1 C H A P T E R 13 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Using Market Power: Price Discrimination

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© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin

Using Market Power: Price Discrimination and

Advertising

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Price Discrimination

Price discrimination is the practice of dividing consumers into two or more groups and charging different prices to each group.

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It is illegal for firms to practice price fixing—the coordination of pricing strategies among firms, but it is not illegal to practice price discrimination. The only legal restriction is that firms cannot use it to drive rival firms out of business.

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One approach is to identify a group of customers who are not willing to pay the regular price, and offer them a discount.

Examples: Airline tickets

Grocery coupons

Manufacturer’s rebates

Senior-citizen discounts

Student discounts

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Conditions Necessary for Price Discrimination

Market power: firms must have control over price.

Different consumer groups: consumers must differ in their willingness to pay.

Resale is not possible: unless the firm can prevent the resale of their products, price discrimination will break down.

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Different Groups Have Different Demands

Senior citizens have more elastic demand because they have lower income and more time to shop for substitutes.

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Elasticity, Revenue and Profit

If demand is inelastic, an increase in price has two advantages: it will increase total revenue and decrease quantity demanded. The firm will produce less and reduce its production costs.

If demand is elastic, a decrease in price will increase total revenue. But lower prices will increase quantity produced, thus result in higher costs. If profit is to increase, the increase in revenue must be greater than the increase in cost.

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Profit With a Single-price Policy

Total profit with the single price policy: $1,600

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Profit When Pricing in Accordance With Elasticity

Total profit with the senior discount: $1,860

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Advertising and the Marginal Principle

To decide how much firms should spend on advertising, firms can use the marginal principle.

Marginal PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

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Advertising and the Marginal Principle

Number ofAdvertisements

Quantity of Detergent Sold

(boxes)

Marginal Benefit(assuming profit

of $1 per box)

MarginalCost

(each 30-second TV commercial)

0 100,000 $7,000

1 110,000 $10,000 $7,000

2 119,000 9,000 $7,000

3 127,000 8,000 $7,000

4 134,000 7,000 $ 7,000

5 140,000 6,000 $7,000

6 145,000 5,000 $7,000

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What Sorts of Firms Will Advertise?

For advertising to be profitable, the increase in sales must be large relative to the cost of advertising.

Advertising makes sense only if consumer choices are sensitive to advertising, and the good sold by the firm is a close but not a perfect substitute for others.

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The Advertisers’ Dilemma

The advertisers’ dilemma states that although firms would be better off if they did not advertise, the firms advertise anyway.

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Neither Advertises

Both Advertise

Jack Advertises

Jack Jill Jack Jill Jack Jill

Net Revenue from Sales ($ million)

8 8 13 13 17 5

Cost of Advertising($ million)

0 0 7 7 7 0

Net Profit Advertising($ million)

8 8 6 6 9 5

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Jill’s dominant strategy is to advertise.

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Outcome of the Advertising Game

Knowing that Jill’s dominant strategy is to advertise, Jack’s best response is to advertise too.

Each firm earns $2 million less than in the absence of advertising.

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Tradeoffs From Advertising

Advertising helps consumers make more informed decisions.

Information in advertising about prices helps to promote competition, thus advertising leads to lower prices.

Benefits of advertising:

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Tradeoffs From Advertising

When firms are trapped in the advertisers’ dilemma, resources used in advertising may be wasted. Advertising results in a net decrease in industry profits.

Some advertisements give the impression that there are real differences between products when there are none.

Costs of advertising:

Documents

1 C H A P T E R 13 1 © 2001 Prentice Hall Business PublishingEconomics: Principles and Tools, 2/eO’Sullivan & Sheffrin Using Market Power: Price Discrimination