Text book: Brander & Perloff. (2017). Managerial Economics and Strategy, 2nd Edition Pearson ISBN: 97801344727681. Study Chapters 9 and 10 of the recommended textbook.2. Based on the materials in chap

273 Monopoly Monopoly: one parrot. 9 273 A firm that creates a new drug may receive a patent that gives it the right to be the monopoly or sole producer of the drug for up to 20 years. As a result, the firm can charge a price much greater than its marginal cost of production. For example, one of the world’s best-selling drugs, the heart medication Plavix, sold for about $7 per pill but can be produced for about 3¢ per pill.

Prices for drugs used to treat rare diseases are often very high. Drugs used for certain rare types of anemia cost patients about $5,000 per year. As high as this price is, it pales in com- parison with the price of over $400,000 per year for Soliris, a drug used to treat a rare blood disorder. 1 Recently, firms have increased their prices substantially for specialty drugs in response to perceived changes in will- ingness to pay by consumers and their insurance companies. In 2008, the price of a crucial antiseizure drug, H.P. Acthar Gel, which is used to treat children with a rare and severe form of epilepsy, increased from $1,600 to $23,000 per vial. Two courses of Acthar treatment for a severely ill 3-year-old girl, Reegan Schwartz, cost her father’s health plan about $226,000. Steve Cartt, an execu- tive vice president at the drug’s manu- facturer, Questcor, explained that this price increase was based on a review of the prices of other specialty drugs and estimates of how much of the price insurers and employers would be willing to bear.

In 2013, 107 U.S. drug patents expired, including major products such as Cymbalta and OxyContin. When a patent for a highly profitable drug expires, many firms enter the market 1When asked to defend such prices, executives of pharmaceutical companies emphasize the high costs of drug development—in the hundreds of millions of dollars—that must be recouped from a relatively small number of patients with a given rare condition. Brand-Name and Generic Drugs Managerial Problem 274 CHAPTER 9 Monopoly W hy can a firm with a patent-based monopoly charge a high price? Why might a brand-name pharmaceutical’s price rise after its patent expires?

To answer these questions, we need to understand the decision-making process for a monopoly: the sole supplier of a good that has no close substitute. 3 Monopolies have been common since ancient times. In the fifth century b.c., the Greek philosopher Thales gained control of most of the olive presses during a year of exceptionally productive harvests. The ancient Egyptian pharaohs controlled the sale of food. In England, until Parliament limited the practice in 1624, kings granted monopoly rights called royal charters to court favorites. Particularly valuable royal charters went to companies that controlled trade with North America, the Hudson Bay Company, and with India, the British East India Company.

In modern times, government actions continue to play an important role in creating monopolies. For example, governments grant patents that allow the inventor of a new product to be the sole supplier of that product for up to 20 years. Similarly, until 1999, the U.S. government gave one company the right to be the sole registrar of Internet domain names. Many public utilities are government-owned or government-protected monopolies. 4 3Analogously, a monopsony is the only buyer of a good in a given market.

4Whether the law views a firm as a monopoly depends on how broadly the market is defined. Is the market limited to a particular drug or the pharmaceutical industry as a whole? The manufacturer of the drug is a monopoly in the former case, but just one of many firms in the latter case. Thus, defining a market is critical in legal cases. A market definition depends on whether other products are good substitutes for those in that market.

and sell generic (equivalent) versions of the brand-name drug. 2 Generics account for nearly 70% of all U.S. prescriptions and half of Canadian prescriptions.

Congress, when it passed laws permitting generic drugs to quickly enter a market after a patent expires, expected that patent expiration would subsequently lead to sharp declines in drug prices. If consumers view the generic product and the brand-name product as perfect substitutes, both goods will sell for the same price, and entry by many firms will drive the price down to the competitive level. Even if consumers view the goods as imperfect substitutes, one might expect the price of the brand-name drug to fall.

However, the prices of many brand-name drugs have increased after their patents expired and generics entered the market. The generic drugs are relatively inexpensive, but the brand- name drugs often continue to enjoy a significant market share and sell for high prices. Even after the patent for what was then the world’s largest selling drug, Lipitor, expired in 2011, it continued to sell for high prices despite competition from generics selling at much lower prices. Indeed, Regan (2008), who studied the effects of generic entry on post-patent price competition for 18 prescription drugs, found an average 2% increase in brand-name prices.

Studies based on older data have found up to a 7% average increase. Why do some brand- name prices rise after the entry of generic drugs? 2Under the 1984 Hatch-Waxman Act, the U.S. government allows a firm to sell a generic product after a brand-name drug’s patent expires if the generic-drug firm can prove that its product delivers the same amount of active ingredient or drug to the body in the same way as the brand-name product.

Sometimes the same firm manufactures both a brand-name drug and an identical generic drug, so the two have identical ingredients. Generics produced by other firms usually differ in appearance and name from the original product and may have different nonactive ingredients but the same active ingredients. 275 9.1 Monopoly Profit Maximization Unlike a competitive firm, which is a price taker (Chapter  8), a monopoly can set its price. A monopoly’s output is the market output, and the demand curve a monopoly faces is the market demand curve. Because the market demand curve is downward sloping, the monopoly (unlike a competitive firm) doesn’t lose all its sales if it raises its price. As a consequence, a profit-maximizing monopoly sets its price above marginal cost, the price that would prevail in a competitive market.

Consumers buy less at this relatively high monopoly price than they would at the competitive price. In this chapter, we examine six main topics Main Topics 1. Monopoly Profit Maximization: Like all firms, a monopoly maximizes profit by setting its output so that its marginal revenue equals marginal cost. 2. Market Power: A monopoly sets its price above the competitive level, which equals the marginal cost. 3. Market Failure Due to Monopoly Pricing: By setting its price above marginal cost, a monopoly creates a deadweight loss because the market fails to maximize total surplus. 4. Causes of Monopoly: Two important causes of monopoly are cost factors and government actions that restrict entry, such as patents. 5. Advertising: A monopoly advertises to shift its demand curve so as to increase its profit. 6. Networks, Dynamics, and Behavioral Economics: If its current sales affect a monopoly’s future demand curve, a monopoly may charge a low initial price so as to maximize its long-run profit. 9.1 Monopoly Profit Maximization All firms, including competitive firms and monopolies, maximize their profits by setting quantity such that marginal revenue equals marginal cost (Chapter 7). Chapter 6 demonstrates how to derive a marginal cost curve. We now derive the monopoly’s marginal revenue curve and then use the marginal revenue and marginal cost curves to examine how the manager of a monopoly sets quantity to maximize profit.

Marginal Revenue A firm’s marginal revenue curve depends on its demand curve. We will show that a monopoly’s marginal revenue curve lies below its demand curve at any positive quantity because its demand curve is downward sloping.

Marginal Revenue and Price. A firm’s demand curve shows the price, p, it receives for selling a given quantity, q. The price is the average revenue the firm receives, so a firm’s revenue is R=pq.

A firm’s marginal revenue,MR, is the change in its revenue from selling one more unit. A firm that earns ΔR more revenue when it sells Δq extra units of output has a marginal revenue of MR=ΔR Δq. 276 CHAPTER 9 Monopoly If the firm sells exactly one more unit (Δq=1), then its marginal revenue, MR, is ΔR(=ΔR/1).

The marginal revenue of a monopoly differs from that of a competitive firm because the monopoly faces a downward-sloping demand curve, unlike the com- petitive firm. The competitive firm in panel a of Figure  9.1 faces a horizontal demand curve at the market price, p 1. Because its demand curve is horizontal, the competitive firm can sell another unit of output without reducing its price.

As a result, the marginal revenue it receives from selling the last unit of output is the market price.

Initially, the competitive firm sells q units of output at the market price of p 1, so its revenue, R 1, is area A, which is a rectangle that is p1*q. If the firm sells one more unit, its revenue is R 2=A+B, where area B is p 1*1=p 1. The competitive firm’s marginal revenue equals the market price:

ΔR=R 2-R 1=(A+B)-A=B=p 1.

A monopoly faces a downward-sloping market demand curve, as in panel b of Figure 9.1. (So far we have used q to represent the output of a single firm and Q to represent the combined market output of all firms in a market. Because a monopoly FIGURE 9.1 Average and Marginal Revenue p, $ per unit qq+1q, Units per year p 1 (a) Competitive Firm Demand curve AB QQ+1Q, Units per year p 1 p2 p, $ per unit (b) Monopoly Demand curve ABC Revenue with One More Unit, R 2 Initial Revenue, R 1 Marginal Revenue, R 2- R1 CompetitionAA+BB=p 1 MonopolyA+CA+BB − C=p 2 − C The demand curve shows the average revenue or price per unit of output sold. (a) The competitive firm’s mar- ginal revenue, area B, equals the market price, p 1. (b) The monopoly’s marginal revenue is less than the price p 2 by areaC, the revenue lost due to a lower price on the Q units originally sold. 277 9.1 Monopoly Profit Maximization is the only firm in the market, q and Q are identical, so we useQ to describe both the firm’s output and market output.

The monopoly, which initially sells Q units at p 1, can sell one extra unit only if it lowers its price to p 2 on all units. The monopoly’s initial revenue, p 1*Q, is R 1=A+C. When it sells the extra unit, its revenue, p2*(Q+1), is R 2=A+B.

Thus, its marginal revenue is ΔR=R 2-R 1=(A+B)-(A+C)=B-C.

The monopoly sells the extra unit of output at the new price, p 2, so its extra rev- enue is B=p 2*1=p 2. The monopoly loses the difference between the new price and the original price, Δp=(p 2-p 1), on the Q units it originally sold: C=Δp*Q.

Therefore the monopoly’s marginal revenue, B-C=p 2-C, is less than the price it charges by an amount equal to area C.

Because the competitive firm in panel a can sell as many units as it wants at the market price, it does not have to cut its price to sell an extra unit, so it does not have to give up revenue such as Area C in panel b. It is the downward slope of the monopoly’s demand curve that causes its marginal revenue to be less than its price.

For a monopoly to sell one more unit in a given period it must lower the price on all the units it sells that period, so its marginal revenue is less than the price obtained for the extra unit. The marginal revenue is this new price minus the loss in revenue arising from charging a lower price for all other units sold. The Marginal Revenue Curve. Thus,the monopoly’s marginal revenue curve lies below a downward-sloping demand curve at every positive quantity. The relation- ship between the marginal revenue and demand curves depends on the shape of the demand curve.

For linear demand curves, the marginal revenue curve is a straight line that starts at the same point on the vertical (price) axis as the demand curve but has twice the slope. Therefore, the marginal revenue curve hits the horizontal (quantity) axis at half the quantity at which the demand curve hits the quantity axis. In Figure 9.2, the demand curve has a slope of -1 and hits the horizontal axis at 24 units, while the marginal revenue curve has a slope of -2 and hits the horizontal axis at 12 units.

We now derive an equation for the monopoly’s marginal revenue curve. For a monopoly to increase its output by one unit, the monopoly lowers its price per unit by an amount indicated by the demand curve, as panel b of Figure  9.1 illustrates.

Specifically, output demanded rises by one unit if price falls by the slope of the demand curve, Δp/ΔQ. By lowering its price, the monopoly loses (Δp/ΔQ)*Q on the units it originally sold at the higher price (area C), but it earns an additional p on the extra output it now sells (area B). Thus, the monopoly’s marginal revenue is MR=p+Δp ΔQQ. (9.1) Because the slope of the monopoly’s demand curve, Δp/ΔQ, is negative, the last term in Equation 9.1, (Δp/ΔQ)Q, is negative. Equation 9.1 confirms that the price is greater than the marginal revenue, which equals p plus a negative term and must therefore be less than the price.

We now use Equation 9.1 to derive the marginal revenue curve when the monop- oly faces the linear inverse demand function (Chapter 3) p=24-Q, (9.2) 278 CHAPTER 9 Monopoly that Figure 9.2 illustrates. Equation 9.2 shows that the price consumers are willing to pay falls $1 if quantity increases by one unit. More generally, if quantity increases by ΔQ, price falls by Δp=-ΔQ. Thus, the slope of the demand curve is Δp/ΔQ=-1.

We obtain the marginal revenue function for this monopoly by substituting into Equation 9.1 the actual slope of the demand function, Δp/ΔQ=-1, and replacing p with 24-Q (using Equation 9.2):

MR=p+Δp ΔQQ=(24-Q)+(-1)Q=24-2Q. (9.3) Figure  9.2 shows a plot of Equation  9.3. The slope of this marginal revenue curve isΔMR/ΔQ=-2, so the marginal revenue curve is twice as steep as the demand curve. Using Calculus Using calculus, if a firm’s revenue function is R(Q), then its marginal revenue function is defined as MR(Q)=dR(Q) dQ.

For our example, where the inverse demand function is p=24-Q, the revenue function is R(Q)=(24-Q)Q=24Q-Q 2. (9.4) Deriving a Monopoly’s Marginal Revenue Function p, $ per unit Demand (p = 24 – Q) Perfectly elastic,ε→ –∞ Perfectly inelastic, ε = 0 Elastic,ε < –1 Inelastic, –1 < ε <0 ε = –1 Δp = –1 ΔQ=1 ΔQ = 1 ΔMR = –2 Q, Units per day 24 12 01224 Marginal Revenue (MR = 24 – 2Q) FIGURE 9.2 Elasticity of Demand and Total, Average, and Marginal Revenue The demand curve (or average revenue curve), p=24-Q, lies above the marginal revenue curve, MR=24-2Q. Where the marginal revenue equals zero,Q=12, the elasticity of demand is ε=-1. For larger quantities, the marginal revenue is negative, so the MR curve is below the horizontal axis. 279 9.1 Monopoly Profit Maximization Marginal Revenue and Price Elasticity of Demand. The marginal revenue at any given quantity depends on the demand curve’s height (the price) and shape. The shape of the demand curve at a particular quantity is described by the price elasticity of demand (Chapter  3),ε=(ΔQ/Q)/(Δp/p)60, which tells us the percentage by which quantity demanded falls as the price increases by 1%.

At a given quantity, the marginal revenue equals the price times a term involving the elasticity of demand (Chapter 3): 5 MR=p¢1+1 ε≤. (9.5) 5By multiplying the last term in Equation  9.1 by p/p(=1) and using algebra, we can rewrite the expression as MR=p+pΔp ΔQQ p=pJ1+1 (ΔQ/Δp)(p/Q)R. The last term in this expression is 1/ε, because ε=(ΔQ/Δp)(p/Q). Q&A 9.1 Given a general linear inverse demand curve p(Q)=a-bQ, where a and b are posi- tive constants, use calculus to show that the marginal revenue curve is twice as steeply sloped as the inverse demand curve.

Answer 1.Differentiate a general inverse linear demand curve with respect to Q to determine its slope. The derivative of the linear inverse demand function with respect to Q is dp(Q) dQ=d(a-bQ) dQ=-b.

2.Differentiate the monopoly’s revenue function with respect to Q to obtain the mar- ginal revenue function, then differentiate the marginal revenue function with respect to Q to determine its slope. The monopoly’s revenue function is R(Q)= p(Q)Q=(a-bQ)Q=aQ-bQ 2. Differentiating the revenue function with respect to quantity, we find that the marginal revenue function is linear, MR(Q)=dR(Q)/dQ=a-2bQ.

Thus, the slope of the marginal revenue curve, dMR(Q) dQ=-2b, is twice that of the inverse demand curve, dp/dQ=-b.

Comment: Note that the vertical axis intercept is a for both the inverse demand and MR curves. Thus, if the demand curve is linear, its marginal revenue curve is twice as steep and intercepts the horizontal axis at half the quantity as does the demand curve. By differentiating Equation  9.4 with respect to Q, we obtain the marginal revenue function, MR(Q)=dR(Q)/dQ=24-2Q, which is the same as Equation 9.3. 280 CHAPTER 9 Monopoly According to Equation 9.5, marginal revenue is closer to price as demand becomes more elastic. Where the demand curve hits the price axis (Q=0), the demand curve is perfectly elastic, so the marginal revenue equals price: MR=p.6 Where the demand elasticity is unitary, ε=-1, marginal revenue is zero: MR=p[1+1/(-1)]=0. Marginal revenue is negative where the demand curve is inelastic, -16ε…0.

With the demand function in Equation  9.2, ΔQ/Δp=-1, so the elasticity of demand is ε=(ΔQ/Δp)(p/Q)=-p/Q. Table  9.1 shows the relationship among quantity, price, marginal revenue, and elasticity of demand for this linear exam- ple. As Q approaches 24, ε approaches 0, and marginal revenue is negative. As Q approaches zero, the demand becomes increasingly elastic, and marginal revenue approaches the price. Choosing Price or Quantity Any firm maximizes its profit by operating where its marginal revenue equals its marginal cost. Unlike a competitive firm, a monopoly can adjust its price, so it has a choice of setting its price or its quantity to maximize its profit. (A competitive firm sets its quantity to maximize profit because it cannot affect market price.) 6Asε approaches -∞(perfectly elastic demand), the 1/ε term approaches zero, so MR=p(1+1/ε) approachesp. Quantity, QPrice, pMarginal Revenue, MRElasticity of Demand, ε=-p/Q 024 24-∞ 123 22-23 222 20-11 321 18-7 420 16-5 519 14-3.8 618 12-3 717 10-2.43 816 8-2 915 6-1.67 10 14 4-1.4 11 13 2-1.18 12 12 0-1 13 11 -2 -0.85 ff f f 23 1-22-0.043 24 0-24 0 TABLE 9.1 Quantity, Price, Marginal Revenue, and Elasticity for the Linear Inverse Demand Function p=24-Q more elastic S d less elastic 281 9.1 Monopoly Profit Maximization Whether the monopoly sets its price or its quantity, the other variable is deter- mined by the market demand curve. Because the demand curve slopes down, the monopoly faces a trade-off between a higher price and a lower quantity or a lower price and a higher quantity. A profit-maximizing monopoly chooses the point on the demand curve that maximizes its profit. Unfortunately for the monopoly, it cannot set both its quantity and its price, such as a point that lies above its demand curve. If it could do so, the monopoly would choose an extremely high price and an extremely large output and would earn a very high profit. However, the monopoly cannot choose a point that lies above the demand curve.

If the monopoly sets its price, the demand curve determines how much output it sells. If the monopoly picks an output level, the demand curve determines the price. Because the monopoly wants to operate at the price and output at which its profit is maximized, it chooses the same profit-maximizing solution whether it sets the price or output. Thus, setting price and setting quantity are equivalent for a monopoly. In the following discussion, we assume that the monopoly sets quantity. Two Steps to Maximizing Profit All profit-maximizing firms, including monopolies, use a two-step analysis to deter- mine the output level that maximizes their profit (Chapter 7). First, the firm deter- mines the output, Q*, at which it makes the highest possible profit (or minimizes its loss). Second, the firm decides whether to produce Q* or shut down.

Profit-Maximizing Output. In Chapter  7, we saw that profit is maximized wheremarginal profit equals zero. Equivalently, because marginal profit equals marginal revenue minus marginal cost (Chapter 7), marginal profit is zero where marginal revenue equals marginal cost.

To illustrate how a monopoly chooses its output to maximize its profit, we use the same linear demand and marginal revenue curves as above and add a linear marginal cost curve in panel a of Figure 9.3. Panel b shows the corresponding profit curve.

The marginal revenue curve, MR, intersects the marginal cost curve, MC, at 6 units in panel a. The corresponding price, 18, is the height of the demand curve, pointe, at 6 units. The profit, π, is the gold rectangle. The height of this rectangle is the average profit per unit, p-AC=18-8=10. The length of the rectangle is 6 units. Thus, the area of the rectangle is the average profit per unit times the number of units, which is the profit, π=60.

The profit at 6 units is the maximum possible profit: The profit curve in panel b reaches its peak, 60, at 6 units. At the peak of the profit curve, the marginal profit is zero, which is consistent with the marginal revenue equaling the marginal cost.

Why does the monopoly maximize its profit by producing where its marginal revenue equals its marginal cost? At smaller quantities, the monopoly’s marginal revenue is greater than its marginal cost, so its marginal profit is positive—the profit curve is upward sloping. By increasing its output, the monopoly raises its profit.

Similarly, at quantities greater than 6 units, the monopoly’s marginal cost is greater than its marginal revenue, so its marginal profit is negative, and the monopoly can increase its profit by reducing its output.

As Figure 9.2 illustrates, the marginal revenue curve is positive where the elastic- ity of demand is elastic, is zero at the quantity where the demand curve has a unitary 282 CHAPTER 9 Monopoly elasticity, and is negative at larger quantities where the demand curve is inelastic.

Because the marginal cost curve is never negative, the marginal revenue curve can only intersect the marginal cost curve where the marginal revenue curve is positive, in the range in which the demand curve is elastic. That is, a monopoly’s profit is maxi- mized in the elastic portion of the demand curve. In our example, profit is maximized atQ=6, where the elasticity of demand is -3.A profit-maximizing monopoly never operates in the inelastic portion of its demand curve.

The Shutdown Decision. A monopoly shuts down to avoid making a loss in the short run if its price is below its average variable cost at its profit-maximizing (or loss-minimizing) quantity (Chapter 7). In the long run, the monopoly shuts down if the price is less than its average cost.

In the short-run example in Figure 9.3, the average variable cost, AVC=6, is less than the price, p=18, at the profit-maximizing output, Q=6, so the firm chooses to produce. Price is also above average cost at Q=6, so the average profit per unit, p-AC is positive (the height of the gold profit rectangle), so the monopoly makes a positive profit. 1218 24 8 6 606 0 12 24 π,$ 0126AC AV C e Demand π = 60MC MR Q, Units per day Profit,π Q, Units per day p, $ per unit (a) Monopolized Market (b) Profit FIGURE 9.3 Maximizing Profit (a) At Q=6, where marginal revenue,MR, equals marginal cost, MC, profit is maximized. The rect- angle shows that the profit is $60, where the height of the rectangle is the average profit per unit, p-AC=$18-$8=$10, and the length is the number of units, 6. (b) Profit is maximized at Q=6 (where marginal revenue equals marginal cost). 283 9.1 Monopoly Profit Maximization Effects of a Shift of the Demand Curve Shifts in the demand curve or marginal cost curve affect the profit-maximizing monopoly price and quantity and can have a wider variety of effects with a monopoly than with a competitive market. In a competitive market, the effect of a shift in demand on a competitive firm’s output depends only on the shape of the Using Calculus We can also solve for the profit-maximizing quantity mathematically. We already know the demand and marginal revenue functions for this monopoly. We need to determine its cost curves.

The monopoly’s cost is a function of its output, C(Q). In Figure 9.3, we assume that the monopoly faces a short-run cost function of C(Q)=12+Q 2, (9.6) where Q 2 is the monopoly’s variable cost as a function of output and 12 is its fixed cost. Given this cost function, Equation 9.6, the monopoly’s marginal cost function is dC(Q) dQ=MC(Q)=2Q. (9.7) This marginal cost curve in panel a is a straight line through the origin with a slope of 2.

The average variable cost is AVC=Q 2/Q=Q, so it is a straight line through the ori- gin with a slope of 1. The average cost is AC=C/Q=(12+Q 2)/Q=12/Q+Q, which is U-shaped.

Using Equations 9.4 and 9.6, we can write the monopoly’s profit as π(Q)=R(Q)-C(Q)=(24Q-Q 2)-(12+Q 2).

By setting the derivative of this profit function with respect to Q equal to zero, we have an equation that determines the profit-maximizing output:

dπ(Q) dQ=dR(Q) dQ-dC(Q) dQ =MR-MC =(24-2Q)-2Q=0.

That is, MR=24-2Q=2Q=MC. To determine the profit-maximizing out- put, we solve this equation and find that Q=6. Substituting Q=6 into the inverse demand function (Equation  9.2), we learn that the profit-maximizing price is p=24-Q=24-6=18.

Should the monopoly operate at Q=6? At that quantity, average variable cost is AVC=Q 2/Q=6, which is less than the price, so the firm does not shut down. The average cost is AC=(6+12/6)=8, which is less than the price, so the firm makes a profit. Solving for the Profit-Maximizing Output 284 CHAPTER 9 Monopoly marginal cost curve. In contrast, the effect of a shift in demand on a monopoly’s output depends on the shapes of both the marginal cost curve and the demand curve.

As we saw in Chapter 8, a competitive firm’s marginal cost curve tells us every- thing we need to know about the amount that the firm is willing to supply at any given market price. The competitive firm’s supply curve is its upward-sloping mar- ginal cost curve above its minimum average variable cost. A competitive firm’s sup- ply behavior does not depend on the shape of the market demand curve because it always faces a horizontal demand curve at the market price. Thus, if we know a competitive firm’s marginal cost curve, we can predict how much that firm will produce at any given market price.

In contrast, a monopoly’s output decision depends on the shapes of its marginal cost curve and its demand curve. Unlike a competitive firm, a monopoly does not have a supply curve. Knowing the monopoly’s marginal cost curve is not enough for us to predict how much a monopoly will sell at any given price.

Figure 9.4 illustrates that the relationship between price and quantity is unique in a competitive market but not in a monopolistic market. If the market is competitive, the initial equilibrium is e 1 in panel a, where the original demand curve D 1 intersects the supply curve, MC, which is the sum of the marginal cost curves of a large number of competitive firms. When the demand curve shifts to D 2, the new competitive equi- librium,e 2, has a higher price and quantity. A shift of the demand curve maps out competitive equilibria along the marginal cost curve, so every equilibrium quantity has a single corresponding equilibrium price.

