BSP1005 Lecture Notes 8 - Sophisticate Pricing Strategies With Market Power

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Lecture Notes 8

SOPHISTICATED PRICING STRATEGIES WITH MARKET POWER

Semester II, AY2013-2014NUS Business School

BSP1005 Managerial Economics

By Jo Seung-Gyu

Part A: Price DiscriminationsPart B: Two-Part PricingPart C: Bundling

Outline

Part A: Price Discriminations

IntroductionFirst Degree Price Discrimination

Second Degree Price Discrimination

Third Degree Price Discrimination

Direct vs Indirect Segmentation

Economics of Coupons/Rebates

More Examples

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Introduction

• Pricing without market power (perfect competition) is determined by market supply and demand.

• Pricing with market power in the simple (i.e. uniform pricing) monopoly case implies

o Produce and price where MR = MC

o One price applies to all sales units and all markets served.

• Pricing with market power in the real world involves sophisticated output and price decisions

o Pricing of a product over different quantities (beer price) or pricing of a product over various consumer segments (air fare)

o Pricing through upfront fixed fees and per-unit prices (country club)

o Pricing of many products through packaging (McDonald value meals)

• Such strategies are categorized into:

o Price discrimination

o Two part pricing

o Product bundling 3

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Prices of Our Economics Textbook

NUS COOP, Singapore: S$63.10 Australia Pearson: A$153.95 (=S$175.50) US Amazon.com: US$193.98 (=S$259.88)

Amazon’s Shipping Options:

Free Amazon Global Saver (9-14 days): S$0 Amazon Global Standard Shipping (9-12 days): S$13.37 Amazon Global Expedited Shipping (5-10 days): S$26.77 Amazon Global Priority Shipping (2-4 days): S$48.20

What do you think?

Case of Air Fare

• The details of segmentation rules are various. For the KLM, as of February 2013, the segmentation rules were: o Ticket Types

─ economy/business/first plus various ticket codes in each class

o Restrictions

─ Time of travel

─ Minimum Stay Requirement – weekend stay is important

─ Schedule change or cancellation? Even if allowed: free or additional charge?

─ Upgrade allowed?

─ Mileage to be earned? Even if yes: different class with different mileage input

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• In your next overseas trip, ask her (him) how much she (he) paid for the seat.

– You and she (he) more likely must have paid different fare. Why?

– Different willingness to pay!

Example: Booking Classes on KLM Flights

6You should be able to explain the economics behind the above chart.

For an effective pricing strategy,

• Information on demand characteristics (in addition to the production cost conditions) is critical, allowing managers to take advantage of market power to improve profitability.

The Key is how to capture consumer surplus.

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D

PM

Quantity

Price

P0

MR

MC

QC

PC

A

BF

E

H

L

QM

• Customers in section H realize a surplus, since reservation price > market price

Consumers in section L have reservation prices lower than the market prices but still higher than the marginal cost.

• If P=PM and Q=QM, managers forgo potential profit ( yellow area + green area).

• The strategic issue facing managers is straightforward. You want to price to capture as much consumers’ surplus as possible away from the buyers.

Outline


Introduction

First Degree Price DiscriminationSecond Degree Price Discrimination




More Examples

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first degree price discrimination: Practice of charging each customer her reservation price.

First Degree Price Discrimination

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• The seller identifies the reservation price of each consumer and charges each customer as revealed through her demand curve.

• Continue to produce until P = MC (i.e. Pc), so the firm will produce output QC and buyers are being charged up to their maximum willingness to pay following D.

PM

QM

Quantity

Price

P0

D (= MR under 1st degree price discriminating monopoly)

MR under pure monopoly

MC

QC

PC

A

BF

E

• If uniform price (PM) is charged:─ Variable profit is the area [PMFBA]─ Consumer surplus is the area [P0PMA]

• If first degree price discrimination is exercised (i.e. Charge based on D curve): ─ Each consumer simply pays her reservation price defined by D curve, so

D curve now becomes the firm’s MR curve. ─ The monopolist’s variable profit is the area [P0FE]─ Consumer surplus is zero.

• Profit increases by [PoPMA] and [ABE] (=yellow area and green area from the previous slide.)

