Prices and Profits

Question 1

a. In lectures we analysed pricing methods (such as two part pricing, third degree price discrimination, bundling etc) in isolation. However sometimes firms use pricing methods in combination. Provide an example of a good which is price using a combination of two pricing methods, apart from linear pricing, discussed in this unit. The example should not be one discussed elsewhere in this unit.
[10 marks]

b. Use an economic argument to explain why, in your example in part a, it might be profit maximising for the firm to use both mechanisms rather than just using one mechanism?
[10 marks] Note: marks will be given for the novelty of the example used in this question.

[Total: 20 marks] [Word limit: 600 words] 
Question 2

The table below shows the monthly MB from movies for two individuals: Rey and Finn.

Rey
MB
($/movie) Sales
(movie/month)
75.00 1
10.00 2
0.00 3
0.00 4
Finn
MB
($/movie) Sales
(movie/month)
30.00 1
25.00 2
20.00 3
15.00 4
0.00 5

a Suppose the cinema has marginal cost $4. Initially suppose that last month the market consisted only of Rey and Finn.

i What would have been the cinema’s profit maximising linear price last month? Identify this price using the concepts of marginal revenue and marginal cost.
[3 marks] ii How many units are purchased by Rey and how many by Finn when the firm sets the profit maximising price? What is the value of each customer’s consumer surplus?
[1 mark]

b Suppose that this month the cinema obtained an additional customer: Poe. (Thus this month the market consists of 3 customers.) Poe has the same monthly MB for movies as Finn.

i What would be the cinema’s profit maximising linear price this month? Identify this price using the concepts of marginal revenue and marginal cost.
[3 marks]

ii How many units are purchased by each customer when the firm sets the new profit maximising price? What is the value of each customer’s consumer surplus?
[1 mark]  
iii Provide intuition for the difference in the results between this month’s and last month’s price and consumer surplus.
[2 marks]

iv In the above example, provide an intuitive explanation for the change in the cinema’s profit when Han joins the market?
[2 marks]

v Would the addition of extra customers ever cause the firm’s profit to fall? Provide a succinct explanation.
[2 marks]

vi You should not have need to know the value of the firm’s fixed cost to answer the above question. Provide an explanation why that was not necessary. However, on this point, one should really add a caveat to the conclusions made in the earlier sections. What is that?
[3 marks]

c Now suppose, in contrast to part b above, that Rey and Finn live in the village “Jakku” while Poe lives in the village “D’Qar”. Also assume now that each village has a cinema owned by the firm. Rey, Finn and Poe are the firm’s only customers.

i What would be the profit maximising pricing strategy in this case, given each cinema must set a linear price?

[3 marks]

[Total: 20 marks] [Word limit: 600 words]  
Question 3

Consider the following data for the marginal benefit (MB) of three consumers for a particular good.

Luke
MB
($ per unit) Sales
(units a month)
24.00 1
18.00 2
12.00 3
6.00 4
0 5
Leia
MB
($ per unit) Sales
(units a month)
20.00 1
14.00 2
8.00 3
2.00 4
0 5
Han
MB
($/movie) Sales
(movies/ month)
16.00 1
10.00 2
4.00 3
0.00 4
0 5

Suppose that the firm which supplies this good has a fixed cost of $10 and marginal cost of $3, so that total cost is TC = 10 + 3Q, where Q represents output. Suppose the firm is able to bundle its output.

a Suppose Han is a student and thus has a student card, and the other two customers do not. In this case the firm could offer separate prices for students and non-students.

i Find the profit maximising bundles the firm sells.
[4 marks]

ii What level of consumer surplus does each consumer receive? Provide an intuitive reason for the differences in consumer surplus received by customers.
[1 mark]

b Now consider the case in which Leia and Han are both students, but Luke does not. In this case also the firm could offer separate prices for students and non-students.

i Find the profit maximising bundles the firm sells.
[4 marks]

ii What level of consumer surplus does each consumer receive? Provide an intuitive reason for the differences in consumer surplus received by customers.
[1 mark]

c Provide an explanation for the difference in profit you found in part a and part b?
[3 marks]

d Now consider the case in which neither Leia nor Han have identification, like student cards discussed above, which could be used to identify them as members of a low MB group. However Luke has a membership card to an exclusive golf club.

i In this example, could the firm profit by offering a particular price to people who show their golf club membership card?