For the monopoly in panel b, as the demand curve shifts from D 1 to D 2, the profit-maximizing monopoly outcome shifts from E 1 to E 2, so the price rises but the quantity stays constant, Q 1=Q 2. Thus, a given quantity can correspond to more than one profit-maximizing price, depending on the position of the demand curve. A shift in p, $ per unit Q, Units per year p 1 p2 Q2 Q1 (a) Competition MC, Supply curve e 2 e1 D1 D2 Q, Units per year p 1 p2 Q2 Q1= p, $ per unit (b) Monopoly MC D 1 D2 MR 1 E2 E1 MR 2 FIGURE 9.4 Effects of a Shift of the Demand Curve (a) A shift of the demand curve from D 1 to D 2 causes the competitive equilibrium to move from e 1 to e 2 along the supply curve (which is the horizontal sum of the marginal cost curves of all the competitive firms). Because the com- petitive equilibrium lies on the supply curve, each quan- tity (such as Q 1 and Q2) corresponds to only one possible equilibrium price. (b) With a monopoly, this same shift of demand causes the monopoly optimum to change from E 1 to E 2. The monopoly quantity stays the same, but the monopoly price rises. Thus, a shift in demand does not map out a unique relationship between price and quantity in a monopolized market. The same quantity, Q 1=Q 2, is associated with two different prices, p 1 and p 2. 285 9.2 Market Power the demand curve may cause the profit-maximizing price to stay constant while the quantity changes. More commonly, both the profit-maximizing price and quantity would change. 9.2 Market Power A monopoly has market power, which is the ability to significantly affect the market price. In contrast, no single competitive firm can significantly affect the market price.

A profit-maximizing monopoly charges a price that exceeds its marginal cost. The extent to which the monopoly price exceeds marginal cost depends on the shape of the demand curve.

Market Power and the Shape of the Demand Curve If the monopoly faces a highly elastic—nearly flat—demand curve at the profit- maximizing quantity, it would lose substantial sales if it raised its price by even a small amount. Conversely, if the demand curve is not very elastic (relatively steep) at that quantity, the monopoly would lose fewer sales from raising its price by the same amount.

We can derive the relationship between markup of price over marginal cost and the elasticity of demand at the profit-maximizing quantity using the expression for marginal revenue in Equation  9.5 and the firm’s profit-maximizing condition that marginal revenue equals marginal cost:

MR=p¢1+1 ε≤=MC. (9.8) By rearranging terms, we see that a profit-maximizing manager chooses quantity such that p MC=1 1+(1/ε).

(9.9) In our linear demand example in panel a of Figure 9.3, the elasticity of demand isε=-3 at the monopoly optimum where Q=6. As a result, the ratio of price to marginal cost is p/MC=1/[1+1/(-3)]=1.5, or p=1.5MC. The profit-maximizing price, $18, in panel a is 1.5 times the marginal cost of $12.

Table  9.2 illustrates how the ratio of price to marginal cost varies with the elasticity of demand. When the elasticity is -1.01, only slightly elastic, the monopoly’s profit-maximizing price is 101 times larger than its marginal cost:

p/MC=1/[1+1/(-1.01)]≈101. As the elasticity of demand approaches nega- tive infinity (becomes perfectly elastic), the ratio of price to marginal cost shrinks top/MC=1. 7 Thus, even in the absence of rivals, the shape of the demand curve constrains the monopolist’s ability to exercise market power. 7As the elasticity approaches negative infinity, 1/ε approaches zero, so 1/(1+1/ε) approaches 1/1=1. 286 CHAPTER 9 Monopoly A manager can use this last result to determine whether the firm is maximiz- ing its profit. Typically a monopoly knows its costs accurately, but is somewhat uncertain about the demand curve it faces and hence what price (or quantity) to set. Many private firms—such as ACNielsen, IRI, and IMS Health—and industry groups collect data on quantities and prices in a wide variety of industries includ- ing automobiles, foods and beverages, drugs, and many services. Firms can use these data to estimate the firm’s demand curve (Chapter  3). More commonly, firms hire consulting firms (often the same firms that collect data) to estimate the elasticity of demand facing their firm.

A manager can use the estimated elasticity of demand to check whether the firm is maximizing profit. If the p/MC ratio does not approximately equal 1/(1+1/ε), as required by Equation 9.9, then the manager knows that the firm is not setting its price to maximize its profit. Of course, the manager can also check whether the firm is maximizing profit by varying its price or quantity. However, often such experiments may be more costly than using statistical techniques to estimate the elasticity of demand. Checking Whether the Firm Is Maximizing Profit Managerial Implication Mini-Case Since San Francisco’s cable car system started operating in 1873, it has been one of the city’s main tourist attractions. In 2005, the cash-strapped Municipal Railway raised the one-way fare by two-thirds from $3 to $5. Not surprisingly, the number of riders dropped substantially, and many in the city called for a rate reduction.

The rate increase prompted many locals to switch to buses or other forms of transportation, but most tourists have a relatively inelastic demand curve for cable car rides. Frank Bernstein of Arizona, who visited San Francisco with his wife, two children, and mother-in-law, said they would not visit San Francisco without riding a cable car: “That’s what you do when you’re here.” But the round-trip $50 cost for his family to ride a cable car from the Powell Street turn- around to Fisherman’s Wharf and back “is a lot of money for our family. We’ll do it once, but we won’t do it again.” Cable Cars and Profit Maximization Elasticity of Demand, ε Price/Marginal Cost Ratio, p/MC=1/[1+(1/ε)]Lerner Index, (p-MC)/p=-1/ε -1.01 101 0.99 -1.1 11 0.91 -2 2 0.5 -3 1.5 0.33 -5 1.25 0.2 -10 1.11 0.1 -100 1.01 0.01 -∞1 0 TABLE 9.2 Elasticity of Demand, Price, and Marginal Cost less elasticS d more elastic 287 9.2 Market Power If the city ran the cable car system like a profit-maximizing monopoly, the decision to raise fares would be clear. The 67% rate hike resulted in a 23% increase in revenue to $9,045,792 in the 2005–2006 fiscal year. Given that the revenue increased when the price rose, the city must have been operating in the inelas- tic portion of its demand curve (ε7-1), where MR=p(1+1/ε)60 prior to the fare increase. 8 With fewer riders, costs stayed con- stant (they would have fallen if the city had decided to run fewer than its traditional 40 cars), so the city’s profit increased given the increase in revenue. Presumably the profit- maximizing price is even higher in the elastic portion of the demand curve.

However, the city may not be interested in maximizing its profit on the cable cars. At the time, then-Mayor Gavin Newsom said that having fewer riders “was my biggest fear when we raised the fare. I think we’re right at the cusp of losing visitors who come to San Francisco and want to enjoy a ride on a cable car.” The mayor said that he believed keeping the price of a cable car ride relatively low helps attract tourists to the city, thereby ben- efiting many local businesses. Newsom observed, “Cable cars are so funda- mental to the lifeblood of the city, and they represent so much more than the revenue they bring in.” The mayor decided to continue to run the cable cars at a price below the profit-maximizing level. The fare stayed at $5 for six years, then rose to $6 in 2011 and has stayed there through at least the first half of 2013. 8The marginal revenue is the slope of the revenue function. Thus, if a reduction in quantity causes the revenue to increase, the marginal revenue must be negative. As Figure 9.2 illustrates, marginal revenue is negative in the inelastic portion of the demand curve.

The Lerner Index Another way to show how the elasticity of demand affects a monopoly’s price rela- tive to its marginal cost is to look at the firm’s Lerner Index (or price markup)—the ratio of the difference between price and marginal cost to the price: (p-MC)/p.

This index can be calculated for any firm, whether or not the firm is a monopoly.

The Lerner Index is zero for a competitive firm because a competitive firm pro- duces where marginal cost equals price. The Lerner Index measures a firm’s market power: the larger the difference between price and marginal cost, the larger the Lerner Index.

If the firm is maximizing its profit, we can express the Lerner Index in terms of the elasticity of demand by rearranging Equation 9.9:

p-MC p=-1 ε.

(9.10) 288 CHAPTER 9 Monopoly The Lerner Index ranges between 0 and 1 for a profit-maximizing monopoly. 9 Equation 9.10 confirms that a competitive firm has a Lerner Index of zero because its demand curve is perfectly elastic. 10 As Table 9.2 illustrates, the Lerner Index for a monopoly increases as the demand becomes less elastic. If ε=-5, the monopoly’s markup (Lerner Index) is 1/5=0.2; if ε=-2, the markup is 1/2=0.5; and if ε=-1.01, the markup is 0.99. Monopolies that face demand curves that are only slightly elastic set prices that are multiples of their marginal cost and have Lerner Indexes close to 1. 9For the Lerner Index to be above 1 in Equation 9.10, ε would have to be a negative fraction, indicat- ing that the demand curve was inelastic at the monopol s output choice. However, as w ve already seen, a profit-maximizing monopoly never operates in the inelastic portion of its demand curve. 10As the elasticity of demand approaches negative infinity, the Lerner Index, -1/ε, approaches zero. Mini-Case Apple started selling the iPad on April 3, 2010. The iPad was not the first tablet.

Indeed, it wasn’t Apple’s first tablet: Apple sold another tablet, the Newton, from 1993–1998. But it was the most elegant one, and the first one large numbers of consumers wanted to own. Users interact with the iPad using Apple’s multi- touch, finger-sensitive touchscreen (rather than a pressure-triggered stylus that most previous tablets used) and a virtual onscreen keyboard (rather than a physical one). Most importantly, the iPad offered an intuitive interface and was very well integrated with Apple’s iTunes, eBooks, and various application programs.

People loved the original iPad. Even at $499 for the basic model, Apple had a virtual monopoly in its first year. According to the research firm IDC, Apple’s share of the 2010 tablet market was 87%. Moreover, the other tablets available in 2010 were not viewed by most consumers as close substitutes. Apple reported that it sold 25 million iPads worldwide in its first full year, 2010–2011. Accord- ing to one estimate, the basic iPad’s marginal cost was MC=$220, so its Lerner Index was (p-MC)/p=(499-220)/499=0.56.

Within a year of the iPad’s introduction, over a hundred iPad want-to-be tablets were launched. To maintain its dominance, Apple replaced the original iPad with the feature-rich iPad 2 in 2011, added the enhanced iPad 3 in 2012, and cut the price of the iPad 2 by $100 in 2012. According to court documents Apple filed in 2012, its Lerner Index fell to between 0.23 and 0.32.

Industry experts believe that Apple can produce tablets at far lower cost than most if not all of its competitors. Apple has formed strategic partnerships with other companies to buy large supplies of components, securing a lower price from suppliers than its competitors. Using its own patents, Apple avoids paying as many licensing fees as do other firms.

Copycat competitors with 10″ screens have gained some market share from Apple. More basic tablets with smaller 7″ screens that are little more than e-readers have sold a substantial number of units, so that the iPad’s share of the total tablet market was 68% in the first quarter of 2012. Apple’s iPad 289 9.2 Market Power Q&A 9.2 When the iPad was introduced, Apple’s constant marginal cost of producing this iPad was about $220. We estimate that Apple’s inverse demand function for the iPad was p=770-11Q, where Q is the millions of iPads purchased. 11 What was Apple’s marginal revenue function? What were its profit-maximizing price and quantity?

Given that the Lerner Index for the iPad was (p-MC)/p=0.56 (see the “Apple’s iPad” Mini-Case), what was the elasticity of demand at the profit-maximizing level? Answer 1.Derive Apple’s marginal revenue function using the information about its demand function.Given that Apple’s inverse demand function was linear, p=770-11Q, its marginal revenue function has the same intercept and twice the slope: MR=770-22Q. 12 2.Derive Apple’s profit-maximizing quantity and price by equating the marginal rev- enue and marginal cost functions and solving.Apple maximized its profit where MR=MC:

770-22Q=220.

Solving this equation for the profit-maximizing output, we find that Q=25 million iPads. By substituting this quantity into the inverse demand function, we determine that the profit-maximizing price was p=$495 per unit.

3.Use Equation 9.10 to infer Apple’s demand elasticity based on its Lerner Index.We can write Equation  9.10 as (p-MC)/p=0.56=-1/ε. Solving this last equality for ε, we find that ε≈-1.79. (Of course, we could also calculate the demand elasticity by using the demand function.) 11See the Sources for “Pricing Apple’s iPad” for details on these estimates.

12Alternatively, we can use calculus to derive the marginal revenue curve. Multiplying the inverse demand function by Q to obtain Apple’s revenue function, R =770Q-11Q 2. Then, we derive the marginal revenue function by differentiating the revenue with respect to quantity:

MR=dR/dQ=770-22Q. Sources of Market Power What factors cause a monopoly to face a relatively elastic demand curve and hence have little market power? Ultimately, the elasticity of demand of the market demand curve depends on consumers’ tastes and options. The more consumers want a good—the more willing they are to pay “virtually anything” for it—the less elastic is the demand curve.

Other things equal, the demand curve a firm (not necessarily a monopoly) faces becomes more elastic as (1) better substitutes for the firm’s product are introduced, (2)more firms enter the market selling the same product, or (3) firms that provide the same service locate closer to this firm. The demand curves for Xerox, the U.S. Postal Service, and McDonald’s have become more elastic in recent decades for these three reasons.

When Xerox started selling its plain-paper copier, no other firm sold a close sub- stitute. Other companies’ machines produced copies on special heat-sensitive paper 290 CHAPTER 9 Monopoly that yellowed quickly. As other firms developed plain-paper copiers, the demand curve that Xerox faced became more elastic.

In the past, the U.S. Postal Service (USPS) had a monopoly in overnight delivery services. Now FedEx, United Parcel Service, and many other firms compete with the USPS in providing overnight deliveries.

Because of these increases in competition, the USPS’s share of business and personal correspondence fell from 77% in 1988 to 59% in 1996. Its total mail volume fell 40% from 2006 to 2010. Its overnight market fell to 15% by 2010. 13 Compared to when it was a monopoly, the USPS’s demand curves for first-class mail and package delivery have shifted downward and become more elastic.

As you drive down a highway, you may notice that McDonald’s restaurants are located miles apart. The purpose of this spacing is to reduce the likelihood that two McDonald’s outlets will com- pete for the same customer. Although McDonald’s can prevent its own restaurants from competing with each other, it cannot prevent Wendy’s or Burger King from locating near its restaurants. As other fast-food restaurants open near a McDonald’s, that restaurant faces a more elastic demand. What happens as a profit-maximizing monopoly faces more elastic demand? It has to lower its price. 9.3 Market Failure Due to Monopoly Pricing Unlike perfect competition, which achieves economic efficiency—that is, maximizes total surplus, TS(=consumer surplus+producer surplus=CS+PS)—a profit- maximizing monopoly is economically inefficient because it wastes potential sur- plus, resulting in a deadweight loss. The inefficiency of monopoly pricing is an example of a market failure: a non-optimal allocation of goods and services such that a market does not achieve economic efficiency. Market failure often occurs because the price differs from the marginal cost, as with a monopoly. This eco- nomic inefficiency creates a rationale for governments to intervene, as we discuss in Chapter 16.

Total surplus (Chapter 8) is lower under monopoly than under competition. That is, monopoly destroys some of the potential gains from trade. Chapter 8 showed that competition maximizes total surplus because price equals marginal cost. By setting its price above its marginal cost, a monopoly causes consumers to buy less than the competitive level of the good, so society suffers a deadweight loss.

If the monopoly were to act like a competitive market, it would produce where the marginal cost curve cuts the demand curve—the output where price equals marginal 13Peter Passell, “Battered by Its Rivals,” New York Times, May 15, 1997, C1; Grace Wyler, “11 Things You Should Know about the U.S. Postal Service Before It Goes Bankrupt,” Business Insider, May 31, 2011; “The U.S. Postal Service Nears Collapse,” BloombergBusinessweek, May 26, 2011; www .economicfreedom.org/2012/12/12/stamping-out-waste. 291 9.3 Market Failure Due to Monopoly Pricing cost. For example, using the demand curve given by Equation 9.2 and the marginal cost curve given by Equation 9.7, p=24-Q=2Q=MC.

Solving this equation, we find that the competitive quantity, Q c, would be 8 units and the price would be $16, as Figure 9.5 shows. At this competitive price, consumer surplus is area A+B+C and producer surplus is D+E.

If instead the firm acts like a profit-maximizing monopoly and operates where its marginal revenue equals its marginal cost, the monopoly output Q m is only 6 units and the monopoly price is $18. Consumer surplus is only A. Part of the lost consumer surplus, B, goes to the monopoly, but the rest, C, is lost. The benefit of being a monopoly is that it allows the firm to extract some consumer surplus from consumers and convert it to profit.

By charging the monopoly price of $18 instead of the competitive price of $16, the monopoly receives $2 more per unit and earns an extra profit of area B=$12 on the p, $ per unit Demand Q, Units per day MR MC p c = 16B = $12 D = $60C = $2 MR = MC = 12 p m = 1824 Q m = 6Q c = 8 24 0e m ec Competition Monopoly Change Consumer Surplus,CSA+B+C−B−C=ΔCS Producer Surplus,PSD+ EB−E=ΔPS A+ B+ C+ D+ EA B+D A+B+D−C−E=ΔTS=DWL A = $18 E = $4 12 Total Surplus, TS = CS + PS FIGURE 9.5 Deadweight Loss of Monopoly A competitive market would produce Q c=8 at p c=$16, where the demand curve intersects the marginal cost (supply) curve. A monopoly produces only Q m=6 at p m=$18, where the marginal revenue curve intersects the marginal cost curve. Under monopoly, consumer sur- plus is A, producer surplus is B+D, and the inefficiency or deadweight loss of monopoly is -C-E. 292 CHAPTER 9 Monopoly Qm=6 units it sells. The monopoly loses area E, however, because it sells less than the competitive output. Consequently, the monopoly’s producer surplus increases byB-E over the competitive level. Monopoly pricing increases producer surplus relative to competition.

Total surplus is less under monopoly than under competition. The deadweight loss of monopoly is -C-E, which represents the potential surplus that is wasted because less than the competitive output is produced. The deadweight loss is due to the gap between price and marginal cost at the monopoly output. At Q m=6, the price, $18, is above the marginal cost, $12, so consumers are willing to pay more for the last unit of output than it costs to produce it. Q&A 9.3 In the linear example in panel a of Figure  9.3, how does charging the monopoly a specific tax of τ=$8 per unit affect the profit-maximizing price and quantity and the well-being of consumers, the monopoly, and society (where total surplus includes the tax revenue)? What is the tax incidence on consumers (the increase in the price they pay as a fraction of the tax)?

Answer 1.Determine how imposing the tax affects the monopoly price and quantity. In the accompanying graph, the intersection of the marginal revenue curve, MR, and the before-tax marginal cost curve, MC 1, determines the monopoly quantity, Q 1=6. At the before-tax solution, e 1, the price is p 1=18. The specific tax causes the monopoly’s before-tax marginal cost curve, MC 1=2Q, to shift upward by 8 to MC 2=MC 1+8=2Q+8. After the tax is applied, the monopoly operates where MR=24-2Q=2Q+8=MC 2. In the after- tax monopoly solution, e 2, the quantity is Q 2=4 and the price is p 2=20.

Thus, output falls by ΔQ=6-4=2 units and the price increases by Δp=20-18=2.

2.Calculate the change in the various surplus measures. The graph shows how the surplus measures change. Area G is the tax revenue collected by the govern- ment,τQ=32, because its height is the distance between the two marginal cost curves, τ=8, and its width is the output the monopoly produces after the tax is imposed, Q=4. The tax reduces consumer and producer surplus and increases the deadweight loss. We know that producer surplus falls because (a) the monopoly could have produced this reduced output level in the absence of the tax but did not because it was not the profit-maximizing output, so its before-tax profit falls, and (b) the monopoly must now pay taxes. The before- tax deadweight loss from monopoly is -F. The after-tax deadweight loss is -C-E-F, so the increase in deadweight loss due to the tax is -C-E. The table below the graph shows that consumer surplus changes by -B-C and producer surplus by B-E-G.

3.Calculate the incidence of the tax on consumers. Because the tax goes from 0 to 8, the change in the tax is Δτ=8. Because the change in the price that the consumer pays is Δp=2, the share of the tax paid by consumers is Δp/Δτ=2/8= 14.

Thus, the monopoly absorbs $6 of the tax and passes on only $2. 293 9.4 Causes of Monopoly Monopoly Before Tax Monopoly After Tax Change Consumer Surplus, CSA+B+CA -B-C=ΔCS Producer Surplus, PSD+E+GB+D B-E-G=ΔPS Tax Revenues, T=τQ0G G=ΔT Total Surplus, TS=CS+PS+TA+B+C+D+E+G A+B+D+G -C-E=ΔTS Deadweight Loss, DWL-F-C-E-F -C-E=ΔDWL p, $ per unit Demand Q, Units per day MRMC 1 (before tax) MC 2 (after tax) p 1 = 18 DE C F G B A τ = $8 0 8 p 2 = 2024 Q 2 = 4Q 1 = 6 2412 e 1 e2 Monopoly Before Tax Monopoly After Tax Change Consumer Surplus,CSA+B+C A−B− C= ΔCS Producer Surplus,PSD+E+GB+DB− E− G= ΔPS Tax Revenues, T= τQ 0GG= ΔT A+B+C+D+E+GA+B+D+G−C− E= ΔTS Deadweight Loss,DWL−F−C− E− F−C− E= ΔDWL Total Surplus, TS = CS + PS+T 9.4 Causes of Monopoly Why are some markets monopolized? The two most important reasons are cost considerations and government policy. 14 14In later chapters, we discuss other means by which monopolies are created. One method is the merger of several firms into a single firm. This method creates a monopoly if new firms fail to enter the market. A second method is for a monopoly to use strategies that discourage other firms from entering the market. A third possibility is that firms coordinate their activities and set their prices as a monopoly would. Firms that act collectively in this way are called a cartel rather than a monopoly. 294 CHAPTER 9 Monopoly Cost-Based Monopoly Certain cost structures may facilitate the creation of a monopoly. One possibility is that a firm may have substantially lower costs than potential rivals. A second pos- sibility is that the firms in an industry have cost functions such that one firm can produce any given output at a lower cost than two or more firms can.

Cost Advantages. If a low-cost firm profitably sells at a price so low that other potential competitors with higher costs would lose money, no other firms enter the market. Thus, the low-cost firm is a monopoly. A firm can have a cost advantage over potential rivals for several reasons. It may have a superior technology or a better way of organizing production. 15 For example, Henry Ford’s methods of organizing production using assembly lines and standardization allowed him to produce cars at substantially lower cost than rival firms until they copied his organizational techniques.

If a firm controls an essential facility or a scarce resource that is needed to produce a particular output, no other firm can produce at all—at least not at a reasonable cost. For example, a firm that owns the only quarry in a region is the only firm that can profitably sell gravel to local construction firms. Natural Monopoly. A market has a natural monopoly if one firm can produce the total output of the market at lower cost than two or more firms could. A firm can be a natural monopoly even if it does not have a cost advantage over rivals provided that average cost is lower if only one firm operates. Specifically, if the cost for any firm to produce q is C(q), the condition for a natural monopoly is C(Q)6C(q 1)+C(q 2)+ g+C(q n), (9.11) whereQ=q 1+q 2+ g+q n is the sum of the output of any n firms where nÚ2 firms.

If a firm has economies of scale at all levels of output, its average cost curve falls as output increases for any observed level of output. If all potential firms have the same strictly declining average cost curve, this market is a natural monopoly, as we now illustrate. 16 A company that supplies water to homes incurs a high fixed cost, F, to build a plant and connect houses to the plant. The firm’s marginal cost, m, of supply- ing water is constant, so its marginal cost curve is horizontal and its average cost, AC=m+F/Q, declines as output rises.

Figure  9.6 shows such marginal and average cost curves where m=10 and F=60. If the market output is 12 units per day, one firm produces that output 15When a firm develops a better production method that provides it with a cost advantage, it is important for the firm to either keep the information secret or obtain a patent, whereby the government protects it from having its innovation imitated. Thus, both secrecy and patents facilitate cost-based monopolies.

16A firm may be a natural monopoly even if its cost curve does not fall at all levels of output. If aU-shaped average cost curve reaches its minimum at 100 units of output, it may be less costly for only one firm to produce an output of 101 units even though average cost is rising at that output. Thus, a cost function with economies of scale everywhere is a sufficient but not a necessary condition for a natural monopoly. 295 9.4 Causes of Monopoly at an average cost of 15, or a total cost of 180 (=15*12). If two firms each pro- duce 6 units, the average cost is 20 and the cost of producing the market output is 240 (=20*12), which is greater than the cost with a single firm.

If the two firms divided total production in any other way, their cost of produc- tion would still exceed the cost of a single firm (as the following question asks you to prove). The reason is that the marginal cost per unit is the same no matter how many firms produce, but each additional firm adds a fixed cost, which raises the cost of producing a given quantity. If only one firm provides water, the cost of building a second plant and a second set of pipes is avoided.

