Semester II, AY2013-2014

NUS Business School

BSP1005 Managerial Economics

Lecture Notes 8

SOPHISTICATED PRICING STRATEGIES

WITH MARKET POWER
By Jo Seung-Gyu
Part A: Price Discriminations
Part B: Two-Part Pricing
Part C: Bundling

Outline

Part A: Price Discriminations

Introduction
First Degree Price Discrimination
Second Degree Price Discrimination
Third Degree Price Discrimination
Direct vs Indirect Segmentation
Economics of Coupons/Rebates
More Examples

Introduction

Pricing without market power (perfect competition) is determined by market

supply and demand.
Pricing with market power in the simple (i.e. uniform pricing) monopoly case
implies
o Produce and price where MR = MC
o One price applies to all sales units and all markets served.

Pricing with market power in the real world involves sophisticated output and
price decisions
o Pricing of a product over different quantities (beer price) or pricing of a
product over various consumer segments (air fare)
o Pricing through upfront fixed fees and per-unit prices (country club)
o Pricing of many products through packaging (McDonald value meals)

Such strategies are categorized into:

o Price discrimination
o Two part pricing
o Product bundling

Prices of Our Economics Textbook

NUS COOP, Singapore:

Australia Pearson:
US Amazon.com:

S$63.10
A$153.95 (=S$175.50)
US$193.98 (=S$259.88)

Amazons Shipping Options:

Free Amazon Global Saver (9-14 days):

Amazon Global Standard Shipping (9-12 days):
Amazon Global Expedited Shipping (5-10 days):
Amazon Global Priority Shipping (2-4 days):

S$0
S$13.37
S$26.77
S$48.20

What do you
think?
4

Case of Air Fare

In your next overseas trip, ask her (him) how
much she (he) paid for the seat.
You and she (he) more likely must have
paid different fare. Why?
Different willingness to pay!

The details of segmentation rules are various. For the KLM, as of

February 2013, the segmentation rules were:
o Ticket Types
economy/business/first plus various ticket codes in each class
o Restrictions
Time of travel
Minimum Stay Requirement weekend stay is important
Schedule change or cancellation? Even if allowed: free or additional
charge?
Upgrade allowed?
Mileage to be earned? Even if yes: different class with different
mileage input

Example: Booking Classes on KLM Flights

You should be able to explain the economics behind the above chart.

For an effective pricing strategy,

Information on demand characteristics (in addition to the production cost conditions) is

critical, allowing managers to take advantage of market power to improve profitability.
The Key is how to capture consumer surplus.

Price

Customers in section H realize a surplus, since

reservation price > market price

P0

Consumers in section L have reservation prices

lower than the market prices but still higher than
the marginal cost.

L
MC

PM

A
E

PC
B

If P=PM and Q=QM, managers forgo potential

profit ( yellow area + green area).

The strategic issue facing managers is

straightforward. You want to price to capture as
much consumers surplus as possible away from
the buyers.

F
MR

Quantity

QM

QC

Outline

Part A: Price Discriminations

Introduction

First Degree Price Discrimination

Second Degree Price Discrimination
Third Degree Price Discrimination
Direct vs Indirect Segmentation
Economics of Coupons/Rebates
More Examples

first degree price discrimination: Practice of charging each

customer her reservation price.

First Degree Price Discrimination

Pric
e
P0
A
PM

The seller identifies the reservation

price of each consumer and charges
each customer as revealed through her
demand curve.

Continue to produce until P = MC (i.e.

Pc), so the firm will produce output
QC and buyers are being charged up to
their maximum willingness to pay
following D.

MC
E
D (= MR under 1st degree price
discriminating monopoly)

PC
B
F

MR under pure monopoly

Quantity

QM

QC

If uniform price (PM) is charged:

Variable profit is the area [PMFBA]

Consumer surplus is the area [P0PMA]

If first degree price discrimination is exercised (i.e. Charge based on D curve):

Each consumer simply pays her reservation price defined by D curve, so
D curve now becomes the firms MR curve.
The monopolists variable profit is the area [P0FE]
Consumer surplus is zero.

Profit increases by [PoPMA] and [ABE] (=yellow area and green area from the
previous slide.)
Note that social deadweight loss disappeared.

