ECON 3125 Metzgar Chap 3

Chapter 3 Optimal Pricing

Exploration Concept Introduction - Application

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Exploration:

A manager experiments with cutting price by 5%. He finds that this increases sales a great degree, by
20%. What does this experiment tell you about the businesses customers?

- cut the price, sell more - cut small, small change

* The customers are price sensitive at this level

Concept: The price elasticity of demand measures the percentage change in quantity demanded for a
given price change

PEd = % change in Q/ % change in P

Application:

If price increases by 10%, and quantity sold falls by 10%, what is the price elasticity of demand?

Ped = -10%/10% = -1

What is the price elasticity of demand for kidney transplants?

- not price sensitive; not concerned with price

CQ1. A person always gets $20 worth of gas at the gas station, no matter what the price. What is his
price elasticity of demand? 2x10 = 20 4x5=20

1. Inelastic not very price sensitive -1<EP<0

2. Unitary equal % change in Q for a % change in P EP = -1 (ANS)
3. Elastic more price sensitive EP<-1

P1 = 2 Q1 = 10 P2 = 4 Q2 = 5

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Ep = (-5/7.50)/(2/3) = (-2/3)/(2/3) = -1 unitary

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Exp:

From previous research, a firm estimates its demand curve to be Q = 20 P. At P = $5, what is the
elasticity at that point?

Concept: Point elasticity is the elasticity at a specific point on the demand curve

(dQ/dP)(P/Q)

(-1)(5/15) = -5/15 = -1/3 = -0.33 inelastic

Elastic/INELASTIC/Unitary

App: Assume P = 40 2Q. At Q = 4, what is the point elasticity of demand?

P = 40 2Q

2Q/2 = 40 P/2 Q = 20 ( )P

(-1/2)(32/4) = -4 Elastic

As more substitutes become available, what happens to the point elasticity of demand?

More price sensitive; more elastic demand

CQ2. Assume Q = 60 2P. At Q = 50, what is the point elasticity of demand?

Enter as a value.

50 = 60 2P 50 + 2P = 60 2P = 10 P = 5

(-2)(5/50) -0.2 inelastic

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Exp:

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Assume P = 6 Q. Calculate the TR, MR, and Point elasticity for each level. What did you find?

Q P Total Revenue (6Q MR Point Elasticity

Q^2) - P
2 4 12 8 0 (-1)(4/2) = -2
3 3 18 9 1 (-1)(3/3) = -1
4 2 24 8 -1 (-1)(2/4) = -0.5

P=6Q Rearrange = Q = 6 P

dQ/dP = -1

Concept: Total revenue is maximized . When the Point Elasticity is -1

App: If point elasticity = -2, what should a manager do if she wanted to increase revenue?

Lower the price since some customers are price sensitive

If point elasticity = 0, what does that tell you?

Ep = %change in Q/ % change in P = 0 Price changes up or down but quantity is the same

Could increase price if looking to increase revenue; customers will buy the same amount no matter
what the price

Perfectly inelastic

CQ3. If P = 24 Q, what price maximizes total revenue? (Can you solve using the point elasticity
formula?)

Enter as a value.

Q = 24 P (-1)(P/Q)

24Q Q^2 = 24 Q 24Q Q^2 24 2Q = 0

Q = 12 P = 24 12 = 12

P = 24 Q Max revenue

Ep = -1

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 P = 24 Q

+Q P +Q P

Q = 24 P

Ep = (-1)(24 Q/Q) = 1 Q(24-Q/Q) = (1)Q

24 Q = Q 24/2 = 2Q/2 Q = 12 P = 24 24 = 12.

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Exp:

Apple has large price increases for its higher memory iPhones, even though the cost of adding additional
memory is small. Why do they price these higher memory iPhones so high?

- Because customers are willing to pay; customers at this price point may be inelastic; feature cannot be
altered later on

Concept: The optimal markup rule is depends on the marginal cost and how price sensitive customers
are

P = (Ep/(1+Ep)) MC [FORMULA]

how much you should mark up take into account price sensitivity

App: If TC = 40 + 5Q and EP = -2, what price should be charged?

MC = 5

(-2/1+-2) = 5(2) = 10

If TC = 60 + 8Q and EP = -1/2, what price should be charged?

MC = 8

(-1/2)/(1+(-1/2)) x 8 = -1 (8) = -8 not possible?

CQ4. If TC = 40 + 6Q and EP = -4, what price should be charged?

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Enter as a value.

MC = 6

(-4)/(1-4) x 6 = 1.33 x 6 = 7.98; appx 8

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Exp:

Restaurants often give discounts to senior citizens or students. Why?

Students/seniors have lower fixed incomes

Concept: A firm can increase total profit by segmenting customers into different gaps and charging
them different prices

App:

Why might a good produced in the US sell for cheaper abroad than here in the US?

Demand in foreign countries may be less due to lower incomes.

How could a firm derive the maximum benefit from price discrimination?

Find each persons maximum willingness to pay, then charge them that price

CQ5. Is buying in bulk a form of price discrimination?

