Chapter 15 PRICING PRACTICES
QUESTIONS AND ANSWERS Q15.1
Express Express the markup markup on cost formula formula in terms terms of the markup markup on price, price, and use this relation to explain why a 100% markup implies a 50% markup on price.
Q15.1
ANSWER
The mark The markup up on cost, cost, or cost cost plus, plus, form formul ulaa give givess profi profitt marg margin in expre express ssed ed as a percentage percentage of cost: cost: Markup on Cost =
Price - Marginal Cost Marginal Cost
By way of contrast, the markup on price formula gives profit margin expressed as a percentage percentage of price: price: Markup on Price =
Price - Marginal Cost Price
Each Each markup markup formul formulaa provide providess a useful, useful, but differ different, ent, perspect perspective ive on the relati relative ve 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: Marku arkup p on on Co Cost =
Marku arkup p on on Pri Price ce =
Markup on Price 1 - Markup on Price Markup on Cost 1 + Markup on Cost
A product with a 100% markup on cost has a 50% markup on price, a 50% markup on cost implies implies a 33% markup on price, and so on. When comparing comparing the markup earned earned on various items, and in determining the optimal markup, it is crucial to identify the exact specification of the markup formula used.
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Q15.2
Explain Explain why successfu successfull firms firms that employ employ markup markup pricing pricing use fully allocated allocated costs costs under normal conditions, but typically offer price discounts or accept lower margins during off-peak periods when excess capacity is available.
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. production. Under such conditions, conditions, an increase increase in production production requires requires an increase increase in all plant, equipment, equipment, labor, materials, materials, and other expenditures. expenditures. However, However, if a firm has excess capacity, as during off-peak periods, only those costs that actually rise with production--t production--the he incremental incremental costs costs per unit--should unit--should form form a basis basis for setting setting prices. 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 capacity is available. available. In some instances, output produced produced during off-peak off-peak periods is much much cheaper than output produced produced during peak periods. periods. When fixed costs represent a substantial share of total production costs, discounts of 30 percent to to 50 percent percent for output output produced produced during off-peak off-peak periods can often often be justified justified on the basis of lower costs. “Earl “Early y Bird Bird”” or afte afterno rnoon on mati matinee nee disco discount untss at mo movie vie theat theater erss prov provide ide an intere interesti sting ng example. example. Except Except for cleaning cleaning expenses, expenses, which vary according according to the number of customers, customers, most movie theater theater expenses are fixed. As a result, the revenue generated by adding customers during off-peak periods can significantly increase the theater's theater's profit contribution. contribution. When off-peak off-peak customers customers buy regularly priced candy, popcorn, and soda, soda, even lower afternoon ticket ticket prices can be justified. justified. Conversely, 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 Ticket prices prices during during these peak periods periods reflect reflect fully allocated allocated costs. costs. Simila Similarly rly,, McDonald’s, Burger King, Arby's, and other fast-food outlets have increased their profitability profitability substantia substantially lly by introducing introducing breakfast breakfast menus. If fixed restaurant restaurant expenses expenses are covered by lunch and dinner business, even promotionally priced breakfast items can make a notable contribution to profits. Q15.3
Discuss Discuss how how seasona seasonall factors factors influen influence ce supply supply and and demand, demand, and and why why markups markups on fresh fresh fruits fruits and vegetable vegetable are at at their their highest highest during during the peak peak of of season. season.
Q15.3
ANSWER
It is interesting to see how seasonal factors affect markups for grocery items, like fruits and vegetables. vegetables. When a fruit or vegetable vegetable is in season, spoilage and transportat transportation ion costs costs are at their their lowest lowest levels. levels. At the same time, time, during the peak peak of season, season, high product quality translates translates into enthusiastic enthusiastic consumer consumer demand. Both factors lead to high margins margins for fresh fresh fruits fruits and vegetable vegetabless during during the peak of season. season. Consume Consumer r demand shifts away from high-cost/low-quality fresh fruits and vegetables when they
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are out of season, thereby reducing margins on these items. Similarly, markups tend to be high on on bargain-price bargain-priced d Turkey at at Thanksgiving, Thanksgiving, Ham Ham at Easter, Easter, and so so on. In addition to seasonal factors that affect margins over the course of a year, market market forces forces affect affect margins margins within within a given given product product class class at the grocery grocery store. store. In breakfast breakfast cereals, cereals, for example, example, the markup markup on cost for highly popular corn flakes average averagess only 5 percent percent to 6 percent percent,, with with brands brands offered offered by Post Post and Kellogg's 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, availabi availabilit lity y of substitut substitutes es directly directly affects affects the markups markups on various cereal cereals. s. It is interesting to note that among the wide variety of items sold in a typical grocery store, among the highest margins margins are charged on spices. Apparently, Apparently, consumer consumer demand for nutmeg, nutmeg, cloves, thyme, bay leaves, and other spices spices is quite insensitive 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 bargain rates to students students but not to business business executives. Journal to students, and it's not out of It is surely not because it costs less to deliver the Journal benevolence; benevolence; it's because because students students are not willing willing or able to pay pay the standard standard rate. rate. Even at 50 percent off regular prices, student bargain rates more than cover marginal costs and make a significant significant profit contribution. Similarly, senior citizens who eat eat at Holiday Inns enjoy a 10 to 15 percent discount and make a meaningful contribution to profits. Conve Converse rsely ly,, relat relative ively ly high high price pricess for popco popcorn rn at mo movi viee theat theater ers, s, peanu peanuts ts at the the ballpark, ballpark, and clothing at the height of the season reflect the fact that customers 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 marginal revenues equal to marginal marginal costs.” Discuss this statement. statement.
