ECON 2100 Principles of Microeconomics (Fall 2018) Price Discrimination, Product Differentiation, and Bundling

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1 ECON Princiles of Microeconomics (Fall 8) Price Discrimination, Product Differentiation, and Bundling elevant readings from the textook: Mankiw, Ch. 5 Monooly Suggested rolems from the textook: Chater 5 Quick Quiz Multile Choice (Page 33): 6 Chater 5 Questions for eview (Page 34): 6 Chater 5 Prolems and Alications (Pages 35-37): 6 and Definitions and Concets: Price Discrimination the ractice of charging a different rice for different units sold of an essentially identical good (with the difference in rice not eing a result of differences in cost of roduction) First Degree Price Discrimination or Perfect Price Discrimination a ractice in which a firm charges every consumer an amount exactly equal to uyer s reservation rice for every unit sold equires firm to know the exact value of reservation rice of every consumer for every unit => assumtions are so extreme that it can never e used in ractice Second Degree Price Discrimination or Menu Pricing a ractice in which a firm resents all consumers with different ricing menus and allows each consumer to choose the menu which they refer Firm simly needs to know that there are fundamental differences across consumers, ut need not e ale to identify the articular tye of any secific consumer Examle: cell hone ricing ackages Third Degree Price Discrimination or Segmented Pricing a ractice under which a firm searates consumers into different market segments, and then charges each different segment of consumers a different constant er unit rice for each unit urchased Must e ale to easily searate the consumers into different markets (and effectively revent resale across segments), and have reason to susect that the otimal constant er unit rice differs across the two market segments Examles: student discounts, senior discounts, different rices for DVDs and harmaceuticals across different countries Versioning the ractice of selling different variations of a roduct Examles of versioning: air travel first class vs. coach ; comuter software/as full feature version vs. are ones version ; comuter rinters IBM LaserPrinter vs. LaserPrinter E Product Differentiation differences in the characteristics of two similar roducts that result in a consumer having different reservation rices for the two roducts

2 Vertical Product Differentiation roduct differentiation for which all consumers agree on which characteristics are more desirale ut differ with resect to how much they value the more desirale characteristic e.g., Kia Forte versus BMW 38i Horizontal Product Differentiation roduct differentiation for which all consumers do not agree on which characteristics are more desirale (due to fundamental differences in tastes/references across consumers) e.g., Cherry Coca-Cola, versus Vanilla Coca-Cola, versus Coca-Cola with Lime Issues to kee in mind when versioning. The est rices are not always ovious you often can t simly charge each intended segment of consumers a rice equal to their reservation rice for the intended version. The firm often has a choice over how many different versions to offer and a choice over the secific characteristics/features of each different version => the est choices in these matters deend critically uon how costly it is to create an additional version may at first seem counterintuitive (consider free version and value sutracted version ) 3. It may make sense to offer a free version => articularly if having a network of users matters (e.g., Adoe gives away a free version of Acroat eader so that more eole use PDF files ) enefits of your roduct are difficult for consumers to know efore consuming/using the roduct (e.g., offer a free version of a video game with only initial levels unlocked, and then charge for all levels ) there is the otential for follow-on sales (offer a low frills version for free, with the intention of selling extensions, ugrades, suscrition fees, and/or suort services down the road => e.g., in-a urchases ) 4. It may make sense to create a value sutracted versions, even if ositive costs must e incurred to do so IBM LaserPrinter ( ages er minute) vs. LaserPrinter E (5 ages er minute) LaserPrinter E essentially manufactured y taking a LaserPrinter and inserting an extra chi to slow down the rinting seed => it actually cost MOE to roduce the LOWE QUALITY version! thinking aout what a firm must do to have different consumers self-select different versions, these examles make sense. Intuitive examle: an airline that offers first class service and coach service each consumer determines a remium he would e willing to ay for first class. What could we do to make more eole fly first class? o lower rice of the first class ticket or raise rice of the coach ticket o increase quality of the first class exerience or decrease quality of the coach exerience To get eole to fly first class, on some level the airline has to make coach sufficiently unearale for a segment of otential consumer Bundling the ractice of selling multile distinct roducts together as a ackage

