economic instructor manual

Chapter 15

PRICING PRACTICES

QUESTIONS AND ANSWERS

Q15.1 Express the markup on cost formula in terms of the markup on price, and use this relation to explain why a 100% markup implies a 50% markup on price.

Q15.1 ANSWER

The markup on cost, or cost plus, formula gives profit margin expressed as a percentage of cost:

Markup on Cost =

By way of contrast, the markup on price formula gives profit margin expressed as a percentage of price:

Markup on Price =

Each markup formula provides a useful, but different, perspective on the relative magnitude of the difference between price and cost, or the profit margin.

Through simple algebraic substitution and manipulation, each markup formula can be expressed in terms of the other:

Markup on Cost =

Markup on Price =

A product with a 100% markup on cost has a 50% markup on price, a 50% markup on cost implies a 33% markup on price, and so on. When comparing the markup earned on various items, and in determining the optimal markup, it is crucial to identify the exact specification of the markup formula used.

Q15.2 Explain why successful firms that employ markup pricing use fully allocated costs under normal conditions, but typically offer price discounts or accept lower margins during off-peak periods when excess capacity is available.

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Q15.2 ANSWER

Fully allocated costs can be appropriate when a firm is operating at full capacity. During peak periods, when facilities are fully utilized, expansion is required to increase production. Under such conditions, an increase in production requires an increase in all plant, equipment, labor, materials, and other expenditures. However, if a firm has excess capacity, as during off-peak periods, only those costs that actually rise with production--the incremental costs per unit--should form a basis for setting prices.

Successful firms that employ markup pricing use fully allocated costs under normal conditions but offer price discounts or accept lower margins during off-peak periods when excess capacity is available. In some instances, output produced during off-peak periods is much cheaper than output produced during peak periods. When fixed costs represent a substantial share of total production costs, discounts of 30 percent to 50 percent for output produced during off-peak periods can often be justified on the basis of lower costs.

“Early Bird” or afternoon matinee discounts at movie theaters provide an interesting example. Except for cleaning expenses, which vary according to the number of customers, most movie theater expenses are fixed. As a result, the revenue generated by adding customers during off-peak periods can significantly increase the theater's profit contribution. When off-peak customers buy regularly priced candy, popcorn, and soda, even lower afternoon ticket prices can be justified. Conversely, on Friday and Saturday nights when movie theaters operate at peak capacity, a small increase in the number of customers would require a costly expansion of facilities. Ticket prices during these peak periods reflect fully allocated costs. Similarly, McDonald’s, Burger King, Arby's, and other fast-food outlets have increased their profitability substantially by introducing breakfast menus. If fixed restaurant expenses are covered by lunch and dinner business, even promotionally priced breakfast items can make a notable contribution to profits.

Q15.3 Discuss how seasonal factors influence supply and demand, and why markups on fresh fruits and vegetable are at their highest during the peak of season.

Q15.3 ANSWER

It is interesting to see how seasonal factors affect markups for grocery items, like fruits and vegetables. When a fruit or vegetable is in season, spoilage and transportation costs are at their lowest levels. At the same time, during the peak of season, high product quality translates into enthusiastic consumer demand. Both factors lead to high margins for fresh fruits and vegetables during the peak of season. Consumer demand shifts away from high-cost/low-quality fresh fruits and vegetables when they are out of season, thereby reducing margins on these items. Similarly,

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markups tend to be high on bargain-priced Turkey at Thanksgiving, Ham at Easter, and so on.

In addition to seasonal factors that affect margins over the course of a year, market forces affect margins within a given product class at the grocery store. In breakfast cereals, for example, the markup on cost for highly popular corn flakes averages only 5 percent to 6 percent, with brands offered by Post and Kellogg's competing with a variety of local store brands. Cheerios and Wheaties, both offered only by General Mills, Inc., enjoy a markup on cost of 15 percent to 20 percent. Thus, availability of substitutes directly affects the markups on various cereals. It is interesting to note that among the wide variety of items sold in a typical grocery store, among the highest margins are charged on spices. Apparently, consumer demand for nutmeg, cloves, thyme, bay leaves, and other spices is quite insensitive to price. The manager interviewed said that in more than 20 years in the grocery business, he could not recall a single store coupon or special offered on spices.

Q15.4 Why does The Wall Street Journal offer bargain rates to students but not to business executives?

Q15.4 ANSWER

The Wall Street Journal offers bargain rates to students but not to business executives. It is surely not because it costs less to deliver the Journal to students, and it's not out of benevolence; it's because students are not willing or able to pay the standard rate. Even at 50 percent off regular prices, student bargain rates more than cover marginal costs and make a significant profit contribution. Similarly, senior citizens who eat at Holiday Inns enjoy a 10 to 15 percent discount and make a meaningful contribution to profits. Conversely, relatively high prices for popcorn at movie theaters, peanuts at the ballpark, and clothing at the height of the season reflect the fact that customers can be insensitive to price changes at different places and at different times of the year. Regular prices, discounts, rebates, and coupon promotions are all pricing mechanisms used to probe the breadth and depth of customer demand and to maximize profitability.

Q15.5 “One of the least practical suggestions that economists have offered to managers is that they set marginal revenues equal to marginal costs.” Discuss this statement.

Q15.5 ANSWER

Profit-maximizing pricing practices can be effectively employed with scant direct reference to marginal analysis. Although profit maximization requires that prices be set so that marginal revenues equal marginal cost, it is not necessary to calculate both in order to set optimal prices. Just using information on marginal costs and the point price elasticity of demand, the calculation of profit maximizing prices is quick and easy. Flexible markup pricing practices that reflect differences in marginal costs and

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demand elasticities are an efficient method for ensuring that MR = MC for each line of products sold. Widespread support for the use of incremental analysis in the pricing practices of highly successful and profitable firms, like the use of markup pricing practices, can be interpreted as support for the practical equivalent of marginal analysis.

