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MSU Weekend MBA Program– May 5, 2012

MSU Weekend MBA Program– May 5, 2012. Price Discrimination- Ch. 11, pgs 395-400, pgs 402-415. Profit Maximization when setting a Single Price. CONSUMER SURPLUS. PROFITS. Profits are maximized at Q=4 and P=6. Profits=TR-TC= 6*4-4.5*4= 24-18=6 Or Profits=P*Q-ATC*Q =(P-ATC)*Q

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MSU Weekend MBA Program– May 5, 2012

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  1. MSU Weekend MBA Program– May 5, 2012 Price Discrimination- Ch. 11, pgs 395-400, pgs 402-415

  2. Profit Maximization when setting a Single Price CONSUMER SURPLUS PROFITS • Profits are maximized at Q=4 and P=6. Profits=TR-TC= 6*4-4.5*4= 24-18=6 Or Profits=P*Q-ATC*Q =(P-ATC)*Q =(6-4.5)*4=6 • Consumer Surplus -the value consumers get from a good but do not have to pay for. Q MR

  3. Definition of Price Discrimination • The practice of charging different prices to consumers for the same good or service (and the price differences do not reflect cost differences)

  4. Web May Reduce Price DiscriminationThe New York Times, December 6, 2001

  5. Web May Reduce Price DiscriminationThe New York Times, December 6, 2001

  6. Three Conditions Required for Price Discrimination to Occur • Seller must exercise some “price control” (i.e. face a downward sloping demand) • Seller must be able to distinguish among customers who are willing to pay different prices. • It must be impossible or too costly for one buyer to resell the good to other buyers (i.e., buyers cannot arbitrage).

  7. Strategic Behavior By Firms What actions do firms take to prevent resale or make resale more “costly”? • Warranty becomes invalid if item is resold. • Software firms do not provide support services if software is resold. Any others you can think of?

  8. Types of Price Discrimination • First-Degree (Perfect) Price Discrimination - Occurs when the seller charges the highest price each consumer would be willing to pay for the product (consumer's reservation values) rather than go without it. • Universities, Car Dealers, Contractors, Flea Market (at least they all try) • Third-Degree Price Discrimination - Occurs when the seller charges different prices in different markets, or charges a different price to different segments of the buying population. • Movies, Soda, Computers, prescription drugs, textbooks, safety gates, airlines, dry cleaning, haircuts, …

  9. Types of Price Discrimination • Second-Degree Price Discrimination - Occurs when the seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on. QUANTITY DISCOUNTS (2-part Pricing is a type of quantity discount) • Electric Utilities, Country Clubs, Michigan Athletic Club, Disneyland (in old days), Grocery Stores, Espresso Royale, … • Peak Load Pricing – the practice of charging higher prices during “peak hours” (i.e. high demand times) than during off-peak hours. • Hotels, Ski Resorts, Airlines, Stadiums, Restaurants, Toll roads, Bridges, …

  10. Types of Price Discrimination • Bundling – the practice of bundling several different products together and selling them at a single “bundle price”. • Happy Meals, Restaurants, Stereos, Cars with Options, Celebrity Endorsements, Movies (years ago),… • Screening- the practice of requiring consumers to “jump over a hurdle” to obtain a lower price. • Coupons, Warranties, Rebates, Outlet malls, Saturday Night Stayovers for airlines,….

  11. No Price Discrimination • Profits are maximized at Q=20 and P=30. Profits=TR-TC =P*Q-ATC*Q =30*20-14*20=320 MR

  12. First-Degree (Perfect) Price Discrimination Definition: Occurs when the seller charges the highest price each consumer would be willing to pay for the product (consumer's reservation values) rather than go without it. • Universities, Car Dealers, Contractors, Flea Market (at least they all try)

  13. 1st-Degree Price Discrimination Charge Every Consumer the maximum he/she is willing to pay. The demand curve is based on what consumers are willing to pay.