In an industry with a natural monopoly cost structure, having just one firm is the cheapest way to produce any given output level. Governments often use a natural monopoly argument to justify their granting the right to be a monopoly to public utilities, which provide essential goods or services such as water, gas, electric power, or mail delivery. Q&A 9.4 A firm that delivers Q units of water to households has a total cost of C(Q)=mQ+F.

If any entrant would have the same cost, does this market have a natural monopoly?

Answer Determine whether costs rise if two firms produce a given quantity. Let q 1 be the output of Firm 1 and q 2 be the output of Firm 2. The combined cost of these two firms producingQ=q 1+q 2 is C(q 1)+C(q 2)=(mq 1+F)+(mq 2+F)=m(q 1+q 2)+2F=mQ+2F.

If a single firm produces Q, its cost is C(Q)=mQ+F. Thus, the cost of pro- ducing any given Q is greater with two firms than with one firm (the condition in Equation 9.11), so this market is a natural monopoly. 1520 40 10 6 0 12 15 AC= 10 + 60/Q MC= 10 Q, Units per day AC,MC, $ per unit FIGURE 9.6 Natural Monopoly This natural monopoly has a strictly declining average cost, AC=10+60/Q. 296 CHAPTER 9 Monopoly Government Creation of Monopoly Governments have created many monopolies. Sometimes governments own and manage such monopolies. In the United States, as in most countries, first class mail delivery is a government monopoly. Many local governments own and operate pub- lic utility monopolies that provide garbage collection, electricity, water, gas, phone services, and other utilities.

Barriers to Entry. Frequently governments create monopolies by preventing competing firms from entering a market occupied by an existing incumbent firm.

Several countries, such as China, maintain a tobacco monopoly. Similarly, most gov- ernments grant patents that limit entry and allow the patent-holding firm to earn a monopoly profit from an invention—a reward for developing the new product that acts as an incentive for research and development.

By preventing other firms from entering a market, governments create monopo- lies. Typically, governments create monopolies either by making it difficult for new firms to obtain a license to operate or by explicitly granting a monopoly right to one firm, thereby excluding other firms. By auctioning a monopoly right to a private firm, a government can capture the future value of monopoly earnings. 17 Frequently, firms need government licenses to operate. If one initial incumbent has a license and governments make it difficult for new firms to obtain licenses, the incumbent firm may maintain its monopoly for a substantial period. Until recently, many U.S. cities required that new hospitals or other inpatient facilities demonstrate the need for a new facility to obtain a certificate of need, which allowed them to enter the market.

Government grants of monopoly rights have been common for public utilities.

Instead of running a public utility itself, a government might give a private sector company the monopoly rights to operate the utility. A government may capture some of the monopoly profits by charging the firm in some way for its monopoly rights.

In many countries or other political jurisdictions, such a system is an inducement to bribery as public officials may be bribed by firms seeking monopoly privileges.

Governments around the world have privatized many state-owned monopolies in the past several decades. By selling cable television, garbage collection, phone service, towing, and other monopolies to private firms, a government can capture the value of future monopoly earnings today. However, for political or other reasons, governments frequently sell at a lower price that does not capture all future profits. Patents. If an innovating firm cannot prevent imitation by keeping its discoveries secret, it may try to obtain government protection to prevent other firms from dupli- cating its discovery and entering the market. Most countries provide such protec- tion through patents. A patent is an exclusive right granted to the inventor of a new and useful product, process, substance, or design for a specified length of time. The length of a patent varies across countries, although it is now 20 years in the United States and in most other countries.

This right allows the patent holder to be the exclusive seller or user of the new invention.

18 Patents often give rise to monopoly, but not always. For example, 17Alternatively, a government could auction the rights to the firm that offers to charge the lowest price, so as to maximize total surplus.

18Owners of patents may sell or grant the right to use a patented process or produce a patented product to other firms. This practice is called licensing. 297 9.4 Causes of Monopoly Mini-Case Ophthalmologist Dr. Alan Scott turned the deadly poison botulinum toxin into a miracle drug to treat two eye conditions: strabismus, which affects about 4% of children, and blepharospasm, an uncontrollable closure of the eyes. Blepha- rospasm left about 25,000 Americans functionally blind before Scott’s discovery.

His patented drug, Botox, is sold by Allergan, Inc.

Dr. Scott has been amused to see several of the unintended beneficiaries of his research at the Academy Awards. Even before it was explicitly approved for cosmetic use, many doctors were injecting Botox into the facial muscles of actors, models, and others to smooth out their wrinkles. (The drug paralyzes the muscles, so those injected with it also lose the ability to frown—and, some would say, to act.) The treatment is only temporary, lasting up to 120 days, so repeated injections are necessary. Allergan had expected to sell $400 million worth of Botox in 2002. However, in April of that year, the U.S. Food and Drug Administration approved the use of Botox for cosmetic purposes, a ruling that allows the company to advertise the drug widely.

Allergan had Botox sales of $800 million in 2004 and about $1.8 billion in 2012. Allergan has a near-monopoly in the treatment of wrinkles, although plastic surgery and collagen, Restylane, hyaluronic acids, and other filler injections provide limited competition. Between 2002 and 2004, the number of facelifts dropped 3% to about 114,000 according to the American Society of Plastic Surgeons, while the number of Botox injections skyrocketed 166% to nearly 3 million.

Dr. Scott says that he can produce a vial of Botox in his lab for about $25.

Allergan then sells the potion to doctors for about $400. Assuming that the firm is setting its price to maximize its short-run profit, we can rearrange Equa- tion 9.10 to determine the elasticity of demand for Botox:

ε=-p p-MC=-400 400-25≈-1.067.

Thus, the demand that Allergan faces is only slightly elastic: A 1% increase in price causes quantity to fall by only a little more than 1%.

If we assume that the demand curve is linear and that the elasticity of demand is-1.067 at the 2002 monopoly optimum, e m (one million vials sold at $400 each, producing revenue of $400 million), then Allergan’s inverse demand function is p=775-375Q.

This demand curve (see graph) has a slope of -375 and hits the price axis at $775 and the quantity axis at about 2.07 million vials per year. The corresponding marginal revenue curve, MR=775-750Q, intersects the price axis at $775 and has twice the slope, -750, as the demand curve. Botox although a patent may grant a firm the exclusive right to use a particular process in producing a product, other firms may be able to produce the same product using different processes. In Chapter 16, we discuss the reasons why governments grant patents. 298 CHAPTER 9 Monopoly 9.5 Advertising You can fool all the people all the time if the advertising is right and the budget is big enough. —Joseph E. Levine (film producer) In addition to setting prices or quantities and choosing investments, firms engage in many other strategic actions to boost their profits. One of the most important is advertising. By advertising, a monopoly can shift its demand curve, which may allow it to sell more units at a higher price. In contrast, a competitive firm has no incentive to advertise as it can sell as many units as it wants at the going price with- out advertising.

Advertising is only one way to promote a product. Other promotional activities include providing free samples and using sales agents. Some promotional tactics are subtle. For example, grocery stores place sugary breakfast cereals on lower shelves so that they are at children’s eye level. According to a survey of 27 supermarkets nationwide by the Center for Science in the Public Interest, the average position of 10 child-appealing brands (44% sugar) was on the next-to-bottom shelf, while the average position of 10 adult brands (10% sugar) was on the next-to-top shelf.

A monopoly advertises to raise its profit. A successful advertising campaign shifts the market demand curve by changing consumers’ tastes or informing them about new products. The monopoly may be able to change the tastes of some consumers At the point where the MR and MC curves inter- sect,MR=MC. Therefore, 775-750Q=25.

We can then solve for the profit-maximizing quantity of 1 million vials per year and the associated price of $400 per vial.

Were the company to sell Botox at a price equal to its marginal cost of $25 (as a competitive industry would), consumer surplus would equal areas A+B+C= $750 million per year. At the higher monopoly price of $400, the consumer sur- plus is A=$187.5 million.

Compared to the competi- tive solution, e c, buyers lose consumer surplus of B+C=$562.5 million per year. Part of this loss, B=$375 million per year, is transferred from consumers to Allergan. The rest, C=$187.5 million per year, is the deadweight loss from monopoly pricing. Allergan’s profit is its producer surplus, B, minus its fixed costs. p, $ per vial 2 2.07 A ≈ $187.5 million C ≈ $187.5 million B ≈ $375 millionDemand Q, Million vials of Botox per year 400 25 0e s ec MC = AV C MR 775 1 299 9.5 Advertising by telling them that a famous athlete or performer uses the product. Children and teenagers are frequently the targets of such advertising. If the advertising convinces some consumers that they can’t live without the product, the monopoly’s demand curve may shift outward and become less elastic at the new equilibrium, at which the firm charges a higher price for its product.

If a firm informs potential consumers about a new use for the product, the demand curve shifts to the right. For example, a 1927 Heinz advertisement suggested that putting its baked beans on toast was a good way to eat beans for breakfast as well as dinner. By so doing, it created a British national dish and shifted the demand curve for its product to the right.

Deciding Whether to Advertise I have always believed that writing advertisements is the second most profitable form of writing. The first, of course, is ransom notes. . . . —Philip Dusenberry (advertising executive) Even if advertising succeeds in shifting demand, it may not pay for the firm to adver- tise. If advertising shifts demand outward or makes it less elastic, the firm’s gross profit, ignoring the cost of advertising, must rise. The firm undertakes this advertis- ing campaign, however, only if it expects its net profit (gross profit minus the cost of advertising) to increase.

We illustrate a monopoly’s decision making about advertising in Figure  9.7. If the monopoly does not advertise, it faces the demand curve D 1. If it advertises, its demand curve shifts from D 1 to D 2.

The monopoly’s marginal cost, MC, is constant and equals its average cost, AC.

Before advertising, the monopoly chooses its output, Q 1, where its marginal cost hits its marginal revenue curve, MR 1, that corresponds to demand curve, D 1. The profit-maximizing equilibrium is e 1, and the monopoly charges a price of p 1. The monopoly’s profit, π1, is a box whose height is the difference between the price and the average cost and whose length is the quantity, Q 1.

After its advertising campaign shifts its demand curve to D 2, the monopoly chooses a higher quantity, Q 2(7Q 1), where the MR 2 and MC curves intersect. In this new equilibrium, e 2, the monopoly charges p 2. Despite this higher price, the monopoly sells more units after advertising because of the outward shift of its demand curve.

As a consequence, the monopoly’s gross profit rises. Its new gross profit is the rectangleπ 1+B, where the height of the rectangle is the new price minus the aver- age cost, and the length is the quantity, Q 2. Thus, the benefit, B, to the monopoly from advertising at this level is the increase in its gross profit. If its cost of advertising is less than B, its net profit rises, and it pays for the monopoly to advertise at this level rather than not to advertise at all. How Much to Advertise The man who stops advertising to save money is like the man who stops the clock to save time.

How much should a monopoly advertise to maximize its net profit? The rule for setting the profit-maximizing amount of advertising is the same as that for setting the profit-maximizing amount of output: Set advertising or quantity where the marginal benefit (the extra gross profit from one more unit of advertising or the marginal revenue from one more unit of output) equals its marginal cost. 300 CHAPTER 9 Monopoly Using Calculus We can derive this marginal rule for optimal advertising using calculus. A monopoly’s inverse demand function is p=p(Q,A), which says that the price it must charge to clear the market depends on the number of units it chooses to sell,Q, and on the level of its advertising, A. As a result, the firm’s revenue func- tion is R(Q,A)=p(Q,A)Q. The firm’s cost function is C(Q)+A, where C(Q) is the cost of manufacturing Q units and A is the cost of advertising, because each unit of advertising costs $1 (by choosing the units of measure appropriately). The monopoly’s profit is π(Q,A)=R(Q,A)-C(Q)-A. (9.12) Optimal Advertising Consider what happens if the monopoly raises or lowers its advertising expenditures by $1, which is its marginal cost of an additional unit of advertising. If a monopoly spends one more dollar on advertising—its marginal cost of advertising— and its gross profit rises by more than $1, its net profit rises, so the extra advertising pays. A profit-maximizing monopoly keeps increasing its advertising until the last dollar of advertising raises its gross profit by exactly $1. If it were to advertise more, its profit would fall. p, $ per unit B Q, Units per year Q 2 Q1 MR 1 MR 2 D2 D1 p2p1 e2 e1 π1 MC= AC FIGURE 9.7 Advertising If the monopoly does not advertise, its demand curve is D1. At its actual level of advertising, its demand curve is D2. Advertising increases the monopoly’s gross profit (ignoring the cost of advertising) from π1 to π 2=π 1+B.Thus, if the cost of advertising is less than the benefits from advertising, B, the monopoly’s net profit (gross profit minus the cost of advertising) rises. 301 9.5 Advertising Q&A 9.5 A monopoly’s inverse demand function is p=800-4Q+0.2A 0.5, where Q is its quantity,p is its price, and A is the level of advertising. Its marginal cost of production is 2, and its cost of a unit of advertising is 1. What are the firm’s profit-maximizing price, quantity, and level of advertising? Answer 1.Write the firm’s profit function using its inverse demand function. The monopoly’s profit is π=(800-4Q+0.2A 0.5)Q-2Q-A =798Q-4Q 2+0.2A 0.5Q-A.(9.15) 2.Set the partial derivatives of the profit function in Equation  9.15 with respect to Q and A to zero to obtain the equations that determine the profit-maximizing levels, as in Equations 9.13 and 9.14. The first-order conditions are 0π 0Q=798-8Q+0.2A 0.5 =0, (9.16) 0π 0A=0.1A -0.5 Q-1=0. (9.17) 3.Solve Equations 9.16 and 9.17 for the profit-maximizing levels of Q and A. We can rearrange Equation  9.17 to show that A0.5 =0.1Q. Substituting this expres- sion into the Equation 9.16, we find that 798-8Q+0.02Q=0, or Q=100.

Thus,A 0.5 =0.1Q=10, so A=100. The monopoly maximizes its profit by choosing Q and A. Its first-order conditions to maximize its profit are found by partially differentiating the profit function in Equation 9.12 with respect to Q and A in turn:

0π(Q,A) 0Q=0R(Q,A) 0Q-dC(Q) dQ=0, (9.13) 0π(Q,A) 0A=0R(Q,A) 0A-1=0. (9.14) The profit-maximizing output and advertising levels are the Q and A that simultaneously satisfy Equations  9.13 and 9.14. Equation  9.13 says that the monopoly should set its output so that the marginal revenue from one more unit of output, 0R/0Q, equals the marginal cost, dC/dQ, which is the same condition that we previously derived before considering advertising. According to Equation 9.14, the monopoly should advertise to the point where its marginal revenue or marginal benefit from the last unit of advertising, 0R/0A, equals the marginal cost of the last unit of advertising, $1. Mini-Case Super Bowl commercials are the most expensive commercials on U.S. television.

A 30-second spot during the Super Bowl averaged over $3.8 million in 2013. A high price for these commercials is not surprising because the cost of commer- cials generally increases with the number of viewers (eyeballs in industry jargon), Super Bowl Commercials 302 CHAPTER 9 Monopoly 9.6 Networks, Dynamics, and Behavioral Economics We have examined how a monopoly behaves in the current period, ignoring the future. For many markets, such an analysis is appropriate as each period can be treated separately. However, in some markets, decisions today affect demand or cost in a future period, creating a need for a dynamic analysis, in which managers explicitly consider relationships between different periods.

In such markets, the monopoly may maximize its long-run profit by making a decision today that does not maximize its short-run profit. For example, frequently a firm introduces a new product—such as a new type of candy bar—by initially charg- ing a low price or giving away free samples to generate word-of-mouth publicity or to let customers learn about its quality in hopes of getting their future business.

We now consider an important reason why consumers’ demand in the future may depend on a monopoly’s actions in the present.

Network Externalities The number of customers a firm has today may affect the demand curve it faces in the future. A good has a network externality if one person’s demand depends on the consumption of the good by others. 19 If a good has a positive network externality, its value to a consumer grows as the number of units sold increases. 19In Chapter 16, we discuss the more general case of an externality, which occurs when a person’s well-being or a firm’s production capability is directly affected by the actions of other consumers or firms rather than indirectly through changes in prices. The following discussion on network externalities is based on Leibenstein (1950), Rohlfs (1974), Katz and Shapiro (1994), Economides (1996), Shapiro and Varian (1999), and Rohlfs (2001).

and the Super Bowl is the most widely watched show, with over 108 million viewers in 2013. What is surprising is that Super Bowl advertising costs 2.5 times as much per viewer as other TV commercials.

However, a Super Bowl commercial is much more likely to influence viewers than commercials on other shows. The Super Bowl is not only a premier sports event; it showcases the most memorable commercials of the year, such as Apple’s classic 1984 Macintosh ad, which is still discussed today. Indeed, many Super Bowl viewers are not even football fans—they watch to see these superior ads.

Moreover, Super Bowl commercials receive extra exposure because these ads oftengo viral on the Internet.

Given that Super Bowl ads are more likely to be remembered by viewers, are these commercials worth the extra price? Obviously many advertisers believe so, as their demand for these ads has bid up the price. Kim (2011) found that immediately after a Super Bowl commercial airs, the advertising firm’s stock value rises. Thus, investors apparently believe that Super Bowl commercials raise a firm’s profits despite the high cost of the commercial. Ho et al. (2009) found that, for the typical movie with a substantial advertising budget, a Super Bowl commercial advertising the movie raises theater revenues by more than the same expenditure on other television advertising. They also concluded that movie firms’ advertising during the Super Bowl was at (or close to) the profit-maximizing amount. 303 9.6 Networks, Dynamics, and Behavioral Economics When a firm introduces a new good with a network externality, it faces a chicken- and-egg problem: It can’t get Max to buy the good unless Sofia will buy it, but it can’t get Sofia to buy it unless Max will. The firm wants its customers to coordinate or to make their purchase decisions simultaneously.

The telephone provides a classic example of a positive network externality. When the phone was introduced, potential adopters had no reason to get phone service unless their family and friends did. Why buy a phone if there’s no one to call?

For Bell’s phone network to succeed, it had to achieve a critical mass of users— enough adopters that others wanted to join. Had it failed to achieve this critical mass, demand would have withered and the network would have died. Similarly, the market for fax machines grew very slowly until a critical mass was achieved where many firms had them. Direct Size Effects. Many industries exhibit positive network externalities where the customer gets a direct benefit from a larger network. The larger an auto- mated teller machine (ATM) network, such as the Plus network, the greater the odds that you will find an ATM when you want one, so the more likely it is that you will want to use that network. The more people who use a particular computer program, the more attractive it is to someone who wants to exchange files with other users. Indirect Effects. In some markets, positive network externalities are indirect and stem from complementary goods that are offered when a product has a critical mass of users. The more applications (apps) available for a smart phone, the more people want to buy that smart phone. However, many of these extra apps will be written only if a critical mass of customers buys the smart phone. Similarly, the more people who drive diesel-powered cars, the more likely it is that gas stations will sell diesel fuel; and the more stations that sell the fuel, the more likely it is that someone will want to drive a diesel car. As a final example, once a critical mass of customers had broadband Internet service, more services provided downloadable music and movies and more high-definition Web pages become available. Once those popular apps appeared, more people signed up for broadband service. Network Externalities and Behavioral Economics The direct effect of network externalities depends on the size of the network, because customers want to interact with each other. However, sometimes consumers’ behav- ior depends on beliefs or tastes that can be explained by psychological and sociologi- cal theories, which economists study in behavioral economics (Chapter 4).

One such explanation for a direct network externality effect is based on consumer attitudes toward other consumers. Harvey Leibenstein (1950) suggested that con- sumers sometimes want a good because “everyone else has it.” A fad or other popularity-based explanation for a positive network externality is called a band- wagon effect: A person places greater value on a good as more and more other people possess it. 20 The success of the iPad today may be partially due to its early popularity.

The opposite, negative network externality is called a snob effect: A person places greater value on a good as fewer and fewer other people possess it. Some people prefer an original painting by an unknown artist to a lithograph by a star because no 20Jargon alert: Some economists use bandwagon effect to mean any positive network externality—not just those that are based on popularity. 304 CHAPTER 9 Monopoly Mini-Case In recent years, many people have argued that natural monopolies emerge after brief periods of Internet competition. A typical Web business requires a large up-front fixed cost—primarily for development and promotion—but has a relatively low marginal cost. Thus, Internet start-ups typically have downward-sloping average cost-per-user curves. Which of the actual or potential firms with decreasing average costs will dominate and become a natural monopoly? 21 In the early years, eBay’s online auction site, which started in 1995, faced competition from a variety of other Internet sites, including one created in 1998 by then mighty Yahoo!. At the time, many commentators correctly predicted that whichever auction site first achieved a critical mass of users would drive the other sites out of business. Indeed, most of these alternative sites died or faded into obscurity. For example, Yahoo! Auctions closed its U.K. and Irish sites in 2002, its Australian site in 2003, its U.S. and Canadian sites in 2007, and its Singapore site in 2008 (however, as of early 2013 its Hong Kong, Taiwanese, and Japanese sites continue to operate).

Apparently the convenience of having one site where virtually all buyers and sellers congregate is valuable to consumers. Such a site lowers buyers’ search 21If Internet sites provide differentiated products (Chapter 11), then several sites may coexist even though average costs are strictly decreasing. In 2007, commentators were predicting the emergence of natural monopolies in social networks such as MySpace, which has since lost its dominance.

However, whether a single social network can dominate for long is debatable given frequent innova- tions. Even if MySpace or Facebook temporarily dominates other similar sites, it may eventually lose ground to Web businesses with new models, such as Twitter. Critical Mass and eBay one else can possess that painting. (As Yogi Berra is reported to have said, “Nobody goes there anymore; it’s too crowded.”) Network Externalities as an Explanation for Monopolies Because of the need for a critical mass of customers in a market with a positive network externality, we sometimes see only one large firm surviving. Visa’s ad campaign tells consumers that Visa cards are accepted “everywhere you want to be,” including places that “don’t take American Express.” One could view its ad campaign as an attempt to convince consumers that its card has a critical mass and therefore that everyone should carry it.

The Windows operating system largely dominates the market—not because it is technically superior to Apple’s operating system or Linux—but because it has a critical mass of users. Consequently, a developer can earn more producing software that works with Windows than with other operating systems, and the larger number of software programs makes Windows increasingly attractive to users.

But having obtained a monopoly, a firm does not necessarily keep it. History is filled with examples where one product knocks off another: “The king is dead; long live the king.” Google replaced Yahoo! as the predominant search engine.

Microsoft’s Explorer displaced Netscape as the big-dog browser, followed in turn by Google Chrome. Levi Strauss is no longer the fashion leader among the jeans set. 305 9.6 Networks, Dynamics, and Behavioral Economics Managers should consider initially selling a new product at a low introductory price to obtain a critical mass. By doing so, the manager maximizes long-run profit but not short-run profit.

Suppose that a monopoly sells its good—say, root-beer-scented jeans—for only two periods (after that, the demand goes to zero as a new craze hits the market).

If the monopoly sells less than a critical quantity of output, Q, in the first period, then its second-period demand curve lies close to the price axis. However, if the good is a success in the first period—at least Q units are sold—the second-period demand curve shifts substantially to the right.

If the monopoly maximizes its short-run profit in the first period, it charges p* and sells Q* units, which is fewer than Q. To sell Q units, it would have to lower its first-period price below p*, which would reduce its first-period profit from π* to π.

In the second period, the monopoly maximizes its profit given its second-period demand curve. If the monopoly sold only Q* units in the first period, it earns a relatively low second-period profit of πl. However, if it sells Q units in the first period, it makes a relatively high second-period profit, πh.

Should the monopoly charge a low introductory price in the first period? Its objective is to maximize its long-run profit: the sum of its profit in the two periods. 22 If the firm has a critical mass in the second period, its extra profit is πh- πl. To obtain this critical mass by charging a low introductory price in the first period, it lowers its first-period profit by π*-π. Thus, a manager should charge a low introductory price in the first period if the first-period loss is less than the extra profit in the second period. This policy is apparently profitable for many firms: A 2012 Google search found 103 million Web pages touting an introductory price. 22Firms place lower value on profit in the future than profit today (Chapter 7). However, for simplicity, we assume that the monopoly places equal value on profit in either period. Introductory Prices Managerial Implication When generic drugs enter the market after the patent on a brand-name drug expires, the demand curve facing the brand-name firm shifts toward the ori- gin (to the left). Why do the managers of many brand-name drug companies raise their prices after generic rivals enter the market? The reason is that the demand curve not only shifts to the left but it rotates so that it is less elastic at the original price. Brand-Name and Generic Drugs Managerial Solution costs and allows the creation of useful reputation systems for providing user feedback (Brown and Morgan, 2006). These benefits attract more buyers, thereby raising the prices that sellers can expect to receive, which in turn attracts more sellers. Brown and Morgan (2010) found that, prior to the demise of the U.S.

Yahoo! Auction site, the same type of items attracted an average of two addi- tional bidders on eBay and, consequently, the prices on eBay were consistently 20% to 70% percent higher than Yahoo! prices—making eBay more attractive than Yahoo! to sellers. 306 CHAPTER 9 Monopoly The price the brand-name firm sets depends on the elasticity of demand.