Practical Implementation of First Degree Price Discrimination

First degree price discrimination is not easy to implement in practice.

o Customers are too many and often heterogeneous and the information about
individual customer demands is hard to establish.

But you dont want to give up.

o Imperfect price discrimination is better than uniform pricing. Apply
identifiable reservation prices for each consumer.

10

Imperfect (First Degree) Price Discrimination

At a doctors office

o Doctors ask patients for great deal of information occupation, home

address, office address to use this for price discrimination.
What does your home address have to do with medical treatment?)
Guess what the first question we were asked at the reception desk in KL for
my boss knee surgery in 2012.

o The same for lawyers, catering, spa etc.

o Amazon.com is one obvous example
Auction/Bidding is institutional practice to approximate complete price
discrimination (Singapore public auctions for COE)
Car Dealers
11

Outline

Part A: Price Discriminations

Introduction
First Degree Price Discrimination

Second Degree Price Discrimination

Third Degree Price Discrimination
Direct vs Indirect Segmentation
Economics of Coupons/Rebates
More Examples

Second-degree price discrimination: Practice of charging

different prices per unit for different quantities of the same
good or service.
12

Second Degree Price Discrimination (or Block Pricing)

The first order price discrimination not
being too practical, managers can think of
a second option. Second degree price
discrimination entails charging different
prices (to the same customer or groups of
customers) for different quantities or
blocks of the same good.

$/Q
P1

PM
P2
AC

P3

MC

D
MR

Q1 QM
1st Block

Q2

Q3

Without discrimination:
P = PM and Q = QM.
With the second-degree discrimination in
the left, there are three unit prices P1, P2,
and P3, each applying to purchasing units
up to Q1, Q2 and Q3.

2nd Block 3rd Block

In this case, there are also economies of

scale, and average and marginal costs are
declining. Second-degree price
discrimination can then make consumers
better off by expanding output and lowering
cost.

13

Second Degree Price Discrimination (or Block Pricing) cont.

Examples are:
Bulk discounts (4 mugs of beer vs one jug?)
At the bar, charge P1Q1 with coupons for Q1, P2Q2 with coupons
for Q2, P3Q3 with coupons for Q3.

14

Second Degree Price Discrimination (or Block Pricing) cont.

LOL.
Puzzling Episode or Ridiculous?
An interesting business conduct I encountered recently.
For my MBA Midterm Exam Bash last year, I visited the BLooiE's to
negotiate the beer price for the party. Their pricing was as below:
One keg of Tiger beer: $540
One Tower of Tiger beer: $63
Funny thing was that one keg makes about 8 towers.
---- My answer is.There are dumb people out there!

15

Outline

Part A: Price Discriminations

Introduction
First Degree Price Discrimination
Second Degree Price Discrimination

Third Degree Price Discrimination

Direct vs Indirect Segmentation
Economics of Coupons/Rebates
More Examples

Third-degree price discrimination Practice of dividing

consumers into two or more groups with separate demand curves
and charging different prices to each group.
16

Third Degree Price Discrimination

You import coconuts from Malaysia to supply NUS and SMU. Your decisions
include:
o How many coconuts to import
o How many to sell at NUS and SMU at which price

SMU
MR2(Q2)

NUS
MR1(Q1)

Malaysia
MC(Q1 + Q2)

Experiment: What would you do if MR1 > MR2 = MCT ?

17

Rule of Third Degree Price Discrimination

If third-degree price discrimination is feasible,

o We know that, however much is produced, total output should be divided
between the groups of customers so that marginal revenues for each
group are equal.

(MR1 = MR2)
o We know that total output must be such that the marginal revenue for each
group of consumers is equal to the marginal cost of production.

