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Chapter Twelve

Pricing and
Advertising

Topics
Why and How Firms Price
Discriminate.
Perfect Price Discrimination.
Quantity Discrimination.
Multimarket Price Discrimination.
Two-Part Tariffs.
Tie-In Sales.
Advertising.

Nonuniform pricing
nonuniform pricing - charging
consumers different prices for the same
product or charging a single customer a
price that depends on the number of
units the customer buys

Price discrimination
Price discrimination - practice in which
a firm charges consumers different
prices for the same good

Why Price Discrimination Pays


A price-discriminating firm earns a
higher profit from price discrimination
because:
it charges a higher price to customers who
are willing to pay more than the uniform
price, capturing some or all of their
consumer surplus
it sells to some people who were not willing
to pay as much as the uniform price.

Table 12.1 A Theaters Profit Based


on the Pricing Method Used

Who Can Price Discriminate


Three conditions:
a firm must have market power.
consumers must differ in their sensitivity to
price, and a firm must be able to identify
how consumers differ in this sensitivity.
a firm must be able to prevent or limit
resales

Not All Price Differences Are Price


Discrimination
Not every seller who charges
consumers different prices is price
discriminating.

Types of Price Discrimination


perfect price discrimination (firstdegree price discrimination) - situation in
which a firm sells each unit at the
maximum amount any customer is
willing to pay for it, so prices differ
across customers and a given customer
may pay more for some units than for
others

Types of Price Discrimination (cont).


quantity discrimination (seconddegree price discrimination) - situation in
which a firm charges a different price for
large quantities than for small quantities
but all customers who buy a given
quantity pay the same price

Perfect Price Discrimination


multimarket price discrimination
(thirddegree price discrimination) - a
situation in which a firm charges
different groups of customers different
prices but charges a given customer the
same price for every unit of output sold

Perfect Price Discrimination (cont).


reservation price - the maximum
amount a person would be willing to pay
for a unit of output

Figure 12.1 Perfect Price


Discrimination

Perfect Price Discrimination: Efficient


But Hurts Consumers
A perfect price discrimination equilibrium
is efficient and maximizes total welfare.
Perfect price discrimination equilibrium
differs from the competitive equilibrium
in two ways:
perfect price discrimination equilibrium, only
the last unit is sold at that price.
perfectly price-discriminating monopoly
captures all the welfare.

p, $ per unit

Figure 12.2 Competitive, Single-Price,


and Perfect Discrimination Equilibria
p1

A
ps

MC

es

pc = MCc

ec

E
D

MCs

Demand, MRd

MC1
MRs
Qs

Qc = Qd

Q, Units per day

Figure 12.2 Competitive, Single-Price, and


Perfect Discrimination Equilibria (cont.)

Application Botox Revisited

Solved Problem 12.1


How does welfare change if the movie
theater described in Table 12.1 goes
from charging a single price to perfectly
price discriminating?

Solved Problem 12.2


Competitive firms are the customers of a
union, which is the monopoly supplier of labor
services. Show the unions producer surplus
if it perfectly price discriminates. Then
suppose that the union makes the firms a
take-it-or-leave-it offer: They must guarantee
to hire a minimum of H* hours of work at a
wage of w*, or they can hire no one. Show
that by setting w* and H* appropriately, the
union can achieve the same outcome as if it
could perfectly price discriminate.

Solved Problem 12.2

Quantity Discrimination
Most customers are willing to pay more
for the first unit than for successive
units:
the typical customers demand curve is
downward sloping.

block-pricing schedules - charge one


price for the first few units (a block) of
usage and a different price for
subsequent blocks.

(a) Quantity Discrimination

(b) Single-Price Monopoly

p1, $ per unit

p2, $ per unit

Figure 12.3 Quantity Discrimination


90

70

A=
$200

60

C=
$200

50
B=
$1,200

D=
$200

30

90

E = $450

F = $900
m

30

G = $450
m

Demand

Demand
MR

20

40

90
Q, Units per day

30

90
Q, Units per day

Figure 12.3 Quantity Discrimination


(cont.)

Multimarket Price Discrimination


The most common method of
multimarket price discrimination is to
divide potential customers into two or
more groups and set a different price for
each group.

