Chapter 11
Pricing with
Market Power
Chapter 11 Slide 2
Topics to be Discussed
Capturing Consumer Surplus
Price Discrimination
Intertemporal Price Discrimination and
Peak-Load Pricing
Chapter 11 Slide 3
Topics to be Discussed
The Two-Part Tariff
Bundling
Advertising
Chapter 11 Slide 4
Introduction
Pricing without market power (perfect
competition) is determined by market
supply and demand.
The individual producer must be able to
forecast the market and then
concentrate on managing production
(cost) to maximize profits.
Chapter 11 Slide 5
Introduction
Pricing with market power (imperfect
competition) requires the individual
producer to know much more about the
characteristics of demand as well as
manage production.
Chapter 11 Slide 6
Capturing Consumer Surplus
Quantity
$/Q
D
MR
Pmax
MC If price is raised above
P*,the firm will lose
sales and reduce profit.
PC
PC is the price
that would exist in
a perfectly competitive
market.
A
P*
Q*
P1
Between 0 and Q*,consumers
will pay more than
P*--consumer surplus (A).
B
P2
Beyond Q*,price will
have to fall to create a
consumer surplus (B).
Chapter 11 Slide 7
Capturing Consumer Surplus
P*Q*,single P & Q @ MC=MR
A,consumer surplus with P*
B,P>MC & consumer would buy
at a lower price
P1,less sales and profits
P2,increase sales & and reduce
revenue and profits
PC,competitive price
Quantity
$/Q
D
MR
Pmax
MCP
C
A
P*
Q*
P1
B
P2
Chapter 11 Slide 8
Capturing Consumer Surplus
Quantity
$/Q
D
MR
Pmax
MCP
C
A
P*
Q*
P1
B
P2
Question
How can the firm
capture the consumer surplus
in A and sell profitably in B?
Answer
Price discrimination
Two-part tariffs
Bundling
Chapter 11 Slide 9
Capturing Consumer Surplus
Price discrimination is the charging of
different prices to different consumers
for similar goods.
Chapter 11 Slide 10
Price Discrimination
First Degree Price Discrimination
Charge a separate price to each customer,
the maximum or reservation price they are
willing to pay.
Chapter 11 Slide 11
P*
Q*
Without price discrimination,
output is Q* and price is P*.
Variable profit is the area
between the MC & MR (yellow).
Additional Profit From Perfect First-
Degree Price Discrimination
Quantity
$/Q Pmax
With perfect discrimination,each
consumer pays the maximum
price they are willing to pay.
Consumer surplus is the area
above P* and between
0 and Q* output.
D = AR
MR
MC
Output expands to Q** and price
falls to PC where MC = MR = AR = D.
Profits increase by the area above MC
between old MR and D to output
Q** (purple)
Q**
PC
Chapter 11 Slide 12
P*
Q*
Consumer surplus when a
single price P* is charged.
Variable profit when a
single price P* is charged.
Additional profit from
perfect price discrimination
Quantity
$/Q Pmax
D = AR
MR
MC
Q**
PC
With perfect discrimination
Each customer pays their
reservation price
Profits increase
Additional Profit From Perfect First-
Degree Price Discrimination
Chapter 11 Slide 13
Question
Why would a producer have difficulty in
achieving first-degree price discrimination?
Answer
1) Too many customers (impractical)
2) Could not estimate the reservation
price for each customer
Additional Profit From Perfect First-
Degree Price Discrimination
Chapter 11 Slide 14
Price Discrimination
First Degree Price Discrimination
The model does demonstrate the potential
profit (incentive) of practicing price
discrimination to some degree.
Chapter 11 Slide 15
Price Discrimination
First Degree Price Discrimination
Examples of imperfect price discrimination
where the seller has the ability to
segregate the market to some extent and
charge different prices for the same
product:
Lawyers,doctors,accountants
Car salesperson (15% profit margin)
Colleges and universities
Chapter 11 Slide 16
First-Degree Price
Discrimination in Practice
Quantity
D
MR
MC
$/Q
P2
P3
P*4
P5
P6
P1
Six prices exist resulting
in higher profits,With a single price
P*4,there are few consumers and
those who pay P5 or P6 may have a surplus.
Q
Second-Degree Price Discrimination
Quantity
$/Q
D
MR
MC
AC
P0
Q0
Without discrimination,P = P0
and Q = Q0,With second-degree
discrimination there are three
prices P1,P2,and P3.
(e.g,electric utilities)
P1
Q1
1st Block
P2
Q2
P3
Q3
2nd Block 3rd Block
Second-degree price
discrimination is pricing
according to quantity
consumed--or in blocks.
Second-Degree Price Discrimination
Quantity
$/Q
D
MR
MC
AC
P0
Q0
P1
Q1
1st Block
P2
Q2
P3
Q3
2nd Block 3rd Block
Economies of scale permit:
Increase consumer welfare
Higher profits
Chapter 11 Slide 19
Price Discrimination
Third Degree Price Discrimination
1) Divides the market into two-groups.
2) Each group has its own demand
function.
Chapter 11 Slide 20
Price Discrimination
Third Degree Price Discrimination
3) Most common type of price
discrimination.
Examples,airlines,liquor,vegetables,
discounts to students and senior
citizens.
Chapter 11 Slide 21
Price Discrimination
Third Degree Price Discrimination
4) Third-degree price discrimination is
feasible when the seller can
separate his/her market into groups
who have different price elasticities
of demand (e.g,business air
travelers versus vacation air
travelers)
Chapter 11 Slide 22
Price Discrimination
Third Degree Price Discrimination
Objectives
MR1 = MR2
MC1 = MR1 and MC2 = MR2
MR1 = MR2 = MC
Chapter 11 Slide 23
Price Discrimination
Third Degree Price Discrimination
P1,price first group
P2,price second group
C(Qr) = total cost of QT = Q1 + Q2
Profit ( ) = P1Q1 + P2Q2 - C(Qr)?
Chapter 11 Slide 24
Price Discrimination
Third Degree Price Discrimination
Set incremental for sales to group 1 = 0
0
(
11
)11
1
Q
C
Q
QP
Q
MC
Q
CMR
Q
QP?
1
1
1
11 )(
Chapter 11 Slide 25
Price Discrimination
Third Degree Price Discrimination
Second group of customers,MR2 = MC
MR1 = MR2 = MC
Chapter 11 Slide 26
Price Discrimination
Third Degree Price Discrimination
Determining relative prices
)11()11(
11
222111 EPMREPMR
EPMR d
,T h e n
,R e ca l l
Chapter 11 Slide 27
Price Discrimination
Third Degree Price Discrimination
Determining relative prices
Pricing,Charge higher price to group with
a low demand elasticity
)11(
)11(
1
2
2
1
E
E
P
P
,An d
Chapter 11 Slide 28
Price Discrimination
Third Degree Price Discrimination
Example,E1 = -2 & E2 = -4
P1 should be 1.5 times as high as P2
5.12143
)211(
)411(
2
1
P
P
Chapter 11 Slide 29
Third-Degree Price Discrimination
Quantity
D2 = AR2
MR2
$/Q
D1 = AR1MR1
Consumers are divided into
two groups,with separate
demand curves for each group.