Q15.5
ANSWER
ProfitProfit-max maximi imizing zing pricing pricing practice practicess can be effect effectivel ively y employe employed d with with scant scant direct direct reference reference to marginal marginal analysis. Although Although profit maximization 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. prices. Just using information information on marginal marginal costs and the point price elasticity elasticity of demand, the calculation calculation of profit maximizing maximizing prices is quick and easy. Flexible Flexible markup pricing practices practices that reflect differences differences in marginal costs and demand elasticities are an efficient method for ensuring that MR = MC for each line of
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products products sold. Widespread Widespread support for the use of incremental analysis analysis in the pricing practices practices of highly successful successful and profitable profitable firms, firms, like the use of markup pricing practices, practices, can be interpreted interpreted as support for the practical practical equivalent equivalent of marginal marginal analysis. Q15.6
“Marginal cost pricing, as well as the use of incremental incremental analysis, is looked upon with favor favor by economists, economists, especially especially those on the staffs of regulator regulatoryy agencies. agencies. With this encouragement, regulated industries do indeed employ these rational techniques quite frequent frequently. ly. Unregula Unregulated ted firms, firms, on the other hand, hand, use margina marginall or increme incremental ntal cost pricing pricing much less frequently frequently,, sticking sticking to cost-plus cost-plus,, or full-cost, full-cost, pricing except under under unusual unusual circumsta circumstances nces.. In my opinion, opinion, this goes a long way toward explaini explaining ng the problems problems of the regulated regulated firms firms vis-à-vis vis-à-vis unregula unregulated ted industry. industry.” ” Discuss Discuss this statemen statement. t.
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, statement, however, however, it might be noted that incorrect use of the incre increme menta ntall conce concept pt has some someti time mess led led to disa disast stro rous us resul results ts for firm firmss who 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 closely related products in such a manner that price differences differences are not proportional proportional to cost differences. differences. Price discriminat discrimination ion exists among among multiple multiple customers customers of an identical product product if: P1 P2
≠
MC1 MC2
Note that price discrimination discrimination can exist when equal or unequal prices are charged different different customers. customers. It simply implies implies that different customers customers are charged different different markups.
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Q15.8
What What condit condition ionss are neces necessar saryy before before price price discri discrimi minat nation ion is both both possib possible le and profitable profitable? ? Why does does price price discrimin discrimination ation result result in higher higher profits? profits?
Q15.8
ANSWER
The primary requirement for price discrimination is an ability to segment the market by preventing preventing transfers transfers among sub-markets. sub-markets. A second requirement requirement for price discrimination to be worthwhile is that demand elasticities must be different in the various sub-markets. Otherwise, an optimal pricing pricing scheme will result in equal prices in all markets. Price Price discri discrimina minatio tion n is profita profitable ble because because it allows allows firms firms to charge charge higher 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 Discuss the the role role of comm common on costs costs in pricing pricing practi practice. ce.
Q15.9
ANSWER
Common costs are expenses that are necessary for manufacture of a joint product. Comm Common on costs costs of produ product ction ion---ra raw w mater material ial and and equip equipme ment nt costs costs,, manag managem ement ent expenses, and other overhead--cannot be allocated to each individual by-product on any economically economically sound basis. Only costs that can be separately separately identified as associated associated with a specific by-product by-product can and should be allocated. allocated. For example, 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 production in fixed fixed proportions, proportions, however, output of one product product is perfectly perfectly correlated correlated with output of another, and it is impossible to identify identify individual individual production production costs. In such instances, instances, one can only measure measure the marginal marginal cost of producing producing another unit of the output “package” “package” composed composed of the two or more joint products. products.
SELF-TEST SELF-TEST PROBLEMS PROBLEMS AND SOLUTIONS SOLUTIONS
212
ST15.1
Chapter 15
George Constanza is a project coordinator at Kramer-Seinfeld & Associates, Ltd., a large Brooklyn-based Brooklyn-based painting contractor. contractor. Constanza has asked asked you to complete an analysis of profit marg margins ins earned on a number number of recent projects. Unfortunately, Unfortunately, your predeces predecessor sor on this project project got an abrupt abrupt transfer, transfer, and left you with only sketchy sketchy information on the firm’s pricing practices.
Pricing Pricing Practi Practices ces
A.
213
Use the available data to complete the following table:
Price
Marginal Marginal Cost
Markup on Cost (%)
Markup on 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
B.
0.0
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:
Project
Price Elasticity Elasticity
1
- 1.5
2
- 2.0
3
Optimal Markup on Cost (%)
200.0 66.7
4 5
- 5.0
11.1
7
- 15.0
8
- 20.0
SOLUTION SOLUTION
25.0 10.0 5.0
9
ST15.1
66.7
25.0
6
10
Optimal Markup on Price (%)
4.0 - 50.0
2.0
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A.
Price
Marginal Cost
Markup on Cost (%)
Markup on 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.
ST15.2
Optimal Markup on Cost (%)
Optimal Markup on Price (%)
Project
Price 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
Optimal Markup Markup on Price. TLC Lawncare, Inc., provides fertilizer and weed control lawn services to residential residential customers. Its seasonal service package, package, regularly priced at $250, includes several several chemical spray treatments. treatments. As part of an effort to expand its
Pricing Pricing Practi Practices ces
215
customer base, TLC offered $50 off its regular price to customers in the Dallas area. Response Response was was enthusiastic enthusiastic,, with sales rising to 5,750 units (packages (packages)) from the 3,250 units sold in the same period last year.
ST15.2
A.
Calculate the arc price elasticity of demand for TLC service.
B.
Assume Assume that the arc price price elasticity elasticity (from Part A) is the best available available estimate estimate of the point price elasticit elasticityy of demand. If marginal marginal cost is $135 per unit for labor and materials, calculate TLC’s optimal markup on price and its optimal price. price.
SOLUTION SOLUTION A.
EP
=
=
∆Q
×
∆P
P 2 + P1 Q2 + Q1
5,750 - 3,250
×
$200 - $250
$200 + $250 5,750 + 3,250
= -2.5 B.
