ECONOMICS CHAPTER 8 & 9 ASSIGNMENT

Subject: Economics / Accounting
Question
Chapter 8 Monopoly LEARNING OBJECTIVES Appreciate how to gain market power.
For a seller with market power, identify the scale of production/sales
that maximizes profit.
Appreciate how to adjust sales to changes in demand and costs.
For a seller with market power, identify the levels of advertising and
R&D expenditure that maximize profit.
Appreciate that sellers with market power restrict sales to raise
margins and profit.
Apply the incremental margin percentage to measure market power.
For a buyer with market power, identify the scale of purchases that
maximize profit. KEY TAKEAWAYS Gain market power by limiting competition and making demand less
price-elastic.
To maximize profit, produce if total revenue covers total cost, and,
then, produce at the scale where marginal revenue equals marginal
cost.
When demand or costs change, adjust production to the scale where
marginal revenue equals marginal cost. To maximize profit, spend on advertising to the level where the
advertising-sales ratio equals the incremental margin percentage
multiplied by the advertising elasticity of demand.
To maximize profit, spend on R&D to the level where the R&D-sales
ratio equals the incremental margin percentage multiplied by the R&D
elasticity of demand.
Sellers with market power restrict sales to raise margins and profit.
Measure market power by the incremental margin percentage.
To maximize profit, purchase at the scale where marginal benefit
equals marginal expenditure. DETAILED NOTES
A Introduction.
1 Market power: The ability of a buyer or seller to influence market
conditions.
i) A seller with market power can influence market demand, in
particular, the price and quantity demanded.
ii) A buyer with market power can influence market supply, in
particular, the price and quantity supplied.
2 Business can use their market power to increase revenue, reduce cost
and so increase economic profit.
3 Monopoly: the only one seller in the market.
4 Monopsony: the only one buyer in the market.
B Sources of Market Power.
1 Ingredients of market power.
i) Barriers to competition. Competitors must be deterred or
prevented from entering the market to compete for the business.
ii) Elasticity of demand or supply. Seller with market power can
reduce the price elasticity of demand, raise prices and increase
profit.
2 Sellers can create barriers to competition and reduce the price
elasticity of demand in four ways:
i) Product differentiation. To the extent that differentiation appeals
to buyers it would increase demand and reduce price elasticity of
demand.
(1)Design (appearance, form and feel): an appealing design can
transform utilitarian products into distinctive offerings.
(2)Function.
(3)Distribution channels. (a) Luxury products: exclusive distribution to build brand image
and demand.
(b)Mass consumer goods: intensive distribution to provide wide
and timely availability.
(4)Advertising and promotion introduce the buyers to products and
communicate the brand image; and can be used to influence and
sustain buyers’ preferences.
ii) Intellectual property (IP). Product differentiation builds, in part,
on innovation. Innovators may able to exclude competitors by
establishing IP over their innovators.
(1)Patent: gives the owner exclusive right to an invention for a
specified period of time. E.g., Pfizer’s patent over Lipitor.
(2)Copyright: exclusivity over published expressions for a specified
period of time. E.g., Microsoft’s copyright over Windows.
(3)Trademarks: exclusivity over words or symbols associated with a
good or service; the basis for branding, advertising, and
promotion. E.g., Pfizer’s Lipitor trademark.
(4)Trade secrecy: exclusivity over information that is not generally
known and provides commercial advantage; broader in scope
than patents – extends to customer lists and technical
information. E.g., Google’s algorithms.
iii) Economies of scale, scope, and experience. By establishing a
sufficient cost advantage and through strategic management of
costs, an incumbent producer may be able to deter entry by
potential competitors.
(1)Economies of scale. A producer that produces on a larger scale
has a cost advantage over smaller scale competitors. E.g., cable
network (large fixed costs and relatively low variable costs).
(2)Economies of scope. A combined provider of multiple products
can achieve lower costs/gain a cost advantage over specialized
competitors. E.g., the broadband and cable TV industries (both
depend on a network of cables) tend to be dominated by a few
providers, each providing both services.
(3)Economies of experience. A producer that accumulates larger
production can gain a cost advantage over competitors with less
experience.
iv) Regulation. The government may limit competition by law and in
the extreme, allow only a single producer.
(1)Economic reason: the presence of large fixed costs in production.
E.g., the government may award exclusive franchises (intended
to avoid duplication of the fixed costs of the distribution network)
in the distribution of electricity, natural gas, and water.
(2)Social policy or profit maximization: major sports, mass media,
alcohol, tobacco, gambling. (3)In advanced economies: indirectly restrict competition through
trade policy against imports or through health or environmental
policy.