MRT
MRT = MR1 + MR2
Chapter 11 Slide 30
Third-Degree Price Discrimination
Quantity
D2 = AR2
MR2
$/Q
D1 = AR1MR1
MRT
MC
Q2
P2
QT
QT,MC = MRT
Group 1,P1Q1 ; more elastic
Group 2,P2Q2; more inelastic
MR1 = MR2 = MC
QT control MC
Q1
P1
MC = MR1 at Q1 and P1
Chapter 11 Slide 31
No Sales to Smaller Market
Even if third-degree price
discrimination is feasible,it doesn’t
always pay to sell to both groups
of consumers if marginal cost is rising.
Chapter 11 Slide 32
No Sales to Smaller Market
Quantity
D2
MR2
$/Q
MC
D1
MR1 Q*
P*
Group one,with
demand D1,are not
willing to pay enough
for the good to
make price
discrimination profitable.
Chapter 11 Slide 33
The Economics of Coupons and Rebates
Those consumers who are more price
elastic will tend to use the
coupon/rebate more often when they
purchase the product than those
consumers with a less elastic demand.
Coupons and rebate programs allow
firms to price discriminate.
Price Discrimination
Chapter 11 Slide 34
Price Elasticities of Demand for Users
Versus Nonusers of Coupons
Toilet tissue -0.60 -0.66
Stuffing/dressing -0.71 -0.96
Shampoo -0.84 -1.04
Cooking/salad oil -1.22 -1.32
Dry mix dinner -0.88 -1.09
Cake mix -0.21 -0.43
Price Elasticity
Product Nonusers Users
Chapter 11 Slide 35
Cat food -0.49 -1.13
Frozen entrée -0.60 -0.95
Gelatin -0.97 -1.25
Spaghetti sauce -1.65 -1.81
Crème rinse/conditioner -0.82 -1.12
Soup -1.05 -1.22
Hot dogs -0.59 -0.77
Price Elasticity
Product Nonusers Users
Price Elasticities of Demand for Users
Versus Nonusers of Coupons
Chapter 11 Slide 36
The Economics of Coupons and Rebates
Cake Mix
Nonusers of coupons,PE = -0.21
Users,PE = -0.43
Chapter 11 Slide 37
The Economics of Coupons and Rebates
Cake Mix Brand (Pillsbury)
PE,8 to 10 times cake mix PE
Example
PE Users,-4
PE Nonusers,-2
Chapter 11 Slide 38
The Economics of Coupons and Rebates
Using,
Price of nonusers should be 1.5 times
users
Or,if cake mix sells for $1.50,coupons
should be 50 cents
)11(
)11(
1
2
2
1
E
E
P
P
Chapter 11 Slide 39
Airline Fares
Differences in elasticities imply that
some customers will pay a higher fare
than others.
Business travelers have few choices
and their demand is less elastic.
Casual travelers have choices and are
more price sensitive.
Chapter 11 Slide 40
Elasticities of
Demand for Air Travel
Price -0.3 -0.4 -0.9
Income 1.2 1.2 1.8
Fare Category
Elasticity First-Class Unrestricted Coach Discount
Chapter 11 Slide 41
Airline Fares
The airlines separate the market by
setting various restrictions on the
tickets.
Less expensive,notice,stay over the
weekend,no refund
Most expensive,no restrictions
Chapter 11 Slide 42
Intertemporal Price
Discrimination and Peak-Load Pricing
Separating the Market With Time
Initial release of a product,the demand is
inelastic
Book
Movie
Computer
Chapter 11 Slide 43
Separating the Market With Time
Once this market has yielded a maximum
profit,firms lower the price to appeal to a
general market with a more elastic demand
Paper back books
Dollar Movies
Discount computers
Intertemporal Price
Discrimination and Peak-Load Pricing
Chapter 11 Slide 44
Intertemporal Price Discrimination
Quantity
AC = MC
$/Q
Over time,demand becomes
more elastic and price
is reduced to appeal to the
mass market.
Q2
MR2
D2 = AR2
P2
D1 = AR1MR1
P1
Q1
Consumers are divided
into groups over time.
Initially,demand is less
elastic resulting in a
price of P1,
Chapter 11 Slide 45
Demand for some products may peak at
particular times.
Rush hour traffic
Electricity - late summer afternoons
Ski resorts on weekends
Intertemporal Price
Discrimination and Peak-Load Pricing
Peak-Load Pricing
Chapter 11 Slide 46
Capacity restraints will also increase
MC.
Increased MR and MC would indicate a
higher price.
Peak-Load Pricing
Intertemporal Price
Discrimination and Peak-Load Pricing
Chapter 11 Slide 47
MR is not equal for each market
because one market does not impact
the other market.
Peak-Load Pricing
Intertemporal Price
Discrimination and Peak-Load Pricing
Chapter 11 Slide 48
MR1
D1 = AR1
MC
P1
Q1
Peak-load
price = P1,
Peak-Load Pricing
Quantity
$/Q
MR2
D2 = AR2
Off- load
price = P2,
Q2
P2
Chapter 11 Slide 49
How to Price a Best Selling Novel
What Do You Think?
1) How would you arrive at the price for
the initial release of the hardbound
edition of a book?
Chapter 11 Slide 50
How to Price a Best Selling Novel
What Do You Think?
2) How long do you wait to release the
paperback edition? Could the
popularity of the book impact your
decision?
Chapter 11 Slide 51
What Do You Think?
3) How do you determine the price for
the paperback edition?
How to Price a Best Selling Novel
Chapter 11 Slide 52
The Two-Part Tariff
The purchase of some products and
services can be separated into two
decisions,and therefore,two prices.
Chapter 11 Slide 53
The Two-Part Tariff
Examples
1) Amusement Park
Pay to enter
Pay for rides and food within the park
2) Tennis Club
Pay to join
Pay to play
Chapter 11 Slide 54
The Two-Part Tariff
Examples
3) Rental of Mainframe Computers
Flat Fee
Processing Time
4) Safety Razor
Pay for razor
Pay for blades
Chapter 11 Slide 55
The Two-Part Tariff
Examples
5) Polaroid Film
Pay for the camera
Pay for the film
Chapter 11 Slide 56
The Two-Part Tariff
Pricing decision is setting the entry
fee (T) and the usage fee (P).
Choosing the trade-off between free-
entry and high use prices or high-entry
and zero use prices.