Given εP = EP = -2.5, the optimal TLC markup on price is:
Optimal Markup on Price
=
-1 ε P
=
-1 - 2.5
= 0.4 or 40% Given MC = $135, the optimal price is: Optimal Markup on Price
=
0.4
=
0.4P
P - MC P P - $135 P
= P - $135
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0.6P
= $135
P
= $225
PROBLEMS AND AND SOLUTIONS SOLUTIONS P15.1
P15.1
P15.2
Markup Markup Calculation. Calculation. Controller Elliot Reid has asked you to review the pricing practices practices of Hollyw Hollywood ood Medical, Medical, Inc. Inc. Use the follow following ing data to calcula calculate te the relevant relevant markup on cost and markup on price for the following disposable items:
Product Product
Price
Marginal Marginal Cost
A
$2
$0.20
B
3
0.6
C
4
1.2
D
5
2
E
6
3
Markup Markup on Cost (%)
Markup Markup on Price (%)
SOLUTION SOLUTION Markup on Cost (%)
Markup on Price (%)
Product
Price
Marginal Cost
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%
Optimal Markup. Markup. Dr. John Dorian, chief of staff at the Northern Medical Center, has asked asked you to propose propose an appropria appropriate te markup markup pricing pricing policy for various medical medical procedure proceduress performed performed in the hospital’s hospital’s emergenc emergencyy room. To help in this regard, regard, you consult a trade industry publication that provides data about the price elasticity of demand demand for medical medical procedures. procedures. Unfortun Unfortunately ately,, the abrasive abrasive Dr. Dorian failed failed to mention whether he wanted you to calculate the optimal markup as a percentage of price price or as a percenta percentage ge of cost. cost. To be safe, calculate calculate the optimal optimal markup on price and optimal markup on cost for each of the following procedures:
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Optimal Markup Markup on Cost
Price Elasticity Elasticity
Procedure Procedure A.
-1
B.
-2
C.
-3
D.
-4
E.
-5
Optimal Markup Markup on Price
P15.2 SOLUTION SOLUTION
Price Elasticity
Procedure
Optimal Markup on Cost
Optimal Markup 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%
Brake-Checku eckup, p, Inc., offers automobile automobile brake brake analysis analysis and repair at a P15.3 Markup on Cost. Brake-Ch number number of outlets outlets in the Philadelp Philadelphia hia area. The company company recently recently initiated initiated a policy policy of matching matching the lowest advertised advertised competit competitor or price. As a result, result, Brake-Check Brake-Checkup up has been forced forced to reduce reduce the averag averagee price price for brake brake jobs by by 3%, but but it has has enjoyed enjoyed a 15% increase increase in customer traffic. Meanwhile, marginal marginal costs have held steady steady at $120 per brake job. A.
Calculate the point price elasticity of demand for brake jobs.
B.
Calculate Brake-Checkup’s Brake-Checkup’s optimal price and markup on cost.
P15.3 SOLUTION SOLUTION A.
εP
=
=
Percentage change in output Percentage change in price 0.15 - 0.03
= -5
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B.
Chapter 15
Given εP = -5, the optimal markup on cost is: Optimal Markup
-1
=
on Cost
ε P
=
+1
-1 -5 +1
= 0.25 or 25% 25% Given MC = $120, the optimal price is: Optimal Markup on Cost
=
0.25 =
P - MC MC P - $120 $120
$30 = P - $120 P = $150 P15.4
P15.4 A.
Optimal Markup on Cost. The Bristol, Inc. is an elegant dining establishment that features features French French cuisine cuisine at dinner dinner six six nights nights per week, week, and brunch brunch on on weekends weekends.. In an effort to boost traffic from shoppers during the Christmas season, the Bristol offered Saturday customers customers $4 off its $16 $16 regular price for brunch. brunch. The promotion promotion proved successfu successful, l, with with brunch brunch sales sales rising rising from 250 to to 750 750 units units per day. A.
Calculate the arc price elasticity of demand for brunch at the Bristol.
B.
Assume Assume that that the arc price price elasti elasticity city (from (from part A) is the best best availa available ble estima estimate te of the point price elasticity elasticity of demand. demand. If marginal cost cost is $8.56 per unit for labor labor and materials, calculate the Bristol’s optimal markup on cost and its optimal price. price.
SOLUTION SOLUTION
EP
=
=
∆Q ∆P
×
P 2 + P1 Q2 + Q1
750 - 250 $12 - $16
×
$12 + $16 750 + 250
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219
= -3.5 B.
Given εP = EP = -3.5, the optimal markup on cost for Saturday brunch at the Bristol during this time frame is: Optimal Markup on Cost
=
-1 ε P
=
+1 -1
- 3.5 + 1
= 0.4 0.4 or or 40% 40% Given MC = $8.56, the optimal price is: Optimal Markup on Cost
=
0.4
=
$3.424 P P15.5
P - MC MC P - $8.56 $8.56
= P - $8.56 = $11.99
Betty's Boutique Boutique is a small small specialty specialty retailer retailer located located in a Markup Markup Pricing Practice. Practice. Betty's suburban suburban shopping shopping mall. mall. In setting setting the regular regular $36 price price for a new spring spring line of blouses, blouses, Betty's Betty's added a 50 percent percent markup markup on cost. Costs Costs were estimated estimated at $24 each: the $12 purchase price of each blouse, plus $6 in allocated variable overhead costs, costs, plus an allocated allocated fixed overhea overhead d charge of $6. Custome Customerr response response was so strong strong that when when Betty's raised raised prices prices from $36 $36 to $39 per blouse blouse,, sales fell only only from 54 to 46 blouses per week. At first blush, Betty's Betty's pricing pricing policy policy seems seems clearly clearly inappropr inappropriate. iate. It is always always improper to consider allocated fixed costs in setting prices for any good or service; only marginal marginal or increme incremental ntal costs should be included. included. However However,, by adjusting adjusting the amoun amountt of marku markup p on cost cost em emplo ployed yed,, Betty' Betty'ss can implic implicitl itlyy compen compensat satee for the inappropriate use use of fully allocated costs. It is necessary to carefully analyze analyze both the cost categories categories included included and the markup markup percenta percentages ges chosen chosen before before judging judging the appropriateness appropriateness of a given pricing practice.
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A.
Use the arc price elasticity formula to estimate the price elasticity of demand for Betty's Betty's blouses blouses
B.
Determin Determinee Betty's Betty's optimal optimal markup markup on cost using using the arc price price elasticity elasticity as an estimate of the point price elasticity elasticity of demand. Based upon relevant relevant marginal costs, calculate Betty's optimal optimal price. Explain.
P15.5
SOLUTION 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: Q2 - Q1 P 2 + P1 × EP = P 2 - P1 Q 2 + Q1 =
B.
46 - 54 $39 - $36
×
$39 + $36 46 + 54
= - 2. If it can be assumed that this arc price elasticity of demand E P = -2 is the best available -1 Optimal Markup = on Cost εP + 1 =
-1 - 2 +1
= 1 or 100%. 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 variable costs, plus $6 fixed overhead overhead charges. However, However, for pricing purposes, purposes, only the $12 purchase cost plus the allocated variable overhead charge of $6 are relevant. Thus, the relevant marginal marginal cost for pricing purposes purposes is $18 per blouse. blouse. The allocated 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
=
$36 - $18
$18 = 1 (or (or 100 100 perc percen ent) t)..
