PRICING WITH

MARKET POWER-II
ME, SESSION 13
13th August, 2012
PROF. SAMAR K. DATTA

Checklist for students

Two-part tariff
Advertising
Pricing of Joint
Products
Bundling & tying

Two-Part Pricing
When it isnt feasible to charge different
prices for different units sold, but demand
information is known, two-part pricing may
permit you to extract all surplus from
consumers.
Two-part pricing consists of a fixed fee
and a per unit charge.
Example: Athletic club memberships.

How Two-Part Pricing Works

Price

1. Set price at marginal cost.

2. Compute consumer surplus.
3. Charge a fixed-fee equal to
consumer surplus.

10
8
6

Fixed Fee = Profits* = $16

Per Unit 4
Charge

MC

D
1

* Assuming no fixed costs

Quantity

Meaning of Two-Part Tariff

The purchase of some products and services can be
separated into two decisions, and therefore, two prices.
Examples
1)

Amusement Park

Pay to enter
Pay for rides and food within the park

2) Tennis Club
Pay to join
Pay to play

Pricing decision is setting the entry fee (T) and the

usage fee (P), thus choosing the trade-off between freeentry and high use prices, or high-entry and zero use
prices

Two-Part Tariff with a

Single Consumer
$/Q
T*

P*

Usage price P* is set where

MC = D. Entry price T*
is equal to the entire
consumer surplus.

MC
D

Quantity

Two-Part Tariff with Two

Consumers
$/Q
T*

The price, P*, will be

greater than MC. Set T*
at the surplus value of D2.

=2T*+(P*-MC).(Q1+Q2)>2ABC

Thus there is a trade-off

between high entry fee &
high user price

P*

MC
D1 = consumer 1
D2 = consumer 2

Q2

Q1

Quantity

The Two-Part Tariff with

Many 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.

To find optimum combination, choose several

combinations of P and T
Choose the combination that maximizes profit

Rule of Thumb

Similar demand: Choose P close to MC and high T

Dissimilar demand: Choose high P and low T.

Two-Part Tariff With A Twist

Suppose, 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

Advertising
Assumptions
Firm sets only one price
Firm knows Q(P,A)
How quantity demanded depends on price
and advertising

Effects of Advertising
AR and MR are average
and marginal revenue when
the firm doesnt advertise.

$/Q

If the firm advertises,

its average and marginal
revenue curves shift to
the right -- average costs
rise, but marginal cost
does not.

MC

P1
AC
P0

AR

AC

MR
AR
MR
Q0

Q1

Quantity

Advertising
Choosing Price and Advertising Expenditure

PQ( P, A) C (Q) A
Q
Q
MRAds P
1 MC
full MC of adv.
A
A
A Rule of Thumb for Advertising

( P MC ) / P 1 / E P for pricing
Q
( P-MC )
1
A
P MC A Q
A

Adv. to sales ratio

P
PQ
Q A

Advertising
A Rule of Thumb for Advertising

( A Q)(Q A) E A Adv. elasticity of demand

( P MC ) P 1 EP
A PQ ( E A EP ) Rule of Thumb

To maximize profit, the firms advertisingto-sales ratio should be equal to minus the
ratio of the advertising and price elasticities
of demand

Advertising An Example

R(Q) = $1 million/yr
$10,000 budget for A (advertising--1% of
revenues)
EA = 0.2 (increase budget $20,000, sales increase
by 20%
EP = -4 (markup price over MC is substantial)

Should the firm increase advertising?

YES
A/PQ = -(0.2/-4) = 5%
Increase budget to $50,000

Meaning of Joint Products

Goods jointly produced in fixed
proportions:

Interdependence in production
Single marginal cost curve for both products or
product package; e.g., beef & hides

However, demand curves & MR curves are

independent
Pricing decision must recognize interdependence in production

Marginal revenue of product package is vertical

sum of two MR curves;

Pricing of Joint Products w/o Excess

production of Hides (case 1: MR>0 for both
products at equilibrium)

Prices etc.