Multimarket Price Discrimination with


Two Groups
A copyright gives Warner Home
Entertainment the legal monopoly to
produce and sell the Harry Potter and
the Prisoner of Azkaban two-DVD movie
set, which it released in November
2004.
Warner engages in multimarket price
discrimination by charging different prices
in various countries because it believes that
the elasticities of demand differ compared
to the U.S. price

Multimarket Price Discrimination with


Two Groups (cont).
= A + B = [pAQA mQA] + [pBQB mQB]
pAQA = revenue from American customers
pBQB = revenue from British customers
= American and British profits
Warner sets its quantities so that the marginal
revenue for each group equals the common
marginal cost, m, which is about $1 per unit.

Multimarket Price Discrimination with


Two Groups (cont).
Because the monopoly equates the marginal
revenue for each group to its common marginal
cost, :
MRA = m = MRB.
Therefore, using price elasticities:

1
1
MR p A 1 m pB 1 MR B
A
B

Multimarket Price Discrimination with


Two Groups (cont).
From previous slide:

1
1
MR p A 1 m pB 1 MR B
A
B

and rearranging,

1
1
pA
A

pB 1 1
B

Figure 12.4 Multimarket Pricing of


Harry Potter DVD

Solved Problem 12.3


A monopoly drug producer with a
constant marginal cost of m = 1 sells in
only two countries and faces a linear
demand curve of Q1 = 12 2p1 in
Country 1 and Q2 = 9 p2 in Country 2.
What price does the monopoly charge in
each country, how much does it sell in
each, and what profit does it earn in
each with and without a ban against
shipments between the countries?

Solved Problem 12.3

Solved Problem 12.3 (contd)

Identifying Groups
Two approaches to divide customers
into groups:
divide buyers into groups based on
observable characteristics of consumers.
identify and divide consumers on the basis
of their actions

Welfare Effects of Multimarket Price


Discrimination
Multimarket price discrimination results
in inefficient production and
consumption.
As a result, welfare under multimarket price
discrimination is lower than that under
competition or perfect price discrimination.

Two-Part Tariffs
two-part tariff - a pricing system in
which the firm charges a customer a
lump-sum fee (the first tariff or price) for
the right to buy as many units of the
good as the consumer wants at a
specified price (the second tariff)

A Two-Part Tariff with Identical


Consumers
A monopoly that knows its customers
demand curve can set a two-part tariff
that has the same two properties as the
perfect price discrimination equilibrium.
the efficient quantity, Q1, is sold because
the price of the last unit equals marginal
cost.
all consumer surplus is transferred from
consumers to the firm.

Figure 12.5 Two-Part Tariff

Tie-In Sales
tie-in sale- a type of nonlinear pricing in
which customers can buy one product
only if they agree to buy another product
as well.
requirement tie - in sale a tie-in sale in
which customers who buy one product
from a firm are required to make all their
purchases of another product from that
firm

Tie-In Sales (cont).


bundling (package tie-in sale) - a type
of tie-in sale in which two goods are
combined so that customers cannot buy
either good separately.
bundling a pair of goods pays only if their
demands are negatively correlated:

Table 12.2 Bundling of Tickets to


Football Game

Advertising
A monopoly advertises to raise its profit.
A successful advertising campaign shifts
the market demand curve by changing
consumers tastes or informing them about
new products.

The Decision Whether to Advertise


Even if advertising succeeds in shifting
demand, it may not pay for the firm to
advertise.
If advertising shifts demand outward, the
firms gross profit must rise.
The firm undertakes this advertising
campaign only if it expects its net profit
(gross profit minus the cost of advertising)
to increase.

Price of Co ke, pc , $ per unit

Figure 12.6 Advertising


19
17

p2 = 12
p1 = 11

e2
B

e1
1
MC = AC

MR 1
0

Q1 = 24 Q2 = 28

MR 2

D1

D2

68

76

Qc , Units of Co ke per year

Marginal beneft, marginal cost, $ per unit

Figure 12.7 Shift in the Marginal Benefit


of Advertising
MB 2

MB 1

MC

A2
A1
Minutes of advertising time purchased per day

Cross-Chapter Analysis: Magazine


Subscriptions