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221
Therefore, Betty's initial $36 price on blouses is optimal, and the subsequent $3 price increase should be rescinded. This This simp simple le exam example ple teaches teaches an impor importa tant nt less lesson. on. Despi Despite te the the impro improper per cons conside idera rati tion on of fixe fixed d overhe overhead ad costs costs and and a mark markup up that that migh mightt at firs firstt appea appear r unsuitable, Betty's pricing policy is entirely consistent with profit-maximizing behavior because the end result is an efficient efficient pricing policy. p olicy. Given the prevalence prevalence of markup pricing in everyday everyday business business practice, practice, it is important important that these pricing practices 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 typically employed in ways that are consistent with 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
Nash Bridges Bridges Construct Construction ion Company Company is a building building Peak/Off-Peak Peak/Off-Peak Pricing. Nash contractor serving serving the Gulf Coast region. The company company recently bid on a Gulf-front causew causeway ay impro improvem vement ent in Biloxi Biloxi,, Missis Mississip sippi. pi. Nash Nash Bridg Bridges es has incurre incurred d bid development development and job cost-out expenses expenses of $25,000 prio priorr to submission of the bid. The bid was based on the following projected costs: Cost Category
Amount
Bid devel developme opment nt and and job cost-out cost-out expenses expenses
$25,000 $25,000
Materials Materials
881,000 881,000
Labor Labor (50,000 (50,000 hours hours @ $26) $26)
1,300,000 1,300,000
Variable overhead (40% of direct labor)
520,000
Allocate Allocated d fixed fixed overhea overhead d (6% of total total costs) costs)
174,000 174,000
Total costs
$2,900,000
A.
What What is Nash Nash Bridg Bridges’ es’ minimu minimum m accept acceptabl ablee (break (breakeve even) n) contr contract act price 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 SOLUTION
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
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$2,875,000 + ε (=$2,900,000 - $25,000). In particular, note that that the 6% fixed overhead charge is relevant as it represents an opportunity cost of turning away other profitable business. business. B.
Assu Assumi ming ng an econo economi micc downtu downturn rn has has left left the the comp company any with with subst substant antia iall exces excesss capacity, neither the $25,000 sunk development expense nor the 6% fixed overhead charg chargee are are rele relevan vant. t. When When opera operati ting ng at less than peak peak capac capacit ity, y, the the minim minimum um 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). $174,000). Any price above that level will will make a positive contribution contribution to overhead and should be accepted.
P15.7
General Eclectic Eclectic Company Company manufac manufacture turess an Incremental Incremental Pricing Analysis. Analysis. The General electric toaster. Sales of the toaster have have increased steadily during during the previous five years, years, and, because because of a recently recently complete completed d expansion expansion program, program, annual annual capacity capacity is now 500,000 units. Production and sales during during the upcoming year are are forecast to be 400,000 units, and standard production costs are estimated as follows: Materials Materials
$6.00 $6.00
Direct Direct labor labor
4.00
Variable indirect labor
2.00
Fixed Fixed overhead overhead
3.00
Allocate Allocated d cost cost per unit
$15.00 $15.00
In addition addition to produ production ction costs, costs, GE incur incurss fixed selling selling expens expenses es of $1.50 $1.50 per unit unit and variable warranty warranty repair expenses expenses of $1.20 per unit. GE currently receives receives $20 per unit from its customers (primarily retail department stores), and it expects this price to hold during the coming year. After making making the precedin preceding g projectio projections, ns, GE received received an inquiry inquiry about about the purchase purchase of a large number number of toasters toasters by a discount discount department department store. The inquiry contained two purchase offers:
A.
Offer 1: The department department store would purchase purchase 80,000 units units at $14.60 per unit. unit. These These units units would would bear the GE label label and be covere covered d by the GE warranty. Offer 2: The department department store would purchase purchase 120,000 units units at $14.00 per unit. These These units would be sold under under the buyer’s buyer’s private label, label, and GE would not provide warranty service.
Evaluate Evaluate the increm incrementa entall net incom incomee potentia potentiall of each each offer. offer.
Pricing Pricing Practi Practices ces
223
B.
What other factors should GE consider when deciding which offer to accept?
C.
Which offer (if either) either) should GE accept? Why?
P15.7
SOLUTION SOLUTION
A.
The incremental net income from these offers can be determined as follows: Offer 1
Unit price
Offer 2
$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
Unit incremental profit
13.20
0.00
12.00
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 Incremental profit
$0
$136,000
$112,000
$104,000
Both offers involve a substantial incremental incremental profit, but offer 1 appears to be the more attractive on a simple dollar basis. B.
(i)
The image of GE’s quality may be affected by sales of the appliance in the department store chain with a private label.
(ii)
Other buyers may demand the reduced price if GE accepts offer 1 and the department store undercuts them at the retail price level.
(iii)
The sales lost if GE accepts offer 2 may affect future orders from regular customers.
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C.
It depends upon upon how you evaluate evaluate the factors discussed discussed in part B. B. The incremental incremental profits profits of offer 1 exceed those of offer 2, but other long-run long-run concerns might well dictate that it not be accepted.
P15.8
Coac Coach h Indu Indust stri ries es,, Inc. Inc.,, is a lead leadin ing g manu manufa fact ctur urer er of Price Discrimination Discrimination. recreational vehicle vehicle products. Its products include travel trailers, fifth-wheel trailers 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 Ernie Pantusso, Pantusso, Coach’s Coach’s controlle controller, r, estimates estimates that each fifth-whe fifth-wheel el trailer trailer costs costs the company company $10,000 $10,000 in variable variable labor and material material expenses. expenses. Demand Demand and marginal marginal revenue relations for fifth-wheel trailers are P W $15,00 000 0 - $5Q $5QW W = $15,
(Wholesale),
MRW = ΔTRW /ΔQW = $15,000 - $10Q W . P R = $50, $50,00 000 0 - $20Q 20Q R
(Retail),
MR R = = ΔTR R /ΔQ R = $50,000 - $40Q R. A.
