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Managerial Tools from the
microeconomics
Miguel URDANOZ
10/10/2015
www.tbs-education.fr

## Pricing Strategies - BRICK7

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### Uniform pricing Price Discrimination:

First Degree Second Degree Third Degree

### Bundling Dynamic Price Discrimination

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Uniform pricing with market power

3

### Facing a downward sloping demand curve, a firm has a trade-off between

high-margin/small volume low-margin/large volume

### The price-sensitivity of consumers demand determines which of the two strategies is the optimal one

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Price-sensitivity of consumers (2)

4

Price p

D
1

p 0

p 1

q 0

q 1

Quantity q

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Price-sensitivity of consumers

5

Elasticity

Demand price elasticity is the ratio of a relative quantity variation to a relative price variation, in absolute value (i.e. an elasticity is always positive even if demand decreases with price)

= |(Q/Q) / (P/P)|

If the price relative variation is 1% (P/P = 1), the relative quantity variation is Q/Q %

If 0 < < 1, demand is inelastic: a price increase of 1% reduces the volume by less than 1%

If 1 < , demand is elastic and an increase in price by 1% reduces the volume sold by more than 1%

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Price-sensitivity of consumers (1)

6

Elasticity

Demand price elasticity is the ratio of a relative quantity variation to a relative price variation, in absolute value (i.e. an elasticity is always positive even if demand decreases with price)

= |(Q/Q) / (P/P)|

If the price relative variation is 1% (P/P = 1), the relative quantity variation is Q/Q %

If 0 < < 1, demand is inelastic: a price increase of 1% reduces the volume by less than 1%

If 1 < , demand is elastic and an increase in price by 1% reduces the volume sold by more than 1%

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

Price-sensitivity of consumers (2)
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Price p
p 0
∆p 1
p 1
∆q 1
D
1
q 0
q 1
Quantity q
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015

## Price-sensitivity of consumers (3)

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### With an inelastic demand, the strategy should be a high price (margin) With an elastic demand, the strategy should be volume (and a low margin) Elasticity is not constant: changes in time and over demand Other elasticities can be computed:

Cross-price: substitutes (+) or complements (-) Income: normal and inferior goods

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

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Author

Year of

Market

Price Elasticity

Publication

Short run

Long run

Behrens and

London-

Pels

2009

Paris

-0.41 -0.56

Wardman

2006

UK

-0.99

Ivaldi and

Cologne-

Vibes

2005

Berlin

-1.21 -1.29

Asteriou et al.

2005

UK

-0.18 -0.2

-0.7 -1.01

Van Vuuren et

2002

Netherland

-1.37

Rietveld Wardman et al.

1996

UK

-0.59

Goodwin et al.

1992

UK

-0.65 -0.79

-1.08

De Rus Ben-Akiva &

1990

Spain

-0.18 -0.41

Morikawa Owen and

1990

Netherland

-0.15 -1.50

Phillips

1987

UK

-0.69

-1.08

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## How to measure elasticity of demand

10

### Pricing experiments:

can only be conducted in certain markets characterized by relatively low demand with excess capacity

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Optimal uniform price of a firm with market power

11

### Average and marginal revenues

When increasing the price it charges, a firm with market power must integrate the reduction in volume and vice-versa

The marginal revenue of a price increase decomposes as a gain in price when increasing slightly the quantity, and a loss in volume

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

Optimal uniform price of a firm with
market power
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Price P
When lowering the price from P 0 to P 1 , a monopoly
looses (P 0 - P 1 ) x Q’, and gains P 1 x (Q 1 - Q 0 )
The revenue variation is equal to
∆R = P 1 x ∆Q - ∆P x Q 0
Relatively to the increase in quantity, the variation is
Decrease in
∆R / ∆Q = P 1 – (∆P / ∆Q ) x Q 0
< P 1
revenue
P
0
Demand
What is the variation of the cost of production,
relatively to a production increase? Price to fix?
∆P
P
Increase in
1
revenue
Q 0
Q 1
Quantity Q
∆Q
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
Optimal uniform price of a firm with
market power
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Price (€)
Marginal Revenue: “Twice as steep rule” applies
only for linear demand functions
Demand
100
Marginal revenue
When Marginal Revenue = 0, total revenue is at
its maximum level
>1 >1 >1 >1
=1
50
<1 <1 <1 <1
0
Quantity
5000
10000
(units)
0
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015

## MR vs MC

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### Marginal Revenue (MR):

Change in Total revenue given a one-unit (or marginal) change in quantity

### Marginal Cost (MC):

Change in Total cost given a one-unit (or marginal) change in quantity Is Marginal cost the same as average cost?

