"CHAPTER 5 PRODUCT DIFFERENTIATIO"
CHAPTER 9: PRODUCT DIFFERENTIATION AND PRICING STRATEGIES LEARNING OBJECTIVES In this chapter, students will be able to: 1. Use the models of perfect competition and monopolistic competition to demonstrate the need for firms to differentiate their products. 2. Explain how firms can differentiate their products, services, personnel, and image 3. Explain the short- and long-run implications of product differentiation on prices, output, and profits 4. Compare and contrast first-, second-, and third-degree price discrimination 5. Compare and contrast various methods of dynamic pricing. 6. Recommend strategies at each stage of the product life cycle 7. Identify the limitations underlying cost-plus pricing. Overview of American Airlines Value Pricing In April 1992, Robert Crandall, chairman, president, and CEO of American Airlines called a press conference to announce a new initiative for its pricing of airfares. The new system, called Value Pricing, was a vast simplification of its previous scheme. For years, American Airlines followed a pricing policy, called yield management, which was tantamount to “selling the right seats to the right customers at the right prices.” Rather than to charge the same price for a given flight, a sophisticated database, called SABRE, allowed the airlines to charge a myriad of prices for each flight. In contrast to yield management, Value Pricing was a much more simplified pricing structure. Rather than charge dozens of different prices for a given flight, Value Pricing would offer only four airfares: first class, regular coach, and two discount fares based on seven and 21-day advanced purchases, respectively. On average, airfares would be lower for both business and leisure travelers. First class fares would be 20-50% cheaper under the new plan while the price of regular coach fares would drop by 38%. Crandall believed that the less complex system of pricing, coupled with lower airfares, would appeal to air travelers and increase the firm’s profits. Market Structures and Profitability The previous chapter discussed the four basic market structures and their effects on the individual firm’s price, output, and potential for long-term profitability. Two factors stand out that limit the individual firm’s profitability: the ability of consumers to find adequate substitutes and the propensity for firms to enter profitable industries and compete prices and profits downward. The focus of this chapter is to discuss ways to reduce the substitutability of one’s good and slow the inevitable push toward a normal profit. Let’s begin with a discussion of a market structure for which no pricing strategies exist and the potential for the entry of new firms is high. As we discussed in the previous chapter, perfect competition is characterized by a large number of perfectly informed buyers and sellers, an undifferentiated product, and the lack of market barriers. 2 The model of perfect competition is illustrated in Figure 1. The graph on the left shows the market price as determined by supply and demand in the industry. The graph on the right shows the market from the perspective of a single firm. Because the firm faces many competitors with identical substitutes, its demand curve is horizontal (a.k.a. perfectly elastic) at the market price. Therefore, it can sell an unlimited quantity at the market price, but could sell nothing if it charged a higher price. The firm produces every unit whose marginal revenue exceeds its marginal cost. In other words, the firm produces every unit whose marginal cost is less than the market price. Because marginal cost rises under conventional economic theory, eventually marginal cost exceeds the market price. Therefore, even though the firm can sell an unlimited quantity, rising marginal costs force the firm to produce and sell a finite quantity. In Figure 1, the firm is depicted as earning an economic profit. The economic profit is shown as the difference between the market price and the average total cost (assuming opportunity costs are part of average costs) at the profit-maximizing quantity (q*). [Figure 1] As Figure 2 indicates, the promise of economic profits lures competitors into the industry. As market supply increases, the market price is competed downward. As the market price drops, each firm must decrease its price and reduce its output. As firms continue to flood the industry, eventually the economic profits are eliminated. Surviving firms in the industry are left with a normal profit, implying that their accounting profits are no better or worse than what could be earned elsewhere (at q2, the average total cost is 3 exactly equal to the new market price). At this point, the incentive to enter the industry comes to a halt and the market is in a long-run equilibrium. [Figure 2 here] Even though the perfect competition model is too extreme to be seriously considered by business managers, its implications should not be ignored. The firm’s flexibility in setting a price and its potential for long-term profitability are most jeopardized as the availability of identical substitutes increases and the potential for market entry is high. In our discussions of monopoly, we noted the significance of market barriers. Market barriers constitute factors that eliminate or restrict the entry of competitors into the market. Clearly, if the firm is protected by market barriers, consumers cannot avail themselves to cheaper substitutes and the firm need not worry that its price and profit will be competed downward as competitors flood the industry. Ownership of a key resource, significant economies of scale, and institutional restrictions such as patents are among the most common market barriers. Unfortunately, these factors are usually not within the control of the individual firm. This brings us full circle. The perfect competition model illustrates the market environment that most constrains a firm’s profitability. Although monopoly promises the greatest potential for price flexibility and long-term profitability, the factors that create market barriers are beyond the control of most firms. How can a firm can price flexibility and sustain economic profits for as long as possible? The monopolistic competition model provides some direction. Perfect competition’s price taker assumption is based on the notion of an undifferentiated 4 product; that as long as consumers view each firm’s product as indistinguishable, the manager is powerless to charge a price above those of competing firms (absent the transportation and search cost considerations). Clearly, therefore, if competitive markets tie the hands of individual firms, it is in their interest to distinguish themselves from their competitors. Through product differentiation, firms can distance themselves from their competitors and gain some price flexibility. The degree to which a firm can differentiate its product can vary. In some industries, such as agriculture or financial securities, the market may approximate perfect competition. In other industries, such as the manufacturers of digital cameras or designer jeans, the producer’s ability to distinguish itself from its competitors is much more distinct. IMPORTANT IMPLICATIONS FOR THE MANAGER: 1. Unless a firm is protected by market barriers, competition by new firms will drive prices downward, reduce a firm’s market share, and decrease its profits. 2. A firm can delay this process by differentiating its product and retaining some price flexibility. Product Differentiation So your firm has developed a nifty product and hopes to hang onto its economic profits for as long as it can. Clearly, by differentiating its product, it might be able to establish some semblance of brand loyalty among its customers. In doing so, competing products will seem less substitutable and the firm retains its price flexibility. How can the firm differentiate its product? Basically, a firm can alter its good to make it better, newer, 5 faster, or simply cheaper. Initially, for example, video cameras were large, clunky appliances that required the user to carry not only the camera, but a separate VCR (carrying 50 pounds of video equipment makes for a very unpleasant hike down the Grand Canyon!). Eventually, video camera manufacturers figured out how to build the VCR directly into the camera. Today’s video cameras are tiny and use digital technology. Alternatively, a firm can develop a newer product. This goes beyond a simple adaptation of an existing product. Camera manufacturers developed digital cameras that gave users the ability to alter and fix pictures and email their photos to friends. A firm may also distinguish its product by reducing the performance time or delivery time in using or purchasing a product. Netflix sought to grab a niche of the DVD rental market by allowing customers to have DVDs delivered to their homes. Finally, firms may decide to distance themselves by cutting costs to offer a low- priced alternative to buyers. Southwest Airlines became a market leader by eliminating in-flight meals and seat assignments to position itself to the price-conscious buyer who is willing to forego certain “luxuries” to get a lower price. Features Let’s delve deeper into these options. How does one go about developing a product that’s better, newer, or faster? One way is to develop features that supplement the product’s primary function. Consider how automobiles have evolved since the cookie- cutter Model T’s. Although the original function of a car was simply to get someone from one place to another, today’s cars add air conditioning, power steering, DVD players, etc. In determining what options might give your product a competitive edge, 6 the firm needs to consider its target market. Each innovation entails a cost and the target market must be willing to bear the added cost if it is going to add to a firm’s profits. If Southwest Airlines targets price-conscious buyers, it might not make sense to add in- flight movies. Firms that target high-end buyers, on the other hand, such as Porsche, market themselves to less price-conscious consumers who are willing to pay a premium for quality options. Quality A firm can also differentiate its product by improving its quality. Hybrid cars promote greater gas mileage whereas sports cars tout handling and the time it takes for the vehicle to go from zero to sixty miles/hour. Some firms, such as the manufacturers of higher-end stereo equipment adopt a strategy of continually improving its good whereas other firms upgrade performance and make no subsequent alterations unless problems or new opportunities arise. Beyond performance, a firm may market the durability of its product. Consumers are usually willing to pay a higher price for a good that is expected to have a longer-than- average life. Although promoting a high expected operating life may be useful, the firm needs to be cognizant that a high operating life in a rapidly changing industry may not bring a competitive advantage. Personal computers become nearly obsolete within a year of manufacture, so marketing the long expected life of a PC is of minimal value to a consumer who expects to replace the machine within a few years anyway. Related to a good’s durability is its reliability. Maytag used its “lonely Maytag repairman” campaign to establish its reputation for a low repair history. Image 7 Sometimes product differentiation is more illusion than real. A firm’s identity refers to the way it wishes to be viewed by the public. The public’s perception of the firm is its image. McDonald’s ads, including Ronald McDonald himself, seek to establish the fast- food giant as a family-friendly eating establishment. A firm’s identity can be established by something as simple as a symbol. Nike products can be identified by its “swoosh”. Products associated with the Disney Corporation are readily identified by Mickey Mouse or the Disney signature. A critical element of image differentiation involves the use of written and audio/visual media. Firms can portray their identity through their choice of magazine, radio, and television