Pricing Practices: Questions & Answers Q15.1

Chapter 15
PRICING PRACTICES
QUESTIONS & ANSWERS

Q15.1
Through simple algebraic substitution and manipulation, express the markup on cost
formula in terms of the markup on price, and use this relation to explain why a 100%
markup implies a 50% markup on price.
Q15.1
ANSWER
The markup on cost, or cost plus, formula gives profit margin expressed as a
percentage of cost:
Markup on Cost =
Price - Marginal Cost

Marginal Cost
By way of contrast, the markup on price formula gives profit margin expressed as a
percentage of price:
Markup on Price =
Price - Marginal Cost

Price
Each markup formula provides a useful, but different, perspective on the relative
magnitude of the difference between price and cost, or the profit margin.
Through simple algebraic substitution and manipulation, each markup formula
can be expressed in terms of the other:
Markup on Cost =
Markup on Price
1 - Markup on Price
Markup on Price =
Markup on Cost
1 + Markup on Cost
A product with a 100% markup on cost has a 50% markup on price, a 50% markup
on cost implies a 33% markup on price, and so on. When comparing the markup
Presented by Suong Jian & Liu Yan, MGMT Panel , Guangdong University of Finance.
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earned on various items, and in determining the optimal markup, it is crucial to

identify the exact specification of the markup formula used.
Q15.2
Explain why successful firms that employ markup pricing use fully allocated costs
under normal conditions, but typically offer price discounts or accept lower margins
during off-peak periods when excess capacity is available.
Q15.2
ANSWER
Fully allocated costs can be appropriate when a firm is operating at full capacity.
During peak periods, when facilities are fully utilized, expansion is required to
increase production. Under such conditions, an increase in production requires an
increase in all plant, equipment, labor, materials, and other expenditures. However,
if a firm has excess capacity, as during off-peak periods, only those costs that
actually rise with production--the incremental costs per unit--should form a basis for
setting prices.
Successful firms that employ markup pricing use fully allocated costs under
normal conditions but offer price discounts or accept lower margins during off-peak
periods when excess capacity is available. In some instances, output produced
during off-peak periods is much cheaper than output produced during peak periods.
When fixed costs represent a substantial share of total production costs, discounts of
30 per cent to 50 per cent for output produced during off-peak periods can often be
justified on the basis of lower costs.
"Early Bird" or afternoon matinee discounts at movie theaters provide an
interesting example. Except for cleaning expenses, which vary according to the
number of customers, most movie theater expenses are fixed. As a result, the
revenue generated by adding customers during off-peak periods can significantly
increase the theater's profit contribution. When off-peak customers buy regularly
priced candy, popcorn, and soda, even lower afternoon ticket prices can be justified.
Conversely, on Friday and Saturday nights when movie theaters operate at peak
capacity, a small increase in the number of customers would require a costly
expansion of facilities. Ticket prices during these peak periods reflect fully allocated
costs. Similarly, McDonald=s, Burger King, Arby's, and other fast-food outlets have
increased their profitability substantially by introducing breakfast menus. If fixed
restaurant expenses are covered by lunch and dinner business, even promotionally
priced breakfast items can make a notable contribution to profits.
Q15.3
Discuss how seasonal factors influence supply and demand, and why markups on
fresh fruits and vegetable are at their highest during the peak of season.
Q15.3
ANSWER
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Chapter 15
It is interesting to see how seasonal factors affect markups for grocery items, like
fruits and vegetables. When a fruit or vegetable is in season, spoilage and
transportation costs are at their lowest levels. At the same time, during the peak of
season, high product quality translates into enthusiastic consumer demand. Both
factors lead to high margins for fresh fruits and vegetables during the peak of season.
Consumer demand shifts away from high-cost/low-quality fresh fruits and
vegetables when they are out of season, thereby reducing margins on these items.
Similarly, markups tend to be high on bargain-priced Turkey at Thanksgiving , Ham
at Easter, and so on.
In addition to seasonal factors that affect margins over the course of a year,
market forces affect margins within a given product class at the grocery store. In
breakfast cereals, for example, the markup on cost for highly popular corn flakes
averages only 5 per cent to 6 per cent, with brands offered by Post and Kellogg's
competing with a variety of local store brands. Cheerios and Wheaties, both offered
only by General Mills, Inc., enjoy a markup on cost of 15 per cent to 20 per cent.
Thus, availability of substitutes directly affects the markups on various cereals. It is
interesting to note that among the wide variety of items sold in a typical grocery store,
among the highest margins are charged on spices. Apparently, consumer demand for
nutmeg, cloves, thyme, bay leaves, and other spices is quite insensitive to price. The
manager interviewed said that in more than 20 years in the grocery business, he
could not recall a single store coupon or special offered on spices.
Q15.4
Why does The Wall Street Journal offer bargain rates to students but not to business
executives?
Q15.4
ANSWER
The Wall Street Journal offers bargain rates to students but not to business
executives. It is surely not because it costs less to deliver the Journal to students,
and it's not out of benevolence; it's because students are not willing or able to pay the
standard rate. Even at 50 per cent off regular prices, student bargain rates more than
cover marginal costs and make a significant profit contribution. Similarly, senior
citizens who eat at Holiday Inns enjoy a 10 to 15 per cent discount and make a
meaningful contribution to profits. Conversely, relatively high prices for popcorn at
movie theaters, peanuts at the ball park, and clothing at the height of the season
reflect the fact that customers can be insensitive to price changes at different places
and at different times of the year. Regular prices, discounts, rebates, and coupon
promotions are all pricing mechanisms used to probe the breadth and depth of
customer demand and to maximize profitability.
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Pricing Practices
Q15.5
AOne of the least practical suggestions that economists have offered to managers is
that they set marginal revenues equal to marginal costs.@ Discuss this statement.
Q15.5
ANSWER
Profit-maximizing pricing practices can be effectively employed with scant direct

