Managerial Economics: Applying the Tools Topic 7, Part 2

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Managerial Economics Applying the ToolsTopic
7, Part 2

• Review of 2 Topic 6 topics Elasticity, Simple
  Monopoly PricingTopic 7 Innovative Pricing
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Demand elasticity, from Topic 6

• Elasticity is a negative number
• ex a 10 increase in the price of oil decreases
  quantity demanded by 20. Therefore, ED -2
• Sometimes the negative sign is treated as
  implicit
• when we talk about unit elasticity, we mean
  its (-1)
• Point elasticity the elasticity exactly at
  that point (that price or that quantity)

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Understanding your demand curve

• Often you are only familiar with your demand
  curve near the current price you have
  experimented with prices that are slightly higher
  or lower, but not beyond
• You know the point elasticity of demand, at
  your current price, but not much more
• But that is enough information to determine
  whether or not youre currently at the right
  price!
• Your Price should be times your
  marginal cost
• (Remember that ? is a
  negative number, here)
• Increase your Price gradually, if its less than
  that

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Checking that youre at the right price

• ? Price should be times marginal
  cost
• WARNING 1 Elasticity changes along the demand
  curve
• ? this is not a shortcut to finding the optimal
  price in a problem set!
• WARNING 2 If Marginal Cost is not constant,
  then MC also changes along the demand curve
• ? You have to know what your current MC is
• (Remember, MC is measured in terms of quantity
  how much do costs go up, if I increase output by
  1 unit?)

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Now Monopoly, from Topic 6

• Demand for widgets in Melbourne is 800 2P.
• Cost of producing widgets is 100
• How much should the monopolist produce?
• How much should she charge?
• How much profit will she earn?
• Suppose now she has the option of selling widgets
  in Sydney, where demand is 600 P.
• She can sell in both locations, if she chooses
• How much does she sell in Melbourne?
• How much does she sell in Sydney?
• How much profit will she earn?

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How to Equalise Marginal Revenue in 2 markets
carefully specify quantities!

• Let
• QM quantity sold in Melbourne
• QS quantity sold in Sydney
• QTOT total quantity produced and sold
• QM QS
• Then set MRM MRS MC
• Be careful which of those quantities you refer
  to!
• For instance MR in Melbourne 400 QM

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Sell in Sydney
MRS MC
Monopolist
Sell in Melbourne
MRM MC
Dont Sell
0
Use Decision Tree thinking Each additional unit
you sell in the Melbourne factory down MRM, until
that option is less attractive (or just as
attractive) as selling in Sydney Each additional
unit you sell pushes down MR, until finally you
choose dont sell
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(a) Two-part pricing -- a type of non- linear
pricing

• 
  QD
• In algebra demand (QD) is QD 1000 - P

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Customers who demand multiple units

• Last week we thought of a demand curve as being
  composed of many individuals, each with a
  different WTP (999,998,997,) and each wanting 1
  unit of the good only
• But in many markets, most customers want more
  than 1 unit mobile phone minutes, for example
• A demand curve is still the right representation
  of the market!
• Example from our demand curve There could be 100
  identical consumers, who each demand 10 (P/100)
  units.
• (but in reality consumers will never be
  identical)
• The quantity each customer buys will depend on
  the price

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Customers who demand multiple units

• 2-part pricing allows a monopolist to extract
  more surplus from customers, in a
  variable-quantity market
• If customers were absolutely identical, 2-part
  pricing would allow the monopolist to capture all
  the value!
• Suppose there are 100 identical consumers, who
  each demand 10 (P/100) units
• If the monopolist charged 200 per unit
  Marginal Cost
• Each customer would purchase 8 units the
  surplus-maximising quantity
• They each earn 3200 in surplus, at that price
• The monopolist could charge an up-front fee of
  3200 per customer, and get all the surplus
• Ex Unlimited-access Internet accounts

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Price Discriminationwhen customers have
different WTP

• By charging different prices to customers with
  different WTP, a monopolist can create more
  surplus
• To achieve this, the monopolist must find ways to
  charge different prices to different buyers
• segment the market

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Price Discrimination

• (b) Group pricing or
• Price discrimination on observables
• charge different prices to different groups that
  you can identify, and prevent arbitrage
• (c) Versioning or
• Price discrimination on WTP for features
• charge more for a product with a special feature
  that high WTP customers choose to buy

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(b) Price discrimination on observable
characteristics

• Why are there often discounts for seniors or
  students?
• Students have lower Willingness-to-Pay, on
  average, and their demand is more elastic
• May want to charge lower price to them
• Membership in the group must be observable to the
  monopolist, to avoid arbitrage
• Arbitrage strategic actions taken by people in
  a market, to exploit price differences
• Ex claiming youre a student

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(b) Different prices to different groups

• Note Selling to different geographical markets
  (Sydney and Melbourne, in our earlier example) is
  price discrimination!
• Pricing to different geographic markets
• US edition textbook 70
• Indian edition textbook 5
• Arbitrage?
• By neighbourhood car insurance versus other
  goods
• AIDS drugs and arbitrage

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Example Railroads

• Railroads set different prices for coal and grain
• coal traffic relatively inelastic
• grain traffic elastic (intermodal competition)
  ? should charge them a lower price
• Coal 2 or 3 times higher than grain
• How are markets segmented?

