economics of the firm

Economics of the Firm

Competitive Pricing Techniques

Market Structure Spectrum

Perfect Competition Monopoly

One Producer With 100% market share

The market is supplied by many producers – each with zero market share

Firm Level Demand DOES NOT equal industry demand

Firm Level Demand EQUALS industry demand

When making pricing decisions, you need to be aware of what your market structure is

Recall the characteristics we laid out for a competitive market

#1: Many buyers and sellers – no individual buyer/firm has any real market power

#2: Homogeneous products – no variation in product across firms

#3: No barriers to entry – it’s costless for new firms to enter the marketplace

#4: Perfect information – prices and quality of products are assumed to be known to all producers/consumers

#5: No Externalities –ALL costs/benefits of the product are absorbed by the consumer

#6: Transactions are costless – buyers and sellers incur no costs in an exchange

Can you think of situations where all these assumptions hold?

Measuring Market Structure – Concentration Ratios

Suppose that we take all the firms in an industry and ranked them by size. Then calculate the cumulative market share of the n largest firms.

# of Firms

Cumulative Market Share

100

80

40

20

01 32 4 5 60 7 2010

A

BC

Measuring Market Structure – Concentration Ratios

# of Firms


100

80

40

20

01 32 4 5 60 7 2010

A

BC

4CR Measures the cumulative market share of the top four firms

Concentration Ratios in US manufacturing; 1947 - 1997

Year1947 17 23 301958 23 30 381967 25 33 421977 24 33 441987 25 33 431992 24 32 421997 24 32 40

100CR 200CR50CR

Aggregate manufacturing in the US hasn’t really changed since WWII

Measuring Market Structure: The Herfindahl-Hirschman Index (HHI)

N

iisHHI

1

2is = Market share of firm i

Rank Market Share

1 25 6252 25 6253 25 6254 5 255 5 256 5 257 5 258 5 25

2is

HHI = 2,000


100

80

40

20

01 32 4 5 60 7 2010

AB HHI = 500

HHI = 1,000

The HHI index penalizes a small number of total firms


100

80

40

20

01 32 4 5 60 7 2010

A

B

HHI = 500HHI = 555

The HHI index also penalizes an unequal distribution of firms

Concentration Ratios in For Selected Industries

Industry CR(4) HHIBreakfast Cereals 83 2446Automobiles 80 2862Aircraft 80 2562Telephone Equipment 55 1061Women’s Footwear 50 795Soft Drinks 47 800Computers & Peripherals 37 464Pharmaceuticals 32 446Petroleum Refineries 28 422Textile Mills 13 94

Recall that in a perfectly competitive world, price equals marginal revenue

The market determines the equilibrium price of $1.44 and 400,000 fish sold by the 1,000 fishermen

Market

Dollars

0

$1.44*

Demand

Supply

400,000*

Dollars

0

1.44*

Individual

At the prevailing market price of $1.44, each fisherman supplies 400 fish

MC

MR

400

In a monopolized market, the single firm in the market faces the industry demand curve

400,000 fish are sold at a market price of $1.44

Market

Dollars

0

$1.44*

Demand

400,000*

Dollars

0

1.44*

Individual

The single firm in the market has chosen that price of $1.44 based off of industry demand

MC

400,000

Demand

TCPQ

We will be assuming that pricing decisions are being made to maximize current period profits

Total Revenues equal price times quantity

Total Costs (note that total costs here are economic costs. That is, we have already included a reasonable rate of return on invested capital given the risk in the industry)

Profits

As with any economic decision, profit maximization involves evaluating every potential sale at the margin

How do my profits change if I increase my sales by 1?

How do my revenues change if I increase my sales by 1? (Marginal Revenues)

How do my costs change if I increase my sales by 1? (Marginal Costs)

TCPQ

In a world where firms have market power, they control their level of sales by setting their price. Suppose that you have the following demand curve (A relationship between price and quantity):

PQ 2100 Total Sales

Your listed price

Q

P

60Q

20$P

D

60202100 Q

For example: If you were to set a price of $20, you can expect 60 sales

We could also talk about inverse demand (a relationship between quantity and price):

PQ 2100

Q

P

40Q

30$P

D

30260

210040

PP

P

For example: If you wanted to make 40 sales, you could set a $30 price

QP 5.50 A price that will hit that target

Your target for sales

Either way, if we know price and total sales, we can calculate revenues

Q

P

40Q

30$P

D

QP 5.50

Total Revenues =($30)(40) = $1200

Total Revenues = Price*Quantity

Can we increase revenues past $1200 and, if so, how?

