Unit 8. - Department of Economics

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Unit 8.
Profit Maintenance/Enhancement
Investment Tip?
 “The most important thing I look at in
evaluating a company for investment
purposes is whether or not they have a
sustainable competitive advantage.”
(Warren Buffett)
Managing a Price Taking Firm
 ‘Competitive’ firms have the biggest
challenge of sustaining π’s.
 Understand market forces to anticipate
changes in input and output prices
 Use cash market contracts, futures
markets, etc. to establish favorable
prices at times other than delivery
 Costs must be minimized
 Look into specialty products, niche
markets, forming cooperatives,etc.
Profit Enhancement/Maintenance
Strategies (P setting firms mainly)
1. Create barriers to entry
2. Decrease P competition with rivals
3. Differentiate product to increase
demand/decrease price elasticity
4. Decrease costs/increase productivity
5. Implement creative pricing policies
Same Price or a Separate Menu?
 Papa Dels is a popular pizzeria on the
University of Illinois campus. The manager of
this restaurant has been informed that the
own price elasticity of demand for their pizza
is -4 for lunch and -2 for dinner. The
incremental cost of making and selling a large
pizza is $6 for this firm, for both lunch and
dinner. Would you recommend that Pap Dels
have a separate menu for lunch and dinner?
If yes, what prices do you suggest be
charged?
Marketing (Pricing) Internationally?
 Kodak is currently selling its camera film in
both the U.S. and Japan. The company’s
research department has estimated the
demand for Kodak film in each country as
follows:
U.S. => QUS = 15 – PUS
Japan => QJ = 9 - .5PJ
If MC = ATC = 3 in both countries, what
pricing strategy would maximize Kodak’s
profits in the U.S. and Japan combined?
Coffee (P) Break?
 Spooky Business sells its own brand of coffee
on line. The company currently sets one
price for each flavor or type sold. The
marketing department has recently given
management two alternative proposals to
‘perk’ up sales. One proposal is to simply
lower price on each item. The second
proposal is to give customers ‘quantity’
discounts (i.e. lower price on greater,
specified quantities). Which option would you
advise management implement?
What Fee to Charge?
 Rick and Joan Thompson recently moved from Iowa
to Phoenix (AZ). They plan to run their own business
there which is a health club called Sun Devil Spa and
Fitness Club. While Rick and Joan are ‘fitness’
experts, they know very little about managing a
business and, in particular, setting prices. They have
noticed other health clubs have ‘members’ who are
typically charged a membership fee. They have
come to you for advice. Would you recommend they
charge a ‘membership’ fee too or simply charge a fee
‘per visit’? If they decide to charge a ‘membership’
fee, what information would assist you in determining
the ‘best’ fee to charge?
Package (or Block) Pricing
 Fruit of the Loom sells men’s tee shirts
in packages (3 shirts per package).
Management is wondering a) if the
company would be better off selling the
shirts individually and b) if not, is the
company charging the ‘best’ price for its
package? What recommendations do
you have for management?
Making ‘Bundles’?
 Hewlett Packard sells both ‘printers’ and ‘print
cartridges’ for microcomputers. Would you
recommend to management that these
products be priced and sold a) separately or
b) together (as a ‘bundle’)? If HP prices
these items separately, which strategy is
likely to generate more profits: a) low price
for the printers, high price for the cartridges or
b) high price for the printers, low price for the
cartridges?
A Slam Dunk Deal?
 Mark Cuban is the owner of the Dallas Mavericks, a
professional NBA team (i.e. basketball). He is a very
visible owner at games and is often seen cheering on
his team as well as yelling at officials when he thinks
they made a bad call. He has even been fined
extensively by the NBA for his outspoken criticism of
league referees. Cuban wants to win an NBA title in
the ‘worst’ way. However, he is concerned that after
he signs his players to ‘big’ contracts, they may not
have the same incentive as he does to win an NBA
title. What managerial ‘econ’ advice would you give
Mr. Cuban on structuring player contracts for his
team so as to provide more incentive for his players
to try to win a championship?
Reality Realty?
 If you hire a real estate agent to sell
your house, do they have the same
economic incentive as you to maximize
the selling price (i.e. get top dollar) for
your house?
Pricing Questions
 Why:
 Are buns sold in a package?
 Is there an entrance fee but no charge for
individual rides at some amusement parks?
 Is the markup on coffee less than the markup on
fresh flowers at a grocery store?
 Are there senior-citizen and student discounts?
 Does it cost more to do certain things at different
times of the wk (e.g. fly, play golf, make phone
calls, etc.)
 Do travel agencies sell vacation ‘packages’?
 Creating barriers to entry
 Advertise/differentiate
 Proliferate
new products (introduce first)
 Maintain excess production capacity
 Seek out sustainable niches
 Guard trade secrets/plans
 Obtain and/or extend patents
 Entry limit pricing
More Demand for Us, Less
Demand for You?
$
$
ATC
D2
D1
Q
Potential Entrant
D2
D1
Q
Existing Firm
Entry Limit Pricing
 Decreasing competitive P rivalry
 Match
P
 Random
 Non
P
price competition
 Customer
service
Creative Pricing Policies
 Price discrimination
 2-part block (package)
 Bundling
 Q discounts
 Multiple (joint) product
Types of P Discrimination
 First degree (= complete or perfect)
 Selling each unit for a different price which = the
maximum P any buyer is willing to pay (i.e. charge
the maximum prices along a given D curve)
 Second degree
 Selling different quantity units for different prices to
all buyers (i.e. quantity discounts)
 Third degree
 Selling all quantity units to different buyer groups
at different prices (i.e. divide the market into
different D segments and charge optimal prices
accordingly)
Robinson Patman Act (1936)
 Makes it illegal for firms to price discriminate
in ‘business’ markets (sales to other business
firms) where the effect may be to injure
competition.
 The concern was over sellers giving ‘chains’
or large corporate buyers price discounts that
would lower their costs and make it difficult
for smaller firms to compete with them.
 Does NOT disallow quantity discounts (if cost
justified), cash payment discounts, and
advance order/payment discounts if made
available to all buyers.
Third Degree Price Discrimination
 The practice of charging different
groups of consumers different prices for
the same product
 Examples include student discounts,
senior citizen’s discounts, regional and
international pricing
Change in TR Due to Q (i.e.
MR)
TR
 PQ  QP 