3 Pure Bundling the ractice of undling, while not allowing consumers the otion of urchasing the undled items searately (i.e., outside of the undle) Mixed Bundling the ractice of undling, while also allowing consumers the otion of urchasing the undled items searately (i.e., outside of the undle) First Degree or Perfect Price Discrimination: Again, the knowledge required y the seller to actually engage in such ehavior can almost never e known => no good real world examles of st Degree P.D. However, it is still insightful to figure out what a firm would do if they were ale to engage in such ricing If (at each quantity along the demand curve) the firm charges each consumer an amount exactly equal to reservation rice, then Marginal evenue is simly equal to height of demand $ MC(q) Demand = M Q FDPD quantity Firm would sell (Q FDPD ) units => extract the entire area elow the demand curve, u to the quantity sold as evenue => (evenue)=( lue + yellow ) ( yellow ) = (Variale Costs) => (PS) = ( lue ) Note that (CS) = () => Consumers are worse off (comared to traditional monooly ) (DWL) = () => Social Surlus is larger (comared to traditional monooly ) So, P.D. can clearly increase oth PS and Social Welfare

4 Examle of Segmented Pricing leading to increase in CS : Segment A has demand given y the linear inverse function P A D ( q) q Segment B has demand given y the linear inverse function P B D ( q) q Firm has constant marginal costs of MC 4 If these two segments were treated as one single market (i.e., if a common rice was set across the two markets), then $ Demand 5 - MC(q) quantity -6 M(q) Profit maximized y setting rice of $5, selling 48 units in Segment A and comletely ignoring Segment B Segment A : (CS) and (PS) oth ositive Segment B : (CS) and (PS) oth zero If the firm is allowed to engage in Segmented Pricing : set rice of $5 in Segment A => sell 48 units in Segment A set rice of $ in Segment B => sell 8 units in Segment B Outcome in Segment A is identical to what is was efore But now, in Segment B : (CS) and (PS) are oth ositive instead of zero Thus, when the firm is ale to ractice Segment Pricing (as oosed to restricting the firm to charging a common rice across oth segments) in this examle: Producer s Surlus is larger Total Consumers Surlus is larger Therefore, Total Social Surlus is larger (DWL is smaller) Noody is worse off and some eole are strictly etter off

5 Examle to illustrate how versioning increases rofit consider a software comany otentially serving two tyes of consumers: students vs. usinesses => develoed a high end version and a low end version of their roduct. suose consumer reservation rices are: Students Business Users low end version $6 $ high end version $75 $9 note: vertical differentiation (oth lace a higher value on the high end version than on the low end version ) suose there are an equal numer of students and usiness users ( of each) $ marginal cost for roducing any unit of either version Otions availale to firm: offer only low end version, offer only high end version, or offer oth versions I. If the firm offers only the low end version, they can either: Sell to oth tyes, y charging a rice of $6 => rofit of: (6-)() = $ Sell to only usiness users, y charging a rice of $ => rofit of: (-)() = $9 The etter choice is clearly to charge a rice of $6 and sell to oth tyes II. If the firm offers only the high end version, they can either: Sell to oth tyes, y charging a rice of $75 => rofit of: (75-)() = $3 Sell to only usiness users, y charging a rice of $9 => Profit of: (9-)() = $8 Of these two, the etter choice is clearly to charge a rice of $9 and sell to only usiness users Further, this ( sell only the high end version at a rice of $9 ) is the est of the four otions considered thus far III. What if the firm sells oth versions? Would want the students to uy the low end version and the usiness users to uy the high end version Charge a rice of $6 for the low end version => selling this version to the students at this rice gives a rofit of: (6-)() = $5 What rice to charge for the high end version? Charge the highest rice you can for the high end version for which the intended segment (i.e., usiness users ) refers to uy that version o usiness users can get a surlus of (-6) = $4 from uying the low end version for $6 o most you could charge for the high end version and still sell to the usiness users is $5 (so that their surlus from this urchase is (9-5) = $4) Thus, set rices of $6 for the low end version and $5 for the high end version o students will uy the low end version o usiness users will uy the high end version Profit is: (6-)+(5-) = 5+4 = $9 Offering two versions allowed the firm to realize greater rofit