Either way, if we know price and total sales, we can calculate revenues

Q

P

40Q

30$P

D

QP 5.50

Turns out lowering price was the right thing to do to raise revenues.

50Q30Q

35$P

Total Revenues =($35)(30) = $1050

Total Revenues =($25)(50) = $1250

25$P

Q

p

Q

p

D

Initially, you have chosen a price (P) to charge and are making Q sales.

Total Revenues = PQ

Suppose that you want to increase your sales. What do you need to do?

Q

p

D

Your demand curve will tell you how much you need to lower your price to reach one more customer

This area represents the revenues that you lose because you have to lower your price to existing customers

This area represents the revenues that you gain from attracting a new customerp

Q

Q

p

D

Your demand curve will tell you how much you need to lower your price to reach one more customer

30$p

40Q

Revenues =($30)(40) = $1200

41Q

50.29$p($.50)(40) =$20

($29.50)(1) =$29.50

$29.50 From additional sale- $20 loss from lowering price$9.50 increase in revenues

Revenues =($29.50)(41) = $1209.50

QP 5.50

Demand curves slope downwards – this reflects the negative relationship between price and quantity. Elasticity of Demand measures this effect quantitatively

Quantity

Price

$2.50

5

000,50$ID

$2.75

4

%20100*554

%10100*50.250.275.2

21020

%%

PQD

D

Note that elasticities vary along a linear demand curve

Quantity

Price

$35

30

D

3.2D

60 80

$20

61.D

PQ 2100 P Q % Change in

Q% Change in P

Elasticity

$35 30

$34 32 6.7 -2.9 -2.3

$20 60

$19 62 3.3 -5 -.61

$10 80

$9 82 2.5 -10 -.255

12 18 24 30 36 42 48 54 60 66 72 78 84 90 96

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

Let’s calculate the elasticity of demand at a quantity of 40 (a.k.a. a price of $30)

Q

P

40Q

30$P

D

QP 5.50

41Q

50.29$P7.1% P

5.2% Q

47.17.15.2

%%

PQ

At a quantity of 40, the elasticity of demand is bigger that 1 in absolute value

Let’s calculate the elasticity of demand at a quantity of 40 (a.k.a. a price of $30)

Q

P

40Q

30$P

D

QP 5.50

41Q

50.29$P

47.1

PQTR

If I want to increase my sales target, I need to lower my price to all my existing customers

Total Revenues =($29.50)(41) = $1209.5

Total Revenues =($30)(40) = $1200

% Change in revenues = .80%

An elasticity of demand that is greater than 1 in absolute value indicates that lowering price will increase revenues

Q

P

40Q

30$P

D41Q

50.29$P

47.1

PQTR

Total Revenues =($29.50)(41) = $1209.5

Total Revenues =($30)(40) = $1200

% Change in revenues = .80%

QPTR %%%

7.1% P

5.2% Q

.80% -1.70% 2.5%

47.17.15.2

%%

PQ

An elasticity of demand that is less than 1 in absolute value indicates that raising price will increase revenues

Q

P

79Q

50.10$P

D80Q

00.10$P25.

PQTR

Total Revenues =($10)(80) = $800

Total Revenues =($10.50)(79) = $829.50

% Change in revenues = 3 .75%

QPTR %%%

5% P

25.1% Q

3.75% 5.00% -1.25%

25.0.525.1

%%

PQ

10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95

-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

Elasticity

1 9 17 25 33 41 49 57 65 73 81 89 970

200

400

600

800

1000

1200

1400

Total Revenues

Revenues are maximized when the elasticity of demand equals -1

Max RevenuesQuantity = 50Price =$25Revenues = $1,250

Quantity = 50Price =$25Elasticity = -1

Elasticity is less than -1: raise price

Elasticity is greater than -1: lower price

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95100

-60

-40

-20

0

20

40

60

P

MR

P = $30

MR = $9.50

Q = 40P = $30Revenues = ($30)(40) = $1200

Q = 41P = $29.50Revenues = ($29.50)(41) = $1209.50

Marginal Revenues = $9.50

Because you must lower your price to existing customers to attract new customers, marginal revenue will always be less than price

0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95100

-60

-40

-20

0

20

40

60

0

200

400

600

800

1000

1200

1400

P

MR

P = $25

MR = MC = $0

Note that because we have ignored the cost side, we are assuming marginal costs are equal to zero!