  14. Market Demand is Obtained from Adding Individual Demand Curves

  15. Suppose Market Demand is Obtained from Individual Demands Below

  16. 1st-Degree Price Discrimination • What output would the firm produce to maximize profits if it could 1st-degree price discriminate? Q=30 • What would be the firm’s total revenue? TR=.5*(50-20)*30+20*30 =1050 • What would be the firm’s TC at an output of 30? TC=ATC*Q=15*30=450 • Profits=1050-450=600 TR TC Marginal Revenue is the Demand Curve

  17. Certain Degrees Now Cost More at UniversitiesThe New York Times, July 29, 2007

  18. Expensive Lesson: Colleges Manipulate Financial Aid OffersThe Wall Street Journal, April 4, 1996

  19. Expensive Lesson: Colleges Manipulate Financial Aid OffersThe Wall Street Journal, April 4, 1996

  20. Expensive Lesson: Colleges Manipulate Financial Aid OffersThe Wall Street Journal, April 4, 1996

  21. Expensive Lesson: Colleges Manipulate Financial Aid OffersThe Wall Street Journal, April 4, 1996

  22. Expensive Lesson: Colleges Manipulate Financial Aid OffersThe Wall Street Journal, April 4, 1996

  23. Expensive Lesson: Colleges Manipulate Financial Aid OffersThe Wall Street Journal, April 4, 1996

  24. Reckonings; What Price Fairness?The New York Times, October 4, 2000

  25. Third-Degree Price Discrimination Definition: Occurs when the seller charges different prices in different markets, or charges a different price to different segments of the buying population. • Movies, Soda, Computers, prescription drugs, textbooks, safety gates, airlines, …

  26. Suppose MC for airline is constant at $50 up to the capacity limit of 75. Also assume that Fixed Cost of airlines is $1000. 400-10Q 200-10Q MRt=MRb=MC=50 Note: Not at capacity limit. Profits=125*15+225*35- 50*(15+35)-1000 =6250 MC MC Db Dt MRt MRb 15 Note: When MC constant, MC=AVC. 30 35

  27. Summarize • Firm sells 50 tickets • 35 to business travelers @ $225/ticket • 15 to tourists @ $125/ticket Which type of traveler is relatively more elastic?

  28. Lower Rates for Women Are Ruled UnfairNew York Times, August 13, 2008

  29. Insurance ‘eggheads” Make Women PayLos Angeles Times, June 22, 2008

  30. Second-Degree Price Discrimination Definition: Second-Degree Price Discrimination - Occurs when the seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on. QUANTITY DISCOUNTS (2-part Pricing is a type of quantity discount). • Electric Utilities, Country Clubs, Michigan Athletic Club, Disneyland (in old days), Espresso Royale, … http://steelers.strmarketplace.com/

  31. 2-Part Pricing Suppose the graph to the right depicts the demand and cost curves for a country club where quantity (Q) represents the number of rounds of golf. Q

  32. Suppose the country club sets the price per round of golf at $20. What membership fee (fixed fee) should the country club set? Individual A • If the price per round is $20 and the membership fee isn’t too high, how many rounds of golf will Individual A play? • 3 • What is the maximum membership fee Individual A will pay given the price per round is $20? • .5*(50-20)*3=45 Maximum membership fee Individual A is willing to pay.

  33. Suppose the country club sets the price per round of golf at $20. What membership fee (fixed fee) should the country club set? Individual B • If the price per round is $20 and the membership fee isn’t too high, how many rounds of golf will Individual B play? • 6 • What is the maximum membership fee Individual B will pay given the price per round is $20? • .5*(50-20)*6=90 Maximum membership fee Individual B is willing to pay.

