Econ Exam Chapter 11

Chapter 11 Notes  Beyond The Single Price Per Unit Model o In some markets, managers can enhance profits beyond those resulting from charging all consumers a single, per-unit price. o Models that yield greater profits fall into three categories:  Pricing strategies:  that extract surplus from consumers.  for special cost and demand structures.  in markets with intense price competition.   Model That Extracts Surplus From Customers o Strategies for surplus extraction:  Price discrimination (first, second and third degrees)  Two-part pricing  Block pricing  Commodity bundling o Each strategy is appropriate for firms with various cost structures and degrees of market interdependence. Surplus Extraction: First Degree Price Discrimination o Price discrimination is the practice of charging different prices to consumers for the same good or service. o First-degree price discrimination is the practice of charging each consumer the maximum price he or she would be willing to pay for each unit of the good purchased.  Implication: the firm extracts all surplus from consumers and earns the highest possible profit. o Problem: managers rarely know each consumers’ maximum willingness to pay for each unit of the product  Surplus Extraction o Second-degree price discrimination is the practice of posting a discrete schedule of declining prices for different ranges of quantity. o Implication: firm extracts some surplus from consumers without needing to know the identity of various consumers’ demand. Higher the elasticity, lower the price. Price elasticity of demand explains how responsive we are to a change in price. Third Degree Price discrimination groups people by their price elasticity of demand. Price elasticity of demand depends on how much money you have. Higher the elasticity, the lower the price you pay. Great application of this is coupons. In the example of a store with a membership fee (Costco), the higher the entry fee, the lower the number of customers.  Surplus Extraction: Two Part Pricing o Two-part pricing is a pricing strategy whereby a firm with market power charges a fixed fee for the right to purchase its goods, plus a per-unit charge for each unit purchased.  Surplus Extraction: Commodity Bundling o Commodity bundling is the practice of bundling several different products together and selling them at a single “bundle price.” o Key assumption: Consumers differ with respect to the amounts they are willing to pay for multiple products sold by a firm. o Managers cannot observe different consumers’ valuations.  Pricing Strategies for Special Cost and Demand Structures: Peak-Load Pricing o Peak-load pricing is a pricing strategy in which higher prices are charged during peak hours than during off-peak hours.    Intense Price Competition: Price Matching o Price matching is a strategy in which a firm advertises a price and a promise to match any lower price offered by a competitor.  Used to mitigate the stark outcome associated with firms competing in a homogeneousproduct, Bertrand oligopoly.  Outcome: If all firms in the market adopt a price matching policy, all firms can set the monopoly price and earn monopoly profits; instead of the zero profits it would earn in the usual one-shot Bertrand oligopoly. o Potential issues:  Dealing with false consumer claims of low prices.  Competitor’s with lower cost structures. Intense Price Competition: Inducing Brand Loyalty o Brand loyal customers continue to buy a firm’s product even if another firm offers a (slightly) better price.  Strategy used to mitigate the tension of Bertrand competition. o Methods for inducing brand loyalty.  Advertising campaigns.  “Frequent-buyer” programs. Intense Price Competition: Randomized Pricing o Randomized pricing is a strategy in which a firm intentionally varies its price in an attempt to “hide” price information from consumers and rivals. o Benefits of randomized pricing to firms:  Consumers cannot learn from experience which firm charges the lowest price in the market.  Reduces the ability of rival firms to undercut a firm’s price. o Not always profitable. Chapter 11 Practice Problems 1) One of the conditions under which price discrimination is profitable is: A) inability to resell the good. B) differences in demand elasticities. C) ability to identify consumer types. D) All of the statements associated with this question are correct. 