C Profit Maximum.
1 Extent: Scale of production and price. A monopoly (unlike a
perfectly competitive seller) has to consider how its sales will affect the
market price.
i) Given a downward sloping market demand curve, a monopoly can
either:
(1)Decide how much to sell and let the market determine the price
at which it is willing to buy that quantity; or
(2)Set the price and let the market determine how much it will buy.
A monopoly can set either sales or price, but not both. Otherwise,
there may be inconsistency (a combination of sales and price off the
demand curve).
2 Profit-maximizing sales.
i) Revenue. Consider the relationship among price, sales, and
revenue.
(1)For simplicity: scale of production and sales are equivalent (by
ignoring inventories, hence production = sales).
(2)Total revenue = price x sales.
(3)To sell additional units, the price must be reduced. When
increasing sales by one unit, the monopoly:
(a) Gains revenue from selling the additional or marginal unit; but
(b)Loses revenue on the inframarginal units.
(c) Inframarginal units are those units sold other than the
marginal unit. The monopoly would have sold the
Inframarginal units without reducing the price.
(4)Marginal revenue = change in total revenue arising from selling
an additional unit.
(a) In general, the marginal revenue from selling an additional
unit will be less than the price of that unit. It is the price of
the marginal unit minus the loss of revenue on the
inframarginal units.
(i) The difference between price and marginal revenue
depends on the elasticity of demand.
(ii) If demand is very elastic, the seller need not reduce the
price very much to increase sales, the marginal revenue
will be close to price.
(iii)
If demand is very inelastic, the seller must reduce
the price substantially to increase sales, the marginal
revenue will be much lower than price.
(b)Marginal revenue could be negative: if the loss of revenue on
the inframarginal units exceeds the gain on the marginal unit.
ii) Costs. The other side to profit is cost. (1)Total cost increases with the scale of production.
(2)Marginal cost = change in total cost due to the production of an
additional unit.
(a) The change in total cost arises from change in the variable
cost.
iii) Profit-maximizing scale.
(1)Profit = total revenue – total (fixed and variable) cost.
(2)Profit-maximizing scale of operation (and profit-maximizing price)
is where: Marginal revenue balances marginal cost.
3 Participation: participate if the total revenue covers total cost – with
both revenue and cost calculated at the profit-maximizing scale.
4 Profit measures:
i) Profit contribution is the total revenue less variable cost.
ii) The incremental margin =
(1)Price less marginal cost; or
(2)The increase in the profit contribution (and profit) from selling an
additional unit, holding the price constant.
iii) The incremental marginal percentage = the ratio of the
incremental margin (price less marginal cost) to the price.
5 A seller should simultaneously maximize on price, advertising, and
other influences on demand.
D Changes in demand and cost. The monopoly should adjust sales until
marginal revenue equals marginal cost.
1 Demand change. Suppose that demand increases:
i) From the new demand curve, calculate the new marginal revenue
curve. The new marginal revenue curve lies further to the right.
ii) The original marginal cost curve does not change.
iii) The new marginal revenue curve and the original marginal cost
curve cross at a larger scale.
iv) The new profit-maximizing price is higher.
2 Marginal cost change. Suppose that marginal cost decreases:
i) The original marginal revenue curve and the new marginal cost
curves cross at a larger scale.
ii) The new profit-maximizing price is lower. The cut in price is less
than the fall in marginal cost.
3 Fixed cost change.
i) So long as fixed cost is not too large, changes in fixed cost do not
affect marginal cost, and will not affect the profit maximizing price
and scale.
ii) However, if the fixed cost is so large that total cost exceeds total
revenue, then the monopoly should shut down.
iii) Fixed costs only matter for the break-even decision (whether to be
in business at all). iv) Note: knowledge-intensive industries like media and publishing,
pharmaceuticals, software characterized by relatively high fixed
costs and low variable costs.
E Advertising.
1 A seller with market power and can influence market demand (changes
in demand and/or elasticity of demand) through promotion.
i) Advertising can influence market demand by:
(1)Shifting out the demand curve; and
(2)Causing demand to be less price elastic.
2 Benefit of advertising.
i) Increase in sales will affect total revenue and variable cost and the
profit contribution.
3 Profit-maximizing level of advertising expenditure. Advertise up
to:
i) The level that the marginal benefit = the marginal cost, i.e., where
the increase in contribution margin = the additional advertising
expenditure; or
ii) The level that the Advertising-sales ratio = the incremental
margin percentage multiplied by the advertising elasticity of
demand.
(1)Advertising-sales ratio = the ratio of the advertising
expenditure to sales revenue.
