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Unit 8. Profit Maintenance/Enhancement. Investment Tip?. “The most important thing I look at in evaluating a company for investment purposes is whether or not they have a sustainable competitive advantage .” (Warren Buffett). Managing a Price Taking Firm.

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Unit 8

Unit 8.

Profit Maintenance/Enhancement


Investment tip
Investment Tip?

  • “The most important thing I look at in evaluating a company for investment purposes is whether or not they have a sustainable competitive advantage.” (Warren Buffett)


Managing a price taking firm
Managing a Price Taking Firm

  • ‘Competitive’ firms have the biggest challenge of sustaining π’s.

  • Understand market forces to anticipate changes in input and output prices

  • Use cash market contracts, futures markets, etc. to establish favorable prices at times other than delivery

  • Costs must be minimized

  • Look into specialty products, niche markets, forming cooperatives,etc.


Profit enhancement maintenance strategies p setting firms mainly
Profit Enhancement/Maintenance Strategies (P setting firms mainly)

  • Create barriers to entry

  • Decrease P competition with rivals

  • Differentiate product to increase demand/decrease price elasticity

  • Decrease costs/increase productivity

  • Implement creative pricing policies


Same price or a separate menu
Same Price or a Separate Menu? mainly)

  • Papa Dels is a popular pizzeria on the University of Illinois campus. The manager of this restaurant has been informed that the own price elasticity of demand for their pizza is -4 for lunch and -2 for dinner. The incremental cost of making and selling a large pizza is $6 for this firm, for both lunch and dinner. Would you recommend that Pap Dels have a separate menu for lunch and dinner? If yes, what prices do you suggest be charged?


Marketing pricing internationally
Marketing (Pricing) Internationally? mainly)

  • Kodak is currently selling its camera film in both the U.S. and Japan. The company’s research department has estimated the demand for Kodak film in each country as follows:

    U.S. => QUS = 15 – PUS

    Japan => QJ = 9 - .5PJ

    If MC = ATC = 3 in both countries, what pricing strategy would maximize Kodak’s profits in the U.S. and Japan combined?


Coffee p break
Coffee (P) Break? mainly)

  • Spooky Business sells its own brand of coffee on line. The company currently sets one price for each flavor or type sold. The marketing department has recently given management two alternative proposals to ‘perk’ up sales. One proposal is to simply lower price on each item. The second proposal is to give customers ‘quantity’ discounts (i.e. lower price on greater, specified quantities). Which option would you advise management implement?


What fee to charge
What Fee to Charge? mainly)

  • Rick and Joan Thompson recently moved from Iowa to Phoenix (AZ). They plan to run their own business there which is a health club called Sun Devil Spa and Fitness Club. While Rick and Joan are ‘fitness’ experts, they know very little about managing a business and, in particular, setting prices. They have noticed other health clubs have ‘members’ who are typically charged a membership fee. They have come to you for advice. Would you recommend they charge a ‘membership’ fee too or simply charge a fee ‘per visit’? If they decide to charge a ‘membership’ fee, what information would assist you in determining the ‘best’ fee to charge?


Package or block pricing
Package (or Block) Pricing mainly)

  • Fruit of the Loom sells men’s tee shirts in packages (3 shirts per package). Management is wondering a) if the company would be better off selling the shirts individually and b) if not, is the company charging the ‘best’ price for its package? What recommendations do you have for management?


Making bundles
Making ‘Bundles’? mainly)

  • Hewlett Packard sells both ‘printers’ and ‘print cartridges’ for microcomputers. Would you recommend to management that these products be priced and sold a) separately or b) together (as a ‘bundle’)? If HP prices these items separately, which strategy is likely to generate more profits: a) low price for the printers, high price for the cartridges or b) high price for the printers, low price for the cartridges?


A slam dunk deal
A Slam Dunk Deal? mainly)

  • Mark Cuban is the owner of the Dallas Mavericks, a professional NBA team (i.e. basketball). He is a very visible owner at games and is often seen cheering on his team as well as yelling at officials when he thinks they made a bad call. He has even been fined extensively by the NBA for his outspoken criticism of league referees. Cuban wants to win an NBA title in the ‘worst’ way. However, he is concerned that after he signs his players to ‘big’ contracts, they may not have the same incentive as he does to win an NBA title. What managerial ‘econ’ advice would you give Mr. Cuban on structuring player contracts for his team so as to provide more incentive for his players to try to win a championship?


Reality realty
Reality Realty? mainly)

  • If you hire a real estate agent to sell your house, do they have the same economic incentive as you to maximize the selling price (i.e. get top dollar) for your house?


Pricing questions
Pricing Questions mainly)

  • Why:

    • Are buns sold in a package?

    • Is there an entrance fee but no charge for individual rides at some amusement parks?

    • Is the markup on coffee less than the markup on fresh flowers at a grocery store?

    • Are there senior-citizen and student discounts?

    • Does it cost more to do certain things at different times of the wk (e.g. fly, play golf, make phone calls, etc.)

    • Do travel agencies sell vacation ‘packages’?


