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Chapter 14: Advanced Pricing Techniques McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. Advanced Pricing Techniques • Price discrimination • Multiple products • Cost-plus pricing 14-2 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 The Trouble with Uniform Pricing (Figure 14.1) 14-4 Price Discrimination • Exists when the price-to-marginal cost ratio differs between two products: PA PB MC A MCB 14-5 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 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 First-Degree (Perfect) Price Discrimination (Figure 14.2) 14-8 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 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 TE A fq Average price (p) is: p q q A f q 14-10 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 Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14.3) 14-12 Demand at Northvale Golf Club (Figure 14.4) 14-13 Second-Degree Price Discrimination • Declining block pricing • Offers quantity discounts over successive discrete blocks of quantities purchased 14-14 Block Pricing with Five Blocks (Figure 14.5) 14-15 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 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 Allocating Sales Between Markets (Figure 14.6) 14-18 Constructing the Marginal Revenue Curve (Figure 14.7) 14-19 Profit-Maximization Under Third-Degree Price Discrimination (Figure 14.8) 14-20 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 Bundling Multiple Products • When price discrimination is not possible, bundling multiple goods and charging a single price can be more profitable than charging individual prices for multiple goods • Two conditions for profitable bundling • Consumers must have different demand prices for each good in the bundle • Demand prices must be negatively correlated across consumer types 14-22 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 14-23 Cost-Plus Pricing • Does not generally produce profitmaximizing price • Fails to incorporate information on demand & marginal revenue • Uses average, not marginal, cost 14-24 Practical Problems with Cost-Plus Pricing (Figure 14.13) 14-25