ads. In choosing its promotional mix, the firm should focus on its target market. Beer commercials are designed to appeal to men and consequently run during football games. Products designed to appeal to women, on the other hand, may appear during soap operas. The public’s perception of a firm can often depend on the atmosphere of the firm. Check out the law firms in your town. Some are in large buildings with lavish offices whereas others are smaller, more cramped, and have sparse furnishings. Which one would you prefer to defend your legal interests? Finally, a firm can build its identity through the events it sponsors. Companies spend millions of dollars/year to obtain naming rights for stadiums, with prices ranging from $620,000 by Alltel Corporation for the Jacksonville Jaguar’s Alltel Stadium to $10 million for Reliant Energy’s right to bear its name on the Houston Texans’ stadium.1 Service Differentiation 1 Stadium Naming Rights. http://espn.go.com/sportsbusiness/s/stadiumnames.html 8 In addition to differentiating the physical product, a firm may attempt to distance itself from competitors by offering better services. This is particularly important when the product is difficult to differentiate. A firm can market, for example, the speed and reliability of its delivery. FedEx capitalized on its reputation for reliable delivery through its “Relax. It’s FedEx” advertising campaign. Firms can also differentiate their services through their installation policies. In addition to offering free installation of its equipment through its vendors, DirecTV promises that if its customers relocate, it will send a replacement satellite dish with free installation to his/her new residence. Some firms may offer customer training to assure the buyers get the optimum use of the company product. Finally, when looking to buy a car, many dealerships tout the quality and availability of their repair service to customers. Personnel Differentiation Some firms enhance the experience of buying their product by hiring “better” employees than the competition. This often conforms to the efficiency wage hypothesis to be discussed later in the text. Here, firms pay above-market wages to attract a large pool of applicants, from which they hire the most promising and productive. Stock brokerage firms often engage in cut-throat competition to obtain the most successful brokers. Many universities promote the high quality of their faculties to attract student applicants. And where would Hooters be without its famous Hooters girls? 9 IMPORTANT IMPLICATIONS FOR THE MANAGER: A firm can differentiate its product via: 1. Product Differentiation - The firm alters the features, quality, or image of its product 2. Service Differentiation - The firm improves the quality and/or speed of delivery, installation, customer training, or repair service 3. Personnel Differentiation - The firm pays above-market wages to attract the most productive employees The Economics of Product Differentiation The purpose of product differentiation is to distance your good from other available substitutes---to make your product less substitutable. As you may recall from the chapter on the price elasticity of demand, the more substitutable the product, the more elastic the demand and the less flexibility a firm has over its price. This is illustrated in Figure 3. Assume the product is perceived as having identical substitutes. The only sources of the downward-sloping demand curve are consumers’ transportation and search costs. With the undifferentiated product, an increase in the price from P1 to P2 causes the quantity demanded to drop from q1 to q2. By differentiating the good, the same price increase causes the quantity demanded to fall only to q2'. [Figure 3 here] In addition, by improving your good, the demand for your particular brand increases. Let’s see how the increased product demand and the diminished price elasticity affect the profit-maximizing price, quantity, and level of profits. Table 1 shows the quantity demanded at each price if the firm produces a fairly undifferentiated product. 10 Table 1 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $12 0 $0 --- $6 --- -$6 $10 1 $10 $10 $11 $5 -$1 $8 2 $16 $6 $16 $5 $0 $6 3 $18 $2 $21 $5 -$3 $4 4 $16 -$2 $26 $5 -$10 $2 5 $10 -$6 $31 $5 -$21 In the example, fixed costs, which are assumed to include opportunity costs, are equal to $6 and variable costs are $5/unit. At the profit-maximizing price and quantity of $8 and three units, respectively, the firm has a normal profit. Table 2 shows the firm’s demand schedule after differentiating its product. Table 2 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $14 0 $0 --- $6 --- -$6 $13 1 $13 $13 $11 $5 $2 $12 2 $24 $11 $16 $5 $8 $11 3 $33 $9 $21 $5 $12 $10 4 $40 $7 $26 $5 $14 $9 5 $45 $5 $31 $5 $14 $8 6 $48 $3 $36 $5 $12 11 Note how both demand has increased and become less elastic. At each level of output, the firm can charge a higher price than it could prior to differentiating its good. Moreover, the quantity demanded is less sensitive to price increases. At the new level of demand, the profit-maximizing price is $9 and the quantity is five units. The firm charges a higher price, sells more output, and its profits rise from $0 (normal profit) to $14 (economic profit). The effect of product differentiation on the profit-maximizing price and quantity is shown in Figure 4. The solid demand and marginal revenue curves represent the good prior to differentiation. As the graph indicates, the profit-maximizing price and quantity are P1 and q1, respectively. The second graph shows the profit-maximizing price and quantity after product differentiation. Note how the demand and marginal revenue curves shift to the right and become less elastic. At the new level of demand, the profit- maximizing price and quantity increase. [Figure 4 here] In reviewing Table 2, you may have noted that product differentiation did not affect the firm’s costs. In fact, firms pour money into product development to improve their products. As we learned in the profit maximization chapter, if the increased expenditure comes in the form of fixed costs, the profit-maximizing price and quantity are the same as in Table 2, but the level of economic profit is smaller. Table 3 illustrates such a scenario. Previously, the fixed costs without product differentiation were $6. Suppose the firm incurs an additional $4 in fixed costs to develop the new product innovation. 12 Table 3 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $14 0 $0 --- $10 --- -$10 $13 1 $13 $13 $15 $5 -$2 $12 2 $24 $11 $20 $5 $4 $11 3 $33 $9 $25 $5 $8 $10 4 $40 $7 $30 $5 $10 $9 5 $45 $5 $35 $5 $10 $8 6 $48 $3 $41 $5 $8 Instead of affecting the firm’s fixed costs, let’s suppose the new innovation raises the firm’s variable costs. Table 4 reveals the implications with fixed costs of $6 and variable costs of $6/unit. Here, the profit-maximizing price and quantity are $10 and 4 units, respectively. If we compare the results with the pre-differentiation scenario in Table 1, we can again see that product differentiation increased the profit-maximizing price and quantity while generating economic profits. Compared with Table 3, however, we can see that higher variable costs resulted in less output and a higher price than if product differentiation had been costless. 13 Table 4 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $14 0 $0 --- $6 --- -$6 $13 1 $13 $13 $12 $6 $1 $12 2 $24 $11 $18 $6 $6 $11 3 $33 $9 $24 $6 $9 $10 4 $40 $7 $30 $6 $10 $9 5 $45 $5 $36 $6 $9 $8 6 $48 $3 $42 $6 $6 Is product differentiation always beneficial to the firm? As one might expect, not necessarily. Table 5 indicates such a possibility. In comparison with Table 3, the innovation raises variable costs by $4/unit while having a smaller impact on demand. Table 5 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $13 0 $0 --- $6 --- -$6 $12 1 $12 $12 $15 $9 -$3 $11 2 $22 $10 $24 $9 -$2 $10 3 $30 $8 $33 $9 -$3 $9 4 $36 $6 $42 $9 -$6 $8 5 $40 $4 $51 $9 -$11 In this case, the higher variable cost is not justified by the relatively small increase in demand. In deciding whether to undertake an innovation, the firm needs to determine if 14 buyers place a sufficiently high value on the product’s new features to justify the added cost. However, one should also keep in mind that by increasing unit sales, the firm can take advantage of the downward-sloping component of the average total cost curve. Consequently, the increased cost of the new product features may be at least partially offset by increased economies of scale in production. IMPORTANT IMPLICATIONS FOR THE MANAGER: By differentiating its product, 1. A firm can increase the demand for its product and make it less price elastic 2. A firm can increase both its price and the quantity of output it sells 3. A firm can increase its profits and delay the market push toward a normal profit. So what are we saying? That in a world with undifferentiated products, economic profits attract competitors who drive down prices and wipe out the “surplus” profits? And that by differentiating our good, we can preserve our economic profits indefinitely? Well, not exactly. As long as market barriers do not exist, eventually economic profits will be eliminated through competition. Product differentiation can help to preserve economic profits, but only for a finite period of time. Consider the dynamic. To make your product less substitutable, you develop features that distinguish it from the competition. If the marginal benefits from product differentiation exceed the marginal costs, your profits will rise. But a new twist on your good is hardly a market barrier. If your innovation is popular, competing firms will note 15 what you’ve done and replicate it. Of course, you can apply for a patent or copyright, but these are not divvied out indiscriminately. Most new features can easily be copied by the competition. So what does this imply for the firm that initiated the product development? Clearly, once firms begin to duplicate your “distinguishing characteristic,” the distance between your good and those made available by rival firms diminishes. This simply reverses the process: the demand for your particular good becomes more elastic as it becomes more substitutable. In addition, the demand for your good decreases because you are now sharing your product niche with other firms. And now the bad news: once this occurs, the marketplace pushes you back to a normal profit. This process is illustrated in Figure 5. The top graph shows the firm after it has differentiated its product. Note that at the profit-maximizing quantity (q1), the price exceeds the average total cost, indicating an economic profit. Depicting the scenario after firms copy the innovation on the same graph could get a little messy, so we’ll create a second graph to show the long-run equilibrium. [Figure 5 here] In the long run, after other firms duplicate the new features, the firm’s demand curve shifts to the left and becomes more elastic. As a result, the profit-maximizing price and quantity decrease and the firm returns toward a normal profit. I know what you’re thinking: if the firm returns to a normal profit with or without product differentiation, what’s the point? The answer is time. By differentiating, the firm can increase its profits above the normal profit level---for a time. Indeed, if the new features attract buyers, rival firms will eventually catch on and prices and profits will fall, but between the time the features were introduced and the time profits were driven back 16 down, the innovating firm enjoys an economic profit. What to do when profits return to normal? Simple: think up another innovation and the entire process starts over again. Price Discrimination Another strategy a firm can employ to increase its profits is price discrimination. Price discrimination exists when different customers are charged different prices. You can probably think of many examples of price discrimination in real life. Senior citizens receive discounts at restaurants, children receive discounts on movie tickets, some