(MR1 = MR2 =MC)

18

 Mathematically,
Assume two different markets with different demand characteristics D1 and D2.
Firm profit = TR1(q1) + TR2(q2) TC(q1 + q2).
Note that TRi(qi) is the total revenue from market i (which is a function of qi ) while
TC(q1 + q2) is the total cost of producing the firms total output q1 + q2. That is, q1
and q2 share the same cost function.
Firm profit is maximized when
/ q1 = dTR1/dq1 TC/q1 = MR1 MC = 0
/ q2 = dTR1/dq2 TC/q2 = MR2 MC = 0
MR1(q1)= MC(q1 + q2) for sub-market 1 and
MR2(q2)= MC(q1 + q2) for sub-market 2,

That is,
implying

(Have you noticed the similarity between this decision rule and the economics of
monopoly with multiple plants?)
19

Graphical Illustration
$/Q
P1
MC

P2
MR1 =
MR2 =
MC

D2 = AR2
MRT (q1 + q2)
MR2 (q2)
MR1 (q1)
Q1

D1 = AR1
Q2

QT

Quantity

Group 1: P1 and Q1 ; less elastic thus higher price

Group 2: P2 and Q2; more elastic thus lower price

Choose Q1 and Q2 so that MR1 = MR2 = MC

Graphical Tip: Since MC depends on QT, choose QT first so that MC

= MRT and distribute QT to market 1 and 2 so that MR1 = MR2 = MC,
where MRT is a horizontal summation of MR1 and MR2.

20

Importance of Elasticity in Third Degree Price Discrimination

Third degree price discrimination is actually charging higher (lower) price
to those whose demand is less (more) elastic.
[MR1 = P1(1+1/e1)] = [MR2=P2(1+1/e2)]

Why?

Example: Consider e1 = 2 and e2 = 4 as an example:

It follows
P1/P2 = [1 + 1/ e2]/ [1 + 1/ e1] = 0.75/0.50 = 1.5
or

P1 = 1.5P2

That is, the less elastic market (market 1 with e1 = 2) will have a higher price (1.5
times higher in this case) than the more elastic market (market 2 with e2 = 4).

When cost function is known, we can determine exact levels of P1 and P2.
21

Case for No sales to Smaller Markets

Even if third-degree price discrimination is
feasible, it doesnt always pay to sell to both
groups of consumers.
(example: luxurious restaurant)
$/Q
MC

P*
D2

MR2

MR1

D1

Q*

Group one, with demand D1, is not

willing to pay high enough for the good
to make price discrimination profitable.

Quantity

Average dining costs

$250/person
22

Outline

Part A: Price Discriminations

Introduction
First Degree Price Discrimination
Second Degree Price Discrimination
Third Degree Price Discrimination

Direct vs Indirect Segmentation

Economics of Coupons/Rebates
More Examples

Sometimes managers cannot directly identify consumer types. Yet

you dont want to give up exercising sophisticated pricing
strategies.
23

Direct vs. Indirect Segmentation

Direct Segment Discrimination: price discrimination when the seller can
identify different consumer groups (or segments).

Then apply third-degree price discrimination or perfect price discrimination to each

segment directly.

Indirect Segment Discrimination: price discrimination when the seller

cannot identify different consumer groups (or segments)

When buyers are not directly identifiable, sellers can design and offer a set of menu
to the unidentifiable consumer groups through which consumers can self-reveal
their types.

It is important to link different prices to the attributes that are specific only to some
consumer segments.

24

Examples of Indirect Segment Discrimination

Air fare
Shoe-repair person in Holland Village: Are you a local?
HP Printer (10 ppm vs 20 ppm)
Information goods
(Scientific Word Academic Version vs Professional Version)
Summer sale in Philadelphia hammering the fridge/audio set
Starbucks warm beverage cup sizes

25

Recent email I received from

Amazon.com
How about this?

General Pricing for the public

General Price at Amazon.com: US$79.11

Personalized Price for Me: US$59.49

26

From the readings

Direct vs Indirect - Be Careful of Backlash!
Coca Colas Smart Vending Machine (1999):
Coca Cola considered introducing the machines that automatically adjusts prices:
price goes up if temperature is high
Price goes down if temperature is low
Reactions:
"What's next? A machine that X-rays people's pockets to find out how much
change they have and raises the price accordingly? (NYT)
A cynical ploy to exploit the thirst of faithful customers (San Francisco
Chronicle)

Gender-pricing is prohibited in many states.

In NYC nail shops, first time violators are to be fined from $50 to $200, while
those for subsequent ones are $100 to $500.

This is why indirect segmentation is important!