• Note that social deadweight loss disappeared.

Practical Implementation of First Degree Price Discrimination

• First degree price discrimination is not easy to implement in practice.o Customers are too many and often heterogeneous and the information about

individual customer demands is hard to establish.

• But you don’t want to give up.

o Imperfect price discrimination is better than uniform pricing. Apply identifiable reservation prices for each consumer.

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Imperfect (First Degree) Price Discrimination

o Doctors ask patients for great deal of information – occupation, home address, office address – to use this for price discrimination. ─ What does your home address have to do with medical treatment?)

─ Guess what the first question we were asked at the reception desk in KL for my boss’ knee surgery in 2012.

o The same for lawyers, catering, spa etc.

o Amazon.com is one obvous example

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• At a doctor’s office…

• Auction/Bidding is institutional practice to approximate complete price discrimination (Singapore public auctions for COE)

• Car Dealers

Outline


Introduction


Second Degree Price DiscriminationThird Degree Price Discrimination



More Examples

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Second-degree price discrimination: Practice of charging different prices per unit for different quantities of the same good or service.

Second Degree Price Discrimination (or Block Pricing)

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• The first order price discrimination not being too practical, managers can think of a second option. Second degree price discrimination entails charging different prices (to the same customer or groups of customers) for different quantities or ‘blocks’ of the same good.

– Without discrimination: P = PM and Q = QM.

– With the second-degree discrimination in the left, there are three unit prices P1, P2, and P3, each applying to purchasing units up to Q1, Q2 and Q3.

• In this case, there are also economies of scale, and average and marginal costs are declining. Second-degree price discrimination can then make consumers better off by expanding output and lowering cost.

$/Q

Q

DMR

MC

AC

PM

QMQ1

P1

1st Block

P2

Q2

2nd Block

P3

Q3

3rd Block

Second Degree Price Discrimination (or Block Pricing) – cont.

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Examples are:

• Bulk discounts (4 mugs of beer vs one jug?)

• At the bar, charge P1Q1 with coupons for Q1, P2Q2 with coupons for Q2, P3Q3 with coupons for Q3.

Second Degree Price Discrimination (or Block Pricing) – cont.

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LOL.Puzzling Episode…… or Ridiculous?

An interesting business conduct I encountered recently.

For my MBA Midterm Exam Bash last year, I visited the BLooiE's to negotiate the beer price for the party. Their pricing was as below:

One keg of Tiger beer: $540 One Tower of Tiger beer: $63

Funny thing was that one keg makes about 8 towers.

---- My answer is….There are dumb people out there!

Outline


Introduction



Third Degree Price DiscriminationDirect vs Indirect Segmentation


More Examples

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Third-degree price discrimination Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group.


• You import coconuts from Malaysia to supply NUS and SMU. Your decisions include:

o How many coconuts to import

o How many to sell at NUS and SMU at which price

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NUSMR1(Q1)

MalaysiaMC(Q1 + Q2)

SMUMR2(Q2)

Experiment: What would you do if MR1 > MR2 = MCT ?

Rule of Third Degree Price Discrimination

• If third-degree price discrimination is feasible,

o We know that, however much is produced, total output should be divided between the groups of customers so that marginal revenues for each group are equal. (MR1 = MR2)

o We know that total output must be such that the marginal revenue for each group of consumers is equal to the marginal cost of production. (MR1 = MR2 =MC)

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Mathematically,

Assume two different markets with different demand characteristics D1 and D2.

Firm profit π = TR1(q1) + TR2(q2) – TC(q1 + q2).

Note that TRi(qi) is the total revenue from market i (which is a function of qi ) while TC(q1 + q2) is the total cost of producing the firm’s total output q1 + q2. That is, q1

and q2 share the same cost function.

Firm profit π is maximized when

π / q1 = dTR1/dq1 – TC/q1 = MR1 – MC = 0 π / q2 = dTR1/dq2 – TC/q2 = MR2 – MC = 0

That is, MR1(q1)= MC(q1 + q2) for sub-market 1 and MR2(q2)= MC(q1 + q2) for sub-market 2,

implying

(Have you noticed the similarity between this decision rule and the economics of monopoly with multiple plants?)

