Managerial Economics

ninth edition

Thomas Maurice

Chapter 14
Advanced Pricing Techniques
McGraw-Hill/Irwin McGraw-Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

Managerial Economics

Advanced Pricing Techniques

Price discrimination Multiple products Cost-plus pricing

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Capturing Consumer Surplus

Uniform pricing
Charging the same price for every unit of the product
More profitable alternative to uniform pricing Market conditions must allow this practice to be profitably executed Technique of charging different prices for the same product Used to capture consumer surplus (turning consumer surplus into profit)

Price discrimination

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The Trouble with Uniform Pricing

(Figure 14.1)

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Price Discrimination
Exists when the price-to-marginal cost ratio differs between two products:

PA PB MC A MC B

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Price Discrimination
Three conditions necessary to practice price discrimination profitably:

1) Firm must possess some degree of market power 2) A cost-effective means of preventing resale between lower- and higher-price buyers (consumer arbitrage) must be implemented 3) Price elasticities must differ between individual buyers or groups of buyers
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First-Degree (Perfect) Price Discrimination

Every unit is sold for the maximum price each consumer is willing to pay
Allows the firm to capture entire consumer surplus

Difficulties
Requires precise knowledge about every buyers demand for the good Seller must negotiate a different price for every unit sold to every buyer
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First-Degree (Perfect) Price Discrimination (Figure 14.2)

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Second-Degree Price Discrimination

Lower prices are offered for larger quantities and buyers can self-select the price by choosing how much to buy When the same consumer buys more than one unit of a good or service at a time, the marginal value placed on additional units declines as more units are consumed
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Second-Degree Price Discrimination

Two-part pricing
Charges buyers a fixed access charge (A) to purchase as many units as they wish for a constant fee (f) per unit
Total expenditure (TE) for q units is:

TE A fq
Average price ( p) is:

TE A fq p q q

A f q
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Second-Degree Price Discrimination

When consumers have identical demands, entire consumer surplus can be captured by: Setting f = MC Setting A = consumer surplus (CS) Optimal usage fee when two groups of buyers have identical demands is the level for which MRf = MCf
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Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14.3)

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Demand at Northvale Golf Club

(Figure 14.4)

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Second-Degree Price Discrimination

Declining block pricing
Offers quantity discounts over successive discrete blocks of quantities purchased

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Block Pricing with Five Blocks

(Figure 14.5)

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Third-Degree Price Discrimination

If a firm sells in two markets, 1 & 2
Allocate output (sales) so MR1 = MR2 Optimal total output is that for which

MRT = MC

For profit-maximization, allocate sales of total output so that

MRT = MC = MR1 = MR2

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Third-Degree Price Discrimination

Equal-marginal-revenue principle
Allocating output (sales) so MR1 = MR2 which will maximize total revenue for the firm (TR1 + TR2) More elastic market gets lower price Less elastic market gets higher price

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Allocating Sales Between Markets

(Figure 14.6)

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Constructing the Marginal Revenue Curve (Figure 14.7)

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Profit-Maximization Under Third-Degree Price Discrimination (Figure 14.8)

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Multiple Products
Related in consumption
For two products, X & Y, produce & sell levels of output for which

MRX = MCX and MRY = MCY

MRX is a function not only of QX but also of QY (as is MRY) -- conditions

must be satisfied simultaneously

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Multiple Products
Related in production as substitutes For two products, X & Y, allocate
production facility so that

Optimal level of facility usage in the long run is where MRPT = MC For profit-maximization:

MRPX = MRPY

MRPT = MC = MRPX = MRPY

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Multiple Products
Related in production as complements
To maximize profit, set joint marginal revenue equal to marginal cost:

If profit-maximizing level of joint production exceeds output where MRJ kinks, units beyond zero MR are disposed of rather than sold Profit-maximizing prices are found using demand functions for the two goods
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MRJ = MC

Managerial Economics

Profit-Maximizing Allocation of Production Facilities (Figure 14.9)

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Profit-Maximization with Joint Products (Figure 14.11)

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Cost-Plus Pricing
Common technique for pricing when firms do not wish to estimate demand & cost conditions to apply the MR = MC rule for profit-maximization Price charged represents a markup (margin) over average cost:

P = (1 + m)ATC
Where m is the markup on unit cost
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Cost-Plus Pricing
Does not generally produce profitmaximizing price
Fails to incorporate information on demand & marginal revenue Uses average, not marginal, cost

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Practical Problems with Cost-Plus Pricing (Figure 14.13)

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