reference to marginal analysis. Although profit maximization requires that prices be
set so that marginal revenues equal marginal cost, it is not necessary to calculate both
in order to set optimal prices. Just using information on marginal costs and the point
price elasticity of demand, the calculation of profit maximizing prices is quick and
easy. Flexible markup pricing practices that reflect differences in marginal costs and
demand elasticities are an efficient method for ensuring that MR = MC for each line
of products sold. Widespread support for the use of incremental analysis in the
pricing practices of highly successful and profitable firms, like the use of markup
pricing practices, can be interpreted as support for the practical equivalent of
marginal analysis.
Q15.6
AMarginal cost pricing, as well as the use of incremental analysis, is looked upon
with favor by economists, especially those on the staffs of regulatory agencies. With
this encouragement, regulated industries do indeed employ these rational techniques
quite frequently. Unregulated firms, on the other hand, use marginal or incremental
cost pricing much less frequently, sticking to cost-plus, or full-cost, pricing except
under unusual circumstances. In my opinion, this goes a long way toward explaining
the problems of the regulated firms vis--vis unregulated industry.@ Discuss this
statement.
Q15.6
ANSWER
This statement is typical of managers who feel that if you don=t cover Afull costs@
on each and every item sold, you are not covering your costs of producing a given
product or service. It reveals a complete lack of understanding of marginal analysis
in decision making. In defense of the statement, however, it might be noted that
incorrect use of the incremental concept has sometimes led to disastrous results for
firms who improperly employ the technique by misjudging incremental revenues
and/or costs. Like any tool employed in decision making, incremental analysis is
only as powerful as the judgment and ability of the decision maker employing it.
Q15.7
What is price discrimination?

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Chapter 15
Q15.7
ANSWER
Price discrimination is the practice of charging different markups for the same
product. Price discrimination can result if a firm charges different prices for the
same product, or prices closely related products in such a manner that price
differences are not proportional to cost differences. Price discrimination exists
among multiple customers of an identical product if:
P1 MC1
P 2 MC 2
Note that price discrimination can exist when equal or unequal prices are charged
different customers. It simply implies that different customers are charged different
markups.
Q15.8
What conditions are necessary before price discrimination is both possible and
profitable? Why does price discrimination result in higher profits?
Q15.8
ANSWER
The primary requirement for price discrimination is an ability to segment the market
by preventing transfers among sub-markets. A second requirement for price
discrimination to be worthwhile is that demand elasticities must be different in the
various sub-markets. Otherwise, an optimal pricing scheme will result in equal
prices in all markets.
Price discrimination is profitable because it allows firms to charge higher
average prices, by setting MR = MC for each customer or customer class, and
thereby acquire more of what is called consumers= surplus.
Q15.9
Discuss the role of common costs in pricing practice.
Q15.9
ANSWER
Common costs are expenses that are necessary for manufacture of a joint product.
Common costs of production--raw material and equipment costs, management
expenses, and other overhead--cannot be allocated to each individual by-product on
any economically sound basis. Only costs that can be separately identified as
associated with a specific by-product can and should be allocated. For example,
tanning costs for hides and refrigeration costs for beef are separate identifiable costs
of each by-product. Feed costs are common, and cannot be allocated between hide
and beef production. Any allocation of such common costs is wrong and arbitrary.
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Pricing Practices
Q15.10
Why is it possible to determine the marginal costs of joint products produced in

variable proportions but not those of joint products produced in fixed proportions?
Q15.10
ANSWER
It is possible to estimate the marginal costs of joint products where output

proportions are variable because variations in output can be statistically related to
variations in cost. With joint production in fixed proportions, however, output of one
product is perfectly correlated with output of another, and it is impossible to identify
individual production costs. In such instances, one can only measure the marginal
cost of producing another unit of the output Apackage@ composed of the two or more
joint products.
SELF-TEST PROBLEMS & SOLUTIONS

ST15.1
George Constanza is a project coordinator at Kramer-Seinfeld & Associates, Ltd., a

large Brooklyn-based painting contractor. Constanza has asked you to complete an
analysis of profit margins earned on a number of recent projects. Unfortunately,
your predecessor on this project was abruptly transferred, leaving you with only
sketchy information on the firm=s pricing practices.
A.
Use the available data to complete the following table:
Price
Marginal
Cost
Markup
on Cost
(%)
$100
$25
300.0
75.0
240
72
680
272
150.0
60.0
750
Markup
on Price
(%)
100.0
2,800
40.0
2,700
33.3
3,360
20.0
5,800
10.0
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Chapter 15
Price
6,250
Markup
on Cost
(%)
5.3
Marginal
Cost
Markup
on Price
(%)
10000
B.
0.0
Calculate the missing data for each of the following proposed projects, based
on the available estimates of the point price elasticity of demand, optimal
markup on cost, and optimal markup on price:
Project
Price
Elasticity
-1.5
-2.0
Optimal
Markup
on Cost
(%)
Optimal
Markup
on Price
(%)
200.0
66.7
66.7
25.0
-5.0
25.0
11.1
-15.0
-20.0
10.0
5.0
4.0
10
ST15.1
-50.0
2.0
SOLUTION
A.
Price
Marginal
Cost
Markup
on Cost
(%)
Markup
on Price
(%)
$100
$25
300.0
75.0
240
72
233.3
70.0
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Pricing Practices
Price
680
Marginal
Cost
272
Markup
on Cost
(%)
150.0
Markup
on Price
(%)
60.0
750
375
100.0
50.0
2,800
1,680
66.7
40.0
3,600
2,700
33.3
25.0
4,200
3,360
25.0
20.0
5,800
5,220
11.1
10.0
6,250
5,938
5.3
5.0
10,000
10,000
0.0
0.0
B.
ST15.2
Optimal
Markup
on Cost
(%)
Optimal
Markup
on Price
(%)
Project
Price
Elasticity
-1.5
200.0
66.7
-2.0
100.0
50.0
-2.5
66.7
40.0
-4.0
33.3
25.0
-5.0
25.0
20.0
-10.0
11.1
10.0
-15.0
7.1
6.7
-20.0
5.3
5.0
-25.0
4.2
4.0
10
-50.0
2.0
2.0
Optimal Markup on Price. TLC Lawncare, Inc., provides fertilizer and weed control
lawn services to residential customers. Its seasonal service package, regularly
priced at $250, includes several chemical spray treatments. As part of an effort to
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Chapter 15
expand its customer base, TLC offered $50 off its regular price to customers in the
Dallas area. Response was enthusiastic, with sales rising to 5,750 units (packages)
from the 3,250 units sold in the same period last year.
ST15.2
A.
Calculate the arc price elasticity of demand for TLC service.
B.
Assume that the arc price elasticity (from Part A) is the best available estimate
of the point price elasticity of demand. If marginal cost is $135 per unit for
labor and materials, calculate TLC=s optimal markup on price and its optimal
price.
SOLUTION
A.
EP
Q P 2 + P1
x
P Q 2 + Q1
5, 750 - 3, 250 $200 + $250

