You are on page 1of 35

ECO 610-401

Monday, September 15
– Topics
• Price Elasticity,
• Marginal Revenue
• Price Elasticity & Marginal Revenue
• Pricing Decisions
• Pricing with Market Power
• Markup Pricing
• Price Discrimination
– Readings
• Brickley et. al, Chapters 4 & 7;
• Hoyt, Lectures 1:11-16-2:1-6
Assignment for Monday, September 22
nd

Monday, September 22
nd
• Topics:
– Pricing with Market Power (continued);
– Costs & Decision Making: Level of Production & Mix of
Resources
• Readings:
– Brickley et. al, Chapters 5,7;
– Hoyt, Lectures 2-3:103-115
• Homework due (Assignment 1)
Questions to Consider for today
• Provide some examples of goods and services that differ in how responsive
the demand for them is to changes in price (differences in elasticity).
• How can price discrimination reduce the extent of this tradeoff?
• What is the tradeoff a monopolist faces when making pricing decisions?
• Entertainment and sporting events frequently do not sell out. Can it be
profit-maximizing not to sell all seats to a performance?
• Think about some examples in which different consumers (or firms) face
different prices for the same, or almost same, product. What might account
for these differences in prices? Specifically are they motivated by differences
in the cost of serving or selling to customers or differences in the customer’s
willingness to pay?
• Frequently, goods and services are “packaged” or “bundled”. Occasionally
firms will only sell these goods as a bundle (pure bundle) though often they
will sell the items separately and as a bundle (mixed bundling). Think of some
examples. Why and when might firms want to offer items as a bundle?
Figure 5
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Q
P
S=-50+10P
D=100-10P
Horizontal Demand & Constant MR
0
1
2
3
4
5
6
0 1 2 3 4 5 6 7 8 9 10
Quantity
P
r
i
c
e
MR = P
Downward Sloping Demand & MR < P
-100
-90
-80
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
40
50
60
70
80
90
100
0 1 2 3 4 5 6 7 8 9 10
Quantity
P
r
i
c
e
MR
D
P
ΔPQ
The Demand Relationship
Q P TR MR
0 100 0
1 90 90 90
2 80 160 70
3 70 210 50
4 60 240 30
5 50 250 10
6 40 240 -10
7 30 210 -30
8 20 160 -50
9 10 90 -70
10 0 0 -90
Figure 7
0
2
4
6
8
10
12
14
16
18
20
0 20 40 60 80 100 120 140 160 180 200
Q
P

(
$
)
D
MR
E < -1
E > -1
E = -1
Elasticity & Marginal Revenue on a Demand
Curve
Table 2: Elasticity and
Marginal Revenue
Q P MR E
0 20 20
20 18 16 -9.0
40 16 12 -4.0
60 14 8 -2.3
0 12 4 -1.5
100 10 0 -1.0
120 8 -4 -0.7
140 6 -8 -0.4
160 4 -12 -0.3
180 2 -16 -0.1
200 0 -20 0.0

Pricing Lesson 1. A profit maximizing firm should never sell at a price at
which c > -1 (inelastic) since an increase in price will increase revenues and
reduce costs (by reducing output), thereby increasing profits.

More on Marginal Revenue
Why does total revenue sometimes decrease (MR is negative) with increase in Q?
– Increase in Q  Decrease in P
– 2 effects of increase in Q
– More sales (Revenue increase is PdQ)
– Lower price on current sales (Revenue loss is QdP)
Quantity Increases and Revenue
Figure 7
0
2
4
6
8
10
12
14
16
18
20
0 20 40 60 80 100 120 140 160 180 200
Q
P

(
$
)
D
MR
E < -1
E > -1
E = -1
QdP
PdQ
QdP
PdQ
Pricing Strategies, Profit Maximization, and
Optimal Markup

Conditions for Profit Maximization
Optimal Markup Rule
Applications:
– When to sell out

Conditions for Profit Maximization

Revenue (R) = price-quantity = P-Q;
Marginal Revenue (MR) is "the additional revenue from an additional
unit of output".
– Formally we have MR =dR/dQ,
– Note that "average revenue", R/Q, is simply price.
– MR decreases with Q

The Cost Side
Total Cost=C(Q) depends on output.
– Total cost is increasing with output.
Marginal Cost (MC) is the "additional cost of an additional unit of
output"
– Generally we argue that for the "relevant" range of output,
MC is increasing in output ,
– Instances when we might expect it to decrease with output
(economies of scale)

Profit Maximization
Figure 1b
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
0 50 100 150 200 250 300 350 400 450 500
Q
$
R(Q)
C(Q)
Profit Maximization (2)
Figure 1c
0
2
4
6
8
10
12
14
16
18
20
0 50 100 150 200 250 300 350 400 450 500
Q
M
R
,

M
C
MR
MC
Graphical Example of MR=MC
Solving for Profit-Maximizing Price and Quantity

In the figure given the MR and MC depicted the profit
maximizing Q and P are 35 and 6.50.

