MSci 607: Applied economics for management

Managerial Economics and Strategy (2017) by Perloff and Brander

Topic 5: Pricing
Chapter 10 (Pricing with market power) Solutions

1.2. The pharmaceutical firms offer the discount to low-income seniors because the seniors
would probably not purchase the medicines if they were not discounted. By segregating this
portion of the market, they are able to price discriminate profitably because the marginal cost of
producing the extra medications is very low. Thus if they can still charge higher prices to the rest
of the market, they will profit from the discounted prescriptions as well. (In addition to the short-
run profits, the pharmaceutical firms get good publicity, which could forestall more costly
regulation in the future.)

1.3. In order to price discriminate, the firm must have market power—the ability to set prices.
Consumers must have varying price sensitivities, and the firm must be able to identify individual
consumers or groups of individuals based on willingness to pay. The firm must also be able to
prevent reselling after the initial sale.

1.6. Price discrimination is charging consumers different prices for the same good based on
individual characteristics of consumers, membership in an identifiable subgroup of consumers,
or on the quantity purchased by the consumers. To practice price discrimination, a firm must be
able to prevent or limit resale. In some industries, preventing resale is easier than others. In
industries where resale is initially easy, managers can act to make resale more costly. Some firms
act to raise transaction costs or otherwise make resale difficult. For example, firms could require
customers to sign a contract that forbids resale. Government tariffs (taxes on imports) limit resale
by making it expensive to buy a branded good in a low-price country and resell it in a high-price
country. In another example, firms could provide a warranty that is only good in the country in
which the good is supposed to be sold. Limiting the quantity purchased is also designed to
prevent resale.

2.2. With perfect price discrimination, the firm sells each unit at the maximum amount any
customer is willing to pay for it, so prices differ across customers, and a given customer may pay
more for some units than for others. The perfectly price-discriminating monopoly captures all
possible consumer surplus. The monopoly’s profit is $1,800 (= 60  60  0.5), consumer surplus
is $0, welfare is $1,800, and deadweight loss is $0.
If the firm charges a single price, then the firm maximizes profit by setting marginal cost ($30)
equal to marginal revenue.
90 – 2Q = 30  Q = 30, p = 60
Profit = $900, CS = $450, Welfare = $1,350, DWL = $450

2.6. The monopoly produces Q* units (where marginal cost equals marginal revenue) and
charges the price indicated by the demand curve at the profit-maximizing quantity (p*). The
monopoly could not profitably produce where price equals marginal cost because at that quantity

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(indicated below by QMC) the price is below the average cost of production, so the monopoly
would incur losses.

3.2. The American marginal revenue function is MRA = 100 – 2QA, and the Japanese one is MRJ
= 80 – 4QJ. To determine how many units to sell in the United States, the monopoly sets its
American marginal revenue equal to its marginal cost, MRA = 100 – 2QA = 20, and solves for the
optimal quantity, QA = 40 units. Similarly, because MRJ = 80 – 4QJ = 20, the optimal quantity is
QJ = 15 units in Japan. Substituting QA = 40 into the American demand function, we find that pA
= 100 – 40 = $60. Similarly, substituting QJ = 15 units into the Japanese demand function, we
learn that pJ = 80 – (2  15) = $50. Thus the price-discriminating monopoly charges 20 percent
more in the United States than in Japan.
We can also show this result using elasticities. We know that the elasticity of demand is A = –
p /Q = –60/40 = –3/2 in the United States and  J  ( 1/2)( pJ / QJ ) = –50/(2  15) = –5/3 in
A A
Japan. The ratio of the prices depends on the relative elasticities of demand: pA/pJ = 60/50 = (1 +
1/J)/(1 + 1/A) = (1 – 3/5)/(1 – 2/3) = 6/5.

3.3. The two marginal revenue curves are MRJ = 3,500  QJ and MRA = 4,500  2QA. Equating
the marginal revenues with the marginal cost of $500, we find that QJ = 3,000 and QA = 2,000.
Substituting these quantities into the inverse demand curves, we learn that pJ = $2,000 and pA =
4
$2,500. We know that the elasticities of demand are J = p/(MC  p) = 2,000/(500  2,000) = 3
and  = 2,500/(500  2,500) =  4 . Thus, we find that
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A

pJ 2,000 1  1/( 45 ) 1  1/  A
  0.8   .
pA 2,500 1  1/(  43 ) 1  1/  J
The profit in Japan is (pJ  m)QJ = ($2,000  $500)  3,000 = $4.5 million, and the U.S. profit is
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$4 million. The deadweight loss is greater in Japan, $2.25 million (= 2  $1,500  3,000), than in
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the United States, $2 million (= 2  $2,000  2,000).

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3.9. Output expands, as do profit and consumer surplus. When the markets are combined, the
monopolist sells Q2 for $5, all to customers in Market 2. When the markets can be separated,
*

price and quantity remain unchanged in Market 2, but the monopolist also sells Q1 for p1.
*

3.11. This policy allows the firm to maximize its profit by price discriminating if people who put
a lower value on their time (so are willing to drive to the store and move their purchases
themselves) have a higher elasticity of demand than people who want to order over the phone
and have the goods delivered.