27

Outline

Part A: Price Discriminations

Introduction
First Degree Price Discrimination
Second Degree Price Discrimination
Third Degree Price Discrimination
Direct vs Indirect Segmentation

Economics of Coupons/Rebates
More Examples

Countless coupons are issued every year. Why?

28

Economics of Coupons/Rebates

Countless coupons are issued every year. Why?

Coupons and rebates are devices to reduce the price
of products. But why not just mark down the prices?
o It would be a lot simpler and easier to run an ad on sale than to require consumers
to clip coupons (or fill out rebate forms) and remember to bring them in when they
shop (or mail)?
o Coupons and rebates also create extra work for financial officers, cashiers and store
managers.

Primarily, because coupons and rebates are used to price discriminate (and so
are the rebates).
o Not all consumers use coupons. Only a certain segment (20-30% on average and 25% for certain products) regularly clip and use coupons in buying goods and
services. This demand segment is more price-sensitive. Therefore lower prices to
those who would otherwise shop elsewhere. A practical approximations to this ideal
is lower prices to those with enough free time to clip coupons. But consumers who
are less price-sensitive are willing to pay higher prices without taking trouble to
clip coupons (or fill out and mail back the rebate forms.
29

Elasticity is the key information to implement a coupon/rebate strategy.

Price Elasticities for Coupon Users and Nonusers:

30

Numerical Example of Coupon Strategy

By estimating the elasticity of demand, managers can approximate how much

coupons should be worth.

For example, if a manager believes that elasticity of demand for coupon users
(call them group 1) is 5, and for non-users (call them group 2) is 2.5, and
MC = 0.8, she can calculate the optimal value of coupons.
Profit maximization implies
[MR1 = P1(1+1/e1)] = [MR2=P2(1+1/e2)] = MC
P1 = MC/(1+1/e1) = (0.8)/[1 (1/5)] = 1 and
P2 = MC/(1+1/e2) = (0.8)/[1 (1/2.5)] = 1.33.
Since you dont know who to charge $1.33 and who to charge $1, you simply
charge $1.33 for the product and issue the coupon worth 0.33.
31

In real life.

Off-the-Record Episode:
J&Js 1 Day ACUVUE Contact Lenses

Wall Street Journal:

5.8 billion of 291.9 billion coupons distributed annually were redeemed - the
most elastic consumers clip and redeem them. Recall you want to lower prices
to them
But P&G (and others) are now restricting their use.- Why?
Coupons or rebates would make no sense if everyone used them. Likewise, why
hand out coupons if the users are completely random? Coupons work by offering
discounts to precisely those customers who are most sensitive to price.
32

LOL

Dilbert Principle

33

Outline

Part A: Price Discriminations

Introduction
First Degree Price Discrimination
Second Degree Price Discrimination
Third Degree Price Discrimination
Direct vs Indirect Segmentation
Economics of Coupons/Rebates

Real Life Examples

Now lets look at the real life.

34

Real Life Examples of Price Discrimination

Big buyers are favored (group rate for movie tickets is cheaper)
Senior/Student/Early-bird Discounts for bus fair or movies.
You often dump in foreign market, or vice versa.
Gender Pricing: Hair Salon (Next at Holland Village)
Laundry /Cleaner (Bucks County Cleaner at Newtown, NJ)
Journal of International Economics annual subscription: US$130 for personal
and US$1,330 for institutional
Wall Street Journals monthly subscription (as of 2011):
S$50 in Singapore, 7,875 (=S$120) in Tokyo, 26,500 (=S$ 34) in Korea,
US$55 (=S$75) in China, but S$18 worldwide for on-line edition.
Hard cover books vs Paperback (intertemporal price discrimination)
Electricity bill (peak-load pricing)
Standby flights are often cheap. But low-cost carriers require full fare for a
standby travel

35

Real Life Examples of Price Discrimination cont.

Internet/Wifi Connection Fee at Hotels

Ibiz Hotel Seoul vs College Hotel Amsterdam

Honma 3 star vs 5 star iron set, or gold-plated iron set

Haggling - Size up your income

You fill up questionnaires at doctors office.

Nowadays, scholarships are more based on need than merits.

An optical shop conversation:

How much are these glasses?
The price is $200. lenses onlyper one, sir.