shoppers use coupons at the supermarket whereas others pay full price, car buyers routinely haggle over the price of a car, etc. The list goes on and on. To help us understand the potential benefits from price discrimination, let’s recall our discussion of consumer surplus from the demand analysis chapter. Consumer surplus refers to the difference between the price and what the consumer is willing to pay. You may recall that in Table 1, the firm maximized profits by charging a price of $8 and selling two units. However, the firm could have sold one unit at a price of $10. Consequently, because both units are sold for $8, someone paid $2 less than he/she was willing to. Consumer surplus in this instance is equal to $2. However, if the firm were to sell one unit for $10 and the other unit for $8, it would increase its profits by $2 and wipe out the consumer surplus. Now, before we get all excited about opportunities to price discriminate, we need to lay out some of the ground rules. Suppose, for example, you own a gas station and suddenly a Rolls Royce drove up. Clearly, here’s someone loaded with cash---the driver is capable of paying a lot more than your other customers. Why not tell him the price of gas just went up to $10/gallon? The answer is simple: he can afford $10/gallon, but like 17 your other customers, he would prefer to get it cheaper. Rather than to shell out the money for the gas, he’s likely to get back into his car and go across the street to your nearest competitor. To effectively price discriminate, the firm must have some degree of market power. The easier it is for a buyer to purchase an identical (or very similar) product from a competing firm, the harder it is to price discriminate. Scenario #2. You host a college football bowl game. You want to sell as many tickets as possible. You recognize that many potential ticket-buyers are “fair-weather” fans that would be content to watch the game on television if the price was too high. Other potential customers, on the other hand, are rabid fans who would pay any price to see their alma mater play in the bowl game. You have no competing firm, so that gives you some degree of market power. You hope to be able to sell tickets for $20 to the fair- weather fans and $150 to the rabid fans. After discussing the situation with your dim- witted assistant, Mortimer, you decide to leave the ticket sales to him. A week later, you ask how ticket sales are going so far. “Not so good,” says Mortimer, “I quoted the ticket prices as $20 for fair-weather fans and $150 for rabid fans. Then I asked them whether they were fair-weather fans or rabid fans. So far, only fair-weather fans have called to order tickets.” Granted, most ticket managers are not going to be as dim-witted as Mortimer (notice how I said “most”). The point is that Mortimer needed a way to identify members of each group. Absent that ability, he could not price discriminate. Scenario #3. Furious with Mortimer, you decide to take over ticket sales. Sales have been brisk, but the stadium seats 75,000 and you’ve only managed to sell 30,000. You note that very few tickets have been purchased by students, which would seem unusual, given that their college team is playing. You decide to charge a price of $10 to 18 students. By asking to see their student ID cards, identifying students is easy. You’ve got the system licked. Everything seems to be going just dandy until you notice an ad in the classifieds selling tickets for $15 apiece. The ad was placed by the students you just sold tickets to! They’re taking your tickets, reselling them and undercutting your non- student prices! This brings us to the third lesson on price discrimination: the buyer should not in a strong position to resell the good. What might you and Mortimer have done to successfully price discriminate? Rather than to have Mortimer ask if the ticket buyers are fair-weather fans or rabid fans, he may have sorted the groups out indirectly. He may have offered priority seating to persons who pay $150 or some other perks designed to weed out the rabid fans from the fair-weather fans. Regarding the students reselling tickets, you might have short- circuited the resale such that the tickets had an easily identifiable “STUDENT TICKET” printed on them, with student IDs checked at the gate. This would have kept students from buying tickets at $10 and selling them to adults for $15. Of course, the students may have been able to resell the tickets to other students, but why would other students pay $15 when you are selling student tickets for $10? IMPORTANT IMPLICATIONS FOR THE MANAGER: To price discriminate, a firm must: 1. Have some degree of market power 2. Be able to segment the buyers in terms of their willingness to pay 3. Be able to limit resale of the good 19 Before continuing, you may wish to ask if price discrimination is legal? Interestingly, the Robinson-Patman Act of 1936 was passed to bar many types of price discrimination. However, the Act was passed to promote competition rather than to assure all buyers paid the same price. The fear was that large powerful firms could use predatory pricing tactics to eliminate smaller competitors. Historically, the courts have allowed price discrimination under the following circumstances: 1. The lower prices were needed to meet the competition. 2. The price differences were justified by differences in the costs of providing the good 3. The lower prices reflected changing conditions, including the perishability of the good in question and the obsolescence of seasonal goods. When one considers the many examples in which firms price discriminate, it seems fairly clear that the Robinson-Patman Act gives businesses a long leash when it comes to acceptable pricing practices. First-Degree Price Discrimination There are three degrees of price discrimination. We will begin with the most extreme (and profitable) circumstance and gradually work our way to more practical business applications. The goal of the firm in first-degree price discrimination is to extract 100% of the consumer surplus. Here, the firm charges the maximum each consumer is willing to pay for each unit. Tables 6 and 7 distinguish between the conventional case in which the producer sets a single price and first degree price discrimination. 20 Table 6 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $11 0 ---- $0 $5 --- -$5 $10 1 $10 $10 $10 $5 $0 $9 2 $18 $8 $15 $5 $3 $8 3 $24 $6 $20 $5 $4 $7 4 $28 $4 $25 $5 $3 $6 5 $30 $2 $30 $5 $0 $5 6 $30 $0 $35 $5 -$5 $4 7 $28 -$2 $40 $5 -$12 Table 6 reveals the conventional situation in which the firm charges a single price. Producing as long as marginal revenue exceeds marginal cost, the profit-maximizing price is $8, the output level is 3 units, and the firm earns a profit equal to $4. Table 7 uses the same demand and cost schedules, but introduces first-degree discrimination. With first-degree price discrimination, each unit is sold at the highest price the buyer is willing to pay. Let’s see how the price discriminator compares with the single-price firm. In both cases, the firm is willing to produce the first unit because its marginal revenue ($10) exceeds its marginal cost ($5). In the single price case, the producer recognizes that he/she cannot sell two units at a price of $10, so he/she lowers the price to $9. Both units sell for $9, so marginal revenue is $8 (i.e. the output effect is the $9 collected from the second unit and -$1 is the price effect from having dropped the price of the first unit from $10 to $9). With first degree price discrimination, however, there is no price effect. The firm continues to sell the first unit for $10, but sells the 21 second unit for $9. Marginal revenue is equal to the $9 (the output effect) because no price reduction on the first unit took place. Unlike the single price firm, the first degree price discriminator produces as long as the price of the good exceeds the marginal cost (absent the price effect, the marginal revenue is equal to the price). As Table 7 illustrates, the firm sells six units at prices ranging from $5 to $10 for a total profit of $10. First degree price discrimination is shown graphically in Figure 6. Note that without the price effect, the marginal revenue curve is no longer below the demand curve, but is now identical to the demand curve. Note the impact that first degree price discrimination has on the relevant cost/relevant revenue analysis that has been woven throughout this book. By eliminating price effects, price discrimination effectively raises the firm’s marginal (i.e. relevant) revenue with regard to production decisions. The result is not only greater revenues but greater production. [Figure 6 here] So that’s all there is to first-degree price discrimination? Just charge each buyer the maximum he/she is willing to pay? Clearly, it’s easier to illustrate first degree price discrimination than it is to pull it off. Auto dealers attempt to engage in first degree price discrimination every time they try to sell a car. In negotiating a price, however, the buyer is never foolish enough to reveal what he/she is willing to pay. In real life, therefore, it isn’t easy to ascertain the buyer’s willingness to pay. The likelihood the firm can completely eliminate consumer surplus, therefore, is rather small. However, one can reasonably conclude that even unsuccessful efforts to extract consumer surplus do better than the conventional single-price strategy. 22 Table 7 Price Quantity Marginal Total Total Marginal Total Revenue Revenue Cost Cost Profit $11 0 ---- $0 $5 --- -$5 $10 1 $10 $10 $10 $5 $0 $9 2 $9 $19 $15 $5 $4 $8 3 $8 $27 $20 $5 $7 $7 4 $7 $34 $25 $5 $9 $6 5 $6 $40 $30 $5 $10 $5 6 $5 $45 $35 $5 $10 $4 7 $4 $49 $40 $5 $9 Airlines and hotels attempt to price discriminate. In both cases, an empty seat or an empty room represents money the airline/hotel could have made, given that the marginal cost of an airline seat or a hotel room is very close to zero. Consequently, plane tickets and hotel rooms are sold over a wide variety of prices, all based on the buyers’ inferred willingness to pay. Most airlines utilize sophisticated (and expensive) software to determine the prices they should charge for various flights on any given day. The willingness to pay is extracted via restrictions on ticket purchases. For example, because business travelers are usually willing to pay more for their flights than leisure passengers, discount tickets often require a 21-day advance purchase or a Saturday-night stayover. “Name-your-price” firms such as Priceline.com serve to dump remaining seats to those with the lowest willingness-to-pay. 23 Second Degree Price Discrimination A less extreme version (and much easier to practice) is second degree price discrimination. With this form of price discrimination, the prices charged depend on the quantities purchased. A common example of second degree price discrimination may be found with mail-order music clubs. Often, the club offers a deal in which the buyer pays the full price on the first compact disk, but receives a discount on additional CDs purchased. Tables 8 and 9 show how second degree price discrimination can increase the firm’s profits and reduce consumer surplus. Suppose the table shows the demand schedule for a member of a CD club. If all consumers had a similar schedule, the firm would maximize profits by charging $10 for a CD. The average consumer would purchase three CDs per month and the firm would generate a monthly profit of $5 from each buyer. Because the consumer is willing to pay $14 for the first CD and $12 for the second CD, consumer surplus is equal to $6. Table 8 Price Quantity Total Total Total Revenue Cost Profit $16 0 $0 $10 -$10 $14 1 $14 $15 -$1 $12 2 $24 $20 $4 $10 3 $30 $25 $5 Table 9 shows the same demand curve, but under a second degree price discrimination strategy. Rather than charge $10 per CD, suppose the firm offers a deal. If the consumer purchases one CD at a price of $14, it can purchase additional CDs at a price of $10 each. 24 The consumer continues to purchase three CDs, but the firm captures $4 in consumer