2) A local video store estimates its average customer's demand per year is Q = 7 - 2P, and it knows the marginal cost of each rental is $0.5. How much should the store charge for an annual membership in order to extract the entire consumer surplus via an optimal two-part pricing strategy? B) $9 P = Marginal cost If price = .5 Q = 7- (2*.5) Q = 6 Shaded area = consumer surplus CS = area of triangle CS= .5 *6*(3.5 -.05) CS= .5 * 6 * 3 = $9 3) Cinemas sometimes give senior citizens discounts. What is the possible privately motivated purpose for them to do so? C) Senior citizens have a more elastic demand for movies than ordinary citizens. (they don’t really care about movies) 4) A Broadway theater sells weekday show tickets at a lower price than for a weekend show. This is an example of: B) price discrimination or peak-load pricing. 5) Which of the following statements about a price-matching strategy is incorrect? A) It reduces the incentive for a rival firm to initiate a price war. B) It may be applied in situations besides Bertrand oligopoly. C) It only guarantees to match prices that are advertised publicly. D) It requires that the firms can monitor their rival's prices. 6) Suppose two types of consumers buy suits. Consumers of type A will pay $100 for a coat and $50 for pants. Consumers of type B will pay $75 for a coat and $75 for pants. The firm selling suits faces no competition and has a marginal cost of zero. If the firm charges $100 for a suit (which includes both pants and a coat), the firm will sell a suit to: B) type A consumers and type B consumers. Consumer A: coat and pant want to pay $150 total Consumer B: coat and pant want to pay $150 total They both want to pay the same amount total 7) Refer to the figure below. During low-peak times, what price-quantity combination should the firm charge to maximize profit? C) P3 and Q1 When demand is low marginal revenue is equal to marginal cost 8) Suppose a manager is interested in implementing third-degree price discrimination. The manager knows that the price elasticity of demand for Group 1 is 􀃭2 and the price elasticity of demand for Group 2 is 􀃭1.2. Based on this information alone we can conclude that the price charged to Group 2 will be: C) higher than the price charged to Group 1. Higher the elasticity, the lower the price. Group 1’s price elasticity of demand is higher, so group 2’s price will be higher 9) First-degree price discrimination: A) occurs when a firm charges each consumer the maximum price he or she would be willing to pay for each unit of the good purchased and results in the firm extracting all surplus from consumers. 10) Second-degree price discrimination: B) is the practice of posting a discrete schedule of declining prices for different ranges of quantities. The more you buy, the lower the per unit price. 11) The price of on-campus parking from 8:00 AM to 5:00 PM, Monday through Friday, is $3.00. From 5:00 PM to 10:00 PM, Monday through Friday, the price is $1.00. At all other times parking is free. This is an example of A) a two-part tariff. B) second-degree price discrimination. C) tying. D) bundling. E) none of the above This is called Peak load-pricing Chapter 10 Homework 1. Consider the following information for a simultaneous move game: If you advertise and your rival advertises, you each will earn $5 million in profits. If neither of you advertises, you will each earn $10 million in profits. However, if one of you advertises and the other does not, the firm that advertises will earn $15 million and the non-advertising firm will earn $1 million. If you and your rival plan to be in business for only one year, the Nash equilibrium is: for each firm to advertise. Looking at the row for "A advertises": B advertises = 5, 5 B does not advertise = 15, 1 It appears that "A and B" could be a Nash Equilibrium. Check row "B advertises": A advertises = 5, 5 A does not advertise = 1, 15 A has no potential gain by not advertising. Now looking at the row for "A does not advertise": B advertises = 1, 15 B does not advertise = 10, 10 There is no gain for B to not advertise, so let "B advertises": A advertises = 5, 5 A does not advertise = 1, 15 Same situation as before, A will advertise. Thus "both A and B advertise" is the only nash equilibrium. 2. Refer to the normal-form game of bargaining shown below. Union $0 Management $0 ($0, $0) $250 ($0, $250) $500 ($0, $500) $250 $500 ($250, $0) ($500, $0) ($250, $250) (-$10, -$10) (-$10, -$10) (-$10, -$10) Suppose that management and the union are bargaining over how much of a $500 surplus to give to the union. It is assumed that the surplus can only be split into $250 increments. Furthermore, negotiations are set up such that management and the union must simultaneously and independently write down the amount of surplus to allocate to the union. The payoff structure to this one-shot bargaining game is listed in Figure 10-16. Find the Nash equilibrium(ia) to this game. All of the statements associated with this question constitute Nash equilibria. 