[3 marks] ii How would the firm go about pricing in this case? Identify the key economic characteristics of the firm’s optimal pricing scheme. Will profit be higher or lower than that obtained under the assumptions of part a and part b?
[4 marks] [Total: 20 marks] [Word limit: 600 words]

 
Question 4

a Consider the following customers, who purchase only one unit of a product but differ in their marginal benefit from quality.

Snoke
Quality
($ in production per unit) MB
($ per $ in production per unit)
1 6.50
2 4.50
3 3.00
4 0.50
5 0.00
6 0.00
Kylo
Quality
($ in production per unit) MB
($ per $ in production per unit)
1 3.50
2 2.00
3 1.50
4 1.25
5 0.25
6 0.00

Identify the profit maximising way to price and produce this product if the firm cannot identify which customer is Snoke and which is Kylo? Assume zero fixed cost.
[10 marks]

b Consider a coffee shop which sells only one product, cups of coffee. Suppose the world price of coffee beans (which are used to make the firm’s coffee) has just risen significantly. The increase in the world price of coffee beans is expected to last one month.
i Someone in the shop argues that the price they set for a cup of coffee should be increased while the world price of coffee beans is high to minimise the fall in profit. What would standard economic reasoning say about this suggestion?
[4 marks] ii What implications, if any, might prospect theory have for the suggestion made in part i?
[6 marks] [Total: 20 marks] [Word limit: 600 words] 144
ECO550 Week 7 Scenario Script: Best-Practice Tactics, Game Theory, and Pricing Techniques and Analysis
Slide # Scene # Narrations
Slide 1 Scene 1
An older cottage style family run business (Katrina’s Candies)

Slide 2 Scene 2
In Gigi’s office where Herb explains to Gigi why a large company like Katrina’s Candies cannot ignore industry
rivals and why predicting rival responses is an important determinant of decisions Katrina’s Candies makes. Gigi: Good Afternoon, Herb!

Herb: Hello, Gigi.

Gigi: I called you into my office today to talk about rival behaviors in our chocolate market. I had a couple of questions pertaining to this subject. My first question is, based on your time with Renee, what kind of market structure does Katrina’s Candies operate in?

Herb: Renee and I determined that its Chocolates operate within an Oligopolistic market structure, and we noted that there are only three firms in our market that are larger than Katrina’s Candies.

Gigi: This market classification means that the market has consolidated over the past fifteen years. When I started working here, there were a lot of other candy manufacturers and the market seemed to feature more monopolistic competition.

Herb: Perhaps the trend towards healthier life-styles was too much for those firms that left the market; especially burdensome is the higher cost associated with innovating products just to be able to stay in the market. Therefore, it’s good Katrina’s Candies was able to survive the adjustment that took place in the market.

Gigi: I couldn’t agree more, Herb. All of its employees have helped maintain our competitive posture so far—from management to employees working on the manufacturing side of the operation. We’ll just have to repeat the effort we organized.. We ignored all of the other chocolate manufacturers and focused our efforts on making good chocolate. We should implement a similar strategy now.

Herb: The narrowly focused strategy Katrina’s Candies used previously to survive in the market might have worked with a larger number of manufacturers than what is present in today’s market. However, today, given the information that the market has a few dominant firms, the strategy of ignoring other firms will not work. Katrina’s Candies has to be aware of these markets and consider the reactions of other firms.
Slide 3 Scene 3
In Gigi’s office where Herb explains to Gigi why a large company like Katrina’s Candies cannot ignore industry rivals and why predicting rival responses is an important determinant of decisions it makes. Gigi: I’ll defer to your opinion on this one, Herb. We brought you on the team because you have the most current information about best practices, so with that being said, how should Katrina’s Candies proceed?