(2)The advertising elasticity of demand = the percentage by
which demand will change if the seller’s advertising expenditure
rises by 1%, other things equal.
4 A seller should spend more on advertising if:
i) The incremental margin percentage is higher, as each dollar of
advertising produces relatively more benefit as measured by the
incremental margin percentage. This means that, whenever a seller
raises its price or its marginal cost falls, it should also increase
advertising expenditure; or
ii) Either the advertising elasticity of demand or the sales revenue is
higher, as the influence of advertising on buyer demand is relatively
greater.
F Research and Development.
1 A seller with market power and can influence market demand (changes
in demand and/or elasticity of demand) through R&D.
i) R&D can:
(1)Shift out the demand curve; and
(2)Cause demand to be less price elastic
ii) Generally, R&D in knowledge-intensive industries drives new
products and refreshes existing products.
2 Benefit of R&D. i) Increase in sales will affect total revenue and variable cost and the
profit contribution.
ii) Net benefit from R&D = change in profit contribution less the R&D
expenditure.
3 Profit-maximizing level of R&D expenditure.
i) R&D-sales ratio = the incremental margin percentage
multiplied by the R&D elasticity of demand.
(1)R&D-sales ratio = the ratio of the R&D expenditure to sales
revenue.
(2)The R&D elasticity of demand = the percentage by which
demand will change if the seller’s R&D expenditure rises by 1%,
other things equal. This elasticity depends on two factors:
(a) The effectiveness of R&D in generating new products and
enhancing existing product,
(b)The effect of new and enhanced products on demand.
4 A seller should increase R&D expenditure relative to sales revenue if:
i) The incremental margin percentage is higher (higher price or lower
marginal cost); or
ii) Either the R&D elasticity of demand or the sales revenue is higher.
G Market Structure. Production and price depend on the competitive
structure of the market.
1 Effects of competition. Perfect competition (a market with numerous
sellers, each too small to affect market conditions) vis a vis monopoly.
i) Market price.
(1)A monopoly restricts production below the competitive level to
raise price above competitive level, and so, extract a relatively
higher margin and larger profit.
(2)Competition drives the market price down toward the long run
average cost and results in more production.
ii) The profit of a monopoly exceeds what would be the combined
profit of all the sellers if the same market were perfectly
competitive.
2 Potential competition.
i) A monopoly in a perfectly contestable market cannot raise its price
substantially above its long run average cost. Other sellers can
profit by entering the market – they will quickly enter to compete for
a share of the market. The resulting increase in supply will drive the
market price back toward the long run average cost.
(1)A perfectly contestable market is one where sellers can enter
and exit at no cost.
(2)So, even potential competition would be sufficient to keep the
market price close to the long run average cost.
ii) The degree to which a market is contestable depends on the extent
of barriers to enter and barriers to exit (e.g., liquidation costs, which will be considered by potential competitors when they decide
whether to enter the market for temporary profits in the first place).
3 Measuring market power: the incremental margin percentage.
i) It measures the degree of actual and potential competition in a
market.
ii) It enables comparison of market power in markets with different
prices and different currencies.
(1)Perfectly competitive market. Every seller produces at a scale
where market price equals marginal cost, hence the incremental
margin percentage = 0.
(2)With potential competition: if a monopoly sets a price close to its
marginal cost, the incremental margin percentage will be
relatively low.
(3)A seller with market power restricts sales to raise its price above
its marginal cost. The more inelastic is market demand, the more
a seller can raise its price above its marginal cost.
H Monopsony: A Single Buyer.
1 Benefit and expenditure.
i) Assumption: Maximization of net benefit of an input.
ii) Net benefit = benefit less expenditure.
iii) Suppose the marginal benefit of a small quantity is very high and
falls with the scale of purchases.
iv) The supply curve represents the monopsony’s average expenditure
for every possible quantity of purchases.
(1)Since the price must be higher to induce a greater quantity of
supply, the average expenditure curve slopes upward.
v) Marginal expenditure is the change in expenditure resulting from
an increase in purchases by one unit.
(1)For the average expenditure curve to slope upward, the marginal
expenditure curve must lie above the average expenditure curve
and slope upward more steeply.
2 Maximizing net benefit.
i) A buyer with market power will maximize its net benefit by
purchasing at the scale such that its marginal benefit equals
marginal expenditure.
ii) A monopsony restricts purchases (demand) to get a lower price and
increases its net benefit above the competitive level.

Chapter 9 Pricing Policy LEARNING OBJECTIVES Apply uniform pricing.
Appreciate how price discrimination can increase profit beyond uniform
pricing.