surplus from the first CD. As a result, the firm’s profits rise by $4 (from $5 to $9). Table 9 Price Quantity Total Total Total Revenue Cost Profit $16 0 $0 $10 -$10 $14 1 $14 $15 -$1 $12 2 $24 $20 $4 $10 3 $34 $25 $9 Second degree price discrimination can be viewed graphically in Figure 7. Although we’ve been relying on the linear demand curve in most of our graphs, second degree price discrimination can best be seen through the stairstep demand curve. If the firm adopts a standard single-price strategy by setting the price at $10, consumer surplus is equal to the sum of the A, B, and C boxes. By charging $14 for the first CD and $10 for any additional CDs, the firm is able to capture the A and B boxes, transferring $4 in consumer surplus from the buyer to the seller. The additional $2 the consumer was willing to pay for the second CD is the only remaining consumer surplus. [Figure 7 here] In examining the graph, you may have noticed that second degree price discrimination incorporates the law of diminishing marginal utility. As you may recall from the demand analysis chapter, each additional unit of a good generates less additional satisfaction (a.k.a. utility). Because a consumer places less value on subsequent units of a good, the firm must offer a progressively lower price to encourage consumption. In this example, the consumer is willing to pay $14 for the first CD but does not believe 25 additional CDs justify the $14 expenditure. To encourage the buyer to purchase three CDs, the firm must lower the price to $10. However, by dropping the price only on the additional CDs, second degree price discrimination captures the consumer surplus on the first CD. Walt Disney World routinely practices second degree price discrimination through its ticket pricing packages. Below are the ticket prices for 20062: Number of days Price 1 $63 2 $125 3 $181 4 $195 5 $199 Walt Disney World has four theme parks: the Magic Kingdom, EPCOT, MGM Studios, and Animal Kingdom. Note how the price of a two- or three-day ticket is not appreciably less than the cost of two or three one-day tickets purchased separately; the consumer would pay $126 for two one-day tickets and $189 for three one-day tickets. One can infer from this package that the “average” vacationer visits three theme parks during a trip to Orlando. To get the buyer into the fourth park, the added price is only $14. Given that most costs associated with operating the theme parks are fixed, this package lures in consumers who might not have visited the fourth park. One can also envision relatively few customers who would purchase one-day tickets for all four theme parks and then pay $63 to visit one of the parks a second time. Disney deals with the law of diminishing 2 Taken from the Walt Disney World website: http://disneyworld.disney.go.com/wdw/tickets/ticketStore 26 marginal utility by pricing a five-day ticket at $199---only $4 more than for a four-day ticket. Sometimes, second degree price discrimination is not so obvious. All-you-can-eat buffets seem like the ultimate bargain; after all, for a single price, there’s no limit on how many times you can go back for more. Of course, there is a limit to how many times you can go back; it’s not based on restaurant policy, but rather your own ability to take in food. Once you’re full, you’re done. In the meantime, however, you got a salad, an appetizer, a main dish, and a dessert. Would you have ordered them had a separate price been charged for each? Finally, second degree price discrimination may be practiced by charging “entry fees” for the right to make purchases. For example, patrons of Sam’s Club must pay a membership fee for the right to shop there. Similarly, professional sports franchise and intercollegiate athletics departments often tie purchases to donations to the athletic department. Although anyone has the right to purchase season tickets to football or basketball games, those who buy personal seat licenses or who donate money to the athletic department get first choice on seats. In this manner, the more rabid fans pay a fee for the right to buy tickets on the 50-yard line or at center court. Third Degree Price Discrimination The final type of price discrimination is third degree price discrimination. Here, the firm sets separate prices for different groups based on each group’s price elasticity of demand. Most movie theaters, for example, have discounted tickets for senior citizens. As a group, seniors tend to have fairly elastic demand curves because they are living on fixed incomes. At the same time, they only comprise a small fraction of the potential 27 theater-going audience. By offering a separate discounted price for seniors, the theater can collect the full price from its primary audience, while simultaneously pricing the more price-elastic group into the market. Tables 10 and 11 reveal the theory of third degree price discrimination. Assuming most costs associated with a movie are fixed, the single-price theater owner would maximize profits by charging the price that maximizes revenues. In Table 10, the revenue-maximizing price would be $5 and the theater would generate $700 from the movie. Table 10 Price Quantity Total (overall) Revenue $10 50 $500 $8 80 $640 $6 110 $660 $5 140 $700 $4 170 $680 Table 11 takes the quantities from Table 10 and segregates them into levels of elasticity; in this case, senior citizens are assumed to have the more elastic demand. In essence, the theater owner maximizes revenues (or profits, assuming variable costs exist) from each group individually. Seniors would be charged a price of $4, generating $260 whereas the others would be charged a price of $8, bringing in $480. Collectively, therefore, the combined revenues from each group total $740, a $40 improvement over the single-price strategy. 28 The critical element in third degree price discrimination lies in the ability of the manager to segregate the market into identifiable groups. Senior citizens can be readily identified by their appearance. Furthermore, the theater owner can demand proof of age at the box office. This particular market also has limited potential for resale. Tickets are typically sold within a half-hour or less of the time of the showing and are only honored at that time. This limits the ability of enterprising seniors to purchase tickets at $4 and then sell them for $7. Table 11 Aged 65 and over Under age 65 Price Quantity Total Price Quantity Total Revenue Revenue $10 10 $100 $10 40 $400 $8 20 $160 $8 60 $480 $6 35 $210 $6 75 $450 $5 50 $250 $5 90 $450 $4 65 $260 $4 105 $420 Often, firms can price discriminate by offering pricing packages that self-select patrons on the basis of elasticity. In 2006, for example, the University of Alabama Athletic Department created Tide Totals, an extension of its Tide Pride donor program. As a means to distribute football tickets to road games and establish priorities distributing tickets for post-season events, donors will receive points based on their cumulative donations to and longevity in the Tide Pride football and basketball programs, their season ticket purchasing history in six different sports, and other recognized charitable 29 contributions to the Crimson Tide Foundation. The point totals will be used to establish top-to-bottom priorities for the upcoming season.3 There are two features one should note about the Tide Totals programs. First, the athletic department does not need to formally segregate the fans’ intensity of interest in Crimson Tide games. Instead, the program forces the fans to identify themselves. Second, unlike many athletic programs that offer perks based on established contribution levels, Tide Totals establishes only a rank-order based on point totals that are correlated with money spent on tickets and charitable contributions. In this manner, Tide Totals seeks to extract the maximum consumer surplus from its most devoted patrons. IMPORTANT IMPLICATIONS FOR THE MANAGER: 1. In first degree price discrimination, the firm attempts to sell each unit at the highest price warranted by market demand 2. In second degree price discrimination, the firm offers discounts on additional quantities purchased 3. In third degree price discrimination, the firm charges different prices based on the groups’ price elasticities of demand We can compare and contrast the implications of first- and third-degree price discrimination to analyze American Airlines’ Value Pricing strategy. Clearly, the yield management philosophy of “selling the right seats to the right customers at the right prices” was an attempt at first-degree price discrimination. If the airline had perfect knowledge, it could charge individual prices for each seat that reflected the travelers’ willingness to pay. Assuming it could extract the consumers’ willingness to pay for each 3 www.rolltide.com/fls/8000/files/files/21095.pdf. 30 seat, consumer surplus would be equal to zero. Of course, in the real world, firms never have perfect information regarding one’s willing to pay. Hence, American Airlines’ attempt to engage in first-degree price discrimination is likely to reduce, but not eliminate consumer surplus. The SABRE database was created to assist the airline in terms of determining the appropriate fares. The simplified pricing system implied by Value Pricing is a clear attempt to move toward third-degree price discrimination. Here, the airfares are in four discrete categories, each based on the price elasticity of demand for a specific segment of the market. First class tickets will be priced to appeal to business travelers and leisure travelers who are willing to pay a premium for more seating room and other perks offered to first class ticketbuyers. Regular coach fares are priced to appeal to more price sensitive buyers whereas the two discounted fares are offered to travelers who are most price elastic. Although Crandall hopes the simplified system will increase the airlines’ profits, theory suggests otherwise. Unlike first-degree price discrimination, third-degree price discrimination, even if executed perfectly, does not eliminate consumer surplus. The alleged reduction in airfares across pricing categories is simply a reflection of average fares under the two systems. Under yield management, each seat is sold at a different price. This creates the possibility that a few tickets may be sold at exceedingly high prices. In contrast, the corresponding Value Pricing airfare reflects the profit-maximizing price for that particular market segment. Thus, the average price for any particular market segment may be lower with Value Pricing than with yield management. 