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Welcome to EC 209: Managerial Economics- Group A By: Dr. Jacqueline Khorassani

This class discusses pricing strategies for firms with market power, including standard pricing and profits, and explores first, second, and third-degree price discrimination. Learn how to maximize profits and implement different pricing strategies. Don't forget to attend the review session tonight at 7PM!

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Welcome to EC 209: Managerial Economics- Group A By: Dr. Jacqueline Khorassani

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  1. Welcome to EC 209: Managerial Economics- Group ABy:Dr. Jacqueline Khorassani Week Twelve

  2. Managerial Economics- Group A Week Twelve- Class 1 Monday, November 19 11:10-12:00Fottrell (AM) Aplia Asst Due tomorrow before 5 PM Don’t forget Review Session 7PM Tonight O'Flaherty Theatre

  3. Chapter 11 Pricing Strategies for Firms with Market Power

  4. Standard Pricing and Profits for Firms with Market Power Price Profits from standard pricing = Q * (P – AC) = $8 10 If C(Q) = 2Q Then MC = 2 Remember If P = 10-2Q R = PQ = 10Q -2Q2 MR = 10-4Q 8 6 4 To max profits MC = MR 2 = 10-4Q Q = 2 MC=AC 2 P = 10 - 2Q 1 2 3 4 5 Quantity MR = 10 - 4Q Plug Q = 2 into your demand equation  P = 10- 2 (2)  P = 6

  5. Marginal Revenue and Elasticity • Recall own price elasticity of demand E = %Δ Q / %ΔP Where %Δ Q= dQ/Q %ΔP = dP/P E= dQ/Q divided by dP/P E = (dQ/dP) * P/Q

  6. Also revenue is R = P.Q • Where P is a function of Q • so R(Q) = P(Q).Q • dR/dQ = dR/dP . dP/dQ + dR/dQ . dQ/dQ • dR/dQ = Q * dP/dQ + P * 1 • MR = P (Q/P . dP/dQ + 1) • We know that (dQ/dP) * P/Q = E • MR = P ( 1/E + 1) • MR = P(E + 1)/E

  7. MR = P(E + 1)/E • If E = -1  MR = 0 • If E is a smaller negative number  MR <0 • If E is a bigger negative number MR> 0 • Note: A firm will never produce a level where MR < 0.

  8. A Simple Markup Rule • Suppose the elasticity of demand for the firm’s product is EF. • Since MR = P[1 + EF]/ EF • Setting MR = MC • P[1 + EF]/ EF = MC • P = [EF/(1+ EF)]  MC • P = K x MC where K is the markup factor • The optimal price is a simple markup over relevant costs!

  9. Mark-up Factor= EF/(1+ EF) • If EF = -2 • Then Mark-up factor = -2/ -1 • Price is 2 times MC • If EF = -4 • Then Mark-up factor = -4/ -3 • Price is 4/3 of MC • The more elastic the demand, the lower the markup.

  10. Markup Rule for Cournot Oligopoly • Homogeneous product Cournot oligopoly. • N = total number of firms in the industry. • Market elasticity of demand EM . • Elasticity of individual firm’s demand is given by EF = N x EM. • Since P = [EF/(1+ EF)]  MC, • Then, P = [NEM/(1+ NEM)]  MC. • The greater the number of firmsthe lower the profit-maximizing markup factor.

  11. An Example • Homogeneous product Cournot industry, 3 firms. • MC = $10. • Elasticity of market demand = - ½. • Determine the profit-maximizing price? • EF = NEM = 3  (-1/2) = -1.5. • P = [NEM/(1+ NEM)]  MC. • P = [-1.5/(1- 1.5]  $10. • P = 3  $10 = $30.

  12. First-Degree or Perfect Price Discrimination • Practice of charging each consumer the maximum amount he or she will pay for each incremental unit. • Permits a firm to extract all surplus from consumers.

  13. Perfect Price Discrimination Price Profits*: .5(4-0)(10 - 2) = $16 10 In practice, transactions costs and information constraints make this difficult to implement perfectly. Price discrimination won’t work if consumers can resell the good. 8 6 Total Cost* =$8 4 2 MC = AC D 1 2 3 4 5 Quantity

  14. Second-Degree Price Discrimination Part of Consumer surplus is captured by the firm Price • The practice of posting a discrete schedule of declining prices for different quantities. • Eliminates the information constraint present in first-degree price discrimination. • Example: Electric utilities MC $10 $8 $5 D 2 4 Quantity The first 2 units are sold at $8/unit The second 2 units are sold at $5/unit

  15. Managerial Economics- Group A • Week Twelve- Class 2 • Tuesday, November 20 • Cairnes • 15:10-16:00 • Aplia assignment is due before 5PM today • Send me questions on the entire course material

  16. Last Class we talked about two types of price discrimination • First-Degree or Perfect Price Discrimination • charging each consumer the maximum amount he or she will pay for each incremental unit. • Firm captures the entire Consumer Surplus • Hard to implement • Second-Degree Price Discrimination • posting a discrete schedule of declining prices for different quantities. • Does not capture the entire Consumer Surplus • Easier to implement

  17. Third-Degree Price Discrimination • charging different groups of consumers different prices for the same product. • Group must have observable characteristics for third-degree price discrimination to work. • Examples • student discounts, • senior citizen’s discounts, • regional & international pricing.