  34. Suppose the country club sets the price per round of golf at $20. What membership fee (fixed fee) should the country club set? • Given the cost of each round is $20, the country club should charge a membership fee of either $45 or $90. • Profits if membership fee is $45 Both types of individuals join with Type A golfing 3 rounds each and Type B golfing 6 rounds. 45*9+20*(8*3+1*6)-15*30= 555 • Profits if membership fee is $90 Only Type B joins and Type B golfs 6 rounds. 90*1+20*(1*6)-35*6= 0 SET MEMBERSHIP FEE AT $45

  35. 2-Part Pricing • If membership fee is $45, total number of rounds golfed is 8*3+1*6=30. At Q=30, ATC=15 so TC=ATC*Q=15*30=450. • If membership fee is $90, total number of rounds golfed is 1*6=60. At Q=6, ATC=35 so TC=ATC*Q=35*6=210. Q

  36. Peak Load Pricing • Definition The practice of charging higher prices during “peak hours” (i.e. high demand times) than during off-peak hours. • Hotels, Ski Resorts, Airlines, Stadiums, Restaurants, … http://panynj.info/bridges-tunnels/tolls.html

  37. Demands at a Restaurant for Lunch and Dinner

  38. Suppose Restaurant’s Capacity is 45 seats, Fixed Costs are $1800 per day and Marginal Cost of a meal is constant at $20 • What prices will the Restaurant charge for lunch and dinner? PL=$35 and PD=$60 • What are the Restaurant’s daily profits? TR-TC=TR-TVC-TFC= 35*15+60*40-20*(15+40)-1800= 25 PD= PL= MC=AVC

  39. Suppose Restaurant’s Capacity is 30 seats, Fixed Costs are $1200 per day and Marginal Cost of a meal is constant at $20 • What prices will the Restaurant charge for lunch and dinner? PL=$35 and PD=$70 • What are the Restaurant’s daily profits? TR-TC=TR-TVC-TFC= 35*15+70*30-20*(15+30)-1200= 525 PD= PL= MC=AVC

  40. Bundling • Definition The practice of bundling several different products together and selling them at a single “bundle price”. • Happy Meals, Restaurants, Stereos, Cars with Options, Celebrity Endorsements, Movies (years ago),… What are possible explanations as to why firms do this?

  41. Quote from Lebron James (article in November 28, 2007 Fortune) So in 2006, James founded LRMR Marketing, so named for the initials of the four buddies: Lebron, Randy Mims, Maverick Carter, and Richard Paul. While James is LRMR's core business, the goal is to diversify by representing other athletes. Right now they have only one other client. In August the company signed a contract with Ted Ginn Jr., the Ohio State star and a rookie wide receiver on the Miami Dolphins. … "He should be looking at multiyear deals with a vested interest," says Doug Shabelman, the president of Burns Entertainment & Sports Marketing. "He'll probably be in a position to take some ownership stakes." Shabelman added that if LRMR develops a stable of athletes, it could package them in deals for marketers. In other words, if you want LeBron, you gotta take the others.

  42. Bundling – Example 1 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

  43. Bundling – Example 1 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero. • No Bundling PA=8, PE=12 Profits= 8*20+12*20=400 • Bundling PAE=22 Profits = 22*20 = 440

  44. Bundling – Example 1 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero. • No Bundling PA=8, PE=12 Profits= 8*20+12*20=400 • Bundling PAE=22 Profits = 22*20 = 440

  45. Bundling – Example 2 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero. • No Bundling PA=8, PE=12 Profits= 8*20+12*20=400 • Bundling PAE=20 Profits = 20*20 = 400

  46. Bundling – Example 2 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero. • No Bundling PA=8, PE=12 Profits= 8*20+12*20=400 • Bundling PAE=20 Profits = 20*20 = 400

  47. Bundling – Example 3 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero. • No Bundling PA=10, PE=12 Profits= 10*10+12*20=340 • Bundling PAE=17 Profits = 17*20 = 340

  48. Bundling – Example 3 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero. • No Bundling PA=10, PE=12 Profits= 10*10+12*20=340 • Bundling PAE=17 Profits = 17*20 = 340 • Mixed Bundling PE=15, PAE=22 Profits= 15*10+22*10=370

  49. Bundling – Example 4 • Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero. • No Bundling PA=10, PE=12 Profits= 10*10+12*20=340 • Bundling PAE=14 Profits = 14*20 = 280

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