Transcript Chapter 13

CHAPTER
13
Using Market Power:
Price Discrimination and
Advertising
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
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Price Discrimination

Price discrimination is the practice of
dividing consumers into two or more
groups and charging different prices to
each group.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Price Discrimination

It is illegal for firms to practice price
fixing—the coordination of pricing
strategies among firms, but it is not illegal
to practice price discrimination. The only
legal restriction is that firms cannot use it
to drive rival firms out of business.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Price Discrimination

One approach is to
identify a group of
customers who are
not willing to pay the
regular price, and
offer them a
discount.

Examples:

Airline tickets

Grocery coupons



Manufacturer’s
rebates
Senior-citizen
discounts
Student discounts
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Conditions Necessary for Price
Discrimination

Market power: firms must have control
over price.

Different consumer groups: consumers
must differ in their willingness to pay.

Resale is not possible: unless the firm
can prevent the resale of their products,
price discrimination will break down.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Different Groups Have Different
Demands
Senior citizens have more elastic demand because they
have lower income and more time to shop for
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substitutes.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin

Elasticity, Revenue and Profit

If demand is inelastic, an increase in price has
two advantages: it will increase total revenue
and decrease quantity demanded. The firm will
produce less and reduce its production costs.

If demand is elastic, a decrease in price will
increase total revenue. But lower prices will
increase quantity produced, thus result in
higher costs. If profit is to increase, the
increase in revenue must be greater than the
increase in cost.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Profit With a Single-price Policy

Total profit with the single price policy: $1,600
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Profit When Pricing in Accordance
With Elasticity

Total profit with the senior discount: $1,860
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Advertising and the Marginal Principle

To decide how much firms should spend
on advertising, firms can use the marginal
principle.
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost, but reduce the level if the
marginal cost exceeds the marginal benefit. If
possible, pick the level at which the marginal benefit
equals the marginal cost.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Advertising and the Marginal Principle
Marginal Benefit
(assuming profit
of $1 per box)
Marginal
Cost
(each 30-second
TV commercial)
Number of
Advertisements
Quantity of
Detergent Sold
(boxes)
0
100,000
1
110,000
$10,000
$7,000
2
119,000
9,000
$7,000
3
127,000
8,000
$7,000
4
134,000
7,000
$ 7,000
5
140,000
6,000
$7,000
6
145,000
5,000
$7,000
$7,000
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
What Sorts of Firms Will Advertise?

For advertising to be profitable, the
increase in sales must be large relative to
the cost of advertising.

Advertising makes sense only if consumer
choices are sensitive to advertising, and
the good sold by the firm is a close but
not a perfect substitute for others.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Advertisers’ Dilemma

The advertisers’ dilemma
states that although firms
would be better off if they
did not advertise, the firms
advertise anyway.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Advertisers’ Dilemma
Neither
Advertises
Both
Advertise
Jack
Advertises
Jack
Jill
Jack
Jill
Jack
Jill
Net Revenue
from Sales ($
million)
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8
13
13
17
5
Cost of
Advertising
($ million)
0
0
7
7
7
0
Net Profit
Advertising
($ million)
8
8
6
6
9
5
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Advertisers’ Dilemma

Jill’s
dominant
strategy is to
advertise.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Outcome of the Advertising Game

Knowing that
Jill’s dominant
strategy is to
advertise, Jack’s
best response is
to advertise too.

Each firm earns
$2 million less
than in the
absence of
advertising.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tradeoffs From Advertising
Benefits of advertising:

Advertising helps consumers make more
informed decisions.

Information in advertising about prices
helps to promote competition, thus
advertising leads to lower prices.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tradeoffs From Advertising
Costs of advertising:

When firms are trapped in the advertisers’
dilemma, resources used in advertising
may be wasted. Advertising results in a
net decrease in industry profits.

Some advertisements give the impression
that there are real differences between
products when there are none.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin