HBX- Economics 5

Question 1

Pricing Power

Answer 1

The ability of a firm to set prices above cost without meaningful competitive retaliation from other firms.

Ex: When you’re considering having Malaysian food for dinner or joining a gym, you’re not going to drive 15 miles every time. In effect, that firm in your area or neighborhood enjoys pricing power over its customers.

Question 2

Two fundamental concepts in business strategy:

Answer 2

pricing and product differentiation.

Question 3

What are some considerations that went into pricing decisions about the pricing of Epogen (a life prolonging drug)?

How to tackle hard pricing decisions like this?

Answer 3

• what it cost to make the product,
• patient WTP,
• government insurance, and
• fairness.
• the incentive for producers to price appropriately (balancing access, fixed cost recovery, and profit),
• the incentives for governments to step in, and
• the incentives of other players in the health care system (for-profit versus non-profit delivery providers)—and how these various parties interact.

Start simple and then see how each relevant factor might affect your decision.

Question 4

What happens when there is no differentiation between firms?

Answer 4

(If companies are providing the same product, get into a price war and are selling at variable cost)
no firm creates any unique value. As a result, no firm captures any.

Question 5

Compare the two situations you’ve just analyzed. Why exactly are prices different in a competitive market than for a monopolist?

• A monopolist has different objectives than a competitive firm does.
• A monopolist doesn’t face the risk of a price war, so it can price higher and increase profits.
• A monopolist faces a tradeoff between pricing for volume and pricing for profit, whereas a competitive firm does not.
• A monopolist doesn’t care about access and fairness, but a competitive firm does.

Answer 5

A monopolist doesn’t face the risk of a price war, so it can price higher and increase profits.

• A competitive firm would be undercut by its competitors if it raised prices.

Question 6

What is a general principle that might help a firm figure out its optimal price?

Answer 6

Marginal Revenue!

Question 7

What’s Average Revenue?

Answer 7

The revenues received per unit sold; mathematically, the total revenues for a business, divided by the total volume of goods sold; average revenue is equal to price unless there is price discrimination.

(revenue that you get
from customers who you currently serve)

Question 8

What’s Marginal Revenue?

Answer 8

The additional revenue earned by producing extra unit(s) of a product or service.

Question 9

Where are profits maximized for a monopolist?

• A monopolist should price at the point on the demand curve where its marginal revenue is zero.
• A monopolist should price at the point on the demand curve where its marginal revenue is equal to its average revenue.
• A monopolist should price at its variable cost.
• A monopolist should price exactly halfway down the demand curve, where elasticity is equal to 1.
• A monopolist should price at the point on the demand curve where its marginal revenue is equal to its variable (or marginal) cost.

Answer 9

A monopolist should price at the point on the demand curve where its marginal revenue is equal to its variable (or marginal) cost.

• Profits are maximized when MR = MC. If marginal revenue is greater than marginal cost, you can increase profits by producing and selling an additional unit of the good. Note that the quantity produced is determined by the quantity at which MR = MC. The price is determined by the price on the demand curve that corresponds to this quantity.

Also… Why this one (D) isn’t right!!!

A monopolist should price exactly halfway down the demand curve, where elasticity is equal to 1.

• Pricing where elasticity is equal to 1 will maximize revenues, but will not necessarily maximize profit.

Question 10

The price at which total profits are maximized for a company can be determined in two ways- what are they? Which one is smarter/easier?

Answer 10

1. First, you can compute total revenues and total costs corresponding to different prices and quantities. If you approach the problem this way, you’d set a price where the difference between total revenue and total cost– or your total profits– were maximized.
2. But you can also approach the problem in a different way. Rather than try to figure out revenues and costs for every single price, at whatever price you’re charging or whatever output you’re producing, simply ask the question, “Is my marginal revenue from producing one extra unit greater than my marginal cost?” And if it is, keep dropping the price or increasing production until that’s no longer the case.

THE 2ND ONE IS EASIER
Instead of looking at the demand curve in its entirety and knowing all the data, all you need to do is figure out whether small changes in prices and output can additionally help you. That decision approach will lead you to the same result.

The MR = MC pricing principle is one of the most important ideas in economics and strategy.

Question 11

Is MR = MC great for monopolies or competitive markets?

Answer 11

For competitive markets is that, for a competitive firm, its marginal revenue is just equal to the demand curve!

