PRICING WITH MARKET POWER II. Overview Two-part tariff Bundling Tying.

PRICING WITH PRICING WITH MARKET POWER MARKET POWER

IIII

PRICING WITH PRICING WITH MARKET POWER MARKET POWER

IIII

Overview

•Two-part tariff

•Bundling•Tying

Meaning of Two-Part Tariff

• The purchase of some products and services can be separated into two decisions, and therefore, two prices. Examples

1) Amusement Park• Pay to enter• Pay for rides and food within the park

2) Tennis Club• Pay to join• Pay to play

• Pricing decision is setting the entry fee (T) and the usage fee (P), thus choosing the trade-off between free-entry and high use prices, or

high-entry and zero use prices

Usage price P* is set where MC = D. Entry price T* is equal to the entire consumer surplus. How do you find out T* ?

T*

Two-Part Tariff with a Single Consumer

Quantity

$/Q

MCP*

D

D2 = consumer 2

D1 = consumer 1

Two-Part Tariff with Two Consumers

Quantity

$/Q

MC

Q1Q2

The price, P*, will be greater than MC. Set T* at the surplus value of D2.T*

P*

Thus there is a trade-off between high entry fee & high user price

A

C

Π=2T*+(P*-MC).(Q1+Q2)>ΔABC

B

The Two-Part Tariff with Many Consumers

• No exact way to determine P* and T*.• Must consider the trade-off between the entry

fee T* and the use fee P*.– Low entry fee=> High sales revenue, but less

entry,

– Low price=> More use, but falling profit with lower price.

• To find optimum combination, choose several combinations of P and T

• Choose the combination that maximizes profit

• Rule of Thumb– Similar demand: Choose P close to MC and high

T– Dissimilar demand: Choose high P and low T.

Two-Part Tariff withMany Different Consumers

(choosing T)

T

Profit

a :entry fee

s :sales

Total

T*

Total profit is the sum of the profit from the entry fee andthe profit from sales. Both

depend on T.

entrantsn

nQMCPTTnsa

)()()(

Two-Part Tariff with many different Consumers

(choosing n, alternatively)Optimum two-part tariff that globally maximizes profits is attained at

0)(

dn

d

dn

d

dn

nd SA

The optimum is achieved where the vertical sum (curve not shown) of ПA and ПS

reaches the maximum.

Two-Part Tariff With A Twist

• Suppose, entry price (T) entitles the buyer to a certain number of free units

•Gillette razors with several blades

•Amusement parks with some tokens

•On-line with free time

Bundling

• Bundling is packaging two or more products to gain a pricing advantage.

• Conditions necessary for bundling– Heterogeneous customers– Price discrimination is not possible– Demands must be negatively correlated

Bundling Example With Two Consumers (theaters A-

B)

Spiderman Spaceballs

Theater A $12,000 $3,000

Theater B $10,000 $4,000

• Renting the movies separately would result in each theater paying the lowest reservation price for each movie

– Total Revenue = $26,000

• If the movies are bundled and if each were charged the lower of the two prices

– Total revenue will be $28,000.

Reservation Price

Bundling Example With Two Consumers – Importance of Negative

Correlation of Demands• If the demands were positively correlated

(Theater A would pay more for both films as shown), bundling would not result in an increase in revenue.

Gone with the Wind Getting Gertie’s Garter

Theater A $12,000 $4,000

Theater B $10,000 $3,000

If the movies are bundled and if each were charged the lower of the two prices, total revenue will be $26,000, the same as by selling the films, separately.

Bundling Example With Two Heterogeneous Goods and Many

Consumersr2

(reservationprice Good 2)

r1 (reservation price Good 1)

$5

$10

$5 $10

$6

$3.25 $8.25

$3.25

ConsumerA

ConsumerC

ConsumerB

Each consumer represented by a dot – A, B, C. Consumer A is willing to pay up to $3.25 for good 1 andup to $6 for good 2.

Consumption Decisions When

Products are Sold Separately

r2

r1

P2

II

Consumers buyonly good 2

22

11

Pr

Pr

P1

Consumers fall intofour categories basedon their reservation

price.I

Consumers buyboth goods

22

11

Pr

Pr

III

Consumers buyneither good

22

11

Pr

Pr

IV

Consumers buyonly Good 1

22

11

Pr

Pr

P (P1, P2)

Two sets of choice involved:(i) Whether to choose P further up inside I or further down inside III – i.e., choice of intercept of intercept of a straight line;(ii) Whether to swing the lineto capture more customers from one quadrant or the other – i.e., from II and IV(thus involving choice ofslope of the line)

Consumption DecisionsWhen Products are

Bundledr2

r1

r2 = PB - r1

I

II

Consumersbuy bundle

(r > PB)

Consumers donot buy bundle

(r < PB)

Consumers compare the sum of their reservation prices, r1 + r2, with the bundle price PB. They buy the bundle only if r1 + r2 is at least as large as PB.

Consumption DecisionsWhen Products are Bundled

Depending on the prices, some of the consumers in regions II and IV might have bought one of the goods if they were sold separately. These customers are lost to the firm.

However, the other customers in regions II and IV now buy both goods where they formerly bought only one.

The firm then, must decide whether it can do better by bundling.

Buyers who buy neither good

Buyers of good 1 lost to the firm

Buyers of good 1 who now buy good 2 also

Buyers of good 2 lost to the firm

Buyers of good 2 who now buy good 1 also

Buyers who buy both the goods

Efficiency of Bundling Depends on the Degree of Negative

Correlation

r2

r1

Bundling pays due to negative correlation

(Spaceballs)

(Spiderman)

5,000 14,00010,000

5,000

10,000

12,000

4,000

3,000

B

A

Mixed Versus Pure Bundling

r2

r110 20 30 40 50 60 70 80 90 100

10

20

30

40

50

60

70

80

90

100

C2 = MC2 = 30

Consumer A, for example, has a reservation price for good 1 that is below marginal cost c1.With mixed bundling, consumer A is induced to buy only good 2, while consumer D is induced to buy only good 1, reducing the firm’s cost.

A

B

D

C

C1 = MC1 = 20With positive marginalcosts, mixed bundling may be more profitable

than pure bundling.

Is MC>0 sufficient condition for mixed bundling to dominate?

Sell separately $80 $80 ----$320

Pure bundling ---- ---- $100 $400

Mixed bundling $90 $90 $120$420

P1 P2 PB Profit

Mixed Bundlingwith Zero Marginal Costs

Is MC>0 sufficient condition for mixed bundling to dominate?

Mixed Bundlingwith Zero Marginal Costs

r2

r120 40 60 80 100

20

40

60

80

100

120

120

In this example, consumers B and C are willing to pay $20 more for the bundle than are consumersA and D. With mixed bundling, the price of the Bundle can be increased to $120. A & D can be charged $90 for a single good.

C

10 90

10

90A

B

D

Mixed Bundling in Practice

• Use of market surveys to determine reservation prices

• Design a pricing strategy from the survey results

• Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.

Tying• Practice of requiring a customer to

purchase one good in order to purchase another.

• Allows the seller to meter the customer and use a two-part tariff to discriminate against the heavy user

• Examples:– Xerox machines and the paper

– IBM mainframe and computer cards

– Renting out tractor along with driver

– Rural moneylenders providing credit against sale of output and/or input purchase (even land leasing-in) contract

• Is tying necessarily ‘exploitative’?