When the firm has a patent monopoly, it faces demand curve D 1 in the figure. Its monopoly optimum, e 1, is determined by the intersection of the corresponding marginal revenue curve MR 1 and the marginal cost curve. (Because it is twice as steeply sloped as the demand curve, MR 1 intersects the MC curve at Q 1, while the demand curve D 1 intersects the MC curve at 2Q 1.) The monopoly sells the Q 1 units at a price of p 1.

After the generic drugs enter the market, the linear demand curve facing the original patent holder shifts left to D 2 and becomes steeper and less elastic at the original price. The firm now maximizes its profit at e 2, where the quantity, Q 2, is smaller than Q 1 because D 2 lies to the left of D 1. However, the new price p 2 is higher than the initial price p 1 because the D 2 demand curve is less elastic at the new optimum quantity Q 2 than is the D 1 curve at Q 1.

Why might the demand curve rotate and become less elastic at the initial price?

One explanation is that the brand-name firm has two types of consumers with different elasticities of demand who differ in their willingness to switch to a generic. One group of consumers is relatively price-sensitive and will switch to the lower-priced generics. However, the brand-name drug remains the monopoly supplier to the remaining brand-loyal customers whose demand is less elastic than that of the price-sensitive consumers. These loyal customers prefer the brand-name drug because they are more comfortable with a familiar product, worry that new products may be substandard, or fear that differences in the inactive ingredients might affect them.

Older customers are less likely to switch brands than younger people. A survey of the American Association of Retired Persons found that people aged 65 and older were 15% less likely than people aged 45 to 64 to request generic versions of a drug from their doctor or pharmacist. Similarly, patients with generous insurance plans may be more likely to pay for expensive drugs (if their insurer permits) than customers without insurance. p, $ per unit D1 Q, Units per day MR 1 D2 e2 e1 p1 p2 MC MR 2 Q1 Q2 2Q 2 2Q 1 307 Questions SUMMARY 1. Monopoly Profit Maximization. Like any firm, a monopoly—a single seller—maximizes its profit by setting its output so that its marginal revenue equals its marginal cost. The monopoly makes a positive profit if its average cost is less than the price at the profit-maximizing output. 2. Market Power. Market power is the ability of a firm to significantly affect the market price.

The extent of a firm’s market power depends on the shape of the demand curve. The more elastic the demand curve at the point where the firm is producing, the lower the markup of price over marginal cost. 3. Market Failure Due to Monopoly Pricing. Because a monopoly’s price is above its marginal cost, too little output is produced, and society suffers a deadweight loss. The monopoly makes higher profit than it would if it acted as a price taker. Consumers are worse off, buying less output at a higher price. 4. Causes of Monopoly. A firm may be a monopoly if it has lower operating costs than rivals, due to reasons such as from superior knowledge or con- trol of a key input. A market may also have a natu- ral monopoly if one firm can produce the market output at lower average cost than can a larger number of firms (even if all firms have the same cost function). Many, if not most, monopolies are created by governments, which prevent other firms from entering the markets. One important barrier to entry is a patent, which gives the inven- tor of a new product or process the exclusive right to sell the product or use the process for 20 years in most countries. 5. Advertising. A monopoly advertises or engages in other promotional activity to shift its demand curve to the right or make it less elastic so as to raise its profit net of its advertising expenses. 6. Networks, Dynamics, and Behavioral Economics. If a good has a positive network externality so that its value to a consumer grows as the number of units sold increases, then current sales affect a monopoly’s future demand curve. A monopoly may maximize its profit over time by setting a low introductory price in the first period in which it sells the good and then later raising its price as its product’s popularity ensures large future sales at a higher price. Consequently, the monopoly is not maximizing its short-run profit in the first period but is maximizing the sum of its profits over all periods. Behavioral economics provides an explanation for some network exter- nalities, such as bandwagon effects and snob effects. QUESTIONS All exercises are available on MyEconLab ;*=answer at the back of this book; C = use of calculus may be necessary.

revenue function reaches its peak, the slope of the reve- nue function is zero. That is, MR=0.) Why is revenue maximized at a larger quantity than profit? Modify panel b of Figure 9.3 to show the revenue curve.

1.6. Are major-league baseball clubs profit-maximizing monopolies? Some observers of this market have contended that baseball club owners want to maximize attendance or revenue. Alexander (2001) says that one test of whether a firm is a profit-maximizing monopoly is to check whether the firm is operating in the elastic portion of its demand curve (which he finds is true).

Why is that a relevant test? What would the elasticity be if a baseball club were maximizing revenue?

1.7. Using a graph, show under what condition the monopoly operates—does not shut down—in the long run. Discuss your result in terms of the demand curve and the average cost curve at the profit- maximizing quantity. 1. Monopoly Profit Maximization 1.1. If the inverse demand function is p=300-3Q, what is the marginal revenue function? Draw the demand and marginal revenue curves. At what quantities do the demand and marginal revenue lines hit the quantity axis? (Hint: See Q&A 9.1.) 1.2. If the inverse demand curve a monopoly faces is p=10Q -0.5 , what is the firm’s marginal revenue curve? C (Hint: See Q&A 9.1.) *1.3. If the inverse demand function is p=500-10Q, what is the elasticity of demand and revenue at Q=10?

1.4. Does it affect a monopoly’s profit if it chooses price or quantity (assuming it chooses them optimally)? Why can’t a monopoly choose both price and quantity?

1.5. For the monopoly in Figure 9.3 at what quantity is its revenue maximized? (Hint: At the quantity where the 308 CHAPTER 9 Monopoly 1.8.Why might a monopoly operate in any part (downward sloping, flat, upward sloping) of its long- run average cost curve, but a competitive firm will operate only at the bottom or in the upward-sloping section?

1.9. AT&T Inc., the large U.S. phone company and the one-time monopoly, left the payphone business at the beginning of 2009 because people were switching to wireless phones. U.S. consumers owning cellphones reached 80% by 2007 and 86% by 2012 according to the Pew Research Center. Consequently, the number of payphones fell from 2.6 million at the peak in 1998 to 1 million in 2006 (Crayton Harrison, “AT&T to Disconnect Pay-Phone Business After 129 Years,” Bloomberg.com, December 3, 2007). (Where will Clark Kent go to change into Superman now?) Use graphs to explain why a monopoly exits a market when its demand curve shifts to the left.

*1.10.The inverse demand function a monopoly faces is p=100-Q. The firm’s cost curve is C(Q)=10+5Q. What is the profit-maximizing solution? How does your answer change if C(Q)=100+5Q?

1.11. The inverse demand function a monopoly faces is p=10Q -0.5 (Hint: See Question 1.2). The firm’s cost curve is C(Q)=5Q. What is the profit-maximizing solution?

C 1.12.Show that after a shift in the demand curve, a monopoly’s price may remain constant but its output may rise.

2. Market Power 2.1. Why is the ratio of the monopoly’s price to its mar- ginal cost, p/MC, larger if the demand curve is less elastic at the optimum quantity? Can the demand curve be inelastic at that quantity?

2.2.When will a monopoly set its price equal to its marginal cost?

2.3. At the profit-maximizing quantity in Figure  9.2, what is the elasticity of demand? What is the Lerner Index? (Hint: Can you determine the answers to these questions using only the price and marginal cost information from the figure?) 2.4. The U.S. Postal Service (USPS) has a constitutionally guaranteed monopoly on first-class mail. In 2012, it charged 44¢ for a stamp, which was not the profit-maximizing price—the USPS’s goal, allegedly, is to break even rather than to turn a profit. Following the postal services in Australia, Britain, Canada, Switzerland, and Ireland, the USPS allowed Stamps.com to sell a sheet of twenty 44¢ stamps with a photo of your dog, your mommy, or whatever image you want for $18.99 (that’s 94.95¢ per stamp, or a 216% markup). Stamps.com keeps the extra beyond the 44¢ it pays the USPS.

What is the firm’s Lerner Index? If Stamps.com is a profit-maximizing monopoly, what elasticity of demand does it face for a customized stamp?

2.5. According to the California Nurses Association, Tenet Healthcare hospitals marked up drugs substantially.

At Tenet’s Sierra Vista Regional Medical Center, drug prices were 1,840.80% of the hospital’s costs (Chuck Squatriglia and Tyche Hendricks, “Tenet Hiked Drug Prices, Study Finds More Than Double U.S. Average,” San Francisco Chronicle, November 24, 2002: A1, A10).

Assuming Tenet was maximizing its profit, what was the elasticity of demand that Tenet believed it faced?

What was its Lerner Index for drugs?

2.6. Using the information in Q&A  9.2, calculate the elasticity of demand faced by Apple at the profit maximizing price and quantity using the inverse demand function.

*2.7. In 2009, the price of Amazon’s Kindle 2 was $359, while iSuppli estimated that its marginal cost was $159. What was Amazon’s Lerner Index? What elas- ticity of demand did it face if it was engaging in short-run profit maximization?

2.8. When the iPod was introduced, Apple’s constant marginal cost of producing its top-of-the-line iPod was $200 (iSuppli), its fixed cost was approximately $736 million, and we estimate that its inverse demand function was p=600-25Q, where Q is units measured in millions. What was Apple’s average cost function? Assuming that Apple was maximizing its short-run monopoly profit, what was its marginal revenue function? What were its profit-maximizing price and quantity, profit, and Lerner Index? What was the elasticity of demand at the profit-maximizing level? Show Apple’s profit- maximizing solution in a figure. (Hint: See Q&A 9.2.) 3. Market Failure Due to Monopoly Pricing 3.1. A monopoly has a constant marginal cost of production of $1 per unit and a fixed cost of $10. Draw the firm’s MC,AVC, and AC curves. Add a downward-sloping demand curve, and show the profit-maximizing quan- tity and price. Indicate the profit as an area on your diagram. Show the deadweight loss.

3.2. A monopoly has an inverse demand function given by p=120-Q and a constant marginal cost of 10. Calculate the deadweight loss if the monopoly charges the profit-maximizing price.

3.3. What is the effect of a lump-sum tax (which is like an additional fixed cost) on a monopoly? (Hint:

Consider the possibility that the firm may shut down, and see Q&A 9.3.) 309 Questions 3.4. If the inverse demand function is p=120-Q and the marginal cost is constant at 10, how does charg- ing the monopoly a specific tax of τ=10 per unit affect price and quantity and the welfare of consum- ers, the monopoly, and society (where society’s wel- fare includes the tax revenue)? What is the incidence of the tax on consumers? (Hint: See Q&A 9.3.) *3.5.Show mathematically that a monopoly may raise the price to consumers by more than a specific tax imposed on it. (Hint: Consider a monopoly facing a constant-elasticity demand curve and a constant marginal cost, m.) C 4. Causes of Monopoly *4.1.Can a firm be a natural monopoly if it has a U-shaped average cost curve? Why or why not? (Hint: See Q&A 9.4.) 4.2. Can a firm operating in the upward-sloping portion of its average cost curve be a natural monopoly?

Explain. (Hint: See Q&A 9.4.) 4.3. Once the copyright runs out on a book or music, it can legally be placed on the Internet for anyone to download. In 1998 the U.S. Congress extended the copyright law to 95 years after the original publica- tion. But the copyright holds for only 50 years in Australia and 70 years in the European Union. Thus, an Australian website could post Gone With the Wind, a 1936 novel, or Elvis Presley’s 1954 single “That’s All Right,” while a U.S. site could not. Obviously, this legal nicety won’t stop U.S. fans from down- loading from Australian or European sites. Discuss how limiting the length of a copyright would affect the pricing used by the publisher of a novel.

4.4. In the “Botox” Mini-Case, consumer surplus, trian- gleA, equals the deadweight loss, triangle C. Show that this equality is a result of the linear demand and constant marginal cost assumptions.

4.5. Based on the information in the “Botox” Mini-Case, what would happen to the equilibrium price and quantity if the government had set a price ceiling of $200 per vial of Botox? What welfare effects would such a policy have?

5. Advertising 5.1. Using a graph, explain why a firm might not want to spend money on advertising, even if such an expenditure would shift the firm’s demand curve to the right.

*5.2. A monopoly’s inverse demand function is p=100 -Q+(5A-A 2)/Q, where Q is its quan- tity, p is its price, and A is the level of advertising.

Its marginal cost of production is constant at 10, and its cost of a unit of advertising is 1. What are the firm’s profit-maximizing price, quantity, and level of advertising? (Hint: See Q&A 9.5.) C 5.3. A monopoly’s inverse demand function is p=Q -0.25 A0.5, where Q is its quantity, p is its price, and A is the level of advertising. Its constant marginal and average cost of production is 6, and its cost of a unit of advertising is 0.25. What are the firm’s profit-maximizing price, quantity, and level of advertising? (Hint: See Q&A 9.5.) C 5.4. Why are newsstand prices higher than subscription prices for an issue of a magazine?

5.5.Canada subsidizes Canadian magazines to offset the invasion of foreign (primarily U.S.) magazines, which take 90% of the country’s sales. The Canada Magazine Fund provides a lump-sum subsidy to various magazines to “maintain a Canadian presence against the overwhelming presence of foreign magazines.” Eligibility is based on high levels of investment in Canadian editorial content and reliance on advertising revenues. What effect will a lump-sum subsidy have on the number of subscriptions sold?

5.6.Use a diagram similar to Figure  9.7 to illustrate the effect of social media on the demand for Super Bowl commercials. (Hint: See the “Super Bowl Commercials” Mini-Case.) 6. Networks, Dynamics, and Behavioral Economics 6.1. A monopoly chocolate manufacturer faces two types of consumers. The larger group, the hoi polloi, loves desserts and has a relatively flat, linear demand curve for chocolate. The smaller group, the snobs, is interested in buying chocolate only if the hoi polloi do not buy it. Given that the hoi polloi do not buy the chocolate, the snobs have a relatively steep, linear demand curve. Show the monopoly’s possible outcomes—high price, low quantity; low price, high quantity—and explain the condition under which the monopoly chooses to cater to the snobs rather than to the hoi polloi.

*6.2. A monopoly produces a good with a network externality at a constant marginal and average cost of 2. In the first period, its inverse demand function is p=10-Q. In the second period, its demand is p=10-Q unless it sells at least Q=8 units in the first period. If it meets or exceeds this target, then the demand curve rotates out by α (it sells α times as many units for any given price), so that its inverse demand curve is p=10-Q/α. The monopoly knows that it can sell no output after the second period. The monopoly’s objective is to maximize the sum of its profits over the two periods. In the first period, should the monopoly set the output that 310 CHAPTER 9 Monopoly maximizes its profit in that period? How does your answer depend on α? C 7. Managerial Problem 7.1.Under what circumstances will a drug company charge more for its drug after its patent expires?

7.2. Does the Managerial Solution change if the entry of the generic causes a parallel shift to the left of the patent monopoly’s linear demand curve?

7.3. Proposals to reduce patent length for drugs are sometimes made, but some critics argue that such a change would result in even higher prices during the patent period as companies would need to recover drug development costs more quickly. Is this argument valid if drug companies maximize profit?

8. Spreadsheet Exercises 8.1. A monopoly faces the inverse demand function:

p=100-2Q, with the corresponding marginal revenue function, MR=100-4Q. The firm’s total cost of production is C=50+10Q+3Q 2, with a corresponding marginal cost of MC=10+6Q.a. Create a spreadsheet for Q=1, 2, 3,c, 15.

Using the MR=MC rule, determine the profit-maximizing output and price for the firm and the consequent level of profit.

b. Calculate the Lerner Index of monopoly power for each output level and verify its relationship with the value of the price elasticity of demand (ε) at the profit-maximizing level of output.

c. Now suppose that a specific tax of 20 per unit is imposed on the monopoly. What is the effect on the monopoly’s profit-maximizing price?

8.2. A firm’s demand function is Q=110-p+2A 0.5, where A is the amount of advertising undertaken by the firm and the price of advertising is one. The firm’s cost of production is C=50+10Q+2Q 2.

The government imposes a binding price control at $135. Use Excel to determine the profit-maximizing level of advertising. Try advertising levels that vary in hundreds from 0 to $1,000. Select the most profitable range and try smaller increments within that range. What is the firm’s profit-maximizing advertising level and quantity? 311 Pricing with Market Power S ales are not the only means that firms use to charge customers different prices.

Why are airline fares often substantially less if you book in advance? Why do the spiritualists who live at the Wonewoc Spiritualist Camp give readings for $40 for half an hour, but charge seniors only $35 on Wednesdays? 1 Why are some goods, including computers and software, combined and sold as a bundle? To answer these questions, we need to examine how monopolies and other noncompetitive firms set prices.

In Chapter  9, we examined how a monopoly maximizes its profit when it uses uniform pricing: charging the same price for every unit sold of a particular good.

However, a monopoly can increase its profit if it can use nonuniform pricing, where a firm charges consumers different prices for the same product or charges a single customer a price that depends on the number of units the customer buys. In this 1www.msnbc.msn.com/id/20377308/wid/11915829, August 29, 2007.

Everything is worth what its purchaser will pay for it. —Publilius Syrus (first century B.C.) 10 Because many retail managers use sales—temporarily setting the price below the usual price—some customers pay lower prices than others over time. Grocery stores are particularly likely to put products on sale frequently. In large U.S. supermarkets, a soft drink brand is on sale 94% of the time. Either Coke or Pepsi is on sale half the weeks in a year.

Heinz Ketchup controls up to 60% of the U.S. ketchup market, 70% of the Canadian market, and nearly 80% of the U.K. market. In 2012, Heinz sold over 650 million bottles of ketchup in more than 140 countries and had annual sales of more than $1.5 billion. When Heinz goes on sale, switchers—ketchup customers who normally buy whichever brand is least expensive—purchase Heinz rather than the low-price generic ketchup. How can Heinz’s managers design a pattern of sales that maximizes Heinz’s profit by obtaining extra sales from switchers without losing substantial sums by selling to its loyal customers at a discount price? Under what conditions does it pay for Heinz to have a policy of periodic sales? Sale Prices Managerial Problem 312 CHAPTER 10 Pricing with Market Power chapter, we analyze nonuniform pricing for monopolies, but similar principles apply to any firm with market power.

As we saw in Chapter  9, a monopoly that sets a uniform price sells only to customers who value the good enough to buy it at the monopoly price, and those customers receive some consumer surplus. The monopoly does not sell the good to other customers who value the good at less than the single price, even if those consumers would be willing to pay more than the marginal cost of production. These lost sales cause deadweight loss, which is the foregone value of these potential sales in excess of the cost of producing the good.

A firm with market power can earn a higher profit using nonuniform pricing than by setting a uniform price for two reasons. First, the firm captures some or all of the single-price consumer surplus. Second, the firm converts at least some of the single-price deadweight loss into profit by charging a price below the uniform price to some customers who would not purchase at the single-price level. A monopoly that uses nonuniform pricing can lower the price to these otherwise excluded consumers without lowering the price to consumers who are willing to pay higher prices.

In this chapter, we examine several types of nonuniform pricing including price discrimination, two-part pricing, bundling, and peak-load pricing. The most common form of nonuniform pricing is price discrimination: charging consumers different prices for the same good based on individual characteristics of consumers, membership in an identifiable subgroup of consumers, or on the quantity purchased by the consumers. For example, for a full-year combination print and online subscription, the Wall Street Journal charges $99.95 to students, who are price sensitive, and $155 to other subscribers, who are less price sensitive.

Some firms with market power use other forms of nonuniform pricing to increase profits. A firm may use two-part pricing, where it charges a customer one fee for the right to buy the good and an additional fee for each unit purchased. For example, members of health or golf clubs typically pay an annual fee to belong to the club and then pay an additional amount each time they use the facilities. Similarly, cable television companies often charge a monthly fee for basic service and an additional fee for recent movies.

Another type of nonuniform pricing is called bundling, where several products are sold together as a package. For example, many restaurants provide full-course dinners for a fixed price that is less than the sum of the prices charged if the items (appetizer, main dish, and dessert) are ordered separately (à la carte).

Finally, some firms use peak-load pricing: charging higher prices in periods of peak demand than at other times. For example, ticket prices for flights from cold northern cities to Hawaii are higher in the winter months when demand is higher than in the summer. In this chapter, we examine seven main topics Main Topics 1. Conditions for Price Discrimination: A firm can increase its profit using price discrimination if it has market power, if customers differ in their willingness to pay, if the firm can identify which customers are more price sensitive than others, and if it can prevent customers who pay low prices from reselling to those who pay high prices. 2. Perfect Price Discrimination: If a firm can charge the maximum each customer is willing to pay for each unit of output, the firm captures all potential consumer surplus. 313 10.1 Conditions for Price Discrimination 10.1 Conditions for Price Discrimination We start by studying the most common form of nonuniform pricing, price discrimina- tion, where a firm charges various consumers different prices for a good. 2 Why Price Discrimination Pays For almost any good or service, some consumers are willing to pay more than others.

A firm that sets a single price faces a trade-off between charging consumers with a high willingness to pay a high price and charging a low enough price to sell to some customers with a lower willingness to pay. As a result, a single-price firm sets an intermediate price. By price discriminating, a firm can partially or entirely avoid this trade-off.

As with any kind of nonuniform pricing, price discrimination increases profit above the uniform pricing level through two channels. Price discrimination can extract additional consumer surplus from consumers who place a high value on the good and can simultaneously sell to new customers who would not be willing to pay the profit-maximizing uniform price. We use a pair of extreme examples to illustrate these two benefits of price discrimination to firms—capturing more of the consumer surplus and selling to more customers.

Suppose that the only movie theater in town has two types of patrons: college students and senior citizens. College students see the Saturday night movie if the price is $20 or less, and senior citizens attend if the price is $10 or less. Thus, college students have a willingness to pay of $20 and senior citizens have a willingness to pay of $10. For simplicity, we assume that the theater incurs no cost when showing the movie, so profit is the same as revenue. We also assume that the theater is large enough to hold all potential customers, so the marginal cost of admitting one more customer is zero. Table 10.1 shows how pricing affects the theater’s profit.

2Price discrimination is legal in the United States unless it harms competition between firms, as specified in the Robinson-Patman Act.

3. Group Price Discrimination: A firm that lacks the ability to charge each individual a different price may be able to charge different prices to various groups of customers that differ in their willingness to pay for the good. 4. Nonlinear Price Discrimination: A firm may set different prices for large purchases than for small ones, discriminating among consumers by inducing them to self-select the effective price they pay based on the quantity they buy. 5. Two-Part Pricing: By charging consumers a fee for the right to buy a good and then allowing them to purchase as much as they wish at an additional per-unit fee, a firm earns a higher profit than with uniform pricing. 6. Bundling: By selling a combination of different products in a package or bundle, a firm earns a higher profit than by selling the goods or services separately. 7. Peak-Load Pricing: By charging higher prices during periods of peak demand and lower prices at other times, a firm increases its profit. 314 CHAPTER 10 Pricing with Market Power In panel a, the theater potentially has 10 college student and 20 senior citizen customers. If the theater charges everyone $10, its profit is $300 because all 30 potential customers buy a ticket. If it charges $20, the senior citizens do not go to the movie, so the theater makes only $200, receiving $20 each from the 10 college students. Thus, if the theater charges everyone the same price, it maximizes its profit by setting the price at $10. The theater does not want to charge less than $10 because the same number of people go to the movie as go when $10 is charged. Charging between $10 and $20 is less profitable than charging $20 because no extra seniors go and the college students are willing to pay $20. Charging more than $20 results in no customers.

If the price is $10, the seniors have no consumer surplus: They pay exactly what seeing the movie is worth to them. Seeing the movie is worth $20 to the college students so, if the price is only $10, each has a consumer surplus of $10, and their combined consumer surplus is $100.

If the theater can price discriminate by charging senior citizens $10 and college students $20, its profit increases to $400. Its profit rises because the theater makes $200 from the seniors (the same amount as when it was selling all tickets for $10) but gets an extra $100 from the college students ($10 more from each of the 10 students).

By price discriminating, the theater sells the same number of seats but makes more money from the college students, capturing all the consumer surplus they had under uniform pricing. Neither group of customers has any consumer surplus if the theater price discriminates.

In panel b, the theater potentially has 10 college student and 5 senior citizen customers. If the theater must charge a single price, it charges $20. Only college students see the movie, so the theater’s profit is $200. (If it charges $10, both students and seniors go to the theater, but its profit is only $150.) If the theater can price discriminate and charge seniors $10 and college students $20, its profit increases to $250. Here the gain from price discrimination comes from selling more tickets (those sold to seniors) and not from making more money on the same number of tickets, as in panel a. The theater earns as much from the students as before and makes more from the seniors, and neither group enjoys any consumer surplus. TABLE 10.1 Theater Profits Based on the Pricing Method Used (a) No Extra Customers from Price Discrimination PricingProfit from 10 College StudentsProfit from 20 Senior Citizens Total Profit Uniform, $10 $100 $200 $300 Uniform, $20 $200 $0 $200 Price discrimination * $200 $200 $400 (b) Extra Customers from Price Discrimination PricingProfit from 10 College StudentsProfit from 5 Senior Citizens Total Profit Uniform, $10 $100 $50 $150 Uniform, $20 $200 $0 $200 Price discrimination * $200 $50 $250 *The theater price discriminates by charging college students $20 and senior citizens $10.