x
$200 - $250 5, 750 + 3, 250
= -2.5
B.
Given P = EP = -2.5, the optimal TLC markup on price is:
Optimal Markup
on Price
-1
P
-1
-2.5
= 0.4 or 40%
Given MC = $135, the optimal price is:
Optimal Markup
on Price
P - MC
P
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Pricing Practices
0.4
P - $135
P
0.4P
= P - $135
0.6P
= $135
= $225
PROBLEMS & SOLUTIONS

P15.1
P15.1
Markup Calculation. Controller Dana Scully has asked you to review the pricing
practices of Fox Mulder, Inc., an importer and regional distributor of low-priced
cosmetics products (e.g., The Black Oil). Use the following data to calculate the
relevant markup on cost and markup on price for the following five items:
Product
Price
Marginal
Cost
$2
$0.20
0.6
1.2
Markup
on Cost
(%)
Markup
on Price
(%)
SOLUTION
Markup
on Cost
(%)
Markup
on Price
(%)
Product
Price
Marginal
Cost
$2
$0.20
900%
90%
0.6
400%
80%
1.2
233%
70%
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Chapter 15
P15.2
Product
D
Price
5
Marginal
Cost
2
Markup
on Cost
(%)
150%
Markup
on Price
(%)
60%
100%
50%
Optimal Markup. Dr. Robert Romano, chief of staff at County General Hospital,
has asked you to propose an appropriate markup pricing policy for various medical
procedures performed in the hospital=s emergency room. To help in this regard, you
consult a trade industry publication that provides data about the price elasticity of
demand for medical procedures. Unfortunately, the abrasive Dr. Romano failed to
mention whether he wanted you to calculate the optimal markup as a percentage of
price or as a percentage of cost. To be safe, calculate the optimal markup on price
and optimal markup on cost for each of the following procedures:
Procedure
Optimal
Markup
on Cost
Price
Elasticity
A.
-1
B.
-2
C.
-3
D.
-4
E.
-5
Optimal
Markup
on Price
P15.2 SOLUTION
Procedure
Optimal
Markup
on Cost
Price
Elasticity
Optimal
Markup
on Price
A.
-1
---%
100.0%
B.
-2
100.0%
50.0%
C.
-3
50.0%
33.3%
D.
-4
33.3%
25.0%
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Pricing Practices
Price
Elasticity
-5
Procedure
E.
Optimal
Markup
on Cost
25.0%
Optimal
Markup
on Price
20.0%
P15.3 Markup on Cost. Brake-Checkup, Inc., offers automobile brake analysis and repair at a
number of outlets in the Philadelphia area. The company recently initiated a policy of
matching the lowest advertised competitor price. As a result, Brake-Checkup has been
forced to reduce the average price for brake jobs by 3%, but it has enjoyed a 15%
increase in customer traffic. Meanwhile, marginal costs have held steady at $120 per
brake job.
A.
Calculate the point price elasticity of demand for brake jobs.
B.
Calculate Brake-Checkup=s optimal price and markup on cost.
P15.3 SOLUTION
P
A.
Percentage change in output

Percentage change in price
0.15
-0.03
= -5
B.
Given P = -5, the optimal markup on cost is:

Optimal Markup
on Cost
-1
P + 1
-1
-5 + 1
= 0.25 or 25%
Given MC = $120, the optimal price is:
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Chapter 15
Optimal Markup
on Cost
0.25 =
P - MC
MC
P - $120
$120
$30 = P - $120
P = $150
P15.4
P15.4
Optimal Markup on Cost. The Bristol, Inc. is an elegant dining establishment that
features French cuisine at dinner six nights per week, and brunch on weekends. In
an effort to boost traffic from shoppers during the Christmas season, the Bristol
offered Saturday customers $4 off its $16 regular price for brunch. The promotion
proved successful, with brunch sales rising from 250 to 750 units per day.
A.
Calculate the arc price elasticity of demand for brunch at the Bristol.
B.
Assume that the arc price elasticity (from part A) is the best available estimate
of the point price elasticity of demand. If marginal cost is $8.56 per unit for
labor and materials, calculate the Bristol=s optimal markup on cost and its
optimal price.
SOLUTION
EP
A.
Q P 2 + P1
x
P Q 2 + Q1
750 - 250 $12 + $16

x
$12 - $16 750 + 250
= -3.5
B.
Given P = EP = -3.5, the optimal markup on cost for Saturday brunch at the Bristol
during this time frame is:
Optimal Markup
on Cost
-1
P +1
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Pricing Practices
-1
-3.5 +1
= 0.4 or 40%
Given MC = $8.56, the optimal price is:
Optimal Markup
on Cost
0.4
$3.424
P
P15.5
P - MC
MC
P - $8.56
$8.56
= P - $8.56
= $11.99
Markup Pricing Practice. Betty's Boutique is a small specialty retailer located in a

suburban shopping mall. In setting the regular $36 price for a new spring line of
blouses, Betty's added a 50 per cent markup on cost. Costs were estimated at $24
each: the $12 purchase price of each blouse, plus $6 in allocated variable overhead
costs, plus an allocated fixed overhead charge of $6. Customer response was so
strong that when Betty's raised prices from $36 to $39 per blouse, sales fell only
from 54 to 46 blouses per week.
At first blush, Betty's pricing policy seems clearly inappropriate. It is always
improper to consider allocated fixed costs in setting prices for any good or service;
only marginal or incremental costs should be included. However, by adjusting the
amount of markup on cost employed, Betty's can implicitly compensate for the
inappropriate use of fully allocated costs. It is necessary to carefully analyze both
the cost categories included and the markup percentages chosen before judging the
appropriateness of a given pricing practice.
A.
Use the arc price elasticity formula to estimate the price elasticity of demand
for Betty's blouses
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Chapter 15
B.
Determine Betty's optimal markup on cost using the arc price elasticity as an
estimate of the point price elasticity of demand. Based upon relevant marginal
costs, calculate Betty's optimal price. Explain.
P15.4
SOLUTION
A.
The $3 price increase to $39 represents a moderate 7.7 per cent rise in price. Using
the arc price elasticity formula, the implied arc price elasticity of demand for Betty's
blouses is:
Q 2 - Q1 P 2 + P1
x
EP =
P 2 - P1 Q 2 + Q1
46 - 54
$39 + $36
=
x
$39 - $36
46 + 54
= - 2.
If it can be assumed that this arc price elasticity of demand EP = -2 is the best
available estimate of the current point price elasticity of demand, the optimal markup
B.
Optimal Markup
-1
=
on Cost
P + 1
-1
=
-2 + 1
= 1 or 100%.
on cost is:
Betty's standard cost per blouse includes the $12 purchase cost, plus $6 allocated
variable costs, plus $6 fixed overhead charges. However, for pricing purposes, only
the $12 purchase cost plus the allocated variable overhead charge of $6 are relevant.
Thus, the relevant marginal cost for pricing purposes is $18 per blouse. The
allocated fixed overhead charge of $6 is irrelevant for pricing purposes because fixed
overhead costs are unaffected by blouse sales.
At the $36 price, Betty's actual markup on relevant marginal costs per blouse is
an optimal 100 per cent, because
Markup on Cost
$36 - $18
$18
= 1 (or 100 per cent).
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Pricing Practices
Therefore, Betty's initial $36 price on blouses is optimal, and the subsequent $3 price
increase should be rescinded.
This simple example teaches an important lesson. Despite the improper
consideration of fixed overhead costs and a markup that might at first appear
unsuitable, Betty's pricing policy is entirely consistent with profit-maximizing
behavior because the end result is an efficient pricing policy. Given the prevalence
of markup pricing in everyday business practice, it is important that these pricing
practices be carefully analyzed before they are judged sub-optimal. The widespread
use of markup pricing methods among highly successful firms suggests that the
method is typically employed in ways that are consistent with profit maximization.
Far from being a naive rule of thumb, markup pricing practices allow firms to arrive
at optimal prices in an efficient manner.
P15.5
Peak/Off-Peak Pricing. Nash Bridges Construction Company is a building

contractor serving the Gulf Coast region. The company recently bid on a Gulf-front
causeway improvement in Buloxi, Mississippi. Nash Bridges has incurred bid
development and job cost-out expenses of $25,000 prior to submission of the bid.
The bid was based on the following projected costs:
Cost Category
Amount
Bid development and job cost-out expenses
$25,000
Materials
881,000
Labor (50,000 hours @ $26)
1,300,000
Variable overhead (40% of direct labor)
520,000
Allocated fixed overhead (6% of total costs)
174,000
Total costs
P15.6
$2,900,000
A.
What is Nash Bridges= minimum acceptable (breakeven) contract price,

assuming that the company is operating at peak capacity?
B.
What is the Nash Bridges= minimum acceptable contract price if an economic

downturn has left the company with substantial excess capacity?
SOLUTION
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Chapter 15
A.
Because the $25,000 bid development and job cost-out expenses were incurred prior
to submission of the bid, they are sunk costs and irrelevant in determining a
minimum acceptable contract price.
When operating at peak capacity, the company is fully employed and able to
obtain prices covering fully allocated costs. Thus, assuming the company is
operating at peak capacity, all non-sunk costs are relevant and a minimum acceptable
bid price is $2,875,000 + (=$2,900,000 - $25,000). In particular, note that the 6%
fixed overhead charge is relevant as it represents an opportunity cost of turning away
other profitable business.
B.
Assuming an economic downturn has left the company with substantial excess
capacity, neither the $25,000 sunk development expense nor the 6% fixed overhead
charge are relevant. When operating at less than peak capacity, the minimum
acceptable contract price is determined solely by the level of incremental costs.
Here, the minimum acceptable contract price off-peak is $2,701,000 +
(=$2,900,000 - $25,000 - $174,000). Any price above that level will make a positive
contribution to overhead and should be accepted.
P15.7
Incremental Pricing Analysis. The General Eclectic Company manufactures an

electric toaster. Sales of the toaster have increased steadily during the previous five
years, and, because of a recently completed expansion program, annual capacity is
now 500,000 units. Production and sales during the upcoming year are forecast to
be 400,000 units, and standard production costs are estimated as follows:
Materials
$6.00
Direct labor
4.00
Variable indirect labor
2.00
Fixed overhead
3.00
Allocated cost per unit
$15.00
In addition to production costs, General incurs fixed selling expenses of $1.50 per
unit and variable warranty repair expenses of $1.20 per unit. General currently
receives $20 per unit from its customers (primarily retail department stores), and it
expects this price to hold during the coming year.
After making the preceding projections, General received an inquiry about the
purchase of a large number of toasters by a discount department store. The inquiry
contained two purchase offers:
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Pricing Practices
#
Offer 1: The department store would purchase 80,000 units at $14.60 per unit.
These units would bear the General label and be covered by the General
warranty.
Offer 2: The department store would purchase 120,000 units at $14.00 per
unit. These units would be sold under the buyer=s private label, and General
would not provide warranty service.
A.
Evaluate the incremental net income potential of each offer.
B.
What other factors should General consider when deciding which offer to
accept?
C.
Which offer (if either) should General accept? Why?
P15.7
SOLUTION
A.
The incremental net income from these offers can be determined as follows:
Offer 1
Unit price
Offer 2
$14.60
$14.00
Unit variable costs:

Materials
$6.00
$6.00
Direct labor
4.00
4.00
Variable indirect labor
2.00
2.00
Variable warranty expense
1.20
Unit incremental profit
13.20
0.00
12.00
1.40
2.00
Units to be sold
80,000
120,000
Total variable profit on units sold at special price
$112,000
$240,000
Less variable profit lost on regular sales:

