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ONLINE APPENDIX 4

Pricing Multiple Products Related in Production1

substitutes in production Goods, produced by the same firm, that compete for limited production facilities.

t is not uncommon for multiproduct firms to produce goods that are substitutes in production. This situation is often encountered when a firm produces several models of the same basic product. These different models compete for the limited production facilities of the firm and are therefore substitutes in the firms production process. In the long run, the firm can adjust its production facility in order to produce the profit-maximizing level of each product. We will now demonstrate how a manager could determine the profit-maximizing number of total hours to operate a production facility (HT *) and the optimal allocation of hours between the production of good X(HX *) and good Y(HY *). The optimization condition for the allocation of the production facility between the production of X and Y is easy to demonstrate. A manager first must determine, for each of the two products X and Y, the additional revenue that can be generated by allocating to a good one more hour of the production facility. Consider production of good X. The amount of additional output of X that can be produced by using the facility one more hour in the production of X can be expressed as DX/DHX, which is the marginal product for good X of one more hour of time spent producing X. The same relation holds for good Y. The marginal products of X and Y for extra hours of production time can be expressed as DX = MP ____ H DHX and
X

DY = MP ____ H DHY

Section 14.5 sets forth the decision rules for pricing multiple products when the products are related as either substitute or complement goods in consumption.

To determine the value to the firm of one more hour of time spent producing either good X or good Y, the manager must have estimates of marginal revenue for each good, MRX and MRY. As shown in Chapter 12, the marginal revenue product of an input measures the additional revenue the firm can earn by using one more unit of an input. For goods X and Y, the marginal revenue products are DTR 5 MR 3 MP DTR 5 MR 3 MP MRPX 5 _____ and MRPY 5 _____ X H Y H DHX DHY For a given number of total hours of production facility time, the firm will maximize total revenue and profit by allocating the facility so that its marginal revenue product in producing each good is the same:
X Y

MRPX 5 MRPY If the allocation of total hours were such that MRPX . MRPY, total revenue could be increased by reallocating hours away from the production of Y to the production of Xincrease HX and decrease HY. This reallocation would reduce MRPX and increase MRPY. Reallocation should continue until the marginal revenue products are equal, MRPX 5 MRPY. To find the optimal number of total hours to operate a facility (HT *), the total marginal revenue product curve (MPRT) must be constructed by horizontally summing MRPX and MRPY, as shown in Figure 1. The profit-maximizing condition is MRPT 5 MC 5 MRPX 5 MRPY
FIGURE 1 Profit-Maximizing Allocation of Production Facilities

MC

MRPX
0

MRPY H* T

MRPT

H* X

* HY

Level of use of the production facility (H )

Profits will be maximized when total marginal revenue product equals marginal cost and this production is allocated so that the marginal additions to revenue are the same for the two products. HX * is devoted to the production of X, HY * is devoted to the production of Y, and HX * + HY * = HT *. To see how this condition can be utilized, lets look at a simplified example. Multiple-Product Production at Surefire Products Surefire Products, Inc., manufactures two products, X and Y, that are unrelated in consumption but are substitutes in production. The manager can increase or decrease the total number of hours that the firm can use its production facilities. The manager wants to know the answer to two questions: (1) What is the optimal level of usage (hours of operation) of the plant? (2) How should the level of usage be allocated between the production of the two products? The demand functions for the two products were forecasted to be QX 5 60 0.5PX and QY 5 40 0.67PY where the quantities were the number of units demanded per day and the prices were expressed in dollars per unit. The inverse demand functions were PX 5 120 2QX and PY 5 60 1.5QY From these inverse demand functions, the marginal revenue functions were MRX 5 120 4QX and MRY 5 60 3QY Discussions with the plant supervisor indicated that in one hour of production time either 2 units of X or 4 units of Y could be produced. In a sense, the production functions for the two products are QX 5 2HX and QY 5 4HY where HX and HY denote, respectively, hours of assembly-line time in the production of X and Y. From the production functions, the marginal products are MPH 5 2 and MPH 5 4.
X Y

Using the demand forecasts and the estimates of the production functions provided by the plant supervisor, estimates of the marginal revenue product of the production facility in the production of X and Y were MPH 5 MRX 3 MPH 5 [120 2 4(2HX)] 3 (2)
X X

5 240 2 16HX and MPH 5 MRY 3 MPH 5 [60 2 3(4HY)] 3 (4)