Chapter 11 Slide 57
Usage price P*is set where
MC = D,Entry price T*
is equal to the entire
consumer surplus.
T*
Two-Part Tariff with a Single Consumer
Quantity
$/Q
MCP*
D
Chapter 11 Slide 58
D2 = consumer 2
D1 = consumer 1
Q1Q2
The price,P*,will be
greater than MC,Set T*
at the surplus value of D2.T*
Two-Part Tariff with Two Consumers
Quantity
$/Q
MC
A
B
C
A B C e t h an t w i cm o r e
)()(2 21**
QQxMCPT
Chapter 11 Slide 59
The Two-Part Tariff
The Two-Part Tariff With Many Different
Consumers
No exact way to determine P* and T*.
Must consider the trade-off between the
entry fee T* and the use fee P*.
Low entry fee,High sales and falling
profit with lower price and more entrants.
Chapter 11 Slide 60
The Two-Part Tariff
The Two-Part Tariff With Many Different
Consumers
To find optimum combination,choose
several combinations of P,T.
Choose the combination that maximizes
profit.
Chapter 11 Slide 61
Two-Part Tariff with
Many Different Consumers
T
Profit
a?
:entry fee
s?,sales
Total?
T*
Total profit is the sum of the
profit from the entry fee and
the profit from sales,Both
depend on T.
e n tr a n tsn
nQMCPTTnsa
)()()(
Chapter 11 Slide 62
The Two-Part Tariff
Rule of Thumb
Similar demand,Choose P close to MC
and high T
Dissimilar demand,Choose high P and low
T.
Chapter 11 Slide 63
The Two-Part Tariff
Two-Part Tariff With A Twist
Entry price (T) entitles the buyer to a
certain number of free units
Gillette razors with several blades
Amusement parks with some tokens
On-line with free time
Chapter 11 Slide 64
Polaroid Cameras
1971 Polaroid introduced the SX-70
camera
What Do You Think?
How would you price the camera and film?
Chapter 11 Slide 65
Polaroid Cameras
Hint
c a m e r a s p r o d u c in g of c o s t
f ilm p r o d u c in g of c o s t
s o ld c a m e r a s of n u m b e r
s o ld f ilm ofq u a n t it y
c a m e r a of p r ic e
f ilm of p r ic e
)(
)(
)()(
2
1
21
nC
QC
n
Q
T
P
nCQCnTPQ?
Chapter 11 Slide 66
Pricing Cellular Phone Service
Question
Why do cellular phone providers offer
several different plans instead of a single
two-part tariff with an access fee and per-
unit charge?
Chapter 11 Slide 67
Bundling
Bundling is packaging two or more
products to gain a pricing advantage.
Conditions necessary for bundling
Heterogeneous customers
Price discrimination is not possible
Demands must be negatively correlated
Chapter 11 Slide 68
Bundling
An example,Leasing,Gone with the
Wind” &,Getting Gerties Garter.”
The reservation prices for each theater and
movie are:
Gone with the Wind Getting Gertie’s Garter
Theater A $12,000 $3,000
Theater B $10,000 $4,000
Chapter 11 Slide 69
Bundling
Renting the movies separately would
result in each theater paying the lowest
reservation price for each movie:
Maximum price Wind = $10,000
Maximum price Gertie = $3,000
Total Revenue = $26,000
Chapter 11 Slide 70
Bundling
If the movies are bundled:
Theater A will pay $15,000 for both
Theater B will pay $14,000 for both
If each were charged the lower of the
two prices,total revenue will be
$28,000.
Chapter 11 Slide 71
Bundling
Negative Correlated,Profitable to
Bundle
A pays more for Wind ($12,000) than B
($10,000).
B pays more for Gertie ($4,000) than A
($3,000).
Relative Valuations
Chapter 11 Slide 72
Bundling
If the demands were positively
correlated (Theater A would pay more
for both films as shown) bundling would
not result in an increase in revenue.
Gone with the Wind Getting Gertie’s Garter
Theater A $12,000 $4,000
Theater B $10,000 $3,000
Relative Valuations
Chapter 11 Slide 73
Bundling
If the movies are bundled:
Theater A will pay $16,000 for both
Theater B will pay $13,000 for both
If each were charged the lower of the
two prices,total revenue will be
$26,000,the same as by selling the
films separately.
Chapter 11 Slide 74
Bundling
Bundling Scenario,Two different goods
and many consumers
Many consumers with different reservation
price combinations for two goods
Chapter 11 Slide 75
Reservation Prices
r2
(reservation
price Good 2)
r1
(reservation price
Good 1)
$5
$10
$5 $10
$6
$3.25 $8.25
$3.25
Consumer
A
Consumer
C
Consumer
B
Consumer A is
willing to pay up to
$3.25 for good 1 and
up to $6 for good 2.
Chapter 11 Slide 76
Consumption Decisions When
Products are Sold Separately
r2
r1
P2
II
Consumers buy
only good 2
22
11
PR
PR
P1
Consumers fall into
four categories based
on their reservation
price.I
Consumers buy
both goods
22
11
PR
PR
III
Consumers buy
neither good
22
11
PR
PR
IV
Consumers buy
only Good 1
22
11
PR
PR
Chapter 11 Slide 77
Consumption Decisions
When Products are Bundled
r2
r1
Consumers buy the bundle
when r1 + r2 > PB
(PB = bundle price).
PB = r1 + r2 or r2 = PB - r1
Region 1,r > PB
Region 2,r < PB
r2 = PB - r1
I
II
Consumers
buy bundle
(r > PB)
Consumers do
not buy bundle
(r < PB)
Chapter 11 Slide 78
The effectiveness of bundling depends
upon the degree of negative correlation
between the two demands.
Consumption Decisions
When Products are Bundled
Chapter 11 Slide 79
Reservation Prices
r2
r1
P2
P1
If the demands are
perfectly positively
correlated,the firm
will not gain by bundling.
It would earn the same
profit by selling the
goods separately.
Chapter 11 Slide 80
Reservation Prices
r2
r1
If the demands are
perfectly negatively
correlated bundling is the
ideal strategy--all the
consumer surplus can
be extracted and a higher
profit results.
Chapter 11 Slide 81
Movie Example
r2
r1
Bundling pays due to
negative correlation
(Wind)
(Gertie)
5,000 14,00010,000
5,000
10,000
12,000
4,000
3,000
B
A
Chapter 11 Slide 82
Bundling
Mixed Bundling
Selling both as a bundle and separately
Pure Bundling
Selling only a package
Chapter 11 Slide 83
Mixed Versus Pure Bundling
r2
r110 20 30 40 50 60 70 80 90 100
10
20
30
40
50
60
70
80
90
100
C2 = MC2
C2 = 30
Consumer A,for example,has
a reservation price for good 1
that is below marginal cost c1.