Regular price
$20.00
Regular variable costs
- 13.20
Regular variable profit
6.80
Units that cannot be sold at regular price if

20,000
Offer 2 is accepted
Opportunity cost of lost regular sales
$0
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$136,000
Chapter 15
Offer 1
Incremental profit
$112,000
Offer 2
$104,000
Both offers involve a substantial incremental profit, but offer 1 appears to be the
more attractive on a simple dollar basis.
B.
(i)The image of General=s quality may be affected by sales of the appliance in the
department store chain with a private label.
(ii)Other buyers may demand the reduced price if General accepts offer 1 and the
department store undercuts them at the retail price level.
(iii)The sales lost if General accepts offer 2 may affect future orders from regular
customers.
C.
It depends upon how you evaluate the factors discussed in part B. The incremental
profits of offer 1 exceed those of offer 2, but other long-run concerns might well
dictate that it not be accepted.
P15.8
Price Discrimination. Coach Industries, Inc., is a leading manufacturer of

recreational vehicle products. Its products include travel trailers, fifth-wheel trailers
(towed behind pick-up trucks), and van campers, as well as parts and accessories.
Coach offers its fifth-wheel trailers to both dealers (wholesale) and retail customers.
Ernie Pantusso, Coach=s controller, estimates that each fifth-wheel trailer costs the
company $10,000 in variable labor and material expenses. Demand and marginal
revenue relations for fifth-wheel trailers are
PW = $15,000 - $5QW
(Wholesale),
MRW = TRW/QW = $15,000 - $10QW.

PR = $50,000 - $20QR
(Retail),
MRR = = TRR/QR = $50,000 - $40QR.

A.
Assuming that the company can price discriminate between its two types of
customers, calculate the profit-maximizing price, output, and profit contribution
levels.
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Pricing Practices
B.
Calculate point price elasticities for each customer type at the activity levels
identified in part A. Are the differences in these elasticities consistent with your
recommended price differences in part A? Why or why not?
P15.8
SOLUTION
A.
With price discrimination, profits are maximized by setting MR = MC in each market,

where MC = $10,000.
Wholesale
MRW = MC
$15,000 - $10QW = $10,000
QW = 500 units
PW = $15,000 - $5QW
= $15,000 - $5(500)
= $12,500.
Retail
MRR = MC
$50,000 - $40QR = $10,000
QR = 1,000 units
PR = $50,000 - $20QR
= $50,000 - $20(1,000)
= $30,000
The profit contribution earned by the company is:
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Chapter 15
= PWQW + PRQR - AVC(QW + QR)

= $12,500(500) + $30,000(1,000)
- $10,000(500 + 1,000)
= $21,250,000
B.
Yes, the point price elasticity of demand for each customer class is:
Wholesale
QW = 3,000 - 0.2PW
P = QW/PW PW/QW
= -0.2 ($12,500/500)
= -5
Retail
QR
= 2,500 - 0.05PR
P = QR/PR PR/QR
= -0.05 ($30,000/1,000)
= -1.5
A higher price for retail customers is consistent with the lower degree or price
elasticity observed in that market.
P15.9
Joint Product Pricing. Each ton of ore mined from the Baby Doe Mine in Leadville,
Colorado, produces one ounce of silver and one pound of lead in a fixed 1:1 ratio.
Marginal costs are $10 per ton of ore mined.
The demand and marginal revenue curves for silver are
PS
= $11 - $0.00003QS
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Pricing Practices
MRS = TRS/QS
= $11 - $0.00006QS
and the demand and marginal revenue curve for lead are
PL = $0.4 - $0.000005QL
MRL = TRL/QL = $0.4 - $0.00001QL
where QS is ounces of silver and QL is pounds of lead.
A.
B.
Calculate profit-maximizing sales quantities and prices for silver and lead.
Now assume that wild speculation in the silver market has created a fivefold
(or 500%) increase in silver demand. Calculate optimal sales quantities and
prices for both silver and lead under these conditions.
P15.9
SOLUTION
A.
It is appropriate to begin analysis of this problem by examining the optimal activity

level, assuming the firm mines and sells equal quantities of silver and lead.
For profit maximization where Q = QS = QL, set:
MC = MRS + MRL = MR
$10 = $11 - $0.00006Q + $0.4 - $0.00001Q
$0.00007Q = 1.4
Q = 20,000
Profit maximization with equal sales of each product requires that the firm mine Q =
20,000 tons of ore. Under this assumption, marginal revenues for the two products
are:
MRS = $11 - $0.00006(20,000) = $9.80
MRL = $0.4 - $0.00001(20,000) = $0.20
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Chapter 15
Because each product is making a positive contribution to marginal costs of $10 per
ton, Q = 20,000 is an optimal activity level.
Relevant prices are:
PS = $11 - $0.00003(20,000) = $10.40
PL = $0.4 - $0.000005(20,000) = $0.30
B.
A five-fold (or 500%) increase in silver demand means that a given quantity could be
sold at 5 times the original price. Alternatively, 5 times the original quantity
demanded could be sold at a given price. Therefore, the new silver demand and
marginal revenue curves can be written:
PS' = 5($11 - $0.00003QS)
= $55 - $0.00015QS
MRS' = 5($11 - $0.00006QS)
= $55 - $0.0003QS
Now, assuming all output is sold,
MC = MRS' + MRL = MR
$10 = $55 - $0.0003Q + $0.4 - $0.00001Q
0.00031Q = 45.4
Q = 146,452
Thus, profit maximization with equal sales of each product requires that the
firm mine Q = 146,452 tons of ore. Under this assumption, marginal revenues for the
two products are:
MRS'
= $55 - $0.0003(146,452) = $11.06
MRL
= $0.4 - $0.00001(146,452) = -$1.06
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Pricing Practices
Even though MR S' + MRL = MC = $10, the above Q = 146,452 solution is