How about the prostitute in Prof. Steven Levitts Talk in Freakonomics Radio
Live in St. Paul?
Source: http://www.youtube.com/watch?v=ONwdUCC8If4&feature=related

36

Managerial Implications (Self-reading)

Managers use price discrimination strategies in an attempt to charge
consumers as close as possible to their reservation price. Unfortunately,
managers face many problems when they try to implement such a strategy.
First is the problem of finding out the reservation price. It would be much
easier to price discriminate in markets where you have face-to-face contact, or
when you can ascertain a customers reservation price. Second is the
separability of markets. A price discrimination strategy will not work unless
arbitrage is prevented.
Again, the followings are necessary for an effective price discrimination in
practice.
Multiple demand elasticities- there must be differences in demand
elasticities between buyers. These demand differences can be caused by
differences in income, location, available alternatives, tastes, use of
product.
Market segmentation- the seller must be able to partition the total
market by effectively segregating buyers into submarkets based on
elasticites. Profits are increased by charging different prices in each
segment.
Market sealing or No arbitrage- the seller must prevent any
significant resale of goods from a lower priced segment to higher priced
one.
37

Outline

Part B: Two Part Pricing

Introduction
Homogeneous Consumers Case
Heterogeneous Consumers Case
Numerical Examples

Two part pricing: Form of pricing in which

consumers are charged both an entry and a usage fee.

38

Introduction
Two part pricing is a very clever way to (possibly) materialize what a first
degree price discrimination strategy aims to establish. The strategy uses
An upfront fee (many times called an entry fee and denoted by T) and
An additional fee for each unit of consumption (many times called a use fee
and denoted by P)

Health clubs/Country clubs - Pay to join and pay to work out/play golf.
Amusement/Theme parks - Pay to enter and pay for rides
Mobile phone carriers - Pay a flat initiation fee and pay for the
processing time
Pro Sport Games or City Orchestra: Personal Seat Licenses (PSLs)
Pay to secure your seats (i.e. pay for the right to buy the tickets)
and pay for tickets

Often, upfront fee and use fee are combined into one bill, with the upfront fee
entitling the buyers a certain units of goods/services.

Mobile phone: free 700 minutes/month at $200 monthly fee

Bars/Clubs: free 3 drinks at $20 entry fee or unlimited drinks at $100 entry fee
39

Example: PSLs for NEW YORK JETS - TICKETS AND METLIFE STADIUM

40

PSLs for NEW YORK JETS - TICKETS AND METLIFE STADIUM

cont.

41

Outline

Part B: Two Part Pricing

Introduction

Economics of Two Part Pricing

Homogeneous Consumers Case
Heterogeneous Consumers Case
Numerical Examples

Two part pricing works better when consumers have

identical or very similar demands.

42

A. Homogeneous Consumers Case

$/Q
A

T(= area ABC = consumer surplus at P = P*)

P1

V (= area OBCQ*)
B

C
*

P*= MC

MC
D

Q1

Q*

The optimal strategy in the above

case is simple:
Set the use fee (P*) at marginal cost
(MC) and the entry fee (T) at the
corresponding maximum consumer
surplus.

Quantity

The variable profit = total revenue(TR) total variable cost (TVC)

TR = TR(from entry fee) + TR(from use fee) = T + V
TVC = V
Thus, Variable Profit = V (or Total Profit = V fixed cost)
Note that this yields the same result as first degree price discrimination.
43

B. Heterogeneous Consumers Case

Two part pricing strategy is most effective when consumers have similar
demand characteristics.
When demand across consumers is not identical and not identifiable, the
optimal strategy is more complicated because:
o if not identical CS is not the same for each consumer group
o if not identifiable entry fee cannot be consumer-specific

The Case of Two Consumer Types:

Below, lets consider the case of two heterogeneous consumer types, D1 and
D2. Assume that we only know that there exist two such types but cannot
identify them. (If the types are identifiable, you can simply treat each
consumer separately.)
44

Heterogeneous Consumers Case cont.