With mixed bundling,consumer A
is induced to buy only good 2,while
consumer D is induced to buy only good 1,
reducing the firm’s cost.
A
B
D
C
C1 = MC1
C1 = 20 With positive marginalcosts,mixed bundling
may be more profitable
than pure bundling.
Chapter 11 Slide 84
Bundling
Scenario
Perfect negative correlation
Significant marginal cost
Mixed vs,Pure Bundling
Chapter 11 Slide 85
Bundling
Observations
Reservation price is below MC for some
consumers
Mixed bundling induces the consumers to buy only
goods for which their reservation price is greater
than MC
Mixed vs,Pure Bundling
Chapter 11 Slide 86
Bundling Example
Sell Separately
Consumers B,C,and D buy 1 and A buys 2
Pure Bundling
Consumers A,B,C,and D buy the bundle
Mixed Bundling
Consumer D buys 1,A buys 2,and B & C
buys the bundle
Chapter 11 Slide 87
Bundling Example
Sell separately $50 $90 ---- $150
Pure bundling ---- ---- $100 $200
Mixed bundling $89.95 $89.95 $100 $229.90
C1 = $20
C2 = $30
P1 P2 PB Profit
Chapter 11 Slide 88
Bundling
Sell Separately
3($50 - $20) + 1($90 - $30) = $150
Pure Bundling
4($100 - $20 - $30) = $200
Mixed Bundling
($89.95 - $20) + ($89.95 - $30) - 2($100 - $20 - $30) =
$229.90
C1 = $20 C2 = $30
Chapter 11 Slide 89
Bundling
Question
If MC = 0,would mixed bundling still be the
most profitable strategy with perfect
negative correlation?
Chapter 11 Slide 90
Mixed Bundling
with Zero Marginal Costs
r2
r120 40 60 80 100
20
40
60
80
100
120
120
In this example,consumers B and C
are willing to pay $20 more for the bundle
than are consumers A and D,With
mixed bundling,the price of the bundle
can be increased to $120.
A & D can be charged $90 for a single good.
C
10 90
10
90 A B
D
Chapter 11 Slide 91
Sell separately $80 $80 ---- $320
Pure bundling ---- ---- $100 $400
Mixed bundling $90 $90 $120 $420
P1 P2 PB Profit
Mixed Bundling
with Zero Marginal Costs
Chapter 11 Slide 92
Bundling
Question
Why is mixed bundling more profitable with
MC = 0?
Chapter 11 Slide 93
Bundling
Bundling in Practice
Automobile option packages
Vacation travel
Cable television
Chapter 11 Slide 94
Bundling
Mixed Bundling in Practice
Use of market surveys to determine
reservation prices
Design a pricing strategy from the survey
results
Chapter 11 Slide 95
Mixed Bundling in Practice
r2
r1
The firm can first choose a price
for the bundle and then try individual
prices P1 and P2 until total profit
is roughly maximized.
P2
PB
PBP1
The dots are estimates of
reservation prices for a
representative sample of consumers.
Chapter 11 Slide 96
The Complete Dinner Versus a la Carte:
A Restaurant’s Pricing Problem
Pricing to match consumer preferences
for various selections
Mixed bundling allows the customer to
get maximum utility from a given
expenditure by allowing a greater
number of choices.
Chapter 11 Slide 97
Bundling
Tying
Practice of requiring a customer to
purchase one good in order to purchase
another.
Examples
Xerox machines and the paper
IBM mainframe and computer cards
Chapter 11 Slide 98
Bundling
Tying
Allows the seller to meter the customer and
use a two-part tariff to discriminate against
the heavy user
McDonald’s
Allows them to protect their brand name.
Chapter 11 Slide 99
Advertising
Assumptions
Firm sets only one price
Firm knows Q(P,A)
How quantity demanded depends on
price and advertising
Chapter 11 Slide 100
Q0
0?
P0
Q1
1?
P1
AR
MR
AR and MR are average
and marginal revenue when
the firm doesn’t advertise.
MC
If the firm advertises,
its average and marginal
revenue curves shift to
the right -- average costs
rise,but marginal cost
does not.
AR’
MR’
AC’
Effects of Advertising
Quantity
$/Q
AC
Chapter 11 Slide 101
Advertising
Choosing Price and Advertising
Expenditure
a d v,of MC f u ll1
)(),(
A
Q
MC
A
Q
PMR
AQCAPPQ
A d s
Chapter 11 Slide 102
Advertising
A Rule of Thumb for Advertising
r a t i o s a l e s t oA d v,
1)(
p r i c i n gf o r /1/)(
PQ
A
A
Q
Q
A
P
MCP
A
Q
P - MC
EPMCP
P
Chapter 11 Slide 103
Advertising
A Rule of Thumb for Advertising
T h u m b of R u l e
d e m a n d of e l a s t i c i t y A d v,
P
)(
1)(
))((
PA
A
EEPQA
EPMCP
EAQQA
Chapter 11 Slide 104
Advertising
A Rule of Thumb for Advertising
To maximize profit,the firm’s
advertising-to-sales ratio should be
equal to minus the ratio of the
advertising and price elasticities of
demand.
Chapter 11 Slide 105
Advertising
An Example
R(Q) = $1 million/yr
$10,000 budget for A (advertising--1% of
revenues)
EA =,2 (increase budget $20,000,sales
increase by 20%
EP = -4 (markup price over MC is
substantial)
Chapter 11 Slide 106
Advertising
Question
Should the firm increase advertising?
Chapter 11 Slide 107
Advertising
YES
A/PQ = -(2/-.4) = 5%
Increase budget to $50,000
Chapter 11 Slide 108
Advertising
Questions
When EA is large,do you advertise more or
less?
When EP is large,do you advertise more or
less?
Chapter 11 Slide 109
Advertising
Advertising,In Practice
Estimate the level of advertising for each of
the firms
Supermarkets
Convenience stores
Designer jeans
Laundry detergents
)3.01.0;10( to AP EE
);5( s m a l lv e r y AP EE
)13.;43( to to AP EE
);43(
la r g eve r y
to
A
P
E
E
Chapter 11 Slide 110
Summary
Firms with market power are in an enviable
position because they have the potential to
earn large profits,but realizing that potential
may depend critically on the firm’s pricing
strategy.
A pricing strategy aims to enlarge the
customer base that the firm can sell to,and
capture as much consumer surplus as
possible.
Chapter 11 Slide 111
Summary
Ideally,the firm would like to perfectly
price discriminate.
The two-part tariff is another means of
capturing consumer surplus.
When demands are heterogeneous and
negatively correlated,bundling can
increase profits.
Chapter 11 Slide 112
Summary
Bundling is a special case of tying,a
requirement that products be bought or
sold in some combination.
Advertising can further increase profits.