MR
MR
TR
 P
Q
 P
P Q
Q P
 P [1 
1
]
MR
MR
 P[

1
E
E
E 1
 P[
]
E
Q
Q
MR = 0 if E is
unitary
P
> 0 if E is elastic
< 0 if E is inelastic
E
E
P
NOTE:
]
Profit-Maximizing Prices
  P where MR = MC
 E0  1
 P
  MC
 E0 
 E0 
 P 
 MC
 E0  1
 E0 

  ' m arkup ' factor applied to M C
 E 0  1
Profit-Maximizing ‘Markup’ Factors

E0
 E0

 E0 


1
-1.05
21
-1.1
11
-1.2
6
-1.4
3.5
-1.6
2.67
-1.8
2.25
-2.0
2
-2.5
1.67
-3.0
1.5
-4.0
1.33
Assume:
 Q
=
 QUS =


QJ =


 QT =
total demand for Kodak film
US demand = 15 – PUS
PUS = 15 – QUS
MRUS = 15 – 2QUS
Japan demand = 18 – 2PJ
PJ = 9 - .5QJ
MRJ = 9 – QJ
QUS + QJ
= 33 – 3P (for P 9)
 P = 11 – 1/3Q
 MR = 11 – 2/3Q
 MC = ATC = 3 in both the US & Japan
Profit Max Example
(with P Discrimination)
 QJ to max J  MRJ = MC
 9 – QJ = 3
 QJ* = 6
 PJ* = 6
 max J = TRJ – TCJ
= (6)(6) – (3)(6) = 36 – 18 = 18
 max  = max US + max J
= 36 + 18 = 54
Profit Max Example
(with P Discrimination)
  max  max US + max J
 QUS to max US  MRUS = MC