Assumin Assuming g that the comp company any can can price discri discrimina minate te between between its two two types of of customer customers, s, 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 differences in these elasticity elasticity consistent consistent with your recommen recommended ded price price differen differences ces in in part part A? Why or or why why not? not?
P15.8
SOLUTION SOLUTION
A.
With price discrimination, profits are maximized by setting MR = MC in each market, where MC = $10,000. Wholesale MR W = MC $15,000 - $10QW = $10,000 QW = 500 500 unit nits PW = $15, $15,00 000 0 - $5Q $5QW = $15,0 $15,000 00 - $5(50 $5(500) 0)
Pricing Pricing Practi Practices ces
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= $12, $12,5 500. Retail MR R R = MC $50,000 - $40QR = $10,000 QR = 1,00 1,000 0 unit unitss PR = $50, $50,00 000 0 - $20Q $20QR = $50 $50,00 ,000 0 - $20( $20(1,0 1,000 00)) = $30,000 The profit contribution earned by the company is: π
= PWQW + PR QR - AVC(QW + QR ) = $12,500 $12,500(50 (500) 0) + $30 $30,000 ,000(1,0 (1,000) 00) - $10,000(500 + 1,000) = $21 $21,250 ,250,0 ,000 00
B.
Yes, the point price elasticity of demand for each customer class is: Wholesale QW εP
= 3,00 ,000 - 0.2PW = ΔQW/ΔPW × PW/QW = -0.2 -0.2 × ($12 ($12,50 ,500/ 0/500 500)) = -5 Retail
QR = 2,50 2,500 0 - 0.0 0.05P 5PR εP
= ΔQR /ΔP /ΔPR × PR /Q /QR
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= -0.05 -0.05 × ($3 ($30,0 0,000 00/1 /1,00 ,000) 0) = -1.5 A highe higherr price price for for retai retaill custo custome mers rs is consi consist stent ent with with the lowe lowerr degr degree ee or pric pricee elasticity observed in that market. P15.9
The Herita itage Club lub at Harbo rbor Town offe offers rs ele elegan gant Consumer Surplus . accom accommo moda dation tionss for discr discrimi imina natin ting g vacati vacatione oners rs on Hilto Hilton n He Head ad Islan Island, d, South South Carolina. Like many vacation resorts, Heritage Club has discovered the advantages of offering its services on on an annual membership membership or “time-sharing” “time-sharing” basis. To illustrate, assume that an individual vacationer’s weekly demand and marginal revenue curves can be written: P = $6,500 $6,500 - $1,250 $1,250Q, Q, MR = ΔTR/ΔQ = $6,500 $6,500 - $2,500Q, $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 purchased during a given year. year. For simplicity, assume assume that the resort’s marginal cost for for a week of vacation time time is $1,500, and that fixed costs costs are nil. This gives gives the following following total and margi marginal nal cost cost relatio relations: ns: TC
=
MC =
$1,500Q, ΔTC/ΔQ ΔTC/ΔQ = $1,500. $1,500.
A.
Calculate Calculate the profit-ma profit-maximi ximizing zing price, price, output, output, profit, profit, and consumer consumer surplus 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 pricing strateg strategyy is adopt adopted ed for for each each custome customer. r.
C.
Now assume assume that fixed costs of $4 million per year are incurred, incurred, and that 500 time-s time-shar haree custo custome mers rs (“own (“owners ers”) ”) are attrac attracted ted when when an optima optimall two-pa two-part rt pricing pricing strateg strategyy is adopt adopted. ed. Calculate Calculate total annual annual profits profits..
P15.9
SOLUTION SOLUTION
A.
If a single per unit price is charged, the profit-maximizing price is found by setting MR = MC, where MR = MC
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227
$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 profits equal $5,000 $5,000 per custome customerr because: because: P = $6,500 - $1,250(2) = $4,000 π = TR - TC = $4,0 $4,000 00(2 (2)) - $1 $1,500 ,500(2 (2)) = $5,0 $5,000 00 per per cus custo tome mer r 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-max profit-maximizing imizing price price of $4,000. Because Because the area of such a triangle is one-half the value of the base times the height, the value of consumer surplus equals: Cons Consum umer er Surp Surplu luss = ½ [2 × ($6 ($6,5 ,500 00 - $4, $4,00 000) 0)]] = $2,5 $2,500 00 per per cus custo tome mer r 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 willing to pay an additional $2,500 for these these two weeks of vacation 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 profits that could be earned earned using a two-part pricing pricing scheme. scheme. To maximize maximize profits, 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 curve that lies above above the per-unit per-unit price. price. When When the per-unit per-unit price is set equal equal to marginal cost, P = $1,500 and Q = 4 because P = MC
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$6,5 $6,500 00 - $1,2 $1,250 50Q Q = $1,5 $1,500 00 Q = 4 P = $6,5 $6,500 00 - $1,2 $1,250 50(4 (4)) =
$1,500
At the unit price of $1,500 and output level of 4, the value of consumer consumer surplus before imposition of fixed fees would be: Cons Consum umer er Surp Surplu luss = ½ [4 × ($6 ($6,5 ,500 00 - $1, $1,50 500) 0)]] = $10, $10,00 000 0 per per cus custo tom mer 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 $1,500 per week was paid for each each week spent spent at the resort. resort. It follows follows that that the profit-maxim profit-maximizing izing two-part two-part pricing scheme is to charge an annual time-share time-share or member membership ship fee of $10,000 $10,000 per year year plus weekly weekly fees fees of $1,500 $1,500 per week. Resort 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 $6,00 $6,000 0 (= 4 × $1,50 $1,500) 0),, and gener generat atee a $10,0 $10,000 00 (= $16 $16,00 ,000 0 - $6,00 $6,000) 0) profit 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 $1,500 per week. If fixed fixed costs are present, present, the $10,000 $10,000 amount amount per customer 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 = To Total tal reven revenue ue - Mar Margi ginal nal cost cost - Fixe Fixed d cos costt = 500 × [$10,000 [$10,000 + $1,500(4)] $1,500(4)] - 500 × [$1,500(4)] [$1,500(4)] - $4,000,000 = $1 mill millio ion n per per yea year r 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 vacation destinations. destinations.