Revenues = $1250

Now, let’s bring in the cost side. For simplicity, lets assume that you face a constant marginal cost equal to $20 per unit.

Quantity Price Total Revenue

Marginal Revenue

Total Cost

Marginal Cost

Profit

1 $49.50 $49.50 $49.50 $20 $20 $29.50

2 $49 $98 $48.50 $40 $20 $58

3 $48.50 $145.50 $47.50 $60 $20 $85.50

4 $48 $192 $46.50 $80 $20 $112

5 $47.50 $237.50 $45.50 $100 $20 $137.50

6 $47 $282 $44.50 $120 $20 $162

7 $46.50 $325.50 $43.50 $140 $20 $185.50

Continuing on down…

29 $35.50 $1029.50 $21.50 $580 $20 $449.50

30 $35 $1050 $20.50 $600 $20 $450

31 $34.50 $1069.50 $19.50 $620 $20 $449.50

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69

-500

0

500

1000

1500

Total Revenue Total CostProfit

Slope = 20

Profits = $450

A profit maximizing price sets marginal revenue equal to marginal cost. Marginal revenue is the change in total revenue (i.e. the slope)

1 5 9 13 17 21 25 29 33 37 41 45 49 53 57 61 65 69

-30

-20

-10

0

10

20

30

40

50

60

Price Marginal CostMarginal Revenue

P = $35

Profit = ($35-$20)*30 = $450

Price = $35Quantity = 30Elasticity = -2.36

42.35$20$35$

PMCP

42.36.211

A profit maximizing price sets marginal revenue equal to marginal cost

This is not a coincidence. A monopoly sets a markup that is inversely proportional to the elasticity of demand!

Markups for Selected Industries

Industry LICommunication .972Paper & Allied Products .930Electric, Gas & Sanitary Services .921Food Products .880General Manufacturing .777Furniture .731Tobacco .638Apparel .444Motor Vehicles .433Machinery .300

Suppose that we assumed the automobile industry were monopolized…

433.PMCP

3.2433.1

So, a 1% increase in automobile prices will lower sales by 2.3%

Q

p

Q

p

D

Loss from charging existing customers a lower price

Gain from attracting new customers

Is it possible to attract new customers without lowering your price to everybody?

Dollars

0

$40

40,000

Let’s suppose that Notre dame has identified three different consumer types for Notre Dame football tickets. Further, assume that Notre Dame has a marginal cost of $20 per ticket.

$120

$80

70,000 80,000

Alumni

Faculty

Students

If Notre Dame had to set one uniform price to everybody, what price would it set?

Dollars

0

$40

40,000

Let’s suppose that Notre dame has identified three different consumer types for Notre Dame football tickets. Further, assume that Notre Dame has a marginal cost of $20 per ticket.

$120

$80

70,000 80,000

Alumni

Faculty

Students

Price Quantity Total Revenue

Total Cost Profit

$120 40,000 $4.8M $800,000 $4.0M

$80 70,000 $5.6M $1.4M $4.2M

$40 80,000 $3.2M $1.6M $1.6M

$20 MC

Dollars

0

$40

40,000

Now, suppose that Notre Dame can set up differential pricing.

$120

$80

70,000 80,000

Alumni

Faculty

Students

Price Quantity Total Revenue

Total Cost Profit

$120 40,000 $4.8M $400,000 $4.4M

$80 30,000 $2.4M $300,000 $2.1M

$40 10,000 $400,000 $200,000 $200,000

Total 80,000 $7.6M $900,000 $6.7M

$20 MC

Pricing Schedule• Regular Price: $120• Faculty/Staff: $80• Student: $40

What would Notre Dame need to do to accomplish this?

Example: DVD codes are a digital rights management technique that allows film distributors to control content, release date, and price according to region.

DVD coding allows for distributors to price discriminate by region.

http://upload.wikimedia.org/wikipedia/commons/9/92/DVD-Regions_with_key-2.svg

Why is movie theatre popcorn so expensive?