Notes: College students go to the theater if they are charged no more than $20. Senior citizens are willing to pay up to $10. The theater ’s marginal cost for an extra customer is zero. 315 10.1 Conditions for Price Discrimination These examples illustrate the two channels through which price discrimination can increase profit: charging some existing customers more or selling extra units.

Leslie (1997) found that Broadway theaters in New York increase their profits 5% by price discriminating rather than using uniform prices.

In the examples just considered, the movie theater’s ability to increase its profits by price discrimination arises from its ability to segment the market into two groups, students and senior citizens, with different levels of willingness to pay. Mini-Case Disneyland, in southern California, is a well-run operation that rarely misses a trick when it comes to increasing its profit. (Indeed, Disneyland mints money:

When you enter the park, you can exchange U.S. currency for Disney dollars, which can be spent only in the park.) 3 In 2012, Disneyland charged out-of-state adults $199 for a 3-day park hopper ticket, which admits one to Disneyland and Disney’s California Adventure Park, but charged residents of southern California only $154. This policy of charging locals a discounted price makes sense if visitors are willing to pay more than locals and if Disneyland can prevent locals from selling discounted tickets to nonlocals. Imagine a Midwesterner who’s never been to Disneyland and wants to visit. Travel accounts for most of the trip’s cost, so an extra few dollars for entrance to the park makes little percentage difference in the total cost of the visit and hence does not greatly affect that person’s decision whether to go. In contrast, for a local who has been to Disneyland many times and for whom the entrance price is a larger share of the total cost, a slightly higher entrance fee might prevent a visit. 4 Charging both groups the same price is not in Disney’s best interest. If Disney were to charge the higher price to everyone, many locals wouldn’t visit the park. If Disney were to use the lower price for everyone, it would be charging nonresidents much less than they are willing to pay. Thus price discrimination increases Disney’s profit. 3According to www.babycenter.com, it costs $411,214 to raise a child from cradle through college.

Parents can cut that total in half, however: They don’t have to take their kids to Disneyland.

4In 2012, a Southern Californian couple, Jeff Reitz and Tonya Mickesh, were out of work, so they decided to cheer themselves up by using their annual passes to visit Disneyland 366 days that year (a leap year). Disneyland Pricing Which Firms Can Price Discriminate Not all firms can price discriminate. For a firm to price discriminate successfully, three conditions must be met.

First, a firm must have market power. Without market power, a firm cannot charge any consumer more than the competitive price. A monopoly, an oligopoly firm, or a monopolistically competitive firm might be able to price discriminate. However, a 316 CHAPTER 10 Pricing with Market Power perfectly competitive firm cannot price discriminate because it must sell its product at the given market price.

Second, for a firm to profitably discriminate, groups of consumers or individual consumers must have demand curves that differ, and the firm must be able to identify how its consumers’ demand curves differ. The movie theater knows that college students and senior citizens differ in their willingness to pay for a ticket, and Disneyland knows that tourists and local residents differ in their willingness to pay for admission. In both cases, the firms can identify members of these two groups by using driver’s licenses or other forms of identification. Similarly, if a firm knows that each individual’s demand curve slopes downward, it may charge each customer a higher price for the first unit of a good than for subsequent units.

Third, a firm must be able to prevent or limit resale. The price-discriminating firm must be able to prevent consumers who buy the good at low prices from reselling the good to customers who would otherwise pay high prices. Price discrimination doesn’t work if resale is easy because the firm would be able to make only low-price sales. A movie theater can charge different prices for different groups of customers because those customers normally enter the theater as soon as they buy their tickets, and therefore they do not have time to resell them. For events that sell tickets in advance, other methods can be used to prevent resale, such as having different colors for children’s tickets and adults’ tickets.

The first two conditions—market power and the ability to identify groups with different price sensitivities—are present in many markets. Usually, the biggest obstacle to price discrimination is a firm’s inability to prevent resale.

In some industries, preventing resale is easier than in others. In industries where resale is initially easy, managers can act to make resale more costly.

Resale is difficult or impossible for most services. If a plumber charges you less than your neighbor for fixing a clogged water pipe, you cannot make a deal with your neighbor to resell this service. Even for physical goods, resale is difficult when transaction costs are high. The higher the transaction costs a consumer must incur to resell a good, the less likely resale becomes. Suppose that you are able to buy a 50-pound bag of cement (which, in addition to being heavy, is also dusty) for $1 less than the usual price. Would you take the time and trouble to buy the cement and seek a buyer willing to pay an extra dollar, or would the transaction costs be prohibitive? The more valuable a product is and the more widely consumed it is, the more likely it is that transaction costs are low enough to allow resale.

Some firms act to raise transaction costs or otherwise make resale difficult. If your college requires that someone with a student ticket to a sporting event show a student identification card containing a photo, it will be difficult to resell your low-price tickets to nonstudents who pay higher prices. When students at some universities buy computers at lower-than-usual prices, they must sign a contract that forbids resale of the computer. Disney prevents resale by locals who can buy a ticket at a lower price by checking driver’s licenses and requiring that the ticket be used for same-day entrance.

Governments frequently aid price discrimination by preventing resale.

Governmenttariffs (taxes on imports) limit resale by making it expensive to buy a branded good in a low-price country and resell it in a high-price country. For example, under U.S. trade laws, certain brand-name perfumes may not be sold in Preventing Resale Managerial Implication 317 10.1 Conditions for Price Discrimination Not All Price Differences Are Price Discrimination Not every seller who charges consumers different prices is price discriminating. A firm price discriminates by charging different prices for units of a good that cost the same to produce. In contrast, newsstand prices and subscription prices for maga- zines differ in large part because of the higher cost of selling at a newsstand rather than the lower cost of mailing magazines directly to consumers.

The 2013 price for 51 weekly issues of the Economist magazine for a year is $356 if you buy it at the newsstand, $160 for a standard print subscription, and $96 for a college student subscription. The difference between the newsstand cost and the standard subscription cost reflects, at least in part, the higher cost of selling magazines at a newsstand versus mailing them directly to customers, so this price difference does not reflect pure price discrimination. In contrast, the price difference between the standard subscription rate and the college student rate does reflect pure price discrimination because the two subscriptions are identical in every respect except the price.

the United States except by their manufacturers. Similarly, if the countries have very different safety rules, a product sold in one country might not be legally sold in another.

However, such a resale is legal for many products. Imported goods that go through legal, but unofficial channels that are unauthorized by the original manufacturer are said to sell in a gray market or parallel market. To make such a transaction unattractive Nikon provides a warranty that is only good in the country in which the good is supposed to be sold. Similarly, Canon sells a Rebel DSLR camera in the United States, but calls it the EOS DSLR elsewhere. Mini-Case During the holiday season, stores often limit how many of the hottest items— such as this year’s best-selling toy—a customer can buy. But it may surprise you that websites of luxury-goods retailers such as Saks Fifth Avenue, Neiman Marcus, and Bergdorf Goodman limit how many designer handbags a person can buy: “Due to popular demand, a customer may order no more than three units of this item every 30 days.” Why wouldn’t manufacturers and stores want to sell as many units as possible? How many customers can even afford more than three Prada Visone Hobo handbags at $4,950 each? The simple explanation is that the restriction has nothing to do with “popular demand.” Instead, it’s designed to prevent resale so as to enable manufacturers to price discriminate internationally. The handbag manufacturers pressure the U.S. retailers to limit sales to prevent anyone from buying large numbers of bags and reselling them in Europe or Asia where the same items in Prada and Gucci stores often cost 20% to 40% more. For example, the Prada Nappa Antique Tote sells for $1,280 at Saks Fifth Avenue in New York City, but sells for $1,570 on Prada’s Swiss website. A weak U.S. dollar makes such international resale even more attractive, which explains why Prada’s online site allows shipments only to selected countries, expressly forbids resale, and limits purchases. Preventing Resale of Designer Bags 318 CHAPTER 10 Pricing with Market Power Types of Price Discrimination Traditionally, economists focus on three types of price discrimination: perfect price discrimination, group price discrimination, and nonlinear price discrimination. With perfect price discrimination—also called first-degree price discrimination—the firm sells each unit at the maximum amount any customer is willing to pay. Under perfect price discrimination, price differs across consumers, and a given consumer may pay higher prices for some units than for others.

Withgroup price discrimination—also called third-degree price discrimination— the firm charges each group of customers a different price, but it does not charge different prices within the group. The price that a firm charges a consumer depends on that consumer’s membership in a particular group. Thus not all customers pay different prices—the firm sets different prices only for a few groups of customers.

Group price discrimination is the most common type of price discrimination.

A firm engages in nonlinear price discrimination (also called second-degree price discrimination) when it charges a different price for large purchases than for small quantities, so that the price paid varies according to the quantity purchased. With pure nonlinear price discrimination, all customers who buy a given quantity pay the same price; however, firms can combine nonlinear price discrimination with group price discrimination, setting different nonlinear price schedules for different groups of consumers. 10.2 Perfect Price Discrimination A firm with market power that knows exactly how much each customer is willing to pay for each unit of its good and that can prevent resale, can charge each person his or her reservation price: the maximum amount a person is willing to pay for a unit of output. Such an all-knowing firm can perfectly price discriminate. By selling each unit of its output to the customer who values it the most at the maximum price that person is willing to pay, the perfectly price-discriminating monopoly captures all possible consumer surplus.

Perfect price discrimination is rare because firms do not have perfect information about their customers. Nevertheless, it is useful to examine perfect price discrimi- nation because it is the most efficient form of price discrimination and provides a benchmark against which we can compare other types of nonuniform pricing.

We now show how a firm with full information about consumer reservation prices can use that information to perfectly price discriminate. Next, we compare the market outcomes (price, quantity, surplus) of a perfectly price-discriminating monopoly to those of perfectly competitive and uniform-price monopoly firms.

How a Firm Perfectly Price Discriminates A firm with market power that can prevent resale and has full information about its customers’ willingness-to-pay price discriminates by selling each unit at its reservation price—the maximum amount any consumer would pay for it. The maximum price for any unit of output is given by the height of the demand curve at that output level. In the demand curve facing a monopoly in Figure 10.1, the first customer is willing to pay $6 for a unit, the next is willing to pay $5, and so forth. A perfectly price-discriminating firm sells its first unit of output for $6. Having sold the first unit, the firm can get at most $5 for its second unit. The firm must drop its price by $1 for each successive unit it sells. 319 10.2 Perfect Price Discrimination A perfectly price-discriminating firm’s marginal revenue is the same as its price.

As the figure shows, the firm’s marginal revenue is MR 1=$6 on the first unit, MR 2=$5 on the second unit, and MR 3=$4 on the third unit. As a result, if it can perfectly price discriminate, a firm’s marginal revenue curve is the same as its demand curve.

This firm has a constant marginal cost of $3 per unit. It pays for the firm to produce the first unit because the firm sells that unit for $6, so its marginal revenue exceeds its marginal cost by $3. Similarly, the firm sells the second unit for $5 and the third unit for $4. The firm breaks even when it sells the fourth unit for $3. The firm is unwilling to sell more than four units because its marginal cost would exceed its marginal revenue on all successive units. Thus, like any profit-maximizing firm, a perfectly price-discriminating firm produces at point e, where its marginal revenue curve intersects its marginal cost curve.

This perfectly price-discriminating firm earns revenues of MR 1+MR 2+MR 3+ MR 4=$6+$5+$4+$3=$18, which is the area under its marginal revenue curve up to the number of units, four, it sells. If the firm has no fixed cost, its cost of producing four units is $12=$3*4, so its profit is $6. Perfect Price Discrimination Is Efficient but Harms Some Consumers Perfect price discrimination is efficient: It maximizes the sum of consumer surplus and producer surplus. Therefore, both perfect competition and perfect price discrimination maximize total surplus. However, with perfect price discrimination, the entire surplus goes to the firm, whereas under competition consumers obtain some surplus.

If the market illustrated in Figure 10.2 is competitive, the intersection of the demand curve and the marginal cost curve, MC, determines the competitive equilibrium at e c, MR 4 = $3 p, $ per unit 6 5 4 3 2 1 Q, Units per day 6 5 4 3 2 1 0MC e Demand, Marginal revenue MR 1 = $6MR 2 = $5MR 3 = $4 FIGURE 10.1 Perfect Price Discrimination The monopoly can charge $6 for the first unit, $5 for the second, and $4 for the third, as the demand curve shows. Its marginal revenue is MR 1=$6 for the first unit, MR 2=$5 for the second unit, and MR 3=$4 for the third unit. Thus, the demand curve is also the marginal revenue curve.

Because the firm’s marginal and average cost is $3 per unit, it is unwilling to sell at a price below $3, so it sells 4 units, point e, and breaks even on the last unit. 320 CHAPTER 10 Pricing with Market Power where price is p c and quantity is Q c. Consumer surplus is A+B+C, producer sur- plus is D+E, and society suffers no deadweight loss. The market is efficient because the price, p c, equals the marginal cost, MC c. With a single-price monopoly (which charges all its customers the same price), the intersection of the MC curve and the single-price monopoly’s marginal revenue curve, MR s, determines the output, Q s.5 The monopoly operates at e s, where it charges p s. The deadweight loss from monopoly isC+E. This efficiency loss is due to charging a price, p s, above marginal cost, MC s, so less is sold than in a competitive market. 5We assume that if we convert a monopoly into a competitive industry, the industry’s marginal cost curve—the lowest cost at which an additional unit can be produced by any firm—is the same as the monopolyMC curve. The industry MC curve is the industry supply curve (Chapter 8). p, $ per unit E DC B A Q, Units per day Q s Qc= Q d MC s Demand,MR d MR s pc = MC c ec es ps MC Monopoly Perfect Price Competition Single Price Discrimination Consumer Surplus,CSA+B+CA 0 Producer Surplus,PSD+EB+DA+B+C+D+E Total Surplus, TS = CS + PS A+B+C+D+EA+B+DA+B+C+D+E Deadweight Loss 0C+E 0 FIGURE 10.2 Competitive, Single-Price, and Perfect Price Discrimination Outcomes In the competitive market equilibrium, e c, price is p c, quantity is Q c, consumer surplus is A+B+C, producer surplus is D+E, and society has no deadweight loss.

In the single-price monopoly equilibrium, e s, price is p s, quantity is Q s, consumer surplus falls to A, producer surplus is B+D, and deadweight loss is C+E. In the perfect price discrimination equilibrium, the monopoly sells each unit at the customer’s reservation price on the demand curve. It sells Q d(=Q c) units, where the last unit is sold at its marginal cost. Customers have no consumer surplus, but society has no deadweight loss. 321 10.2 Perfect Price Discrimination A perfectly price-discriminating firm sells each unit at its reservation price, which is the height of the demand curve. As a result, the firm’s price-discrimination marginal revenue curve, MR d, is the same as its demand curve. It sells the Q d unit for p c, where its marginal revenue curve, MR d, intersects the marginal cost curve, MC, so it just covers its marginal cost on the last unit. The firm is unwilling to sell additional units because its marginal revenue would be less than the marginal cost of producing them.

A perfectly price-discriminating firm’s producer surplus from the Q d units it sells is the area below its demand curve and above its marginal cost curve, A+B+C+D+E. Its profit is the producer surplus minus its fixed cost, if any.

Consumers receive no consumer surplus because each consumer pays his or her reservation price. The perfectly price-discriminating firm’s profit-maximizing solu- tion has no deadweight loss because the last unit is sold at a price, p c, that equals the marginal cost, MC c, as in a competitive market. Thus, both a perfect price discrimina- tion outcome and a competitive equilibrium are efficient.

The perfect price discrimination solution differs from the competitive equilibrium in two important ways. First, in the competitive equilibrium, everyone is charged a price equal to the equilibrium marginal cost, pc=MC c; however, in the perfect price dis- crimination equilibrium, only the last unit is sold at that price. The other units are sold at customers’ reservation prices, which are greater than p c. Second, consumers receive some net benefit (consumer surplus, A+B+C) in a competitive market, whereas a perfectly price-discriminating monopoly captures all the surplus or potential gains from trade. Thus, perfect price discrimination does not reduce efficiency—both output and total surplus are the same as under competition—but it does redistribute income away from consumers. Consumers are much better off under competition.

Is a single-price or perfectly price-discriminating monopoly better for consumers? The perfect price discrimination equilibrium is more efficient than the single-price monopoly equilibrium because more output is produced. A single-price monopoly, however, takes less consumer surplus from consumers than a perfectly price-discriminating monopoly. Consumers who put a very high value on the good are better off under single-price monopoly, where they have consumer surplus, than with perfect price discrimination, where they have none. Consumers with lower reservation prices who purchase from the perfectly price-discriminating monopoly but not from the single-price monopoly have no consumer surplus in either case. All the social gain from the extra output goes to the seller under perfect price discrimination. Consumer surplus is greatest with competition, lower with single-price monopoly, and eliminated by perfect price discrimination. Mini-Case To show how perfect price discrimination differs from competition and single- price monopoly, we revisit the Mini-Case on Allergan’s Botox from Chapter 9.

The graph shows our estimated linear demand curve for Botox and a constant marginal cost (and average variable cost) of $25 per vial. If the market were competitive (so that price equals marginal cost at e c), consumer surplus would be the triangle A+B+C=$750 million per year, and there would have been no producer surplus or deadweight loss. In the (actual) single-price monopoly equilibrium,e s, the Botox vials sell for $400 each, and one million vials are sold.

The corresponding consumer surplus is triangle A=$187.5 million per year, producer surplus is rectangle B=$375 million, and the deadweight loss is tri- angleC=$187.5 million. Botox Revisited 322 CHAPTER 10 Pricing with Market Power If Allergan could perfectly price discriminate, its producer surplus would double to A+B+C=$750 million per year, and consumers would obtain no consumer surplus. The marginal consumer would pay a price equal to the marginal cost of $25, just as in a competitive market.

Both Allergan and society suffer from Allergan’s inability to perfectly price discriminate. The profit of the single-price monopoly is $375 million per year, which is lower than what it could earn if it used perfect price discrimination, A+B+C=$750 million per year. Similarly, society’s total surplus under single-price monopoly is lower than under perfect price discrimination by the deadweight loss, C, of $187.5 million per year. Q&A 10.1 How does total surplus change if the movie theater described in Table 10.1 goes from charging a single price to perfectly price discriminating?

Answer 1.Calculate total surplus for panel a (a) if the theater sets a single price, (b) if it perfectly price discriminates, and (c) compare them. (a) If the theater sets the profit-maximizing single price of $10, it sells 30 tickets and makes a profit of $300. The 20 senior citizen customers are paying their reservation price, so they p, $ per vial 2 2.07 A ≈ $187.5 million C ≈ $187.5 million B ≈ $375 millionDemand Q, Million vials of Botox per year 400 25 0e s ec MC = AV C MR 775 Monopoly Perfect Price Competition Single Price Discrimination Consumer Surplus,CSA+B+C A0 Producer Surplus,PS0BA+B+C A+ B+ CA+BA+B+C Deadweight Loss 0C0 1 Total Surplus, TS = CS + PS 323 10.2 Perfect Price Discrimination Individual Price Discrimination Perfect price discrimination is rarely fully achieved in practice because firms lack full information about individuals’ reservation prices. For example, a coffee shop would have to know that Yi Lin is willing to pay $4 for her first cup of coffee, $3 for her second, and so on and then actually charge these amounts. We use the termindividual price discrimination to refer to a situation in which a firm charges individual-specific prices to different consumers, which may or may not exactly equal consumers’ reservation prices. Even if firms cannot achieve perfect price discrimination, imperfect individual price discrimination can increase their profits significantly.

Some firms do a good job of estimating each person’s reservation price. At most car dealerships, a salesperson negotiates with potential buyers. During the discussions, the salesperson tries to determine each individual’s reservation price from the buyer’s comments and appearance. Is the potential buyer a local? Is the buyer wearing expensive clothing? Does the buyer claim to own other expensive cars? The salesperson uses this information to estimate the buyer’s reservation price and offers to sell the car at that price. As a result, prices vary across consumers for a given car. Similarly, the managers of the Suez Canal set tolls on an individual ship-by-ship basis, taking into account many factors such as weather and each ship’s alternative routes.

Private colleges request and receive financial information from students, which allows the schools to apply individual price discrimination. The schools give partial scholarships as a means of reducing tuition to relatively poor students who presumably have lower willingness to pay than wealthier students.

Transaction costs are a major reason why these firms do not perfectly price discriminate: It is often too difficult or costly to gather information about each customer’s reservation price for each unit of the product. However, recent advances in computer technologies have lowered these transaction costs, causing hotels, car and truck rental companies, cruise lines, airlines and other firms to increasingly use individual price discrimination, as the following Mini-Case illustrates. have no consumer surplus. The 10 college students have reservation prices of $20, so they have consumer surplus of $10 each for a total of $100. Thus, total surplus is $400: the sum of the producer surplus (which equals profit in this case) of $300, and the consumer surplus of $100. (b) If the firm perfectly price discriminates, it charges seniors $10 and college students $20. Because the theater is charging all customers their reservation prices, they have no con- sumer surplus. The firm’s profit rises to $400. (c) Thus, total surplus is the same ($400) under both pricing systems and output stays the same.

2.Calculate total surplus for panel b (a) if the theater sets a single price, (b) if it perfectly price discriminates, and (c) compare them. (a) If the theater sets the profit-maximizing single price of $20, only college students attend and they receive no consumer surplus. The theater ’s profit (producer surplus) is $200, so total surplus is $200. (b) With perfect price discrimination, consumers have no consumer surplus, but profit increases to $250, so total surplus rises to $250. (c) Thus, total surplus is greater with perfect price discrimination and output is greater. (The result that total surplus increases if and only if output rises holds generally.) 324 CHAPTER 10 Pricing with Market Power 10.3 Group Price Discrimination Most firms have no practical way to estimate the reservation price for each of their customers. But many of these firms know which groups of customers are likely to have higher reservation prices on average than others. A firm engages in group price discrimination by dividing potential customers into two or more groups and setting different prices for each group. Consumer groups may differ by age (such as adults and children), by location (such as by country), or in other ways. All units of the good sold to customers within a group are sold at a single price. As with individual price discrimination, to engage in group price discrimination, a firm must have market power, be able to identify groups with different reservation prices, and prevent resale. Mini-Case Selling over the Internet facilitates price discrimination. Managers often use the termdynamic pricing instead of price discrimination. Dynamic pricing refers to a situation in which the firm can easily and quickly change the price it charges across customers or over time as market conditions change. Basically, the firm tries to charge customers the maximum that each is willing to pay for the product under current conditions. Thus, dynamic pricing based on willingness to pay is the same as price discrimination.

Amazon, a giant among e-commerce vendors, collects an enormous amount of information about its millions of customers’ tastes and willingness to buy. If you’ve shopped at Amazon, you’ve probably noticed that its website now greets you by name (thanks to a cookie it leaves on your computer, which provides information about you to Amazon).

A few years ago, Amazon decided to use this information to engage in dynamic pricing, where the price it charged a customer for a product would depend on that customer’s actions in the recent past—including what the customer bought, the prices they paid, the type of shipping purchased (high speed or regular)—and personal data such as where the customer lives. Several Amazon customers discovered this practice. One man reported on the website DVDTalk.com that he had bought Julie Taylor’s “Titus” for $24.49. The next week, he returned to Amazon and saw that the price had jumped to $26.24. As an experiment, he removed the cookie that identified him, and found that the price dropped to $22.74.

Presumably, Amazon reasoned that a returning customer was less likely to compare prices across websites than was a new customer, and was pricing accordingly. Other DVDTalk visitors reported that regular Amazon customers were charged 3% to 5% more than new customers.

Amazon announced that its pricing variations stopped after it received these complaints. It claimed that the variations were random and designed only to determine price elasticities. A spokesperson explained, “This was a pure and simple price test. This was not dynamic pricing. We don’t do that and have no plans ever to do that.” However, an Amazon customer service representative called it dynamic pricing in an e-mail to a DVDTalk member, noting that dynamic pricing was a common practice among firms. However, Amazon does seem to have stopped the practice. An academic study found only random fluctuations in prices that did not appear to be tied to individuals’ purchasing behavior. Dynamic Pricing at Amazon 325 10.3 Group Price Discrimination For example, first-run movie theaters with market power charge seniors a lower ticket price than they charge younger adults because typically the elderly are unwilling to pay as much to see a movie. By admitting seniors immediately after they prove their age and buy tickets, the theater prevents resale. Group Price Discrimination with Two Groups How does a firm set its prices if it sells to two (or more) groups of consumers with different demand curves and if resale between the two groups is impossible? We explain the process in the following example which looks at a firm that sells to groups of consumers in different countries.

A copyright gives Warner Brothers the legal monopoly to produce and sell the Harry Potter and the Deathly Hallows, Part 2 DVD. Warner engaged in group price discrimination by charging different prices in various countries. It can ignore the problem of resale between the countries because the DVDs have incompatible formats.

A Graphical Approach. If it can prevent customers in the low cost country from reselling the movie in the other country and if it has a constant marginal cost, then a firm that uses group price discrimination can maximize its overall profit by acting like a traditional monopoly in each country separately. Resale is not a problem between the United States and the United Kingdom because these countries use different DVD formats. The marginal cost of production—primarily the cost of replicating a DVD— is constant, m, which is about $1 per unit.