Understand complete price discrimination.
Apply direct segment discrimination.
Apply indirect segment discrimination.
Appreciate the choice between alternative pricing policies. KEY TAKEAWAYS To maximize profit with uniform pricing, set the price so that the
incremental margin percentage equals the reciprocal of the absolute
value of price elasticity of demand.
Price discrimination can increase profit by taking buyer surplus and
providing a quantity closer to economically efficient.
Complete price discrimination charges a different price for each unit of
the product.
Direct segment discrimination sets prices to earn different incremental
margins from each segment.
Indirect segment discrimination structures a choice for buyers to earn
different incremental margins from each segment.
Location is one profitable basis for segment discrimination. The ranking of pricing policies from most to least profitable is complete
price discrimination, direct segment discrimination, indirect segment
discrimination, and uniform pricing. DETAILED NOTES
A Introduction. This chapter systematically ties threads from previous
chapters on demand, elasticity, costs, and monopoly to analyze how a
seller with market power should set prices to maximize profit.
B Uniform Pricing.
1 Definition. Uniform pricing is a policy where the seller charges the
same price for every unit of the product.
2 Price elasticity. Generally, if demand is inelastic, an increase in price
will lead to a higher profit. A seller that faces an inelastic demand
should raise the price until the demand is elastic.
3 Profit-maximizing price.
4 In the price elastic range, what price maximizes the seller’s profit?
i) The rule of marginal revenue equals the marginal cost; or
ii) Equivalently, the incremental margin percentage rule: a price
such that the incremental margin percentage (i.e., price less
marginal cost divided by the price) equals the reciprocal of the
absolute value of the price elasticity of demand.
(1)Determining the profit-maximizing price typically involves a
series of trials with different prices as:
(a) price elasticity may vary along a demand curve; and
(b)marginal cost may change with scale of production.
5 Price adjustments following demand and cost changes.
i) The price adjustment following a change in price elasticity or
marginal cost depends on both the price elasticity and marginal
cost.
ii) Changes in price elasticity.
(1)If demand is more elastic (price elasticity will be a larger
negative number), the seller should aim for a lower incremental
margin percentage.
(2)If demand is less elastic, the seller should aim for a higher
incremental margin percentage.
iii) Changes in seller’s marginal cost.
(1)The seller must consider the effect of the price change on the
quantity demanded.
(2)A seller should not necessarily adjust the price by the same
amount as the change in the marginal cost.
6 Common misconceptions. i) Cost-plus pricing (i.e., setting price by marking up average cost) is
problematic.
(1)In businesses with economies of scale, average cost depends on
scale. To apply cost-plus pricing, the seller must make an
assumption about the scale. But sales and production scale
depend on price. Cost-plus pricing leads to circular reasoning.
(2)Cost plus pricing gives no guidance as to the appropriate markup on average cost.
ii) A common mistake is the belief that the profit-maximizing price
depends only on the price elasticity. This approach considers only
the demand and ignores costs. To maximize profits, however,
management should take into account both price elasticity and
marginal costs.
iii) Increasing capacity utilization may lead to lower profit: to achieve
100% utilization requires increasing sales. With uniform pricing,
that means cutting price and losing revenue on the inframarginal
buyers.
C Complete Price discrimination.
1 Shortcomings of uniform pricing. Uniform pricing does not yield
the maximum possible profit.
i) It does not extract the entire buyer surplus: the inframarginal
buyers do not pay as much as they would be willing to pay. By
taking some of the buyer surplus, a seller could increase profit.
ii) It does not provide the economically efficient quantity. By providing
the service to everyone whose marginal benefit exceeds the
marginal cost, a seller could also earn more profit.
2 Price discrimination/price differentiation. This is a pricing policy
under which a seller sets prices to earn different incremental margins
on various units of the same or a similar product.
3 Complete price discrimination is the policy whereby the seller
prices each unit at the buyer’s benefit and sells a quantity such that
the marginal benefit equals the marginal cost. “Complete” as it
charges every buyer the maximum they are willing for pay for each
unit. Hence, the policy leaves each buyer with no surplus. A seller
earns a higher profit with complete price discrimination than with
uniform pricing. It resolves the two shortcomings of uniform pricing:
i) By pricing each unit at the buyer’s benefit, the policy extracts all
the buyer surplus.
ii) The policy provides the economically efficient quantity; hence, it
exploits all opportunity for additional profit through increasing sales.
4 Economic efficiency. Maximizing profit is aligned with the social goal
of economic efficiency: allocating resources so that no person can be
better off without making another person worse off. By charging more
to customers who are willing to pay more, a non-profit or government organization can use the additional revenue to provide service to more
(poorer) customers.