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Graphical Illustration

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Quantity

D2 = AR2

MR2 (q2)

$/Q

D1 = AR1MR1 (q1)

MRT (q1 + q2)

MC

Q2

P2

QTQ1

P1

MR1 = MR2 = MC

• Group 1: P1 and Q1 ; less elastic thus higher priceGroup 2: P2 and Q2; more elastic thus lower price

* Choose Q1 and Q2 so that MR1 = MR2 = MC

* Graphical Tip: Since MC depends on QT, choose QT first so that MC = MRT and distribute QT to market 1 and 2 so that MR1 = MR2 = MC, where MRT is a horizontal summation of MR1 and MR2.

Importance of Elasticity in Third Degree Price Discrimination

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Third degree price discrimination is actually charging higher (lower) price to those whose demand is less (more) elastic.

Example: Consider e1 = –2 and e2 = – 4 as an example:

It followsP1/P2 = [1 + 1/ e2]/ [1 + 1/ e1] = 0.75/0.50 = 1.5

or P1 = 1.5P2

• That is, the less elastic market (market 1 with e1 = – 2) will have a higher price (1.5 times higher in this case) than the more elastic market (market 2 with e2 = – 4).

• When cost function is known, we can determine exact levels of P1 and P2.

[MR1 = P1(1+1/e1)] = [MR2=P2(1+1/e2)]Why?

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Case for ‘No sales to Smaller Markets’

Even if third-degree price discrimination is feasible, it doesn’t always pay to sell to both groups of consumers. (example: luxurious restaurant)

Quantity

D2

MR2

$/Q

MC

D1MR1Q*

P*

Group one, with demand D1, is not willing to pay high enough for the good to make price discrimination profitable.

Average dining costs$250/person

Outline


Introduction




Direct vs Indirect SegmentationEconomics of Coupons/Rebates

More Examples

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Sometimes managers cannot directly identify consumer types. Yet you don’t want to give up exercising sophisticated pricing strategies.

Direct vs. Indirect Segmentation

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Direct Segment Discrimination: price discrimination when the seller can identify different consumer groups (or segments).

• Then apply third-degree price discrimination or perfect price discrimination to each segment directly.

Indirect Segment Discrimination: price discrimination when the seller cannot identify different consumer groups (or segments)

• When buyers are not directly identifiable, sellers can design and offer a set of menu to the unidentifiable consumer groups through which consumers can self-reveal their types.

•

• It is important to link different prices to the attributes that are specific only to some consumer segments.

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Examples of ‘Indirect Segment Discrimination’

• Air fare

• Shoe-repair person in Holland Village: “Are you a local?”

• HP Printer (10 ppm vs 20 ppm)

• Information goods (‘Scientific Word’ – Academic Version vs Professional Version)

• Summer sale in Philadelphia – hammering the fridge/audio set

• Starbucks – warm beverage cup sizes

Recent email I received from Amazon.com

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General Pricing for the public

Personalized Price for Me: US$59.49

General Price at Amazon.com: US$79.11

How about this?

From the readingsDirect vs Indirect - Be Careful of Backlash!

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Coca Cola’s Smart Vending Machine (1999):

Coca Cola considered introducing the machines that automatically adjusts prices: ─ price goes up if temperature is high─ Price goes down if temperature is low

Reactions:─ "What's next? A machine that X-rays people's pockets to find out how much

change they have and raises the price accordingly?“ (NYT) ─ “A cynical ploy to exploit the thirst of faithful customers” (San Francisco

Chronicle)

Gender-pricing is prohibited in many states.

In NYC nail shops, first time violators are to be fined from $50 to $200, while those for subsequent ones are $100 to $500.

This is why ‘indirect segmentation’ is important!

Outline


Introduction





Economics of Coupons/RebatesMore Examples

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Countless coupons are issued every year. Why?


• Countless coupons are issued every year. Why? Coupons and rebates are devices to reduce the price of products. But why not just mark down the prices?