Herb: The simple answer to your question is that we now need to focus attention on its competitors. We can develop a matrix of how competitors might respond if Katrina’s Candies expands into the international market.

Gigi: How can we create a matrix of other firms’ reactions? We can’t survey our competitors to ask what they will do if we expand; I think that would violate U.S. anti-trust laws prohibiting collusion amongst firms.

Herb: That’s correct! We cannot directly engage competitors by telephoning firms and asking questions. However, we can build a matrix of hypothesized reactions based upon theories that attempt to explain the behavior of oligopolistic firms. There are several theories we can review and use such as:

The Kinked Demand Curve theory;
The Price Leadership Theory; and
Game Theory.

The common assumption among these theories is that firms operating in oligopolistic markets are “interdependent” meaning that the level of profit each firm earns depends upon the behavior of other firms within the market.

Gigi: Can you elaborate on this connection between interdependence and Katrina’s Candies profit?

Herb: Yes. It works like this. Remember how overall profit is defined as the difference between total revenue and total cost?

Gigi: Yes, I remember.

Herb: Also recall that Total Revenue is derived by multiplying Price times the Quantity sold. In the market Katrina’s Candies is in, the price we set depends upon the price our competitors set; and vice versa. That’s the reason the three oligopoly theories assume interdependence.

Gigi: Okay, I believe I understand the interdependence assumption now.
Slide 4 Scene 4
In Gigi’s office where Herb explains to Gigi why a large company like Katrina’s Candies cannot ignore industry
rivals and why predicting rival responses is an important determinant of decisions it makes. Herb: Let’s now review Kinked Demand Theory. Assume there are two firms considering two decisions about price. Decision one is to raise prices and decision two is to lower prices. According to kinked demand curve theory, if one firm chooses to lower prices, the other firm will also lower their prices. However, if one firm raises prices, the other firm may not raise prices.

Gigi: Why would a firm ignore a price increase? Wouldn’t an increase in price increase the firm’s total revenue?

Herb: An increase in the price of an oligopolist’s product would increase total revenue only if the other firm reacted by also increasing the price of its product. However, if firm A were to increase price and firm B did not react by increasing price, consumers would switch from consuming firm A’s product to consuming firm B’s product because both sell the same type of product.

Gigi: Is this all there is to kinked demand curve theory?

Herb: Almost. Although the theory states that firms would follow price cuts, oligopolists avoid using price to compete. Instead, oligopolists engage in lots of non-price competition; for example, spending on advertising as a way to compete.

Gigi: Is there a reason firms behave differently than theorists predict?

Herb: Yes, by using price to compete this can sometimes cause a price war for the best prices. To avoid that outcome, it’s best for firms to compete in ways that don’t affect price. Let’s look at an example of the Kinked Demand Curve Theory.
Slide 5 Scene 5
Interaction Slide
Ipad will be showcasing the video:
• Kinked Demand Oligopoly: The lack of price competition.
o http://www.youtube.com/watch?v=HT9t-zjYi_A

Slide 6 Scene 6
In Gigi’s office with Herb briefly commenting on Kinked demand curve theory and preparing to view other presentations Gigi: That was a very interesting explanation of Kinked demand theory. The example brought everything into perspective.

Herb: Fantastic! The next concept I want to cover is Price Leadership theory. I found two short videos that will give you a basic overview of the basic assumptions of this theory.
Slide 7 Scene 7
Interaction Slide
Ipad will be showcasing these videos:
• Price Leadership 1
o http://www.youtube.com/watch?v=AtH4_lU_T8k
• Price Leadership 2
o http://www.youtube.com/watch?v=GeD2fwjJ8_U

Slide 8 Scene 8
In Gigi’s office where Herb talks about Price Leadership Theory and Game Theory with Gigi Gigi: Thank you for showing me those videos Herb; they were a great overview! I now understand the difference between a firm’s behavior in a kinked demand curve environment and in a price leadership environment. Initially, I thought the uncertainty in the kinked demand curve outcome was restrictive. After learning the basics of price leadership theory, the kinked demand scenario seems more attractive.