5 Information and resale. To implement complete price discrimination:
i) The seller must know each potential buyer’s entire individual
demand curve. It is not enough to know the price elasticities of the
individual demand curve.
ii) The seller must be able to prevent customers from buying at a low
price and reselling to others at a higher price.
(1)Hence, complete price discrimination is more widespread in
services (especially personal services) than goods.
D Direct Segment Discrimination.
1 Introduction. If a seller does not know the entire individual demand
curve of each potential buyer and cannot price on an individual basis,
the seller may still be able to discriminate among segments of buyers.
2 Direct Segment Discrimination is the policy of pricing to earn
different incremental margins from each identifiable segment (e.g.,
adults vis a vis seniors). A segment is a significant, cohesive group of
buyers within a larger market.
3 Homogeneous segments.
i) If the buyers within each segment are homogeneous, direct
segment discrimination will achieve complete price discrimination.
ii) For each segment, the profit-maximizing price is the buyers’
willingness to pay (which is also their benefit from the item).
4 Heterogeneous segments.
i) If the buyers within each segment are heterogeneous and:
(1)The seller lacks sufficient information to identify sub-segments;
or
(2)The seller cannot prevent resale within the sub-segments, direct
segment discrimination will not achieve complete price
discrimination. There are two alternatives for pricing within each
segment:
(a) Apply uniform pricing within each segment.
(i) Profit maximizing prices: Set prices so that the incremental
margin percentage of each segment equals the reciprocal
of the absolute value of that segment’s price elasticity of
demand.
(b)Apply indirect segment discrimination within each
segment.
ii) Generally, prices should be set to derive a relatively lower
incremental margin percentage from the segment with the more
elastic demand and a relatively higher incremental margin
percentage from the segment with the less elastic demand.
5 Implementation.
i) The seller must identify and be able to use some identifiable and
fixed (otherwise the buyer might switch segments to take advantage of a lower price) buyer characteristic that divides the
market into segments with different demand curves (e.g., age,
gender, location…etc).
ii) The seller must be able to prevent resale. Generally, resale of
services is more difficult than resale of goods, hence it is easier to
implement price discrimination in services than goods.
E Discrimination by Location. To the extent that a product is costly to
transport and the seller can identify a buyer’s location, a seller can
discriminate on the basis of a buyer’s location:
1 FOB pricing: set a common price to all buyers that does not
include delivery.
i) A free on board price (FOB or ex-works price) does not include the
cost of delivery to the buyer.
ii) Each buyer pays the FOB price plus the cost of delivery to its
respective location.
iii) FOB pricing ignores the differences between the price elasticities of
demand in various markets.
iv) The differences among prices at various locations are exactly the
differences in the costs of delivery to those locations.
2 CF pricing: set prices that include delivery.
i) A cost including freight price (CF price) includes the cost of delivery
to the buyer.
ii) The seller can implement direct segment discrimination across the
markets (with uniform pricing in each market), aim for different
incremental margin percentages (= the reciprocal of the absolute
value of the price elasticity of demand) in the markets (e.g.,
domestic vis a vis Japan), and obtain higher profit.
(1)If the Japanese demand is more elastic than domestic demand,
the seller should set prices so that is incremental margin
percentage is lower in Japan than in the domestic market. A
lower margin does not necessarily mean a lower price, because
the seller’s marginal cost of supplying to the Japanese market is
higher owing to the cost of freight.
(2)If the Japanese demand is less elastic than domestic demand,
the seller should set prices so that is incremental margin
percentage is higher in Japan than in the domestic market. This
definitely means a higher price in Japan, taking into account the
seller’s higher marginal cost of supplying to the Japanese market
owing to the cost of freight.
iii) The differences among CF prices at various locations need not
necessarily correspond to the differences in the cost of delivery to
the respective locations. The differences are the result of the
different incremental margin percentages and the different marginal
costs of supplying the various markets, and may be larger or
smaller than the freight costs. 3 Direct segment discrimination provides more profit than uniform
pricing. CF pricing yields more profit than FOB pricing, because it
takes account of differences in the price elasticity of demand.
4 Parallel imports.
i) For most products, a seller can control only the location at which it
sells the product and cannot directly monitor the buyer’s location. If
the difference between the prices of a product in two markets
exceeds the transportation cost, retailers and consumers might buy
the item in one market and ship it to another.
ii) To deal with the “grey market”, manufacturers can:
(1)Customize the product;
(2)Limit sales to the sources of parallel imports, and to markets
where prices are low;
(3)Restrict warranty service to the country of purchase (durable
goods).