  • Creating barriers to entry mainly)

    • Advertise/differentiate

    • Proliferate new products (introduce first)

    • Maintain excess production capacity

    • Seek out sustainable niches

    • Guard trade secrets/plans

    • Obtain and/or extend patents

    • Entry limit pricing


More demand for us less demand for you
More Demand for Us, Less Demand for You? mainly)

$

$

ATC

D2

D1

D2

D1

Q

Q

Potential Entrant

Existing Firm




Creative pricing policies
Creative Pricing Policies mainly)

  • Price discrimination

  • 2-part block (package)

  • Bundling

  • Q discounts

  • Multiple (joint) product


Types of p discrimination
Types of P Discrimination mainly)

  • First degree (= complete or perfect)

    • Selling each unit for a different price which = the maximum P any buyer is willing to pay (i.e. charge the maximum prices along a given D curve)

  • Second degree

    • Selling different quantity units for different prices to all buyers (i.e. quantity discounts)

  • Third degree

    • Selling all quantity units to different buyer groups at different prices (i.e. divide the market into different D segments and charge optimal prices accordingly)


Robinson patman act 1936
Robinson Patman Act (1936) mainly)

  • Makes it illegal for firms to price discriminate in ‘business’ markets (sales to other business firms) where the effect may be to injure competition.

  • The concern was over sellers giving ‘chains’ or large corporate buyers price discounts that would lower their costs and make it difficult for smaller firms to compete with them.

  • Does NOT disallow quantity discounts (if cost justified), cash payment discounts, and advance order/payment discounts if made available to all buyers.


Third degree price discrimination
Third Degree Price Discrimination mainly)

  • The practice of charging different groups of consumers different prices for the same product

  • Examples include student discounts, senior citizen’s discounts, regional and international pricing


Change in tr due to q i e mr
Change in TR Due to Q (i.e. MR) mainly)

NOTE:

MR = 0 if E is unitary

> 0 if E is elastic

< 0 if E is inelastic


Profit maximizing prices
Profit-Maximizing Prices mainly)

  •  P where MR = MC



Assume
Assume: mainly)

  • Q = total demand for Kodak film

  • QUS = US demand = 15 – PUS

     PUS = 15 – QUS

     MRUS = 15 – 2QUS

    QJ = Japan demand = 18 – 2PJ

     PJ = 9 - .5QJ

     MRJ = 9 – QJ

     QT = QUS + QJ

    = 33 – 3P (for P 9)

     P = 11 – 1/3Q

     MR = 11 – 2/3Q

  • MC = ATC = 3 in both the US & Japan


Profit max example with p discrimination
Profit Max Example mainly)(with P Discrimination)

  • QJ to max J  MRJ = MC

     9 – QJ = 3

     QJ* = 6

     PJ* = 6

     max J = TRJ – TCJ

    = (6)(6) – (3)(6) = 36 – 18 = 18

     max  = max US + max J

    = 36 + 18 = 54


Profit max example with p discrimination1
Profit Max Example mainly)(with P Discrimination)

  •  max  max US + max J

  • QUS to max US  MRUS = MC

     15 – 2QUS = 3

     QUS* = 6

     PUS* = 9

     max US = TRUS – TCUS

    = (9)(6) – (3)(6) = 54 – 18 = 36


P discrimination differential markup pricing
P Discrimination mainly) Differential Markup Pricing

  • E0 in US at PUS = 9

  • E0 in J at PJ = 6


W o discriminating
Π mainly) w/o Discriminating

  • NOTE:

    QU = 15 - PU

    = 15 – 7

    = 8  U =(4)(8) = 32

    QJ = 18 – 2PJ

    = 18 – 2(7)

    = 18 – 14

    = 4

     J = (4)(4) = 16

  •  Max if PU = PJ

     MRT = MC

     11 – 2/3Qr = 3

     2/3QT = 8

     QT = 12

     P = 11 – 1/3(QT)

    = 11 – 1/3(12)

    = 7

     = (P-ATC)(QT)

    = (7-3)(12)

    = 48


Charging different p s to different customers markets
Charging Different P mainly)S to Different Customers (markets)

P

P

PB

PA

MC

MC

DA

DB

Q

Q

MRB

MRA

Mkt A

Mkt B


Peak load pricing
Peak-Load Pricing mainly)

  • When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.

  • Charge a higher price (PH) during peak times (DH)

  • Charge a lower price (PL) during off-peak times (DL)


Extracting consumer surplus
Extracting Consumer Surplus: mainly)

  • Block Pricing: For items sold in a package (block), add units up to point where consumer willingness to pay = MC of adding last unit. Charge P = consumer surplus value at that point.

  • Two-part Pricing: For items sold where the seller can limit buyer access to the product, charge P = MC and also charge a ‘fee’ = to remaining consumer surplus.

  • Volume Discounts: Charge lower price for units purchased beyond given level.


Block p example
Block P Example mainly)

  • Typical consumer’s demand is P = 10 – 2Q

  • C(Q) = 2Q

  • Optimal number of units in a package?

  • Optimal package price?