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o It would be a lot simpler and easier to run an ad on sale than to require consumers to clip coupons (or fill out rebate forms) and remember to bring them in when they shop (or mail)?

o Coupons and rebates also create extra work for financial officers, cashiers and store managers.

• Primarily, because coupons and rebates are used to price discriminate (and so are the rebates).

o Not all consumers use coupons. Only a certain segment (20-30% on average and 2-5% for certain products) regularly clip and use coupons in buying goods and services. This demand segment is more price-sensitive. Therefore lower prices to those who would otherwise shop elsewhere. A practical approximations to this ideal is lower prices to those with enough free time to clip coupons. But consumers who are less price-sensitive are willing to pay “higher prices” without taking trouble to clip coupons (or fill out and mail back the rebate forms.

Price Elasticities for Coupon Users and Nonusers:

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Elasticity is the key information to implement a coupon/rebate strategy.

Numerical Example of Coupon Strategy

• By estimating the elasticity of demand, managers can approximate how much coupons should be worth.

• For example, if a manager believes that elasticity of demand for coupon users (call them group 1) is –5, and for non-users (call them group 2) is –2.5, and MC = 0.8, she can calculate the optimal value of coupons.

Profit maximization implies

[MR1 = P1(1+1/e1)] = [MR2=P2(1+1/e2)] = MC

P1 = MC/(1+1/e1) = (0.8)/[1– (1/5)] = 1 and

P2 = MC/(1+1/e2) = (0.8)/[1– (1/2.5)] = 1.33.

Since you don’t know who to charge $1.33 and who to charge $1, you simply charge $1.33 for the product and issue the coupon worth 0.33.

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Wall Street Journal:

• “5.8 billion of 291.9 billion coupons distributed annually were redeemed - the most elastic consumers clip and redeem them. Recall you want to lower prices to them”

But P&G (and others) are now restricting their use.- Why?

─ Coupons or rebates would make no sense if everyone used them. Likewise, why hand out coupons if the users are completely random? Coupons work by offering discounts to precisely those customers who are most sensitive to price.

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Off-the-Record Episode:

• J&J’s 1 Day ACUVUE Contact Lenses

In real life….

‘Dilbert Principle’

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LOL

Outline


Introduction






Real Life Examples

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Now let’s look at the real life.

Real Life Examples of Price Discrimination

• Big buyers are favored (group rate for movie tickets is cheaper)

─ Senior/Student/Early-bird Discounts for bus fair or movies.

• You often dump in foreign market, or vice versa.

• Gender Pricing: Hair Salon (‘Next’ at Holland Village)

Laundry /Cleaner (‘Bucks County’ Cleaner at Newtown, NJ)

• ‘Journal of International Economics’ annual subscription: US$130 for personal and US$1,330 for institutional

• Wall Street Journal’s monthly subscription (as of 2011):S$50 in Singapore, Ұ7,875 (=S$120) in Tokyo, ₩ 26,500 (=S$ 34) in Korea, US$55 (=S$75) in China, but S$18 worldwide for on-line edition.

• Hard cover books vs Paperback (intertemporal price discrimination)

• Electricity bill (peak-load pricing)

• Standby flights are often cheap. But low-cost carriers require full fare for a standby travel 35

Real Life Examples of Price Discrimination– cont.

• Internet/Wifi Connection Fee at Hotels─ Ibiz Hotel Seoul vs College Hotel Amsterdam

• Honma 3 star vs 5 star iron set, or gold-plated iron set

• Haggling - Size up your income─ You fill up questionnaires at doctor’s office.

─ Nowadays, scholarships are more based on need than merits.

• An optical shop conversation: ─ “How much are these glasses?”

“The price is $200. …lenses only…per one, sir.”

• How about the prostitute in Prof. Steven Levitt’s Talk in ‘Freakonomics Radio Live in St. Paul’?

Source: http://www.youtube.com/watch?v=ONwdUCC8If4&feature=related

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Managerial Implications (Self-reading)

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Managers use price discrimination strategies in an attempt to charge consumers as close as possible to their reservation price. Unfortunately, managers face many problems when they try to implement such a strategy. First is the problem of finding out the reservation price. It would be much easier to price discriminate in markets where you have face-to-face contact, or when you can ascertain a customer’s reservation price. Second is the separability of markets. A price discrimination strategy will not work unless arbitrage is prevented. Again, the followings are necessary for an effective price discrimination in practice.