suboptimal. MRS' = $11.06 > $10 = MC implies that a $1.06 profit contribution was
earned on each marginal ton of ore mined when just considering S sales. This means
that the firm would like to expand production beyond Q = 146,452 just to sell more S.
The negative marginal revenue for L implies that the firm had to reduce price so
much in order to sell all 146,452 pounds of L (indeed offer a negative price or
subsidy of 334 per pound) that total revenues fell by $1.06 on the last pound sold.
Rather than sell L under such unfavorable conditions, the firm would like to reduce L
sales below 146,452 pounds.
The firm would sell L only up to the point where MRL = 0 because, given
additional production to sell S, the marginal cost of L is zero. Set,
MRL
$0.4 - $0.00001Q
$0.00001Q
QL
PL
= MCL
= 0
= 0.4
= 40,000
= $0.4 - $0.000005(40,000)
= $0.20
The optimal production and sales level of S is found by setting MRS = MC,
because S is the only product sold from the marginal ton of ore being mined.
MRS
$55 - $0.0003QS
0.0003QS
QS
= MC = MCS
= $10
= 45
= 150,000
and
PS
= $55 - $0.00015(150,000)
= $32.50
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Chapter 15
Therefore, the firm should mine 150,000 tons of ore, and sell all 150,000
ounces of S produced at a price of $32.50. Only 40,000 pounds of lead should be
sold at a price of 204 per pound, with the remaining 110,000 pounds produced being
held off the market.
(Note: Despite a five-fold increase in demand, prices increase by less than
five-fold given the firm=s expansion in output.)
P15.10
Transfer Pricing. Simpson Flanders, Inc., is a Motor City-based manufacturer and

distributor of valves used in nuclear power plants. Currently, all output is sold to
North American customers. Demand and marginal revenue curves for the firm are
as follows:
P
MR = TR/Q
= $1,000 - $0.015Q
= $1,000 - $0.03Q
Relevant total cost, marginal cost, and profit functions are

TC = $1,500,000 + $600Q + $0.005Q2
MC = TC/Q = $600 + $0.01Q
= TR - TC
= -$0.02Q2 + $400Q - $1,500,000
A.
Calculate the profit-maximizing activity level for Simpson Flanders when the
firm is operated as an integrated unit.
B.
Assume that the company is reorganized into two independent profit centers
with the following cost conditions:
TCMfg
= $1,250,000 + $500Q + $0.005Q2
MCMfg
=TCMfg/Q =500 + $0.01Q
TCDistr
= $250,000 + $100Q
MCDistr = TCDistr/Q =$100.

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Pricing Practices
Calculate the transfer price that ensures a profit-maximizing level of profit for
the firm, with divisional operation based on the assumption that all output
produced is to be transferred internally.
C.
Now assume that a major distributor in the European market offers to buy as
many valves as Simpson Flanders wishes to offer at a price of $645. No impact
on demand from the company=s North American customers is expected, and
current facilities can be used to supply both markets. Calculate the company=s
optimal price(s), output(s), and profits in this situation.
P15.10
SOLUTION
A.
Profit maximization occurs at the point where MR = MC, so the optimal output level
is:
MR
$1,000 - $0.03Q
= MC,
= $600 + $0.01Q,
400
= 0.04Q,
= 10,000.
= $1,000 - $0.015(10,000),
This implies:
= $850,
= TR - TC,
= -$0.02(10,0002) + $400(10,000) - $1,500,000,
= $500,000.
B.
To derive an appropriate transfer price when no external market is present, the net
marginal revenue for the distribution division is set equal to marginal cost of the
manufacturing division to identify the firm=s profit-maximizing activity level:
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Chapter 15
MR - MCDistr = MCMfg,
$1,000 - $0.03Q - $100 = $500 + $0.01Q,
400 = 0.04Q,
Q = 10,000.
The 10,000-unit output level remains optimal for profit maximization, as must
be the case. If the distribution division determines the quantity it will purchase by
movement along its marginal revenue curve, and the manufacturing division supplies
output along its marginal cost curve, then the market clearing transfer price is the
price that results when MR - MCDistr = MCMfg. At 10,000 units of output, the optimal
transfer price is:
PT
= MCMfg,
= $500 + $0.01(10,000),
= $600.
At a transfer price of $600, the quantity supplied by the manufacturing division

equals 10,000. Similarly, the quantity demanded by the distribution division also
equals 10,000 at a transfer price of $600:
MR - MCDistr = PT,
$1,000 - $0.03Q - $100 = $600,
300 = 0.03Q,
Q = 10,000,
At a transfer price PT > $600, the distribution division will accept fewer units of
output than the manufacturing division wants to supply. If PT < $600, the
distribution division will seek to purchase more units than the manufacturing division
desires to produce. Only at a $600 transfer price are supply and demand in balance
in the firm=s internal market.
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Pricing Practices
C.
If a perfectly competitive external market exists for the transferred product, the
optimal transfer price equals the external market price. Because the new European
customer is willing buy all output supplied at a price of $645, this value represents
the opportunity cost of North American versus European sales. A transfer price of PT
= $645 should be established. At this price, the quantity demanded by the
distribution division is:
MR - MCDistr = PT,
$1,000 - $0.03Q - $100 = $645,
255 = 0.03Q,
Q = 8,500,
whereas the quantity supplied by the manufacturing division is:
PT
$645
= MCMfg,
= $500 + $0.01Q,
145
= 0.01Q,
= 14,500.
In this instance of excess internal supply, the distribution division will purchase
internally all units desired for the North American market, and QNA = 8,500. The
optimal price for the North American market is:
PNA = $1,000 - $0.015(8,500),
= $872.50.
The manufacturing division will offer an additional QE = 6,000 units to new
customers in the European market at a price of PE = $645.
Maximum total profits are:
= TRNA + TRE - TCMfg - TCDistr,
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Chapter 15
= $872.50(8,500) + $645(6,000) -$1,250,000

