ECO 3101 Chapter 11

What are the uses of tying?

-Can be used to extend a firm's market power -To protect customer goodwill connected with a brand name.

If demand increases for one​ group, the firm should ______ the output for that​ group, while ____ the output and ____ the price for the other group. In the group with the increased​ demand, the price may or may not increase depending on how the curve shifts.

-Increase -Decreasing -Increasing

What is one of the main benefits of tying?

-It often allows a firm to meter demand and thereby practice price discrimination more effectively.

Why did MGM bundle Gone with the Wind and Getting​ Gertie's Garter​? What characteristic of demand is needed for bundling to increase​ profits?

-MGM bundled the movies to increase revenue. -For bundling to increase profits demand must be negatively correlated and firms must be unable to price discriminate.

Many retail video stores offer two alternative plans for renting​ films: A​ two-part tariff: Pay an annual membership fee​ (e.g., $40) and then pay a small fee for the daily rental of each film​ (e.g., $2 per film per​ day). A straight rental​ fee: Pay no membership​ fee, but pay a higher daily rental fee​ (e.g., $4 per film per​ day). What is the logic behind the​ two-part tariff in this​ case?

-Offering these two plans is intended to segment the market into low and high volume customers.

Bundling

A pricing strategy that involves tying products together and selling them as a package.

Two-Part Tariff

A situation in which consumers pay one price (or tariff) for the right to buy as much of a related good as they want at a second price.

Pure Bundling

A type of bundling in which the firm offers the products only as a bundle.

If scale economies cause average and marginal costs to decline, why would the government agency that controls rates may encourage block pricing?

Because it leads to expanded output and greater scale economies, this policy can increase consumer welfare while allowing for greater profit to the company: -While prices are reduced overall, the savings from the lower unit cost still permits the company to increase its profit.

Why do managers of firms with market power have a harder job than those who manage perfectly competitive firms?

Because the managers of a firm with monopoly power must also worry about the characteristics of demand.

Negatively Correlated

Describes two series that move in opposite directions

Positively Correlated

Describes two series that move in the same direction.

Relative Valuation

Employs a measure, commonly the P/E ratio, for a company and similar stocks and industry peers.

Imperfect Price Discrimination

Groups of consumers are charged different prices. -Profits are increased relative to using a single price, but not as high as using perfect price discrimination. -Consumer surplus is decreased, but consumer surplus is not equal to zero.

Can​ third-degree price discrimination be effective if the different groups of consumers have different levels of demand but the same price​ elasticities?

If consumers have different levels of demand but the same price​ elasticities, then the​ firm's profits will not increase because prices will be the same in both markets.

If marginal costs are zero, when can mixed bundling still be more profitable than pure bundling?

If consumers' demands are not perfectly negatively correlated.

Why does optimal​ third-degree price discrimination require that marginal revenue for each group of consumers equals marginal​ cost? Assume that marginal cost increases with output and that there are only two groups of consumers.

If marginal revenue for one group was greater than marginal​ cost, the firm could increase profit by lowering the price and increasing output for that​ group, and then decreasing output and raising the price for the other group.

How does the ability to discriminate correctly affect his or her​ earnings?

If the negotiated price is higher than the reservation​ price, a sale is​ lost, and if the negotiated price is lower than the reservation​ price, some profit is lost.

What does advertising lead to?

Increased output

Must Gillette be a monopoly producer of its blades as well as its​ razors?

It​ doesn't have to be a monopoly producer of blades if all customers have identical demand curves.

When pricing​ automobiles, American car companies typically charge a much higher percentage markup over cost for​ "luxury option" items​ (such as leather​ trim, etc.) than for the car itself or for more​ "basic" options such as power steering and automatic transmission. Explain why.

Luxury options have a lower price elasticity of demand than basic options.

Reservation Price

Maximum price that a customer is willing to pay for a good.

Block Pricing

Practice of charging different prices for quantities or "blocks" of goods.

First-Degree Price Discrimination

Practice of charging each customer his/her reservation price.

Tying

Practice of requiring a customer to purchase one good in order to purchase another.

Intertemporal Price Discrimination

Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time.