$/Q

G
A

P > MC

MC

P = MC

D2 = consumer 2
D1 = consumer 1
Q

Q1

Q2

We can think of the following options:

Charge P = MC & T = area GBI (serve only D2)
Charge P = MC & T = area ABC (serve both D1 and D2)
Charge P > MC & T = area AEF (serve both D1 and D2)
Remarks:
Is it an option to charge (P,T) such that
P > MC, T = area GEH and serve only D2?
How about charging (P,T) such that
P > MC and, area AEF <T < area GEH

45

Two Part Pricing - Numerical Example

Exercise 1: Homogeneous Consumers
A tennis club is dealing with 1000
identical members.

Optimal two part pricing:

Each individual has the demand of

Q=6P
Q - court hours per month
P - price per court hour

Use fee P = MC = 1 and

T = CS = 12.5 /month
Profits are:

FC = 0, MC = 1

per month
= TR(entry fee) + TR(use fee) VC FC
= [(1,000x12.5) + (1,000x1x5)}]
[(1,000x1x5) + 5,000] 0
= 12,500 + 5,000 5,000 0
= 7,500

Consumer surplus (CS)

= 5x5x0.5 = 12.5

MC

Q
5

D: P = 6 Q

46

Two Part Pricing - Numerical Example cont.

Exercise 2: Heterogeneous Consumers
We consider three options:

Two unidentifiable types (with equal

number N of consumers in each type),
each consumer with the following
demand:

Option 1 (Serve DS only):

P = MC = 2 and T = 18
=18N

Option 2 (serve both Ds and Dw)

DS (strong D): P= 8 Q
DW (Weak D): P= 6 Q

P = MC = 2 and T = 8
=16N

FC = 0 and MC = 2

Option 3 (serve both with a use fee > MC)

P =P* > MC and T = (6-P*)2(1/2)

= N( Entry Fee + Use Fee)

= N{(6-P*)2( )2} + {(P*-2)(6-P* + 8P*)}

is maximized at P* = 3. Then T = 4.5

and =17N.

P*

MC

DS
6 - P*

4 (8 - P*)

Thus, Option 1 turns out optimal.

DW

47

Two Part Pricing - Numerical Example cont.

Remarks 1:
What if consumer types were identifiable in the previous example?
Charge
P = MC = $2 to both types and charge
TW = CSW = 8 and TS = CSS = 18
Then profit will be = N(8 + 18) = 26N > 18N
Implication: You have a great incentive to gather information on consumer
demands.

Remarks 2:
Two part pricing works better when consumers have identical or very similar
demands.
48

Outline

Part C: Bundling

Introduction
Economics of Bundling
Pure Bundling vs Mixed Bundling
Bundling: Bundling is an alternative pricing strategy. It is
about packaging two or more products into one to gain a
pricing advantage.
NOTE:
We will cover bundling only lightly. Or we may get to skip this part.
Naturally, it is to be excluded from the final exam.
49

Introduction

To those of you who dislike BSP1005 (Managerial Economics) classes

by Professors Jo and Yang:
I feel your pain but I am sorry its a package deal for your choice of
NUS.

Been to the Botanical Garden recently?

o Not so good continental/American breakfast was bundled with a very
pleasant coffee, thereby incidentally denying access to my custom for the
local a la carte menu.

50

 Bundling is an alternative pricing strategy. It is about packaging two or more

products into one to gain a pricing advantage.
There are several ways managers implement bundling strategies.
Price-separately strategy: no bundling
Pure (or simple) bundling: sell only as a package
Auto loan mandatory for Toyota auto deal
Mixed bundling: choose between a packaged bundle or separate units,
bundle pricing being less than the sum of components prices
Season tickets vs per-show or per-game tickets (Philadelphia
Orchestra, Pro sports)
Fast food chains (MacDonalds or Burger Kings value meals.)
Restaurant (Set Menu vs A La Carte)
Brewerkz at Clarke Quay:
Pay for Lunch then one free microbrewery beer
51

Outline

Part C: Bundling
Introduction

Economics of Bundling
Pure Bundling vs Mixed Bundling

52

Economics of Bundling

Bundling works better the stronger the negative correlation is among

the valuations of different consumer groups.
o Increased firm performance through bundling is primarily derived from
diverse valuations (or reservation prices) consumers have for the product
not just different valuations but a negative correlation in their reservation
prices over the goods.
o In fact, a bundling strategy is never better than a price-separately strategy
if the consumers demand are positively correlated, i.e., if one group
values all products more than another group, who, in turn, values all
products more than a third group, etc.
o However, a negative correlation in consumer demands does not
necessarily mean that a bundling strategy is always better than a priceseparately strategy. (Thus, negative correlation is only necessary but not
sufficient to make a bundling strategy profitable.)

