Remember
If P = 10-2Q
R = PQ = 10Q -2Q2
MR = 10-4Q
8
6
4
To max profits
MC = MR
2 = 10-4Q
MC=AC
2
P = 10 - 2Q
1
2
3
4
5
Q=2
MR = 10 - 4Q
Plug Q = 2 into your demand equation
 P = 10- 2 (2)  P = 6
Quantity
4
Marginal Revenue and
Elasticity

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
5
Also revenue is R = P.Q








Where P is a function of Q
so R(Q) = P(Q).Q
dR/dQ = dR/dP . dP/dQ + dR/dQ . dQ/dQ
dR/dQ = Q * dP/dQ + P * 1
MR = P (Q/P . dP/dQ + 1)
We know that (dQ/dP) * P/Q = E
MR = P ( 1/E + 1)
MR = P(E + 1)/E
6
MR = P(E + 1)/E




If E = -1  MR = 0
If E is a smaller negative number 
MR <0
If E is a bigger negative number
MR> 0
Note: A firm will never produce a level
where MR < 0.
7
A Simple Markup Rule







Suppose the elasticity of demand for
the firm’s product is EF.
Since MR = P[1 + EF]/ EF
Setting MR = MC
P[1 + EF]/ EF = MC
P = [EF/(1+ EF)]  MC
P = K x MC where K is the markup
factor
The optimal price is a simple markup
over relevant costs!
8
Mark-up Factor= EF/(1+ EF)


If EF = -2
Then Mark-up factor = -2/ -1
– Price is 2 times MC


If EF = -4
Then Mark-up factor = -4/ -3
– Price is 4/3 of MC

The more elastic the demand, the
lower the markup.
9
Markup Rule for Cournot
Oligopoly







Homogeneous product Cournot oligopoly.
N = total number of firms in the industry.
Market elasticity of demand EM .
Elasticity of individual firm’s demand is given
by EF = N x EM.
Since P = [EF/(1+ EF)]  MC,
Then, P = [NEM/(1+ NEM)]  MC.
The greater the number of firms the
lower the profit-maximizing markup factor.
10
An Example








Homogeneous product Cournot industry, 3
firms.
MC = $10.
Elasticity of market demand = - ½.
Determine the profit-maximizing price?
EF = NEM = 3  (-1/2) = -1.5.
P = [NEM/(1+ NEM)]  MC.
P = [-1.5/(1- 1.5]  $10.
P = 3  $10 = $30.
11
First-Degree or Perfect
Price Discrimination


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.
12
Perfect Price Discrimination
Price
Profits*:
.5(4-0)(10 - 2)
= $16
10
In practice,
8
transactions costs
and information
6
constraints make
this difficult to
4
implement
perfectly.
2
Price discrimination
won’t work if
consumers can
resell the good.
Total Cost* = $8
MC = AC
D
1
2
3
4
5
Quantity
13
Second-Degree
Price Discrimination



The practice of posting
a discrete schedule of
declining prices for
different quantities.
Eliminates the
information constraint
present in first-degree
price discrimination.
Example: Electric
utilities
Price
MC
$10
$8
$5
D
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
4
Quantity
14
Managerial EconomicsGroup A

Week Twelve- Class 2
– Tuesday, November 20
– Cairnes
– 15:10-16:00


Aplia assignment is due before 5PM
today
Send me questions on the entire
course material
15
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.


2.
Firm captures the entire Consumer Surplus
Hard to implement
Second-Degree Price Discrimination
 posting a discrete schedule of declining
prices for different quantities.


Does not capture the entire Consumer Surplus
Easier to implement
16
Third-Degree Price
Discrimination



charging different groups of consumers
different prices for the same product.
Group must have observable
characteristics for third-degree price
discrimination to work.
Examples
– student discounts,
– senior citizen’s discounts,
– regional & international pricing.
17
Implementing ThirdDegree Price
Discrimination


Demands by two groups have different
elasticities, E1 < E2.
Notice that group 2 is more price sensitive
than group 1.
– Who should be paying a lower price?
– Group 2



Profit-maximizing prices?
P1 = [E1/(1+ E1)]  MC
P2 = [E2/(1+ E2)]  MC
18
An Example