Multiple demand elasticities- there must be differences in demand elasticities between buyers. These demand differences can be caused by differences in income, location, available alternatives, tastes, use of product.

Market segmentation- the seller must be able to partition the total

market by effectively segregating buyers into submarkets based on elasticites. Profits are increased by charging different prices in each segment.

Market sealing or No arbitrage- the seller must prevent any

significant resale of goods from a lower priced segment to higher priced one.

Outline

Part B: Two Part Pricing

IntroductionHomogeneous Consumers Case

Heterogeneous Consumers Case

Numerical Examples

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Two part pricing: Form of pricing in which consumers are charged both an entry and a usage fee.

Introduction

Two part pricing is a very clever way to (possibly) materialize what a first degree price discrimination strategy aims to establish. The strategy uses

─ An upfront fee (many times called an entry fee and denoted by T) and

─ An additional fee for each unit of consumption (many times called a use feeand denoted by P)

• Health clubs/Country clubs - Pay to join and pay to work out/play golf.

• Amusement/Theme parks - Pay to enter and pay for rides

• Mobile phone carriers - Pay a flat initiation fee and pay for the processing time

• Pro Sport Games or City Orchestra: Personal Seat Licenses (PSLs)

─ Pay to secure your seats (i.e. pay for the right to buy the tickets) and pay for tickets

Often, upfront fee and use fee are combined into one bill, with the upfront fee entitling the buyers a certain units of goods/services.

• Mobile phone: free 700 minutes/month at $200 monthly fee

• Bars/Clubs: free 3 drinks at $20 entry fee or unlimited drinks at $100 entry fee

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Example:

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PSLs for NEW YORK JETS - TICKETS AND METLIFE STADIUM

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PSLs for NEW YORK JETS - TICKETS AND METLIFE STADIUM –cont.

Outline

Part B: Two Part Pricing

Introduction

Economics of Two Part Pricing─ Homogeneous Consumers Case

─ Heterogeneous Consumers Case

─ Numerical Examples

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Two part pricing works better when consumers have identical or very similar demands.

A. Homogeneous Consumers Case

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T(= area ABC = consumer surplus at P = P*)

Quantity

$/Q

MCP*= MC

D

A

B C*

Q*

V (= area OBCQ*)

OQ1

P1

The optimal strategy in the above case is simple:

Set the use fee (P*) at marginal cost (MC) and the entry fee (T) at the corresponding maximum consumer surplus.

• The variable profit = total revenue(TR) – total variable cost (TVC)

TR = TR(from entry fee) + TR(from use fee) = T + V TVC = V

Thus, Variable Profit = V (or Total Profit = V – fixed cost)

• Note that this yields the same result as first degree price discrimination.

B. Heterogeneous Consumers Case

• Two part pricing strategy is most effective when consumers have similar demand characteristics.

When demand across consumers is not identical and not identifiable, the optimal strategy is more complicated because:

o if not identical CS is not the same for each consumer group

o if not identifiable entry fee cannot be consumer-specific

• The Case of Two Consumer Types:

Below, let’s consider the case of two heterogeneous consumer types, D1 and D2. Assume that we only know that there exist two such types but cannot identify them. (If the types are identifiable, you can simply treat each consumer separately.)

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45

D1 = consumer 1

D2 = consumer 2

Q

$/Q

MC

A

B C

Q2Q1

P > MCF

G

H

I

P = MC

E

Heterogeneous Consumers Case – cont.

We can think of the following options:

Charge P = MC & T = area GBI (serve only D2) Charge P = MC & T = area ABC (serve both D1 and D2) Charge P > MC & T = area AEF (serve both D1 and D2)

Remarks:• Is it an option to charge (P,T) such that

P > MC, T = area GEH and serve only D2?• How about charging (P,T) such that

P > MC and, area AEF <T < area GEH

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A tennis club is dealing with 1000 identical members.

