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This week

Monday Tuesday Wednesday Thursday Friday

Session 9 Review Quiz Session 10 –

Starts 8:45 Roxy case

(Answer survey by 1:30PM day of class)

P1 Sep–Oct 2012 • Timothy Van Zandt • Prices & Markets

Session 9 • How Pricing Depends on Demand Slide 1

Pricing with market power

(Sessions 1–6)

Firms are price-takers(Perfect competition)

Firms have market power(Imperfect competition)

(Sessions 7–11)

Individualdecisions

(Sessions 12–15)

Equilibrium



Review: elasticity and the sign of MR

• Where demand is elastic, MR>0 (higher output → more revenue)

• Where demand is inelastic, MR<0 (higher output → less revenue)

Never set price where demand is inelastic!

Better to raise price (produce less)!

Brings both lower cost and more revenue.



From a 2001 study on telecom privatization in Peru (1990s data)

service, indicating some degree of substitution between the two products. Based onthese estimates and deriving Equation 7 with regard to price, we can recover the priceelasticities of the demand for use for each of the three services under study (see Table11).

Table 11

City Services Elasticity

Lima 1/ Local -0.494

Domestic Long Distance -0.478

International Long Distance -1.095

Province2/

Local -0.689



1/ Lima M etropolitana's High, M edium, Low and Very Low SEL

2/ Cusco, Arequipa, Trujillo and Chiclayo's High and M edium SEL

Price Elasticities of the Use Demand

Table 11 shows that, use demand for local and domestic long-distance servicesare inelastic in the different cities of Peru. This result is consistent with many other

13



Review: elasticity of linear demand

On the next slide:

1. Mark the choke price.

2. Write the formula for elasticity of a linear demand curve.

3. What is the elasticity at P = 20 ?

4. Mark the regions on the curve where demand is inelastic and elastic.

5. Mark the points where demand is perfectly elastic, unit elastic, andperfectly inelastic.

6. Mark the point at which revenue is highest.



Review: elasticity of linear demand

5

10

15

20

25

30

50 100 150 200 250 300

P

Q



Elasticity and a shift in demand

This firm X competes mainly with one other firm Y .

Demand curve in previous figure is Q = 300 − 10P .= X ’s demand curve when firm Y ’s price is 25.

More generally, X ’s demand function is

Q = 100 − 10P + 8PY .

1. Which way does X ’s demand curve shift if Y lowers its price to 20?

2. Write out the formula for the new demand curve and graph it.

3. What is now the elasticity of X ’s demand at P = 20 ?

4. Is demand more or less elastic than when firm Y ’s price was 25?



Elasticity and a shift in demand

5

10

15

20

25

30

50 100 150 200 250 300

P

Q



Our intuition about elasticity

Telecom in Peru: In which market is demand more price sensitive:

the provinces or the capital city?

Demand is typically more elastic for people with lowerincome.



From a 2001 study on telecom privatization in Peru (1990s data)

service, indicating some degree of substitution between the two products. Based onthese estimates and deriving Equation 7 with regard to price, we can recover the priceelasticities of the demand for use for each of the three services under study (see Table11).

Table 11

City Services Elasticity

Lima 1/ Local -0.494



Province2/

Local -0.689



1/ Lima M etropolitana's High, M edium, Low and Very Low SEL

2/ Cusco, Arequipa, Trujillo and Chiclayo's High and M edium SEL

Price Elasticities of the Use Demand

Table 11 shows that, use demand for local and domestic long-distance servicesare inelastic in the different cities of Peru. This result is consistent with many other

13



More intuition about elasticity

1. The more close substitutes a good has, the elastic is demand.

2. ⇒ Demand for a particular brand (Samsung) or type ( 23′′ flat panel) iselastic than demand for the entire category (computer

displays).

3. ⇒ The more differentiated the brand, the elastic is demand.

4. ⇒ Advertising usually both increases demand and makes itelastic.