Q15.6 “Marginal cost pricing, as well as the use of incremental analysis, is looked upon with favor by economists, especially those on the staffs of regulatory agencies. With this encouragement, regulated industries do indeed employ these rational techniques quite frequently. Unregulated firms, on the other hand, use marginal or incremental cost pricing much less frequently, sticking to cost-plus, or full-cost, pricing except under unusual circumstances. In my opinion, this goes a long way toward explaining the problems of the regulated firms vis-à-vis unregulated industry.” Discuss this statement.

Q15.6 ANSWER

This statement is typical of managers who feel that if you don’t cover “full costs” on each and every item sold, you are not covering your costs of producing a given product or service. It reveals a complete lack of understanding of marginal analysis in decision making. In defense of the statement, however, it might be noted that incorrect use of the incremental concept has sometimes led to disastrous results for firms who improperly employ the technique by misjudging incremental revenues and/or costs. Like any tool used in managerial decision making, careful judgment must be employed in incremental analysis.

Q15.7 What is price discrimination?

Q15.7 ANSWER

Price discrimination is the practice of charging different markups for the same product. Price discrimination can result if a firm charges different prices for the same product or prices closely related products in such a manner that price differences are not proportional to cost differences. Price discrimination exists among multiple customers of an identical product if:

Note that price discrimination can exist when equal or unequal prices are charged different customers. It simply implies that different customers are charged different markups.


Q15.8 What conditions are necessary before price discrimination is both possible and profitable? Why does price discrimination result in higher profits?

Q15.8 ANSWER

The primary requirement for price discrimination is an ability to segment the market by preventing transfers among sub-markets. A second requirement for price discrimination to be worthwhile is that demand elasticities must be different in the various sub-markets. Otherwise, an optimal pricing scheme will result in equal prices in all markets.

Price discrimination is profitable because it allows firms to charge higher average prices, by setting MR = MC for each customer or customer class, and thereby acquire more of what is called consumers’ surplus.

Q15.9 Discuss the role of common costs in pricing practice.

Q15.9 ANSWER

Common costs are expenses that are necessary for manufacture of a joint product. Common costs of production--raw material and equipment costs, management expenses, and other overhead--cannot be allocated to each individual by-product on any economically sound basis. Only costs that can be separately identified as associated with a specific by-product can and should be allocated. For example, tanning costs for hides and refrigeration costs for beef are separate identifiable costs of each by-product. Feed costs are common, and cannot be allocated between hide and beef production. Any allocation of such common costs is wrong and arbitrary.

Q15.10 Why is it possible to determine the marginal costs of joint products produced in variable proportions but not those of joint products produced in fixed proportions?

Q15.10 ANSWER

It is possible to estimate the marginal costs of joint products where output proportions are variable because variations in output can be statistically related to variations in cost. With joint production in fixed proportions, however, output of one product is perfectly correlated with output of another, and it is impossible to identify individual production costs. In such instances, one can only measure the marginal cost of producing another unit of the output “package” composed of the two or more joint products.

SELF-TEST PROBLEMS AND SOLUTIONS

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ST15.1 George Constanza is a project coordinator at Kramer-Seinfeld & Associates, Ltd., a large Brooklyn-based painting contractor. Constanza has asked you to complete an analysis of profit margins earned on a number of recent projects. Unfortunately, your predecessor on this project got an abrupt transfer, and left you with only sketchy information on the firm’s pricing practices.


A. Use the available data to complete the following table:

PriceMarginal

Cost

Markupon Cost

(%)

Markupon Price

(%)

$100 $25 300.0 75.0

240 72

680 272 150.0 60.0

750 100.0

2,800 40.0

2,700 33.3

3,360 20.0

5,800 10.0

6,250 5.3

10000 0.0

B. Calculate the missing data for each of the following proposed projects, based on the available estimates of the point price elasticity of demand, optimal markup on cost, and optimal markup on price:

ProjectPrice

Elasticity

OptimalMarkupon Cost

(%)

OptimalMarkupon Price

(%)

1 -1.5 200.0 66.7

2 -2.0

3 66.7

4 25.0

5 -5.0 25.0

6 11.1 10.0

7 -15.0

8 -20.0 5.0

9 4.0

10 -50.0 2.0

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ST15.1 SOLUTION

A.

PriceMarginal

Cost

Markupon Cost

(%)

Markupon Price

(%)

$100 $25 300.0 75.0

240 72 233.3 70.0

680 272 150.0 60.0

750 375 100.0 50.0

2,800 1,680 66.7 40.0

3,600 2,700 33.3 25.0

4,200 3,360 25.0 20.0

5,800 5,220 11.1 10.0

6,250 5,938 5.3 5.0

10,000 10,000 0.0 0.0

B.

ProjectPrice

Elasticity


(%)


(%)

1 -1.5 200.0 66.7

2 -2.0 100.0 50.0

3 -2.5 66.7 40.0

4 -4.0 33.3 25.0

5 -5.0 25.0 20.0

6 -10.0 11.1 10.0

7 -15.0 7.1 6.7

8 -20.0 5.3 5.0

9 -25.0 4.2 4.0

10 -50.0 2.0 2.0


ST15.2 Optimal Markup on Price. TLC Lawncare, Inc., provides fertilizer and weed control lawn services to residential customers. Its seasonal service package, regularly priced at $250, includes several chemical spray treatments. As part of an effort to expand its customer base, TLC offered $50 off its regular price to customers in the Dallas area. Response was enthusiastic, with sales rising to 5,750 units (packages) from the 3,250 units sold in the same period last year.

A. Calculate the arc price elasticity of demand for TLC service.

B. Assume that the arc price elasticity (from Part A) is the best available estimate of the point price elasticity of demand. If marginal cost is $135 per unit for labor and materials, calculate TLC’s optimal markup on price and its optimal price.