How should Warner Brothers set its prices p A and p B—or, equivalently, Q A and Q B— so that it maximizes its combined profit? Because its marginal cost is the same for both sets of customers, we can use our understanding of a single-price monopoly’s behavior to answer this question. A group-price-discriminating monopoly with a constant marginal cost maximizes its total profit by maximizing its profit from each group separately. Warner Brothers sets its quantities so that the marginal revenue for each group equals the common marginal cost, m, which is about $1 per unit.

The DVD was released during the holiday season of 2011 and sold Q A=5.8 million copies to American consumers at p A=$29 and Q B=2.0 million copies to British consumers at p B=$39 (£25). 6 We estimate that Warner Brothers has a constant marginal cost of m=$1 in both countries. Figure  10.3 shows our estimates of the linear demand curves in the two countries. In panel a, Warner maximizes its U.S.

profit by selling Q A=5.8 million DVDs, where its marginal revenue equals its marginal cost MR A=m=1 (Chapter 9), and charging p A=$29. Similarly in panel b, Warner maximizes its U.K. profit by selling Q B=2.0 million DVDs where MR B=m=$1, and charging p B=$39.

Thus, the price-discriminating firm maximizes its profit by operating where its marginal revenue for each country equals its common marginal cost, m=$1, so the marginal revenues in the two countries are equal:

MR A=m=MR B. (10.1) 6Sources of information and data for this section (viewed July 10, 2012) include Amazon websites for each country, warnerbros.com, the UK Film Council, www.the-numbers.com/dvd/charts/ annual/2011.php, and www.bbc.co.uk/newsbeat/16444062, January 6, 2012. We assume that the demand curves in each country are linear. 326 CHAPTER 10 Pricing with Market Power Using Calculus We can also derive these results using calculus. The group discriminating monopoly’s total profit, π, is the sum of its American profit, πA, and its British profit, πB:

π(Q A,Q B)=π A(Q A)+π B(Q B)=[R A(Q A)-mQ A]+[R B(Q B)-mQ B], where R A(Q A)=p A(Q A)Q A, is the revenue function for Country A,p A(Q A) is the inverse demand function for Country A, and R B(Q B) is similarly defined. Again, because of the constant marginal cost of production, the firm’s profit in either country depends only on the quantity that it sells in that country. 7 To find the Q A and Q B that maximize Warner’s total profit, we can maximize its profit in each country separately as we did in the graphical approach. However, here we solve for the optimal quantities simultaneously (which we would have to do if the marginal cost were not constant). We differentiate the monopoly’s 7For a more general cost function, C(Q A,Q B), Warner’s profit in each country would depend on the amount it sold in both countries. Maximizing Profit for a Group Discriminating Monopoly pA, $ per DVD QA, Million DVDs per year π A 57 (a) United States 1m DWL A 5.8 29CS A DA πB QB, Million DVDs per year MR B DWL B pB, $ per DVD 77 (b) United Kingdom 1m 2.0 39D B MR A 11.8 4.1 CS B FIGURE 10.3 Group Pricing of the Harry Potter DVD Warner Brothers, the monopoly producer of the Harry Potter and the Deathly Hallows, Part 2 DVD, charges more in the United Kingdom, p B=$39 (£25), than in the United States, p A=$29, because demand is more elastic in the United States. Warner Brothers sets the quantity independently in each country, where its relevant marginal revenue equals its common, constant marginal cost, m=$1. As a result, it maximizes its profit by equating the two marginal revenues: MR A=1=MR B. 327 10.3 Group Price Discrimination Prices and Elasticities. We can use Equation 10.1, MR A=m=MR B, to deter- mine how the prices in the two countries vary with the price elasticities of demand at the profit-maximizing outputs. Each country’s marginal revenue is a function of its price and the price elasticity of demand (Chapter 9). The U.S. marginal revenue is MR A=p A(1+1/ε A), where ε A is the price elasticity of demand for U.S. consumers, and the U.K. marginal revenue is MR B=p B(1+1/ε B), where ε B is the price elasticity of demand for British consumers.

Rewriting Equation 10.1 using these expressions for marginal revenue, we find that MR A=p A¢1+1 εA≤=m=p B¢1+1 εB≤=MR B. (10.4) Given that m=$1,p A=$29, and p B=$39 in Equation 10.4, Warner Brothers must believe that ε A=p A/[m-p A]=29/[-28]≈-1.0357 and ε B=p B/[m-p B]= 39/[-38]≈-1.0263. 8 By rearranging Equation 10.4, we learn that the ratio of prices in the two countries can be written as a function of the demand elasticities in those countries:

p B pA =1+1/ε A 1+1/ε B .

(10.5) Substituting the prices and the demand elasticities into Equation 10.5, we determine that p B pA =$39 $29≈1.345≈1+1/(-1.0357) 1+1/(-1.0263)=1+1/ε A 1+1/ε B .

Thus, Warner Brothers apparently believed that the British demand curve was less elastic at its profit-maximizing prices than the U.S. demand curve, as ε B≈-1.0263 8We obtain the expression that ε i=p i/(m-p i) by rearranging the expression in Equation 10.4:

p i(1+1/ε i)=m. profit function with respect to each quantity, holding the other quantity fixed, and set these derivatives equal to zero:

0π(Q A,Q B) 0Q A =dR A(Q A) dQ A -m=0, (10.2) 0π(Q A,Q B) 0Q B =dR B(Q B) dQ B -m=0. (10.3) According to Equation 10.2, the monopoly sets the marginal revenue in Country A,MR A=dR A/dQ A, equal to its constant marginal cost, m. Similarly, Equa- tion 10.3 says the marginal revenue in Country B, MR B=dR B/dQ B, equals the marginal cost, m. Consequently, Equation 10.1 holds: MR A=m=MR B. 328 CHAPTER 10 Pricing with Market Power is closer to zero than is ε A≈-1.0357. Consequently, Warner charged British consumers 34% more than U.S. customers. 9 9By mid-2012, Amazon dropped the price for this DVD at its sites around the world, but maintained its price differentials. Amazon’s U.S. price fell to $7, while its U.K. price dropped to $9.50, which still reflected about the same British markup: 36%. Mini-Case When Supap Kirtsaeng, a Thai math student, was an undergraduate at Cornell University and later a Ph.D. student at the University of Southern California, he found a way to pay for his education. He had his friends and relatives ship him textbooks that they bought in Thailand, which he resold to U.S. college students on eBay and elsewhere, netting hundreds of thousands of dollars.

Why was reselling these books profitable? U.S. textbooks sell at much lower prices in foreign markets. Many of these books differ from their U.S. versions only by having a soft cover with an “international edition” label.

John Wiley & Sons, a publisher, sued Mr. Kirtsaeng for copyright infringement.

The company claimed that by importing and selling its books, Mr. Kirtsaeng infringed the company’s copyright. It asserted that the first-saledoctrine—which allows people who buy something to use or resell it however they want—did not apply to goods produced specifically for sale overseas.

The U.S. Court of Appeals for the 2nd Circuit in New York agreed with Wiley and upheld a $600,000 judgment against Mr. Kirtsaeng. However, in 2013, the U.S. Supreme Court reversed that ruling by a six-to-three vote, concluding that the first-sale rule holds generally. This decision applies to records, movies, art, software, and other goods as well as books that are covered under copyright law. 10 Thus, unless Congress changes the copyright law, publishers will find it more difficult to maintain price differentials across countries. A possible consequence of this ruling is that low-income foreign students will no longer be able to afford textbooks because the foreign price will rise. The U.S. and foreign price will differ by only the transaction cost of reselling the books. If those transaction costs are negligible, a single price will be charged throughout the world.

Alternatively, publishers may prevent resale. One possibility is that they will differentiate U.S. and foreign textbooks substantially to prevent reselling; however, doing so is expensive and time-consuming. Once electronic textbooks become common, students will likely rent the books for the term and be unable to resell them. 10However, the Supreme Court held in 2010 that Omega could prevent Costco from selling its watches produced outside the United States, citing a tiny trademark on each watch, so that they came under the jurisdiction of trademark laws, which provide owners more protection than do copyright laws. Reselling Textbooks Q&A 10.2 A monopoly book publisher with a constant marginal cost (and average cost) of MC=1 sells a novel in only two countries and faces a linear inverse demand curve ofp 1=6- 12Q1 in Country 1 and p 2=9-Q 2 in Country 2. What price would a profit-maximizing monopoly charge in each country with and without a ban against shipments between the countries? 329 10.3 Group Price Discrimination Answer If resale across borders is banned so that price discrimination is possible:

1.Determine the profit-maximizing price that the monopoly sets in each country by setting the relevant marginal revenue equal to the marginal cost. If the monopoly can price discriminate, it sets a monopoly price independently in each country.

The marginal revenue curve is twice as steeply sloped as is the linear inverse demand function (see Q&A 9.1), so the marginal revenue function in Country 1 is MR 1=6-Q 1, as panel a of the figure shows. The monopoly maximizes its profit where its marginal revenue function equals its marginal cost, MR 1=6-Q 1=1=MC.

Solving, we find that its profit-maximizing output is Q1=5. Substituting this expression back into the monopoly’s inverse demand function, we learn that its profit-maximizing price is p 1=3.5, as panel a illustrates. In Country 2, the inverse demand function is p 2=9-Q 2, so the monopoly chooses Q 2 such that MR 2=9-2Q 2=1=MC. Thus, it maximizes its profit in Country 2 where Q 2=4 and p 2=5, as panel b shows.

If imports are permitted so that price discrimination is impossible:

2.Derive the total demand curve. If the monopoly cannot price discriminate, it charges the same price, p, in both countries. The monopoly faces the total demand curve in panel c, which is the horizontal sum of the demand curves for each of the two countries in panels a and b (Chapter  2). If the price is between 6 and 9, the quantity demanded is positive in only Country 2, so the total demand curve (panel c) is the same as Country 2’s demand curve (panel b).

If the price is less than 6 where both countries demand a positive quantity, the total demand curve (panel c) is the horizontal sum of the two individual coun- tries’ demand curves (panels a and b). 11 As panel c shows, the total demand 11Rearranging the inverse demand functions, we find that the Country 1 demand function is Q 1=12-p 1 and the Country 2 demand function is Q 2=9-p 2. As a result for price below 6, the total demand function is Q=(12-2p)+(9-p)=21-3p, where Q=Q 1+Q 2 is the total quantity that the monopoly sells in both countries. MC MR 1 D1 p1, $ per book Q1, Books per day 1 3.56 512 (a) Country 1 MC MR p, $ per book Q, Books per day 1 9 6 4 39 21 (c) Single-Price Monopoly MC D 2 MR 2 p2, $ per book Q2, Books per day 1 9 5 49 (b) Country 2 D 330 CHAPTER 10 Pricing with Market Power curve has a kink at p=6, because the quantity demanded in Country 1 is positive only below this price.

3.Determine the marginal revenue curve corresponding to the total demand curve.

Because the total demand curve has a kink at p=6, the corresponding marginal revenue curve has two sections. At prices above 6, the marginal revenue curve is the same as that of Country 2 in panel b. At prices below 6, where the total demand curve is the horizontal sum of the two countries’ demand curves, the marginal revenue curve has twice the slope of the linear total inverse demand curve. The inverse total demand function is p=7- 13Q, and the marginal revenue function is MR = 723Q. 12 Panel c shows that the marginal revenue curve jumps—is discontinuous—at the quantity where the total demand curve has a kink.

4.Solve for the single-price monopoly solution. The monopoly maximizes its profit where its marginal revenue equals its marginal cost. From inspecting panel c, we learn that the intersection occurs in the section where both countries are buying the good: MR=7- 23Q=1=MC. Thus, the profit-maximizing output is Q=9. Substituting that quantity into the inverse total demand function, we find that the monopoly charges p=4. Thus, the price of the nondiscriminating monopoly, 4, lies between the two prices it would charge if it could price discriminate: 3.506465. 12From the previous footnote, we know that the total demand function for prices less than 6 is Q=21-3p. Rearranging this expression, we find that the inverse demand function is p=7- 13Q.

Because the marginal revenue function has twice as steep a slope, it is MR=7 - 23Q. Identifying Groups Firms use two main approaches to divide customers into groups. One method is to divide buyers into groups based on observable characteristics of consumers that the firm believes are associated with unusually high or low reservation prices or demand elasticities. For example, movie theaters price discriminate using the age of customers, charging higher prices for adults than for children. Similarly, some firms charge customers in one country higher prices than those in another country.

In 2012, Windows 8 Pro upgrade sold for $95 in the United States, £97 ($125) in the United Kingdom, C$160 ($156) in Canada, €54 ($70) in France, and ¥7,290 ($77) in Japan. Most of these differences are much greater than can be explained by shipping costs and reflect group price discrimination.

Another approach is to identify and divide consumers on the basis of their actions:

The firm allows consumers to self-select the group to which they belong. For exam- ple, customers may be identified by their willingness to spend time to buy a good at a lower price or to order goods and services in advance of delivery.

Firms use differences in the value customers place on their time to discriminate by using queues (making people wait in line) and other time-intensive methods of selling goods. Store managers who believe that high-wage people are unwilling to “waste their time shopping” may have sales that require consumers to visit the store and pick up the good themselves while consumers who order over the phone or online pay a higher price. This type of price discrimination increases profit if people who put a high value on their time also have less elastic demand for the good. 331 10.3 Group Price Discrimination Early adopters of a new product are often very enthusiastic and will pay premium prices. Firms can take advantage of early adopters by charging a high initial price for a new product and then lowering the price after the initial sales are made.

To make sure that price discrimination pays, managers should not offer discounts to all their customers. Rather, they should only give discounts to those consumers who are willing to incur a cost, such as their time, to obtain the discount. Consumers willing to spend extra time to obtain a discount are typically more price-sensitive than others. Skilled managers use a variety of methods to induce customers to self-identify as being price sensitive by incurring a cost. Coupons Many firms use discount coupons to price discriminate. Through this device, firms divide customers into two groups: those who clip coupons and those who do not. People who are willing to spend their time clipping coupons buy cereals and other goods at lower prices than those who value their time more. A 2009 study by the Promotion Marketing Association Coupon Council found that consumers who spend 20 minutes per week clipping and organizing coupons could save up to $1,000 on an average annual grocery bill of $5,000 or more.

More than three-quarters of U.S. consumers redeem coupons at least occasionally. In 2011, coupons with a face value of $470 billion were distributed by consumer package goods mar- keters to U.S. consumers. Of these, 3.5 billion coupons were redeemed for $4.6 billion.

The introduction of digital (for example, EverSave.com and zavers.com) coupons has made it easier for firms to target appropriate groups, but has lowered consumers’ costs of using coupons, which means that a larger share of people use them. Accord- ing to eMarketer, 47% of U.S. adults used online coupons in 2012. Digital coupons are more likely to be redeemed (15%–20%) than are paper coupons (less than 1%). Airline Tickets By choosing between two different types of tickets, airline customers indicate whether they are likely to be business travelers or vacationers. Airlines give customers a choice between high-price tickets with no strings attached and low-price fares that must be purchased long in advance.

Airlines know that many business travelers have little advance warning before they book a flight and have relatively inelastic demand curves. In contrast, vacation travelers can usually plan in advance and have relatively high elasticities of demand for air travel. The airlines’ rules ensure that vacationers with relatively elastic demand obtain low fares while most business travelers with relatively inelastic demand buy high-price tickets (often more than four times higher than the plan-ahead rate). Discounts Managerial Implication 332 CHAPTER 10 Pricing with Market Power Effects of Group Price Discrimination on Total Surplus Group price discrimination results in inefficient production and consumption. As a result, total surplus under group price discrimination is lower than that under competition or perfect price discrimination. However, total surplus may be lower or higher with group price discrimination than with a single-price monopoly.

Group Price Discrimination Versus Competition. Consumer surplus is greater and more output is produced with perfect competition than with group price discrimination. In Figure  10.3, consumer surplus with group price discrimination isCS A for American consumers, shown in panel a and CS B for British consumers, shown in panel b. Under competition, consumer surplus is the area below the demand curve and above the marginal cost curve: CS A+π A+DWL A in panel a andCS B+π B+DWL B in panel b.

Thus, group price discrimination transfers some of the competitive consumer surplus, πA and πB, to the firm as additional profit and causes deadweight loss, DWL A and DWL B, which is reduced consumer surplus that is simply lost or wasted.

The deadweight loss is due to the price-discriminating firm charging prices above marginal cost, which results in reduced production from the optimal competitive level. Group Price Discrimination Versus Single-Price Monopoly. From theory alone, we cannot tell whether total surplus is higher if the monopoly uses group price discrimination or if it sets a single price. Both approaches include a price above marginal cost, so too little is produced relative to competition. If a Reverse Auctions Priceline.com and other online merchants use a name-your-own-price or reverse auction to identify price-sensitive customers. A customer enters a relatively low-price bid for a good, such as a grocery product, or a service, such as a concert ticket. Then the merchant decides whether to accept that bid or not. To keep their less price-sensitive customers from using those methods, airlines force successful Priceline bidders to be flexible: to fly at off hours, to make one or more connections, and to accept any type of aircraft. As Jay Walker, Priceline’s founder explained, “The manufacturers would rather not give you a discount, of course, but if you prove that you’re willing to switch brands, they’re willing to pay to keep you.” Rebates Why do many firms offer a rebate of, say, $5 instead of reducing the price on their product by $5? The reason is that a consumer must incur an extra, time-consuming step to receive the rebate. Thus, only those consumers who are price sensitive or place a low value on their time will actually apply for the rebate. According to a 2009 Consumer Reports survey, 47% of customers always or often apply for a rebate, 23% sometimes apply, 25% never apply, and 5% responded that the question was not applicable to them. 333 10.4 Nonlinear Price Discrimination firm changes from uniform pricing to group price discrimination, it may attract additional price-sensitive customers by charging them low prices, which may cause its total sales to increase.

The closer the firm comes to perfect price discrimination using group price discrimination (by, for example, dividing its customers into many groups rather than just two), the more output it produces, and the less production inefficiency—the greater the total surplus. However, total surplus falls if the firm switches to group price discrimination and total output falls. 13 10.4 Nonlinear Price Discrimination Many firms are unable to determine which of their customers have the highest reservation prices. However, such firms may know that most customers are willing to pay more for the first unit than for successive units—that is, a typical customer’s demand curve is downward sloping. Such a firm can price discriminate by letting the price each customer pays vary with the number of units the customer buys. That is, the firm uses nonlinear price discrimination (second-degree price discrimination).

Here, the price varies with quantity but each customer faces the same nonlinear pricing schedule. 14 To use nonlinear pricing, a firm must have market power and be able to prevent customers who buy at a low price from reselling to those who would otherwise pay a high price.

A 64-ounce bottle of V8 vegetable juice sells for $4.39 or 6.8¢ an ounce, while a 12-ounce bottle sells for $2.79 or 23¢ an ounce. This difference in the price per ounce reflects nonlinear price discrimination unless the price difference is due to cost differences. This quantity discount results in customers who make large purchases paying less per unit than those who make small purchases.

Another nonlinear pricing strategy is block pricing. Many utilities use block pricing schedules, by which they charge one price per unit for the first few units (a block) purchased and a different price per unit for subsequent blocks. Both declining-block and increasing-block pricing are commonly used by gas, electric, water, and other utilities.

The block-pricing monopoly in Figure 10.4 faces a linear demand curve for each identical customer. The demand curve hits the vertical axis at $90 and the horizontal axis at 90 units. The monopoly has a constant marginal and average cost of m=$30.

Panel a shows how this monopoly maximizes its profit if it can engage in nonlinear price discrimination by setting two prices. The firm uses declining block prices to maximize its profit. The firm charges a price of $70 on any quantity between 1 and 20—the first block—and $50 on any units beyond the first 20—the second block. (The points that determine the blocks, $70 and 20 units and $50 and 40 units, lie on the demand curve.) Given each consumer’s demand curve, a consumer decides to buy 40 units and pays $1,400 (=$70*20) for the first block and $1,000 (=$50*20) 13An additional source of inefficiency is time spent by consumers trying to resell the product to high-willingness-to-pay customers or searching for low prices. These activities do not occur if everyone knows the firm sets a uniform price.

14The term nonlinear is used because a consumer’s expenditure is a nonlinear function of the quan- tity purchased. A consumer’s expenditure, E, is a linear function of quantity, q, only if the price, p, is constant:

E=pq. If the price varies with quantity, then the expenditure is not linear in quantity. 334 CHAPTER 10 Pricing with Market Power for the second block. The consumer gains consumer surplus equal to A on the first block and C on the second block, for a total of A+C. The discriminating monopoly’s profit or producer surplus is area B. Society suffers a deadweight loss of D because price, $50, is above marginal cost, $30, on the last unit purchased.

In panel b, the firm can set only a single price. It produces where its marginal revenue equals its marginal cost, and sells 30 units at $60 per unit. By using nonlinear price discrimination instead of setting a single price, the utility sells more units, 40 instead of 30, and makes a larger profit, B=$1,200 instead of F=$900. With quantity discounting, consumer surplus is lower, A+C=$400 instead of E=$450; total surplus (consumer surplus plus producer surplus) is higher, A+B+C=$1,600 instead of E+F=$1,350; and deadweight loss is lower, D=$200 instead of G=$450. Thus, in this example, the firm is better off with nonlinear price discrimi- nation, but consumers as a group suffer. Society as a whole—the combination of the firm and consumers—benefits. p1, $ per unit 30 50 70 90 Q, Units per day 20 40 90 0m (a) Quantity Discrimination Demand A= $200 C= $200 B= $1,200D= $200 p2, $ per unit 30 60 90 Q, Units per day 30 90 0m (b) Single-Price Monopoly Demand F= $900 G= $450 MR E= $450 Block Pricing Single Price Consumer Surplus,CSA+C=$400E=$450 Producer Surplus or Profit,PS=πB=$1,200F=$900 A+B+C=$1,600E+F=$1,350 Deadweight Loss,DWLD=$200G=$450 Total Surplus, TS=CS+PS FIGURE 10.4 Block Pricing If this monopoly engages in block pricing with quantity dis- counting, it makes a larger profit than it does if it sets a single price, and total surplus is greater. (a) With block pricing, its profit is B=$1,200, total surplus is A+B+C=$1,600, and the deadweight loss is D=$200. (b) If the monopoly sets a single price (so that its marginal revenue equals its marginal cost), the monopoly’s profit is F=$900, total surplus is E+F=$1,350, and the deadweight loss is G=$450. 335 10.5 Two-Part Pricing The more block prices that a firm can set, the closer the firm gets to perfect price discrimination, where it captures all the potential consumer surplus, and its profit or producer surplus equals total surplus. Moreover, because the last unit is sold at a price equal to marginal cost, total surplus is maximized and society suffers no deadweight loss. 10.5 Two-Part Pricing We now turn to another form of nonuniform pricing, two-part pricing. It is similar to nonlinear price discrimination in that the average price per unit paid by a consumer varies with the number of units purchased by that consumer.

Withtwo-part pricing, the firm charges each consumer a lump-sum access fee for the right to buy as many units of the good as the consumer wants at a per-unit price. 15 Thus, a consumer’s overall expenditure for amount q consists of two parts: an access fee,A and a per-unit price, p. Therefore, expenditure is E=A+pq. 16 Because of the access fee, the average amount per unit that consumers pay is greater if they buy a small number of units than if they buy a larger number.

Two-part pricing is commonly used. 17 Many fitness clubs charge a yearly access fee and a price per session. Many warehouse stores require that customers buy an annual membership before being allowed to buy goods at relatively low prices. Some car rental firms charge a rental or access fee for the day and an additional price per mile driven. To buy season tickets to the Dallas Cowboys football games in the lower seating areas (at a price from $590 to $1,250), a fan first must pay between $16,000 to $150,000 for a personal seat license (PSL), giving the fan the right to buy season tickets for the next 30 years.

To profit from two-part pricing, a firm must have market power and must successfully prevent resale. In addition, a firm must know how individual demand curves vary across its customers. We start by examining a firm’s two-part pricing problem in the extreme case in which all customers have the same demand curve.

We then consider what happens when the demand curves of individual customers differ. Two-Part Pricing with Identical Consumers If all its customers are identical, a firm that knows its customers’ demand curve can set a two-part price that has the same two important properties that perfect price discrimination has. First, the efficient quantity is sold because the price of the last unit equals marginal cost. Second, all potential consumer surplus is transferred from consumers to the firm.

15The prices used in two-part pricing are often referred to as two-part tariffs.

16The average price varies with quantity with two-part pricing and nonlinear price discrimination.

However, the expenditure in two-part pricing, E=A+pq, is linear in quantity, unlike with nonlinear price discrimination. 17For example, venting stores are springing up in shopping malls in China. A customer pays to enter, and then pays for each second-hand mobile phone, television set, or other product that the customer smashes. (english.people.com.cn/90001/90782/90872/6915069.html, viewed April 17, 2013.) 336 CHAPTER 10 Pricing with Market Power To illustrate these points we consider a monopoly that has a constant marginal cost of MC=10 and no fixed cost, so its average cost is also constant at 10. All of the monopoly’s customers have the same demand curve, Q=80-p. Panel a of Figure 10.5 shows the demand curve, D 1, of one such customer, Valerie.