6 Determining consumer urchasing decisions under Simle Monooly Pricing (i.e., no undling), Pure Bundling, and Mixed Bundling Consider a firm selling two different goods ( good and good ) Denote Consumer i i s reservation rice for the two goods e denoted y and i (assume unit demand for each) Each consumer is at a secific oint in, ) -sace ( i i I. Simle Monooly Pricing firm offers good for sale at a rice of and offers good for sale at a rice of Each consumer assesses the urchase of each good searately => uy good if and only if i ; uy good if and only if i Thus, the ehavior of all consumers can e illustrated as =(uy oth goods) =(uy good ut not good ) =(uy good ut not good ) =(uy neither good)

7 ( Bundling continued) II. Pure Bundling firm offers the undle for sale at a rice of (and consumers do not have the otion of uying the goods searately) i i Consumer i s surlus from urchasing the undle is => urchase undle if and only if this is ositive (i.e., if and only if i i ) Thus, the ehavior of all consumers can e illustrated as =(uy undle) =(do not uy undle) III. Mixed Bundling firm offers the undle for sale at a rice of, ut consumers also have the otion of searately uying good at a rice of and good at a rice of For anyone to ever uy the undle, the firm must set Consumer i s surlus from urchasing i i o the undle is o only good is i o only good is i o neither good is =(uy undle) =(uy only good ) =(uy only good ) =(uy neither good)

8 ( Bundling continued) Potential advantage of mixed undling => allows the seller to: i extract a very high rice of from those consumers with relatively high ut i relatively low i extract a very high rice of from those consumers with relatively high ut i relatively low while still continuing to serve those consumers with intermediate valuations for i i oth goods (i.e., those eole who don t have a high value of or, ut still i i have a high value of ) y selling them the undle at a lower comined rice of Some intuition on rofitaility of the different otions => ecognize, mixed undling can cover oth of the otions of simle monooly and ure undling That is: Mixed Bundling with would give the same outcome as Simle Monooly ricing with and (since any customer that wanted oth goods would still never uy the undle ) Mixed Bundling with min{, } would give the same outcome as Pure Bundling with a rice of (since uying the undle is less exensive than uying either good individually) Thus The maximum rofit from Mixed Bundling has to e at least as large as the * * maximum rofit from Simle Monooly => MB SM The maximum rofit from Mixed Bundling has to e at least as large as the * * maximum rofit from Pure Bundling => MB PB But these inequalities need not e strict (i.e., the est Mixed Bundle might e * * the one that relicates Simle Monooly ricing, in which case ) * * we could have either or SM PB * * SM PB MB SM

9 ( Bundling continued) Examle : (simle examle to illustrate that Pure Bundling can yield greater rofit than Simle Monooly) => firm sells Good I and Good II two tyes of consumers, with reservation rices of: Good I Good II sum Tye A Tye B 3 35 Bundling is most advantageous when the different tyes of consumers have reservation rices that are negatively correlated with each other suose marginal costs of $5 straightforward to verify that the est Simle Monooly rices are $3 for Good I and $3 for Good II => sell only Good I to Tye A and only * Good II to Tye B => SM 45 what if we offer a undle that includes oth goods? Charge $35 and sell * undle to each consumer => (35 )() 5 Examle : monoolist selling two goods suose a constant marginal cost of $ for each good three different consumers with reservation rices of Good Good Sum Consumer A Consumer B 5 6 Consumer C 8 Grahically illustrate reservation rices as: PB C 8 B 6 A 5 A 75 C B 5

10 ( Bundling continued) Otimal Simle Monooly rices? o For good : => rofit = ( )(3) = 4 est 5 => rofit = (5 )() = 76 choice 75 => rofit = (75 )() = 63 o For good : 5 => rofit = (5 )(3) = 9 est 6 choice => rofit = (6 )() = 96 8 => rofit = (8 )() = 68 o Thus, the est Simle Monooly choice is 5 and 6 => rofit = = 7 Otimal Pure Bundling rice? o Price of undle: est 9 choice => rofit = (9 4)(3) = 98 => rofit = ( 4)() = 5 => rofit = ( 4)() = 86 o Thus, the est Pure Bundle choice is 9 => rofit of 98 o In this examle, Pure Bundling results in greater rofit than Simle Monooly ricing Otimal Mixed Bundling rices? ecall: C 8 B 6 A 5 A 75 C B 5