ST15.2 SOLUTION

A. EP =

=

= -2.5

B. Given εP = EP = -2.5, the optimal TLC markup on price is:

=

=

= 0.4 or 40%

Given MC = $135, the optimal price is:

=

0.4 =

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0.4P = P - $135

0.6P = $135

P = $225

PROBLEMS AND SOLUTIONS

P15.1 Markup Calculation. Controller Elliot Reid has asked you to review the pricing practices of Hollywood Medical, Inc. Use the following data to calculate the relevant markup on cost and markup on price for the following disposable items:

Product PriceMarginal

Cost

Markupon Cost

(%)

Markupon Price

(%)

A $2 $0.20

B 3 0.6

C 4 1.2

D 5 2

E 6 3

P15.1 SOLUTION

Product PriceMarginal

Cost

Markup on Cost

(%)

Markup on Price

(%)

A $2 $0.20 900% 90%

B 3 0.6 400% 80%

C 4 1.2 233% 70%

D 5 2 150% 60%

E 6 3 100% 50%

P15.2 Optimal Markup. Dr. John Dorian, chief of staff at the Northern Medical Center, has asked you to propose an appropriate markup pricing policy for various medical procedures performed in the hospital’s emergency room. To help in this regard, you consult a trade industry publication that provides data about the price elasticity of demand for medical procedures. Unfortunately, the abrasive Dr. Dorian failed to mention whether he wanted you to calculate the optimal markup as a percentage of


price or as a percentage of cost. To be safe, calculate the optimal markup on price and optimal markup on cost for each of the following procedures:

ProcedurePrice

Elasticity



A. -1

B. -2

C. -3

D. -4

E. -5

P15.2 SOLUTION

ProcedurePrice

Elasticity


OptimalMarkup on Price

A. -1 ---% 100.0%

B. -2 100.0% 50.0%

C. -3 50.0% 33.3%

D. -4 33.3% 25.0%

E. -5 25.0% 20.0%

P15.3 Markup on Cost. Brake-Checkup, Inc., offers automobile brake analysis and repair at a number of outlets in the Philadelphia area. The company recently initiated a policy of matching the lowest advertised competitor price. As a result, Brake-Checkup has been forced to reduce the average price for brake jobs by 3%, but it has enjoyed a 15% increase in customer traffic. Meanwhile, marginal costs have held steady at $120 per brake job.

A. Calculate the point price elasticity of demand for brake jobs.

B. Calculate Brake-Checkup’s optimal price and markup on cost.

P15.3 SOLUTION

A. εP =

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=

= -5

B. Given εP = -5, the optimal markup on cost is:

=

=

= 0.25 or 25%

Given MC = $120, the optimal price is:

=

0.25 =

$30 = P - $120

P = $150

P15.4 Optimal Markup on Cost. The Bristol, Inc. is an elegant dining establishment that features French cuisine at dinner six nights per week, and brunch on weekends. In an effort to boost traffic from shoppers during the Christmas season, the Bristol offered Saturday customers $4 off its $16 regular price for brunch. The promotion proved successful, with brunch sales rising from 250 to 750 units per day.

A. Calculate the arc price elasticity of demand for brunch at the Bristol.

B. Assume that the arc price elasticity (from part A) is the best available estimate of the point price elasticity of demand. If marginal cost is $8.56 per unit for labor and materials, calculate the Bristol’s optimal markup on cost and its optimal price.

P15.4 SOLUTION


A. EP =

=

= -3.5

B. Given εP = EP = -3.5, the optimal markup on cost for Saturday brunch at the Bristol during this time frame is:

=

=

= 0.4 or 40%

Given MC = $8.56, the optimal price is:

=

0.4 =

$3.424 = P - $8.56

P = $11.99

P15.5 Markup Pricing Practice. Betty's Boutique is a small specialty retailer located in a suburban shopping mall. In setting the regular $36 price for a new spring line of blouses, Betty's added a 50 percent markup on cost. Costs were estimated at $24 each: the $12 purchase price of each blouse, plus $6 in allocated variable overhead costs, plus an allocated fixed overhead charge of $6. Customer response was so strong that when Betty's raised prices from $36 to $39 per blouse, sales fell only from 54 to 46 blouses per week.

At first blush, Betty's pricing policy seems clearly inappropriate. It is always improper to consider allocated fixed costs in setting prices for any good or service; only marginal or incremental costs should be included. However, by adjusting the amount of markup on cost employed, Betty's can implicitly compensate for the inappropriate use of fully allocated costs. It is necessary to carefully analyze both

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the cost categories included and the markup percentages chosen before judging the appropriateness of a given pricing practice.

A. Use the arc price elasticity formula to estimate the price elasticity of demand for Betty's blouses

B. Determine Betty's optimal markup on cost using the arc price elasticity as an estimate of the point price elasticity of demand. Based upon relevant marginal costs, calculate Betty's optimal price. Explain.

P15.5 SOLUTION

A. The $3 price increase to $39 represents a moderate 7.7 percent rise in price. Using the arc price elasticity formula, the implied arc price elasticity of demand for Betty's blouses is:

B. If it can be assumed that this arc price elasticity of demand EP = -2 is the best available estimate of the current point price elasticity of demand, the optimal markup

on cost is:Betty's standard cost per blouse includes the $12 purchase cost, plus $6 allocated variable costs, plus $6 fixed overhead charges. However, for pricing purposes, only the $12 purchase cost plus the allocated variable overhead charge of $6 are relevant. Thus, the relevant marginal cost for pricing purposes is $18 per blouse. The allocated fixed overhead charge of $6 is irrelevant for pricing purposes because fixed overhead costs are unaffected by blouse sales.

At the $36 price, Betty's actual markup on relevant marginal costs per blouse is an optimal 100 percent, because


Markup on Cost =

= 1 (or 100 percent).

