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ECO 610-401

ECO 610-401. Monday, September 15 Topics Price Elasticity, Marginal Revenue Price Elasticity & Marginal Revenue Pricing Decisions Pricing with Market Power Markup Pricing Price Discrimination Readings Brickley et. al, Chapters 4 & 7; Hoyt, Lectures 1:11-16-2:1-6 .

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ECO 610-401

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  1. ECO 610-401 • Monday, September 15 • Topics • Price Elasticity, • Marginal Revenue • Price Elasticity & Marginal Revenue • Pricing Decisions • Pricing with Market Power • Markup Pricing • Price Discrimination • Readings • Brickley et. al, Chapters 4 & 7; • Hoyt, Lectures 1:11-16-2:1-6

  2. Assignment for Monday, September 22nd • Monday, September 22nd • Topics: • Pricing with Market Power (continued); • Costs & Decision Making: Level of Production & Mix of Resources • Readings: • Brickley et. al, Chapters 5,7; • Hoyt, Lectures 2-3:103-115 • Homework due (Assignment 1)

  3. Questions to Consider for today • Provide some examples of goods and services that differ in how responsive the demand for them is to changes in price (differences in elasticity). • How can price discrimination reduce the extent of this tradeoff? • What is the tradeoff a monopolist faces when making pricing decisions? • Entertainment and sporting events frequently do not sell out. Can it be profit-maximizing not to sell all seats to a performance? • Think about some examples in which different consumers (or firms) face different prices for the same, or almost same, product. What might account for these differences in prices? Specifically are they motivated by differences in the cost of serving or selling to customers or differences in the customer’s willingness to pay? • Frequently, goods and services are “packaged” or “bundled”. Occasionally firms will only sell these goods as a bundle (pure bundle) though often they will sell the items separately and as a bundle (mixed bundling). Think of some examples. Why and when might firms want to offer items as a bundle?

  4. Horizontal Demand & Constant MR

  5. Downward Sloping Demand & MR < P

  6. The Demand Relationship

  7. Elasticity & Marginal Revenue on a Demand Curve

  8. Pricing Lesson 1. A profit maximizing firm should never sell at a price at which  > -1 (inelastic) since an increase in price will increase revenues and reduce costs (by reducing output), thereby increasing profits.

  9. More on Marginal Revenue • Why does total revenue sometimes decrease (MR is negative) with increase in Q? • Increase in Q  Decrease in P • 2 effects of increase in Q • More sales (Revenue increase is PdQ) • Lower price on current sales (Revenue loss is QdP)

  10. Quantity Increases and Revenue QdP PdQ QdP PdQ

  11. Pricing Strategies, Profit Maximization, and Optimal Markup • Conditions for Profit Maximization • Optimal Markup Rule • Applications: • When to sell out

  12. Conditions for Profit Maximization • Revenue (R) = pricequantity = PQ; • Marginal Revenue (MR) is "the additional revenue from an additional unit of output". • Formally we have MR =dR/dQ, • Note that "average revenue", R/Q, is simply price. • MR decreases with Q

  13. The Cost Side • Total Cost=C(Q) depends on output. • Total cost is increasing with output. • Marginal Cost (MC) is the "additional cost of an additional unit of output" • Generally we argue that for the "relevant" range of output, MC is increasing in output , • Instances when we might expect it to decrease with output (economies of scale)

  14. Profit Maximization

  15. Profit Maximization (2)

  16. Graphical Example of MR=MC

  17. Solving for Profit-Maximizing Price and Quantity • In the figure given the MR and MC depicted the profit maximizing Q and P are 35 and 6.50. • We can solve this algebraically • MR = MC--> 10- (1/5)Q = 3 or Q =35 • and P = 10- (1/10)(35) = 6.5.

  18. When to Sell Out • No marginal costs associated with selling an extra ticket. • Given no marginal costs, profit maximization= revenue maximization. • Then why don’t promoters set the price to sell out all concerts (or games)? • Simple explanation: The price needed to sell out the arena may be below the revenue maximizing price.

  19. Operas versus Rock Concerts • If pricing of tickets is based on maximizing revenues what explains the large difference in the prices of different forms of live entertainment? • DO in the figure represents the demand for opera • DR represents the demand for a (typical, but not great) rock concert. • Demand curve for rock concerts is much more elastic, so a lower price ischarged for the rock concert and many more people attend it.

  20. Markup Pricing and Elasticity of Demand • We often hear of markup pricing or “cost-plus” pricing but how much should the markup be? • Should all products sold be marked up the same amount? • What should the base (for costs) be? The Markup Rule • Elasticities provided an answer to what the profit-maximizing markup should be.

  21. General Implications for Pricing Strategy • Pricing Lesson 2. • The profit-maximizing "markup" is determined by the elasticity of demand. The less elastic the demand for the good, the higher the markup should be.

  22. General Implications • Price depends only on marginal cost • Not costs unrelated to changes in Q. • Markup only depends on demand and not cost conditions. • Markup should be higher on goods with less elastic demands. • This means the markup on a good should be higher if: • No good substitutes for it. • It is a necessity. • It is a small share of the budget. • If the demand elasticity is less than 1 then markup is too low. • If a price increase of say 10% reduces sales by less than 10% then raise price.

  23. Markups in Retail Grocery

  24. Class Exercise MRb MRb

  25. Class Exercise • Algebraically, the two demand curves are: • Qa = 140 – 4Pa or Pa = 35 – (1/4)Qa • Qb = 130 – 2Pb or Pb = 65 – (1/2)Qa • Then • TRa = PaQa = 35Qa – (1/4)Qa2 • TRb = PbQb = 65Qb – (1/2)Qb2 • MRa= 35 – (1/2)Qa • MRb= 65 – Qb • MRa=MC  35 – (1/2)Qa = 5  Qa = 60, Pa = 35 – (1/4)60 =20 • MRb=MC  65 – Qb = 5  Qb = 60, Pb = 65 – (1/2)60 =35

  26. Class Exercise (3) • Why the difference in prices? • Elasticity:

  27. Price Discrimination • Why do ticket prices to movies depending on the age of the purchaser? • Why do grocery stores offer coupons rather than simply lower prices? • Why are advanced ticket purchases for airlines so much cheaper? • Here we discuss the practice of price discrimination or market segmentation, • Setting different prices for different types of consumers.

  28. The Monopolist’s Dilemna • High Price -- Extract Consumer Surplus from consumers who buy • But don’t include everyone willing to pay above Marginal Cost

  29. Extraction Consumers are charged exactly what their reservation price. • Exclusion. No individual consumes a good if the cost that good exceeds her reservation price. • Inclusion. Any individual whose reservation price exceeds the cost of the good consumes it.

  30. Problem to Consider • Can set 2 different prices – • 1 for students and 1 for adults for cinema tickets. • The table gives the relationship between ticket sales and prices for the 2 groups. • Suppose that you had a capacity of 600, what prices would you set?

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