15 – 2QUS = 3
QUS* = 6
PUS* = 9
max US = TRUS – TCUS
= (9)(6) – (3)(6) = 54 – 18 = 36
P Discrimination  Differential
Markup Pricing
 E0 in US at PUS = 9
Q

P


P
 (  1)
Q
E0
E0  1
9
  1.50
6

 1.50
 1.50  1

 1.5
 .5
  3 m arkup
 E0 in J at PJ = 6

Q
P

P

 (2)
Q
E0
E0  1
6
2
6

2
2  1
  2 m arkup
Π w/o Discriminating
  Max if PU = PJ
 MRT = MC
 11 – 2/3Qr = 3
 2/3QT = 8
 QT = 12
 P
= 11 – 1/3(QT)
= 11 – 1/3(12)
=7
 =
(P-ATC)(QT)
=
(7-3)(12)
=
48
 NOTE:
QU = 15 - PU
= 15 – 7
= 8  U =(4)(8) = 32
QJ = 18 – 2PJ
= 18 – 2(7)
= 18 – 14
=4
 J = (4)(4) = 16
Charging Different PS to Different
Customers (markets)
P
P
PB
PA
MC
MC
DA
MRA
Mkt A
DB
Q
MRB
Mkt B
Q
Peak-Load Pricing
 When demand during
peak times is higher
than the capacity of the
firm, the firm should
engage in peak-load
pricing.
 Charge a higher price
(PH) during peak times
(DH)
 Charge a lower price
(PL) during off-peak
times (DL)
Extracting Consumer Surplus:
1.
2.
3.
Block Pricing: For items sold in a package
(block), add units up to point where
consumer willingness to pay = MC of
adding last unit. Charge P = consumer
surplus value at that point.
Two-part Pricing: For items sold where the
seller can limit buyer access to the product,
charge P = MC and also charge a ‘fee’ = to
remaining consumer surplus.
Volume Discounts: Charge lower price for
units purchased beyond given level.
Block P Example
 Typical consumer’s demand is P = 10 –
2Q
 C(Q) = 2Q
 Optimal number of units in a package?
 Optimal package price?
Costs and Profits with Block Pricing

Results with Standard MR =
MC Profit Max
 P = 10 – 2Q
  MR = 10 – 4Q
 TC = 2Q
  MC = 2
  Max
  MR = MC
  10 – 4Q = 2
 Q = 2, P = 6
  TR – TC = (6)(2) – (2)(2) = 12-4 = 8
Optimal Quantity to Package: 4 Units

Optimal Price for the Package: $24

Costs and Profits with Two-Part
Pricing
Price
Charge fee = CS
10
8
½ (4) (10-2) = $16
6
Costs = $8
4
2
D
1
2 3
4
5
Set P = MC = $2
Quantity
Commodity Bundling
 The practice of bundling two or more
products together and charging one
price for the bundle.
 Examples
 Vacation
packages
 Computers and software
 Film and developing
A Kodak Bundle
 Total market size is 4 million customers
 Four types of consumers
 25% will use only Kodak film
 25% will use only Kodak developing
 25% will use only Kodak film and use only Kodak
developing
 25% have no preference
 Zero costs (for simplicity)
 Maximum price each type of consumer will
pay is as follows:
Reservation Prices for Kodak Film and
Developing by Type of Consumer
Type
Film
Developing
F
$8
$3
FD
$8
$4
D
$4
$6
N
$3
$2
Demand for Kodak Film

Demand for Kodak Developing

Revenue-Maximizing Film P?

P
Buyers
TR
8
F, FD
8 x 2 = 16
4
F, FD, D
4 x 3 = 12
3
F, FD, D, N
3 x 4 = 12
Revenue-Maximizing Developing P?

P
Buyers
TR
6
D
6x1=6
4
D, FD
4x2=8
3
D, FD, F
3x3=9
2
D, FD, F, N
2x4=8
Maximum TR Pricing Items
Separately?
 = Max Film TR + Max Developing
TR
 16 + 9
 = 25
Demand for Film & Developing
‘Bundle’

Revenue-Maximizing ‘Bundle’ P?