Results with standard mr mc profit max
Results with Standard MR = MC Profit Max mainly)

  • P = 10 – 2Q

  •  MR = 10 – 4Q

  • TC = 2Q

  •  MC = 2

  •  Max

  •  MR = MC

  •  10 – 4Q = 2

  • Q = 2, P = 6

  •  TR – TC = (6)(2) – (2)(2) = 12-4 = 8




Costs and profits with two part pricing
Costs and Profits with Two-Part Pricing mainly)

Price

Chargefee = CS

10

½ (4) (10-2) = $16

8

6

Costs = $8

4

2

SetP = MC = $2

D

1

4

5

2

3

Quantity


Commodity bundling
Commodity Bundling mainly)

  • 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


A kodak bundle
A Kodak Bundle mainly)

  • Total market size is 4 million customers

  • Four types of consumers

    • 25% will use only Kodak film

    • 25% will use only Kodak developing

    • 25% will use only Kodak film and use only Kodak developing

    • 25% have no preference

  • Zero costs (for simplicity)

  • Maximum price each type of consumer will pay is as follows:







Maximum tr pricing items separately
Maximum TR Pricing Items Separately? Consumer

  • = Max Film TR + Max Developing TR

  • 16 + 9

  • = 25



Revenue maximizing bundle p
Revenue-Maximizing ‘Bundle’ P? Consumer

  • Note: previous Max TR pricing items separately = 25.


Bundles of goods
Bundles of Goods Consumer

  • Bundling often involves one ‘physical’ or ‘capital’ type good being sold with a related ‘services’ type good.

Physical/capital good

Razor

Camera

Computer

Water softener

Phone

Copy machine

Fertilizer

Hotel room

Service good

Razor blades

Film, film development

Software, technical support

Salt packets

Calling plans

Paper, cartridges, tech support

Application, soil testing

Transportation, meal


Q discount
Q Discount Consumer

  • Assume P = 100 - .1Q (Q = 00’s)

    • MC = ATC = 10

  • What is firm π w/

    • MR = MC production/pricing?

    • Charge P = 75 for Q up to 250, P = 55 for additional Q?


P Consumer

No Q Discount π

120

100

80

  • Std MR=MC pricing π

  • Π = (P-ATC)Q

    = (55-10) 450

    = 20,250

60

40

P=100-.1Q

20

10

MC=ATC

Q (00)

450

MR

1000

MR = 100 - .2Q

=> MR = MC

=> 100 - .2Q = 10

=> .2Q = 90

=> Q = 450 => P = 55


P Consumer

Q Discount π

120

100

Π = (75-10)(250)

+ (55-10)(200)

= 16,250 + 9,000

= 25,250

80

75

60

55

40

P=100-.1Q

20

10

MC=ATC

Q (00)

250

450

MR

1000


Cross subsidies
Cross-Subsidies Consumer

  • Prices charged for one product are subsidized by the sale of another product.

  • May be profitable when there are significant demand complementarities effects.

  • Examples

    • Browser and server software

    • Drinks and meals at restaurants

    • => TR = PXQX + PYQY


Economic incentive questions
Economic ‘Incentive’ Questions Consumer

  • Suppose a business firm manager hires a tax return preparer, a lawyer, a contractor, and an employee. What do they have in common from the business firm manager’s perspective?

  • Do employees have an incentive to ‘shirk’ their duties and, if so, how do personnel managers attempt to reduce ‘shirking’ by employees?

  • What do most home insurance, car insurance, and medical insurance policies have in common and why?


Principal agent problem
Principal-Agent Problem Consumer

  • Problem  agent has incentive to pursue their own goals which hinders principal’s ability to achieve their goals.

  • Principal = individual

  • who employs or

  • supervises others

  • (agents)

  • stockholders

  • management

  • business owner

  • defendant

  • team owner

  • Agent = individual

  • employed to

  • assist a principal

  • management

  • employees

  • sub contractor

  • lawyer

  • team player


Principal agent solutions
Principal-Agent Solutions Consumer

  • Supervision of Agent

    • Time clock

    • Spot check

  • Internal Incentives

    • Profit sharing (e.g. bonus)

    • Revenue sharing (e.g. tips, commissions)

    • Piece rate pay

  • External Incentives

    • Reputation concerns

    • Takeover threat


Economic problems caused by asymmetric information
Economic Problems Caused by Asymmetric Information: Consumer

  • Adverse selection  one party can benefit at the expense of another because they have more information about an unobserved characteristic.

    Examples:

    Potential employee’s work ethic

    Health status of an insurance customer

    Driving tendencies of insurance customer

    Product quality

  • Moral hazard  one party can benefit at the expense of another because they have more information about unobserved actions

    Solution = contracts to make incentives more compatible


Types of contracts
Types of Contracts Consumer

1. Fixed fee

a. To agent (e.g. person hired)

b. To principal (e.g. land or property owner)

2. Hire

a. wage or salary

b. piece rate

3. Contingent

a. revenue sharing

b. profit sharing

c. some outcome (e.g. no wrong doing by policy holder, outcome of the trial)

Conclusions:

1. Contracts provide economic incentives to both parties; best contracts provide compatible incentives

2. Need to examine incentives provided and likely consequences of contract terms

3. Contracts that usually provide the most compatible economic incentive to agents are 1b and 3b above


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