Pricing Pricing Practi Practices ces
P15.10
229
Each ton of ore mined from from the Baby Doe Mine Mine in Leadville, Leadville, Joint Product Pricing. Each Colorado, produces one ounce of silver and one pound of lead in a fixed 1:1 ratio. Marginal Marginal costs costs are $10 $10 per per ton of ore ore mined. mined. The demand and marginal revenue curves for silver are P S S
= $11 $11 - $0. $0.00 0000 003Q 3QS
MRS = ΔTRS /ΔQS
= $11 $11 - $0. $0.00 0000 006Q 6QS
and the demand and marginal revenue curve for lead are P L = $0.4 $0.4 - $0. $0.00 0000 0005 05Q Q L MR L = ΔTR L /ΔQ L = $0.4 $0.4 - $0.0 $0.000 0001 01Q Q L where QS is ounces of silver and Q L is pounds of lead. A.
Calculate profit-maximizing profit-maximizing sales quantities and prices for silver si lver and lead.
B.
Now assume assume that that wild specula speculation tion in the silver silver market market has created created a fivefold fivefold (or 500%) increase in silver silver demand. Calculate optimal optimal sales quantities and prices prices for both both silver silver and and lead lead under under these these condi conditions tions..
P15.10
SOLUTION 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 + MR L = MR $10 $10 = $11 $11 - $0.0 $0.000 0006 06Q Q + $0.4 $0.4 - $0. $0.00 0000 001Q 1Q $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 marginal revenues for the two products are: MR S
= $11 $11 - $0.00 $0.0000 006(2 6(20,0 0,000 00)) = $9.80 $9.80
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MR L
= $0.4 $0.4 - $0.00 $0.0000 001( 1(20, 20,00 000) 0) = $0.20 $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:
B.
PS
= $11 $11 - $0.00 $0.0000 003(2 3(20,0 0,000 00)) = $10.40 $10.40
PL
= $0.4 $0.4 - $0.0000 $0.000005(20 05(20,000 ,000)) = $0.30 $0.30
A five-fold (or 500%) increase in silver demand means that a given quantity could be sold sold at 5 time timess the the orig origina inall pric price. e. Alte Alterna rnati tivel vely, y, 5 time timess the the orig origina inall quanti quantity ty demande demanded d could be sold at a given given price. price. Theref Therefore, ore, the new silver silver demand demand and marginal revenue curves can be written: PS’
= 5($11 - $0.00003QS) = $55 $55 - $0.0 $0.000 0015 15Q QS
MR S’
= 5($11 - $0.00006QS) = $55 $55 - $0.0 $0.000 003Q 3QS
Now, assuming assuming all output output is sold, sold, MC
= MRS’ + MR L = MR
$10 $10
= $55 $55 - $0.0 $0.000 003Q 3Q + $0. $0.4 4 - $0.0 $0.000 0001 01Q Q
0.00031Q Q
= 45.4 = 146,452
Thus, profit maximization with equal sales of each product requires that the firm mine Q = 146,452 tons of ore. ore. Under this assumpti assumption, on, marginal revenues revenues for the two products products are: MR S’ MR L
= $55 - $0 $0.0003(1 3(146,4 6,452) 52) = $11 $11.06 = $0.4 $0.4 - $0.000 $0.00001(1 01(146,4 46,452) 52) = -$1. -$1.06 06
Pricing Pricing Practi Practices ces
231
Even though MR S’ + MR L = MC = $10, the above Q = 146,452 solution is suboptimal. MR S’ = $11.06 > $10 = MC implies that a $1.06 profit contribution was earned on each marginal marginal ton of ore mined when just consider considering ing S sales. This means that 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 revenues fell by $1.06 on the last pound sold. Rather than sell L under under such unfavorabl unfavorablee conditi conditions, ons, the firm firm would would like like to reduce reduce L sales sales below below 146,452 pounds. The firm would sell L only up to the point where MR L = 0 because, given additional production to sell S, the the marginal cost of L is zero. Set, MR L $0.4 - $0.00001Q $0.00001Q
= MCL = 0 = 0.4
QL
= 40,000
PL
= $0.4 $0.4 - $0.0 $0.000 00005 005(40 (40,00 ,000) 0) = $0.20
The optimal production and sales level of S is found by setting MR S = MC, because S is the only only product product sold from the the marginal marginal ton of ore being being mined. MR S $55 - $0.0003QS 0.0003QS QS
= MC = MCS = $10 = 45 = 150,000 and
PS
= $55 $55 - $0.00 $0.00015 015(1 (150, 50,000 000)) = $32.50
Therefore, the firm should mine 150,000 tons of ore, and sell all 150,000 ounces of S produced produced at a price of $32.50. Only 40,000 40,000 pounds of lead should should be sold at a
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price of 20¢ per pound, with the remaining remaining 110,000 pounds produced produced being held off the market. ( Note Despite a five-fold increase increase in demand, prices increase increase by less than five Note: Despite fold given the firm’s expansion in output.)