31 Despite what theory suggests, it is not unambiguously clear that the switch to Value Pricing will result in lower revenues. For years, American Airlines invested in SABRE as a means to determine airfares. According to the case, the switch from yield management to Value Pricing will result in a cost saving of $25 million/year. Therefore, it Value Pricing reduces revenues by less than $25 million/year, the airline will be better off with the new pricing scheme. If, on the other hand, the change causes revenues to fall by more than $25 million/year, the new pricing strategy will backfire. Ironically, the case implies the latter. Crandall is quoted in the case as stating that yield management will increase revenues by $500 million/year. The only remaining rationale for supporting the switch to Value Pricing is the belief that the simplified airfares will cause the demand for American Airlines’ flights to increase. Price changes do not cause demand curves to shift. However, one must suppose that a subset of travelers are less concerned about getting the “best price”. From this perspective, reliable, unfluctuating airfares may be appealing and might conceivably increase demand. If so, the lost revenue from switching from first-degree to third-degree price discrimination will be offset by a combination of cost savings and any demand increase associated with a more user-friendly pricing system. E-Commerce and Dynamic Pricing Price discrimination has gone high-tech. For years, airlines such as American Airlines have used yield management software to determine what price to charge on various flights on various days to extract as much consumer surplus as possible while endeavoring to sell every seat on the plane. The era of information technology and e- 32 commerce has given a re-birth to the concept of dynamic pricing.4 With dynamic pricing, prices respond to supply and demand in near real-time. Dynamic pricing allows prices to vary by customer, time, or other situations. Ironically, dynamic pricing is a giant step backward. In the days of the small merchant, haggling over prices was routine and is still practiced today in many parts of the world. When mass production became the norm during the Industrial Revolution, individual negotiations between buyers and sellers to clear out inventory simply wasn’t feasible, and fixed posted prices became the norm. With advances in information technology, dynamic pricing is making a dramatic return. In the pre- or under-developed technology, a fixed posted price might remain unchanged for relatively long periods of time due to the lack of adequate information about aggregate demand or , alternatively, because of the high transactions costs associated with changing prices continuously to suit the moment. Posted fixed prices on websites for e-commerce are still common, if not the rule, but information technology now allows firms to manage the prices and inventories for a multitude of items. As a result, the posted prices change much more frequently to match supply with demand in near real-time. Created in 1999, easyInternetCafe (eIC) adapted dynamic pricing to the internet café market. Popular throughout Europe, eIC consumers purchase online access to one of the available terminals for a fixed period of time. Although the number of terminals is fixed, the level of demand varies by the time of day. In peak periods, the cost of an 4 Sahay, Arvind. “How to Reap Higher Profits with Dynamic Pricing,” MIT Sloan Management Review, Vol. 48, No. 4, Summer 2007:53-60. 33 online hour increases. Accordingly, therefore, higher prices leads to less time spent online, thereby allowing allocating online access to suit the limited supply of terminals. Another variation of dynamic pricing is price discovery. As opposed to a firm posting its prices online, the price of the good is determined through an active interaction with the prospective customer. Price discovery is the established mode for auction-type websites such as EBay or Ubid.com. Although most consumers are familiar with the basic concept of an auction, price discovery websites may practice alternative auction methods. The reverse auction is the opposite of the standard auction in which the buyers bid up the price. Pioneered by FreeMarkets, Inc., in the typical reverse auction, a buyer contracts with a market maker, who makes a request for quotation. Then, at a designated date and time, suppliers log on and quote the prices at which they would be willing to supply the good or service. In the Dutch auction, the auctioneer begins with a high asking price and then gradually lowers it until a buyer accepts the asking price. Google employed a version of the Dutch auction when it went public in 2004. Prospective investors bid on the price they were willing to pay for a share of Google stock and the number of shares they wished to purchase. Google gathered up the bids and determined the lowest price that would allow all of the shares of stock to be sold. Those who bid at or above this price received their shares at the market-clearing price. In the Yankee auction, a variation of the Dutch auction, the bidders pay the price they bid. With group buying, a group of smaller buyers form buying pools to make a large purchases. The company operating the group buying website presents the buying pools 34 to companies that might be willing to sell large volumes at discounted prices. Online Choice, McNOPOLY, and LetsBuyIt are examples of group buying companies. Cost-Plus Pricing One of the most common means of setting prices is through cost-plus pricing. Here, the price is set as some pre-determined percentage over unit cost. As we will soon discover, cost-plus pricing is largely a myth. To begin with, let’s assume a firm routinely sets its price as 50% above unit cost. Under absorption costing, the firm is setting its price above average total cost. At face value, cost-plus pricing guarantees the firm will earn a profit. In fact, if firms can routinely set their prices at some percentage over unit cost, all firms will earn a profit. Taken a step further, cost-plus pricing implicitly assumes firms have no particular reason to be efficient; if costs rise due to inefficiency in production, all they have to do is jack up the price and they’re covered. In truth, the logic underlying cost-plus pricing is backward. Whereas a firm cannot earn a profit unless its price exceeds average total cost, it is incorrect to assume a firm should determine its average total cost and purposefully set its price at some percentage over cost. A simple example will illustrate why. Suppose a firm produces 1,000 units of a good. The firm’s fixed costs total $1,000 and its variable costs sum to $500. At this level of production, average variable costs are $500/1,000 units, or $.50/unit and average total cost is $1,500/1,000 units, or $1.50/unit. The firm, seeking to guarantee a profit, sets its price at its customary 50% over cost, or at $2.25/unit. Unfortunately, competitors produce a nearly identical product and sell it at a price of $1.40. Consequently, unit sales fall to 500 units. 35 What happens to the unit cost when unit sales fall? Assuming average variable costs are constant over this range of production, total costs are now $1,250 and average total costs have risen to $2.50/unit. Now, the price cannot cover unit cost. Given that the firm experienced a significant decrease in unit sales because its price was not competitive, would it be wise to apply cost-plus pricing and raise the price to $3.75? Rather than raise its price, suppose the firm instead lowered its price to $1.40, matching its competitors. At first glance, this would appear to be nonsensical; after all, we already know that unit costs are $2.50/unit. Why would a firm set its price below unit cost? The answer is simple: $1,000 of the firm’s total production costs are unavoidable fixed costs. The only relevant cost to pricing is the variable component, or $.50/unit. Therefore, any price above $.50 potentially makes sense. Assume the firm is able to sell 2,300 units at $1.40. Now, its total costs are $2,150, or $.935/unit. Note that the firm’s price is 50% above unit cost ($.935 x 1.50 = $1.40). What happened? To begin with, because the $1,000 constituted unavoidable fixed costs, when unit sales increased due to the price cut, the $1,000 was spread over more units, bringing the average total cost down. Ultimately, the firm has a price that is marked up 50% over unit cost, but not because it deliberately set is price 50% above unit cost. Get the difference? Would the firm be better off establishing its markup over average variable costs instead of average total cost? Maybe, but let’s continue with the same example. In this case, given that average variable cost equals $.50, the firm using its 50% markup rule would set its price at $.75---well below the price charged by its competition. Suppose the low price propelled unit sales to 3,500. If so, its costs would total $2,750 and its unit cost 36 would be $.79---not enough to make a profit. How many units would the firm need to sell to make the price worthwhile? We can use breakeven analysis to find out. In this case, the breakeven quantity would be: Q = $1,000/($.75 - $.50) = 4,000 units. All right, let’s suppose the firm believes it can sell 4,200 units at $.75. This would generate profits of $50. Are we done? Not really. According to economic theory, what happens next? By dropping its price to $.75, well below the $1.40 charged by competitors, some of its increase in unit sales is going to come at the expense of rival firms. What if the rival firms decide to match the $.75 price? Clearly, the initial firm’s unit sales will fall. If they fall to, say, 1,500 units, the firm suddenly experiences a $625 loss. The point of this exercise is to show that the cost-plus pricing is a moving target. An acceptable cost-plus percentage one day may not be an acceptable cost-plus percentage another day. As long as firms are entering or exiting an industry, as long as firms continually seek ways to differentiate their products, and as long as the prices of substitute/complementary goods change, the optimal cost-plus percentage changes. In short, cost-plus pricing is really suitable only for static markets. But let’s face it---how many competitive markets are truly static? In the appendix, we will show the microeconomic representation of cost-plus pricing. Unfortunately, as we will see, theory presents a mathematical identity rather than a proactive tool for managers. Despite the questionable use of cost-plus pricing as a decision rule, we can still use our understanding of markets to discern when cost-plus percentages are likely to be 37 relatively high or low. The optimal cost-plus markup also depends on the elasticity of demand for the good. Necessities are going to allow for greater percentage markups than luxuries. Similarly, the more readily available are close substitutes, the lower the percentage markup over unit cost. This is one of the reasons why markups change over the PLC: as competitors enter the industry, the optimal percentage markup diminishes in size. In summary, cost-plus pricing implicitly assumes a static marketplace: a very dangerous assumption to make. In practice, firms should be more concerned with value pricing (i.e. charging the price the market is willing to bear) while keeping a close watch on the prices charged by rival firms. Again, the optimal cost-plus price tends to be a result of these other factors; it is not a pre-emptive pricing strategy. Strategies for the Product Life Cycle Introduction Stage Marketing theory suggests that most goods go through a product life cycle (PLC). Each stage presents its own opportunities and challenges. In setting prices, managers need to be aware of the stage of the product life cycle their good is in and plan appropriately. Figure 8 depicts the product life cycle graphically. The initial stage of the PLC is the introduction. The product is relatively new, distribution channels have not been established, and consumer awareness is low. The firm loses money at this stage because it bears heavy start-up and promotional expenses. Moreover, because unit sales are somewhat low, production costs are at the higher end of the U-shaped average total cost curve. [Figure 8 here] 38 Managers can adopt one of two pricing strategies during this stage. First is the skimming strategy. Here, the firm takes advantage of being the sole producer and charges a relatively high price. By charging a high price, the firm can take advantage of its monopoly power while maintaining the flexibility to drop prices as competitors enter the industry. In the meantime, the high profit margin allows it to recover its startup expenses and fixed costs faster. Moreover, because unit sales are likely to be low, production places the firm on the higher end of the average variable cost, thereby warranting a higher price. Skimming is also a form of third degree price discrimination. Most consumers are aware that in many product markets such as electronics, prices drop dramatically if they have the patience to wait. However, some consumers love to be “the first one on the block” to obtain the latest gadget and don’t mind paying a premium to do so. In time, the firm will lower its price and lure the more price sensitive buyers into the market. The alternative is to utilize a penetration strategy. Here, the firm foregoes to the opportunity to capitalize on its “monopoly” status by introducing a lower price. By taking the first mover advantage, the low-priced firm can attain market penetration rapidly, which places production at the lower-cost portion of the average total cost curve. The penetration strategy makes the most sense when the product is such that brand loyalty is going to be difficult to establish. It’s also a prudent strategy when competitors can enter the market easily. Although the firm sacrifices some short-term profit, its long- term profits may be higher. The lower the entry price, the higher the breakeven output for the potential competitor who is weighing the costs and benefits of entering the 39 market. If the penetration strategy wards off the more risk-averse competitors, the first mover’s long-term profits may be higher. IMPORTANT IMPLICATIONS FOR THE MANAGER: During the introduction stage of the product life cycle, 1. Firms can attempt to recover the startup expenses quickly with a high-price skimming strategy while maintaining the flexibility to lower prices as competitors enter the market. 