Dollars

0 200

$15

300

General Public

Senior Citizens

$8

This would be an easy price discrimination problem…

Pricing Schedule• Regular Price: $15• Senior Citizens: $8

Now, suppose that the identities are unknown? How can the theatre extract more money out of the avid moviegoer?

Dollars

0 200

$15

300

Avid Moviegoer

Occasional Moviegoer

$8

Ticket Price Popcorn Price Total

Option #1 $14 $1 $15

Option #2 $8 $7 $15

Option #3 $2 $13 $15

As long as the total price (popcorn + ticket) is $15 or less, avid moviegoers will still go

Which pricing option would you choose?

PQ 100100

Suppose that Disneyworld knows something about the average consumer’s demand for amusement park rides. Disneyworld has a constant marginal cost of $.02 per ride

Dollars

0

.50

Demand

50

Price (per ride) Quantity (rides)

$1 0

$.99 1

$.98 2

$0 100

PQ 100100

As a first pass, we could solve for a profit maximizing price per ride

Dollars

0

.51

Demand

49

Price (per ride)

Quantity (rides)

Total Revenues

MarginalRevenues

Marginal Cost

$1 0 $0

$.99 1 $.99 $.99 $.02

$.98 2 $1.96 $.97 $.02

$.52 48 $24.96 $.05 $.02

$.51 49 $24.99 $.03 $.02

$.50 50 $25 $.01 $.02MC

MR

.02

Profit = $24.01

PQ 100100

If all Disney does is charge a price per ride, they are leaving some money on the table

Dollars

0

.51

Demand

49

MC

MR

.02

Profit = $24.01

$1CS = (1/2)($1-.51)*49 = $12.00

We are charging this person $24.01 for 49 rides when they would’ve $36.01!

PQ 100100

Like the movie theatre, Disney has two prices to play with. We have a price per ride as well as an entry fee. For any price per ride, we can set the entry fee equal to the consumer surplus generated.

Dollars

0

$P

Demand

Q

MC.02

Profit = (P-.02)*Q

$1 Fee = (1/2)($1-P)*Q

Price (per ride)

Quantity (rides)

Ride Revenue

Fee Revenue

Total Revenues

MarginalRevenues

Marginal Cost

$1 0 $0 $0 $0 --- ---

$.99 1 $.99 $.005 $.995 $.995 $.02

$.98 2 $1.96 $.02 $1.98 $.985 $.02

$.03 97 $2.91 $47.05 $49.96 $.03 $.02

$.02 98 $1.96 $48.02 $49.98 $.02 $.02

$.01 99 $.99 $49 $49.99 $.01 $.02

Total Profit = $48.02

We are still looking to where marginal revenues equal marginal costs.

PQ 100100

The optimal pricing scheme here is to set a price per ride equal to marginal cost. We then set the entry fee equal to the consumer surplus generated.

Dollars

0

Demand

98

MC.02

$1 Fee = (1/2)($1-.02)*98 = $48.02

Total Profit = $48.02

Pricing Schedule• Entry Fee: $48.02• Price Per Ride: $.02

Or, we could combine the two

Entry Fee: $48.02+ Ride Charges: $1.9698 Ride Package = $49.98Ride Revenue = .02*98 = $1.96

Dollars

0

.51

Demand

49

MC

MR

.02

Profit = $24.01

$1

Now, suppose that we introduced two different clientele. Say, senior citizens and Non-seniors. We could discriminate based on price per ride (assume there is one of each type)

PQ 100100 Non-Seniors

Dollars

0

.41

Demand

39

MC

MR

.02

Profit = $15.21

$.80

PQ 10080 Seniors

Total Profit = $24.01 + $15.21 = $39.22

Alternatively, you set the cost of the rides at their marginal cost ($.02) for everybody and discriminate on the entry fee.

Entry Fee =$48.02 Young

$30.42 OldP = $.02/Ride

Dollars

0

Demand

98

MC.02

$1

0

Demand

78

MC.02

$.80

Total Profit = $48.02 + $30.42 = $78.44

Fee = (1/2)($1-.02)*98 = $48.02 Fee = (1/2)($.80-.02)*78 = $30.42

Ride Revenue = .02*98 = $1.96 Ride Revenue = .02*78 = $1.56

PQ 10080 Seniors


Or, you could establish different package prices.

