Managerial Economics (MBA ZC416)

Session 19: Joint Product Problem, Transfer Product Problem;

Price Discrimination, Two Part Pricing, Bundling
Instructor
Monika Gupta
Economics and Finance Department
monika.gupta@pilani.bits-pilani.ac.in
Assignment Guidelines
• Description: Assignment is based on your learning of the course till now.
You are expected to apply different concepts of Managerial Economics in
order to do the assignment problem.

• Pages - 10 pages.

• Type of submission - Soft copy. M.S. word only to check plagiarism.

• Kindly note if plagiarism is found to be more than 30%, the awarded marks
will be zero and no further evaluation would be done.

• Marks & Weightage(%) – 15

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Discussion of the assignment
Problem Statement -
• Write and prepare a caselet of an Industry or a firm of your choice and analyze
any one of the following in detail. The case and analysis of the any one of the
following should be based on the facts, figures, actual data, calculation and
estimation. You are expected to use different concepts which you have learnt
from the course.
• Collusion Activities
• Product pricing strategies – Price discrimination, Two-part pricing etc.
• Market structure and competition level
• Production technique and input pricing model
• Strategies based on Game theory
• Major characteristic of the product’s demand and measurement of different elasticities
• Demand forecasting on the basis of historical data
• Different types of costs and cost structure

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Major Data Sources
General Sources
• Economic Survey
• Annual Budget
• Census of India
• National Sample Survey Reports
• Plan Reports
• Statistical Abstract of the Indian union
• India Year Book
• Guidelines to Industries
• Annual Survey of Industries

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Major Data Sources
Annual Reports of the Development Wing
Annual Bulletin of Statistics of Exports and Imports
Techno- Economic survey
Industry Potential Survey
The stock exchange directory
Monthly Studies of Production of Selected industries
Reserve Bank of India, ETIG, World Bank
Publications of Advertising Agencies
Other Publications

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Different Databases (Check Library)
• CMIE – Prowess
• SDC Platinum
• Indiastats
• Moneycontrol
Industry specific sources
• Annual reports of the companies
• Bloomberg
• Reports of Industrial Organizations such as SIAM for automobile
Industry
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A Quick Recap…
• Asymmetric Information
• Market Signaling
• Adverse selection and Moral Hazard
• The Principal – Agent Problem

• Different Pricing Methods

• Mark-up Pricing

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Plan of this session
Different Pricing Methods
• Pricing in multiproduct firm
• Joint product/byproduct
• Numerical
• Joined product pricing in variable proportions
• Transfer pricing – vertical Integration
• Numerical
• Price discrimination – First order, Second order and Third order
• Numerical
• Two part pricing, Block Pricing
• Bundling

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Pricing of Multiple Products
• Products with Interrelated Demands
• Plant Capacity Utilization and Optimal Product Pricing
• Optimal Pricing of Joint Products
• Fixed Proportions (Please listen pre-recorded session )
• Variable Proportions

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Pricing of Multiple Products
• Products with Interrelated Demands
• (Remember – Economies of Scope!!)
• For a two-product (A and B) firm, the marginal revenue functions of
the firm are:
TRA TRB
MRA  
QA QA
TRB TRA
MRB  
QB QB

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 Joint Product in Variable proportions

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Pricing of Multiple Products: Numerical (page 458)
• Joint Product Pricing in Fixed proportions

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Pricing of Multiple Products: Numerical (page 458)
• The Firm will not able to sell all its wood chips
• Pw =0.8 -.00Qw
• MRw = 0.8 - .002Qw
• Putting it equal to Zero Qw = 400 which is same as Qn

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Transfer Pricing
• Pricing of intermediate products sold by one division of a firm and
purchased by another division of the same firm
• Made necessary by decentralization and the creation of semiautonomous
profit centers within firms
• To overcome double marginalization, the internal price at which an
upstream division sells inputs to a downstream division should be set in
order to maximize the overall firm profits.
• To achieve this goal, the upstream division produces such that its marginal
cost, MCu, equals the net marginal revenue to the downstream division
(NMRd):
NMRd = MRd - MCd = MCu

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Upstream Division’s Problem
• Demand for the final product P =
10 - 2Q.
• C(Q) = 2Q.
• Suppose the upstream manager
sets MR = MC to maximize
profits.
• 10 - 4Q = 2, so Q* = 2.
• P* = 10 - 2(2) = $6, so upstream
manager charges the
downstream division $6 per unit.

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Downstream Division’s Problem
• Demand for the final product P = 10 - 2Q.
• Downstream division’s marginal cost is the $6 charged by the upstream
division.
• Downstream division sets MR = MC to maximize profits.
• 10 - 4Q = 6, so Q* = 1.
• P* = 10 - 2(1) = $8, so downstream division charges $8 per unit.