  18. Implementing Third-Degree Price Discrimination • Demands by two groups have different elasticities, E1 < E2. • Notice that group 2 is more price sensitive than group 1. • Who should be paying a lower price? • Group 2 • Profit-maximizing prices? • P1 = [E1/(1+ E1)]  MC • P2 = [E2/(1+ E2)]  MC

  19. An Example • Suppose the elasticity of demand for Kodak film in the US is EU = -1.5, and the elasticity of demand in Japan is EJ = -2.5. • Marginal cost of manufacturing film is $3. • PU = [EU/(1+ EU)]  MC = [-1.5/(1 - 1.5)]  $3 = $9 • PJ = [EJ/(1+ EJ)]  MC = [-2.5/(1 - 2.5)]  $3 = $5 • Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic.

  20. Two-Part Pricing • If it isn’t feasible to charge different prices for different units sold, • but demand information is known, • two-part pricing may permit you to extract all surplus from consumers. • Two-part pricing consists of a fixed fee and a per unit charge. • Example: • Athletic club memberships. • You may pay a monthly membership fee • Plus a small fee for each visit

  21. Example • An average (typical) consumer’s demand is P = 10 – 2Q & MC = 2 • Set P = MC = 2 • Find Q • 10 - 2Q = 2  Q = 4 • Find Consumer surplus

  22. To find Consumer Surplus Price • Draw the demand curve P = 10 -2 Q • Draw the MC curve • Intersection gives you the price 10 8 6 Fixed Fee = consumer surplus = Profits = €16 Per Unit Charge 4 MC 2 D 1 2 3 4 5 Quantity

  23. Block Pricing • packaging multiple units of an identical product together and selling them as one package. • Examples • Paper towels. • Six-packs of soda.

  24. An Algebraic Example • Typical consumer’s demand is P = 10 - 2Q • C(Q) = 2Q • Optimal number of units in a package? • Optimal package price?

  25. To determine the optimal quantity per package Price • Find Q from P = MC • MC = 2 • P= 10 - 2Q • 2= 10-2Q • Q = 4 10 8 6 4 MC = AC 2 D 1 2 3 4 5 Quantity

  26. To find the optimal price for the Package Price Consumer’s valuation of 4 units = .5(8)(4) + (2)(4) = $24 Therefore, set P = $24! Find out the value of 4 units to consumer & set a price equal to that The value to consumer is the area under the demand curve 10 8 6 4 MC = AC 2 D 1 2 3 4 5 Quantity

  27. Costs and Profits with Block Pricing Price 10 Profits = [.5(8)(4) + (2)(4)] – (2)(4) = $16 8 6 4 Costs = (2)(4) = $8 2 MC = AC D 1 2 3 4 5 Quantity

  28. Commodity Bundling • The practice of bundling two or more products together and charging one price for the bundle. • Examples • Holiday packages. • Computers and software. • Film and developing.

  29. MC PH DH PL MRH DL MRL QL QH Peak-Load Pricing Price • demand during peak times is higher than the capacity of the firm • the firm engages in peak-load pricing. • Charge a higher price (PH) during peak times (DH). • Charge a lower price (PL) during off-peak times (DL). Quantity

  30. 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.

  31. Double Marginalization • Example • A large firm has division • the upstream division is the sole provider of a key input. • the downstream division uses the input produced by the upstream division to produce the final output. • Incentives to maximize divisional profits leads the upstream manager to produce where MRU = MCU. • Implication: PU > MCU.

  32. Double Marginalization • Similarly the downstream division has market power and has an incentive to maximize divisional profits, the manager will produce where MRD = MCD. • Implication: PD > MCD. • Thus, both divisions mark price up over marginal cost resulting in a phenomenon called double marginalization. • Result: less than optimal overall profits for the firm.

  33. Managerial Economics- Group A • Week Twelve- Class 3 • Thursday, November 22 • 15:10-16:00 • Tyndall • Next Aplia Assignment is due before 5 PM on Tuesday, November 27

  34. Last time we talked about • Double marginalization • What doe it mean? • The manager of the pasta factory that belongs to the restaurant and only provides pastas to the restaurant • And the manager of the restaurant • Maximizing their profits separately • Not the best strategy

  35. Instead the firm should maximize the overall profits of selling the final good (product of the restaurant) • This is called “Transfer Pricing” • That is MRr = MCr + MCp where MRr is marginal revenue of restaurant MCr is marginal cost of restaurant MCp is marginal cost of pasta factory MRr - MCr = MCp NMRr = MCp • The pasta factory produces such that its marginal cost equals the net marginal revenue of restaurant (NMRr)

  36. Pricing in Markets with Intense Price Competition • Price Matching • Advertising a price and a promise to match any lower price offered by a competitor. • No firm has an incentive to lower their prices. • Each firm charges the monopoly price and shares the market.

  37. Pricing in Markets with Intense Price Competition • Randomized Pricing • A strategy of constantly changing prices. • Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price. • Reduces the ability of rival firms to undercut a firm’s prices

  38. Other information • Posted three sample MCQ on my website & on blackboard as well • Also, remember to check blackboard for sample of previous years’ exams • There is going to be another Review Session on Wednesday, November 28 at 7-9 pm in IT250 1st floor • Send me your questions • I will post the answers on my website.

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