5. When a product’s close substitutes become more expensive, demand forthe product becomes elastic.



Elasticity of demand for some cars in USA (1980s data)

Model Elasticity

Mazda 323 6.3

Honda Accord 4.8

Nissan Maxima 4.8

Nissan Sentra 6.5

Ford Taurus 4.2

Ford Escort 6.0

Lexus LS400 3.0

Chevrolet Cavalier 6.4

Cadillac Seville 3.9

BMW 735i 3.5

But for entire category: 0.8



Session 9: How demand affects pricing

1.✓ Review of elasticity.

2.➥ How a shift in demand affects pricing

3. Applications



Price after a shift in demand: perfect competition

30

60

90

3000 6000 9000

€

Q

d (P )

s(P )

�

�

dnew(P )

Change in price is due entirely to increasing marginal costs(of existing firms, of new entrants, or of scarce inputs).



But for a firm with market power?

5

10

15

20

25

20 40 60 80 100 120 140 160

Q

$

d (P )

MCPπ

Qπ MR

Pricing reflects both marginal cost and a markup over MC.



From last class, variants of the same equation

Less elastic demand ⇒ markup is a larger fraction of P

P − MC =

(1E

)P

Less elastic demand ⇒ markup is greater multiple of MC

P − MC =

(1

E − 1

)MC



So, with constant MC, if demand becomes …

… less elastic at each price, then the firm should raise its price.

This is called the “price-sensitivity” effect.



For which demand curve do you charge a higher price?

(Assume constant MC .)

2

4

6

8

10

12

14

16

18

2 4 6 8 10 12 14 16 18Q

P

d1 (P ) 2

4

6

8

10

12

14

16

18

2 4 6 8 10 12 14 16 18Q

P

d2 (P )



MR, the markup, and elasticity

Starting at P = 8 , for which demand curve is MR smaller?

2

4

6

8

10

12

14

16

18

2 4 6 8 10 12 14 16 18Q

P

d1 (P ) 2

4

6

8

10

12

14

16

18

2 4 6 8 10 12 14 16 18Q

P

d2 (P )



At a price P : E2 < E1 implies MR2 < MR1

MR = P +dPdQ

× Q or MR = P(

1 − 1E

)

2

4

6

8

10

12

14

16

18

2 4 6 8 10 12 14 16 18Q

P

d1 (P ) 2

4

6

8

10

12

14

16

18

2 4 6 8 10 12 14 16 18Q

P

d2 (P )





1

2

3

4

5

1 2 3 4 5 6 7Q

P

d2 (P )

d1 (P )





1

2

3

4

5

1 2 3 4 5 6 7

d1 (P )

d2 (P )

Q

P



So what happens to price after a shift in demand?

(Price-sensitivity effect)

If demand becomes less elastic, the firm will increase its markupover MC , which also feeds into higher prices.

But there is another effect if MC is not constant …

(Volume effect)

If the MC curve is increasing and the firm increases output,then the resulting higher marginal cost feeds into higher prices.

These two effects will often be intertwined.



Isolating the two effects

To isolate the price sensitivity effect, we assumed constant MC.

To isolate the volume effect,consider an increase in demand that does not change the elasticity.

Then:

If a firm has increasing marginal cost and the volume of demandgoes up, the firm should raise its price.




(Assume increasing MC .)

1

2

3

4

5

1 2 3 4 5 6 7

d1 (P )

d2 (P )

Q

P





2.✓ How a shift in demand affects pricing

3.➥ Applications



Peak-load pricing

Thirty

300ml

5.00

7.00

9.00

11.00

9.00

12pm - 3pm

3pm - 6pm

6pm - 8pm

8pm - 11pm

11pm - close

Fifty

500ml

6.00

9.00

12.00

15.00

12.00

Jug

1400ml

14.00

22.00

29.00

37.00

29.00

Tower

4000ml

82.00

82.00

82.00

82.00

82.00

Golden Ale, Pilsner, Darkside Lager,American Pale Ale & Kölsch



Exercise 9.2

Evaluate this statement:

“After an advertising campaign, the cost of the advertising is sunk.Hence, the advertising campaign should have no effect on thefirm’s pricing strategy.”



The price of a substitute good rises. What do you do?

1

2

3

4

5

1 2 3 4 5 6 7

d (P )

Q

P



What happened to airline prices just after September 11, 2001?