Y Y

5 240 2 48HY To obtain the total marginal revenue product function, these two curves were summed horizontally; that is, these functions were inverted to find HX and HY, the

hours were summed (HT 5 HX 1 HY), then the inverse was taken once again. The resulting total MRP was MRPT 5 240 2 12HT Working with the engineers for Surefire, the plant supervisor was able to come up with an estimate of the additional cost of operating the plant an additional hour-an incremental (marginal) cost for usage of the plant. This estimate was MC 5 72 1 2HT Figure 2 shows MRPX, MRPY, MRPT, and MC for this example. Equating the total marginal revenue product of an hours usage of the plant with the marginal cost of an additional hours usage, 240 2 12HT 5 72 1 2HT the manager then solved for HT and found that the optimal level of usage of the plant was 12 hours per day. At this level of usage, MRPT 5 MC 5 \$96. To allocate these hours between the production of X and Y, the marginal revenue

250

96 72

MC = 72 + 2HT

MRPHX = 240 16HX

0 3 5 9 12 15 20

HX , HY , and HT

products for the production facility in the production of X and Y must both be equal to \$96: 240 2 16HX 5 96 and 240 2 48HY 5 96

Now try Technical Problem 1.

Since HX * 5 9 and HY * 5 3, the optimal allocation would be 9 hours in the production of X and 3 hours in the production of Y. Figure 2 shows the profit-maximizing solution for Surefire Products. From the production functions, the quantity of X produced is 18 (5 2 3 9) units, and the quantity of Y produced is 12 (5 4 3 3) units. The prices are PX * 5 \$84 [5 120 2(18)] and PY * 5 \$42 [5 60 1.5 (12)]. Multiple Products That Are Complements in Production

Complements in production Two or more goods that are produced using a common input.

Complements in production typically occur when an ingredient input is used to produce two or more products. One of the classic examples is that of beef carcasses and hides. The food products produced with the beef carcasses and the leather products produced with the hides are complement goods in production. Furthermore, the joint production of the two products is characterized by fixed proportions: For each additional beef carcass produced, one additional hide is produced also. Petroleum refining has similar characteristics. With an existing refinery and a given mix of input crude oils, production of an additional barrel of one of the lighter distillates, such as gasoline, requires that the refinery produce some additional amount of the heavy distillates, such as fuel oil. Complementarity in production can also be observed in mineral extraction. Frequently, two or more metals are found together in the same ore deposit. When the ore goes into the smelter, more than one metal is produced. For example, nickel and zinc frequently are in the same deposit, so the smelters are designed to produce both metals from the same ore. Since complements in production frequently result when one raw material is used to produce two or more products, this type of joint production results in the products being produced in fixed proportions from the ingredient. When a firm produces products that are complements in production, the manager maximizes profit by choosing to produce the level of output of the joint product at which the joint marginal revenue (MRJ) equals the marginal cost: MRJ 5 MC The joint marginal revenue gives the additional revenue attributable to producing one more unit of the joint productsay, one more beef carcass or one more ton of mineral orefrom which two (or more) products will be forthcoming. In the case of complements in production, the relevant marginal revenue for decision making is the joint or combined additional revenue from selling the additional units of both products that come from one extra unit of the joint product. Once the profitmaximizing production level is determined, the prices for the individual products are taken from the individual demand curves. While this decision-making procedure is just another application of the optimization theory developed in Chapter 3, it differs a bit from the other cases in this

appendix, which involved horizontally summing either marginal cost curves or marginal revenues. To derive the joint marginal revenue, we sum the individual marginal revenue curves vertically over the range of production for which both individual marginal revenues are positive. Because the firm earns additional revenue from the sale of two products, for a given level of output of the joint product, the total or joint marginal revenue is the sum of the marginal revenues from the two goods, MRX and MRY. Thus joint marginal revenue, MRJ, is obtained by vertically summing the individual marginal revenues over the range of outputs for which both MRX and MRY are positive. When the marginal revenue of one of the goods becomes zero, as all marginal revenue curves will do at sufficiently high sales levels, that marginal revenue is set equal to zero and the vertical summation continues until all (or both in this case) marginal revenues are zero. At each point where one of the marginal revenue curves being vertically summed is equal to zero, a kink in the joint marginal revenue curve is created. Figure 3 illustrates this vertical summation process for the case of two complement goods in production. In the figure, MRY becomes 0 at an output denoted as QY. For sales of commodity Y in excess of QY, the marginal revenue for Y would be negative. Because no manager would wish to sell a unit of a product for which the marginal revenue is negative, the maximum amount of Y the firm will sell is QY. Therefore, the marginal revenue curve for the joint product is the vertical sum of MRX and MRY until MRY equals 0. For outputs in excess of QY, the excess units of
FIGURE 3 Profit Maximization with Joint Products

MRJ MC
Price and cost (dollars)