End of Chapter 11
Pricing with
Market Power
Pricing with
Market Power
Chapter 11 Slide 2
Topics to be Discussed
Capturing Consumer Surplus
Price Discrimination
Intertemporal Price Discrimination and
Peak-Load Pricing
Chapter 11 Slide 3
Topics to be Discussed
The Two-Part Tariff
Bundling
Advertising
Chapter 11 Slide 4
Introduction
Pricing without market power (perfect
competition) is determined by market
supply and demand.
The individual producer must be able to
forecast the market and then
concentrate on managing production
(cost) to maximize profits.
Chapter 11 Slide 5
Introduction
Pricing with market power (imperfect
competition) requires the individual
producer to know much more about the
characteristics of demand as well as
manage production.
Chapter 11 Slide 6
Capturing Consumer Surplus
Quantity
$/Q
D
MR
Pmax
MC If price is raised above
P*,the firm will lose
sales and reduce profit.
PC
PC is the price
that would exist in
a perfectly competitive
market.
A
P*
Q*
P1
Between 0 and Q*,consumers
will pay more than
P*--consumer surplus (A).
B
P2
Beyond Q*,price will
have to fall to create a
consumer surplus (B).
Chapter 11 Slide 7
Capturing Consumer Surplus
P*Q*,single P & Q @ MC=MR
A,consumer surplus with P*
B,P>MC & consumer would buy
at a lower price
P1,less sales and profits
P2,increase sales & and reduce
revenue and profits
PC,competitive price
Quantity
$/Q
D
MR
Pmax
MCP
C
A
P*
Q*
P1
B
P2
Chapter 11 Slide 8
Capturing Consumer Surplus
Quantity
$/Q
D
MR
Pmax
MCP
C
A
P*
Q*
P1
B
P2
Question
How can the firm
capture the consumer surplus
in A and sell profitably in B?
Answer
Price discrimination
Two-part tariffs
Bundling
Chapter 11 Slide 9
Capturing Consumer Surplus
Price discrimination is the charging of
different prices to different consumers
for similar goods.
Chapter 11 Slide 10
Price Discrimination
First Degree Price Discrimination
Charge a separate price to each customer,
the maximum or reservation price they are
willing to pay.
Chapter 11 Slide 11
P*
Q*
Without price discrimination,
output is Q* and price is P*.
Variable profit is the area
between the MC & MR (yellow).
Additional Profit From Perfect First-
Degree Price Discrimination
Quantity
$/Q Pmax
With perfect discrimination,each
consumer pays the maximum
price they are willing to pay.
Consumer surplus is the area
above P* and between
0 and Q* output.
D = AR
MR
MC
Output expands to Q** and price
falls to PC where MC = MR = AR = D.
Profits increase by the area above MC
between old MR and D to output
Q** (purple)
Q**
PC
Chapter 11 Slide 12
P*
Q*
Consumer surplus when a
single price P* is charged.
Variable profit when a
single price P* is charged.
Additional profit from
perfect price discrimination
Quantity
$/Q Pmax
D = AR
MR
MC
Q**
PC
With perfect discrimination
Each customer pays their
reservation price
Profits increase
Additional Profit From Perfect First-
Degree Price Discrimination
Chapter 11 Slide 13
Question
Why would a producer have difficulty in
achieving first-degree price discrimination?
Answer
1) Too many customers (impractical)
2) Could not estimate the reservation
price for each customer
Additional Profit From Perfect First-
Degree Price Discrimination
Chapter 11 Slide 14
Price Discrimination
First Degree Price Discrimination
The model does demonstrate the potential
profit (incentive) of practicing price
discrimination to some degree.
Chapter 11 Slide 15
Price Discrimination
First Degree Price Discrimination
Examples of imperfect price discrimination
where the seller has the ability to
segregate the market to some extent and
charge different prices for the same
product:
Lawyers,doctors,accountants
Car salesperson (15% profit margin)
Colleges and universities
Chapter 11 Slide 16
First-Degree Price
Discrimination in Practice
Quantity
D
MR
MC
$/Q
P2
P3
P*4
P5
P6
P1
Six prices exist resulting
in higher profits,With a single price
P*4,there are few consumers and
those who pay P5 or P6 may have a surplus.
Q
Second-Degree Price Discrimination
Quantity
$/Q
D
MR
MC
AC
P0
Q0
Without discrimination,P = P0
and Q = Q0,With second-degree
discrimination there are three
prices P1,P2,and P3.
(e.g,electric utilities)
P1
Q1
1st Block
P2
Q2
P3
Q3
2nd Block 3rd Block
Second-degree price
discrimination is pricing
according to quantity
consumed--or in blocks.
Second-Degree Price Discrimination
Quantity
$/Q
D
MR
MC
AC
P0
Q0
P1
Q1
1st Block
P2
Q2
P3
Q3
2nd Block 3rd Block
Economies of scale permit:
Increase consumer welfare
Higher profits
Chapter 11 Slide 19
Price Discrimination
Third Degree Price Discrimination
1) Divides the market into two-groups.
2) Each group has its own demand
function.
Chapter 11 Slide 20
Price Discrimination
Third Degree Price Discrimination
3) Most common type of price
discrimination.
Examples,airlines,liquor,vegetables,
discounts to students and senior
citizens.
Chapter 11 Slide 21
Price Discrimination
Third Degree Price Discrimination
4) Third-degree price discrimination is
feasible when the seller can
separate his/her market into groups
who have different price elasticities
of demand (e.g,business air
travelers versus vacation air
travelers)
Chapter 11 Slide 22
Price Discrimination
Third Degree Price Discrimination
Objectives
MR1 = MR2
MC1 = MR1 and MC2 = MR2
MR1 = MR2 = MC
Chapter 11 Slide 23
Price Discrimination
Third Degree Price Discrimination
P1,price first group
P2,price second group
C(Qr) = total cost of QT = Q1 + Q2
Profit ( ) = P1Q1 + P2Q2 - C(Qr)?
Chapter 11 Slide 24
Price Discrimination
Third Degree Price Discrimination
Set incremental for sales to group 1 = 0
0
(
11
)11
1
Q
C
Q
QP
Q
MC
Q
CMR
Q
QP?
1
1
1
11 )(
Chapter 11 Slide 25
Price Discrimination
Third Degree Price Discrimination
Second group of customers,MR2 = MC
MR1 = MR2 = MC
Chapter 11 Slide 26
Price Discrimination
Third Degree Price Discrimination
Determining relative prices
)11()11(
11
222111 EPMREPMR
EPMR d
,T h e n
,R e ca l l
Chapter 11 Slide 27
Price Discrimination
Third Degree Price Discrimination
Determining relative prices
Pricing,Charge higher price to group with
a low demand elasticity
)11(
)11(
1
2
2
1
E
E
P
P
,An d
Chapter 11 Slide 28
Price Discrimination
Third Degree Price Discrimination
Example,E1 = -2 & E2 = -4
P1 should be 1.5 times as high as P2
5.12143
)211(
)411(
2
1
P
P
Chapter 11 Slide 29
Third-Degree Price Discrimination
Quantity
D2 = AR2
MR2
$/Q
D1 = AR1MR1
Consumers are divided into
two groups,with separate
demand curves for each group.