MC

MRT

MRT
DB

MRB

PB
MRH
PH

X* MRH

MRB

DH

Quantity

As MR for B<0 at Q1, (Q1-Q0) amount of product B ought to be kept off the
market for maximization of

Case 3: Unlike in the two earlier

Cases, outputs A & B are now
produced under flexible proportions,
giving rise to concave to origin
product transformation curves at
constant costs.

Tangency of iso-product curves to the highest possible iso-revenue curves

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

Bundling Example With

Two Consumers
Reservation Price

Spiderman

Spaceballs

Theater A

$12,000

$3,000

Theater B

$10,000

$4,000

Renting the movies separately would result in each theater

paying the lowest reservation price for each movie
Total Revenue = $26,000

If the movies are bundled and if each were charged the

lower of the two prices
Total revenue will be $28,000.

Bundling Example With Two Consumers

Importance of Negative Correlation of
Demands

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 Gerties Garter

Theater A

$12,000

$4,000

Theater B

$10,000

$3,000

If the movies are bundled and if each were charged the

lower of the two prices, total revenue will be $26,000, the
same as by selling the films, separately.

Bundling Example With Two

Heterogeneous Goods and Many
Consumers
r2
(reservation
price Good 2)

Consumer
C

$10

$6

Consumer A is
willing to pay up to
$3.25 for good 1 and
up to $6 for good 2.

Consumer
A
Consumer
B

$5
$3.25

$3.25

$5

$8.25 $10

r1 (reservation
price Good 1)

Consumption Decisions When

Products are Sold Separately
r2

r1 P1

r1 P1

r2 P2

r2 P2

II

Consumers buy
only good 2

P2

Consumers fall into

four categories based
on their reservation
price.

Consumers buy
both goods

r1 P1

r1 P1

r2 P2

r2 P2

III

IV

Consumers buy
neither good

Consumers buy
only Good 1

P1

r1

Consumption
When Products

Decisions
are Bundled

r2
I
Consumers
buy bundle
(r > PB)

Consumers compare the

sum of their reservation
prices, r1 + r2, with the
bundle price PB. They buy
the bundle only if r1 + r2 is at
least as large as PB.

r2 = PB - r1
II
Consumers do
not buy bundle
(r < PB)

r1

Consumption Decisions
When Products are Bundled
Buyers of
good 2 who
now buy
good 1 also

Buyers who buy

both the goods

Buyers of
good 2 lost
to the firm

Buyers who buy

neither good

Buyers of
good 1 who
now buy
good 2 also
Buyers of
good 1 lost
to the firm

Depending on the prices,

some of the consumers in
regions II and IV might
have bought one of the
goods if they were sold
separately. These
customers are lost to the
firm.
However, the other
customers in regions II
and IV now buy both
goods where they formerly
bought only one.
The firm then, must decide
whether it can do better by
bundling.

Efficiency of Bundling Depends on the

Degree of Negative Correlation
(Spiderman) r2

10,000

Bundling pays due to

negative correlation

5,000
4,000

B
A

3,000

5,000

10,000 12,000 14,000

r1 (Spaceballs)

Mixed Versus Pure Bundling

r2
100

C1 = MC1 = 20

With positive marginal

costs, mixed bundling
may be more profitable
than pure bundling.

90
80
70
60
50
40

B
C

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 firms cost.

C2 = MC2 = 30

30
20

10
10 20 30 40 50 60 70 80 90 100

r1

Mixed Bundling
with Zero Marginal Costs
P1

P2

PB

Profit

Sell separately $80

$80

---- $320

Pure bundling

----

----

$100 $400

Mixed bundling

$90

$90

$120 $420

Mixed Bundling
with Zero Marginal Costs
r2

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.

100
90

80

60

C
40

20

10
10 20

40

60

80 90 100

120

r1

Mixed Bundling in Practice

Use of market surveys to determine
reservation prices
Design a pricing strategy from the
survey results
Mixed bundling allows the customer
to get maximum utility from a given
expenditure by allowing a greater
number of choices.

Tying

Practice of requiring a customer to

purchase one good in order to
purchase another.
Allows the seller to meter the
customer and use a two-part tariff
to discriminate against the heavy
user
Examples
Xerox machines and the paper
IBM mainframe and computer cards