Each individual has the demand of

Q = 6 – P

Q - court hours per monthP - price per court hour

FC = 0, MC = 1

• Optimal two part pricing:

Use fee P = MC = 1 and T = CS = 12.5 /month

• Profits are:

π per month= TR(entry fee) + TR(use fee) – VC – FC= [(1,000x12.5) + (1,000x1x5)}] –

[(1,000x1x5) + 5,000] – 0= 12,500 + 5,000 – 5,000 – 0= 7,500

Two Part Pricing - Numerical Example

D: P = 6 – Q

MC

6

65

1

Q

Consumer surplus (CS) = 5x5x0.5 = 12.5

Exercise 1: Homogeneous Consumers

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Two unidentifiable types (with equal number N of consumers in each type), each consumer with the following demand:

DS (strong D): P= 8 – Q

DW (Weak D): P= 6 – Q

FC = 0 and MC = 2

We consider three options:

•Option 1 (Serve DS only):P = MC = 2 and T = 18 =18N

•Option 2 (serve both Ds and Dw)P = MC = 2 and T = 8 =16N

•Option 3 (serve both with a use fee > MC)

P =P* > MC and T = (6-P*)2(1/2)

= N( Entry Fee + Use Fee)

= N{(6-P*)2( ½ )2} + {(P*-2)(6-P* + 8–P*)}

is maximized at P* = 3. Then T = 4.5and =17N.

Thus, Option 1 turns out optimal.

Two Part Pricing - Numerical Example – cont.

DW

DS

MC

6

8

64

2

Q

P*

6 - P* (8 - P*)

P

Exercise 2: Heterogeneous Consumers

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Remarks 1:

What if consumer types were identifiable in the previous example?

Charge – P = MC = $2 to both types and charge – TW = CSW = 8 and TS = CSS = 18

Then profit will be π = N(8 + 18) = 26N > 18N

Implication: You have a great incentive to gather information on consumer demands.

Two Part Pricing - Numerical Example – cont.

Remarks 2:

Two part pricing works better when consumers have identical or very similar demands.

Outline

Part C: Bundling

IntroductionEconomics of Bundling

Pure Bundling vs Mixed Bundling

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Bundling: Bundling is an alternative pricing strategy. It is about packaging two or more products into one to gain a pricing advantage.

NOTE:

We will cover bundling only lightly. Or we may get to skip this part.Naturally, it is to be excluded from the final exam.

Introduction

• To those of you who dislike BSP1005 (Managerial Economics) classes by Professors Jo and Yang:

I feel your pain but I am sorry it’s a package deal for your choice of NUS.

• Been to the Botanical Garden recently?

o Not so good continental/American breakfast was bundled with a very pleasant coffee, thereby incidentally denying access to my custom for the local a la carte menu.

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Bundling is an alternative pricing strategy. It is about packaging two or more products into one to gain a pricing advantage.

There are several ways managers implement bundling strategies.

• Price-separately strategy: no bundling

• Pure (or simple) bundling: sell only as a package

─ Auto loan mandatory for Toyota auto deal

• Mixed bundling: choose between a packaged bundle or separate units, bundle pricing being less than the sum of components’ prices

– Season tickets vs per-show or per-game tickets (Philadelphia Orchestra, Pro sports)

– Fast food chains (MacDonald’s or Burger King’s value meals.)– Restaurant (Set Menu vs A La Carte)

– Brewerkz at Clarke Quay: Pay for Lunch then one free microbrewery beer

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Outline

Part C: Bundling

Introduction

Economics of BundlingPure Bundling vs Mixed Bundling

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Economics of Bundling

• Bundling works better the stronger the negative correlation is among the valuations of different consumer groups.

o Increased firm performance through bundling is primarily derived from diverse valuations (or reservation prices) consumers have for the product –not just different valuations but a negative correlation in their reservation prices over the goods.

o In fact, a bundling strategy is never better than a price-separately strategy if the consumers’ demand are positively correlated, i.e., if one group values all products more than another group, who, in turn, values all products more than a third group, etc.

o However, a negative correlation in consumer demands does not necessarily mean that a bundling strategy is always better than a price-separately strategy. (Thus, negative correlation is only necessary but not sufficient to make a bundling strategy profitable.)