You’ll notice this also means that competitive firms price where marginal revenue equals marginal cost, just as a monopolist does.

Question 12

A firm sells a smartphone. At a price of $500, there is only one customer. At prices above $500, no one purchases the phone. What is the firm’s marginal revenue at a price of $500?

• $0
• $250
• $500
• $1000

Answer 12

$500

• Lowering the price of the phone from $501 to $500 will bring in one new customer, and $500 in new revenues. Since there are no customers who would buy the phone at any price higher than $500, the firm doesn’t lose revenue on any inframarginal customers. MR = $500 - $0.

Question 13

A firm sells a smartphone. At a price of $500, there is only one customer. At prices above $500, no one purchases the phone. If the firm reduces its price slightly, it finds that there are no additional customers willing to purchase a phone at $490, or $450, or $400, etc. At a price of $200, however, two new customers would buy the smartphone (in addition to the customer with a WTP of $500).

What is the firm’s revenue at a price of $200?

• $100
• $200
• $400
• $600

Answer 13

$600

• There are three customers who each purchase the phone at a price of $200. Revenue = $200*3=$600.

Question 14

A firm sells a smartphone. At a price of $500, there is only one customer. At prices above $500, no one purchases the phone. If the firm reduces its price slightly, it finds that there are no additional customers willing to purchase a phone at $490, or $450, or $400, etc. At a price of $200, however, two new customers would buy the smartphone (in addition to the customer with a WTP of $500), making its new revenue $600. What is the firm’s change in revenue when the it reduces prices from $500 to $200?

• -$300
• $100
• $400
• $600

Answer 14

$100

• At a price of $500, the firm sold one phone and earned revenues of $500. At a price of $200, the firm gains $400 in revenues from new customers, but loses $300 that it could have earned by charging the first customer a higher price. The change in revenue = $400 - $300. It could also simply be calculated as the difference in revenue: $600 (revenue after the price change) - $500 (revenue before the price change) = $100. The MR would then be the change in revenue ($100) divided by the change in units sold (2)= $50.

Question 15

Say an airline has 100 tickets for sale for a flight from Boston to New York. At a price of $130, only 70 people would be willing to buy tickets. The airline would generate revenues of $9,100. The airline could, instead, offer the tickets for $115 and sell 80 of them.

What are revenues at a price of $115?

Also, What is the airline’s marginal revenue when it decreases price from $130 to price of $115?

Answer 15

The airline earns $115*80 = $9,200 in revenue.

Although the airline has gained $115*10 = $1150 in revenue from new customers, it has lost $15*70 = $1050 on the higher-WTP customers. A simpler way to look at it is that the firm made $9,100 at a price of $130, and $9,200 at a price of $115. The marginal revenue is the difference in revenue divided by the increase in tickets sold: $100/10=$10.

Question 16

We know that the airline could sell 80 seats at a price of $115. Now, say the airline can lower its price further, to $100, and sell 90 seats.

What is the airline’s marginal revenue when it lowers price from $115 to $100?

Answer 16

- 20

At a price of $115, the airline was earning $9,200 in revenue. At a price of $100, it earns $9,000. The marginal revenue is the difference divided by the increase in seats: -$200/10=-$20. With this price reduction, the airline went too far, and actually lost money.

Question 17

Why don’t real world situations constantly chase demand?

Answer 17

In the real world, you don’t always see firms perfectly adjusting price to demand every instant. The reason is that there are longer-run considerations as well. For example, a Four Seasons Hotel would not offer its empty rooms at $20, even if that covered variable costs. Doing that might encourage customers to do unpleasant things like always wait until the very last moment to make reservations. The extra $20 would hardly be worth the damage to the company’s long-term fortunes.

Question 18

Most pricing decisions—whether being made by a competitive firm or by a monopolist—confront a simple tradeoff: between what two things?

Answer 18

Most pricing decisions—whether being made by a competitive firm or by a monopolist—confront a simple tradeoff: between volume and profit.
Price lower, and a firm might gain more customers. But lower prices also mean lower profits from its existing customers—those who were willing to pay a higher price.

Question 19

What are two rules that are useful to follow in determining optimal prices (whether for a competitive firm or a monopolist)???

Answer 19

1. Price where the difference between total revenue and total cost is greatest (notice that this is just another way of saying “maximize profits”).
2. Price where marginal revenue is equal to marginal cost. (this is different from the above for a monopolist- for a monopolist- do the 2nd one)

Question 20

For a monopolist, is the marginal revenue (MR) curve the same as the demand curve??

Answer 20

For a monopolist, the marginal revenue (MR) curve is NOT the same as the demand curve. Intuitively, MR accounts for not only the marginal (or incremental) customer’s willingness to pay, but also the lost profits from inframarginal customers.

In other words, the reason that monopolists price differently than competitive firms do is not because they have different objectives, different values, or different preferences, but simply because they have different incentives: a decrease in price by a competitive firm results in greater revenue from new customers (it not only grabs the customers who never bought earlier but also steals market share from other firms), but fewer lost profits on existing customers (since it has fewer customers to begin with than a monopolist does).

Question 21

How would fixed costs affect the optimal quantity produced by a monopoly versus a competitive firm?

• Fixed costs reduce the optimal quantity and price of the drug for both competitive firms and monopolies.
• Fixed costs reduce the optimal quantity and price for a monopolist, but not for a competitive firm.
• Fixed costs reduce the optimal quantity and price for a competitive firm, but not for a monopolist.
• Fixed costs have no effect on the optimal price and quantities produced for either a competitive firm or a monopolist.

Answer 21

Fixed costs have no effect on the optimal price and quantities produced for either a competitive firm or a monopolist.

• A monopolist’s optimal price is not affected by the fixed costs it incurs. Also, in the short run, competitive firms are willing to price as low as their variable costs, regardless of what fixed costs are.

Question 22

Are revenues directly affected by fixed cost?

Answer 22

NOOOO - Revenues are not directly affected by fixed cost.

And what about marginal cost? Again, fixed costs at the firm level have no effect on the marginal costs of producing another unit.

In other words, even with very high upfront fixed costs, the optimal quantity and price shouldn’t change at all—whether we are talking about competitive markets or monopolies.

Question 23

For monopolists, why aren’t profits just high enough that firms cover these fixed costs—but no more? Why, after all, are returns so high for pharmaceutical firms?

Answer 23

To understand this, we need to return to our analysis so far and two remarkable results that it reveals—results that are often misunderstood in casual debates.

1. First, fixed costs have no effect on the optimal price. (Remember, the reason is that fixed costs affect neither a firm’s marginal revenue nor its marginal cost.)
2. Second, the incentive to price higher than marginal cost arises even if there are no fixed costs at all. The reason a monopolist priced higher than marginal cost in our earlier analysis was simply because of the volume-profit tradeoff. Since reducing price not only gains new customers but loses profits on existing ones, a monopolist has a greater incentive than a competitive firm would to price higher than marginal cost and restrict access to its products more.
3. High monopoly profits don’t just reflect fixed costs, but also pricing power (The ability of a firm to set prices above cost without meaningful competitive retaliation from other firms).
4. On top of this, there’s one last (and somewhat more subtle) reason for high prices in the pharmaceutical industry. One factor to consider is the risk that firms bear in the R&D process. Not every research project or drug development effort, after all, is successful; indeed, the odds of success are often remarkably low.

Question 24

Answer 24

$20

• At a price of $20, the firm would sell 3000 units of the good and earn $60,000 in revenues - enough to cover the $30,000 in variable costs and the $30,000 in fixed costs.

Question 25

Answer 25

$30

• The firm will sell 2,000 units of the good (the quantity at which MR = MC) at a price of $30.

Question 26

The monopolistic furniture producer now discovers that 40% of the people in the town are willing to pay $250 for a table, another 20% are willing to pay $200, and the remaining 40% are only willing to pay $150. The cost of producing each table is still $100. How much should the monopolist charge for each table?

Answer 26

The furniture seller will earn the same profit pricing at $200 or at $250

• At a price of $200, the firm will earn $100 in profit on each table, and will sell to 60% of its customers. If there are 100 customers, that will result in $6000 in profits.
• At a price of $250, the firm will earn $150 in profit on each table, and will sell to 40% of its customers. If there are 100 customers, that will result in $6000 in profits.

Question 27

Suppose instead of $25,000 in fixed costs, a furniture monopoly producer had to incur $30,000 in fixed costs. How will this affect the price charged by the firm?

Answer 27

The firm’s pricing decision is not affected by fixed costs

• Fixed costs do not influence the pricing decision of a monopoly.

Question 28

Originally, a furniture producer sold furniture to individual students in the college town. However, the college has decided to purchase furniture for its students (increasing college tuition to cover the cost!), and the furniture producer now sells to a single customer. How is this change likely to impact the furniture producer’s profits?

• Profits will likely fall
• Profits will likely not be changed
• Profits will likely increase

Answer 28

Profits will likely fall

• Since the firm now has only one customer, that customer has significant negotiating power. Prices and Profits will likely drop.

Question 29

A monopolist bakery is currently selling its cupcakes for $10 and the quantity demanded is 50. If the monopolist lowers its price to $9, it will have a quantity demanded of 80. Which of the following could be the marginal cost of producing a cupcake if the monopolist is maximizing profits at a price of $10?

$3

$7

$8

$11

Answer 29

$8

If the marginal cost of producing a cupcake is $8, then the monopolist would make gross margin of $9*80 - $8*80 = $80 selling at $9. This is less than the gross margin made selling at $10, which are $10*50 - $8*50 = $100. Thus selling at $10 is better for the monopolist.

Question 30

A dairy farmer is a monopolist in the milk industry and is currently selling milk at the profit maximizing price. As a result of a terrible storm, the dairy farmer sees an increase in cost of feed for the cows. At the same time, the dairy farm receives an insurance check which effectively lowers the fixed costs of the farm. What effect will this cost change have on the optimal price of milk the farmer sets?

• The change in costs does not impact the profit maximizing price and quantity sold for the dairy farmer.
• The increase in variable costs will decrease the optimal price that should be set by the farmer.
• The increase in variable costs will increase the optimal price that should be set by the farmer.
• The impact on price cannot be determined due to some costs increasing, and other costs decreasing.

Answer 30

The increase in variable costs will increase the optimal price that should be set by the farmer.

• If variable (marginal) costs increase, marginal revenue will now be lower than marginal cost. Thus the monopolist must increase the price it charges until marginal revenue is equal to marginal cost.

Question 31

Answer 31

15.00

Question 32

Answer 32

Profit is equal to revenue minus costs. Revenue here is equal to $15 * 1,000 = $15,000. Costs are equal to $5 * 1,000 = $5,000 in variable costs, plus $10,000 in fixed costs, totaling $15,000 in costs. Thus profit is equal to $15,000 - $15,000 = $0.

Question 33

A monopolistic coffee producer discovers that 30% of the people in the region are willing to pay $15 for a pound of coffee, another 25% are willing to pay $20, and the remaining 45% are only willing to pay $12. The cost of producing each pound of coffee is $10. How much should the monopolist charge for each pound of coffee?

• $10
• $12
• $15
• $20

Answer 33

$15

• At a price of $15, the monopolist will not sell coffee to the 45% of people who are only willing to pay $12, so 55% of people in the region will buy coffee. Since the cost of each pound of coffee is $10, the monopolist will make $5 on every pound it sells. Thus profit will be equal to $5 multiplied by 55% multiplied by the number of people in the region. This is equal to $2.75 multiplied by the number of people in the region. This is the greatest amount of profit.

Question 34

A monopolistic Coffee shop finds out that- 30% of the people in the region are willing to pay $30 for a pound of coffee, another 25% are willing to pay $40, and the remaining 45% are only willing to pay $24. The cost of producing each pound of coffee is $10. How much should the monopolist charge for each pound of coffee?

• $10
• $24
• $30
• $40

Answer 34

$24

• At a price of $24, the monopolist will sell coffee to everyone in the region. Since the cost of each pound of coffee is $10, the monopolist will make $14 on every pound it sells. Thus profit will be equal to $14 multiplied by the number of people in the region. This is the greatest amount of profit.

Question 35

Define Price Discrimination & name the 6 kinds.

Answer 35

A form of pricing in which a firm sets different prices for different units of a product or for different customers. price discrimination strategies can also reduce dead-weight loss—in other words, they increase the efficiency of a market (even though the distribution of surplus favors firms rather than consumers).

1. First-Degree (Perfect) Price Discrimination or PERFECT Price Discrimination
   A form of price discrimination in which the producer of the product is able to charge each customer his or her unique willingness to pay and thus captures all value from transactions.
   **It’s rare to observe perfect price discrimination in practice, for all the reasons that were mentioned above.
   EX: The Diagram for the DVD rental place.
2. second-degree price discrimination, where customer types self-select into the desired product offering.
   Ex: When firms offer discounts if customers buy large quantities. For example, a 10 pound bag of flour is typically slightly cheaper, per pound, than a 5 pound bag. Again, customers self-select: those who only want 5 pounds might be willing to pay a slightly higher price per pound, and will choose the smaller bag. Airlines- Well, since airlines can’t ask customers what type they are, they do the next best thing. They deliberately design different varieties of the product– coach and business class tickets, for example. Any traveler can purchase either ticket. But customers self-select.
3. Third-degree price discrimination - The practice of charging different prices to customers based on their observable characteristics
4. Bundling is a form of price discrimination!
5. Two-part tariffs involve firms setting a per-unit price for a product (sometimes equal to $0) and charging a fixed fee to capture additional surplus. Two-part tariffs are an effective (and relatively easy) way for firms to price discriminate.
6. self-selection to price discriminate. For example, firms can create separate versions of a product (business class versus coach for an airline) or offer discounts to consumers who buy in bulk.

Question 36

Dead-weight loss (DWL)

Answer 36

The total lost value of trades that didn’t occur in a market, but would have occurred if the market was at its equilibrium point.

if the store could charge a different price for every unit, there wouldn’t be any dead-weight loss.

Question 37

Two-part Tariff

Answer 37

• A pricing structure in which a firm sets a per-unit price for a product and charges a fixed fee for the right to purchase any units. Ex: Costco, Amazon, Theme Park Entry Fees
• TARIFF PRICES SHOULD BE SET AT MARGINAL COSTS (and the FEE covers more of the surplus profits)
• A two-part tariff allows the firm to reduce the dead-weight loss (and maximize the total value transacted on), but also to capture more value!

How does it do this?

* By using the lump-sum fixed fee to capture the consumer surplus. The result is that, just as with perfect price discrimination, the customer is left with **zero** **surplus****, and dead-weight loss is also eliminated.**

• In effect, two-part tariffs highlight a key point about pricing: in setting prices, a firm should try to separate “cost recovery” from value capture. A low per-unit price allows the store to recover its costs, while a high fixed fee allows it to capture surplus.
• It turns out that the two-part tariff often provides more flexibility for firms in pricing even when they don’t have precise information on WTP for every customer. there’s more room for error—and more room to gain as well.
• Two-part tariffs are also effective with many consumers, though firms encounter a familiar tradeoff here: lowering the fixed fee to capture more surplus from low-WTP consumers versus charging a higher fixed fee to capture more surplus from high-WTP consumers.
• Two-part tariffs are a very simple way to mimic perfect price discrimination strategies with a single consumer—and are widely observed.

Question 38

If first-degree (or “perfect”) price discrimination is possible, which of the following statements are true?

I. The dead-weight loss is equal to zero
II. The consumer’s surplus is equal to zero
III. The producer’s surplus is equal to zero

Answer 38

I and II

With first degree price discrimination, the producer can price each item right at each individual consumer’s willingness to pay. The consumer captures no surplus (it is all captured by the producer) and there is no dead-weight loss.

Question 39

A bar finds that 50% of its customers have a willingness to pay of $8 per drink, and would like to order 2 drinks per night. The other 50% of the bar’s customers have a willingness to pay of $5 per drink, and would like to order 5 drinks per night. Each drink costs the bar $2. What would be the best way for the bar to implement a two-part tariff?

• Charge a $12 cover fee to enter the bar, and sell drinks for $2 each
• Charge a $15 cover fee to enter the bar, and sell drinks for $2 each
• Charge a $16 cover fee to enter the bar, and offer drinks for free
• Allow customers to enter the bar for free, and sell drinks for $5 each

Answer 39

Charge a $12 cover fee to enter the bar, and sell drinks for $2 each

• The price of drinks should be equal to marginal cost ($2), and the cover fee should capture all the remaining surplus. In this case, one customer would be willing to pay a fee of $12, and the other would be willing to pay a fee of $15. The bar will earn more by catering to both customers, and charging a $12 cover fee.

Question 40

True or False: All that is required for first degree price discrimination is knowledge of each consumer’s WTP for each marginal item.

• True
• False

Answer 40

False

First degree price discrimination also requires the ability to charge different consumers at different rates. This may not be feasible if, for example, competing firms have already driven prices down to cost, or if consumers eligible for the low price buy large quantities of the product and resell it to customers with high WTP.

Question 41

A fitness center has 100 prospective clients. 50 of them wish to attend the gym ten times per month, and are willing to pay $10 per visit. The other 50 want to attend 12 times per month but are only willing to pay $8 per visit. The cost to the fitness center of a single person using the equipment and space for a session is $2. Which two-part tariff scheme will result in the highest profits for the fitness center?

• Charge a monthly fee of $20, and $8 per visit.
• Charge no monthly fee, and $8 per visit.
• Charge a monthly fee of $72, and $2 per visit.

Answer 41

Charge a monthly fee of $72, and $2 per visit.

• Both groups would subscribe, yielding a profit of 100 * $72 = $7,200

Question 42

Bundling & When it works best

Answer 42

• The pairing of different goods to be sold together; price bundling is a form of price discrimination.
• Bundling works best when there’s a negative correlation in preferences
  across customers. By offering a bundled product for all, you can capture more value. Bundling, in effect, mimics a price discrimination mechanism. And this rationale for bundling
  has a counterintuitive implication.
• bundling can be powerful even when products are unrelated in use—as long as different consumers have different preferences for the two products.

Question 43

Consider the following scenario. Larry, a retired schoolteacher, has been a Netflix customer since the early days. He likes to watch movies at home so he values the one-at-a-time mail-in DVD service at $12. Margaret is a traveling consultant. Mail-in DVDs don’t thrill her since she’s almost never home, so she values that service only at $4. But she is interested in the new service for streaming movies to her PC and would pay up to $10 to try it out. Larry, on the other hand, rarely uses a computer, so he only values this new service at $3.

• Assuming that Netflix decides to charge separately for the two types of service, what price should it charge for the mail-in service?
• Again assuming that Netflix decides to charge separately for the two types of service, what price should it charge for the streaming service?
• What is the maximum revenue Netflix could earn, pricing in this way, if Larry and Margaret were the only customers?
• Now, say Netflix decides to create a DVD-and-streaming bundle, selling the combination for one price. What price should Netflix charge for the bundle?
• What are revenues with the bundled price?

Answer 43

• Netflix should charge $12 for its mail-in service. If it dropped its price to $4 to get an additional customer, revenue would be only $8.
• 10
• $22 - Netflix would earn $12 from selling its mail-in service to Larry, and $10 from selling its streaming service to Margaret.
• $14 -Larry would be willing to pay $15, and Margaret would be willing to pay $14.
• 28

Question 44

Look @ Graph to Answer below

• If Netflix prices the two services separately, what should it charge for DVDs only?
• Again assuming Netflix prices the two services separately, what should it charge for streaming?
• Now suppose Netflix bundles the two services together and charges a single price. What price should it charge?

Answer 44

• $8
• $7
• $14 for the bundle. Larry, Margaret, and Todd will purchase it, and revenues will be $42. The bundled price is $1 lower than the sum of the two separately set prices, but the total revenues from selling the bundle are $12 higher than the revenues from selling each service separately.

Question 45

Which of the following price discrimination methods does not rely on self-selection?

• Offering a discount to consumers who buy in bulk
• Offering lower prices for children, students, and seniors
• Releasing a 3D version of a movie first, and then releasing it in 2D
• Mailing coupons to prospective customers

Answer 45

Offering lower prices for children, students, and seniors

• This method of price discrimination assumes that children, students, and seniors have a lower WTP, rather than relying on self-selection by the customers.

Question 46

A flower shop finds that about half of its customers are willing to pay $30 for a bouquet of flowers, and are willing to pay $10 for a vase. The other half of its customers are generally willing to pay only $20 for a bouquet, but value vases at about $15. How should the flower shop price its products in order to maximize revenues?

• Sell bouquets of flowers at $20 each, and vases at $10 each
• Sell bouquets of flowers at $30 each, and vases at $10 each
• Sell bouquets of flowers at $35 each, and include a free vase with each bouquet
• Sell bouquets of flowers at $40 each, and include a free vase with each bouquet

Answer 46

Sell bouquets of flowers at $35 each, and include a free vase with each bouquet

• Every customer will buy the bundle. If there were only two customers, this would result in $70 in revenues.

Question 47

Two museums, the Natural History Museum and the Art Museum, are owned and operated by the same city. The city has discovered that most potential visitors to the museums fall into one of three categories:

• 40% of the visitors would be willing to pay $30 for admission to the Natural History Museum, and $15 for admission to the Art Museum
• 40% of the visitors would be willing to pay $20 for admission to the Natural History Museum, and $40 for admission to the Art Museum
• 20% of the visitors would be willing to pay $10 for admission to the Natural History Museum, and $15 for admission to the Art Museum

How should the city price the admissions tickets in order to maximize revenues?

• Sell tickets to the Natural History Museum for $20, and tickets to the Art Museum for $15
• Sell tickets to the Natural History Museum for $20, and tickets to the Art Museum for $40
• Sell the tickets as a bundle for $25
• Sell the tickets as a bundle for $45

Answer 47

Sell the tickets as a bundle for $45

• Imagine there are 100 potential visitors. 80 of them will purchase the bundle, resulting in revenues of $3600.

Question 48

A DVD retailer has two customers, with different willingnesses to pay for the three DVDs it is offering. Customer A is willing to pay $20 for “The Avengers,” $8 for “Frozen,” and $12 for “Gravity.” Customer B is willing to pay $16 for “The Avengers,” $20 for “Frozen,” and $10 for “Gravity.” Each DVD costs the retailer $5. How should the retailer price the three DVDs?

• Sell the three DVDs as a bundle at a price of $40
• Sell “The Avengers” and “Frozen” as a bundle, at a price of $28, and sell “Gravity” separately at a price of $10.
• Sell “The Avengers” for $16, “Frozen” for $8, and “Gravity” for $10.
• Sell “The Avengers” for $16, “Frozen” for $20, and “Gravity” for $10.

Answer 48

Sell the three DVDs as a bundle at a price of $40

• Both customers will purchase this bundle, resulting in revenues of $80 and costs of $30. Profits will be $50.

Question 49

You have decided to join a gym membership as a New Year’s resolution. You just received an email from Livingsocial that if you recommend more than five people to join gym membership, you and the other five people will each receive a 40% discount for gym membership at Boston Sports Club. What type of price discrimination is this most similar to?

• An amusement park charging a daily entrance fee and offering its rides for free
• A printer charging $2/book to print 1000 copies, and $0.75/book to print 2000 copies
• A souvenir seller haggling with individual customers to reach an agreed-upon price
• A university bookstore offering a 5% discount to current students

Answer 49

• An amusement park charging a daily entrance fee and offering its rides for free
  
  • This is an example of a two-part tariff.
• A printer charging $2/book to print 1000 copies, and $0.75/book to print 2000 copies
  
  • This is an example of “bulk” pricing, where the price is lower for higher quantities. Similarly, your gym membership will cost less if you and your friends all join, increasing the quantity of memberships purchased. In both cases, customers self-select into the higher or lower price categories by determining their quantity.
• A souvenir seller haggling with individual customers to reach an agreed-upon price
  
  • This may be close to perfect price discrimination.
• A university bookstore offering a 5% discount to current students
  
  • This uses an observable trait of the customer (whether or not the customer is a student) to bucket customers into higher and lower WTP.

Question 50

KEEP THIS CARD PURPLE IF YOU WANT MORE PRACTICE WITH BUNDLE MATH 5.2.6 HAS MANY MORE P QUESTIONS

Question 51

Vertical Differentiation vs Horizontal Differentiation

Answer 51

• Vertical: A form of product differentiation in which a firm attempts to distinguish its product based on higher quality, lower price or other features for which customer preferences are essentially uniform.
• Horizontal Differentiation: A form of product differentiation in which a firm attempts to distinguish its product or service based on attributes that different customers value differently (e.g. location, color, design, etc.).

Question 52

Here’s a simple question regarding the basic setup: let’s say there’s a customer, Joe, who’s 15 feet away from Bob’s, and another, Frank, who’s 30 feet away. Is Joe’s willingness to pay for Bob’s pizza higher or lower than Frank’s?