Herb: I agree. The price leadership scenario does not theorize a good outcome for Katrina’s Candies Chocolates, even though they are the fourth largest firm in the chocolate industry.

Gigi: So, what can we here at Katrina’s Candies do in this type of market?

Herb: Katrina’s Candies must be very strategic with its decisions! All decisions must be based upon the assumption that its nearest competitors will respond to the decisions they make.

Gigi: So, that’s your recommendation? Let the competitors react to our decisions?

Herb: Yes, I feel we should go along with that assumption and also look into a foundation involving “Game Theory.” Game Theory is a theory that provides a model for predicting the behavior of rivals. It looks at strategic decision making!

Gigi: How do we apply this model to make a prediction?

Herb: Here, take a look at this video. The video will give you an idea of how we need to be rational throughout various scenarios.
Slide 9 Scene 9
Interaction Slide
Ipad will be showcasing the video:
• Game theory in real life
o http://www.youtube.com/watch?v=2o3H0AtEylg

Slide 10 Scene 10
In Gigi’s office where Herb talks about Game Theory with Gigi Gigi: (laughter) That skit is hilarious!!

Herb: Yes, it is! Every time I view it, it makes me laugh!

Gigi: I can see why! However, it’s a great way to summarize the game theory method. Did you hear how many times they used the word “probably”?

Herb: Yes. Can you imagine how we’re going to sound speculating about the reactions of Katrina’s Candies rivals!

Gigi: (Laughter) I hadn’t thought about that! However, we need to stop here for today because I have an appointment with a client in a few minutes.

Herb: Before you go I think it would be best if we did a review since we covered so many new topics today. Therefore, I would like for you to participate in a review activity I put together based on the key items we discussed.

Gigi: Good thinking Herb. I will go through your review activity and then we will have a final review to finish up our time together today.
Slide 11 Scene 11
Interaction Slide
Ipad will be showcasing the video:
• Micro 4.8 Oligopolies and Game Theory
o http://www.youtube.com/watch?v=AOEbJF0k8vM

Slide 12 Scene 12
Check Your Understanding
Answer the following questions based on the payoff matrix for a one quarter time-period, for Katrina’s Candies and Gooey’s. The numbers in the matrix indicate the profit in billions of dollars for an international or national strategy. The profit outcome cells are A, B, C, and D.
(insert matrix picture for question)
Question:
• Which strategies are the dominate ones for Katrina’s Candies and Gooey’s?
Choices:
• International
• National
• Demand theory
• Game theory
Correct Answer:
• The dominant strategy for Katrina’s Candies and Gooey’s is to always choose the international strategy.

Slide 13 Scene 13
Summary
Concluding scene taking place in conference room Herb: Gigi, I hope the review activities were helpful!

Gigi: They were great, Herb! Thank you for sharing these review materials with me; they were a great review tool. Can we now complete a review of what we accomplished today so I can be prepared for my next meeting with Ken?

Herb: Sure thing! We first established that Katrina’s Candies is operating in an oligopolistic market, meaning that at least three chocolate manufacturing firms dominate the market. I also mentioned that currently Katrina’s Candies is number four in this market.
Gigi: I also remember you talking about the primary characteristic of firms in oligopolistic markets is mutual interdependence.
Herb: That is correct, and I’m glad you remembered that! I also explained three theories that offered explanations for the behavior of oligopolistic firms.
Gigi: I believe those three theories were the Kinked Demand Curve theory, Price Leadership Theory, and Game Theory. You also provided me with videos that really helped solidify these three theories.
Herb: I’m glad that those videos were helpful for you! I believe you will be very well prepared for your next meeting with Ken to discuss the future of Katrina’s Candies.

Gigi: That is fantastic and I believe that is all for our meeting today. Until we meet again, don’t forget to complete your weekly threaded discussions based on the key concepts we covered this week.

Herb: Thanks Gigi and have a great day!