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

Optimal uniform price of a firm with
market power
15
Price (€)
As long as the additional revenue from selling an
extra unit exceed the extra cost of production of
this unit, the monopoly may earn a positive
additional profit on this unit …
The production (and market price) of a monopoly
100
Demand
must be such that the marginal revenue of its
production is equal to its marginal cost
Marginal revenue
55
M
M
P
MC
1
Monopoly’ Marginal cost
=
M
P
ε
10
0
Quantity
ε
M
M
4500
10000
(units)
P
=
MC
0
ε
− 1
“Monopoly” Equilibrium
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015

## Competitive pricing

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Price (€)

If at Q 0 price is over marginal cost, firms increase their production or new firms enter the market

Competitive Demand

Consider a very small change in production, say Q = 1 unit. To exhaust all gains from trade, ∆π /

100

Q = C / Q for Q = 1

P

0

P

1

Competitive Supply

10

0

Competitive Equilibrium

Quantity

Q 0

Q 1

9000

10,000

(units)

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Welfare

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### Inverse demand measures willingness to pay Consumer surplus: difference between willingness to pay and actual price paid Welfare: profit of the firm + consumer surplus Monopoly: Dead-weight loss Monopoly: Cost distortions Rent seeking behaviour

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Market power

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k

### = ∑

i = 1

s

i

Concentration Index

C

k

n

Herfindahl Hirshman Index: HHI

HHI

2

s

i

i = 1

### SSNIP test: Small but Significant and Non-transitory Increase in Price

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

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## Pricing strategies, Price and Non-price Discrimination

### How to price when the firm enjoys a large degree of market power?

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Introduction

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### Why?

Consumers are different: willingness to pay varies (price sensitivity) Some consumers receive a surplus with uniform pricing

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Requirements:

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### Instruments: different types of price discrimination Limits: No resale/arbitrage possibilities

Goods: taxes, transportation costs, law Services: train/air tickets

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Introduction

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### Example: Yield Management and the Airline industry

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Price Discrimination and Yield Management

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### Tourists vs. business travelers Offer discounts to early purchasers of tickets The danger of segmented pricing

Lower fare passengers may largely take the available inventory

### So, yield management system is used to adjust seat inventory (seat allocation among different price levels based on expected demand)

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## First degree (or perfect) price discrimination

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DEFINITION: Perfect price discrimination refers to a situation in which a seller

observes perfectly the characteristics of its customers and is able to taylor the tariff

specifically for each of them

DIRECT CONSEQUENCE: if buyers do not have any market power, it is possible to

extract the entire profit created by the purchase of the product from each of them

REAL LIFE EXAMPLES: Past/Present: Doctors in rural areas.

our purchases may allow us to get personal mail/email offers or

pay different prices.

HBR, October 2012 Getting Control of Big Data

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Two possible cases

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### Unitary demand per customer

Example: different hostel rates

### Multiple unit demand per customer:

Take it or leave it package Two part tariff (non linear pricing)

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## A simple example to fix ideas

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Producer P faces two customers, C 1 and C 2 and knows their demand

Customers behave competitively, and cannot resell the product to each other

Each customer has a demand that varies with price

V 1 (Q 1 ) = 100 – Q 1 and V 2 (Q 2 ) = 50 – Q 2

Unit cost of production of P is 10

IDEAL PRICES OF PRODUCER P ?

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

First Degree Price Discrimination
27
Price (€)
PARTICIPATION CONSTRAINTS:
Price (€)
Fee paid by C 1 lower than A 1 ,
50
Fee paid by C 2 lower than A 2
100
Max.
Fee A 2
10
Unit production cost of U
Max.
Fee A 1
Quantity
0
(units)
40
50
0
10
Unit production cost of U
0
Quantity
90
100
(units)
0
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015

## Third degree (or group) price discrimination

28

### Different groups pay different prices:

More price sensitive consumers pay a lower price

Less price sensitive consumers pay a higher price

### Examples of characteristics

age,

employment status (including student),

club membership, …

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Third degree price discrimination

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### Maximize profit for each group Examples:

Cinema

Zara

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
Iphone 5
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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015

## Example: Coca Cola

37

Coca-Cola announces that it is developing a "smart" vending machine. Such machines are able to change prices according to the outside temperature.

Suppose for the purposes of this problem that the temperature can be either "high" or "low". On days of

"high" temperature, demand is given by Q = 280 - 2p, where Q is the number of cans of Coke sold during the

day and p is the price per can measured in cents.