- $500(14,500) - $0.005(14,5002) - $250,000
- $100(8,500),
= $635,000
The offer from the European distributor should be accepted as it results in a
$135,000 increase in profits, from $500,000 to $635,000. Notice that the optimal
transfer price PT = $645 equates the marginal cost of the each division to the
marginal revenue derived from each market. Given the separate nature of the North
American and European markets, the company is able to grow and profitably
segment its market at the same time.
CASE STUDY FOR CHAPTER 15
Pricing Practices in the Denver, Colorado, Newspaper Market
On May 12, 2000, the two daily newspapers in Denver, Colorado, filed an application with the
U.S. Department of Justice for approval of a joint operating arrangement. The application was
filed by The E.W. Scripps Company, whose subsidiary, the Denver Publishing Company,
published the Rocky Mountain News, and the MediaNews Group, Inc., whose subsidiary, the
Denver Post Corporation, published the Denver Post. Under the proposed joint operating
agreement, printing and commercial operations of both newspapers were to be handled by a new
entity, the ADenver Newspaper Agency,@ owned by the parties in equal shares. This type of joint
operating agreement provides for the complete independence of the news and editorial
departments of the two newspapers. The rationale for such an arrangement, as provided for
under the Newspaper Preservation Act, is to preserve multiple independent editorial voices in
towns and cities too small to support two or more newspapers. The act requires joint operating
arrangements, such as that proposed by the Denver newspapers, to obtain the prior written
consent of the attorney general of the United States in order to qualify for the antitrust
exemption provided by the act.
Scripps initiated discussions for a joint operating agreement after determining that
the News would probably fail without such an arrangement. In their petition to the Justice
department, the newspapers argued that the News had sustained $123 million in net operating
losses while the financially stronger Post had reaped $200 million in profits during the 1990s.
This was a crucial point in favor of the joint operating agreement application because the
attorney general must find that one of the publications is a failing newspaper and that approval
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Pricing Practices
of the arrangement is necessary to maintain the independent editorial content of both
newspapers. Like any business, newspapers cannot survive without a respectable bottom line.
In commenting on the joint operating agreement application, Attorney General Janet Reno noted
that Denver was one of only five major American cities still served by competing daily
newspapers. The other four are Boston, Chicago, New York, and Washington, DC. Of course,
these other four cities are not comparable in size to Denver; they are much bigger. None of
those four cities can lay claim to two newspapers that are more or less equally matched and
strive for the same audience. In fact, that there is not a single city in the United States that still
supports two independently owned and evenly matched, high-quality newspapers that vie for the
same broad base of readership.
Economies of scale in production explain why few cities can support more than one
local newspaper. Almost all local newspaper production and distribution costs are fixed.
Marginal production and distribution costs are almost nil. After the local news stories and local
advertising copy are written, there is practically no additional cost involved with expanding
production from, say, 200,000 to 300,000 newspapers per day. Once a daily edition is produced,
marginal costs may be as little as 54 per newspaper. When marginal production costs are
minimal, price competition turns vicious. Whichever competitor is out in front in terms of total
circulation simply keeps prices down until the competition goes out of business or is forced into
accepting a joint operating agreement. This is exactly what happened in Denver. Until recently,
the cost of a daily newspaper in Denver was only 254 each weekday and 504 on Sunday at the
newsstand, and even less when purchased on an annual subscription basis. The smaller News
had much higher unit costs and simply could not afford to compete with the Post at such
ruinously low prices. This is why the production of local newspapers is often described as a
classic example of natural monopoly.
On Friday, January 5, 2001, Attorney General Reno gave the green light to a 50year joint operating agreement between the News and its longtime rival, the Post. Starting
January 22, 2001, the publishing operations of the News and the Post were consolidated. The
Denver Newspaper Agency, owned 50/50 by the owners of the News and Post, is now responsible
for the advertising, circulation, production, and other business departments of the newspapers.
Newsrooms and editorial functions remain independent. Therefore, the owners of the News and
Post are now working together to achieve financial success, but the newsroom operations
remain competitors. Under terms of the agreement, E.W. Scripps Company, parent of the
struggling News, agreed to pay owners of the Post $60 million. Both newspapers publish
separately Monday through Friday. The News publishes the only Saturday paper and the Post
the only Sunday paper.
A.
Use your knowledge of monopoly pricing practices to explain why advertising rates
and newspaper circulation prices were likely to increase, and jobs were likely to be
lost, following adoption of this joint operating agreement. Use company information
- 467 -
Chapter 15
to
support
your
argument
http://www.rockymountainnews.com/).
(see
http://www.denverpost.com
and
B.
In many cases, classified ads to sell real estate in a local newspaper can cost five to
ten times as much as a similar ad used to announce a garage sale. Use your
knowledge of price discrimination to explain how local newspaper monopolies
generate enormous profits from selling classified advertising that varies in price
according to the value of the item advertised.
C.
Widely differing fares for business and vacation travelers on the same flight have led
some to accuse the airlines of price discrimination. Do airline fare differences or
local newspaper classified-ad rate differences provide stronger evidence of price
discrimination?
CASE STUDY SOLUTION

A.
At the time the joint operating agreement was formed, neither news organization
would speculate on job losses or advertising and circulation rate increases resulting
from the deal. Both proclaimed that job losses and rate increases would not be
substantial. In fact, the company announced significant job cuts and steep rate
increases in the period immediately following the start-up of the joint operating
agreement. Prices for single newspapers quickly jumped from 254 to 504 daily, and
from 504 to $1.50 on Sunday. Commensurate increases were noted for long-term
subscriptions and advertising customers.
In a celebrated case, Jake Jabs, who owns the American Furniture Warehouse
chain in Denver, said newspaper officials quickly proposed a new four-year
advertising contract that required ads in both papers, with a 100% rate increase the
first year, and 25% per year for the following three years. Jabs and other major local
advertisers were so incensed that they sued in federal court. They lost. In early 2001,
U. S. District Judge John Kane Jr. rejected a preliminary injunction sought by Jabs
and a coalition of retailers called Coloradans Against Newspaper Monopolies. They
wanted to roll back new ad rates at the News and the Post, and accused the papers of
violating advertisers= free speech rights by raising ad rates too high. Kane found no
authority in support of the alleged constitutional violation, and the suit was dismissed.
Kane said antitrust laws prohibiting business monopolies don=t apply to newspapers
in joint operating agreements.
The circulations of the Post and the News also fell sharply after the two
newspapers introduced sharp increases in subscription rates. In the first two months
after the two papers combined business operations and began sharing profits, the
News lost 17.9 percent of its Monday through Saturday circulation and the Post lost
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Pricing Practices
11.9 percent. The News= Monday-through-Saturday circulation dropped from

