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Econ 5313
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
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
Increase in Demand
• Take your typical stand alone product
• You have maximized profits by setting MR = MC
P
P*
MC
MR
D
Q
Econ 5313
Increase in Demand
• Suppose “something” caused the demand to shift out
• Now it is profitable to increase price
P
P*
MC
MR
D
Q
Econ 5313
Increase in Demand
• Now profits are higher due to:
1.
2.
Higher Price
Higher quantity
P
P*
MC
MR
D
Q
Econ 5313
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
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
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
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
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
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:
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•
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•
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
Loss Leaders
• When do you want to lose money on a complementary
product?
• We can see this in many places too:
•
•
•
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•
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
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
Yield Management
• Difficulty comes from capacity constraints
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•
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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
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
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
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
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
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
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
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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
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