F Indirect Segment Discrimination. A seller may know that specific
segments (e.g., business vis a vis leisure travelers) have different demand
curves but cannot find a fixed characteristic with which to discriminate
directly. The seller may still be able to discriminate on price, but
indirectly.
1 Indirect Segment Discrimination is the policy of structuring (where
a seller cannot directly identify the customer segments) a choice for
buyers so as to earn different incremental margins from each segment.
2 Structured choice. Indirect segment discrimination usually involves a
structured choice that persuades the various buyer segments to
identify themselves through their choices (e.g., an airline structures a
choice between unrestricted and restricted fares to exploit the
differential sensitivity of business and leisure travelers to fees for
changes).
3 Implementation.
i) The seller must control some variable to which buyers in the various
segments are differentially sensitive. The seller then uses this
variable to structure a set of choices that will discriminate among
the segments.
ii) Buyers must not be able to circumvent the differentiating variable.
The seller must strictly enforce all conditions of sale to prevent
switching. Note: since indirect segment discrimination allows each
buyer a choice of products, the seller obviously cannot prevent
buyers from reselling the product.
4 Profit maximizing prices.
i) The seller must consider how buyers with different attributes
substitute among the various choices. Accordingly, the seller must
not price any product in isolation. It must set the prices of all the
products together. ii) Indirect segment discrimination is particularly profitable where the
buyer segments (owing to inertia or poor information) are unwilling
or unable to circumvent the discriminating variable. E.g., in ecommerce, if one segment anchors on free shipping while another
segment anchors on the product price, the vendor can profitably
discriminate by offering a choice of free shipping and paying for
shipping.
G Selecting the Pricing Policy.
1 Ranking. Generally, the ranking of the pricing policies by profitability
and information requirement is as follows.
Policy
Conditions
Profitability
Informatio
n
requireme
nt
Complete
price
discrimination
Direct
segment
discrimination Indirect
segment
discrimination Seller discriminates
directly on the buyer
attributes. Seller can
identify each buyer.
Seller discriminates
directly on the fixed
segment attributes.
Seller can identify
each segment and
prevent one
segment from
buying the product
targeted at another
segment.
Uses product
attributes to
discriminate
indirectly (rather
than directly through
buyer attributes)
among various
buyer segments. Highest (Exception: When all buyers
within each segment are
identical, profit equals that
with complete price
discrimination.) Less profitable than direct
segment discrimination for 2
reasons:
Buyer benefit: the product
provides less benefit to
buyers. To induce buyers
with different attributes to
choose different products, the
seller may resort to designing
low-end products in a less
appealing way. E.g., airlines
deliberately impose
conditions on restricted fares
to make them unappealing to
business travelers.
Cost: indirect discrimination
may involve relatively high
costs. Coupons (to indirectly
discriminate among
consumers with different
price elasticity) impose costs
on manufacturers, retailers, The most and consumers
Uniform
pricing No discrimination Lowest The least 2 Technology.
i) Information technology both facilitates and impedes price
discrimination.
ii) With the explosion in consumer usage of the Internet and the falling
costs of computing power and storage:
(1)Marketers can collect, store, analyze and apply large volumes of
detailed information about consumer preferences.
(2)Sellers can better design and target offers to particular
segments.
iii) With the explosion in consumer usage of the Internet and the falling
costs of computing power and storage:
(1)Consumer-oriented search services grow and help consumers to
compare product and prices, thus identifying the best offer and
circumventing price discrimination.
3 Cannibalization. This occurs when buyers switch from high
incremental margin products to lower incremental margin products,
i.e., high-benefit segments buying the item aimed at low-benefit
segments. E.g., business travelers flying on restricted fares, highincome consumers redeeming coupons.
i) Cannibalization reduces the profitability of indirect segment
discrimination.
ii) Reason for cannibalization: the seller cannot discriminate directly,
and must rely on a structured choice of products to discriminate
indirectly. To the extent that the discriminating variable does not
perfectly separate the buyer segments, cannibalization will occur.
iii) Ways to mitigate cannibalization.
(1)Product design:
(a) Upgrade the high-margin item to make it relatively more
attractive. Degrade low-margin item.
(b)Use multiple discriminating variables to differentiate products.
E.g., airlines specify multiple conditions for restricted fares:
minimum and maximum stay, limits on stopovers, penalties
for changes. Each condition helps to reduce the degree to
which the restricted fare would cannibalize the demand for
the unrestricted fare.
