Managerial Economics

ninth edition

Thoma
Mauric

Chapter 14
Advanced Pricing
Techniques
McGraw-Hill/Irwin
McGraw-Hill/Irwin
Managerial Economics,
Managerial Economics,

Copyright 2008 by the McGraw-Hill Companies, Inc. All

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

Price discrimination

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)

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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 MCB

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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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Managerial Economics

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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Managerial Economics

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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Managerial Economics

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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Managerial Economics

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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Managerial Economics

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

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

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:

MRJ = MC
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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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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