• The following illustrates why a negative correlation in consumer demands is critical:

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• Consider two goods case

─ r1 and r2 denote the consumer groups’ reservation prices for good 1 and good 2.

─ P1 and P2 denote the price of good 1 and good 2 when the goods are priced separately while PB denotes the price of the bundle. (Assume that a bundle here is composed of 1 unit of each good for simplicity)

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A. If goods are priced separately(at P1 and P2):

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B. If products are bundled, one buys the bundle only if (r1 + r2) PB

r2

r1

P2

IIConsumers buy

only good 2

1 1

2 2

r P

r P

P1

IConsumers buy

both goods

1 1

2 2

r P

r P

IIIConsumers buy

neither good

1 1

2 2

r P

r P

IVConsumers buy

only Good 1

1 1

2 2

r P

r P

• Now let’s consider two extreme cases of consumers’ taste correlations to get an idea about when bundling will be useful. The dots in the diagrams represent the reservation prices of the consumers. Assume there is one consumer in each group for simplicity.

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If tastes are perfectly positively correlated, then you don’t gain by bundling, earning just the same profit as under separate pricing.

r2

r1

P2

P1

PB = P1 + P2

If tastes are perfectly negatively correlated, then pure bundling is the better strategy, earning more profits than under separate pricing.

Outline

Part C: Bundling

Introduction

Economics of Bundling

Pure Bundling vs Mixed Bundling

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Pure Bundling vs Mixed Bundling(We may skip on this.)

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• Mixed Bundling -- Selling both as a bundle and separately• Pure Bundling -- Selling bundles only

Mixed bundling may be more profitable if production costs are not sufficiently low or if consumers’ tastes are not perfectly negatively correlated.

Let’s look through some examples below:

Scenario 1: Perfectly Negative Taste Correlation & Significant Marginal Costs

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Reservation price is below MC for some consumers:

For consumer A: r1 < MC1 while r2 > MC2

For consumer D: r2 < MC2 while r1 > MC1

r2

r110 20 30 40 50 60 70 80 90 100

10

20

30

40

50

60

70

80

90

100

MC2 = 30

A

B

D

C

MC1 = 20

If Pure Bundling:

• PB = 100 and all four consumers would buy the bundle• π (pure bundling) = 100x4 – (20x4 + 30x4) = 200

With mixed bundling, consumer A can be induced to buy only good 2, while consumer D is induced to buy only good 1, improving the firm’s profitability compared to the pure bundling.

• PB = 100 for bundle and P1= 90– and P2 = 90– for separate sales (why not 90?). Then

B and C would buy the bundleA buys only good 2 and D only good 1

• π (mixed bundling) = 100x2 + 90- + 90- – (20x3 + 30x3) = 230-

Scenario 1: Negligible Marginal Costs but Imperfectly Negative Correlation of Tastes

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Assume MC1 = MC2 = 0.

Options for pure bundling are:

• Serve B and C only at a higher PB

to earn π = 120x2 = 240

• Serve all four consumers at a lower PB

to earn π = 100x4 = 400

r140 80 100

40

80

100

120

C

10

10

90 AB

D

120

r2

If Pure Bundling

• PB = 100 and • π (pure bundling) = 100x4 = 400

If Mixed Bundling

• PB = 120, P1 = P2 =90

to let B and C buy the bundle while A and D buy good 2 and good 1, respectively.

• π (mixed bundling) = 120x2 + 90x2= 420

WRAP-UP: MONOPOLIST’S PRICING STRATEGIES

• Firms with market power are in an enviable position because they have the potential to earn large profits, but realizing that potential may depend critically on the firm’s pricing strategy.

• A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible.

• Ideally, the firm would like to perfectly price discriminate. If not practically possible, it can try second and third degree price discrimination options. Identifying customer types is important. Otherwise indirect segmentation can be used.

• The two-part tariff is another means of capturing consumer surplus. Its effectiveness is higher as consumer types are more similar.

• When demands are heterogeneous and negatively correlated, bundling can increase profits

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THANK YOU!

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Documents

BSP1005 Lecture Notes 8 - Sophisticate Pricing Strategies With Market Power