Airlines Hold Back on Expected Fare BonanzaBy Laurence Zuckerman and Joe Sharkey

New York Times Service

Despite a decline of as much as 50 percent in passenger traffic, major airlines have been reluctant to lower fares drastically after the terrorist attacks in the United States.

Some bargains are being offered online by travel whole-salers and by small carriers, but the large fare sales that many analysts predicted have not materialized.

The reason, airline executives said, is that fares had been discounted heavily before the attacks to try to counter an industry slowdown. But since the attacks, which involved four hijacked planes, many airlines are convinced that people are not ready to return to the skies at any price.

“Emotions are so high today that even a $99 coast-to-coast fare wouldn't do anything,” said an executive at a major carrier who spoke on the condition of anonymity. “People need a few weeks to realize that we are not being attacked on a daily basis.”

The major carriers have begun carrying out the 20 percent reductions in their schedules, which were announced last week to trim costs and to match reduced demand. Some are culling routes that were unprofitable before this month, or replacing large jets with smaller regional jets. But most are simply reducing the number of flights on existing routes.

For example, both Delta Air Lines and US Airways have reduced their hourly shuttles from Boston to New York, which totaled as many as 17 flights a day, to just four flights a day each.

Many airline executives and analysts acknowledged that they are guessing about the future because no one can be sure when airline traffic will return, particularly the lucrative business travel market, and at what level. The Air Transport Association, the industry's trade group, predicted that industry sales will be down 40 percent during the fourth quarter.

But Samuel Buttrick, an airline analyst at UBS Warburg in New York, said he thought the number would be closer to 25 percent.

“The industry has little insight into what revenues will be in November and December, as do we,” he said.

The major airlines routinely decline to comment on future fares because of past allegations that they breached antitrust laws by signaling their pricing plans to competitors.

But leisure fares “are totally unpredictable” said Alyse Ticker, the manager of Equinox Travel in Manhasset, New York. “The airlines are scrambling. They're falling over themselves” to entice customers back, she said.

Many bargains are being offered quietly by Southwest Airlines and other aggressive low-fare carriers in markets away from the major hubs. Last week, one small carrier, National Airlines, which has about 50 flights a day, began offering round-trip fares as low as $25 between Las Vegas and San Francisco and Los Angeles, or $75 between New York City and Las Vegas.

The major airlines have been cutting some fares on selected routes, often in response to their low-fare competitors. But they also are keeping a low profile about it.

“They're not advcrtising thcm,” said Tom Parsons, thc president of Bestfares.com, an online travel site that spe-cializes in booking discount fares. “They're just loading them into the computer reservations systems. They're really hoping to avoid starting a major fare war” that might spread competitively to the most lucrative business-travel routes from major hubs like New York, Chicago and Dallas.

International Herald Tribune

26 September 2001, Page 2



Sometimes intuition isn’t right

“Apple Slips as Result of Hoarding Chips” WSJ, 30 Jan 1989

Apple Computer, which stockpiled hundreds of millions of dollars worth of precious memorychips during the height of a chip shortage last summer, said Friday that its strategy hadbackfired, and that as a result profit in its current quarter will fall by as much as 43%.

Apple’s cost of memory is $120 higher than current spot prices on a basic model and $480higher on a fully loaded machine.

The purchasing blunder was the first misstep in what Apple’s chairman and chief executiveoffice, John Sculley, concedes as “a series of internal management and marketing decisionsthat, in hindsight, weren’t very good decisions.” Subsequent price increases aimed at shoringup profit margins squeezed by the expensive memory chips boomeranged, as customers anddealers instead bought stripped-down models of Apple’s big-selling Macintosh computers andoutfitted them with less-expensive additional memory chips and add-ons from other suppliers.

Apple’s misguided price increases after buying the expensive DRAMS might have permanentlyharmed its future sales of fully loaded computers.

Deborah A. Coleman, the former chief financial officer, proposed raising prices across theboard last fall. She is currently on leave … and will return in July in a lesser role.





2.✓ How a shift in demand affects pricing

3.✓ Applications



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