On

days of "low" temperature, demand is only Q = 160 - 2p. The marginal cost of a can of coke is 20 cents.

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Example: Coca Cola

38

Suppose that Coca-Cola installs a "smart" vending machine and thus is able to charge different prices for Coke on "hot" and "cold" days. What price should Coca-Cola charge on a "hot" day? What price should Coca-Cola charge on a "cold" day?

Alternatively, suppose that Coca-Cola continues to use its normal vending machines which must be programmed with a fixed price, independent of the weather. What is the optimal price for a can of Coke? Assume there are an equal number of days with "high" and "low" temperature.

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Example: Coca Cola

39

### Applied by Coca Cola in 1999

"A cynical ploy to exploit the thirst of faithful customers" (San Francisco Chronicle)

"Lunk-headed idea", (Honolulu Star-Bulletin) "Soda jerks" (Miami Herald)

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Welfare

40

### Intermediary goods markets: Robinson Patman Act

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## 2 ndDegree price discrimination

41

### Do we offer only one bundle? Offer a menu of bundles

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## 2 ndDegree price discrimination

42

A simple example to fix the ideas …

Producer P faces to customers, C

1

and C , knows it but cannot tell

2

whether any customer coming to the shop is high sensitive to prices or not

Customers behave competitively

Each customer has a demand that varies with price

V 1 (Q 1 ) = 100 – Q 1 and V 2 (Q 2 ) = 50 – Q 2

Unit cost of production of P is 10

IDEAL PRICES OF PRODUCER P ?

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

2 nd Degree price discrimination :
example
43
Price (€)
Price (€)
50
100
Max.
Fee A 2
10
Unit production cost of P
Max.
Fee A 1
Quantity
0
(units)
40
50
0
10
Unit production cost of P
0
Quantity
90
100
(units)
0
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
2 nd Degree price discrimination :
example
44
Price (€)
Under the tariffs offered in PP, T i (q)= A i +
Price (€)
Max. Fee
10 x q for any i=1,2. All customers would
paid by C 1
choose tariff T 2 (q). Anything better for the
50
producer?
100
Max.
Fee A 2
Min.
10
Unit production cost of U
payoff
Quantity
of C 1
0
(units)
40
50
0
10
Unit production cost of U
0
Quantity
90
100
(units)
0
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015

## 2 ndDegree price discrimination

45

### If the producer wants customer i to use the tariff tailored for himself, customer i must earn a larger payoff than if he chooses the tariff of customer j …

Known as the INCENTIVE COMPTABILITY CONSTRAINT

If customers incentives are not compatible with a firm’s objectives, then the firm will miss its goal

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## An example of possible tariff

46

### between participating or not (i.e. A 2maximal), set w 1=10 but leave him a positive payoff

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

An example of possible tariff
47
Price (€)
The loss accepted by P due to the increase
Price (€)
Max. Fee paid
by C 1 under T 2
in w 2 is compensated by the extra money
raised on C 1 . Net
gain = 150 € for P.
50
100
Max. Fee
Variable profit on C 2
A 2
20
Min. payoff
of C 1 under
10
Loss on C2 =
Quantity
(40 – 10) x
0
T 2
(units)
(20 –10)/2
30
50
0
as this
Gain for C 1 if he buys
20 = w 2
amount was
at w 1 =10 instead of w 2
10 = w 1
obtained in
= 20. How large A 1 ?
fee A 2 in the
0
Quantity
previous
80
90
100
(units)
0
tariff with
unit price w
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
= c for i=1,2

## Example: phone companies

48

Consider the good offered by the monopoly is a mobile phone, and that two contracts can be offered :

a contract with a small fee A 2 and a high per unit cost of communication w 2 (extreme form is Pay-As-You-Go with A 2 = 0 and w 2 large)

and a regular contract with a fixed fee A 1 (larger than 0 if the other contract is PAYG) and a smaller per unit cost of the communication minute w 1 closer to the unitary cost

The groups of consumers are talkative (group 1) and non- talkative (group 2) so that talkative is more valuable for the firm than non-talkative

You cannot force consumer to buy one contract or the other, you have to let them self-select (i.e. choose the one they prefer)

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Optimal tariffs

49

### Optimum:

Customer C 2 (low demand consumer) is charged his maximum willingness to pay

Customer C 1 (high demand consumer) is charged the highest price that makes him choose tariff 1 rather than tariff 2