Total surplus is maximized if the monopoly sets its price, p, equal to its constant marginal cost of 10. The firm breaks even on each unit sold and has no producer surplus. Valerie buys q=70 units. Her consumer surplus is area A=2,450 (= 12*[80-10]*70).

However, if the firm also charges an access fee of 2,450, it captures this 2,450 as its producer surplus or its profit per customer, and leaves Valerie with no consumer surplus. The firm’s total profit is 2,450 times the number of identical customers.

The firm maximizes its profit by setting its price equal to its marginal cost and charging an access fee that captures the entire potential consumer surplus. If the firm were to charge a price above its marginal cost of 10, it would sell fewer units and make a smaller profit. In panel b of Figure  10.5, the firm charges p=20. At that higher price, Valerie buys only 60 units, which is less than the 70 units that she buys at a price of 10 in panel a. The firm’s profit from selling these 60 units is B 1=(20-10)*60=600. For Valerie to agree to buy any units, the monopoly has to lower its access fee to 1,800 (= 12*60*60), the new potential consumer surplus, areaA 1. The firm’s total profit from Valerie is A 1+B 1=1,800+600=2,400. This amount is less than the 2,450 (=Ain panel a) profit the firm earns if it sets price equal to marginal cost, 10, and charges the higher access fee. Area A in panel a equals A 1+B 1+C 1 in panel b. By charging a price above marginal cost, the firm loses C 1, which is the deadweight loss due to selling fewer units. p, $ per unit Q, Units per day 70 80 D 1 80 10MC A= $2,450 p, $ per unit Q1, Units per day 70 80 D 1 10M C A1= $1,800 80 (a) Price Equals Marginal Cost (b) Price Is Above Marginal Cost 20 60C 1= $50 B1= $600 FIGURE 10.5 Two-Part Pricing with Identical Consumers (a) Because all customers have the same individual demand curve as Valerie, D 1, the monopoly captures the entire potential consumer surplus using two-part pricing.

The monopoly charges a per-unit fee price, p, equal to the marginal cost of 10, and an access fee, A=2,450, which is the blue triangle under the demand curve and above the per-unit price of p=10. (b) Were the monop- oly to set a price at 20, which is above its marginal cost, it would earn less. It makes a profit of B 1=600 from the 10 it earns on the 60 units that Valerie buys at this higher price. However, the largest access fee the firm can make now is A1=1,800, so its total profit is 2,400, which is less than the 2,450 it makes if it sets its price equal to marginal cost. The difference is a deadweight loss of C 1=50, which is due to fewer units being sold at the higher price. 337 10.5 Two-Part Pricing Similarly, if the firm were to charge a price below its marginal cost, it would also earn less profit. It would sell too many units and make a loss on each unit that it could not fully recapture by a higher access fee. Two-Part Pricing with Differing Consumers Two-part pricing is more complex if consumers have different demand curves.

Suppose that the monopoly has two customers, Valerie, Consumer 1, and Neal, Consumer 2. Valerie’s demand curve, Q 1=80-p, is D 1 in panel a of Figure 10.6 (which is the same as panel b of Figure 10.5), and Neal’s demand curve, Q 2=100-p, isD 2 in panel b. The monopoly’s marginal cost, MC, and average cost are constant at 10 per unit.

If the firm knows each customer’s demand curve, can prevent resale, and can charge its customers different prices and access fees, it can capture all the potential consumer surplus. The monopoly sets its price for both customers at p=MC=10 and sets its access fee equal to each customer’s potential consumer surplus. At p=10, Valerie buys 70 units (panel a), and Neal buys 90 units (panel b). If no access fees were charged, Valerie’s consumer surplus would equal the triangle below her demand curve and above the 10 price line, A 1+B 1+C 1, which is 2,450 (= 12*70*70).

Similarly, Neal’s consumer surplus would be 4,050 ( = 12* 90 * 90), which is the triangleA 2+B 2+C 2. Thus, the monopoly charges an access fee of 2,450 to Valerie p, $ per unit Q1, Units per day 60 70 80 D 1 80 20 10MC (a) Valerie B 1= $600C 1= $50 A 1= $1,800 p, $ per unit 100 Q 2, Units per day90 100 80 D 2 20 10MC (b) Neal B 2= $800C 2= $50 A 2= $3,200 FIGURE 10.6 Two-Part Pricing with Different Consumers The monopoly faces two consumers. Valerie’s demand curve is D 1 in panel a, and Neal’s demand curve is D 2 in panel b. If the monopoly can set different prices and access fees for its two customers, it charges both a per-unit price of p=10, which equals its marginal cost, and it charges an access fee of 2,450 (=A 1+B 1+C 1) to Valerie and 4,050 (=A 2+B 2+C 2) to Neal. If the monopoly cannot charge its customers different prices, it sets its per-unit price at p=20, where Valerie purchases 60 and Neal buys 80 units. The firm charges both the same access fee of 1,800=A 1, which is Valerie’s potential consumer surplus. The highest access fee that the firm could charge and have Neal buy is 3,200, but at that level, Valerie would not buy. By charging a price above its marginal cost, the firm captures B 1=600 from Valerie and B 2=800 from Neal. Thus, its total profit is 5,000 (=[2*1,800]+600+800), which is less than the 6,500 (=2,450+4,050) it makes if it can charge separate access fees to each customer. 338 CHAPTER 10 Pricing with Market Power and 4,050 to Neal, so that the customers receive no consumer surplus. The firm’s total profit is 2,450+4,050=6,500. The monopoly maximizes its total profit by capturing the maximum potential consumer surplus from both customers.

Now suppose that the firm cannot charge its customers different prices or different access fees. The firm maximizes its profit by setting a price of 20, which exceeds its marginal cost, and collecting an access fee equal to Valerie’s potential consumer sur- plus,A 1=1,800. Although this access fee captures all of Valerie’s potential consumer surplus, it is less than Neal’s potential consumer surplus, 3,200=A 2. Were the firm to charge an access fee of 3,200, it would sell only to Neal and make less money.

Atp=20, Valerie buys 60 units, and Neal buys 80 units. Because the firm’s average cost is 10, the firm makes 20-10=10 per unit, so it earns B 1=600 (=10*60) from Valerie and B 2=800 (=10*80) from Neal for a total=1,400. Adding that to what it makes from the access fees, 3,600, the monopoly’s total profit is 5,000 (=[2*1,800]+600+800). Valerie receives no consumer surplus, but Neal enjoys a consumer surplus of 1,400 (=3,200-1,800).

This 5,000 profit obtained from pure two-part pricing is less than the 6,500 that it could obtain if it could set different access fees for each customer. On the other hand, its profit from pure two-part pricing exceeds the 3,200 profit that the firm could earn from uniform monopoly pricing. 18 Why does the firm charge a price above marginal cost when using two-part pricing in this case? By raising the price, the firm lowers the amount it can earn from the access fee but increases the amount it can earn from the per-unit price. The amount the firm earns from Valerie because of the higher price is less than the amount it loses from her reduced access fee. However, the situation with Neal is reversed. The gain the firm gets from charging Neal the higher price exceeds the loss from Neal’s smaller access fee. Further, the net gain the firm obtains from Neal exceeds the net loss it takes on Valerie, so it is better off overall. 19 Thus, a price above marginal cost increases profit in this case. 18A single-price monopoly faces an aggregate demand function of the sum of the two individual demand functions:

Q=q 1+q 2=(80-p)+(100-p) or Q=180-2p, for p less than 80, where both consumers demand a positive quantity. Its inverse demand function is p(Q) =90- 12Q.

Its revenue function is R(Q) =p(Q)*Q=90Q- 12Q2, so its marginal revenue function is MR=dR(Q)/dQ=90-Q. To maximize its profit given that it sets a uniform price, the monopoly equates its MR and its MC, so that 90-Q=10, or Q=80. At that quantity, the price is p=90-(80/2)=50. The firm’s profit is π=(p-AC)Q=(50-10)*80=3,200. 19If the monopoly charges a price of $10 per unit, this price just covers its costs. Its profit-maximizing access fee is $2,450, which is the sum of areas A 1,B1, and C 1 in panel a of Figure 10.6. Both Valerie and Neal pay this access fee, so the firm earns a profit of $4,900, which is less than the $5,000 it earns by raising its per unit price to $20 and charging an access fee of $1,800. Mini-Case Prior to 2009, Apple’s iTunes music store, the giant of music downloading, useduniform pricing, where it sold songs at 99¢ each. However, some of its competitors, such as Amazon MP3, did not use uniform pricing. Some record labels told Apple that they would not renew their contracts if Apple continued to use uniform pricing. Apparently responding to this pressure and the success of some of its competitors, Apple switched in 2009 to selling each song at one of three prices.

Did Apple’s one-price-for-all-songs policy cost it substantial potential profit?

How do consumer surplus and deadweight loss vary with pricing methods Available for a Song 339 10.6 Bundling such as a single price, song-specific prices, price discrimination, and two-part pricing? To answer such questions, Shiller and Waldfogel (2011) surveyed nearly 1,000 students and determined each person’s willingness to pay for each of 50 popular songs. Then they used this information to calculate optimal pricing under various pricing schemes.

First, under uniform pricing, the same price is charged for every song. Second, under variable pricing, each song sells at its individual profit-maximizing price.

Third, Apple could use two-part pricing, charging a monthly or annual fee for access and then a fixed price for each download.

If we know the demand curve and the marginal cost, we can determine the consumer surplus (CS), the producer surplus (PS), or profit, and the deadweight loss (DWL) from each pricing regime. By dividing each of these surplus measures by the total available surplus—the area under the demand curve and above the marginal cost curve—we can determine the shares of CS,PS, and DWL. The following table shows Shiller and Waldfogel’s estimates of the percentage shares ofCS,PS, and DWL under each of the three pricing methods:

If these students have tastes similar to those of the general market, then Apple raised its profit by switching from uniform pricing to variable pricing (see the PS column in the table). However, these results suggest that it could do even better using two-part pricing. Deadweight loss decreases under both of the alternatives to uniform pricing. Consumers do best with variable pricing, but two-part pricing is also better for consumers than uniform pricing. PricingPS CS DWL Uniform 28 42 29 Variable 29 45 26 Two-part pricing 37 43 20 10.6 Bundling Firms with market power often pursue a pricing strategy called bundling: selling multiple goods or services for a single price. Indeed, most goods are bundles of many separate parts. Cars come assembled. Left and right shoes are sold together as a pair and include laces. Usually this bundling is done for efficiency because combining goods in a bundle reduces the transaction costs incurred by consumers or the production costs associated with the product. For example, we buy shirts with buttons already attached. Rather than buying shirts without buttons, and then buying buttons, consumers prefer to buy assembled shirts, eliminating the need to make two separate purchases and then sew on buttons. It is also cheaper for the firm to sew on buttons in the factory rather than to distribute two separate products (shirts and buttons) to the marketplace.

However, firms sometimes bundle even when they gain no production advantages and transaction costs are small. Bundling of such products allows firms to increase their profit by taking advantage of differences in consumers’ willingness to pay. For 340 CHAPTER 10 Pricing with Market Power example, a computer firm may sell a package including a computer and a printer for a single price even if it has no cost savings from selling these products together.

There are two common types of bundling. Some firms engage in pure bundling, in which only a package deal is offered, as when a cable company sells a bundle of Internet, phone, and television services for a single price but does not allow customers to purchase the individual services separately. Other firms use mixed bundling, in which the goods are available on a stand-alone basis in addition to being available as part of a bundle, such as a cable company that allows consumers to buy the bundle or the individual services they want.

Pure Bundling Microsoft Works is a pure bundle. The primary components of this bundle are a word processing program and a spreadsheet program. These programs have fewer features than Microsoft’s flagship Word and Excel programs and are not sold individually but only as a bundle.

Whether it pays for Microsoft to sell a bundle or sell the programs separately depends on how reservation prices for the components vary across customers. We use an example of a firm selling word processing and spreadsheet programs to illustrate two cases, one in which pure bundling produces a higher profit than selling the components separately, and one in which pure bundling is not profitable.

The marginal cost of producing an extra copy of either type of software is essentially zero. We assume that the fixed cost is negligible so that the firm’s rev- enue equals its profit. The firm must charge all customers the same price—it cannot price discriminate.

The firm has two customers, Alisha and Bob. The first two columns of Table 10.2 show the reservation prices for each consumer for the two products. Alisha’s reservation price for the word processing program, $120, is greater than Bob’s, $90; however, Alisha’s reservation price for the spreadsheet program, $50, is less than Bob’s, $70. The reservation prices are negatively correlated: The customer who has the higher reservation price for one product has the lower reservation price for the other product. The third column of the table shows each consumer’s reservation price for the bundle, which is the sum of the reservation prices for the two underlying products.

If the firm sells the two products separately, it maximizes its profit by charging $90 for the word processor and selling to both consumers, so that its profit is $180, rather than charging $120 and selling only to Alisha. If it charges between $90 and $120, it still only sells to Alisha and earns less than if it charges $120. Similarly, the firm maximizes its profit by selling the spreadsheet program for $50 to both consum- ers, earning $100, rather than charging $70 and selling to only Bob. The firm’s total profit from selling the programs separately is $280 (=$180+$100). Word Processor Spreadsheet Bundle Alisha $120 $50 $170 Bob $90 $70 $160 Profit-maximizing price $90 $50 $160 Units sold 2 2 2 TABLE 10.2 Negatively Correlated Reservation Prices 341 10.6 Bundling If the firm sells the two products in a bundle, it maximizes its profit by charging $160, selling to both customers, and earning $320. This is a better outcome than charging $170 and selling only to Alisha. Pure bundling is more profitable for the firm because it earns $320 from selling the bundle and only $280 from selling the programs separately.

Pure bundling is more profitable because the firm captures more of the consumers’ potential consumer surplus—their reservation prices. With separate prices, Alisha has consumer surplus of $30 (=$120-$90) from the word processing program and none from the spreadsheet program. Bob receives no consumer surplus from the word processing program and $20 from the spreadsheet program. Thus, the total consumer surplus is $50. With pure bundling, Alisha gets $10 of consumer surplus and Bob gets none, so the total is only $10. Thus, the pure bundling approach captures $40 more potential consumer surplus than does pricing separately.

Whether pure bundling increases the firm’s profit depends on the reservation prices. Table 10.3 shows the reservation prices for two different consumers, Carol and Dmitri. Carol has higher reservation prices for both products than does Dmitri. These reservation prices are positively correlated: A higher reservation price for one product is associated with a higher reservation price for the other product.

If the programs are sold separately, the firm charges $90 for the word processor, sells to both consumers, and earns $180. However, it makes more charging $90 for the spreadsheet program and selling only to Carol, than it does charging $40 for the spreadsheet, selling to both consumers, and earning $80. The firm’s total profit if it prices separately is $270 (=$180+$90).

If the firm uses pure bundling, it maximizes its profit by charging $130 for the bundle, selling to both customers, and making $260. Because the firm earns more selling the programs separately, $270, than when it bundles them, $260, pure bundling is not profitable in this example. Even if Dmitri placed a higher value on the spreadsheet, as long as reservation prices are positively correlated, pure bundling cannot increase the profit. Mixed Bundling Restaurants, computer software firms, and many other companies commonly use mixed bundling—allowing consumers to buy the pure bundle or to buy any of the bundle’s components separately. For example, Microsoft not only sells the bundle Microsoft Office, which includes Microsoft Word, Microsoft Excel, and various other programs, but it also sells the various programs individually. The following example illustrates that mixed bundling may be more profitable than pure bundling Word Processor Spreadsheet Bundle Carol $100 $90 $190 Dmitri $90 $40 $130 Profit-maximizing price $90 $90 $130 Units sold 2 1 2 TABLE 10.3 Positively Correlated Reservation Prices 342 CHAPTER 10 Pricing with Market Power or only selling components separately because it captures more of the potential consumer surplus.

A firm that sells word processing and spreadsheet programs has four potential customers with the reservation prices in Table  10.4. Again, the firm’s cost of production is zero, so maximizing its profit is equivalent to maximizing its revenue.

Aaron, a writer, places high value on the word processing program but has relatively little use for a spreadsheet program. Dorothy, an accountant, has the opposite pattern of preferences—placing a high value on having the spreadsheet program but little value on a word processing program. Brigitte and Charles have intermediate reservation prices. These reservation prices are negatively correlated:

Customers with a relatively high reservation price for one product have relatively low reservation prices for the other program. To determine its best pricing strategy, the firm calculates its profit by pricing the components separately, using pure bundling, and engaging in mixed bundling.

If the firm prices each program separately, it maximizes its profit by charging $90 for each product and selling each to three out of the four potential customers. It sells the word processing program to Aaron, Brigitte, and Charles. It sells the spreadsheet program to Brigitte, Charles, and Dorothy. Thus, it makes $270 (=3*$90) from each program or $540 total, which exceeds what it could earn by setting any other price per program. 20 However, the firm can make a higher profit by engaging in pure bundling. It can charge $150 for the bundle, sell to all four consumers, and earn $600, which is $60 more than the $540 it makes from selling the programs separately.

With mixed bundling, the firm obtains an even larger profit. It charges $200 for the bundle and $120 for each product separately. The firm earns $400 from Brigitte and Charles, who buy the bundle. Aaron buys only the word processing program for $120, and Dorothy buys only the spreadsheet for another $120, so that the firm makes $240 from its individual program sales. Thus its profit is $640 (=$400+$240) from mixed bundling, which exceeds the $600 from pure bundling, and the $540 from individual sales. We could construct other examples with different numbers where selling the programs separately would dominate (such as where reservation prices are positively correlated as in Table 10.3) or where the pure bundle does best (as in Table 10.2). 20If it sets a price of a program as low as $30, it sells both programs to all four customers, but makes only $240. If it charges $110 it sells each program to two customers and earns $440. If it charges $120, it makes a single sale of each program, so it earns $240. Word Processor Spreadsheet Bundle Aaron $120 $30 $150 Brigitte $110 $90 $200 Charles $90 $110 $200 Dorothy $30 $120 $150 TABLE 10.4 Reservation Prices and Mixed Bundling 343 10.6 Bundling Q&A 10.3 Package deals are common in vacation travel. Online travel services such as Expedia, Orbitz, and Travelocity allow travelers to find many attractive package deals that combine a round-trip airfare and a hotel stay or to book airline flights and hotels individually. At some locations, the package price is much less than the sum of the prices for a flight and a hotel room, whereas at other locations, the package pro- vides little savings. Paradise Vacations has two destinations, Hawaii and Cleveland, to which it sends its customers who live in Seattle. The table shows reservation prices for a weekend holiday for the two destinations for three customers. We assume that both hotels and aircraft have excess capacity so that the marginal cost of one more customer is zero.

What are the profit-maximizing pricing strategies for the two destinations? Which destination yields the bigger package deal discount under mixed bundling?

Answer 1.Determine the best stand-alone prices, bundle price, and mixed bundling prices for Hawaii. If the firm prices the flight and the hotel separately, its profit-maximizing prices are $350 for each. The firm sells two units of each product (Allen and Barbara buy flights, and Barbara and Colin rent hotel rooms) and earns $1,400.

The best bundle price is $450, which, although all three customers buy, gen- erates a profit of only $1,350. Therefore, pricing the components separately produces a higher profit than does the bundle. However, mixed bundling pro- duces the highest profit. The firm charges $700 for the bundle and $400 for each stand-alone product, earning a total of $1,500 by selling one bundle to Barbara, one flight to Allen, and one hotel stay to Colin.

2.Determine the best stand-alone prices, bundle price, and mixed bundling prices for Cleveland. With individual pricing, the firm charges $300 for each product, sell- ing two units of each, and makes a profit of $1,200. Bundling is more profitable.

At a bundle price of $450, all customers buy the bundle, generating a profit of $1,350. Mixed bundling is better still. By charging $600 for the bundle and $400 for each item, the firm’s profit is $1,400.

3.Under mixed bundling, compare the bundle price and combined individual prices for Hawaii and Cleveland. For Hawaii with mixed bundling pricing, the cost of a flight and a hotel stay is $800 if purchased separately while the bundle price is $700, for a $100 saving. In Cleveland, the sum of the individual prices is $800 and the bundle price is only $600, for a $200 savings.

Comments: Hawaii has a relatively low bundling discount because Barbara places a very high value on the bundle compared to other customers who are primarily interested in just one of the products. The firm can charge almost as much for the bundle as for the individual prices and still sell to Barbara. For the Cleveland market, Barbara requires a bigger discount for the bundle compared to the sum of the individual prices. Hawaii Cleveland Flight Hotel Bundle Flight Hotel Bundle Allen $400 $50 $450 $400 $50 $450 Barbara $350 $350 $700 $300 $300 $600 Colin $50 $400 $450 $50 $400 $450 344 CHAPTER 10 Pricing with Market Power Managers can increase profit by promoting consumer loyalty. Despite the Magnuson-Moss Act, such loyalty can be induced through warranty provisions.

Printer firms such as Hewlett-Packard (HP) write their warranties to strongly encourage consumers to use only their cartridges and not to refill them:

.  .  .  [I]f printer failure or damage is attributable to the use of a non-HP or refilled cartridge or an expired ink cartridge, HP will charge its standard time and materials charges to service the printer for the particular failure or damage.

Moreover, the company’s literature stresses that HP recommends that you use original HP cartridges. Original HP cartridges are designed and tested with HP printers to help you easily produce great results, time after time.

Are these warranty restrictions and advertising claims sufficient to induce most consumers to buy cartridges only from HP? Apparently so. HP sells its Deskjet D1660 printer for only $29.99. That is, HP is virtually giving away an impressive machine that will print up to 20 pages per minute in black and white and 16 pages per minute in color in up to 4800*1200 optimized dots per inch (dpi) in color. However, HP charges $31.99 for its black and color combination cartridge, which it rates for at most 200 pages in black or 165 in color. If most customers bought inexpensive cartridges or refills from other firms, HP would not sell its printer at a rock-bottom price. Thus, HP demonstrates that the benefits of requirement tie-in sales can be achieved through careful wording of warranties and advertising. Ties That Bind Managerial Implication 10.7 Peak-Load Pricing Rooms in Florida’s resort hotels that can be rented for $100 or $200 per night in the hot, humid summer months often rent for twice as much in the winter months of January and February when snowbirds from northern states and Canada flock to Florida’s warm, sunny beaches. Similarly, in many areas, electricity costs more during business hours than at night. Such pricing strategies are examples of Requirement Tie-In Sales One form of bundling—called a requirement tie-in—requires customers who buy one product from a firm to make all concurrent and subsequent purchases of a related product from that firm. This requirement allows the firm to identify heavier users and charge them more per unit. For example, if a printer manufacturer can require that consumers buy their ink cartridges only from the manufacturer, then that firm can capture most of the consumers’ surplus. Heavy users of the printer, who presum- ably have a less elastic demand for it, pay the firm more than light users because of the high cost of the ink cartridges.

Unfortunately for such a printer manufacturer, the Magnuson-Moss Warranty Improvement Act of 1975 forbids them from requiring consumers to use their ink cartridges as a condition of the warranty. More broadly, the Act prevents any manu- facturer from using such tie-in provisions as a condition of warranty. 345 10.7 Peak-Load Pricing peak-load pricing: charging higher prices during periods of peak demand than in other periods.

Peak-load pricing is commonly used when firms face a production capacity constraint. For example, a hotel’s capacity constraint is the maximum number of rooms, Q , that it can rent. As Figure 10.7 illustrates, the hotel’s marginal cost—primarily the cost of cleaning and maintaining the room—is constant at m up to capacity, where no additional room can be provided at any finite cost in the short run. That is, the marginal cost curve is horizontal at m up to capacity Q , where it becomes vertical.

During the low season, the hotel’s demand curve is D L and its marginal revenue curve is MR L. The hotel maximizes its profit by operating where its marginal revenue equals its marginal cost. Its marginal revenue curve hits the marginal cost curve in its horizontal section at Q L. The corresponding price is p L. Thus, during the off-season, the hotel’s price is above its marginal cost, and it does not rent all available rooms, so the hotel has excess capacity.

The high- or peak-season demand curve D H lies to the right of the low-season demand curve, D L. The peak-season marginal revenue curve, MR H, hits the marginal p, $ per room Q, Rooms per day MC e L m pL QL eH DH DL pH Q = Q H MR L MR H FIGURE 10.7 Peak-Load Pricing A resort has Q rooms, which is its capacity constraint. Its marginal cost of providing a room is m up to Q and then becomes infinite because the hotel cannot provide more than Q rooms. During the low season, the demand curve is D L and the associated marginal revenue curve is MR L. The firm maximizes its profit by renting the number of rooms where its marginal revenue curve crosses its marginal cost curve in the horizontal region and sets its price at p L and rents QL rooms as shown by point e L. The hotel has excess capacity because Q L6Q. During the peak season, the demand curve is D H. The firm maximizes its profit by setting price, p H, so that the quantity demanded is just equal to the available capacity, because its marginal revenue curve, MR H, crosses the marginal cost curve in the vertical section. The price is p H, and the hotel has no excess capacity. 346 CHAPTER 10 Pricing with Market Power cost curve where it is vertical at Q . Here, the firm maximizes its profit by charging a pricep H such that the quantity demanded, Q H, equals the available capacity, Q . Thus, in the peak period, the hotel charges a price, p H, that limits the quantity demanded to the available capacity. Mini-Case The four major pricing tools that we’ve discussed—price discrimination, two-part pricing, bundling, and peak-load pricing—are not mutually exclusive.