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233
CASE STUDY FOR CHAPTER 15 Pricing Practices Practices in the Denver, Denver, Colorado, Colorado, Newspaper Newspaper Market Market
On May 12, 2000, the two daily newspapers in Denver, Colorado, filed an application with the U.S. Department of Justice Justice for approval of a joint operating operating arrangement. arrangement. The application was was filed by The The E.W. Scripp Scrippss Compan Company, y, whose whose subsidi subsidiary, ary, the the Denver Denver Publishin Publishing g Compa Company, ny, publish published ed the Rocky Mountain News, and the MediaNews Group, Inc., whose subsidiary, the Denver Post Corporation, published published the Denver Post. Under the proposed proposed joint operating agreement, agreement, printing and commercial operations of both newspapers were to be handled by a new entity, the “Denver Newspap Newspaper er Agency,” Agency,” owned owned by the the parties parties in equal equal share shares. s. This type type of of joint opera operating ting agree agreement ment provides provides for the complete complete independ independence ence of the news and editorial editorial departme departments nts of the two newspap newspapers. ers. The rationale rationale for such an arrangem arrangement, ent, as provided for under under the Newspape Newspaper r Preserva Preservation tion Act, Act, is to preserv preservee multiple multiple indepen independen dentt editorial editorial voices voices in towns towns and cities cities too too small small to support two or more newspapers. newspapers. The act requires joint joint operating arrangements, arrangements, such as that proposed proposed by the the Denver Denver newspape newspapers, rs, to obtain obtain the prior prior written written consent consent of the attorn attorney ey general 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 News would would probably probably fail without without such an arrangem arrangement. ent. In their petition petition to the Justice Justice Departme Department, nt, the newspape newspapers rs argued argued that the News News had sustaine sustained d $123 million in net operating 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 general must must find that one of the publicati publications ons is a failing failing newspape newspaperr and that approva approvall of the arrangement arrangement is necessary to maintain the independent independent editorial content of both newspapers. newspapers. Like any business, newspapers newspapers cannot survive without a respectable respectable bottom line. In commenting on the joint opera operating ting agreem agreement ent applica application, tion, Attorn Attorney ey Genera Generall Janet Janet Reno noted noted that that Denver Denver was was one of of only five major American American cities still served by competing competing daily newspapers. newspapers. The other four are Boston, Boston, Chicago, Chicago, New York, York, and Washingt Washington, on, DC. Of course, course, these other other four cities cities are not comparable comparable in size to Denver; they are much much bigger. None of those four four cities can lay claim to two newspapers newspapers that are more or less equally equally matched and strive for the same 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. Economi Economies es of scale in producti production on explain explain why few cities can support more than one local local newspa newspaper per.. Almost Almost all local newspa newspaper per producti production on and and distri distribut bution ion costs costs are fixed. fixed. Marginal Marginal productio production n and distribution distribution costs costs are almost nil. After After the local news stories stories and local advertising copy are written, there is practically no additional cost involved with expanding productio production n from, say, 200,000 200,000 to 300,000 300,000 newspape newspapers rs per day. Once a daily daily edition is produce produced, d, margi marginal nal costs costs may may be as little little as 5¢ per newspa newspaper per.. When When margi marginal nal product production ion costs costs are are minimal, price competition competition turns vicious. Whichever competitor 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. agreement. This is exactly exactly what happened happened in Denver. Until recently, 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 purchased on an annual subscription basis. basis. The smaller News had much higher unit costs and simply could not afford to compete with the Post at such ruinously low
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prices. prices. This is why the product production ion of local newspap newspapers ers is often describe described d as a classic classic example example of natural monopoly. On Friday, January 5, 2001, the Justice Department gave the green light to a 50-year joint opera operating ting agreem agreement ent betwee between n the News News and and its longtim longtimee rival, rival, the Post. Post. Starting Starting Janua January ry 22, 2001, 2001, the publish publishing ing operati operations ons of the News News and the Post were were conso consolid lidate ated. d. The The Denve Denver r Newspap Newspaper er Agency, Agency, owned 50/50 by the owners owners of the News and Post, Post, is now responsib responsible le for the advert advertisi ising, ng, circul circulati ation, on, produc productio tion, n, and other other busine business ss depar departm tment entss of the newspa newspaper pers. s. Newsroom Newsroomss and editorial editorial functions functions remain remain independent. independent. Therefore Therefore,, the owners of the News and Post are are now workin working g together together to achiev achievee financial financial succes success, s, but the newsroom newsroom operat operations ions remain remainss competit competitors. ors. Under Under terms of the agreeme agreement, nt, E.W. Scripps Company, Company, parent parent of the struggling struggling News, News, agreed agreed to pay pay owners owners of the Post $60 $60 million. million. Both newsp newspaper aperss publish publish separat separately ely Monday Monday through Friday. The News publishes 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 of this joint operating agreement. agreement. Use company company information to support your argument (see http://www.denverpost.com and http://www.rockymountain http://www.rockymountainnews.com/). news.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 garage sale. Use your knowledge knowledge of price discrimination to explain how local newspaper monopolies generate enormous profits from selling classified classified advertisi advertising ng that varies varies in price according according to the value value of the item advertised.
C.
Widely differing fares for business and vacation travelers on the same flight have led some some to accuse accuse the airlines airlines of price discrimin discrimination ation.. Do airline airline fare differenc differences es or local local newspape newspaperr classifiedclassified-ad ad rate differenc differences es provide provide stronger stronger evidence 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 proclaimed that that job losses losses and rate rate increases increases would not be be substantial. substantial. In fact, the company announced significant job cuts and steep rate increases in the period immediately immediately following following the start-up of the joint operating operating agreement. Prices for single single newspapers quickly jumped from 25¢ to 50¢daily, and from 50¢ to $1.50 on Sunday. Commens Commensura urate te increas increases es were were noted noted for long-t long-term erm subscr subscript iptions ions and adverti advertising sing customers. 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
Pricing Pricing Practi Practices ces
235