4.5. a. The supermarket uses the multimarket price discrimination based on consumers’
willingness to pay.
b. The price markup (P – MC) is inversely related to demand elasticity. Consumers with
high elasticity for certain products should be offered discounts in the products, resulting in
greater purchases.

5.2. The park has two options: low access fee to serve both groups, or high access fee to serve
only teenagers.
Option 1: Low access fee
The access fee A = CS(seniors) = (4 – p)2/2, where p is the optimal price. The profit function is:
 = 800  (4 – p)2/2 + 400p(4 – p) + 400p(5 – p)
The F.O.C. is:
/p = 400  (–8 + 2p) + 400(9 – 4p) = 400 – 800p = 0
 p = 0.5 A = 6.125  = 800  6.125 + 400  0.5  8 = 6,500
Option 2: High access fee
The access fee A = CS(teenagers) = (5 – p)2/2, and the profit function is:
 = 400  (5 – p)2/2 + 400p(5 – p)
The F.O.C. is:
/p = 200  (–10 + 2p) + 400(5 – 2p) = 0 – 400p = 0

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  p=0 A = 12.5  = 400  12.5 = 5,000
The park gets more profit from option 1, so it charges A = $6.125 and p = $0.5.

5.3. With identical consumer demand p = 120 – 2q, the optimal two-part pricing for the Club is
to charge Joe a per-unit price equal to marginal cost ($20) and set the lump-sum fee equal to
Joe’s consumer surplus. Joe’s consumer surplus (CS) is CS = (50 2 = 2,500, so the
manager charges a membership fee of $2,500.
If the firm charges a single price, the firm maximizes profit by setting marginal cost ($20)
equal to marginal revenue.
120 – 4q = 20  q = 25, p = 70, and  = 1,250
The firm makes an extra of $1,250 (= 2,500 – 1,250) from the two-part pricing.

5.4. The answer to question 5.3 is the case where the firm charges a high access fee and serves
only Joe. If it charges a lower access fee, it can serve both Joe and Susan. The access fee is L =
(100 – p)(50 – p/2)/2.
The profit function is (with marginal cost = $20):
 = 2  (100 – p)(50 – p/2)/2 + (p – 20)(50 – p/2) + (p – 20)(60 – p/2)
The F.O.C. is:
/p = –50 – 50 + p + 110 + 20 – 2p = 30 – p = 0
 p = 30 L = 1,225  = 2  1,225 + (30 – 20)  80 = 3,250
The firm is better off with a lower access fee and serves both Joe and Susan.

6.1. No. If no consumers want the second product, profits are reduced by bundling it with the
first product. The reason is that, because there is no demand for the second product, consumer
demand for the bundled products will be equal to the demand for the first (desired) product
alone. If there is no secondary market for the undesired product and the consumer must pay to
dispose of it, then profits will be reduced rather than increased, as consumer demand falls to
reflect the disposal cost.

6.2. a. For laptop, the firm charges $600 and sells to all customers, so the profit is $1,800. If it
charges $800, the profit is $1,600. For $1,000, it sells only to customer B and makes $1,000. For
printers, the firm charges $100 and makes $200. If it charges $50, it makes $150. For $150, it
makes $150. The firm makes a total of $2,000 profit from individual pricing.
b. For bundling, if the firm charges $1,050, the profit is $1,050. For $900, the profit is
$1,800, and for $750, the profit is $2,250. Thus, the firm should charge a bundled price of $750
to earn profit of $2,250.
c. Bundling is profitable because customer reservation values are negatively correlated.

6.3. It is likely that in the past the reservation prices across individuals were positively
correlated. In this scenario it is often the case the price the goods separately will maximize the
firm’s profit (see Table 10.3). Over time reservation prices for the two products may have shifted

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and become negatively correlated (as in Table 10.2) leading to the decision to bundle the goods
together in order to maximize profit.

7.2. Assume the marginal cost of production is zero. For summer, MRS = 200 – 4QS and
200 – 4QS = 0  QS = 50 and pS = $100
Similarly, for winter, MRW = 200 – 2QW, and
200 – 2QW = 0  QW = 100
However, the yacht capacity is only 50, so the profit-maximizing price for winter is pW = $150.

7.5 If Uber has a capacity constraint, then the increase in fares will not help draw in additional
supply (drivers) and surge pricing will only serve to increase Uber’s profits. Rides will be
allocated to those who value them the most (as evidenced by a higher willingness to pay). The
diagram below shows this scenario. Suppose that Uber drivers are willing and able to provide a
ride at price P 1 up to 1000 rides. After that point, no additional rides will be available. If
demand is low or moderate (like Low or Mod) then competition will drive the price down to
cost. Once demand reaches a high level (High) then surge pricing kicks in and price rises to P 2.