Pricing Schedule=Regular Admission (98 rides): $49.98

Senior Citizen Special (78 Rides): $31.98

Dollars

0

Demand

98

MC.02

$1

0

Demand

78

MC.02

$.80

Total Price = $48.02 + $1.96 = $49.98

Fee = (1/2)($1-.02)*98 = $48.02 Fee = (1/2)($.80-.02)*78 = $30.42


Total Price = $30.42 + $1.56 = $31.98

PQ 10080 Seniors


Suppose that you couldn’t distinguish High value customers from low value customers: Would this work?

Dollars

0

Demand

98

MC.02

$1

0

Demand

78

MC.02

$.80Fee = (1/2)($1-.02)*98 = $48.02 Fee = (1/2)($.80-.02)*78 = $30.42


PQ 10080 PQ 100100

Pricing Schedule=Regular Admission (98 rides): $49.98

“Early Bird” Special (78 Rides): $31.98

p

78

$22

$100

We know that is the high value consumer buys 98 ticket package, all her surplus is extracted by the amusement park. How about if she buys the 78 Ride package?

$30.42

$17.16

If the high value customer buys the 78 ride package, she keeps $15.60 of her surplus!

78 Ride Coupons: $31.98Total Willingness to pay for 78 Rides: $47.58

$15.60

-

PQ 100100

D

p

98

$.02

$1.00

You need to set a price for the 98 ride package that is incentive compatible. That is, you need to set a price that the high value customer will self select. (i.e., a package that generates $15.60 of surplus)

$1.96

$48.02

Total Willingness = $49.98 - Required Surplus = $15.60

Package Price = $34.38

q

78 Ride Coupons: $31.9898 Ride Coupons: $34.38

84.62$17602$.38.34$98.31$

Bundling

Suppose that you are selling two products. Marginal costs for these products are $100 (Product 1) and $150 (Product 2). You have 4 potential consumers that will either buy one unit or none of each product (they buy if the price is below their reservation value)

Consumer Product 1 Product 2 Sum

A $50 $450 $500

B $250 $275 $525

C $300 $220 $520

D $450 $50 $500

If you sold each of these products separately, you would choose prices as follows

P Q TR Profit

$450 1 $450 $350

$300 2 $600 $400

$250 3 $750 $450

$50 4 $200 -$200

P Q TR Profit

$450 1 $450 $300

$275 2 $550 $250

$220 3 $660 $210

$50 4 $200 -$400

Product 1 (MC = $100) Product 2 (MC = $150)

Profits = $450 + $300 = $750


A $50 $450 $500

B $250 $275 $525

C $300 $220 $520

D $450 $50 $500

Pure Bundling does not allow the products to be sold separately

Product 2 (MC = $150)


With a bundled price of $500, all four consumers buy both goods:

Profits = 4($500 -$100 - $150) = $1,000


A $50 $450 $500

B $250 $275 $525

C $300 $220 $520

D $450 $50 $500

Mixed Bundling allows the products to be sold separately



Price 1 = $250Price 2 = $450Bundle = $500

Consumer A: Buys Product 2 (Profit = $300) or Bundle (Profit = $250)Consumer B: Buys Bundle (Profit = $250)Consumer C: Buys Product 1 (Profit = $150)Consumer D: Buys Only Product 1 (Profit = $150)

Profit = $850

or $800


A $50 $450 $500

B $250 $275 $525

C $300 $220 $520

D $450 $50 $500

Mixed Bundling allows the products to be sold separately



Price 1 = $450Price 2 = $450Bundle = $520

Consumer A: Buys Only Product 2 (Profit = $300)Consumer B: Buys Bundle (Profit = $270)Consumer C: Buys Bundle (Profit = $270)Consumer D: Buys Only Product 1 (Profit = $350)

Profit = $1,190


A $300 $200 $500

B $300 $200 $500

C $300 $200 $500

D $300 $200 $500



Bundling is only Useful When there is variation over individual consumers with respect to the individual goods, but little variation with respect to the sum!?

Individually Priced: P1 = $300, P2 = $200, Profit = $1,000

Pure Bundling: PB = $500, Profit = $1,000

Mixed Bundling: P1 = $300, P2 = $200, PB = $500, Profit = $1,000

Suppose that you sell laser printers. To create printed pages, you need both a printer and an ink cartridge. For now, assume that the toner cartridges are sold in a competitive market and sell for $2 each. An ink cartridge is good for 1,000 printed pages.