2. Firms can attempt to increase market share, ward off market entry by competitors, and produce at lower unit costs through a low-priced penetration strategy. Growth Stage In the growth stage, sales rise rapidly. The rate of growth accelerates. Market demand rises as the product gains acceptance among consumers. Economic profits rise because the firms’ production is at the lower-cost portion of the average total cost curve. The economic profits also begin to attract competitors and product differentiation among competitors begins to emerge. At this stage of the PLC, the firm must plan for the inevitable “loss of control” over the market. To prolong its hold on economic profits, the firm must differentiate its product. Until that occurs, the firm must recognize the market is placing downward pressure on prices. The purpose of the firm’s strategy is to establish its position in the marketplace. 40 Maturity Stage The maturity stage is frequently longer than the previous two stages. Here, the growth rate for sales slows down, flattens, and eventually begins to decline. The slowdown in sales results in overcapacity which puts downward pressures on prices. At this point, firms intensify their efforts to differentiate their products, and the level of advertising increases. A combination of stagnant sales growth, intensified price competition, and increased promotional and product development expenditures squeezes profits. Some of the weaker firms in the industry sustain economic losses and leave the industry. Firms may wish to expand the size of the market by steering products toward new market segments. Promotional campaigns may encourage more frequent use of the product to increase demand. In their efforts to increase demand, firms must recognize that increased advertising in the maturity stage is likely to produce a prisoner’s dilemma. We will discuss the prisoner’s dilemma in detail in the chapter on game theory. In this context, the prisoner’s dilemma refers to the fact that firms respond to excess production by increasing advertising. If all firms increase their advertising, however, the efforts may cancel out and market demand and the firm’s market share remain largely the same while its promotional costs rise. Generally speaking, rather than attempt to increase demand for the existing product lines, a firm can fend off normal profits in the maturity stage through product differentiation. By improving the quality of the product or adding new features, a firm can increase demand, make it less elastic and increase the level of economic profits. 41 Product differentiation is a dynamic process, however; popular product innovations will inevitably be copied by competitors. IMPORTANT IMPLICATIONS FOR THE MANAGER: During the maturity stage of the product life cycle, 1. Firms can fend off normal profits by differentiating their products 2. Advertising to increase demand is unlikely to increase market share or profits unless the campaign raises awareness of the new features offered by the product. Decline Stage Eventually, most products and services reach the decline stage. Typewriters, 8-track tapes, slide rules, CB radios, and VCRs were once popular goods that have been replaced by technologically superior products. A combination of overproduction and declining consumer demand causes sales to fall (or plummet in some cases) and profits decrease. Many firms begin to sustain economic losses and either drop the product line or leave the industry. This scenario is depicted graphically in Figure 9. As better products render the existing good obsolete, product demand decreases such that the profit-maximizing price and quantity do not generate sufficient profits to cover their opportunity cost. [Figure 9 here] The biggest mistake firms can make in the decline stage is to assume that sales will turn around if it changes its marketing strategy, lowers its price, or the economy 42 improves. Quite often, the early exit of competitors will steer customers toward remaining firms, reinforcing, albeit briefly, the appearance of a rebounding market. Indeed, some firms will survive the shakedown; however, it is important that the manager distinguish between oversupply and a product that is, or soon will be, obsolete. What exit strategies can a firm employ? Harvesting refers to a gradual phase-out of the firm’s support for the product while trying to maintain sales for as long as possible. The firm may cease to invest in product development, it may reduce its salesforce or the level of advertising. Inevitably, of course, sales will follow. Divesting, on the other hand, is an attempt to sell the business to another buyer. Sometimes regional interests in a business remain long after national interests have waned. SUMMARY 1. In the absence of market barriers, economic profits will entice more firms to enter the industry. The influx of competition will compete prices downward, reduce the firm’s market share, and eliminate the surplus profit. 2. By differentiating one’s product, the firm can increase its product demand and make its demand less elastic. Unless the firm continually distinguishes itself in the marketplace, popular innovations will be replicated by rival firms, pushing the innovator toward a normal profit. 3. The firm can differentiate its product by adding features, improving product quality, and establishing an image and brand loyalty through advertising. Beyond the product itself, the firm can improve the quality of services in terms of delivery, repair, and ongoing post-sale customer service. A firm can also 43 distinguish itself from its competitors by paying above-market salaries to attract the most productive personnel. 4. If a firm enjoys some degree of market power, has the ability to limit re-sale of its good, and can segment its buyers by their willingness to pay, it can reduce consumer surplus and increase profits through price discrimination. 5. In first-degree price discrimination, the firm attempts to extract the most consumer surplus by selling each unit for the highest price it can. This is not easy to do because consumers have an incentive not to disclose the maximum price they are willing to pay. 6. Second-degree price discrimination involves the practice of bundling goods together or offering discounts on additional units purchased. 7. With third-degree price discrimination, the firm segments its target market into readily identifiable groups defined by their price elasticity and sets separate prices for each group. 8. Information technology allows firms to adapt their prices at any moment to match supply to demand. Fixed posted prices differ across transactions (i.e. by customer and/or time). Price discovery is where direct interactions with the customer determine the price. In the standard auction, the good is sold to the buyer who bids the highest price. In the reverse auction, the buyer purchases from the seller who bids the lowest price. In the Dutch auction, the auctioneer begins with a high asking price and gradually lowers the price until a buyer is found. With group buying, individual buyers form buying pools to purchase discounted products. 44 9. Cost-plus pricing is a strategy through which the price is set as some percentage markup over unit cost. However, because markets are dynamic, the optimal cost- plus percentage continually changes. Ultimately, the optimal cost-plus percentage is the result of the competitive environment the firm finds itself in at any given point in time; it is not an effective rule of thumb for setting prices. 10. Products often go through four stages of the product life cycle. The stages include the introductory stage, the growth stage, the maturity stage, and the decline stage. Each stage warrants its own pricing and product differentiation strategy with an eye toward maximizing the long-term profits of the good. 11. In the introductory stage, the firm sustains losses. It can use a skimming strategy of setting a high price to recover fixed expenses faster and appeal to the segment of the market that is willing to pay a premium to obtain the good. Alternatively, if brand loyalty is difficult to establish and market entry is relatively easy, a low- price strategy may be preferred. This increases the breakeven quantity for prospective competitors and may slow the entry of new firms. 12. In the growth stage, sales are growing at an increasing rate and competitors are beginning to enter the industry. The firm needs to begin differentiating its product in anticipation of downward pressure on prices and falling profits. 13. In the maturity stage, the growth in sales rises at a slower rate, then becomes stagnant, and eventually begins to decline. Profits decrease as competitors force prices downward and expenditures rise to develop new product innovations and promote and maintain brand loyalty. 45 14. In the decline stage, the product no longer generates sufficient revenues to generate a normal profit. If the product is not obsolete, the exit of weaker firms can increase the firm’s demand and generate a normal profit. If the product is or will soon become obsolete, the firm needs to consider an exit strategy for its good. 46 Mini-Case: The Internet Cafe Barbara Parrington, inspired by her trip to Amsterdam, decided to open an Internet café in Oldfield, Missouri, a college town of 90,000. It included 30 computer terminals with 17-inch LCD flat-screen monitors and eight laptop stations with wireless Internet access. All computers were equipped with the latest versions of word processing, spreadsheet, and instant messaging software. The price list for computer access was $5 per half-hour for a regular terminal and $6/half-hour for use of a laptop station. Because Parrington anticipated that many persons in her target market already owned personal computers or had access to them through the university, she aspired to market the café as not only a place to gain Internet access, but as a place to relax and meet friends. The café was attractively designed to appeal to college students and young professionals, with comfortable sofas, a plasma TV screen, and a small café serving coffee and pastries. The Internet café was a roaring success. Three-quarters of the terminals and laptops were occupied at any point in time and sales of food and drinks at the café were brisk. Within a year, however, three other Internet cafes popped up across town---one in a popular student area in a plaza across the street from the university. Although Parrington enjoyed some regular customers who seemed comfortable with the environment, occupancy at the terminals fell below 50% and sales at the café declined by 15%. As profits decreased, Parrington decided she needed to attract new customers. She toyed with the idea of reducing prices on terminal usage, developing a frequent user discount plan, offering 47 soups and sandwiches at the café, or completely re-designing the café to add to its appeal. At the same time, she worried that her most loyal clientele would be put off by too many changes. PROBLEMS 1. Rick Ferringer opened a racquetball club in suburban Milwaukee. The club charged an annual membership fee of $300 plus court fees of $10/hour. Seventy-five percent of his members are families or married couples (the annual fee is the same regardless of how many persons in the family). The remaining 25% of members are single. The club’s most recent annual income statement appears below. Income Statement Revenues: Membership fees: $157,500 Court fees: $414,720 Total: $572,220 Expenses: Personnel: $150,000 Utilities: $5,250 Supplies: $17,300 Debt Service: $335,400 Total: $507,950 Net Income: $64,270 48 Rick was disappointed in the club’s profits. As a sole proprietorship, he believes he could earn more by selling the club and going back to his old job as human resource manager. He has considered raising his membership fees to increase his revenues, but fears losing members---particularly single members. An alternative is to lower fees to attract more members, but his courts are already occupied 75% of the time. If members have trouble getting court time, they will be less likely to renew their memberships. Another possibility is to raise court fees, but higher fees could deter usage and reduce rentals. Lower fees are unlikely to raise revenues because of the high occupancy rates of the courts. What other pricing strategies might increase Rick’s revenues? 