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Managerial Economics ninth edition Thomas Maurice Chapter 14 Advanced Pricing Techniques McGraw-Hill/Irwin McGraw-Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved. Managerial Economics Advanced Pricing Techniques • Price discrimination • Multiple products • Cost-plus pricing 14-2 Managerial Economics Capturing Consumer Surplus • Uniform pricing • Charging the same price for every unit of the product • Price discrimination • More profitable alternative to uniform pricing • Market conditions must allow this practice to be profitably executed • Technique of charging different prices for the same product • Used to capture consumer surplus (turning consumer surplus into profit) 14-3 Managerial Economics The Trouble with Uniform Pricing (Figure 14.1) 14-4 Managerial Economics Price Discrimination • Exists when the price-to-marginal cost ratio differs between two products: PA PB MC A MCB 14-5 Managerial Economics Price Discrimination Three conditions necessary to practice price discrimination profitably: 1) Firm must possess some degree of market power 2) A cost-effective means of preventing resale between lower- and higher-price buyers (consumer arbitrage) must be implemented 3) Price elasticities must differ between individual buyers or groups of buyers 14-6 Managerial Economics First-Degree (Perfect) Price Discrimination • Every unit is sold for the maximum price each consumer is willing to pay • Allows the firm to capture entire consumer surplus • Difficulties • Requires precise knowledge about every buyer’s demand for the good • Seller must negotiate a different price for every unit sold to every buyer 14-7 Managerial Economics First-Degree (Perfect) Price Discrimination (Figure 14.2) 14-8 Managerial Economics Second-Degree Price Discrimination • Lower prices are offered for larger quantities and buyers can self-select the price by choosing how much to buy • When the same consumer buys more than one unit of a good or service at a time, the marginal value placed on additional units declines as more units are consumed 14-9 Managerial Economics Second-Degree Price Discrimination • Two-part pricing • Charges buyers a fixed access charge (A) to purchase as many units as they wish for a constant fee (f) per unit • Total expenditure (TE) for q units is: TE A fq Average price ( p) is: TE A fq p q q A f q 14-10 Managerial Economics Second-Degree Price Discrimination • When consumers have identical demands, entire consumer surplus can be captured by: • Setting f = MC • Setting A = consumer surplus (CS) • Optimal usage fee when two groups of buyers have identical demands is the level for which MRf = MCf 14-11 Managerial Economics Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14.3) 14-12 Managerial Economics Demand at Northvale Golf Club (Figure 14.4) 14-13 Managerial Economics Second-Degree Price Discrimination • Declining block pricing • Offers quantity discounts over successive discrete blocks of quantities purchased 14-14 Managerial Economics Block Pricing with Five Blocks (Figure 14.5) 14-15 Managerial Economics Third-Degree Price Discrimination • If a firm sells in two markets, 1 & 2 • Allocate output (sales) so MR1 = MR2 • Optimal total output is that for which MRT = MC • For profit-maximization, allocate sales of total output so that MRT = MC = MR1 = MR2 14-16 Managerial Economics Third-Degree Price Discrimination • Equal-marginal-revenue principle • Allocating output (sales) so MR1 = MR2 which will maximize total revenue for the firm (TR1 + TR2) • More elastic market gets lower price • Less elastic market gets higher price 14-17 Managerial Economics Allocating Sales Between Markets (Figure 14.6) 14-18 Managerial Economics Constructing the Marginal Revenue Curve (Figure 14.7) 14-19 Managerial Economics Profit-Maximization Under Third-Degree Price Discrimination (Figure 14.8) 14-20 Managerial Economics Multiple Products • Related in consumption • For two products, X & Y, produce & sell levels of output for which MRX = MCX and MRY = MCY • MRX is a function not only of QX but also of QY (as is MRY) -- conditions must be satisfied simultaneously 14-21 Managerial Economics Multiple Products • Related in production as substitutes • For two products, X & Y, allocate production facility so that MRPX = MRPY • Optimal level of facility usage in the long run is where MRPT = MC • For profit-maximization: MRPT = MC = MRPX = MRPY 14-22 Managerial Economics Multiple Products • Related in production as complements • To maximize profit, set joint marginal revenue equal to marginal cost: MRJ = MC • If profit-maximizing level of joint production exceeds output where MRJ kinks, units beyond zero MR are disposed of rather than sold • Profit-maximizing prices are found using demand functions for the two goods 14-23 Managerial Economics Profit-Maximizing Allocation of Production Facilities (Figure 14.9) 14-24 Managerial Economics Profit-Maximization with Joint Products (Figure 14.11) 14-25 Managerial Economics Cost-Plus Pricing • Common technique for pricing when firms do not wish to estimate demand & cost conditions to apply the MR = MC rule for profit-maximization • Price charged represents a markup (margin) over average cost: P = (1 + m)ATC Where m is the markup on unit cost 14-26 Managerial Economics Cost-Plus Pricing • Does not generally produce profitmaximizing price • Fails to incorporate information on demand & marginal revenue • Uses average, not marginal, cost 14-27 Managerial Economics Practical Problems with Cost-Plus Pricing (Figure 14.13) 14-28