MRT
MRT = MR1 + MR2
Chapter 11 Slide 30
Third-Degree Price Discrimination
Quantity
D2 = AR2
MR2
$/Q
D1 = AR1MR1
MRT
MC
Q2
P2
QT
QT,MC = MRT
Group 1,P1Q1 ; more elastic
Group 2,P2Q2; more inelastic
MR1 = MR2 = MC
QT control MC
Q1
P1
MC = MR1 at Q1 and P1
Chapter 11 Slide 31
No Sales to Smaller Market
Even if third-degree price
discrimination is feasible,it doesn’t
always pay to sell to both groups
of consumers if marginal cost is rising.
Chapter 11 Slide 32
No Sales to Smaller Market
Quantity
D2
MR2
$/Q
MC
D1
MR1 Q*
P*
Group one,with
demand D1,are not
willing to pay enough
for the good to
make price
discrimination profitable.
Chapter 11 Slide 33
The Economics of Coupons and Rebates
Those consumers who are more price
elastic will tend to use the
coupon/rebate more often when they
purchase the product than those
consumers with a less elastic demand.
Coupons and rebate programs allow
firms to price discriminate.
Price Discrimination
Chapter 11 Slide 34
Price Elasticities of Demand for Users
Versus Nonusers of Coupons
Toilet tissue -0.60 -0.66
Stuffing/dressing -0.71 -0.96
Shampoo -0.84 -1.04
Cooking/salad oil -1.22 -1.32
Dry mix dinner -0.88 -1.09
Cake mix -0.21 -0.43
Price Elasticity
Product Nonusers Users
Chapter 11 Slide 35
Cat food -0.49 -1.13
Frozen entrée -0.60 -0.95
Gelatin -0.97 -1.25
Spaghetti sauce -1.65 -1.81
Crème rinse/conditioner -0.82 -1.12
Soup -1.05 -1.22
Hot dogs -0.59 -0.77
Price Elasticity
Product Nonusers Users
Price Elasticities of Demand for Users
Versus Nonusers of Coupons
Chapter 11 Slide 36
The Economics of Coupons and Rebates
Cake Mix
Nonusers of coupons,PE = -0.21
Users,PE = -0.43
Chapter 11 Slide 37
The Economics of Coupons and Rebates
Cake Mix Brand (Pillsbury)
PE,8 to 10 times cake mix PE
Example
PE Users,-4
PE Nonusers,-2
Chapter 11 Slide 38
The Economics of Coupons and Rebates
Using,
Price of nonusers should be 1.5 times
users
Or,if cake mix sells for $1.50,coupons
should be 50 cents
)11(
)11(
1
2
2
1
E
E
P
P
Chapter 11 Slide 39
Airline Fares
Differences in elasticities imply that
some customers will pay a higher fare
than others.
Business travelers have few choices
and their demand is less elastic.
Casual travelers have choices and are
more price sensitive.
Chapter 11 Slide 40
Elasticities of
Demand for Air Travel
Price -0.3 -0.4 -0.9
Income 1.2 1.2 1.8
Fare Category
Elasticity First-Class Unrestricted Coach Discount
Chapter 11 Slide 41
Airline Fares
The airlines separate the market by
setting various restrictions on the
tickets.
Less expensive,notice,stay over the
weekend,no refund
Most expensive,no restrictions
Chapter 11 Slide 42
Intertemporal Price
Discrimination and Peak-Load Pricing
Separating the Market With Time
Initial release of a product,the demand is
inelastic
Book
Movie
Computer
Chapter 11 Slide 43
Separating the Market With Time
Once this market has yielded a maximum
profit,firms lower the price to appeal to a
general market with a more elastic demand
Paper back books
Dollar Movies
Discount computers
Intertemporal Price
Discrimination and Peak-Load Pricing
Chapter 11 Slide 44
Intertemporal Price Discrimination
Quantity
AC = MC
$/Q
Over time,demand becomes
more elastic and price
is reduced to appeal to the
mass market.
Q2
MR2
D2 = AR2
P2
D1 = AR1MR1
P1
Q1
Consumers are divided
into groups over time.
Initially,demand is less
elastic resulting in a
price of P1,
Chapter 11 Slide 45
Demand for some products may peak at
particular times.
Rush hour traffic
Electricity - late summer afternoons
Ski resorts on weekends
Intertemporal Price
Discrimination and Peak-Load Pricing
Peak-Load Pricing
Chapter 11 Slide 46
Capacity restraints will also increase
MC.
Increased MR and MC would indicate a
higher price.
Peak-Load Pricing
Intertemporal Price
Discrimination and Peak-Load Pricing
Chapter 11 Slide 47
MR is not equal for each market
because one market does not impact
the other market.
Peak-Load Pricing
Intertemporal Price
Discrimination and Peak-Load Pricing
Chapter 11 Slide 48
MR1
D1 = AR1
MC
P1
Q1
Peak-load
price = P1,
Peak-Load Pricing
Quantity
$/Q
MR2
D2 = AR2
Off- load
price = P2,
Q2
P2
Chapter 11 Slide 49
How to Price a Best Selling Novel
What Do You Think?
1) How would you arrive at the price for
the initial release of the hardbound
edition of a book?
Chapter 11 Slide 50
How to Price a Best Selling Novel
What Do You Think?
2) How long do you wait to release the
paperback edition? Could the
popularity of the book impact your
decision?
Chapter 11 Slide 51
What Do You Think?
3) How do you determine the price for
the paperback edition?
How to Price a Best Selling Novel
Chapter 11 Slide 52
The Two-Part Tariff
The purchase of some products and
services can be separated into two
decisions,and therefore,two prices.
Chapter 11 Slide 53
The Two-Part Tariff
Examples
1) Amusement Park
Pay to enter
Pay for rides and food within the park
2) Tennis Club
Pay to join
Pay to play
Chapter 11 Slide 54
The Two-Part Tariff
Examples
3) Rental of Mainframe Computers
Flat Fee
Processing Time
4) Safety Razor
Pay for razor
Pay for blades
Chapter 11 Slide 55
The Two-Part Tariff
Examples
5) Polaroid Film
Pay for the camera
Pay for the film
Chapter 11 Slide 56
The Two-Part Tariff
Pricing decision is setting the entry
fee (T) and the usage fee (P).
Choosing the trade-off between free-
entry and high use prices or high-entry
and zero use prices.