2. Box Office Video rents DVDs. It typically orders multiple copies to allow for the heavy rentals that tend to occur within the first three weeks after the DVD is first released. Once the rental has diminished in popularity, the firm shrink- wraps all but one or two of the DVDs and offers them for sale as “pre- viewed”, with prices set at $10. Popular movies sell in this market quite well, but as many as 60% of the films do not sell at all. Box Office experimented with lowering the price of the low-demand DVDs to $5, but did not enjoy appreciable gains in sales. Paul Huggins, one of the marketing executives, suggested the firm stop selling DVDs individually and instead bundle a high- demand film with a low-demand film and sell the package for $12. “All 49 you’re really doing is lowering the price of the low-demand film to $2”, another executive, Julia Bertrand, replied, “why not just sell high-demand films for $10 and low-demand films for $2?” “If you sell a DVD for $2,”, responded Paul, “you’re basically telling consumers it’s a bad movie and that they’re wasting their money.” Comment on the executives’ pricing proposals. 3. Internet Now is an Internet Service Provider (ISP). Five years ago, the firm earned significant profits at its monthly rates of $25 for unlimited access. Since then, ISPs have sprung up all over town, driving prices down to less than $10/month. Over the years, Internet Now has added spam controls, pop- up blockers, and virus protection to distinguish itself from competitors, but each innovation is quickly replicated by rival ISPs. Between the lower price and decreasing subscribers, Internet Now’s profits have fallen to the point where the firm is considering leaving the industry. Moreover, the firm believes few nonusers exist in the market---if a household owns a personal computer, it has already chosen an ISP. Warren Davis, who started the firm seven years ago, offered up an aggressive promotion strategy. “Few ISPs in this town advertise. Occasionally, they’ll run an ad in the newspaper, as we do, but you never see an ad on television. Let’s budget for an aggressive television and radio campaign. If we can get 20% of current users to switch providers, we’ll recover our promotional costs and increase our profits.” 50 Comment on Warren’s proposal. 4. Gamers, Inc. competes in the aggressive video game player market. Recently, it unveiled its newest product. Based on technology similar to satellite radio, owners of the satellite game station pay a monthly fee to gain access to hundreds of video games that can be transmitted via satellite. Executives at Gamers have argued over what pricing policy to employ. Some have argued that Gamers price the new product at $400, arguing that its benefits far exceed the existing video game player market. Others believed the firm should price the good at a level commensurate with existing video game players and penetrate the market quickly. Discuss the pros and cons of each proposal. 5. Barney Barnhill decided to open up a buffet restaurant and was contemplating what he should charge for each buffet. He settled on charging $10/buffet. Children under 3 years old were not charged, as they were allowed to eat from a paying adult’s plate. After the first year of operation, revenues tapered off and averaged $115,000 per month with 11,500 buffets being sold. Barney decided to put a survey/comment box near the restaurant exit to see how he could improve his business. Barney learned that customers with children ages 4-12 tended not to frequent the restaurant as often as customers without children or those with older children. Barney deduced that 51 customers with younger children felt that the $10 price was too high to pay for a child to eat and that these customers chose not to frequent very often because of this. Through the surveys, Barney also estimated that only about 10% (1,150) of the buffets sold were to children ages 4-12. To fix the problem, Barney decided to offer free buffets for children ages 12 and under. The next three months, revenues decreased to $110,000, yet head count for buffets increased to an average of 15,000/month. What caused the restaurant’s decrease in revenues? What alternative strategy could Barney implement that would increase revenues without losing customers? 6. The Kiromi Corporation manufactures plasma televisions. Last year, it sold 800,000 units at an average price of $2,500. Stiff competition in the industry projects a 10% price decrease this year, with Kiromi’s unit sales declining by 15%. To distinguish its product from its competitors, Kiromi is considering new motion adaptive anti-burn technology that will reduce the likelihood of “burn-in” by 50%. Burn-in occurs when an image is permanently burned into the television screen (usually from video games or fixed images at the bottom of the screen). Plasma televisions are particularly prone to burn-in. Kiromi believes the new technology will allow them to maintain the price and unit sales at their current level. However, the new technology will increase unit costs from the current level of $1,155 to $1,460. Is the new technology worthwhile? 52 7. In 1980, the Society of London Theatre opened the TKTS booth. Plays and musicals performed in London’s West End typically sell for prices ranging from ₤35 to ₤70, depending on the popularity of the show. However, relatively few shows are sold out. Patrons willing to wait in line at the TKTS booth may purchase tickets for available shows at half-price, but only on the day of the performance. Explain how the TKTS is an example of third-degree price discrimination. 8. Animal Palace is a wildlife refuge that houses wildlife and is a major attraction for tourists in Durango, Colorado. The refuge recently contracted to extend its grounds to provide more space for the wildlife. The addition of 30 acres will cost the refuge approximately $380,000 for labor and other costs associated with creating the extension. The extension will also result in ongoing additional labor and associated expenses totaling $227,000/year. Management believes the extension will be well- received by tourists. It plans to increase ticket prices from $15 to $20 for a day pass. Annually, 60,000 visitors tour the park. Management believes the higher price will not impact the level of visitation due to the improvements of the park. 53 9. The University of Hoops Athletic Department announced its new program for establishing priorities for post-season ticket distribution. The university has had a long history of performing well in the post-season men’s basketball tournament. Because the level of demand for post-season tickets far exceeds the capacity of the basketball arena, the department announced the following priority schedule: Priority Criteria First Season ticket holders of both men’s and women’s basketball and contributors of at least $5,000 to the Hoops Club Second Season ticket holders of both men’s and women’s basketball season ticket holders and contributors of $1,000- $4,999 to the Hoops Club Third Season ticket holders of both men’s and women’s basketball season ticket holders and contributors of $1- $1,000 to the Hoops Club Fourth First-come, first-served based on availability Explain how the University of Hoops Athletic Department priority post-season ticket distribution program extracts consumer surplus. 10. Mark Patrick, production supervisor at the Kelly Corporation has been under fire by higher level management. Kelly uses absorption costing to determine unit cost and 54 determines its price as a 25% markup over cost. Until recently, the unit cost was reported as $120, leading to a price of $150. A significant re-tooling at the production facility caused the unit cost to rise to $128. Accordingly, management increased its price to $160. At the new price, unit sales fell from 12,500 units to 12,000 units. Moreover, accounting reported that unit costs had risen to $129.17, necessitating a price increase to $161.50. Unfortunately, sales fell to 11,800 units and unit costs rose to $131.63. Patrick has been told on no uncertain terms that unless he can control production costs, his job is in serious jeopardy. Is Patrick the source of the problem? If not, what is? 55 HANDS-ON EXERCISES The Economics of Product Differentiation The firm in the below table produces a fairly undifferentiated product. In the below table, assume fixed costs are $6. Variable costs are equal to $5/unit. Table 1 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $12 0 ____ --- ____ --- _____ $10 1 ____ ____ ____ ____ _____ $8 2 ____ ____ ____ ____ _____ $6 3 ____ ____ ____ ____ _____ $4 4 ____ ____ ____ ____ _____ $2 5 ____ ____ ____ ____ _____ a. Calculate the price elasticity of demand between 0 and 1 unit. Calculate the price elasticity of demand between 1 and 2 units. 0-1 unit: _______________ 1-2 units: ______________ b. Determine the profit-maximizing price and output level. Price: ______ Output: ______ 56 c. Assuming the firm’s fixed costs include the accounting profit it could earn outside the industry, does the firm have an economic profit, an economic loss, or a normal profit? Explain. The below table shows the demand schedule after the firm has differentiated its product. Table 2 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $14 0 ____ --- ____ --- _____ $13 1 ____ ____ ____ ____ _____ $12 2 ____ ____ ____ ____ _____ $11 3 ____ ____ ____ ____ _____ $10 4 ____ ____ ____ ____ _____ $9 5 ____ ____ ____ ____ _____ $8 6 ____ ____ ____ ____ _____ d. Plot the demand curves in Tables 1 and 2 on the same graph. How did product differentiation affect the firm’s demand? Price $14 $12 $10 $8 $6 $4 $2 57 0 1 2 3 4 5 6 Quantity e. Calculate the price elasticity of demand between 0 and 1 unit. Between 1 and 2 units. 0-1 unit: ____________ 1-2 units: ___________ How did product differentiation affect the price elasticity of demand? f. Determine the profit-maximizing price and quantity in Table 2. Price: ______ Output: ______ g. Does the firm have an economic profit, an economic loss, or a normal profit? Explain. 