Unit 8.

1. Unit 8. Profit Maintenance/Enhancement (Ch. 8, 11, 13)

2. 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)

3. 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.

4. Profit Enhancement/Maintenance Strategies (P setting firms mainly) • Create barriers to entry • Decrease P competition with rivals • Differentiate product to increase demand/decrease price elasticity • Decrease costs/increase productivity • Implement creative pricing policies

5. 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?

6. 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?

7. 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?

8. 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?

9. 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?

10. 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?

11. 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?

12. 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

13. Entry Limit Pricing

14. Decreasing competitive P rivalry • Match P • Random P • Non price competition • Customer service

15. Creative Pricing Policies • Price discrimination • 2-part block (package) • Bundling • Q discounts • Multiple (joint) product

16. 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

17. Profit-Maximizing Prices •  P where MR = MC

18. Profit-Maximizing ‘Markup’ Factors

19. 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

20. 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

21. Profit Max Example(with P Discrimination) • 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

22. P Discrimination  Differential Markup Pricing • E0 in US at PUS = 9 • E0 in J at PJ = 6

23. Π w/o Discriminating • NOTE: QU = 15 - PU = 15 – 7 = 8  U =(4)(8) = 32 QJ = 18 – 2PJ = 18 – 2(7) = 18 – 14 = 4  J = (4)(4) = 16 •  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

24. 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)

25. Extracting Consumer Surplus: • 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. • 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. • Volume Discounts: Charge lower price for units purchased beyond given level.

26. Block P Example • Typical consumer’s demand is P = 10 – 2Q • C(Q) = 2Q • Optimal number of units in a package? • Optimal package price?

27. 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

28. Optimal Quantity to Package: 4 Units

29. Optimal Price for the Package: $24

30. Costs and Profits with Block Pricing

31. Costs and Profits with Two-Part Pricing Price Chargefee = CS 10 ½ (4) (10-2) = $16 8 6 Costs = $8 4 2 SetP = MC = $2 D 1 4 5 2 3 Quantity

32. 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

33. 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:

34. Reservation Prices for Kodak Film and Developing by Type of Consumer

35. Demand for Kodak Film

36. Revenue-Maximizing Film P?

37. Demand for Kodak Developing

38. Revenue-Maximizing Developing P?

39. Maximum TR Pricing Items Separately? • = Max Film TR + Max Developing TR • 16 + 9 • = 25

40. Demand for Film & Developing ‘Bundle’

41. Revenue-Maximizing ‘Bundle’ P? • Note: previous Max TR pricing items separately = 25.

42. Q Discount • Assume P = 100 - .1Q (Q = 00’s) • MC = ATC = 10 • What is firm π w/ • MR = MC production/pricing? • Charge P = 75 for Q up to 250, P = 55 for additional Q?

43. 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

44. Principal-Agent Problem • Problem  agent has incentive to pursue their own goals which hinders principal’s ability to achieve their goals. • Principal = individual • who employs or • supervises others • (agents) • stockholders • management • business owner • defendant • team owner • Agent = individual • employed to • assist a principal • management • employees • sub contractor • lawyer • team player

45. 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