Therefore, Betty's initial $36 price on blouses is optimal, and the subsequent $3 price increase should be rescinded.

This simple example teaches an important lesson. Despite the improper consideration of fixed overhead costs and a markup that might at first appear unsuitable, Betty's pricing policy is entirely consistent with profit-maximizing behavior because the end result is an efficient pricing policy. Given the prevalence of markup pricing in everyday business practice, it is important that these pricing practices be carefully analyzed before they are judged sub-optimal. The widespread use of markup pricing methods among highly successful firms suggests that the method is typically employed in ways that are consistent with profit maximization. Far from being a naive rule of thumb, markup pricing practices allow firms to arrive at optimal prices in an efficient manner.

P15.6 Peak/Off-Peak Pricing. Nash Bridges Construction Company is a building contractor serving the Gulf Coast region. The company recently bid on a Gulf-front causeway improvement in Biloxi, Mississippi. Nash Bridges has incurred bid development and job cost-out expenses of $25,000 prior to submission of the bid. The bid was based on the following projected costs:

Cost Category Amount

Bid development and job cost-out expenses $25,000

Materials 881,000

Labor (50,000 hours @ $26) 1,300,000

Variable overhead (40% of direct labor) 520,000

Allocated fixed overhead (6% of total costs) 174,000

Total costs $2,900,000

A. What is Nash Bridges’ minimum acceptable (breakeven) contract price, assuming that the company is operating at peak capacity?

B. What is the Nash Bridges’ minimum acceptable contract price if an economic downturn has left the company with substantial excess capacity?

P15.6 SOLUTION

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A. Because the $25,000 bid development and job cost-out expenses were incurred prior to submission of the bid, they are sunk costs and irrelevant in determining a minimum acceptable contract price.

When operating at peak capacity, the company is fully employed and able to obtain prices covering fully allocated costs. Thus, assuming the company is operating at peak capacity, all non-sunk costs are relevant and a minimum acceptable bid price is $2,875,000 + ε (=$2,900,000 - $25,000). In particular, note that the 6% fixed overhead charge is relevant as it represents an opportunity cost of turning away other profitable business.

B. Assuming an economic downturn has left the company with substantial excess capacity, neither the $25,000 sunk development expense nor the 6% fixed overhead charge are relevant. When operating at less than peak capacity, the minimum acceptable contract price is determined solely by the level of incremental costs. Here, the minimum acceptable contract price off-peak is $2,701,000 + ε (=$2,900,000 - $25,000 - $174,000). Any price above that level will make a positive contribution to overhead and should be accepted.

P15.7 Incremental Pricing Analysis. The General Eclectic Company manufactures an electric toaster. Sales of the toaster have increased steadily during the previous five years, and, because of a recently completed expansion program, annual capacity is now 500,000 units. Production and sales during the upcoming year are forecast to be 400,000 units, and standard production costs are estimated as follows:

Materials $6.00

Direct labor 4.00

Variable indirect labor 2.00

Fixed overhead 3.00

Allocated cost per unit $15.00

In addition to production costs, GE incurs fixed selling expenses of $1.50 per unit and variable warranty repair expenses of $1.20 per unit. GE currently receives $20 per unit from its customers (primarily retail department stores), and it expects this price to hold during the coming year.

After making the preceding projections, GE received an inquiry about the purchase of a large number of toasters by a discount department store. The inquiry contained two purchase offers:

Offer 1: The department store would purchase 80,000 units at $14.60 per unit. These units would bear the GE label and be covered by the GE warranty.


Offer 2: The department store would purchase 120,000 units at $14.00 per unit. These units would be sold under the buyer’s private label, and GE would not provide warranty service.

A. Evaluate the incremental net income potential of each offer.

B. What other factors should GE consider when deciding which offer to accept?

C. Which offer (if either) should GE accept? Why?

P15.7 SOLUTION

A. The incremental net income from these offers can be determined as follows:

Offer 1 Offer 2

Unit price $14.60 $14.00

Unit variable costs:

Materials $6.00 $6.00

Direct labor 4.00 4.00

Variable indirect labor 2.00 2.00

Variable warranty expense 1.20 13.20 0.00 12.00

Unit incremental profit 1.40 2.00

Units to be sold × 80,000 ×120,000

Total variable profit on units sold at special price $112,000 $240,000

Less variable profit lost on regular sales:

Regular price $20.00

Regular variable costs - 13.20

Regular variable profit 6.80

Units that cannot be sold at regular price if

Offer 2 is accepted ×20,000

Opportunity cost of lost regular sales $0 $136,000

Incremental profit $112,000 $104,000

P15.8 Price Discrimination. Coach Industries, Inc., is a leading manufacturer of recreational vehicle products. Its products include travel trailers, fifth-wheel trailers (towed behind pick-up trucks), and van campers, as well as parts and accessories. Coach offers its fifth-wheel trailers to both dealers (wholesale) and retail customers. Ernie Pantusso, Coach’s controller, estimates that each fifth-wheel trailer costs the company $10,000 in variable labor and material expenses. Demand and marginal revenue relations for fifth-wheel trailers are

PW = $15,000 - $5QW (Wholesale),

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MRW = ΔTRW/ΔQW = $15,000 - $10QW.

PR = $50,000 - $20QR (Retail),

MRR = = ΔTRR/ΔQR = $50,000 - $40QR.

A. Assuming that the company can price discriminate between its two types of customers, calculate the profit-maximizing price, output, and profit contribution levels.

B. Calculate point price elasticity for each customer type at the activity levels identified in part A. Are the differences in these elasticity consistent with your recommended price differences in part A? Why or why not?

P15.8 SOLUTION

A. With price discrimination, profits are maximized by setting MR = MC in each market, where MC = $10,000.

Wholesale

MRW = MC

$15,000 - $10QW = $10,000

QW = 500 units

PW = $15,000 - $5QW

= $15,000 - $5(500)

= $12,500.

Retail

MRR = MC

$50,000 - $40QR = $10,000

QR = 1,000 units

PR = $50,000 - $20QR


= $50,000 - $20(1,000)

= $30,000

The profit contribution earned by the company is:

π = PWQW + PRQR - AVC(QW + QR)

= $12,500(500) + $30,000(1,000)

- $10,000(500 + 1,000)

= $21,250,000

B. Yes, the point price elasticity of demand for each customer class is:

Wholesale

QW = 3,000 - 0.2PW

εP = ΔQW/ΔPW × PW/QW

= -0.2 × ($12,500/500)

= -5

Retail

QR = 2,500 - 0.05PR

εP = ΔQR/ΔPR × PR/QR

= -0.05 × ($30,000/1,000)

= -1.5

A higher price for retail customers is consistent with the lower degree or price elasticity observed in that market.

P15.9 Consumer Surplus. The Heritage Club at Harbor Town offers elegant accommodations for discriminating vacationers on Hilton Head Island, South Carolina. Like many vacation resorts, Heritage Club has discovered the advantages of offering its services on an annual membership or “time-sharing” basis. To illustrate, assume that an individual vacationer’s weekly demand and marginal

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revenue curves can be written:

P = $6,500 - $1,250Q,

MR = ΔTR/ΔQ = $6,500 - $2,500Q,

where P is the price of a single week of vacation time, and Q is the number of weeks of vacation time purchased during a given year. For simplicity, assume that the resort’s marginal cost for a week of vacation time is $1,500, and that fixed costs are nil. This gives the following total and marginal cost relations:

TC = $1,500Q,

MC = ΔTC/ΔQ = $1,500.

A. Calculate the profit-maximizing price, output, profit, and consumer surplus assuming a uniform per unit price is charged each customer.

B. Calculate the profit-maximizing price, output and profit assuming a two-part pricing strategy is adopted for each customer.

C. Now assume that fixed costs of $4 million per year are incurred, and that 500 time-share customers (“owners”) are attracted when an optimal two-part pricing strategy is adopted. Calculate total annual profits.

P15.9 SOLUTION

A. If a single per unit price is charged, the profit-maximizing price is found by setting MR = MC, where

MR = MC

$6,500 - $2,500Q = $1,500

2,500Q = 5,000

Q = 2

At the profit-maximizing quantity of 2, the optimal single unit price is $4,000 and total profits equal $5,000 per customer because:

P = $6,500 - $1,250(2)

= $4,000


π = TR - TC

= $4,000(2) - $1,500(2)

= $5,000 per customer

The value of consumer surplus at a standard per unit price is equal to the region under the demand curve that lies above the profit-maximizing price of $4,000. Because the area of such a triangle is one-half the value of the base times the height, the value of consumer surplus equals:

Consumer Surplus = ½ [2 × ($6,500 - $4,000)]


In words, this means that at a single per unit price of $4,000 per week, a typical individual would choose to use 2 weeks of vacation time at the resort, resulting in total revenues of $8,000 and total profits of $5,000 per customer for the resort facility. The fact that consumer surplus equals $2,500 means that the typical vacationer would have been willing to pay an additional $2,500 for these two weeks of vacation time. This is an amount above and beyond the $8,000 paid. The customer received a real bargain.

B. As an alternative to charging a single-unit price of $4,000 per week, consider the profits that could be earned using a two-part pricing scheme. To maximize profits, the resort would choose to charge a per-unit price that equals marginal cost, plus a fixed fee equal to the amount of consumer surplus received by each consumer at this price. Remember, the value of consumer surplus is equal to the region under the demand curve that lies above the per-unit price. When the per-unit price is set equal to marginal cost, P = $1,500 and Q = 4 because

P = MC

$6,500 - $1,250Q = $1,500

Q = 4

P = $6,500 - $1,250(4)

= $1,500

At the unit price of $1,500 and output level of 4, the value of consumer surplus before imposition of fixed fees would be:

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Consumer Surplus = ½ [4 × ($6,500 - $1,500)]


Thus, $10,000 is the maximum time-share or annual membership fee that the typical vacationer would pay to spend 4 weeks at the resort when an additional “use” charge of $1,500 per week was paid for each week spent at the resort. It follows that the profit-maximizing two-part pricing scheme is to charge an annual time-share or membership fee of $10,000 per year plus weekly fees of $1,500 per week. Resort revenues of $16,000 [= $10,000 + (4 × $1,500)] per customer represent the full value derived from a typical customer staying 4 weeks per year, cover marginal costs of $6,000 (= 4 × $1,500), and generate a $10,000 (= $16,000 - $6,000) profit per customer for the resort, again assuming fixed costs are nil.

C. As shown in part B, the profit-maximizing two-part pricing scheme is to charge each customer an annual time-share (or membership) fee of $10,000 per year plus “use fees” of $1,500 per week. If fixed costs are present, the $10,000 amount per customer represents profit contribution before fixed costs rather than net profit.

If the number of paying time-share subscribers is 500 per year, and fixed costs total $4 million per year, then total net profits equal:

π = Total revenue - Marginal cost - Fixed cost

= 500 × [$10,000 + $1,500(4)] - 500 × [$1,500(4)]

- $4,000,000

= $1 million per year

It is interesting to note that time-shares and annual memberships are so profitable that such marketing arrangements have largely replaced pay-as-you-go resorts at many popular vacation destinations.

P15.10 Joint Product Pricing. Each ton of ore mined from the Baby Doe Mine in Leadville, Colorado, produces one ounce of silver and one pound of lead in a fixed 1:1 ratio. Marginal costs are $10 per ton of ore mined.

The demand and marginal revenue curves for silver are

PS = $11 - $0.00003QS

MRS = ΔTRS/ΔQS = $11 - $0.00006QS


and the demand and marginal revenue curve for lead are

PL = $0.4 - $0.000005QL

MRL = ΔTRL/ΔQL = $0.4 - $0.00001QL

where QS is ounces of silver and QL is pounds of lead.

A. Calculate profit-maximizing sales quantities and prices for silver and lead.

B. Now assume that wild speculation in the silver market has created a fivefold (or 500%) increase in silver demand. Calculate optimal sales quantities and prices for both silver and lead under these conditions.

P15.10 SOLUTION

A. It is appropriate to begin analysis of this problem by examining the optimal activity level, assuming the firm mines and sells equal quantities of silver and lead.

For profit maximization where Q = QS = QL, set:

MC = MRS + MRL = MR

$10 = $11 - $0.00006Q + $0.4 - $0.00001Q

$0.00007Q = 1.4

Q = 20,000

Profit maximization with equal sales of each product requires that the firm mine Q = 20,000 tons of ore. Under this assumption, marginal revenues for the two products are:

MRS = $11 - $0.00006(20,000) = $9.80

MRL = $0.4 - $0.00001(20,000) = $0.20

Because each product is making a positive contribution to marginal costs of $10 per ton, Q = 20,000 is an optimal activity level.

Relevant prices are:

PS = $11 - $0.00003(20,000) = $10.40

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PL = $0.4 - $0.000005(20,000) = $0.30

B. A five-fold (or 500%) increase in silver demand means that a given quantity could be sold at 5 times the original price. Alternatively, 5 times the original quantity demanded could be sold at a given price. Therefore, the new silver demand and marginal revenue curves can be written:

PS’ = 5($11 - $0.00003QS)

= $55 - $0.00015QS

MRS’ = 5($11 - $0.00006QS)

= $55 - $0.0003QS

Now, assuming all output is sold,

MC = MRS’ + MRL = MR

$10 = $55 - $0.0003Q + $0.4 - $0.00001Q

0.00031Q = 45.4

Q = 146,452

Thus, profit maximization with equal sales of each product requires that the firm mine Q = 146,452 tons of ore. Under this assumption, marginal revenues for the two products are:

MRS’ = $55 - $0.0003(146,452) = $11.06

MRL = $0.4 - $0.00001(146,452) = -$1.06

Even though MRS’ + MRL = MC = $10, the above Q = 146,452 solution is suboptimal. MRS’ = $11.06 > $10 = MC implies that a $1.06 profit contribution was earned on each marginal ton of ore mined when just considering S sales. This means that the firm would like to expand production beyond Q = 146,452 just to sell more S. The negative marginal revenue for L implies that the firm had to reduce price so much in order to sell all 146,452 pounds of L (indeed offer a negative price or subsidy of 33¢ per pound) that total revenues fell by $1.06 on the last pound sold. Rather than sell L under such unfavorable conditions, the firm would like to reduce L sales below 146,452 pounds.

The firm would sell L only up to the point where MRL = 0 because, given additional production to sell S, the marginal cost of L is zero. Set,


MRL = MCL

$0.4 - $0.00001Q = 0

$0.00001Q = 0.4

QL = 40,000

PL = $0.4 - $0.000005(40,000)

= $0.20

The optimal production and sales level of S is found by setting MRS = MC, because S is the only product sold from the marginal ton of ore being mined.

MRS = MC = MCS

$55 - $0.0003QS = $10

0.0003QS = 45

QS = 150,000

and

PS = $55 - $0.00015(150,000)

= $32.50

Therefore, the firm should mine 150,000 tons of ore, and sell all 150,000 ounces of S produced at a price of $32.50. Only 40,000 pounds of lead should be sold at a price of 20¢ per pound, with the remaining 110,000 pounds produced being held off the market.

(Note: Despite a five-fold increase in demand, prices increase by less than five-fold given the firm’s expansion in output.)

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CASE STUDY FOR CHAPTER 15

Pricing Practices in the Denver, Colorado, Newspaper Market

On May 12, 2000, the two daily newspapers in Denver, Colorado, filed an application with the U.S. Department of Justice for approval of a joint operating arrangement. The application was filed by The E.W. Scripps Company, whose subsidiary, the Denver Publishing Company, published the Rocky Mountain News, and the MediaNews Group, Inc., whose subsidiary, the Denver Post Corporation, published the Denver Post. Under the proposed joint operating agreement, printing and commercial operations of both newspapers were to be handled by a new entity, the “Denver Newspaper Agency,” owned by the parties in equal shares. This type of joint operating agreement provides for the complete independence of the news and editorial departments of the two newspapers. The rationale for such an arrangement, as provided for under the Newspaper Preservation Act, is to preserve multiple independent editorial voices in towns and cities too small to support two or more newspapers. The act requires joint operating arrangements, such as that proposed by the Denver newspapers, to obtain the prior written consent of the attorney general of the United States in order to qualify for the antitrust exemption provided by the act.

Scripps initiated discussions for a joint operating agreement after determining that the News would probably fail without such an arrangement. In their petition to the Justice Department, the newspapers argued that the News had sustained $123 million in net operating losses while the financially stronger Post had reaped $200 million in profits during the 1990s. This was a crucial point in favor of the joint operating agreement application because the attorney general must find that one of the publications is a failing newspaper and that approval of the arrangement is necessary to maintain the independent editorial content of both newspapers. Like any business, newspapers cannot survive without a respectable bottom line. In commenting on the joint operating agreement application, Attorney General Janet Reno noted that Denver was one of only five major American cities still served by competing daily newspapers. The other four are Boston, Chicago, New York, and Washington, DC. Of course, these other four cities are not comparable in size to Denver; they are much bigger. None of those four cities can lay claim to two newspapers that are more or less equally matched and strive for the same audience. In fact, that there is not a single city in the United States that still supports two independently owned and evenly matched, high-quality newspapers that vie for the same broad base of readership.