58 The below table re-produces the demand schedule following product differentiation. Suppose the R&D necessary to develop new product features increases the firm’s fixed costs from $6 to $10, while variable costs remain the same. Table 3 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $14 0 ____ --- ____ --- _____ $13 1 ____ ____ ____ ____ _____ $12 2 ____ ____ ____ ____ _____ $11 3 ____ ____ ____ ____ _____ $10 4 ____ ____ ____ ____ _____ $9 5 ____ ____ ____ ____ _____ $8 6 ____ ____ ____ ____ _____ h. Determine the profit-maximizing price and quantity in Table 3. Price: ______ Output: ______ i. Compared to the results in Table 2, how did the cost of differentiating the good affect the firm’s profit-maximizing price and quantity? Why? 59 j. Comparing Tables 1 and 3, did the benefits from product differentiation justify the costs? Explain. This time we will assume product differentiation does not affect the firm’s fixed costs, which are still $6, but increase the firm’s variable costs from $5/unit to $6/unit. Table 4 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $14 0 ____ --- ____ --- _____ $13 1 ____ ____ ____ ____ _____ $12 2 ____ ____ ____ ____ _____ $11 3 ____ ____ ____ ____ _____ $10 4 ____ ____ ____ ____ _____ $9 5 ____ ____ ____ ____ _____ $8 6 ____ ____ ____ ____ _____ k. Determine the profit-maximizing price and quantity in Table 4. Price: ______ Output: ______ l. Compared with the results from Table 2, how did differentiating the good affect the firm’s profit-maximizing price and quantity? Why? m. Did the benefits from product differentiation justify the costs? Explain 60 In Table 5, we will assume product differentiation raises variable costs from $5/unit to $9/unit while leaving fixed costs unchanged. The new innovation also has a smaller impact on demand than shown in Tables 2-4. Table 5 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $13 0 ____ --- ____ --- _____ $12 1 ____ ____ ____ ____ _____ $11 2 ____ ____ ____ ____ _____ $10 3 ____ ____ ____ ____ _____ $9 4 ____ ____ ____ ____ _____ $8 5 ____ ____ ____ ____ _____ n. Determine the profit-maximizing price and quantity in Table 5. Price: ______ Output: ______ o. Did the benefits from product differentiation justify the costs? Explain. 61 Price Discrimination First-degree price discrimination versus a single-price strategy Table 1 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $11 0 ---- ---- $5 --- _____ $10 1 _____ _____ $10 _____ _____ $9 2 _____ _____ $15 _____ _____ $8 3 _____ _____ $20 _____ _____ $7 4 _____ _____ $25 _____ _____ $6 5 _____ _____ $30 _____ _____ $5 6 _____ _____ $35 _____ _____ $4 7 _____ _____ $40 _____ _____ a. Determine the profit-maximizing price, quantity, and profit-level. Price: ________ Quantity: ________ Profit: __________ b. Calculate the total consumer surplus at the profit-maximizing quantity Unit Consumer Surplus 1st ________ 2nd ________ 62 3rd ________ 4th ________ Total: _________ This time, the firm charges the highest possible price (according to demand) for each unit it sells. Table 2 Price Quantity Total Marginal Total Marginal Total Revenue Revenue Cost Cost Profit $11 0 ---- ---- $5 --- _____ $10 1 _____ _____ $10 _____ _____ $9 2 _____ _____ $15 _____ _____ $8 3 _____ _____ $20 _____ _____ $7 4 _____ _____ $25 _____ _____ $6 5 _____ _____ $30 _____ _____ $5 6 _____ _____ $35 _____ _____ $4 7 _____ _____ $40 _____ _____ c. Determine the profit-maximizing quantity. How does the quantity compare with the optimal output using the single-price strategy? Why do you suppose the quantities differ? d. Calculate the total consumer surplus at the profit-maximizing quantity Unit Consumer Surplus 1st ________ 2nd ________ 63 3rd ________ 4th ________ Total: _________ e. How does first-degree price discrimination affect consumer surplus? The firm’s profits? This strategy is called first degree price discrimination. It attempts to extract consumer surplus by selling each unit for the maximum the consumer is willing to pay. f. Why is first-degree price discrimination had to implement in actual practice? 64 Second degree price discrimination You operate a mail-order compact disk club. The below table represents the monthly demand schedule for your typical customer. Table 1 Price Quantity Total Total Total Revenue Cost Profit $16 0 ____ $10 _____ $14 1 ____ $15 _____ $12 2 ____ $20 _____ $10 3 ____ $25 _____ a. What price should you charge to maximize profits? How many CDs will you sell to the typical customer each month? How much profit will you earn? Price: ___________ Quantity: ________ Profit: _________ b. Calculate the consumer surplus for the typical customer. Unit Consumer surplus 1st ______ 2nd ______ 3rd ______ Total: ______ 65 c. Suppose you offered customers the following deal: they pay $14 for the first CD and get additional CDs at a price of $10. Determine the number of CDs the typical consumer would purchase under this deal. Calculate the firm’s profits. Table 2 Price Quantity Total Total Total Revenue Cost Profit $16 0 ____ $10 _____ $14 1 ____ $15 _____ $12 2 ____ $20 _____ $10 3 ____ $25 _____ d. Compare the profits earned under this strategy with the single-price strategy in Table 1. By how much did the firm’s profits change? e. Calculate the consumer surplus for the typical customer. Unit Consumer surplus 1st ______ 2nd ______ 3rd ______ Total: ______ 66 f. Compare the consumer surplus in part e with the consumer surplus in part b. What happened to consumer surplus with the new strategy? This strategy is called second degree price discrimination. It attempts to extract consumer surplus by offering discounts only on additional units. 67 Third degree price discrimination You own a movie theater. All of your costs are fixed (fixed costs equal $100), so you maximize profits by maximizing revenues. The below table shows the number of ticket- buyers at each price. Table 1 Price Quantity Total Marginal Revenue Revenue $10 50 _____ ______ $8 80 _____ ______ $6 110 _____ ______ $5 140 _____ ______ $4 170 _____ ______ a. Determine the profit-maximizing price and quantity of tickets sold. Calculate the profits earned at this price and quantity. Price: __________ Quantity: _________ Profit: __________ b. Calculate the consumer surplus under the single-price strategy. Unit Consumer surplus 1st 50 tickets ______ Tickets 51-80 ______ Tickets 81-110 ______ 68 Tickets 111-140 ______ Total: ______ c. Table 1 shows the total quantity of tickets demanded at each price. Suppose the market can be segmented into two groups: senior citizens (those aged 65 and over) and everyone else. The below tables show the demand schedule for each group. Suppose you were to treat each group separately and charge each group a separate price. Table 2 Aged 65 and over Price Quantity Total Marginal Revenue Revenue $10 10 $100 _____ $8 20 $160 _____ $6 35 $210 _____ $5 50 $250 _____ $4 65 $260 _____ d. What price would you charge to senior citizens? How many tickets would be sold at that price? Price: ______ Quantity: ______ e. Determine the consumer surplus from the price and quantity in part d. Unit Consumer surplus 1st 10 tickets ______ Tickets 11-20 ______ Tickets 21-35 ______ Tickets 36-50 ______ 69 Tickets 51-65 ______ Total: ______ Table 3 Under age 65 Price Quantity Total Marginal Revenue Revenue $10 40 _____ _____ $8 60 _____ _____ $6 75 _____ _____ $5 90 _____ _____ $4 105 _____ _____ d. What price would you charge to persons under age 65? How many tickets would be sold at that price? Price: ________ Quantity: ________ e. Determine the consumer surplus from the price and quantity in part d. Unit Consumer surplus 1st 40 tickets ______ Tickets 41-60 ______ Total: ______ f. Calculate the sum of the consumer surpluses from each group. How does this compare with the consumer surplus from the single-price strategy in part b? 70 g. Calculate your total profits from Tables 2 and 3 (recall that fixed costs are equal to $100 overall, not $100 per group). How do your profits compare with that generated with the single-price strategy? This strategy is referred to as third degree price discrimination. It attempts to extract consumer surplus by segmenting the market into groups based on their price elasticity of demand and establishing separate prices for each group. 71 Cost-plus Pricing Assume a firm faces fixed costs of $1,000 and variable costs of $.50/unit. a. If the firm currently produces 1,000 units, determine its total cost and its average total cost. Total cost: _________ Average total cost: ____________ b. Suppose the firm has a practice of setting its price at 50% above unit cost. In this case, what price would the firm charge? c. What if the firm’s competitors charged $1.40? What do you think would happen to the firm’s unit sales if it charged the price you calculated in part b? d. Suppose that at the price you charged in part b (and given the rival firm’s price of $1.40), your unit sales fall to 500 units. Calculate your total cost and your average total cost at this output level. Total cost: _________ Average total cost: ____________ 72 Figure 1 Industry Firm P Supply $ MC P ATC P* P* d = P = MR ATC Demand Q q* Q 73 Figure 2 Industry Firm P Supply 1 MC Supply 2 ATC P1 d1 = P1 = MR1 P1 P2 d2 = P2 = MR2 P2 P = ATC Q q2 q1 74 Figure 3 Price P2 P1 Demand (undifferentiated) Demand (differentiated) q2 q2' q1 Quantity 75 Figure 4 MC P1 D1 q1 MR1 P P2 MC Demand increases and P1 becomes less elastic D2 D1 MR1 MR2 q1 q2 Q 76 Figure 5 MC P1 Economic profit ATC D1 q1 MR1 P = ATC = Normal Profit MC P1 ATC P2 Demand shifts to left and becomes more elastic D2 q2 q1 MR2 77 Figure 6 $ $10 $9 $8 $7 $6 MC $5 $4 Demand = MR 1 2 3 4 5 6 7 Quantity 78 Figure 7 $14 A $12 B C $10 Demand 1 2 3 Quantity Figure 8 79 $ Sales Profit Time Introduction Growth Maturity Decline 80 Figure 9 $ MC ATC ATC Economic loss P* Demand q* Quantity MR APPENDIX 81 Cost-Plus Pricing Cost-plus pricing refers to the practice of setting the price as a percentage markup over unit cost. Economic theory illustrates the optimal cost-plus price by manipulating the terms of the familiar rule in which the profit-maximizing output exists where MR=MC. We know that: MR = dTR/dQ (1) Because total revenue is simply P x Q, we can re-write the above as: MR = d(P x Q)/dQ, or: (2) MR = (P x dQ + Q x dP)/dQ, which can be simplified as: MR = P + Q x dP/dQ. (3) If we factor out P, we get: MR = P(1 + Q/P x dP/dQ). (4) You may recall that the price elasticity of demand (εp) is equal to P/Q x dQ/dP. Consequently, the marginal revenue equation can be re-written as: MR = P(1 + 1/ εp). (5) Now, we can bring the MR = MC rule into the mix. Given the above, we know a firm will maximize profits at the output level for which: P(1 + 1/ εp) = MC. (6) Dividing both sides of the equation by (1 + 1/ εp) yields the optimal cost-plus price, or: P= MC x (1/(1 + 1/ εp)). (7) 82 Equation (7) can be re-written as: P= MC x 1 (8) (εp/ εp + 1/ εp)), or, P = MC[εp/(1+ εp)]. (9) Cost-plus pricing sets the price as some percentage markup over unit cost, or as illustrated here, over marginal cost. Hence, the cost-plus price must be: P = MC(1 + % markup). (10) Taken together, equations (9) and (10) imply that (1 + % markup) = εp/(1+ εp). Therefore, the optimal percentage markup is equal to: εp/(1+ εp) – 1 (11) Equations (9) and (11) reveal some of the intuition discussed in the chapter. Equation (9) suggests the optimal cost-plus price depends on marginal cost and the price elasticity of demand. Recalling that the price elasticity of demand is a negative number (as the price rises, the quantity demanded decreases), let’s try an example. If the price elasticity of demand is equal to -3, then according to (11), the optimal cost-plus price is equal to: -3/(1 + (-3)) – 1 = ½. In other words, the optimal percentage is a 50% markup over marginal cost. As demand becomes more elastic, the optimal markup gets smaller. For example, if εp = -4, the optimal percentage markup is equal to: -4/(1 + (-4) – 1 = 0.33, or 33% over marginal cost. At face value, equation (9) appears to be a wonderful tool to use for cost-plus pricing. Unfortunately, a closer examination will reveal that equation (9) is a mathematical identity, not a tool. In this context, the price elasticity of demand (εp) is the 83 point price elasticity of demand. Each point on a linear demand curve has its own unique elasticity. But, if εp is equal to P/Q x dQ/dP, then (9) can be re-written as: P = MC[(P/Q x dQ/dP) /(1+ P/Q x dQ/dP)]. (10) Note that the price of the good (that we presumably hope to solve for) appears on the right side of the equation. That’s why (9) is a mathematical identity rather than a decision-making tool. It merely states that if a firm has selected the profit-maximizing price and quantity, then P = MC[εp/(1+ εp)]. Although not useful as a tool, equation (9) does provide insights as to the importance of the price elasticity of demand in setting a price over marginal cost. 84