Chapter 11 Slide 57
Usage price P*is set where
MC = D,Entry price T*
is equal to the entire
consumer surplus.
T*
Two-Part Tariff with a Single Consumer
Quantity
$/Q
MCP*
D
Chapter 11 Slide 58
D2 = consumer 2
D1 = consumer 1
Q1Q2
The price,P*,will be
greater than MC,Set T*
at the surplus value of D2.T*
Two-Part Tariff with Two Consumers
Quantity
$/Q
MC
A
B
C
A B C e t h an t w i cm o r e
)()(2 21**
QQxMCPT
Chapter 11 Slide 59
The Two-Part Tariff
The Two-Part Tariff With Many Different
Consumers
No exact way to determine P* and T*.
Must consider the trade-off between the
entry fee T* and the use fee P*.
Low entry fee,High sales and falling
profit with lower price and more entrants.
Chapter 11 Slide 60
The Two-Part Tariff
The Two-Part Tariff With Many Different
Consumers
To find optimum combination,choose
several combinations of P,T.
Choose the combination that maximizes
profit.
Chapter 11 Slide 61
Two-Part Tariff with
Many Different Consumers
T
Profit
a?
:entry fee
s?,sales
Total?
T*
Total profit is the sum of the
profit from the entry fee and
the profit from sales,Both
depend on T.
e n tr a n tsn
nQMCPTTnsa
)()()(
Chapter 11 Slide 62
The Two-Part Tariff
Rule of Thumb
Similar demand,Choose P close to MC
and high T
Dissimilar demand,Choose high P and low
T.
Chapter 11 Slide 63
The Two-Part Tariff
Two-Part Tariff With A Twist
Entry price (T) entitles the buyer to a
certain number of free units
Gillette razors with several blades
Amusement parks with some tokens
On-line with free time
Chapter 11 Slide 64
Polaroid Cameras
1971 Polaroid introduced the SX-70
camera
What Do You Think?
How would you price the camera and film?
Chapter 11 Slide 65
Polaroid Cameras
Hint
c a m e r a s p r o d u c in g of c o s t
f ilm p r o d u c in g of c o s t
s o ld c a m e r a s of n u m b e r
s o ld f ilm ofq u a n t it y
c a m e r a of p r ic e
f ilm of p r ic e
)(
)(
)()(
2
1
21
nC
QC
n
Q
T
P
nCQCnTPQ?
Chapter 11 Slide 66
Pricing Cellular Phone Service
Question
Why do cellular phone providers offer
several different plans instead of a single
two-part tariff with an access fee and per-
unit charge?
Chapter 11 Slide 67
Bundling
Bundling is packaging two or more
products to gain a pricing advantage.
Conditions necessary for bundling
Heterogeneous customers
Price discrimination is not possible
Demands must be negatively correlated
Chapter 11 Slide 68
Bundling
An example,Leasing,Gone with the
Wind” &,Getting Gerties Garter.”
The reservation prices for each theater and
movie are:
Gone with the Wind Getting Gertie’s Garter
Theater A $12,000 $3,000
Theater B $10,000 $4,000
Chapter 11 Slide 69
Bundling
Renting the movies separately would
result in each theater paying the lowest
reservation price for each movie:
Maximum price Wind = $10,000
Maximum price Gertie = $3,000
Total Revenue = $26,000
Chapter 11 Slide 70
Bundling
If the movies are bundled:
Theater A will pay $15,000 for both
Theater B will pay $14,000 for both
If each were charged the lower of the
two prices,total revenue will be
$28,000.
Chapter 11 Slide 71
Bundling
Negative Correlated,Profitable to
Bundle
A pays more for Wind ($12,000) than B
($10,000).
B pays more for Gertie ($4,000) than A
($3,000).
Relative Valuations
Chapter 11 Slide 72
Bundling
If the demands were positively
correlated (Theater A would pay more
for both films as shown) bundling would
not result in an increase in revenue.
Gone with the Wind Getting Gertie’s Garter
Theater A $12,000 $4,000
Theater B $10,000 $3,000
Relative Valuations
Chapter 11 Slide 73
Bundling
If the movies are bundled:
Theater A will pay $16,000 for both
Theater B will pay $13,000 for both
If each were charged the lower of the
two prices,total revenue will be
$26,000,the same as by selling the
films separately.
Chapter 11 Slide 74
Bundling
Bundling Scenario,Two different goods
and many consumers
Many consumers with different reservation
price combinations for two goods
Chapter 11 Slide 75
Reservation Prices
r2
(reservation
price Good 2)
r1
(reservation price
Good 1)
$5
$10
$5 $10
$6
$3.25 $8.25
$3.25
Consumer
A
Consumer
C
Consumer
B
Consumer A is
willing to pay up to
$3.25 for good 1 and
up to $6 for good 2.
Chapter 11 Slide 76
Consumption Decisions When
Products are Sold Separately
r2
r1
P2
II
Consumers buy
only good 2
22
11
PR
PR
P1
Consumers fall into
four categories based
on their reservation
price.I
Consumers buy
both goods
22
11
PR
PR
III
Consumers buy
neither good
22
11
PR
PR
IV
Consumers buy
only Good 1
22
11
PR
PR
Chapter 11 Slide 77
Consumption Decisions
When Products are Bundled
r2
r1
Consumers buy the bundle
when r1 + r2 > PB
(PB = bundle price).
PB = r1 + r2 or r2 = PB - r1
Region 1,r > PB
Region 2,r < PB
r2 = PB - r1
I
II
Consumers
buy bundle
(r > PB)
Consumers do
not buy bundle
(r < PB)
Chapter 11 Slide 78
The effectiveness of bundling depends
upon the degree of negative correlation
between the two demands.
Consumption Decisions
When Products are Bundled
Chapter 11 Slide 79
Reservation Prices
r2
r1
P2
P1
If the demands are
perfectly positively
correlated,the firm
will not gain by bundling.
It would earn the same
profit by selling the
goods separately.
Chapter 11 Slide 80
Reservation Prices
r2
r1
If the demands are
perfectly negatively
correlated bundling is the
ideal strategy--all the
consumer surplus can
be extracted and a higher
profit results.
Chapter 11 Slide 81
Movie Example
r2
r1
Bundling pays due to
negative correlation
(Wind)
(Gertie)
5,000 14,00010,000
5,000
10,000
12,000
4,000
3,000
B
A
Chapter 11 Slide 82
Bundling
Mixed Bundling
Selling both as a bundle and separately
Pure Bundling
Selling only a package
Chapter 11 Slide 83
Mixed Versus Pure Bundling
r2
r110 20 30 40 50 60 70 80 90 100
10
20
30
40
50
60
70
80
90
100
C2 = MC2
C2 = 30
Consumer A,for example,has
a reservation price for good 1
that is below marginal cost c1.