Suppose the elasticity of demand for Kodak film
in the US is EU = -1.5, and the elasticity of
demand in Japan is EJ = -2.5.
Marginal cost of manufacturing film is $3.
PU = [EU/(1+ EU)]  MC = [-1.5/(1 - 1.5)]  $3
= $9
PJ = [EJ/(1+ EJ)]  MC = [-2.5/(1 - 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.
19
Two-Part Pricing





If it isn’t feasible to charge different prices
for different units sold,
but demand information is known,
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.
Example:
– Athletic club memberships.
You may pay a monthly membership fee
 Plus a small fee for each visit

20
Example

An average (typical) consumer’s
demand is
P = 10 – 2Q & MC = 2
1.
2.
Set P = MC = 2
Find Q
 10 - 2Q = 2  Q = 4

Find Consumer surplus
21
To find Consumer Surplus
1.
Price
P = 10 -2 Q
2.
10
3.
8
6
Per Unit
Charge
Draw the demand
curve
Draw the MC curve
Intersection gives you
the price
Fixed Fee = consumer surplus = Profits = €16
4
MC
2
D
1
2
3
4
5
Quantity
22
Block Pricing


packaging multiple units of an
identical product together and selling
them as one package.
Examples
– Paper towels.
– Six-packs of soda.
23
An Algebraic Example

Typical consumer’s demand is
P = 10 - 2Q



C(Q) = 2Q
Optimal number of units in a package?
Optimal package price?
24
To determine the optimal quantity
per package
Price
Find Q from P = MC
10
MC = 2
P= 10 - 2Q
2= 10-2Q
Q=4
8
6
4
MC = AC
2
D
1
2
3
4
5
Quantity
25
To find the optimal price for
the Package
Consumer’s valuation of 4
units = .5(8)(4) + (2)(4) = $24
Therefore, set P = $24!
Price
Find out the
value of 4
units to
consumer &
set a price
equal to that
10
8
6
4
The value to
consumer is
the area
under the
demand curve
MC = AC
2
D
1
2
3
4
5
Quantity
26
Costs and Profits with Block
Pricing
Price
10
Profits = [.5(8)(4) + (2)(4)] – (2)(4)
= $16
8
6
Costs = (2)(4) = $8
4
2
D
1
2
3
4
5
MC = AC
Quantity
27
Commodity Bundling


The practice of bundling two or more
products together and charging one
price for the bundle.
Examples
– Holiday packages.
– Computers and software.
– Film and developing.
28
Peak-Load Pricing


demand during peak
times is higher than
the capacity of the
firm
the firm engages in
peak-load pricing.


Charge a higher price
(PH) during peak times
(DH).
Charge a lower price (PL)
during off-peak times
(DL).
Price
MC
PH
DH
PL
MRH
MRL
QL
DL
QH Quantity
29
Cross-Subsidies

Prices charged for one product are
subsidized by the sale of another product.
May be profitable when there are
significant demand complementarities
effects.

Examples

– Browser and server software.
– Drinks and meals at restaurants.
30
Double Marginalization

Example
– A large firm has division
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.

– Incentives to maximize divisional profits
leads the upstream manager to produce
where MRU = MCU.

Implication: PU > MCU.
31
Double Marginalization

Similarly the downstream division has
market power and has an incentive to
maximize divisional profits, the
manager will produce where MRD =
MCD.
– Implication: PD > MCD.

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.
32
Managerial EconomicsGroup A

Week Twelve- Class 3
– Thursday, November 22
– 15:10-16:00
– Tyndall

Next Aplia Assignment is due before 5
PM on Tuesday, November 27
33
Last time we talked about


Double marginalization
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
34
Instead the firm should maximize the
overall profits of selling the final good
(product of the restaurant)


This is called “Transfer Pricing”
That is
MRr = MCr + MCp
where MRr is marginal revenue of restaurant
MCr is marginal cost of restaurant
MCp is marginal cost of pasta factory
MRr - MCr = MCp
NMRr = MCp
– The pasta factory produces such that its marginal
cost equals the net marginal revenue of restaurant
(NMRr)
35
Pricing in Markets with
Intense Price Competition

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.
36
Pricing in Markets with
Intense Price Competition

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
37
Other information
1.
2.
3.
4.
Posted three sample MCQ on my website
& on blackboard as well
Also, remember to check blackboard for
sample of previous years’ exams
There is going to be another Review
Session on Wednesday, November 28 at
7-9 pm in IT250 1st floor
Send me your questions

I will post the answers on my website.
38