(2)Limit the availability of low-margin item, e.g., limited number of
seats allocated to lower fares.Monopoly
Question 4
Atos Origin, Coca-Cola, Eastman Kodak, General Electric, John Hancock Financial Services, Lenovo Group,
McDonald’s, Panasonic, Samsung and Visa Paid a total of $866 Million to the International Olympic
Committee to be global sponsors for the years 2004-2008. The sponsorship period included the 2006
Winter Olympics in Turin and the 2008 Summer Olympics in Beijing. By contrast, total sponsorship for
the years 2000-2004m including the Salt Lake City winter games and the Athens summer games,
amounted to $666 million. (Source: “For Olympic Sponsors, it’s on to Beijing,” International Herald
Tribune, August 31, 2004.)
(a) Compare the benefit from Olympics sponsorship for global brands such as Kodak and Sumsung
relative to regional and local brands.
(b) Considering the relative sizes of the Greek and Chinese consumer markets, explain why sponsors
paid more for the 2004-2008 Olympics than the 2000-2004 Olympics.
(c) Atos Orgin’s customers are primarily other businesses, while Lenovo’s market is mainly within
Chine. Compare the benefit from Olympic sponsorship for these two companies with the
benefit for the other sponsors.
Question 6
In 1992, the state of Victoria, Australia, issued 10-year master licenses to Tattersall’s and Tabcorp for
each to operate 13750 slot machines at clubs and hotels. Eventually, they set up 26,682 machines at 514
locations. In 2008, the government decided to replace the master licenses with individual transferable
10-year Licenses. The market value of Tattersall’s and Tabcorp fell by A$2.8 billion in one day.
Subsequently, the government issued 27,290 new licenses for fees totaling A$980 million. (Source
Victorian Auditor-General, Allocation of Electronic Gaming Machine Entitlements, Melbourne: Victorian
Government Printer, June @2011.)
(a) Consider a club that has acquired one of the new 10-year licenses. Using a suitable diagram,
explain how the club should set the price of gambling to maximize profit. (Hint: you are free to
assume any data necessary to draw the diagram.)
(b) How should the club take account of the once-only license fee in its decisions: (i) whether to
continue in business; (ii) its scale of operations? How does it matter that the license is
transferable?
(c) Comparing the master and individual licensing systems, what effect do you expect on the
quantity and price of gambling Question 8
Cricket is India’s Top spectator sport. Under Indian law, private broadcasters must share any coverage of
Indian cricket matches with the national television and radio broadcasters, Doordarshan and All India
Radio. However, the law does not require national broadcasters to share their cricket telecasts with
private channels. (Source: “DD may get a blank cheque,” Times of India, August 13, 2014.)
(a) How would the Indian law affect the ability of a private television channel to differentiate it self
from Doordarshan?
(b) How would the law affect the amount that a private television channels would bid for rights to
broadcast Indian cricket matches?
(c) How would the law affect Doordarshan’s degree of market power relative to: (i) television
viewers; and (ii) the organizers of Indian cricket matches?
(d) Some predicted that, owing to the law, only national broadcasters would bid for rights to
broadcast Indian cricket matches, and private broadcasters would not bid. Do you agree?
Question 9
Some automobiles parts, such as batteries and tires, wear out with use and must be replaced frequently.
Suppliers of these parts sell their products both as original equipment to auto manufacturers and as
replacement parts to car owners. By contrast, supplies of air bags and ignition systems sell mainly to
auto manufacturers.
(a) Assess the power of automobile manufacturers over suppliers of (ii) batteries and tires as
compared to (ii) air bags and ignition systems.’
(b) For products like batteries and Tires, do you expect prices to be higher in the original equipment
market or the replacement market?
(c) Suppose that the supply of batteries is perfectly competitive. Using an appreciate diagram,
explain how an automobile manufacturer would determine the quantity of batteries to buy. Pricing
Question 2
Doctors routinely ask patient for personal information such as occupation, employer, home address, and
insurance coverage.
(a) How do the following factors affect the scope for price discrimination in medical services? (i)
Doctors treat patients on an individual basis and it is physically impossible to transfer medical
treatment from one person to another. (ii) Characteristics such as occupation and home address
are quite fixed
(b) Explain how, if doctors use price discrimination, they can treat more patients than if they use
uniform pricing.
Questions 4
Up 2 million US consumers buy pharmaceuticals from online Canadian pharmacies, where prices are
substantially lower than in the United States. Monthly sales reached a peak of $43.5 million in early
2004. Then US pharmaceutical manufacturers restricted supplies to Canadian wholesalers that sold to
online pharmacies. In response, universal drugstore and other Canadian pharmacies sourced drugs from
wholesalers in Australia, New Zealand and Britain. (Source: “Kinks in Canada drug pipeline,” New York
Times, April, 2006.)