• Higher
• Lower

Answer 52

Higher

Since Joe is closer to Bob’s thank Frank is, Joe incurs less of a transportation “cost” than Frank does, and is willing to pay more for the pizza.

PHOTO-

every WTP curve represented the WTP of a different customer. And the different points on any given curve represented that customer’s WTP for pizzerias located at those different points.

Question 53

When your competitors can’t easily respond to your moves, it can indeed pay to be _____ to them.

However, when your competitors can respond quickly, then ____ almost never pays: it’s important then to be _____.

Answer 53

When your competitors can’t easily respond to your moves, it can indeed pay to be similar to them.

However, when your competitors can respond quickly, then similarity almost never pays: it’s important then to be different.

Question 54

What we learned from the pizza places!

Answer 54

1. First, we explored what would happen if your (Angela’s pizza) truck can choose to locate anywhere (and prices were fixed), but Bob couldn’t react. This would lead you towards competitive similarity.
2. Second, we examined what would happen if locations were fixed right next to each other, and you competed on price—but Bob was free to react on price too. In this case, competitive similarity results in brutal price competition.
3. “being different” in location protects you from perfect price competition.

Question 55

Suppose that a small town is served by one Internet provider, InterSet, whose firm is set up in a way that it is prohibitively costly to change its offerings to customers. A new Internet provider, SpeedPlus, decides to enter the market. SpeedPlus conducted some market research, and discovered that the consumers in that small town would be very averse to paying any more for their internet than they currently do. SpeedPlus also knows that consumers prefer faster internet, (although speedier service is slightly more expensive to provide). Which of the following should SpeedPlus do?

• Offer Internet speed just below that of InterSet
• Offer internet speed just above that of InterSet
• Offer internet speed far below that of InterSet
• Offer internet speed far above that of InterSet

Assuming speed is the only difference between the two services, how would the surplus split between InterSet and SpeedPlus?

• InterSet (old firm) captures all surplus.
• SpeedPlus (new entrant) captures all surplus.
• InterSet (old firm) and SpeedPlus (new entrant) split the surplus.
• Both firms receive zero profits.

Suppose now that InterSet (the old firm) is able to change its offering. Now both firms can adjust the speed of the Internet they offer. What will happen to the two firms’ profits?

• InterSet (old firm) will now capture some of the surplus.
• SpeedPlus (new entrant) will still capture all surplus.
• InterSet (old firm) will now capture more of the surplus than SpeedPlus (new entrant).
• Both firms are likely to receive zero profits.

Answer 55

Offer internet speed just above that of InterSet

• This will allow SpeedPlus to capture the entire market at the minimal cost.

SpeedPlus (new entrant) captures all surplus.

• Since InterSet cannot change its offering, all consumers will purchase internet from SpeedPlus, and InterSet will capture no surplus.

Both firms are likely to receive zero profits.

• The firms will compete for customers until price equals cost.

Question 56

Two car manufacturers are the only producers of cars in a market. Which of the following circumstances would make the manufacturers more likely to compete on price?

• One manufacturer produces only sedans, and the other produces only trucks
• One manufacturer’s cars are designed to protect the passengers in a crash, while the other manufacturer’s cars are designed to maximize gas mileage
• Customers are indifferent between the two manufacturers’ cars
• The manufacturers both advertise heavily, but to different segments of the market

Answer 56

Customers are indifferent between the two manufacturers’ cars

• If the two manufacturers are not differentiated in any way, they will have to compete on price.

Question 57

We need to be _____ in order to compete.

Answer 57

We need to be different in order to compete.

We need to think hard about where and how we can carve out a unique advantage. Let’s just make that explicit. Competitive advantage requires differentiation.

If you’re similar or identical to your competitors in every respect, that’s almost a surefire recipe for mediocre profits.

Question 58

You want to be different on attributes where either customers are willing to pay more for these differences or where your supplier costs can be lower as a result of differentiation. So keep in mind three things… (what are these things?)

Answer 58

• First: economic value for a business comes not only from being better, but from being different. In the language of economics, think about horizontal differentiation, not just vertical differentiation.
• Second: where you want to be different is a choice that you make as an organization. Choose it carefully.
• Third: a useful principle to follow is to try to be different on things that matter to your customers or your suppliers– in other words, where as a result of being different either your customer willingness to pay is higher or your supplier cost is lower.