11 ( Bundling continued) The otimal Mixed Bundle rices are such that: * C 8 B 6 =( B uys the undle) =( C uys only good ) =( A uys only good ) A 5 C A * 75 B 5 o Thus, the est Mixed Bundle rices are for the undle, 75 for good, and 8 for good B uys the undle, A uys only good, and C uys only good o This choice yields rofit of: ( 4)() + (75 )() + (8 )() = = 7

12 Prolem:. Consider a firm oerating in a market in which Demand, Marginal Costs, and Average Variale Costs are as illustrated elow. Note that demand is a linear function. Also illustrated is the resulting Marginal evenue curve, if the firm charged all consumers the same er unit rice for every unit of outut sold. $ MC(q) AVC(q) Demand quantity,6,5 4,,, M(q) A. If this firm charged a common rice for every unit of outut sold, how many units would they choose to sell and what rice would they charge? B. If this firm can engage in Perfect Price Discrimination, how many units would they sell? How much Total evenue would they generate? For what values of Fixed Costs would they e ale to earn a ositive rofit?. Consider a firm selling two goods in a market in which there are three different tyes of consumers. The tale elow rovides a summary of the reservation rice of each tye of consumer for each good, along with a secification of the numer of each tye of consumer in the market. Consumer Tye eservation Price for Good X eservation Price for Good Y Numer of Consumers Tye A 3 9 Tye B Tye C 8 The marginal cost of roducing each unit of Good X and each unit of Good Y is a constant $5, while Fixed Costs are equal to $5,. A. Suose that the seller is restricted to Simle Monooly Pricing (i.e., choosing x and y, in order to sell each good searately). Determine the rofit maximizing rice for each good and the resulting rofit of the seller.

13 B. Suose that the seller is restricted to Pure Bundling (i.e., selling the two goods together as a ackage, for a rice of ). Determine the otimal value of and the resulting rofit of the seller. C. Suose that the seller is ale to engage in Mixed Bundling (i.e., set a rice of for urchasing the goods as a ackage, in addition to rices of x and y for urchasing the goods searately). If the seller wishes to have tye A consumers urchase only Good Y, tye B consumers urchase the undle, and tye C consumers urchase only Good X, what rices should he set? At these rices, how much rofit does the seller earn? D. How do the maximum rofits from Simle Monooly Pricing, Pure Bundling, and Mixed Bundling comare to each other? Exlain. Multile Choice Questions:. Edna sells athing suits. She offers customers a 5% discount if they show her a valid student I.D. at the time of urchase. This ehavior y Edna is an examle of A. a monoolist erecting a sustantial entry arrier. B. First Degree Price Discrimination (or Perfect Price Discrimination). C. Third Degree Price Discrimination (or Segmented Pricing). D. a firm choosing to roduce a ositive quantity of outut in the short run, even though they are unale to earn a ositive rofit.. Consider a firm that sells two different roducts. If this firm engages in Pure Bundling, then each consumer A. only has the otion of urchasing the two goods searately. B. only has the otion of urchasing the two goods together (as a ackage). C. has the otion of either urchasing the two goods searately or urchasing together (as a ackage). D. must urchase a ositive quantity of oth goods (even if doing so gives him a negative Consumer s Surlus). 3. John has reservation rices for good and good of 46 and 8. He has the otion to uy good at a rice of 4, uy good at a rice of, or a undle consisting of oth good an good at a rice of 55. Given this otions, John should choose to A. urchase only good. B. urchase only good. C. urchase the undle consisting of oth good and good. D. None of the aove answers are necessarily correct (since additional information is needed in order to determine his otimal urchasing decision).