(a) By considering price elastic ties of demand, and production and shipping costs, explain why US
pharmaceutical manufacturers set higher prices in the United States than in Australia and New
Zealand.
(b) How do parallel imports affect US pharmaceutical manufacturers?
(c) Compare the problem of parallel imports for drugs administered by medical professionals
relative to other drugs.
Question 5
Every year, Heinz sells 650 million bottles and over 13 billion packets of ketchup worldwide (Source: H.J
Hein Company). The demand side of the ketchup market comprises a retail segment and an institutional
segment. Institutions order larger quantities and may employ professional purchasing staff. Retail
consumers are supplied through supermarkets and grocery stores.
(a) Explain why institutional demand for ketchup is likely to be more price elastic than retail
demand. How would Heinz like to apply direct segment discrimination?
(b) If Heinz supplies both institutional customers and retail distribution channels through
wholesalers, explain how the wholesalers might undermine direct segment discrimination.
(c) Compare the problem in (b) for ketchup in bottles as compared with packets.
(d) Why does Heinz mark ketchup sold to restaurants “not for retail sale”? Question 6
In 2010, Google earned revenues of $29.3 billion, of which 96% derived from Google search pages
and websites. Google’s Adwords is a service that places advertisements in Google search pages and
websites. In continues auction, Google scores each advertisement by ad the advertiser’s maximum
bid per click multiplied by the click-through rate. Google displays the advertisements in decreasing
order of score. Advertisers pay for each click according to the score of the next highest
advertisement divided by their work click-through rate. (Source: Austin Rachlin, “Introduction to the
ad auction,” adwords.blogspot.com.)
(a) Explain Google’s Ad words auction in terms of complete price discrimination. Discuss whether
Google meets the conditions for such discrimination.
(b) Explain Google’s Ad words auction in terms of indirect segment discrimination. What induces
advertisers who value the advertising space more to bid higher?
(c) Considering the consumer demand for Google search and Google websites why Google takes
account of both the advertiser’s bid and click-through rate in allocating advertising space.
Question 7
The Chinese Visa application Center in London charges applicants for visas an application service fee and
a visa fee. The application service fee is $35.25 for processing within four working days and $47 for
processing within three working days, The single-entry visa fee is $30, $65, and $20 for citizens of the
United Kingdom, United States, and other countries respectively. The corresponding double-entry visa
fees are $45, $65, and $30. (Source: Chinese Visa Application Center, London, January 5,2010.)
(a) Explain the Visa Center’s pricing policies in terms of direct segment discrimination. Discuss
whether issuance of visas meets the conditions for such discrimination.’
(b) Explain the Visa Center’s pricing in terms of indirect segment discrimination between tourists
and business travelers. Discuss whether issuance of visas meets the conditions for such
discrimination.
(c) Should the Chinese government set the same visa fees in all foreign countries?
Question 8
Qantas sells tickets through conventional travel agent, online intermediaries, its own telephone call
center, and its own website. Typically, an airline’s cost per transaction is lowest for bookings through its
own website and highest for booking through conventional travel agent. Qantas’s cheapest fare, the Red
e-Deal, is only available for online booking.
(a) How technologies affect an airline’s ability to discriminate on price?
(b) Considering Qantas’s cost of booking and traveler’s elasticity of demand, explain why airline
offers the Red e-Deal only through online booking. (c) For Flight QF401 departing Sydney on January 6, 2015 at 6 am for Melbourne, the Red e-Deal
fare was A$245. For the next flight, departing at 6:30 am was A$155. Explain the difference in
pricing.
(d) Explain why Qantas limits the number of seats sold by the Red e-Deal. Question 9
Founded by Empress Catherine II (the great), the Hermitage in St Petersburg, Russia, is one of the world’s
great art museums. General admission is free for all students and children, and Russian pensioners. The
price is 350 roubles for Russian adults and 400 roubles (equivalent to $6) for foreign adults. Through its
website, the Hermitage encourages visitors to buy tickets through the internet at a price of $17.95 and
so “avoid a long line at the ticketing office”. The Hermitage also offers free admission to all visitors on the
first Thursday of each month.
(a) Explain how the Hermitage uses direct segment discrimination. Discuss whether Hermitage
pricing meets the conditions for such discrimination.
(b) Explain how the Hermitage uses indirect segment discrimination. Discuss whether Hermitage
pricing meets the conditions for such discrimination.
(c) Comment on the free admission on the first Thursday of each month with regard to: (i)
maximizing the number of visitors served for a given budget; and (ii) canibalization

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