Dollars

0

$2

Demand

14

$16

PQ 16

Quantity of printed pages (000s)

Toner cartridge price

What price would you sell the printer for?

CS = ½*($16 - $2)(14) = $98

Now, suppose that you design a printer that requires a special cartridge that only you produce. What would you do if you could choose a printer price and a cartridge price?

Dollars

0

$9

Demand

7

$16

PQ 16



CS = ½*($9 - $2)(7) = $24.50

MR

MC$2

Q P TR TC MR MC Profit

1 $15 $15 $2 $15 $2 $13

2 $14 $28 $4 $13 $2 $24

3 $13 $39 $6 $11 $2 $33

4 $12 $48 $8 $9 $2 $40

5 $11 $55 $10 $7 $2 $45

6 $10 $60 $12 $5 $2 $48

7 $9 $63 $14 $3 $2 $49

8 $8 $64 $16 $1 $2 $48

We could make our money on the cartridges and sell the printers cheap…

Alternatively, we could do something like the amusement park. We maximize profits combining cartridge revenue AND printer revenue

Dollars

0

Demand

14

$16

PQ 16



CS = ½*($16 - $2)(14) = $98

MR

MC$2

Q P TR CS Total TC MR MC Profit

1 $15 $15 $.5 $15.5 $2 $15.5 $2 $13.5

2 $14 $28 $2 $30 $4 $14.5 $2 $26

3 $13 $39 $4.5 $43.5 $6 $13.5 $2 $37.5

4 $12 $48 $8 $56 $8 $12.5 $2 $48

5 $11 $55 $12.5 $67.5 $10 $11.5 $2 $57.5

13 $3 $39 $84.5 $123.5 $26 $3.5 $2 $97.5

14 $2 $28 $98 $126 $28 $2.5 $2 $98

15 $1 $15 $112.5 $127.5 $30 $1.50 $2 $97.5

We are back to a low cartridge price and a high printer price

Now, suppose that you have two customers. Call them high value and low value. Suppose that you can easily identify them and prevent resale. We could discriminate on both the printer price and the cartridge price.

Dollars

0

$9

Demand

7

$16CS = ½*($16 - $9)(7) = $24.50

MR

MC$2

Dollars

0

$7

Demand

5

$12CS = ½*($12 - $2)(5) = $12.50

MR

MC$2

PQ 12PQ 16

Profit = ($9-$2)7 +$24.50 = $73.50 Profit = ($7-$2)5 +$12.50 = $37.50

Total Profit = $111

Alternatively, we could essentially give the cartridges away and discriminate on the printer (like Disneyworld).

Dollars

0

Demand

14

$16CS = ½*($16 - $2)(14) = $98

MC$2

Dollars

0

Demand

10

$12CS = ½*($12 - $2)(10) = $50

MC$2

PQ 12PQ 16

Profit = $98 Profit $50

Total Profit = $148

Suppose that you couldn’t explicitly price discriminate. Let’s say that you know you have a high value and low value demander, but you don’t know who is who. Let’s first try and do this like the amusement park

Dollars

0

Demand

14

$16CS = ½*($16 - $2)(14) = $98

MC$2

Dollars

0

Demand

10

$12CS = ½*($12 - $2)(10) = $50

MC$2

PQ 12

14 Cartridge Package = $98 + $2*14 = $126

PQ 16

10 Cartridge Package = $50 + $2*10 = $70

Suppose that you couldn’t explicitly price discriminate. Let’s say that you know you have a high value and low value demander, but you don’t know who is who. Let’s first try and do this like the amusement park

Dollars

0

Demand

10

$16CS = ½*($16 - $9)(10) = $50

$60

$6

PQ 16

- 10 Cartridge Package = $70

Total Willingness to Pay = $110

Consumer Surplus = $40

14 Cartridge Package = $126

- required consumer surplus = $40

“Discounted Price” = $86

14 Cartridge Package = $8610 Cartridge Package = $70

Profit = $86 + $70 - $2*24 = $108

Let’s try a different strategy. Suppose that you charge a markup on the cartridges and then charge a common price for the printer to each. We would set the price of the printer equal to the consumer surplus of the lower value demander of insure that both groups buy the printer.