446,465 to 366,499, and Post circulation dropped from 413,730 to 364,451. Sunday
circulation for the News dropped from 552,085 to 448,032, and the Post=s Sunday
circulation dropped from 558,560 to 522,903.
B.
Local newspapers have a formidable niche in the provision of regional news and
classified advertising. If readers want stock quotes or general business news, they
can find that information on the Internet or from a host of national providers, like
The Wall Street Journal and The New York Times. However, if readers want to find
out how the local high school football game turned out, they typically can only find
that information in the local newspaper. Similarly, the local newspaper is frequently
the only place to go for local business advertising and classified ads.
An interesting illustration of price discrimination can be found in the
classified-ad pricing policies of local newspapers. The value of classified advertising
varies according to the value of the item advertised. Real estate advertising has a
much greater value to customers than advertising the sale of lower-priced household
items, boats, pets, and so on. Given these differences, customers are willing to pay
much more to advertise the sale of a personal residence, for example, than to seek
new homes for Spotty and her kittens. Local newspapers satisfy the requirements
necessary for profitable price discrimination, because they can easily identify the
value of the item advertised and often enjoy a monopoly position in the sale of local
advertising. It should not be surprising that local newspaper monopolies generate
enormous profits from selling classified advertising that varies in price according to
the value of the item advertised.
C.
The airline industry provides an interesting basis for discussing price discrimination.
Ticket prices vary dramatically between business customers, whose travel plans
change quickly and whose demand is relatively inelastic with respect to price, and
vacation customers, who can establish travel plans well in advance and whose
demand is typically more price elastic. However, before concluding that the higher
prices charged business customers solely reflect price discrimination, it is important
to recognize that the cost of serving business customers is greater than for vacation
travelers.
Business traffic is particularly heavy on Mondays, and Fridays. This pattern of
business travel often leaves airlines with substantial unused capacity on Tuesdays,
Wednesdays, and Thursdays, as well as on Saturdays and Sundays. Given this
excess capacity, the incremental cost per air traveler can be substantially lower
during midweek and weekend periods. Airlines are also better able to schedule their
use of airplane capacity when demand is predictable as opposed to erratic. This
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Chapter 15
contributes to lower fares for restricted as opposed to unrestricted travelers. The

price differentials common in airline rate structures clearly reflect the influence of
cost differences, perhaps in addition to the effects of price discrimination.
On the other hand, there is absolutely no difference in the cost of providing a
three-line ten-day want-ad for a bicycle versus a personal residence. Both types of
ads require the same amount of labor and raw materials to produce, sell and deliver
to newspaper customers. Because the costs of providing consumer and commercial
want ads are the same, differences in the prices charged these different classes of
customers are based upon differences in the customer price elasticity of demand
rather than cost differences. Demand for want ad advertising by consumers tends to
be quite inelastic with respect to price because consumers have few, if any,
alternatives to placing such ads in the local newspaper. Commercial customer
demand for want ad advertising is much more price elastic because commercial
customers use flyers distributed door-to-door by independent contractors, local radio
and television advertising to promote their products. As a result, the pricing
practices of local newspaper advertising clearly reflects a pricing practice of price
discrimination whereby commercial customers pay much lower prices and markups
than the amounts paid by individual consumers.
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Chapter 15

QUESTIONS & ANSWERS

Price - Marginal Cost

Price - Marginal Cost

earned on various items, and in determining the optimal markup, it is crucial to

Profit-maximizing pricing practices can be effectively employed with scant direct

What is price discrimination?

Discuss the role of common costs in pricing practice.

Why is it possible to determine the marginal costs of joint products produced in

It is possible to estimate the marginal costs of joint products where output

SELF-TEST PROBLEMS & SOLUTIONS

George Constanza is a project coordinator at Kramer-Seinfeld & Associates, Ltd., a

Use the available data to complete the following table:

Calculate the arc price elasticity of demand for TLC service.

5, 750 - 3, 250 $200 + $250

Given P = EP = -2.5, the optimal TLC markup on price is:

PROBLEMS & SOLUTIONS

Calculate the point price elasticity of demand for brake jobs.

Calculate Brake-Checkup=s optimal price and markup on cost.

Percentage change in output

Given P = -5, the optimal markup on cost is:

750 - 250 $12 + $16

Markup Pricing Practice. Betty's Boutique is a small specialty retailer located in a

Peak/Off-Peak Pricing. Nash Bridges Construction Company is a building

Bid development and job cost-out expenses

Labor (50,000 hours @ $26)

Variable overhead (40% of direct labor)

Allocated fixed overhead (6% of total costs)

What is Nash Bridges= minimum acceptable (breakeven) contract price,

What is the Nash Bridges= minimum acceptable contract price if an economic

Incremental Pricing Analysis. The General Eclectic Company manufactures an

Variable indirect labor

Allocated cost per unit

Evaluate the incremental net income potential of each offer.

Which offer (if either) should General accept? Why?

Unit variable costs:

Variable indirect labor

Variable warranty expense

Unit incremental profit

Total variable profit on units sold at special price

Less variable profit lost on regular sales:

Regular variable costs

Regular variable profit

Units that cannot be sold at regular price if

Price Discrimination. Coach Industries, Inc., is a leading manufacturer of

MRW = TRW/QW = $15,000 - $10QW.

MRR = = TRR/QR = $50,000 - $40QR.

With price discrimination, profits are maximized by setting MR = MC in each market,

= PWQW + PRQR - AVC(QW + QR)

It is appropriate to begin analysis of this problem by examining the optimal activity

= $55 - $0.0003(146,452) = $11.06

= $0.4 - $0.00001(146,452) = -$1.06

Even though MR S' + MRL = MC = $10, the above Q = 146,452 solution is

Transfer Pricing. Simpson Flanders, Inc., is a Motor City-based manufacturer and

Relevant total cost, marginal cost, and profit functions are

= $1,250,000 + $500Q + $0.005Q2

=TCMfg/Q =500 + $0.01Q

MCDistr = TCDistr/Q =$100.

At a transfer price of $600, the quantity supplied by the manufacturing division

= TRNA + TRE - TCMfg - TCDistr,

= $872.50(8,500) + $645(6,000) -$1,250,000

CASE STUDY SOLUTION

11.9 percent. The News= Monday-through-Saturday circulation dropped from