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?

$ $

Q QD2

D1

ATC

D1

D2

Potential Entrant Existing Firm

Entry Limit Pricing

Decreasing competitive P rivalry

Match P

Random P

Non 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

TR

QP

P

QQ

MR PP

Q

Q

PP

MR PE

MR PE

E E

MR PE

E

[ ]

[ ]

[ ]

11

1

1

NOTE:

MR = 0 if E is unitary

> 0 if E is elastic

< 0 if E is inelastic

Profit-Maximizing Prices

P where MR = MC

P

E

EMC0

0

1

P

E

EMC0

0 1

E

Em ark u p fac to r ap p lied to M C0

0 1

' '

Profit-Maximizing ‘Markup’ Factors E0

-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

E

E0

0 1

Assume: Q = total demand for Kodak film QUS = US demand = 15 – PUS

PUS = 15 – QUS

MRUS = 15 – 2QUS

QJ = Japan demand = 18 – 2PJ

PJ = 9 - .5QJ

MRJ = 9 – QJ

QT = QUS + QJ

= 33 – 3P (for P 9) P = 11 – 1/3Q MR = 11 – 2/3Q

MC = ATC = 3 in both the US & Japan

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)

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

E0 in J at PJ = 6

Q

P

P

Q( ) .1

9

61 5 0

E

Em ark u p0

0 1

1 5 0

1 5 0 1

1 5

53

.

.

.

.

Q

P

P

Q( )2

6

62

E

Em ark u p0

0 1

2

2 12

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

Π w/o Discriminating

Charging Different PS to Different Customers (markets)

P P

Q Q

PA

PB

MC

DA DB

MRAMRB

MC

Mkt A Mkt B

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. 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.

2. 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.

3. Volume Discounts: Charge lower price for units purchased beyond given level.

Block P Example

Typical consumer’s demand is

P = 10 – 2Q TC = 2Q MC = 2 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

10

8

6

4

2

1 2 3 4 5

D

Quantity

Costs = $8

½ (4) (10-2) = $16

Charge fee = CS

Set P = MC = $2

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 6 x 1 = 6

4 D, FD 4 x 2 = 8

3 D, FD, F 3 x 3 = 9

2 D, FD, F, N 2 x 4 = 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 goodRazorCameraComputerWater softenerPhoneCopy machineFertilizerHotel room

Service goodRazor bladesFilm, film developmentSoftware, technical supportSalt packetsCalling plansPaper, cartridges, tech supportApplication, soil testingTransportation, meal

Q Discount

Assume P = 100 - .1Q (Q = 00’s) MC = ATC = 10

What is firm π w/1) MR = MC production/pricing?

2) Charge P = 75 for Q up to 250, P = 55 for additional Q?

P

Q (00)

120

100

80

60

40

20

10

450 1000MR

MC=ATC

P=100-.1Q

Std MR=MC pricing πΠ = (P-ATC)Q = (55-10) 450 = 20,250

No Q Discount π

MR = 100 - .2Q => MR = MC => 100 - .2Q = 10 => .2Q = 90 => Q = 450 => P = 55

P

Q (00)

120

100

80

60

40

20

10

450 1000MR

MC=ATC

P=100-.1Q

Π = (75-10)(250) + (55-10)(200) = 16,250 + 9,000 = 25,250

Q Discount π

75

55

250

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. 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?

2. Do employees have an incentive to ‘shirk’ their duties and, if so, how do personnel managers attempt to reduce ‘shirking’ by employees?

3. 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 = individualwho employs or supervises others(agents)• stockholders• management• business owner• defendant• team owner

Agent = individualemployed 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 ethicHealth status of an insurance customerDriving tendencies of insurance customerProduct quality

2. Moral hazard one party can benefit at the expense of another because they have more information about unobserved actionsSolution = contracts to make incentives more compatible

Types of Contracts1. Fixed fee

a. To agent (e.g. person hired)b. To principal (e.g. land or property owner)

2. Hirea. wage or salaryb. piece rate

3. Contingenta. revenue sharingb. profit sharingc. 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 incentives2. Need to examine incentives provided and likely consequences of

contract terms3. Contracts that usually provide the most compatible economic

incentive to agents are 1b and 3b above