### You need to design at most as many tariffs as groups of consumers

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Bundling

50

### A multi-product monopoly can use consumers preferences to sell bundles and extract more surplus

Homogeneous goods Heterogeneous goods

### Mixed Bundling: selling products as a bundle and individually

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Bundling

51

Assume 2 products, A and B, that can be separately sold at p A and p B , or together at p AB < p A + p B , with p AB > p A and p AB > p B

Consumers willingness to pay are v A , v B , or v A +v B Then depending on correlations between willingness to pay bundling will increase profits or not …

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Bundling

52

v

A

v

A

p A

Consumers
Consumers
only
and B
Consumers
Consumers
only

p A

Consumers
Consumers
only
and B
Consumers
B only

p B

v

B

p B

• v B

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Bundling

53

### Whether the gains exceed the looses depends on the distribution of valuations

If the masses of consumers are mostly on high v A and low v B (or the opposite), bundling is profitable

Roughly valuations must be negatively correlated

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

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An example: 2 consumers (Mr Pink and Mr Green) and 2 goods (A and B), valuations in the table

Without bundles, the firm is better off fixing p A = 7 (and sell to Mr Green) and p B = 8 (and sell to Mr Pink), raising 15 € of profit

A bundle priced at 9 can be sold twice, raises 18 In that case willingness to pay are negatively correlated

 A B Sum of valuations Mr Pink 3 8 11 Mr Green 7 2 9

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
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Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015

## Price discrimination: next step

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First 6 months subscription: 50% discount Which kind of price discrimination? Renewal of subscription: 35% discount

Why

decides to change the discount?

Which kind of price discrimination?

### Dynamic price discrimination

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Static versus dynamic analysis

58

### level of demand

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Future costs and strategies

59

### Future Costs: price today affects quantity today and this affects costs tomorrow

Learning by doing

### Strategies

Your price today gives information to the action of your competitor tomorrow

INFORMATION!

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Dynamic demand

60

### Price today affects demand today, and demand today structures demand tomorrow:

Durable goods Temporarily storable goods Experience goods Goods with network externalities: penetration pricing

### Prices today affects demand today and this gives information about your present and future demand

Behavior-based price discrimination

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Durable goods

61

### Book: Industrial Organization Rules!

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Durable goods

62

### Book: Industrial Organization Rules!

P

P 1

MR(Q)

c

Q 1

Q

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Durable goods

63

### Time 2

P

c

Q 1

Q

Residual Demand

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Durable goods

64

### Time 2

P

P 2

c

Q 1

Q 2

Q

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Intertemporal Price Discrimination

65

### Time 3, 4, 5…N

P

Q 1

Q 2

Q Q

3

Q 5

4

P

1

P

2

P

3

P

P

4

5

Q

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Intertemporal Price Discrimination

66

### Year 3, 4, 5…N

P

P

1

P

2

P N =c

Q 1

Q 2

Q N =Q c

Q

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Intertemporal Price Discrimination

67

### If you could start again from year 1, would you fix the same price?

Cream skimming or skimming pricing Ex. Movies: Cinema - DVD - Renting - TV

### “a durable goods monopolist has no monopoly power if the time between price adjustments is vanishingly small”

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Coase conjecture

68

### Boycott from 40% cinemas in UK and Ireland

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## How to recover market power:

69

### Contractual commitments: best price clause Leasing: problems New customers

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

2015

## Bundling and the law of large numbers

### A firm selling many products can extract consumer surplus if valuations for the different products are independent across products and consumers by:

Selling products at unit price close to the marginal costs Charging a fixed fee based on the average valuation across products

### Do you know examples of such behavior?

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

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Law of large Numbers
Law of Large Numbers: if
(
t
t
t
v
,
v
,
v
)
are the valuations of
1
2
n
consumer t for n products drawn independently from a
distribution with known mean
µ , then if n sufficiently
n
large
t
, is approximately equal to
n× µ
v
i
i = 1
The same applies to any customer as long as valuations
are independently drawn from the same distribution
Key idea: it is easier to predict consumer’s total surplus
than the consumer’s surplus derived from each product
Efficient outcome is approximately achieved and the
firm extract all the gains
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
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How does it works
Tariff system: two-parts tariffs
*
p
= c
*
F
=
n
*
µ
− ∑
i
i
n
i = 1
c
i
Warning: there exists a marginal cost for each
good higher than zero c>0 that makes bundling
result in lower profits and higher deadweight loss
than selling the goods separately
Case of correlated valuations: menu of tariffs
Analysis applies also to situations in which
consumers buy several units of each product
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
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