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Analysis
• This pricing strategy by the upstream division results in less than optimal
profits!
• The upstream division needs the price to be $6 and the quantity sold to be
2 units in order to maximize profits. Unfortunately,
• The downstream division sets price at $8, which is too high; only 1 unit is
sold at that price.
• Downstream division profits are $8  1 – 6(1) = $2.
• The upstream division’s profits are $6  1 - 2(1) = $4 instead of the
monopoly profits of $6  2 - 2(2) = $8.
• Overall firm profit is $4 + $2 = $6.

• (Another problem of Transfer Pricing with solution is given on page 467 of the text
book)

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Price Discrimination
• Firm must be an imperfect competitor (a price maker)
• Price elasticity must differ for units of the product sold at different
prices
• Firm must be able to segment the market and prevent resale of units
across market segments

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 The example: price discrimination
$/unit
Demand in the US:
36
PU = 36 – 4QU
Marginal revenue:
20
MR = 36 – 8QU Demand
MR
MC = 4 4 MC

Equate MR and MC 4 9
Quantity
QU = 4
Price from the demand curve PU = $20

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 The example: price discrimination
$/unit
Demand in the Europe:
24
PE = 24 – 4QU
Marginal revenue:
14
MR = 24 – 8QU Demand
MR
MC = 4 4 MC

Equate MR and MC 2.5 6

Quantity
QE = 2.5
Price from the demand curve PE = $14

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The example: price discrimination

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First-Degree or Perfect Price Discrimination
(Personalized pricing)

• Practice of charging each consumer the maximum amount he or she will pay for each
incremental unit
• Permits a firm to extract all surplus from consumers.
• Each unit is sold at the highest possible price. Firm maximizes total revenue and profit
from any quantity sold
• Example - car dealerships doctors, and lawyers (service related business)
• Two most common method of first degree price discrimination (non-linear pricing)
• Two-part pricing
• When it is not feasible to charge different prices for different units sold, but demand information is known,
two-part pricing may permit you to extract all surplus from consumers.
• Two-part pricing consists of a fixed fee and a per unit charge.
• Example: Athletic club memberships.
• Block pricing
• bundle different quantities and charge different prices for different bundle

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How Two-Part Pricing Works
Price 1. Set price at
marginal cost.
10 2. Compute
consumer
8
surplus.
6 Fixed Fee = Profits* = $16 3. Charge a
fixed-fee equal
Per Unit 4 to consumer
Charge
surplus.
2 MC
D

1 2 3 4 5
* Assuming no fixed costs
Quantity
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Two-Part Pricing: Numerical
• The demand function is Q =10 - P and the cost function is C(Q) =2Q.
• If the firm adopted a pricing strategy of simply charging a single price
to all consumers, the profit-maximizing level of output would be Q=4
and the profit-maximizing price would be P=6, Profit is 16
• Consumers receive a total of $8 (Consumer Surplus) in value from the
four units purchased that they do not have to pay for. The area of
above triangle

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Two-Part Pricing: Numerical
• Now suppose producer use Two part Pricing that of a single individual and
the firm uses the following pricing scheme: a fixed fee of $32 that gives the
consumer the right to buy the product at a per-unit charge of $2.
• With a per-unit charge of $2, the consumer will purchase eight units
• By charging a fixed fee of $32, the firm extracts all of this consumer’s
surplus.
• The firm sells each unit at its marginal cost of $2, and thus makes no profit
on each unit sold at this price. But the firm also receives the fixed payment
of $32, which is pure profit. The $32 in profits earned using the two-part
pricing scheme is larger than the $16 the firm would earn by using a simple
pricing strategy

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Block pricing
• The practice of packaging multiple units of an identical product together
and selling them as one package.
• Examples
• Paper.
• Six-packs of soda.
• Different sized of cans of green beans.
• There is another pricing method that the club owner can apply
• offer a package of “Entry plus X drinks for $Y”
• To maximize profit apply two rules
• set the quantity offered to each consumer type equal to the amount that type would
buy at price equal to marginal cost
• set the total charge for each consumer type to the total willingness to pay for the
relevant quantity

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An Algebraic Example
• Typical consumer’s demand is P = 10 - 2Q
• C(Q) = 2Q
• Optimal number of units in a package?
• Optimal package price?

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 Optimal Quantity To Package: 4 Units
Price

10

2 MC = AC
D

1 2 3 4 5 Quantity

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 Optimal Price for the Package: $24
Price Consumer’s valuation of 4
units = .5(8)(4) + (2)(4) = $24
10
Therefore, set P = $24!
8

2 MC = AC
D

1 2 3 4 5 Quantity

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 Costs and Profits with Block Pricing
Price

10
Profits* = [.5(8)(4) + (2)(4)] – (2)(4)
8 = $16

4 Costs = (2)(4) = $8

2 MC = AC
D

1 2 3 4 5 Quantity

* Assuming no fixed costs

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Commodity Bundling
• The practice of bundling two or more products
together and charging one price for the bundle.
• Examples
• Vacation packages.
• Computers and software.
• Film and developing.