Dollars

0

Demand

12-P

$12CS = ½*($12 - $P)(12-P)

$60

$P

PQ 12 Example: Cartridge Price: $3Consumer Surplus = ½*($12 - $3)(9) = $40.50

Charge $40.50 for the printer (Both customers will buy)

Low value customers buy 9 cartridges

High Value customers buy 13 cartridges

Profit = 2*$40.50 + ($3-$2)(21) = $103

We need to find the best cartridge price…

Price Quantity 1 Quantity 2

Total Revenue

Consumer Surplus

Printer Revenue

Total Revenue Total Cost Profit

$0 16 12 $0 $72 $144 $144 $56 $88

$.25 15.75 11.75 $6.875 $69.03 $138.06 $144.93 $55 $89.93

$.50 15.5 11.5 $13.50 $66.135 $132.25 $145.75 $54 $91.75

$3 13 9 $66 $40.5 $81 $147 $44 $103

$4 12 8 $80 $32 $64 $144 $40 $104

$4.25 11.75 7.75 $82.875 $30.03 $60.06 $142.93 $39 $103.93

PQ 16PQ 12

21 QQP

2125. QP CS*2 212$ QQ

Let’s try a different strategy. Suppose that you charge a market on the cartridges and then charge a common price for the printer to each. We would set the price of the printer equal to the consumer surplus of the lower value demander of insure that both groups buy the printer.

Dollars

0

Demand

8

$12CS = ½*($12 - $4)(8) = $32

$60

$4

PQ 12 Best Choice:

Charge $32 for the printer (Both customers will buy)

Charge $4 for cartridgesLow value customers buy 8

cartridges High Value customers buy 12

cartridges

Profit = 2*$32 + ($4-$2)(20) = $104

One last example. Consider the market for hot dogs. Most people require a bun for each hot dog they eat (with the exception of the Atkins diet people!)

BH PPQ 12

Price of a Hot Dog Price of a Hot Dog Bun

Hot Dogs and Buns are made by separate companies – each has a monopoly in its own industry. For simplicity, assume that the marginal cost of production for each equals zero.

For simplicity I will assume that marginal costs are zero (i.e. we are maximizing revenues)

PPQ H 102$12

Suppose that you knew that the buns were selling for $2, what should you charge?

Quantity Price Total Revenue Marginal Revenue

1 $9 $9 $9

2 $8 $16 $7

3 $7 $21 $5

4 $6 $24 $3

5 $5 $25 $1

6 $4 $24 -$1

You charge $5

But, if the bun guy sees you charging $5, he needs to react to that…

PPQ B 75$12


1 $6 $6 $6

2 $5 $10 $4

3 $4 $12 $2

4 $3 $12 $0

5 $2 $10 -$2

6 $1 $6 -$4

Bun Guy charge $4

But, if the bun guy is charging $4, you need to react to that…

PPQ B 84$12


1 $7 $7 $7

2 $6 $12 $5

3 $5 $15 $3

4 $4 $16 $1

5 $3 $15 -$1

6 $2 $12 -$3

You charge $4

Now, suppose that these companies merged into one monopoly

PPPQ HB 812

Quantity Combined Price

Total Revenue Marginal Revenue

1 $11 $11 $11

2 $10 $20 $9

3 $9 $27 $7

4 $8 $32 $5

5 $7 $35 -$3

6 $6 $36 -$1

7 $5 $35 -$1

8 $4 $32 -$3

9 $3 $27 -$5

You charge $6 for hot dog/bun

HB PPQ 12

Look at what happened here…

Separate Hot Dog/Bun Suppliers

4$4$

B

H

PP

Consumer Pays $8 for a hot dog/bun pair

Single Hot Dog/Bun Suppliers

6$ BH PP

Consumer Pays $6 for a hot dog/bun pair

Eliminating a company benefits consumers!!!

Example: Microsoft vs. Netscape

The argument against Microsoft was using its monopoly power in the operating system market to force its way into the browser market by “bundling” Internet Explorer with Windows 95.

To prove its claim, the government needed to show:• Microsoft did, in fact, possess monopoly power• The browser and the operating system were, in fact, two distinct

products that did not need to be integrated• Microsoft’s behavior was an abuse of power that hurt

consumers

What should Microsoft’s defense be?

economics of the firm

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