The Whistler Blackcomb ski resort (Whistler) near Vancouver, British Columbia, uses all four pricing tools.

Whistler satisfies the three necessary conditions to be able to apply these nonuniform pricing tools. First, it has considerable market power as one of North America’s top ski resorts. Second, it is able to obtain extensive information about each of its customers. When a consumer buys a ski pass, that transaction goes into a database, typically linked to a credit card or a driver’s license. Whistler is then able to keep track of that person’s skiing habits and other expenditures at the resort over time. And third, Whistler is able to prevent resale or the sharing of discount tickets, such as season passes and various other multiday passes, by putting the person’s photo on the pass.

Whistler engages in individual price discrimination based on individuals’ skiing history. Because Whistler tracks indi- vidual skiing frequency and links that information to the person’s address, Whistler is able to send skiers customized promotional letters, offering them special promotions such as a discounted lesson or a special discount on a daily pass.

Whistler also uses nonlinear price discrimination, offering multiday passes at lower prices per day than single-day passes and offering tickets to large groups at discount prices.

Skiers can obtain a one-day pass, three-day, five-day, and other multiday passes, as well as a season pass.

In addition, Whistler uses group price discrimination.

Prices vary dramatically by age. For the 2012–2013 season, season passes cost $525 for children under 13, $739 for chil- dren 13–18, $1,795 for adults 19–64, $969 for seniors 65–74, and only $225 for super seniors over 75. Groups of 15 or more people can buy a discounted group ticket.

Skiers can obtain lower prices if they are willing to take the time to find tickets sold by certain local vendors at a significant discount. For example, an adult skier can buy a daily pass for $96 instead of the usual $102 at 7-Eleven convenience stores in nearby Vancouver. Thus, Whistler further segments the market on the basis of value of time—charging lower prices for skiers who are willing to invest time in getting discount tickets.

Whistler also uses two-part pricing. Local residents can buy special passes for an access fee that allows them to pay lower daily prices for the season. Whistler also bundles skiing with other products. For example, skiers can buy a daily pass, a lesson, and rental equipment as a package deal for considerably less than the combined stand-alone prices. In addition, Whistler engages in peak-load pricing by varying fees over the week and the season: Skiing on weekdays is cheaper than on weekends. Whistler, like Disney, treats nonuniform pricing as a science. Downhill Pricing 347 10.7 Peak-Load Pricing Sale Prices Managerial Solution By putting Heinz ketchup on sale periodically, Heinz’s managers can price dis- criminate. How often should Heinz put its ketchup on sale? Under what condi- tions does it pay for Heinz to have sales? To answer these questions, we study a simplified market in which Heinz competes with one other ketchup brand, which we refer to as generic ketchup. 21 Every n days, the typical consumer buys either Heinz or generic ketchup. (The number of days between purchases is determined by the storage space in consumers’ homes and how frequently they use ketchup.) Switchers are price sensitive and buy the least expensive ketchup. They pay attention to price information and always know when Heinz is on sale.

Heinz’s managers consider holding periodic sales to capture switchers’ purchases. The generic is sold at a competitive price equal to its marginal cost of production of $2.01 per unit. Suppose that Heinz’s marginal cost is MC=$1 per unit (due to its large scale) and that, if it only sold to its loyal customers, it would charge a monopoly price of p=$3. Heinz’s managers face a trade-off. If Heinz is infrequently on sale for less than the generic price, Heinz sells little to switchers. On the other hand, if Heinz is frequently on sale, it loses money on its sales to loyal customers.

We start by supposing that Heinz’s managers decide to charge a low sales price, $2, once every n days. For the other n-1 days, Heinz sells at the regular, nonsale (monopoly) price of $3, which is the monopoly price given the demand curve of the loyal customers. During a sale, the switchers buy enough Heinz to last them for n days until it’s on sale again. Consequently, the switchers never buy the generic product. (Some other customers are loyal to the generic, so they buy it even when Heinz is on sale.) If the loyal customers find that Heinz is on sale, which happens 1/n of all days, they buy n days’ worth at the sale price. Otherwise, they are willing to pay the regular (monopoly) price. If the other loyal customers were aware of this promo- tion pattern, they could get on a schedule such that they always bought on sale too, thereby making this strategy non-profit maximizing. However, their shop- ping schedules are determined independently: They buy many goods and are not willing to distort their shopping patterns solely to buy this one good on sale. 22 Could Heinz make more money by altering its promotion pattern? It does not want to place its good on sale more frequently because it would earn less from its loyal customers without making more sales to switchers. If it pays to hold sales at all, it does not want to have a sale less frequently because it would sell fewer units to switchers. During a promotion, Heinz wants to charge the highest price it can and yet still attract switchers, which is $2. If it sets a lower price, the quantity sold is unchanged, so its profit falls. If Heinz sets a sale price higher than $2, it loses all switchers.

Does it pay for Heinz to have sales? Whether it pays depends on the number of switchers, S, relative to the number of brand-loyal customers, B. If each cus- tomer buys one unit per day, then Heinz’s profit per day if it sells only to loyals isπ=(p-MC)B=(3-1)B=2B, where p=3 is Heinz’s regular price and 21The rest of the U.S. market consists primarily of Hunt’s Ketchup (15%) and generic or house brands (22%). In the following discussion, we assume that customers who are loyal to Hunt’s or generic ketchup are unaffected by Heinz sales, and hence ignore those customers.

22We make this assumption for simplicity. In the real world, firms achieve a similar result by having random sales or by placing ads announcing sales where the ads are seen by primarily the switchers. 348 CHAPTER 10 Pricing with Market Power MC=1 is its marginal and average cost. If Heinz uses the sale pricing scheme, its average profit per day is π*=2B(n-1)/n+B/n+S/n, where the first term is the profit it makes, $2 per unit, selling B units to loyal customers for the fraction of days that Heinz is not on sale, (n-1)/n, and the second term is the profit it makes, $1 per unit, selling B units to the loyal customers.

The third term is the profit from switching. Each switcher buys n units on the sale day and no units on other days, so the average is 1/n per day for each of the S switchers.

Thus, it pays to put Heinz ketchup on sale if π6π*, or 2B62B(n-1)/n+ (B+S)(1/n). Using algebra, we can simplify this expression to B6S. Thus, if switchers outnumber loyal customers, then having sales is more profitable than selling at a uniform price to only loyal customers. SUMMARY 1. Conditions for Price Discrimination. A firm can price discriminate if it has market power, knows which consumers or groups of consumers are willing to pay more than others for the product, and can prevent customers who pay low prices from reselling to those who are willing to pay high prices. A firm earns a higher profit from price discrimination than from uniform pricing because (a) the firm captures additional consumer surplus from customers who are willing to pay more than the uniform price and (b) the firm sells to some people who would not buy at the uniform price. 2. Perfect Price Discrimination. To perfectly price discriminate, a firm charges each customer the maximum each is willing to pay for each unit of output. The firm captures all potential consumer surplus and sells the efficient (competitive) level of output. Compared to perfect competition, total surplus is the same, consumers as a whole are worse off, and firms are better off under perfect price discrimination. Perfect price discrimination is rare, but seeking to approach perfect price discrimination using individual-specific prices is quite common. 3. Group Price Discrimination. A firm that is not able to perfectly price discriminate can still increase its profit relative to uniform pricing if it can identify different subgroups of consumers with different demand curves. At the profit-maximizing prices, the firm charges groups of consumers prices in proportion to their elasticities of demand, with the group of consumers with the least elastic demand paying the highest price. Total surplus is less under group price discrimination than under competition or perfect price discrimination but may be greater or less than that under uniform monopoly pricing. 4. Nonlinear Price Discrimination. Some firms charge customers different prices depending on how many units they purchase. A common pattern of such prices involves quantity discounts, so that the per-unit price for consumers who buy larger quantities would be less than the per-unit price for consumers who buy smaller quantities. 5. Two-Part Pricing. By charging consumers an access fee for the right to buy a good and a separate fee per unit, firms may earn higher profits than from uniform pricing. In an extreme case, a firm that knew its customers’ demand curves and could charge a different access fee to every customer could use two-part prices to capture all potential consumer surplus. More realistically, even a firm that does not know each customer ’s demand curve or that cannot vary the access fee across customers can still use two-part pricing to earn a higher profit than it could earn using a single (uniform) price. 6. Bundling. Some firms increase their profits by selling products as bundles, often called package deals. Some firms use pure bundling, in which only the bundle is offered for sale. Others use mixed bundling, in which both the bundle and the individual goods are offered for sale. Bundling is likely to be a profitable pricing strategy when consumers have reservation prices that are 349 Questions QUESTIONS 1. Conditions for Price Discrimination 1.1. In the examples in Table  10.1, if the movie theater does not price discriminate, it charges either the highest price the college students are willing to pay or the one that the senior citizens are willing to pay.

Why doesn’t it charge an intermediate price? (Hint:

Discuss how the demand curves of these two groups are unusual.) 1.2. As of 2013, the pharmaceutical companies Abbott Laboratories, AstraZeneca, Aventis Pharmaceuticals, Bristol-Myers Squibb Company, Eli Lilly, GlaxoSmithKline, Janssen, Johnson & Johnson, Novartis, and Pfizer provided low-income, elderly people with a card guaranteeing them discounts on many prescription medicines. Why would these firms do that?

1.3. A monopoly currently sells its product at a single price. What conditions must be met so that it can profitably price discriminate?

*1.4. Many colleges provide students from low-income families with scholarships, subsidized loans, and other programs so that they pay lower tuitions than students from high-income families. Explain why universities behave this way.

1.5. College students could once buy an IBM or other PC computer at a substantial discount through a campus buying program. The discounts largely disappeared in the late 1990s, when PC companies dropped their prices. “The industry’s margins just got too thin to allow for those [college discounts],” said the president of Educause, a group that promotes and surveys using technology on campus (David LaGesse, “A PC Choice: Dorm or Quad?” U.S. News & World Report, May 5, 2003, 64). Using the concepts and terminology discussed in this chapter, explain why shrinking profit margins are associated with the reduction or elimination of student discounts.

Currently, Apple offers college students discounts on computers, often bundled with a printer, an iPod, or other Apple product. Why is Apple more likely to offer discounts to students than other computer companies?

*1.6.Disneyland price discriminates by charging lower entry fees for children than adults and for local residents than for other visitors. Why does it not have a resale problem?

1.7. A jean manufacturer would find it profitable to charge higher prices in Europe than in the United States if it could prevent resale between the two countries. What techniques can it use to discourage resale?

1.8. On July 12, 2012, Hertz charged $126.12 to rent a Nissan Altima for one day in New York City, but only $55.49 a day in Miami. Is this price discrimination?

Explain. 2. Perfect Price Discrimination 2.1.Using the information in the “Botox Revisited” Mini-Case, determine how much Allergan loses by being a single-price monopoly rather than a perfectly price-discriminating monopoly. Explain your answer.

*2.2. If a monopoly faces an inverse demand function of p=90-Q, has a constant marginal and aver- age cost of 30, and can perfectly price discriminate, what is its profit? What are the consumer surplus, total surplus, and deadweight loss? How would these results change if the firm were a single-price monopoly?

2.3. How would the answers to Q&A 10.1 and Table 10.1 change if seniors’ reservation price was $5?

2.4. As described in the “Dynamic Pricing at Amazon” Mini-Case, some Amazon customers contended that Amazon used a dynamic pricing approach where the price offered depended on a customer ’s past purchases. What type of price discrimination is this?

2.5. To promote her platinum-selling CD Feels Like Home in 2005, singer Norah Jones toured the country for live performances. However, she sold an average of only two-thirds of the tickets available for each negatively correlated—when consumers who have a relatively high willingness to pay for one good have a relatively low willingness to pay for the other good. 7. Peak-Load Pricing. Some firms charge higher prices during periods of high demand than during periods of low demand. Such pricing strategies are commonly used by firms that have capacity constraints. During the peak period, the firm sets a high price to limit demand to its available capacity. During the off-peak period, the firm’s profit-maximizing price leaves excess capacity.

All exercises are available on MyEconLab ; *=answer at the back of this book; C = use of calculus may be necessary. 350 CHAPTER 10 Pricing with Market Power show, T* (Robert Levine, “The Trick of Making a Hot Ticket Pay,” New York Times, June 6, 2005, C1, C4).

a. Suppose that the local promoter is the monopoly provider of each concert. Each concert hall has a fixed number of seats. Assume that the promoter ’s cost is independent of the number of people who attend the concert (Ms. Jones received a guaranteed payment). Graph the promoter ’s marginal cost curve for the concert hall, where the number of tickets sold is on the horizontal axis (be sure to show T*).

b. If the monopoly can charge a single market price, does the concert’s failure to sell out prove that the monopoly set too high a price? Explain.

c. Would your answer in part b be the same if the monopoly can perfectly price discriminate? Use a graph to explain.

2.6. A firm is a natural monopoly (Chapter  9). Its mar- ginal cost curve is flat, and its average cost curve is downward sloping (because it has a fixed cost). The firm can perfectly price discriminate.

a. In a graph, show how much the monopoly produces, Q*.

b. Can it profitably produce where its price equals its marginal cost?

c. Show that a monopoly might shut down if it can only set a single price but will operate if it can perfectly price discriminate. 3. Group Price Discrimination 3.1. A firm charges different prices to two groups. Would the firm ever operate where it was suffering a loss from its sales to the low-price group? Explain.

*3.2. A monopoly sells its good in the U.S. and Japanese markets. The American inverse demand function is p A=100-Q A, and the Japanese inverse demand function is p J=80-2Q J, where both prices, p A and p J, are measured in dollars. The firm’s marginal cost of production is m=20 in both countries. If the firm can prevent resale, what price will it charge in both markets? (Hint: The monopoly determines its optimal (monopoly) price in each country separately because customers cannot resell the good.) *3.3. A patent gave Sony a legal monopoly to produce a robot dog called Aibo (“eye-BO”). The Chihuahua-size pooch robot can sit, beg, chase balls, dance, and play an electronic tune. When Sony started selling the toy, it announced that it would sell 3,000 Aibo robots in Japan for about $2,000 each and a limited litter of 2,000 in the United States for $2,500 each. Suppose that Sony’s marginal cost of producing Aibo robots was $500. Its inverse demand function was p J=3,500- 12QJ in Japan and p A=4,500-Q A in the United States. Solve for the equilibrium prices and quantities (assuming that U.S. customers cannot buy robots from Japan). Show how the profit-maximizing price ratio depends on the elasticities of demand in the two countries. What were the deadweight losses in each country, and in which was the loss from monopoly pricing greater?

3.4. A monopoly sells its good in the United States, where the elasticity of demand is -2, and in Japan, where the elasticity of demand is -5. Its marginal cost is $10. At what price does the monopoly sell its good in each country if resale is impossible?

3.5. In Q&A  10.2, calculate the firm’s profit with and without a ban against shipments between the two countries.

3.6.How would the analysis in Q&A  10.2 change if MC=7? 3.7. Does a monopoly’s ability to price discriminate between two groups of consumers depend on its marginal cost curve? Why or why not? [Consider two cases: (a) the marginal cost is so high that the monopoly is uninterested in selling to one group; and (b) the marginal cost is low enough that the monopoly wants to sell to both groups.] 3.8. A monopoly has a marginal cost of zero and faces two groups of consumers. At first, the monopoly could not prevent resale, so it maximized its profit by charging everyone the same price, p=$5. No one from the first group chose to purchase. Now the monopoly can prevent resale, so it decides to price discriminate. Will total output expand? Why or why not? What happens to profit and consumer surplus?

*3.9. Spenser ’s Superior Stoves advertises a one-day sale on electric stoves. The ad specifies that no phone orders are accepted and that the purchaser must transport the stove. Why does the firm include these restrictions?

3.10.According to a report from the Foundation for Taxpayer and Consumer Rights, gasoline costs twice as much in Europe as in the United States because taxes are higher in Europe. However, the amount per gallon net of taxes that U.S. consumers pay is higher than that paid by Europeans (24¢ per gallon net of taxes). The report concludes that “U.S. motor- ists are essentially subsidizing European drivers, who pay more for taxes but substantially less into oil company profits” (Tom Doggett, “US Drivers Subsidize European Pump Prices,” Reuters, August 31, 2006). Given that oil companies have market power and can price discriminate across countries, is it reasonable to conclude that U.S. consumers are subsidizing Europeans? Explain your answer. 351 Questions 4. Nonlinear Price Discrimination *4.1. Are all the (identical) customers of the nonlinear price-discriminating monopoly in panel a of Figure 10.4 worse off than they would be if the firm set a single (uniform) price (panel b)? What if the consumers were not identical?

4.2. In panel b of Figure 10.4, the single-price monopoly faces a demand curve of p=90-Q and a constant marginal (and average) cost of m=30. Find the profit-maximizing quantity (or price) using math (Chapter 9). Determine the profit, consumer surplus, total surplus, and deadweight loss.

4.3. Assume that the quantity-discriminating monopoly in panel a of Figure  10.4 can set three prices, depending on the quantity a consumer purchases.

The firm’s profit is π=p 1Q1+p 2(Q2-Q 1)+p 3(Q3-Q 2)-mQ 3, wherep 1 is the high price charged on the first Q 1 units (first block), p 2 is a lower price charged on the next Q 2-Q 1 units, p 3 is the lowest price charged on the Q 3-Q 2 remaining units, Q 3 is the total number of units actually purchased, and m=$30 is the firm’s constant marginal and average cost. Use calculus to determine the profit-maximizing p 1,p2, and p 3.C 4.4. In the nonlinear price discrimination analysis in panel a of Figure  10.4, suppose that the monopoly can make consumers a take-it-or-leave-it offer.

a. Suppose the monopoly sets a price, p*, and a minimum quantity, Q*, that a consumer must pay to be able to purchase any units at all.

What price and minimum quantity should it set to achieve the same outcome as it would if it perfectly price discriminated?

b. Now suppose the monopolist charges a price of $90 for the first 30 units and a price of $30 for all subsequent units, but requires that a consumer must buy at least 30 units to be allowed to buy any. Compare this outcome to the one in part a and to the perfectly price-discriminating outcome.

4.5. Grocery store chains often set consumer-specific prices by issuing frequent-buyer cards to willing customers and collecting information about their purchases. Grocery chains can use that data to offer customized discount coupons to individuals.

a. Which type of price discrimination—perfect, group, or nonlinear—are these personalized discounts?

b. How should a grocery store use past-purchase data to set individualized prices to maximize its profit? (Hint: Refer to a customer ’s price elasticity of demand.) 5. Two-Part Pricing 5.1. Using math, show why, under two-part pricing, customers who purchase fewer units pay more on average per unit than do customers who buy more units.

5.2.Knoebels Amusement Park in Elysburg, Pennsylvania, charges an access fee, A, to enter its Crystal Pool. It also charges p per trip down the pool’s water slides.

Suppose that 400 teenagers visit the park, each of whom has a demand function of q 1=5-p, and that 400 seniors also visit, each of whom has a demand function of q 2=4-p. Knoebels’ objective is to set A and p so as to maximize its profit given that it has no (non-sunk) cost and must charge both groups the same prices. What are the optimal A and p?

*5.3. Joe has just moved to a small town with only one golf course, the Northlands Golf Club. His inverse demand function is p=120-2q, where q is the number of rounds of golf that he plays per year.

The manager of the Northlands Club negotiates separately with each person who joins the club and can therefore charge individual prices. This manager has a good idea of what Joe’s demand curve is and offers Joe a special deal, where Joe pays an annual membership fee and can play as many rounds as he wants at $20, which is the marginal cost his round imposes on the Club. What membership fee would maximize profit for the Club? The manager could have charged Joe a single price per round.

How much extra profit does the club earn by using two-part pricing?

5.4.Joe in Question  5.3 marries Susan, who is also an enthusiastic golfer. Susan wants to join the Northlands Club. The manager believes that Susan’s inverse demand function is p=100-2q.

The manager has a policy of offering each mem- ber of a married couple the same two-part prices, so he offers them both a new deal. What two-part pricing deal maximizes the club’s profit? Will this new pricing have a higher or lower access fee and per-unit fee than in Joe’s original deal? How much more would the club make if it charged Susan and Joe separate prices?

5.5. As described in the Mini-Case “Available for a Song,” Shiller and Waldfogel (2011) estimated that if iTunes used two-part pricing charging an annual access fee and a low price per song, it would raise its profit by about 30% relative to what it would earn using uniform pricing or variable pricing. Assume that iTunes uses two-part pricing and assume that the marginal cost of an additional download is zero.

How should iTunes set its profit-maximizing price per song if all consumers are identical? Illustrate 352 CHAPTER 10 Pricing with Market Power profit-maximizing two-part pricing in a diagram for the identical consumer case. Explain why the actual profit-maximizing price per song is positive. 6. Bundling 6.1. A monopoly sells two products, of which any given consumer wants to buy only one (and places no value on the other good). If the monopoly can prevent resale, can it increase its profit by bun- dling the goods, forcing consumers to buy both goods?

*6.2. A computer hardware firm sells both laptop computers and printers. It has a large inventory of laptops and printers that it wants to sell, so it has no variable production cost. Through the magic of focus groups, their pricing team determines that they have an equal number of three types of customers, and that these customers’ reservation prices arefor the room and general maintenance and administration. The resort has 100 rooms. What is the resort’s profit-maximizing peak-load pricing strategy? Illustrate the solution in a diagram.

*7.2.Paradise Cruises has a monopoly in renting luxury yachts for sailing in the Caribbean Sea. In winter its monthly inverse demand function is p=200-q. In summer the inverse demand function is p=200-2q.

Paradise has a total of 50 yachts available for rental on a monthly basis.

a. Which season is the peak season. Why?

b. What are the profit-maximizing prices in both seasons?

7.3. Based on the information in Question 7.2, determine the profit-maximizing uniform price. Does Paradise Cruises earn a higher profit under peak-load pricing or uniform pricing? Compare consumer surplus under these two pricing methods. 8. Managerial Problem 8.1.Each week, a department store places a different item of clothing on sale. Give an explanation based on price discrimination for why the store conducts such regular sales.

9. Spreadsheet Exercises 9.1. The manager of an amusement park is considering what price to charge Anil, who is planning a birthday party for his young daughter and her friends.

Anil’s willingness to pay for rides for the party is p=25-0.5Q, where p is the ticket price per ride andQ is the number of rides. The amusement park has a marginal cost of $5 for each additional ride. Its fixed cost for handling the party is $20.

Create a spreadsheet with quantity, price, consumer surplus, revenue, marginal revenue, cost, marginal cost, and profit as column headings. Fill in the spreadsheet’s cells for Q=5 up to Q=50 (in increments of 5 units).

If the manager uses uniform pricing, what is the profit- maximizing ticket price per ride, the number of rides, and the profit earned by the park?

9.2.Modify your spreadsheet from Exercise 9.1 given that the manager uses two-part pricing.

a. Suppose that the manager charges an entry fee for the entire party of young girls in addition to a price per ride. Calculate the optimal entry fee that it can charge while charging the same monopoly price as in Exercise 9.1. Calculate the total profit earned by the park.

b. Now suppose the manger uses two-part pricing with a per-ride price equal to marginal cost and a profit-maximizing entry fee. Determine the price per ride, the number of rides, and the total Laptop Printer Bundle Customer Type A$800 $100 $900 Customer Type B$1,000 $50 $1,050 Customer Type C$600 $150 $750 a. If the firm were to charge only individual prices (not use the bundle price), what prices should it set for its laptops and printers to maximize profit? Assuming for simplicity that the firm has only one customer of each type, how much does it earn in total?

b. After conducting a costly study, an outside consultant suggests that the company could make more money from its customers if it sold laptops and printers together as a bundle instead of separately. Is the consultant right?

Assuming again that the firm has one customer of each type, how much does the firm earn in total from pure bundling?

c. Why does bundling pay or not pay? (Hint: See Q&A 10.3.) 6.3. Why do Honda service departments emphasize to customers the importance of using “genuine Honda parts” when servicing and tuning Honda cars and motorcycles? Is Honda likely to be as successful as Hewlett-Packard in the Managerial Implication “Ties That Bind”? 7. Peak-Load Pricing 7.1.The inverse demand curve facing a resort hotel is p=300-Q during the high season and p=100-Q during the low season. The resort’s marginal cost is $50 per night in cleaning costs 353 Questions profit (including profit from ticket sales and the entry fee) in this case.

9.3. A restaurant faces very high demand for its signa- ture mousse desserts in the evening but is less busy during the day. Its manager estimates that (inverse) demand curves are p e=20-Q e in the evening and p d=11-Q d during the day, where e and d denote evening and daytime. The marginal cost of producing its dessert, MC 1, is $3. Any morning, the restaurant can bring in additional tables and convert its storage space to seating to increase capacity for that day. Creating enough extra capacity to provide one more dessert in the evening or the day costs $5, which is the restaurant’s marginal capacity cost, MC 2.

a. Create a spreadsheet with the column head- ings Q e, pe, MR e, Q d, pd, MR d, MC 1, MC 2, and MC T=MC 1+MC 2. b. Determine the optimal prices for the dessert that the restaurant should charge during the evening hours and during the day, the associated quantities sold, and the total daily profit.