P
Buyers
TR
12
FD
12 x 1 = 12
11
FD, F
11 x 2 = 22
10
FD, F, D
10 x 3 = 30
5
FD, F, D, N
5 x 4 = 20
 Note: previous Max TR pricing items
separately = 25.
Bundles of Goods
 Bundling often involves one ‘physical’ or
‘capital’ type good being sold with a
related ‘services’ type good.
Physical/capital good
Razor
Camera
Computer
Water softener
Phone
Copy machine
Fertilizer
Hotel room
Service good
Razor blades
Film, film development
Software, technical support
Salt packets
Calling plans
Paper, cartridges, tech support
Application, soil testing
Transportation, meal
Q Discount

Assume P = 100 - .1Q (Q = 00’s)


MC = ATC = 10
What is firm π w/
MR = MC production/pricing?
2) Charge P = 75 for Q up to 250, P = 55 for
additional Q?
1)
P
No Q Discount π
120
100
80
Std MR=MC pricing π
Π = (P-ATC)Q
= (55-10) 450
= 20,250
60
40
P=100-.1Q
20
10
MC=ATC
Q (00)
MR = 100 - .2Q
=> MR = MC
=> 100 - .2Q = 10
=> .2Q = 90
=> Q = 450 => P = 55
450
MR
1000
P
Q Discount π
120
100
Π = (75-10)(250)
+ (55-10)(200)
= 16,250 + 9,000
= 25,250
80
75
60
55
40
P=100-.1Q
20
10
MC=ATC
Q (00)
250
450
MR
1000
Cross-Subsidies
 Prices charged for one product are
subsidized by the sale of another product.
 May be profitable when there are significant
demand complementarities effects.
 Examples



Browser and server software
Drinks and meals at restaurants
=> TR = PXQX + PYQY
Economic ‘Incentive’ Questions
1.
2.
3.
Suppose a business firm manager hires a
tax return preparer, a lawyer, a contractor,
and an employee. What do they have in
common from the business firm manager’s
perspective?
Do employees have an incentive to ‘shirk’
their duties and, if so, how do personnel
managers attempt to reduce ‘shirking’ by
employees?
What do most home insurance, car
insurance, and medical insurance policies
have in common and why?
Principal-Agent Problem
 Problem  agent has incentive to
pursue their own goals which hinders
principal’s ability to achieve their goals.
Principal = individual
who employs or
supervises others
(agents)
• stockholders
• management
• business owner
• defendant
• team owner
Agent = individual
employed to
assist a principal
• management
• employees
• sub contractor
• lawyer
• team player
Principal-Agent Solutions
 Supervision of Agent
 Time clock
 Spot check
 Internal Incentives
 Profit sharing (e.g. bonus)
 Revenue sharing (e.g. tips, commissions)
 Piece rate pay
 External Incentives
 Reputation concerns
 Takeover threat
Economic Problems Caused by
Asymmetric Information:
1.
Adverse selection  one party can benefit at the
expense of another because they have more
information about an unobserved characteristic.
Examples:
Potential employee’s work ethic
Health status of an insurance customer
Driving tendencies of insurance customer
Product quality
2.
Moral hazard  one party can benefit at the
expense of another because they have more
information about unobserved actions
Solution = contracts to make incentives more
compatible
Types of Contracts
1.
2.
3.
Fixed fee
a. To agent (e.g. person hired)
b. To principal (e.g. land or property owner)
Hire
a. wage or salary
b. piece rate
Contingent
a. revenue sharing
b. profit sharing
c. some outcome (e.g. no wrong doing by policy holder, outcome of
the trial)
Conclusions:
1.
Contracts provide economic incentives to both parties; best contracts
provide compatible incentives
2.
Need to examine incentives provided and likely consequences of
contract terms
3.
Contracts that usually provide the most compatible economic
incentive to agents are 1b and 3b above

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