MRX PX

PY DX

DY
0

Q*

QY MRY

Quantity

Y would be discarded, and only commodity X would be sold. Beyond QY the joint marginal revenue curve corresponds to MRX. The result is the kinked MRJ curve shown in the figure. Figure 3 shows the profit-maximizing equilibrium situation for a firm producing joint products. The profit-maximizing condition stated above, MRJ 5 MC, determines the optimal level of production of the joint good, Q* (5 QX * 5 QY *). The profit-maximizing prices PX * and PY * are found on the individual demand curves. To see how the firm can implement profit maximization with joint products, we turn to a stylized example. Joint Products at ChemTech Corporation ChemTech Corporation produces refined chemicals, and two of these chemicals are complements in production. As it refines the raw chemical input, the processes yield equal amounts of xylene and ylene, denoted, of course, as X and Y.2 The manager of ChemTech must determine the profit-maximizing amounts of xylene and ylene to produce and the prices to charge. The manager has forecasts of the demand functions for the two products: QX 5 285,000 1,000PX and QY 5 150,000 2,000PY where quantities are measured in 55-gallon drums and prices are in dollars per drum. The marginal revenue curves associated with these demand functions (derived from the inverse demand functions) are MRX 5 285 0.002QX and MRY = 75 0.001QY Note that MRY is equal to 0 at an output of 75,000 drums. Over the range of output from 0 to 75,000 units, the joint marginal revenue function is the vertical summation of the two marginal revenue curves: MRJ 5 285 0.002Q 1 75 0.001Q 5 360 0.003Q where Q represents both QX and QY (Q = QX = QY). For output levels greater than 75,000, the joint marginal revenue is the same as MRX. The joint marginal revenue function for ChemTech is shown in Figure 4 as the line between A and C, with the kink at point B, where MRY becomes negative. If production of the joint product exceeds 75,000 drums, the production of ylene in excess of 75,000 drums will be destroyed, discarded, or disposed of somehow rather than sold. The marginal cost function for refining the raw chemical input is estimated to be MC 5 10 1 0.002Q where Q is the number of drums of joint product, Q 5 QX 5 QY. Equating marginal revenue and marginal cost for the joint product, MRJ 5 MC 360 0.003Q 5 10 1 0.002Q
2 In other words, to keep this example simple, one drum of raw chemical input yields one drum of xylene and one drum of ylene.

360

MRJ = 360 2 0.003Q

Marginal revenue, marginal cost, and price (dollars)

285

MC = 10 1 0.002Q

215

PX

E B (kink point)

75

DY
40

PY
C

DX

70 75

142.5 Quantity (thousands of units)

285

MRY = 75 2 0.001QY

Now try Technical Problems 23.

Solving for the production level of the joint product, the profit-maximizing level of output is 70,000 drums. From the demand functions, the profit-maximizing prices for xylene and ylene are \$215 per drum of xylene and \$40 per drum of ylene.3 Using the profit-maximizing pricing decisions results in total revenue of \$17,850,000 [5 (215 1 40) 3 70,000].

3 The two demand functions, which can be derived from the marginal revenue functions, are PX * 5 285 0.001QX and PY * 5 75 0.0005QY. Substituting 70,000 for QX and QY in the two functions provides the profit-maximizing prices PX * 5 \$215 and PY * 5 \$40.

TECHNICAL PROBLEMS
1. In the example dealing with the optimal usage of a production facility (Surefire Products, Inc.), suppose that the plant supervisor changes the estimate of the marginal cost for usage of the plant to MC 5 150 1 3HT a. What is the optimal level of usage for the plant (hours per day)? b. How will this level of usage be allocated between the production of the two products? c. What will be the daily outputs? d. What prices will be charged? 2. Consider again the pricing and output decision facing the manager at ChemTech Corporation. New estimates for the demand for xylene and ylene are QX 5 200,000 1,000PX and QY 5 180,000 2,000PY The manager also reestimates marginal cost and finds the new marginal cost function to be MC 5 50 1 0.001Q a. Find the equation for the joint marginal revenue function. b. What is the profit-maximizing level of production for the joint product? c. What prices should the manager charge for xylene and ylene to maximize profit? A technological innovation in chemical processing reduces the marginal cost of production to MC 5 3.3 1 0.00005Q d. What is the profit-maximizing level of production of xylene? Of ylene? e. What are the profit-maximizing prices to charge for xylene and ylene? 3. Caytel Products manufactures two models of a particular product: the good model (G) and the best model (B). The two models are substitutes in production and must share Caytels production facilities. Caytel has determined that the production functions for the two models are Good model: QG 5 4.0HG Best model: QB 5 4.0HB where HG and HB measure the number of hours per month Caytels plant spends producing the good and best models, respectively. The demand functions for the two models are forecasted to be QG 5 4,000 256PG and QB 5 600 4PB The marginal cost of using Caytel's plant is estimated to be MC 5 5.0 1 0.05H where H 5 HG 1 HB a. To maximize profit, how many hours per month should Caytels plant operate? b. How should the manager allocate production time between the good model and the best model? c. How many units of the good model should be produced to maximize Caytel's profit? How many units of the best model? d. What prices should Caytel charge for the two models?