so incensed incensed that they they sued in in federal court. court. They lost. lost. In early early 2001, U. S. S. District 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 News and the Post, and and accused the papers of violating advertisers’ free speech speech rights by raising ad rates rates too high. Kane found no authority authority in support of the alleged alleged constitutional constitutional violation, violation, and the suit was dismissed. dismissed. Kane said antitrust antitrust laws prohibiting business monopolies don’t apply to newspapers in joint operating agreements. Post and the News also The circula circulatio tions ns of the Post the News also fell fell shar sharply ply afte afterr the two two newspapers newspapers introduced introduced sharp increases increases in subscription rates. rates. In the first two months News 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. percent. The News’ News’ Monday-through-Saturday circulation dropped from 446,465 to Post circulation 366,499, and Post circulation dropped from from 413,730 to 364,451. 364,451. Sunday circulation circulation News dropped from 552,085 to 448,032, and the Post’s Post’s Sunday circulation for the News 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 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 loca locall high high scho school ol foot footba ball ll game game turn turned ed out, out, they they typi typica call lly y can can only only find find that that information information in the local newspaper. newspaper. Similarly, Similarly, the local newspaper is frequently frequently the only place to go for local business advertising and classified ads. An inte intere rest stin ing g illu illust stra rati tion on of pric pricee disc discri rimi mina nati tion on can can be foun found d in the the classified-ad classified-ad pricing pricing policies of local newspapers. newspapers. The value of classified advertising 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, differences, customers 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. kittens. Local newspapers newspapers satisfy satisfy the requirements requirements necessary necessary for profitable profitable price discrimination, discrimination, because they can easily identify the value of the item adverti advertised sed and often enjoy a mon monopol opoly y position position in the sale of local advertis advertising ing.. 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 custome customers, rs, who can establi establish sh travel travel plans plans well well in advance advance and whose demand demand is typical typically ly more price elastic. elastic. However However,, before before concluding concluding that the higher prices prices charged charged busines businesss custome customers rs solely solely reflec reflectt price price discri discrimin minati ation, on, it is import important ant to
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recognize that the cost of serving business customers is greater than for vacation travelers. Business Business traffic is particularly particularly heavy on Mondays, and Fridays. This pattern pattern of business business travel often leaves airlines airlines with substantial substantial unused capacity on Tuesdays, Tuesdays, Wednesdays, Wednesdays, and Thursdays, Thursdays, as well as on Saturdays Saturdays and Sundays. Given this excess excess capacity capacity,, the increme incremental ntal cost cost per air travele travelerr can be substa substantia ntially lly lower lower during during midweek midweek and weekend periods. periods. Airlines Airlines are also better better able to schedule their use of airplane capacity when demand is predictable as opposed to erratic. This contributes to lower fares fares for restricted restricted as opposed to unrestricted unrestricted travelers. The price differentials differentials common common in airline airline rate rate struct structures ures clearl clearly y reflec reflectt the influenc influencee of cost cost differ difference ences, s, perhaps in addition addition to the the effects effects of price price discriminatio discrimination. n. 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. differences. Demand for want ad advertising 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 Commercial customer customer demand for want ad advertising is much more price elastic because commercial customers use flyers distributed door-todoor by independent contractors, local radio and television advertising to promote their products. products. As a result, result, the pricing practices practices of local newspaper newspaper advertising advertising clearly 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 SOLUTION P15A.1
Transfer Transfer Pricing. Simpson Flanders, Inc., is a Motor City-based manufacturer and distribut distributor or of valves used in nuclear nuclear power plants. plants. Currently Currently,, all output output is sold to North North American American custom customers. ers. Demand Demand and margi marginal nal revenue revenue curves curves for for the firm are as follows: follows:
P MR = ΔTR/ΔQ ΔTR/ΔQ
= $1,000 $1,000 - $0.015Q = $1,000 $1,000 - $0.03Q
Relevant Relevant total total cost, cost, margi marginal nal cost, cost, and and profit profit funct functions ions are are TC MC = ΔTC/ΔQ ΔTC/ΔQ π
= $1,50 1,500, 0,00 000 0 + $60 $600Q + $0. $0.00 005Q 5Q2 = $600 + $0.01Q $0.01Q = TR - TC = -$0.02Q2 + $400Q - $1,500,000
A.
Calculate the profit-maximizing activity level for Simpson Flanders when the firm is is operated operated as an integrated integrated unit.
B.
Assume Assume that that the company company is is reorgan reorganized ized into into two two independ independent ent profit profit cente centers rs with with the following cost conditions: TC Mfg = $1,250 $1,250,00 ,000 0 + $500Q $500Q + $0.00 $0.005Q 5Q2 MC Mfg = ΔTC Mfg /ΔQ =500 =500 + $0.01Q $0.01Q TC Distr = $250 $250,0 ,000 00 + $10 $100Q 0Q MC Distr = ΔTC Distr /ΔQ =$100. =$100. Calculate the transfer price that ensures a profit-maximizing level of profit for the firm, firm, with with divisi division onal al operat operation ion based based on the assum assumpti ption on that that all outpu output t produced produced is to be transfe transferred rred internall internally. y.
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C.
Now assume that a major major distributo distributorr in the European European market offers offers to buy as many valves as as Simpson Flanders Flanders wishes to offer at a price price of $645. No impact on demand from the company’s North American customers is expected, and current facilities can be used to supply supply both markets. Calculate the company’s company’s optimal price(s), output(s), and profits in this situation.
P15A.1
SOLUTION SOLUTION
A.
Profit maximization occurs at the point where MR = MC, so the optimal output level is: MR $1,000 - $0.03Q
= MC, = $600 + $0.01Q,
400
= 0.04Q,
Q
= 10,000.
P
= $1,000 - $0.015(10,000),
This implies:
= $850, π
= TR - TC, = -$0. -$0.02 02(1 (10, 0,00 000 02) + $400(10,000) - $1,500,000, = $500,00 ,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, $1,0 $1,000 00 - $0 $0.03Q .03Q - $100 $100
= $50 $500 + $0.0 $0.01Q 1Q,,
400
= 0.04Q,
Q
= 10,000.
Pricing Pricing Practi Practices ces
239
The 10,000-unit output level remains optimal for profit maximization, as must be the case. If the distribut distribution ion division division determine determiness the quantity quantity it will will purchas purchasee 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: is: PT
= MCMfg, = $50 $500 0 + $0.0 $0.01(1 1(10,0 0,000 00), ), = $600.
At a transfer price of $600, the quantity supplied by the manufacturing division equals 10,000. 10,000. Similar Similarly, ly, the quantit quantity y demande demanded d by the distribu distributio tion n divisi division on also also equals 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 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 the quantity demanded by the distribution division is: is: MR - MCDistr = PT, $1,000 - $0.03Q - $100
= $645,
255
= 0.03Q,
Q
= 8,500,
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Chapter 15
whereas the quantity supplied by the manufacturing division is: PT $645
= MCMfg, = $500 + $0.01Q,
145
= 0.01Q,
Q
= 14,500.
In this this instance instance of excess excess interna internall supply, supply, the distribu distributio tion n divisio division n will will purchas purchasee internally all units desired for the North American market, and Q NA = 8,500. 8,500. The optimal price for the North American market is: P NA
= $1,00 $1,000 0 - $0.01 $0.015(8 5(8,50 ,500) 0),, = $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
= TR NA + TR E - TCMfg - TCDistr , = $87 $872.50 2.50(8,5 (8,500) 00) + $645(6,0 $645(6,000) 00) -$1,2 -$1,250,0 50,000 00 - $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 $135,000 increase increase in profits profits,, from from $50 $500,00 0,000 0 to $635,000. $635,000. Notice Notice that the optimal optimal transfer price PT = $645 equates the marginal marginal cost of the each division to the marginal marginal revenue derived derived from each market. Given the separate separate nature of the North American and European markets, markets, the company is able to grow and profitably segment segment its market at the same time.