We can solve this algebraically

MR = MC--> 10- (1/5)Q = 3 or Q =35
and P = 10- (1/10)(35) = 6.5.


When to Sell Out

• No marginal costs associated with selling an extra
ticket.
• Given no marginal costs, profit maximization=
revenue maximization.
• Then why don’t promoters set the price to sell out
all concerts (or games)?
• Simple explanation: The price needed to sell out the
arena may be below the revenue maximizing price.

Figure 4b
0
10
20
30
40
50
60
70
80
90
100
0 2000 4000 6000 8000 10000 12000 14000
Q (Seats)
P

(
$
/
T
i
c
k
e
t
s
)
D
R
MR
R
D
O
MR
O
Operas versus Rock Concerts

• If pricing of tickets is based on maximizing revenues what
explains the large difference in the prices of different forms of live
entertainment?
– D
O
in the figure represents the demand for opera
– D
R
represents the demand for a (typical, but not great) rock
concert.
• Demand curve for rock concerts is much more elastic, so a lower
price is charged for the rock concert and many more people
attend it.

Markup Pricing and Elasticity of
Demand

 We often hear of markup pricing or “cost-plus” pricing but
how much should the markup be?
 Should all products sold be marked up the same amount?
 What should the base (for costs) be?

The Markup Rule
– Elasticities provided an answer to what the profit-
maximizing markup should be.


(
¸
(

¸

+ =
c
1
1 P MR

so that
MC P or MC P MC MR
(
¸
(

¸

+
= =
(
¸
(

¸

+ ÷ =
c
c
c 1
1
1
(20)

Expressing in terms of a markup (over cost):

Markup:
1
) 1 (
÷
+
=
÷
c
c
MC
MC P
(21)
Table 7: Optimal Markup and the Price
Elasticity of Demand
Price Elasticity Percentage Markup
(100(P/MC-1))
-1.2 500%
-1.4 250
-1.8 125
-2 100
-2.5 67
-5 25
-10 11
-20 5
-50 2
General Implications for Pricing Strategy

Pricing Lesson 2.
The profit-maximizing "markup" is determined by the
elasticity of demand. The less elastic the demand for the
good, the higher the markup should be.



General Implications
• Price depends only on marginal cost
– Not costs unrelated to changes in Q.
Markup only depends on demand and not cost conditions.
Markup should be higher on goods with less elastic demands.
– This means the markup on a good should be higher if:
• No good substitutes for it.
• It is a necessity.
• It is a small share of the budget.
If the demand elasticity is less than 1 then markup is too low.
– If a price increase of say 10% reduces sales by less than
10% then raise price.

Markups in Retail Grocery
Class Exercise
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 105 110 115 120 125 130
Quantity
P
r
i
c
e
D
b
D
a
MR
b

MR
b

Class Exercise
• Algebraically, the two demand curves are:
– Q
a
= 140 – 4P
a
or P
a
= 35 – (1/4)Q
a
– Q
b
= 130 – 2P
b
or P
b
= 65 – (1/2)Q
a
• Then
– TR
a
= P
a
Q
a
= 35Q
a
– (1/4)Q
a
2

– TR
b
= P
b
Q
b
= 65Q
b
– (1/2)Q
b
2
– MR
a
= 35 – (1/2)Q
a
– MR
b
= 65 – Q
b
• MR
a

=

MC  35 – (1/2)Q
a
= 5  Q
a
= 60, P
a
= 35 – (1/4)60 =20
• MR
b

=

MC  65 – Q
b
= 5  Q
b
= 60, P
b
= 65 – (1/2)60 =35





Class Exercise (3)
• Why the difference in prices?
• Elasticity:
Q
P
P
Q
E
A
A
=
333 . 1
60
20
4 20 & 60 4 ÷ = ÷ = = = ÷ =
A
A
a a a
a
a
E P Q at then
P
Q
1667 . 1
60
35
2 35 & 60 2 ÷ = ÷ = = = ÷ =
A
A
b b b
b
b
E P Q at then
P
Q
Price Discrimination
• Why do ticket prices to movies depending on the age of the
purchaser?
• Why do grocery stores offer coupons rather than simply
lower prices?
• Why are advanced ticket purchases for airlines so much
cheaper?
• Here we discuss the practice of price discrimination or
market segmentation,
– Setting different prices for different types of consumers.
The Monopolist’s Dilemna
• High Price -- Extract Consumer Surplus from
consumers who buy
– But don’t include everyone willing to pay above
Marginal Cost
– Extraction Consumers are charged exactly what
their reservation price.
– Exclusion. No individual consumes a good if the cost
that good exceeds her reservation price.
– Inclusion. Any individual whose reservation price
exceeds the cost of the good consumes it.

Problem to Consider
Can set 2 different prices –
– 1 for students and 1 for adults for cinema tickets.
The table gives the relationship between ticket sales and prices
for the 2 groups.
Suppose that you had a capacity of 600, what prices would you
set?