3. A secure strategy is a strategy that:! guarantees the highest payoff given the worst possible scenario. 4. What are the Nash equilibrium strategies for firm A and firm B, respectively, in a one-shot game? Correct! (low price, low price) 5. Which of the following is true? For a finitely repeated game, the game is played enough times to effectively punish cheaters, and therefore collusion is likely. A secure strategy is the optimal strategy for a player no matter what the opponent does. In an infinitely repeated game with a low interest rate, collusion is unlikely because the game unravels so that effective punishment cannot be used during any time period. Correct! None of the answers is correct. 6. Collusion is: not possible when firms interact repeatedly forever. legal in the United States. more likely in industries with a large number of firms. None of the answers is correct. 7. Which of the following is true for a Nash equilibrium of a two-player game? Correct! Given another player's strategy stipulated in that Nash equilibrium, a player cannot improve his welfare by changing his strategy. 8. Suppose that you are a manager. You are considering whether or not to monitor employees with the payoffs in the normal-form game shown below. Manager Worker Not Shirk Shirk Monitor -1,1 1,-1 Don't Monitor 1,-1 -1,1 What should the manager do to solve the shirking problem? Engage in "random" spot checks of the workplace. 9. If you advertise and your rival advertises, you each will earn $4 million in profits. If neither of you advertises, you will each earn $10 million in profits. However, if one of you advertises and the other does not, the firm that advertises will earn $1 million and the non-advertising firm will earn $5 million. If you and your rival plan to be in business for only one year, the Nash equilibrium is:! for neither firm to advertise. 10. Management and a labor union are bargaining over how much of a $50 surplus to give to the union. The $50 is divisible up to one cent. The players have one shot to reach an agreement. Management has the ability to announce what it wants first, and then the labor union can accept or reject the offer. Both players get zero if the total amounts asked for exceed $50. Which of the following is NOT a Nash equilibrium? Management requests $30 and the labor union accepts $10. 11. Refer to the normal-form game of price competition in the payoff matrix below. Firm A Low Price High Price Firm B Low Price 0,0 -10,50 High Price 50,-10 20,20 Suppose the game is infinitely repeated, and the interest rate is 10 percent. Both firms agree to charge a high price, provided no player has charged a low price in the past. If both firms stick to this agreement, then the present value of firm A's payoffs are: 220. 12. Which of the following is a factor(s) affecting collusion in an infinitely repeated pricing game? History Firm size Number of firms All of the statements associated with this question are correct. 13. A Nash equilibrium with a noncredible threat as a component is: not a perfect equilibrium. 14. There are two existing firms in the market for computer chips. Firm A knows how to reduce the production costs for the chip and is considering whether to adopt the innovation or not. Innovation incurs a fixed setup cost of C, while increasing the revenue. However, once the new technology is adopted, another firm, B, can adopt it with a smaller setup cost of C/2. If A innovates and B does not, A earns $20 in revenue while B earns $0. If A innovates and B does likewise, both firms earn $15 in revenue. If neither firm innovates, both earn $5. Under what condition will firm B have an incentive to adopt if firm A adopts the innovation? C < 30 15. Game theory suggests that, in the absence of patents, the privately motivated innovation decisions of firms might lead to: too little innovation. 16. In the game shown below, firms 1 and 2 must independently decide whether to charge high or low prices. Which of the following are Nash equilibrium payoffs in the one-shot game? (10, 10) 17. Game theory is best applied to the analysis of:ect! oligopoly. 18. It is easier to sustain tacit collusion in an infinitely repeated game if: the present value of cheating is lower than collusion. 