14 4. refers to a ractice wherey a seller of a good searates consumers into different grous and then charges each different grou of consumers a different constant er unit rice for each unit of the good urchased. A. Inverse Elasticity Pricing B. st Degree Price Discrimination (or Perfect Price Discrimination ). C. nd Degree Price Discrimination (or Menu Pricing ). D. 3 rd Degree Price Discrimination (or Segmented Pricing ). For Questions 5 and 6, consider a firm facing demand and with marginal costs as illustrated elow. Marginal Costs of roduction are minimized if the firm roduces, units of outut. Suose throughout that this firm is ale to engage in First Degree (i.e., Perfect) Price Discrimination. $ 4.75 MC(q) (i) 8.5 (ii) (v) (iii) (vi) Demand (iv) (vii) 8,75, quantity This firm has Fixed Costs of roduction equal to $56,. Finally, the seven regions identified aove have areas equal to: Area (i) Area (ii) Area (iii) Area (iv) Area (v) Area (vi) Area (vii) $3, $7,5 $35, $,5 $3,5 $3, $48,5 5. When this firm maximizes rofit (y way of engaging in Perfect Price Discrimination), it will sell units of outut. A. more than ut less than, B. exactly, C. more than, ut less than 8,75 D. exactly 8,75 6. When this firm maximizes rofit (y way of engaging in Perfect Price Discrimination), it is ale to earn a rofit of. A. $6,5 B. $, C. $56, D. $7,

15 7. Vanilla Coca-Cola, Cherry Coca-Cola, and Coca-Cola with Lime are examles of goods that are A. vertically differentiated. B. horizontally differentiated. C. sold y a firm with no market ower. D. only ever sold in a ure undle. For questions 8 and 9, consider a firm which sells a good in two different markets: Market Segment A and Market Segment B. The two grahs elow illustrate demand and marginal revenue in each market (when the firm is ale to set a different rice in each market). The firm has constant Marginal Costs of $5 er unit, lus Fixed Costs of $,. If the firm is restricted to charging the same rice in each market, rofit is maximized y charging a rice of $9. 9 $ Market Segment A $ Market Segment B 9 5,,,35 Demand A Q, Marg. ev. A If this firm were ale to engage in 3 rd Degree Price Discrimination (treating the two segments as one single market), then it would choose to sell units in Market Segment A and units in Market Segment B. A.,;,5. B.,;,65. C.,;,5. D.,35;.,5,65 Demand B Marg. ev. B Q 9. If this firm were ale to engage in 3 rd Degree Price Discrimination (treating the two segments as one single market) instead of engaging in standard monooly ricing, then A. consumers in Segment A would e etter off. B. consumers in Segment B would e etter off. C. Both (A) and (B) are correct (i.e., consumers in oth segments would e etter off). D. Neither (A) nor (B) is correct (i.e., consumers in neither segment would e etter off).

16 . Consider a monoolist selling a good for which inverse demand is given y the function P(q) = 5 (.)q and costs of roduction are C(q) = q + 6,. If this seller is ale to engage in Perfect Price Discrimination, then she would A. sell 4, units of outut. B. charge a er unit rice of $3 for every unit sold. C. earn a rofit of $,. D. More than one of the aove answers is correct. For Questions through 3, consider a monoolist facing demand and with marginal costs of roduction as illustrated elow. The Marginal evenue Curve illustrated elow (laeled M(q) ) deicts the marginal revenue of the firm if they charged the same exact rice for all units sold. $ a MC(q) c d e g 5. f Demand.5 quantity,775,,5 M(q),88. If this firm is required to charge everyone the same rice for its outut, it would sell ; if this firm is ale to engage in First Degree (i.e., Perfect) Price Discrimination, it would sell. A. units;,775 units. B., units;,88 units. C.,5 units;, units. D.,88 units; units.. Allowing the firm to engage in First Degree (i.e., Perfect) Price Discrimination instead of restricting the firm to sell all units for the same rice A. increases Deadweight Loss y areas (a)+(). B. decreases Deadweight Loss y area (e). C. changes Deadweight Loss y area (g) area (e) D. None of the aove answers are correct. 3. If this firm engages in First Degree (i.e., Perfect) Price Discrimination A. Producer s Surlus is equal to areas (c)+(d)+(f). B. Total Social Surlus is equal to zero. C. Deadweight Loss is equal to area (g). D. Total Consumers Surlus is equal to zero.