1. Yes ANSWER
2. No

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Exp:

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Assume an airline can price discriminate and charge higher prices for business travelers as opposed to
leisure travelers. Assume the demand for business and leisure travelers are:

QB = 330 PB

QT = 250 PT

180 seats total

ANSWER Max Revenue = Set MR = 0

QB = 330 PB PB = 330 Q8
- TR = 330QB QB^2 MR = 330 2QB 330 = 2QB 330/2 = QB QB = 165

- PB = 330 165 = 165

QT = 250 PT PT = 250 QT
- TR = 250QT QT^2 MR = 250 2QT 250 = 2QT 250/2 = QT QT = 125

- PB = 250 125 = 125

Assume the cost of adding passengers is negligible. What price should be charged to each group?

Set MB(B) = MB(T) MR(B) = MR(T)

330 2QB = 250 2QT 80 = 2QB 2QT QB + QT = 180

QT == 80 = 2(180 QT) 2QT 80 = 360 2QT - 2QT 80 = 360 4QT

-280 = -4QT QT = 70

QB == 110

Concept: A firm can maximize profit by . Selling marginal benefit from each segment equal to each
other.
MB(A) = MB(B)

App:

What is the goal of a used car salesman in terms of price discrimination?

Higher incomes, less knowledgeable, spend time more profitiable

Is ladies night at a bar (where ladies pay no cover) a form of price discrimination?

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Yes, leads to more drinks sold

CQ6. If an amusement park charges an admission fee to get in, and then charges additional fees per
ride, is this price discrimination?

1. Yes ANSWER
2. No

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Review Problems

A. Chapter Review

1. If Q = 400 2P, is revenue maximized at P = 100?

a. Yes ANSWER
b. No

ANSWER: Set MR = 0
- TR = P x Q
- P = 400 1/2Q

- TR = 200Q 1/2Q^2 MR = 200 Q = 0

Q = 200.

- P = 200 (200) 200 100 = 100

2. A goods demand is given by: Q = 500 - 50P. At P = $5, the point price elasticity is

a. -8.0

b. -5.0

c. -1.5

d. -1.0 ANSWER

e. -.5

ANSWER: Point = (dQ/dP)(P/D)

- (when you have price just sub) Q = 500 50(5) = 250

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 - Point Elasticity = -50 (5/250) -250/250 = -1 unitary

3. When the price of smart phones decreases, the demand for data plans will

a. Increase. ANSWER

b. Remain unchanged.

c. Decrease.

d. Increase or decrease, depending on the difference between the two prices.

e. The effect is uncertain. It depends on the price elasticity of demand.

4. Hula Products has reintroduced the hula hoop to the world and faces a growing demand for its
product in two distinct markets: the United States and Europe. Demand in these markets is:

PU = 20 - .1QU

And PE = 10 - .05QE,

Where all quantities are expressed in thousands of units (i.e. QU = 50 means 50 thousand units). Hula
can produce hoops at no cost.

a. What are the profit-maximizing prices and quantities in the two markets?

TR = 20Q 0.1QU^2 TR = 10Q 0.05QE^2

MR = 20 0.2QU = 0 MR = 10 0.1QE = 0

MR = QU = 100(000) MR = Q = 100(000)

PU = 20 0.1(100) = 10 PE = 10 0.05(100) = 5

- entails price discrimination

b. Hula has a capacity constraint and can produce a maximum of 200 thousand hoops. How does this
affect the firms output and prices in part a?

- It does not affect both firms output and prices as Q = 100,000

- Regardless of what they produce, they are below the constraint (no impact)

c. What if the constraint was 95 thousand hoops? What would be the optimal quantities?

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Set MR U = MR E

20Q 0.2QU = 10 0.1QE

10 = .2QU 0.1QE 0.2QU 0.1QE = 10

QU + QE = 95

QE = 95 QU 0.2QU 0.1(95 QU) = 10 0.2QU 9.5 + 0.1QU = 10

3QU 9.5 = 10 QU = 65

PU = 20 0.1(65) PU = 20 6.5 = 13.50

65 + QE = 95 QE = 30

PE = 8.5

B. Cumulative Review

5. If P = 40 Q and TC = 5 + Q2, what Q maximizes profit?

TR = 40Q Q^2 MR = 40 2Q

MC = 2Q

MR = MC 40 2Q = 2Q 40 - 4Q = 0 40 = 4Q Q = 10

P = 40 10 = 30

Maximizing Q = 10 Maximizing P = 30

6. If TC = 40 + 20Q + 20Q2 , what is the marginal cost at the 5 th unit?

MC = dTC/Dq

MC = 20 + 40Q

MC = 20 + 40(5) = 220

7. In the case of an airline pricing business seats and pleasure seats, what rule should the profit-
maximizing airline follow?

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a. Set prices so that marginal revenue from the last business seat equals marginal revenue from the last
pleasure seat. ANSWER (MR sets a stopping point)

b. Set prices so that marginal cost of the last business seat equals the marginal cost of the last pleasure
seat.

c. Set prices so that the demand elasticities are the same for each class of seat.

d. Cut back on pleasure seats to increase business seats.

e. Expand seating in the section with less elastic demand at the current price; contract seating in the
section with more elastic demand.

8. A firm faces the demand curve: P = 800 - 25Q. What is the firms revenue maximizing price?

MR = 0

TR = 800Q 25Q^2

MR = 800 50Q = 0

800 = 50Q Q = 16

P = 800 25(16) 800 400 = 400

P = 400

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