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Bundling: an example
• Two television stations offered two old How
Hollywood
much films
can
How much can
• Speed and Godzilla be charged for
If the films are sold be charged forGodzilla?
• Arbitrage isseparately
possible between
total the stations
Speed?
• Willingness to payisis:$19,000
revenue
$7,000

Willingness to
Willingness to
$2,500
pay for Speed
pay for Godzilla

Station A $8,000 $2,500

Station B $7,000 $3,000

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 How much can
Bundling: an example beBundling
charged is
forprofitable
NowIf suppose
the films are soldthebecause
package? it exploits
that the as
twoa films
packageare totalaggregate willingness
revenue
bundled and is $20,000Willingness
sold payto Total
Willingness to
as a package pay for Willingness
pay for Speed
Godzilla to pay

Station A $8,000 $2,500 $10,500

Station B $7,000 $3,000 $10,000

$10,000

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Second-Degree Price Discrimination
(Product versioning)
Price
• The practice of posting a discrete
schedule of declining prices for $10 MC
different quantities.
• Charging a uniform price per unit for a $8
specific quantity, a lower price per
unit for an additional quantity, and so $5
on. Firm extracts part, but not all, of
the consumers’ surplus
• Example: Electric utilities, menu
pricing, bulk purchase D
2 4
Quantity
MBA ZC416, Managerial Economics, Monika Gupta
Third-Degree Price Discrimination
(Group pricing)

• The practice of charging different groups of consumers different

prices in different markets for the same product.
• Group must have observable characteristics for third-degree price
discrimination to work.
• Examples include student discounts, senior citizen’s discounts,
regional & international pricing.
• Firm maximizes profits by selling a quantity on each market such that
the marginal revenue on each market is equal to the marginal cost of
production

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Implementing Third-Degree Price
Discrimination: An Example
• Suppose the total demand for a product is comprised of two groups with
different elasticities, E1 < E2.
• Elasticity of demand for Kodak film in the US is EU = -1.5, and the elasticity of
demand in Japan is EJ = -2.5.
• Notice that group 1 is less price sensitive than group 2.
• Profit-maximizing prices?
• Marginal cost of manufacturing film is $3. As per the pricing formula -
• PU = [EU/(1+ EU)]  MC = [-1.5/(1 - 1.5)]  $3 = $9
• PJ = [EJ/(1+ EJ)]  MC = [-2.5/(1 - 2.5)]  $3 = $5
• Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US,
where demand is less elastic.

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Legal and Ethical Considerations in Pricing/
Loss of welfare
• Price discrimination
• Price Fixing
• Occurs when two or more companies conspire to keep prices at a certain level
• Horizontal price fixing occurs when competitors making the same product jointly determine what price they each will charge
• Vertical price fixing occurs when manufacturers attempt to force the retailer to charge the suggested retail price

• Predatory Pricing
• Means that a company sets a very low price for the purpose of driving
competitors out of business
• Dumping
• Selling in foreign market at or below cost
• Selling in a foreign market more than 5% below price in home market
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Legal and Ethical Considerations in Pricing/
Loss of welfare – Few Examples
• Airtel's predatory pricing case against Reliance Jio. But CCI has rejected
• Recently, Metropolitan Stock Exchange of India (MSEI) had dragged NSE to
the Competition Commission of India (CCI) citing monopolistic practices.
The competition watchdog held NSE guilty and asked it to compensate
MSEI.
• Recently, India’s National Pharmaceutical Pricing Authority capped the
price of coronary stents at 90 percent below their then-prevailing prices.
Private hospitals were found to be overcharging (up to 500 percent of the
actual cost) for life-saving medical and surgical devices
• In 2012 - The Competition Commission of India (CCI) has imposed a
collective fine of more than 60bn rupees ($1.1bn; £675m) on the firms. It
has accused them of "limiting" supplies and controlling prices through an
"anti-competitive agreement".

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Pricing with Electronic Commerce

• Dynamic pricing strategies

• price can be adjusted to meet changes in the marketplace
• online price changes can occur quickly, easily, and at virtually no cost
• Example – Railways and Aviation Industry
• Auctions
• sites offer chance to bid on items
• sites offer reverse-price auctions (such as bid based construction)

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Annexure
• Topic –Pricing Strategies such as Joint Product Problem, Transfer
Product Problem and Price Discrimination, Two Part Pricing, Bundling
• Please read the chapter 11 from the book
• Please listen prerecorded video 12.1 and 12.2, Concepts are discussed
in details with examples in the videos

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Plan of the next session
• Topic – Factor markets, Profit maximizing level of input;
Determination of optimum level of employment
• Please read the chapter 12 from the book
• Listen prerecorded video 13.1 & 13.2

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Acknowledgements
• All slides in this presentation have been prepared by the instructor
herself.
• I acknowledge my guide Prof. Sanjay K. Singh for providing me the
course materiel.

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Thank you!!

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