17 For questions 4 through 6, consider the following scenario. Singular rovides cell hone service to customers according to the following three ricing lans. Each consumer has the otion of self-selecting the lan which they individually refer. Plan Name Fixed Monthly Fee Free Minutes Charge Per Minute (for minutes used eyond Free Minutes ) Plan A $4 Unlimited not alicale Plan B $5 8.5 Plan C $. 4. Singular is engaging in A. st Degree Price Discrimination (or Perfect Price Discrimination ). B. nd Degree Price Discrimination (or Menu Pricing ). C. 3 rd Degree Price Discrimination (or Segmented Pricing ). D. th Degree Price Discrimination (or Tufnel Pricing ). 5. Suose that Kyle wants to talk on his cellhone exactly minutes er month and Heather wants to talk on her cellhone exactly 45 minutes er month. In order to consume these desired levels of service at lowest exenditure, Kyle should choose and Heather should choose. A. Plan C; Plan B. B. Plan C; Plan A. C. Plan B; Plan B. D. Plan B; Plan A. 6. The monthly ill will e lowest under Plan A A. for all customers, regardless of usage. B. for customers who use less than 75 minutes er month. C. for customers who use more than 75 ut less than 48 minutes er month. D. for customers who use more than 48 minutes er month. Answer to Prolems: A. The firm would maximize rofit y roducing the quantity at which M(q) is equal to MC(q). From insection of the grah, this occurs at,6 units of outut. The corresonding rice which they would want to charge is otained y determining the height of the demand curve at this desired quantity. In section of the grah shows that this otimal rice is $6. er unit. B. If the firm is ale to ractice Perfect Price Discrimination, then Marginal evenue is in essence the Demand Curve. The firm would therefore want to roduce the quantity at which MC(q) intersects Demand. From insection of the grah, this quantity is, units. The given curves reveal that AVC of roducing, are 3.6. Thus, Variale Costs at this quantity are $7,9. Since demand is a linear function, Total evenue (which is the entire area elow the demand curve in this situation)

18 is: (4.5)(,)+(/)(5.5)(,) = (9,9)+(6,5) = 5,95. Thus, Producer s Surlus is 8,3. It follows that the firm could earn a ositive rofit if and only if Fixed Costs are less than $8,3. A. When restricted to Simle Monooly Pricing, for Good X the firm will want to charge either: 3 PS ( 3 5)(,) 5, x x 5 PS ( 5 5)(9) 4, 5 x x x 8 PS x ( 8 5)() 5, The est choice is x 5 (at which the firm sells to tyes B and C, ut not tye A), which results in a Producer s Surlus of PS x 4, 5 from Good X. Similarly, for Good Y the firm will want to charge either: PS ( 5)(,) 5, y y 6 PS ( 6 5)(8) 44, y y y 9 PS y ( 9 5)() 8, 5 The est choice is y 6 (at which the firm sells to tyes A and B, ut not tye C), which results in a Producer s Surlus of PS y 44, from Good Y. These rices give a rofit of M 4,5 44, 5, 34, 5. B. If the seller is only ale to sell y way of Pure Bundling, then he would want to set either: PS ( )(,) 9, PS ( )(8) 8, PS ( )(), The est of these otions is to charge and sell the undle to all three of the different customer tyes. This leads to a rofit of PB 9, 5, 4,. C. With Mixed Bundling, if the seller wants to set rices for which tye A consumers urchase only Good Y, tye B consumers urchase the undle, and tye C consumers urchase only Good X, the est rices to set are for the undle, 8 for Good X, and 8 for Good Y (note that if they charged 9 for Good Y, then tye A consumers would choose to uy the undle instead). These rices result in rofit of (8 5)() + ( )(7) + (8 5)() 5, = (75)() + ()(7) + (75)() 5, = 9,5 5, =4,5. D. Comaring the rofits from the answers to arts (6A), (6B), and (6C), we see that Mixed Bundling results in a strictly greater rofit than Pure Bundling, which in turn results in a strictly greater rofit than Simle Monooly Pricing.

19 Answers to Multile Choice Questions:. C. B 3. C 4. D 5. D 6. B 7. B 8. B 9. B. D (oth A and C are correct). B. B 3. D 4. B 5. C 6. D