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(C) Price discrimination on unobservables or
Versioning Self-Selection

• Find a feature that high WTP buyers care about
  convenience, quality,
• High-WTP buyers must care more about this
  extra feature than low-WTP buyers
• Sell 2 versions of the product one with the
  feature, one without
• Customers self-select they all look identical to
  the monopolist, but they decide which version to
  buy

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Example Stamps

• In Sri Lanka postage of a plain postcard cost 1
  rupee (2 cents). Postage of a pictured postcard
  cost 14 rupees
• Exploit relatively inelastic demand of tourists
• What is the feature that high-WTP buyers are
  willing to pay for?
• Picture

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Example Airline Tickets

• Why is there a discount for a Saturday night
  stay?
• Way of segmenting market. Business travellers
  less likely to stay over weekend.
• price elasticity (discount) -1.83
• price elasticity (full economy) -1.3
• What is the feature that high-WTP buyers pay
  for?
• ability to return on weekday

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Quantity discounts

• Block Electricity Pricing
• suppose there are large and small customers.
• Charge a certain price up to X MWh
• Then have a discount.
• Small buyer demand unchanged
• Larger buyers purchase more
• What is the feature offered?
• The right to buy small quantities

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Making Self-Selection Work

• Adjust prices so that
• Low-WTP buyers want to buy version without the
  feature Price of the basic version is just below
  their WTP
• High-WTP buyers prefer to buy the version with
  the feature than the version without they get
  more surplus from the feature
• Double-check that youre earning more than with
  just one version!
• Application Car with or without GPS
• Notice that if both groups have the same WTP for
  the feature, both groups should have it!
• ? feature should be one that high-WTP buyers
  value much more

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Example Car with or without GPS

• High-WTP buyers
• WTP for car 40,000
• WTP for car with GPS 48,000
• ? WTP for the feature
• Low-WTP buyers
• WTP for car 30,000
• WTP for car with GPS 31,000
• Questions
• How do you price, so that low-WTP buy the basic
  car and high-WTP buy the car with GPS?
• If the cost of producing the car is 17,000 and
  the cost of producing installing GPS is 3,000,
  what will the monopolist do? (What are the other
  alternatives?)

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Example Delay

• Suppose sale can occur immediately or one month
  later
• Buyer dislikes waiting (everyone else wants to
  talk about Harry Potter this month) and will
  evaluate surplus at 50 of this months surplus
• Seller has no delay costs
• The seller can commit to a price schedule a
  price for this month (hardback) and a price for
  next month (softback)
• ? feature offered no delay!
• (From a marketing point of view, its better if
  they view this months product as better, e.g.
  hardback)

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Price Schedule

• Half the buyers have WTP of 60, and half have
  WTP of 40
• What price schedule does the seller choose?
• Choose prices so that
• high value buyers purchase now
• low value buyers purchase later
• Second month price is 40
• What should immediate price p be?
• Make high value buyer indifferent between taking
  that price and waiting
• 60 p gt 0.5 (60 - 40) 10
• So long as p is less than 50, will get
  self-selection

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Profits from Screening

• The seller is using screening, that is,
  structuring prices to reveal information
• Now get 40 from low value buyers and 50 from
  high value buyers
• Thus, on average price will be 45
• Before screening, average price was 40
• Is this worth it? Small gains, yet it cost low
  value buyers a month of waiting
• ? might incur ill-will, maybe not worth it

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Related examples Intertemporal effects

• Product life cycle discrimination
• Early buyers often have much more inelastic
  demand
• first run movies
• computer software
• computer hardware
• CDs
• new sports equipment

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Damaged Goods

• Some firms engage in crimping the product. That
  is, they engage in costly adjustments to
  differentiate products
• Examples Printers
• Student versions of software
• Digital images
• What is the feature offered?
• The better version of the product (the version
  thats not crimped)

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• Monopolists offer multiple products for reasons
  other than price discrimination
• horizontally differentiated products theyre
  all just as good, but different people prefer
  different goods
• ex Sweet cereals, crunchy cereals,
• Often there is a good reason to charge different
  prices for different goods, even in competitive
  markets
• vertically differentiated products we all
  agree about whats the best good, but were not
  all Willing to Pay the extra cost to produce it
• ex Supercomputers, Ferraris,
• But crimping a product is clearly for pricing
  purposes only (even so, its not necessarily bad
  for customers)

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Making Self-Selection Work (continued)

• May need to cut price of high end, or increase
  quality (add more features)
• May need to cut quality (reduce features further)
  at low end
• It may cost more to produce the low-quality
  version, if features have to be subtracted.
• In design, make sure you can turn features off!
• You may want more than 2 versions of the product,
  if there is a range of different WTPs

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Application

• Pricing and the Internet

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Personalised Pricing

• Catalog inserts
• Market research
• Differentiation
• Easy on the Internet

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Personalised pricing in traditional industries

• Airlines
• Direct mail
• Databases
• Supermarket scanners

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Versioning
Need to add value to the initial version of a
product

• Delay
• User Interface
• Convenience
• Image Resolution
• Speed of Operation
• Flexibility of Use

• Capability
• Features Functions
• Comprehensiveness
• Annoyance
• Support

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Example

• There are 40 type As WTP is 100 for speedy
  version, 40 for slow
• 60 type Bs 50 for speed, 30 for slow
• If seller could charge WTP 7000 revenues
• Offer only speedy 50 is best price,
  revenues5,000
• Offer only slow not as profitable

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Versioning Solution

• Try speedy for 100, slow for 30
• Will this work? Compare benefits and costs of
  the speedy version for Type A
• Value of speedy 100-1000, but value of slow
  40-3010 gt 0
• ? A would choose slow version, at this price
• ? Discount the fast version 100-p40-30
• So, p90
• Revenues 5,400 90x40 30x60

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Pitfalls

• Resentment
• Amazon.com
• Arbitrage
• Windows NT workstation/server