Firms with market power employ various pricing strategies designed to immediately capture consumer surplus and convert it into additional profits. Which of the following is not one of those pricing​ strategies?

Predatory pricing

How does tying differ from​ bundling?

Pure bundling is a form of tying where bundled goods can be substitutes or complements.

Advertising Elasticity Of Demand

Represents the change in sales resulting from each monetary unit (e.g.: each euro or dollar) that is spent on advertising. -A/PQ=−(EA/EP)A/PQ=−(EA/EP)

Which of the following is not an example of​ third-degree price​ discrimination?

Reservation pricing for each consumer.

Electric utilities often practice​ second-degree price discrimination. Why might this improve consumer​ welfare?

Second-degree price discrimination might improve consumer welfare​ because, compared with​ single-monopoly pricing, output is higher.

In the town of​ Woodland, California, there are many dentists—the market is competitive—but only one eye doctor. Are senior citizens more likely to be offered discount prices for dental exams or for eye​ exams? Why?

Seniors are more likely to get a discount for an eye exam because a firm must have market power to price discriminate.

Variable Profit

Sum of profits on each incremental unit produced by a firm; i.e., profit ignoring fixed costs.

What is the difference between demand and marginal cost under perfect price discrimination?

The additional profit from producing and selling an incremental unit.

Price Discrimination

The business practice of selling the same good at different prices to different customers.

How can a firm determine an optimal​ two-part tariff if it has two customers with different demand​ curves? ​ (Assume that it knows the demand​ curves.)

The firm should set a usage fee​ (P*) greater than marginal cost and an entry fee​ (T*) equal to the remaining surplus of the consumer with the smaller demand such that profit is maximized with respect to P and T.

Suppose a firm can practice​ perfect, first-degree price discrimination. What is the lowest price it will​ charge, and what will its total output​ be?

The lowest price and total output will occur at the point where the marginal cost curve intersects the demand curve.

Rule Of Thumb For Pricing For A Profit-Maximizing Firm

The markup over marginal cost as a percentage of price should equal minus the inverse of the price elasticity of demand.

Second-Degree Price Discrimination

The practice of charging different prices per unit for different quantities of the same good or service.

Third-Degree Price Discrimination

The practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group.

Mixed Bundling

The practice of packaging different products and services together.

Peak-Loading Pricing

The practice whereby higher prices are charged for goods or services during the periods in which they are consumed most intensively.

Why is the pricing of a Gillette safety razor a form of​ two-part tariff?

The razor is the entry fee and the blades are the usage fee.

How does a car salesperson practice price​ discrimination?

The salesperson practices imperfect price discrimination by trying to determine each​ customer's reservation price.

When does bundling make sense?

Then customers have heterogeneous demands and when the firm cannot price discriminate

Why offer the customer a choice of two plans rather than simply a​ two-part tariff?

This increases profits by combining​ two-part tariff with​ third-degree price discrimination.

Why do many restaurants practice mixed bundling​ (by offering a complete dinner as well as an​ à la carte​ menu) instead of pure​ bundling?

To maximize​ profits, restaurants​ can charge high prices for individual items to capture consumer surplus from those consumers who value some items more highly than​ others, while offering complete dinners at a lower bundled price to retain those customers who have lower variation in their reservation prices for different dishes.

If the demand for​ drive-in movies is more elastic for couples than for single​ individuals, it will be optimal for theaters to charge one admission fee for the driver of the car and an extra fee for passengers. True or​ false? Explain.

True. This is a form of​ two-part tariff with an entry fee equal to the consumer surplus of the driver and a price for each passenger.

Suppose you were advising Gillette on how to determine the two parts of the tariff. What advice could you​ offer?

When consumers have identical demand​ curves, the blade price should equal marginal cost and the razor price should equal consumer surplus for each consumer.

Why might a firm want to practice​ tying?

When the tied products are​ complements, tying can allow firms to more effectively practice price discrimination because in some circumstances demand can be more closely monitored.

How does mixed bundling differ from pure​ bundling? Under what conditions is mixed bundling preferable to pure​ bundling?

With mixed bundling the goods can be sold separately or as a bundle. Mixed bundling is preferable when goods are only slightly negatively correlated and or marginal costs are significant.