Economies of scale in production explain why few cities can support more than one local newspaper. Almost all local newspaper production and distribution costs are fixed. Marginal production and distribution costs are almost nil. After the local news stories and local advertising copy are written, there is practically no additional cost involved with expanding production from, say, 200,000 to 300,000 newspapers per day. Once a daily edition is produced, marginal costs may be as little as 5¢ per newspaper. When marginal production costs are minimal, price competition turns vicious. Whichever competitor is out in front in terms of total circulation simply keeps prices down until the competition goes out of business or is forced into accepting a joint operating agreement. This is exactly what happened in Denver. Until recently, the cost of a daily newspaper in Denver was only 25¢ each weekday and 50¢ on Sunday at the


newsstand, and even less when purchased on an annual subscription basis. The smaller News had much higher unit costs and simply could not afford to compete with the Post at such ruinously low prices. This is why the production of local newspapers is often described as a classic example of natural monopoly.

On Friday, January 5, 2001, the Justice Department gave the green light to a 50-year joint operating agreement between the News and its longtime rival, the Post. Starting January 22, 2001, the publishing operations of the News and the Post were consolidated. The Denver Newspaper Agency, owned 50/50 by the owners of the News and Post, is now responsible for the advertising, circulation, production, and other business departments of the newspapers. Newsrooms and editorial functions remain independent. Therefore, the owners of the News and Post are now working together to achieve financial success, but the newsroom operations remains competitors. Under terms of the agreement, E.W. Scripps Company, parent of the struggling News, agreed to pay owners of the Post $60 million. Both newspapers publish separately Monday through Friday. The News publishes the only Saturday paper and the Post the only Sunday paper.

A. Use your knowledge of monopoly pricing practices to explain why advertising rates and newspaper circulation prices were likely to increase and jobs were likely to be lost, following adoption of this joint operating agreement. Use company information to support your argument (see http://www.denverpost.com and http://www.rockymountainnews.com/).

B. Classified ads to sell real estate in a local newspaper can cost five to ten times as much as a similar ad used to announce a garage sale. Use your knowledge of price discrimination to explain how local newspaper monopolies generate enormous profits from selling classified advertising that varies in price according to the value of the item advertised.

C. Widely differing fares for business and vacation travelers on the same flight have led some to accuse the airlines of price discrimination. Do airline fare differences or local newspaper classified-ad rate differences provide stronger evidence of price discrimination?

CASE STUDY SOLUTION

A. At the time the joint operating agreement was formed, neither news organization would speculate on job losses or advertising and circulation rate increases resulting from the deal. Both proclaimed that job losses and rate increases would not be substantial. In fact, the company announced significant job cuts and steep rate increases in the period immediately following the start-up of the joint operating agreement. Prices for single newspapers quickly jumped from 25¢ to 50¢daily, and from 50¢ to $1.50 on Sunday. Commensurate increases were noted for long-term subscriptions and advertising customers.

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In a celebrated case, Jake Jabs, who owns the American Furniture Warehouse chain in Denver, said newspaper officials quickly proposed a new four-year advertising contract that required ads in both papers, with a 100% rate increase the first year, and 25% per year for the following three years. Jabs and other major local advertisers were so incensed that they sued in federal court. They lost. In early 2001, U. S. District Judge John Kane Jr. rejected a preliminary injunction sought by Jabs and a coalition of retailers called Coloradans Against Newspaper Monopolies. They wanted to roll back new ad rates at the News and the Post, and accused the papers of violating advertisers’ free speech rights by raising ad rates too high. Kane found no authority in support of the alleged constitutional violation, and the suit was dismissed. Kane said antitrust laws prohibiting business monopolies don’t apply to newspapers in joint operating agreements.

The circulations of the Post and the News also fell sharply after the two newspapers introduced sharp increases in subscription rates. In the first two months after the two papers combined business operations and began sharing profits, the News lost 17.9 percent of its Monday through Saturday circulation and the Post lost 11.9 percent. The News’ Monday-through-Saturday circulation dropped from 446,465 to 366,499, and Post circulation dropped from 413,730 to 364,451. Sunday circulation for the News dropped from 552,085 to 448,032, and the Post’s Sunday circulation dropped from 558,560 to 522,903.

B. Local newspapers have a formidable niche in the provision of regional news and classified advertising. If readers want stock quotes or general business news, they can find that information on the Internet or from a host of national providers, like The Wall Street Journal and The New York Times. However, if readers want to find out how the local high school football game turned out, they typically can only find that information in the local newspaper. Similarly, the local newspaper is frequently the only place to go for local business advertising and classified ads.

An interesting illustration of price discrimination can be found in the classified-ad pricing policies of local newspapers. The value of classified advertising varies according to the value of the item advertised. Real estate advertising has a much greater value to customers than advertising the sale of lower-priced household items, boats, pets, and so on. Given these differences, customers are willing to pay much more to advertise the sale of a personal residence, for example, than to seek new homes for Spotty and her kittens. Local newspapers satisfy the requirements necessary for profitable price discrimination, because they can easily identify the value of the item advertised and often enjoy a monopoly position in the sale of local advertising. It should not be surprising that local newspaper monopolies generate enormous profits from selling classified advertising that varies in price according to the value of the item advertised.

C. The airline industry provides an interesting basis for discussing price discrimination. Ticket prices vary dramatically between business customers, whose travel plans change quickly and whose demand is relatively inelastic with respect to price, and


vacation customers, who can establish travel plans well in advance and whose demand is typically more price elastic. However, before concluding that the higher prices charged business customers solely reflect price discrimination, it is important to recognize that the cost of serving business customers is greater than for vacation travelers.

Business traffic is particularly heavy on Mondays, and Fridays. This pattern of business travel often leaves airlines with substantial unused capacity on Tuesdays, Wednesdays, and Thursdays, as well as on Saturdays and Sundays. Given this excess capacity, the incremental cost per air traveler can be substantially lower during midweek and weekend periods. Airlines are also better able to schedule their use of airplane capacity when demand is predictable as opposed to erratic. This contributes to lower fares for restricted as opposed to unrestricted travelers. The price differentials common in airline rate structures clearly reflect the influence of cost differences, perhaps in addition to the effects of price discrimination.