19. In the game shown below, firms 1 and 2 must independently decide whether to charge high or low prices. Firm One Firm Two High Price Low Price High Price (10,10) (5,-5) Low Price (5,-5) (0,0) Suppose the game is infinitely repeated. Then the "best" the firms could do in a Nash equilibrium is to earn ________ per period. (10, 10) 20. Firm B is the incumbent facing potential entry from its rival, firm A. Firm A's strategies consist of {entry, stay out}. Firm B's strategies are then {hard if entry; hard if stay out; soft if entry; soft if stay out}. Find the subgame Nash equilibrium to this game, if one exists.! Firm A plays {entry}; firm B plays {soft if entry}. Homework Chapter 11 1. Which of the following is NOT a condition for a firm to engage in price discrimination? The consumers are sincere in revealing their true natures. 2. Which of the following statements is true? The more elastic the demand, the lower the profit-maximizing markup. 3. The idea of charging two different groups of consumers two different prices is practiced in: price discrimination. 4. You are the manager of a gas station and your goal is to maximize profits. Based on your past experience, the elasticity of demand by Texans for a car wash is −4, while the elasticity of demand by non-Texans for a car wash is −6. If you charge Texans $20 for a car wash, how much should you charge a man with Oklahoma license plates for a car wash? $18.00 5. During spring break, students have an elasticity of demand for a trip to Florida of −3. How much should an airline charge students for a ticket if the price it charges the general public is $360? Assume the general public has an elasticity of −2. $270 6. A local video store estimates its average customer's demand per year is Q = 7 − 2P, and it knows the marginal cost of each rental is $0.5. How much should the store charge for each rental if it engages in optimal two-part pricing? $0.5 7. If your demand for renting videos is Q = 5 − 2P, should you purchase the annual membership from a video store that charges $0.5 per rental, plus an annual membership fee of $12? Definitely no 8. A campus auditorium sells tickets at half price to students during the last 30 minutes before a concert starts. This is an example of: price discrimination or peak-load pricing. 9. The special cost structure that is necessary for a firm to adopt a peak-load pricing policy is: limited capacity 10. Which group of policies aims at discouraging rivals from starting a price war? Price matching and randomized pricing 11. If a product is perceived by consumers as homogeneous, which of the following strategies will work to induce brand loyalty? Frequent buyer rebate programs 12. The purpose of randomized pricing is to reduce: both customer and competitor information about price. 13. Suppose two types of consumers buy suits. Consumers of type A will pay $100 for a coat and $50 for pants. Consumers of type B will pay $75 for a coat and $75 for pants. The firm selling suits faces no competition and has a marginal cost of zero. If the firm sells coats and pants for $25 each, but offers a bundle containing both a coat and pants for $150, how many bundles will the firm sell? 0 14. To engage in first-degree price discrimination, a firm must: be able to set P > MC. prevent low-value consumers from reselling to high-value consumers. know each consumer's maximum willingness to pay. All of the answers are correct. 15. The following table contains different consumers' values for three software titles: PowerPoint, Excel, and Word. Suppose there are 100 consumers of each type. It costs Microsoft $5 to produce each piece of software. If Microsoft wants to devise a pricing strategy that is incentive compatible between consumer types and will maximize its profit, then it should: charge a single price of $300 for the bundle of PowerPoint, Excel, and Word 16. Refer to the figure below. During high-peak times, what price-quantity combination should the firm charge to maximize profit? P4 and Q3 17. A third-degree price discriminating monopolist can sell its output either in the local market or on an internet auction site (or both). After selling all of its output, the firm discovers that the marginal revenue earned in the local market was $20 while its marginal revenue on the internet auction site was $30. To maximize profits the firm should have sold less output in the local market and more on the internet auction site. 18. The maximum price that a consumer is willing to pay for each unit bought is the ________ price. Reservation 19. Second-degree price discrimination is the practice of charging different prices for different quantity blocks of the same good or service. 20. The price of on-campus parking from 8:00 AM to 5:00 PM, Monday through Friday, is $3.00. From 5:00 PM to 10:00 PM, Monday through Friday, the price is $1.00. At all other times parking is free. This is an example of tying. second-degree price discrimination. Bundling a two-part tariff. none of the above