The following illustrates why a negative correlation in consumer demands is

critical:
53

Consider two goods case

r1 and r2 denote the consumer groups reservation prices for good 1
and good 2.
P1 and P2 denote the price of good 1 and good 2 when the goods are
priced separately while PB denotes the price of the bundle. (Assume
that a bundle here is composed of 1 unit of each good for simplicity)

54

B. If products are bundled, one buys the

A. If goods are priced separately

(at P1 and P2):

r2

P2

r1 P1

r1 P1

r2 P2

r2 P2

II

Consumers buy
only good 2

Consumers buy
both goods

r1 P1

r1 P1

r2 P2

r2 P2

III

bundle only if (r1 + r2) PB

IV

Consumers buy
neither good

Consumers buy
only Good 1

P1

r1

55

Now lets consider two extreme cases of consumers taste correlations to get
an idea about when bundling will be useful. The dots in the diagrams
represent the reservation prices of the consumers. Assume there is one
consumer in each group for simplicity.

If tastes are perfectly positively

correlated, then you dont gain by
bundling, earning just the same profit
as under separate pricing.

If tastes are perfectly negatively

correlated, then pure bundling is the
better strategy, earning more profits
than under separate pricing.

r2

P2
PB = P1 + P2
r1
P1

56

Outline

Part C: Bundling
Introduction
Economics of Bundling

Pure Bundling vs Mixed Bundling

57

Pure Bundling vs Mixed Bundling

(We may skip on this.)

Mixed Bundling -- Selling both as a bundle and separately

Pure Bundling -- Selling bundles only
Mixed bundling may be more profitable if production costs are not sufficiently
low or if consumers tastes are not perfectly negatively correlated.
Lets look through some examples below:

58

Scenario 1:
Perfectly Negative Taste Correlation & Significant Marginal Costs
Reservation price is below MC for some
consumers:

If Pure Bundling:

For consumer A: r1 < MC1 while r2 > MC2

For consumer D: r2 < MC2 while r1 > MC1

PB = 100 and all four consumers would buy the bundle

(pure bundling) = 100x4 (20x4 + 30x4) = 200

With mixed bundling, consumer A can be induced

r2
100

to buy only good 2, while consumer D is induced to

buy only good 1, improving the firms profitability
compared to the pure bundling.

A MC1 = 20

90
80
70
60

PB = 100 for bundle and P1= 90 and P2 = 90 for

separate sales (why not 90?). Then

50

40
30

B and C would buy the bundle

A buys only good 2 and
D only good 1

MC2 = 30

20

10
10 20 30 40 50 60 70 80 90 100

(mixed bundling)
= 100x2 + 90- + 90- (20x3 + 30x3) = 230-

r1

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Scenario 1:
Negligible Marginal Costs but Imperfectly Negative Correlation of Tastes
Assume MC1 = MC2 = 0.

If Pure Bundling

Options for pure bundling are:

PB = 100 and
(pure bundling) = 100x4 = 400

Serve B and C only at a higher PB

to earn = 120x2 = 240

Serve all four consumers at a lower PB

to earn = 100x4 = 400

If Mixed Bundling

r2

PB = 120, P1 = P2 =90

120

to let B and C buy the bundle while A

and D buy good 2 and good 1,
respectively.

100
90

80

40

(mixed bundling)
= 120x2 + 90x2
= 420

10
10

40

80

100

120

r1

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WRAP-UP: MONOPOLISTS PRICING STRATEGIES

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 firms 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.

Ideally, the firm would like to perfectly price discriminate. If not

practically possible, it can try second and third degree price
discrimination options. Identifying customer types is important.
Otherwise indirect segmentation can be used.

The two-part tariff is another means of capturing consumer surplus. Its

effectiveness is higher as consumer types are more similar.

When demands are heterogeneous and negatively correlated, bundling

can increase profits
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THANK YOU!

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