With mixed bundling,consumer A
is induced to buy only good 2,while
consumer D is induced to buy only good 1,
reducing the firm’s cost.
A
B
D
C
C1 = MC1
C1 = 20 With positive marginalcosts,mixed bundling
may be more profitable
than pure bundling.
Chapter 11 Slide 84
Bundling
Scenario
Perfect negative correlation
Significant marginal cost
Mixed vs,Pure Bundling
Chapter 11 Slide 85
Bundling
Observations
Reservation price is below MC for some
consumers
Mixed bundling induces the consumers to buy only
goods for which their reservation price is greater
than MC
Mixed vs,Pure Bundling
Chapter 11 Slide 86
Bundling Example
Sell Separately
Consumers B,C,and D buy 1 and A buys 2
Pure Bundling
Consumers A,B,C,and D buy the bundle
Mixed Bundling
Consumer D buys 1,A buys 2,and B & C
buys the bundle
Chapter 11 Slide 87
Bundling Example
Sell separately $50 $90 ---- $150
Pure bundling ---- ---- $100 $200
Mixed bundling $89.95 $89.95 $100 $229.90
C1 = $20
C2 = $30
P1 P2 PB Profit
Chapter 11 Slide 88
Bundling
Sell Separately
3($50 - $20) + 1($90 - $30) = $150
Pure Bundling
4($100 - $20 - $30) = $200
Mixed Bundling
($89.95 - $20) + ($89.95 - $30) - 2($100 - $20 - $30) =
$229.90
C1 = $20 C2 = $30
Chapter 11 Slide 89
Bundling
Question
If MC = 0,would mixed bundling still be the
most profitable strategy with perfect
negative correlation?
Chapter 11 Slide 90
Mixed Bundling
with Zero Marginal Costs
r2
r120 40 60 80 100
20
40
60
80
100
120
120
In this example,consumers B and C
are willing to pay $20 more for the bundle
than are consumers A and D,With
mixed bundling,the price of the bundle
can be increased to $120.
A & D can be charged $90 for a single good.
C
10 90
10
90 A B
D
Chapter 11 Slide 91
Sell separately $80 $80 ---- $320
Pure bundling ---- ---- $100 $400
Mixed bundling $90 $90 $120 $420
P1 P2 PB Profit
Mixed Bundling
with Zero Marginal Costs
Chapter 11 Slide 92
Bundling
Question
Why is mixed bundling more profitable with
MC = 0?
Chapter 11 Slide 93
Bundling
Bundling in Practice
Automobile option packages
Vacation travel
Cable television
Chapter 11 Slide 94
Bundling
Mixed Bundling in Practice
Use of market surveys to determine
reservation prices
Design a pricing strategy from the survey
results
Chapter 11 Slide 95
Mixed Bundling in Practice
r2
r1
The firm can first choose a price
for the bundle and then try individual
prices P1 and P2 until total profit
is roughly maximized.
P2
PB
PBP1
The dots are estimates of
reservation prices for a
representative sample of consumers.
Chapter 11 Slide 96
The Complete Dinner Versus a la Carte:
A Restaurant’s Pricing Problem
Pricing to match consumer preferences
for various selections
Mixed bundling allows the customer to
get maximum utility from a given
expenditure by allowing a greater
number of choices.
Chapter 11 Slide 97
Bundling
Tying
Practice of requiring a customer to
purchase one good in order to purchase
another.
Examples
Xerox machines and the paper
IBM mainframe and computer cards
Chapter 11 Slide 98
Bundling
Tying
Allows the seller to meter the customer and
use a two-part tariff to discriminate against
the heavy user
McDonald’s
Allows them to protect their brand name.
Chapter 11 Slide 99
Advertising
Assumptions
Firm sets only one price
Firm knows Q(P,A)
How quantity demanded depends on
price and advertising
Chapter 11 Slide 100
Q0
0?
P0
Q1
1?
P1
AR
MR
AR and MR are average
and marginal revenue when
the firm doesn’t advertise.
MC
If the firm advertises,
its average and marginal
revenue curves shift to
the right -- average costs
rise,but marginal cost
does not.
AR’
MR’
AC’
Effects of Advertising
Quantity
$/Q
AC
Chapter 11 Slide 101
Advertising
Choosing Price and Advertising
Expenditure
a d v,of MC f u ll1
)(),(
A
Q
MC
A
Q
PMR
AQCAPPQ
A d s
Chapter 11 Slide 102
Advertising
A Rule of Thumb for Advertising
r a t i o s a l e s t oA d v,
1)(
p r i c i n gf o r /1/)(
PQ
A
A
Q
Q
A
P
MCP
A
Q
P - MC
EPMCP
P
Chapter 11 Slide 103
Advertising
A Rule of Thumb for Advertising
T h u m b of R u l e
d e m a n d of e l a s t i c i t y A d v,
P
)(
1)(
))((
PA
A
EEPQA
EPMCP
EAQQA
Chapter 11 Slide 104
Advertising
A Rule of Thumb for Advertising
To maximize profit,the firm’s
advertising-to-sales ratio should be
equal to minus the ratio of the
advertising and price elasticities of
demand.
Chapter 11 Slide 105
Advertising
An Example
R(Q) = $1 million/yr
$10,000 budget for A (advertising--1% of
revenues)
EA =,2 (increase budget $20,000,sales
increase by 20%
EP = -4 (markup price over MC is
substantial)
Chapter 11 Slide 106
Advertising
Question
Should the firm increase advertising?
Chapter 11 Slide 107
Advertising
YES
A/PQ = -(2/-.4) = 5%
Increase budget to $50,000
Chapter 11 Slide 108
Advertising
Questions
When EA is large,do you advertise more or
less?
When EP is large,do you advertise more or
less?
Chapter 11 Slide 109
Advertising
Advertising,In Practice
Estimate the level of advertising for each of
the firms
Supermarkets
Convenience stores
Designer jeans
Laundry detergents
)3.01.0;10( to AP EE
);5( s m a l lv e r y AP EE
)13.;43( to to AP EE
);43(
la r g eve r y
to
A
P
E
E
Chapter 11 Slide 110
Summary
Firms with market power are in an enviable
position because they have the potential to
earn large profits,but realizing that potential
may depend critically on the firm’s pricing
strategy.
A pricing strategy aims to enlarge the
customer base that the firm can sell to,and
capture as much consumer surplus as
possible.
Chapter 11 Slide 111
Summary
Ideally,the firm would like to perfectly
price discriminate.
The two-part tariff is another means of
capturing consumer surplus.
When demands are heterogeneous and
negatively correlated,bundling can
increase profits.
Chapter 11 Slide 112
Summary
Bundling is a special case of tying,a
requirement that products be bought or
sold in some combination.
Advertising can further increase profits.
End of Chapter 11
Pricing with
Market Power