On the other hand, there is absolutely no difference in the cost of providing a three-line ten-day want-ad for a bicycle versus a personal residence. Both types of ads require the same amount of labor and raw materials to produce, sell and deliver to newspaper customers. Because the costs of providing consumer and commercial want ads are the same, differences in the prices charged these different classes of customers are based upon differences in the customer price elasticity of demand rather than cost differences. Demand for want ad advertising by consumers tends to be quite inelastic with respect to price because consumers have few, if any, alternatives to placing such ads in the local newspaper. Commercial customer demand for want ad advertising is much more price elastic because commercial customers use flyers distributed door-to-door by independent contractors, local radio and television advertising to promote their products. As a result, the pricing practices of local newspaper advertising clearly reflects a pricing practice of price discrimination whereby commercial customers pay much lower prices and markups than the amounts paid by individual consumers.

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Appendix 15A

TRANSFER PRICING

PROBLEM & SOLUTION

P15A.1 Transfer Pricing. Simpson Flanders, Inc., is a Motor City-based manufacturer and distributor of valves used in nuclear power plants. Currently, all output is sold to North American customers. Demand and marginal revenue curves for the firm are as follows:

P = $1,000 - $0.015Q

MR = ΔTR/ΔQ = $1,000 - $0.03Q

Relevant total cost, marginal cost, and profit functions are

TC = $1,500,000 + $600Q + $0.005Q2

MC = ΔTC/ΔQ = $600 + $0.01Q

π = TR - TC

= -$0.02Q2 + $400Q - $1,500,000

A. Calculate the profit-maximizing activity level for Simpson Flanders when the firm is operated as an integrated unit.

B. Assume that the company is reorganized into two independent profit centers with the following cost conditions:

TCMfg = $1,250,000 + $500Q + $0.005Q2

MCMfg = ΔTCMfg/ΔQ =500 + $0.01Q

TCDistr = $250,000 + $100Q

MCDistr = ΔTCDistr/ΔQ =$100.

Calculate the transfer price that ensures a profit-maximizing level of profit for the firm, with divisional operation based on the assumption that all output produced is to be transferred internally.


C. Now assume that a major distributor in the European market offers to buy as many valves as Simpson Flanders wishes to offer at a price of $645. No impact on demand from the company’s North American customers is expected, and current facilities can be used to supply both markets. Calculate the company’s optimal price(s), output(s), and profits in this situation.

P15A.1 SOLUTION

A. Profit maximization occurs at the point where MR = MC, so the optimal output level is:

MR = MC,

$1,000 - $0.03Q = $600 + $0.01Q,

400 = 0.04Q,

Q = 10,000.

This implies:

P = $1,000 - $0.015(10,000),

= $850,

π = TR - TC,

= -$0.02(10,0002) + $400(10,000) - $1,500,000,

= $500,000.

B. To derive an appropriate transfer price when no external market is present, the net marginal revenue for the distribution division is set equal to marginal cost of the manufacturing division to identify the firm’s profit-maximizing activity level:

MR - MCDistr = MCMfg,

$1,000 - $0.03Q - $100 = $500 + $0.01Q,

400 = 0.04Q,

Q = 10,000.

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The 10,000-unit output level remains optimal for profit maximization, as must be the case. If the distribution division determines the quantity it will purchase by movement along its marginal revenue curve, and the manufacturing division supplies output along its marginal cost curve, then the market clearing transfer price is the price that results when MR - MCDistr = MCMfg. At 10,000 units of output, the optimal transfer price is:

PT = MCMfg,

= $500 + $0.01(10,000),

= $600.

At a transfer price of $600, the quantity supplied by the manufacturing division equals 10,000. Similarly, the quantity demanded by the distribution division also equals 10,000 at a transfer price of $600:

MR - MCDistr = PT,

$1,000 - $0.03Q - $100 = $600,

300 = 0.03Q,

Q = 10,000,

At a transfer price PT > $600, the distribution division will accept fewer units of output than the manufacturing division wants to supply. If PT < $600, the distribution division will seek to purchase more units than the manufacturing division desires to produce. Only at a $600 transfer price are supply and demand in balance in the firm’s internal market.

C. If a perfectly competitive external market exists for the transferred product, the optimal transfer price equals the external market price. Because the new European customer is willing buy all output supplied at a price of $645, this value represents the opportunity cost of North American versus European sales. A transfer price of PT

= $645 should be established. At this price, the quantity demanded by the distribution division is:

MR - MCDistr = PT,

$1,000 - $0.03Q - $100 = $645,

255 = 0.03Q,


Q = 8,500,

whereas the quantity supplied by the manufacturing division is:

PT = MCMfg,

$645 = $500 + $0.01Q,

145 = 0.01Q,

Q = 14,500.

In this instance of excess internal supply, the distribution division will purchase internally all units desired for the North American market, and QNA = 8,500. The optimal price for the North American market is:

PNA = $1,000 - $0.015(8,500),

= $872.50.

The manufacturing division will offer an additional QE = 6,000 units to new customers in the European market at a price of PE = $645.

Maximum total profits are:

π = TRNA + TRE - TCMfg - TCDistr,

= $872.50(8,500) + $645(6,000) -$1,250,000

- $500(14,500) - $0.005(14,5002) - $250,000

- $100(8,500),

= $635,000

The offer from the European distributor should be accepted as it results in a $135,000 increase in profits, from $500,000 to $635,000. Notice that the optimal transfer price PT = $645 equates the marginal cost of the each division to the marginal revenue derived from each market. Given the separate nature of the North American and European markets, the company is able to grow and profitably segment its market at the same time.

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