Chapter 12 - Pricing and Advertising

Sunday, March 16, 2025 12:53 PM

imagine you own a business, and you’re trying to figure out how to price your
product. You could set one price for everyone—that’s called uniform pricing. It’s
✅ Uniform Pricing: Charging everyone the same price
simple, but it doesn’t always maximize your profits. Why? Because some customers
(simple but less profitable).
would’ve been willing to pay more, while others might have bought if the price was
✅ Nonuniform Pricing: Adjusting prices based on
just a little lower.
customers or purchase quantity.
That’s where nonuniform pricing comes in. Instead of charging everyone the same
price, you adjust prices based on who the customer is or how much they’re buying. ✅ Price Discrimination: Charging different prices for the
Think about airline tickets. If you book months in advance, the price is much lower. same product based on customer characteristics (e.g.,
But if you try to book last-minute, the price shoots up. Why? Because airlines know student discounts, early bird airline tickets).
business travelers usually buy tickets at the last minute and are willing to pay more. ✅ Two-Part Pricing: Charging a fixed fee + per-unit price
On the other hand, vacationers are price-sensitive, so they book early to get a better (e.g., gym memberships).
deal. ✅ Bundling: Selling multiple products together at a
Another example—have you ever seen a student discount at a store? That’s price discounted price (e.g., meal combos).
discrimination! The store knows students don’t have a lot of money, so they offer ✅ Firms use these strategies to increase profits by
lower prices to get them to buy. But regular customers, who can afford more, still capturing more consumer surplus.
pay the full price.
Now, companies don’t just stop at charging different prices—they get creative.
Some use two-part pricing, where they charge you an entry fee and then a price for
each unit you buy. Think of a gym: you pay a monthly membership fee, and then
maybe extra for personal training sessions.
Then there’s bundling, where businesses package multiple things together for a
single price. Ever noticed how fast-food restaurants sell “combo meals” that are
cheaper than buying each item separately? That’s bundling in action!
Why do companies do all of this? Simple: to make more money. If they only set one
price, they leave money on the table—some customers would’ve paid more, while
others wouldn’t have bought at all. By adjusting prices, they capture more of the
market and increase profits.

12.1 conditions for price discrimination

three conditions that must be met for a firm to successfully price discriminate:
1. Market Power:
○ The firm must have control over pricing, meaning it cannot be in a
perfectly competitive market.
○ Monopolies, oligopolies, and firms in monopolistic competition can price
discriminate, but perfectly competitive firms cannot.
2. Ability to Segment the Market:
○ Consumers must have different price sensitivities (elasticities of
demand).
○ The firm must be able to identify these different groups.
○ Example: Movie theaters charging lower prices for students and seniors
because they are more price-sensitive than working adults.
3. Prevention of Resale:
○ Firms must ensure that consumers paying a lower price cannot resell to
those who would pay a higher price.
○ Methods include:
▪ Requiring identification (e.g., student ID for discounts).
▪ Limiting purchases (e.g., luxury handbag brands restricting sales to
prevent international arbitrage).
▪ Vertical integration (e.g., Alcoa producing its own aluminum wire
to prevent resellers from undercutting its pricing strategy).
▪ Government assistance (e.g., tariffs and trade laws that prevent
reselling across borders).

Imagine you own a coffee shop, and you realize that different customers are willing to pay
different prices for the same coffee. Your goal? Make as much money as possible! But you can’t
just charge everyone different prices randomly—you need to follow some rules.
Rule #1: You Need Market Power
You can’t do price discrimination if you’re in a super competitive market where everyone is
selling the exact same thing. Think about a street where there are 10 coffee shops, all selling the
same cappuccino. If you try to charge one group more than another, they’ll just go next door and
get it cheaper.
But let’s say you’re the only café in town, or you sell a special blend that no one else has—now
you have market power. You can start experimenting with prices.
Rule #2: You Need to Separate Your Customers
Not everyone values your coffee the same way. A busy office worker might not care if they pay
$5 for a cup, but a student on a budget will think twice.
So you might offer a student discount. That way, students get a lower price, but businesspeople
still pay full price. The key is that you have to identify who’s willing to pay more and who isn’t.
Rule #3: You Have to Prevent Reselling
This is a big one! If you charge students $3 for coffee and office workers $5, what’s stopping
students from buying extra and selling them to office workers for $4? Now you’re losing money!
To stop this, you make students show their student ID at checkout. That way, they can’t just buy
and resell to someone else.
Companies do this all the time! Airlines ask for proof when selling discounted tickets to seniors,
and software companies prevent reselling by linking software to a single email account.

Key Takeaways
1. You need market power → If too many competitors sell the same product, you can’t
charge different prices.
2. You must be able to separate customers → Some people are willing to pay more than

New Section 1 Page 1

 2. You must be able to separate customers → Some people are willing to pay more than
others, and you need a way to tell them apart.
3. You must prevent reselling → If customers can buy low and sell high, your strategy falls
apart.

Not all price differences are price discrimination. Sometimes, a business charges different prices
because of actual cost differences, not because they’re trying to squeeze more money out of
different types of customers. For example, hotels charging honeymooners more might not be price
discrimination if newlyweds tend to steal more stuff, increasing costs. Similarly, a magazine
charging more at a newsstand than for a subscription isn’t necessarily price discrimination—it just
costs more to distribute that way. But offering students a cheaper subscription is price
discrimination because the product is identical, and the only difference is the price.
Three Types of Price Discrimination:
1. Perfect Price Discrimination (First-Degree)
○ This is the dream scenario for businesses (and a nightmare for customers). The firm
charges each customer the maximum they’re willing to pay for every unit they buy.
○ Example: An airline knowing exactly how much you personally would pay for a ticket
and charging you that amount instead of a fixed price.
2. Group Price Discrimination (Third-Degree)
○ The business divides customers into groups and charges different prices to each group,
but everyone in the same group pays the same price.
○ Example: Movie theaters charging different prices for students, seniors, and regular
adults.
3. Nonlinear Price Discrimination (Second-Degree)
○ Here, the price changes based on how much you buy, but everyone buying the same
quantity pays the same price.
○ Example: Bulk discounts—if you buy one soda, it’s $2, but if you buy a 6-pack, it’s $9
($1.50 per soda).
Key Takeaways:
✅ Price discrimination isn’t just charging different prices—it’s charging different prices for the
same product to different people or groups, without cost differences justifying it.
✅ There are three types:
• First-degree: Charging everyone exactly what they’re willing to pay.
• Third-degree: Charging different groups different prices.
• Second-degree: Charging different prices based on the quantity purchased.
✅ Group price discrimination is the most common, which is why people often just call it
"price discrimination" in general.

12.2 Perfect price discrimination

Reservation Price and Perfect Price Discrimination:

• A reservation price is the maximum someone is willing to pay for a product or service. 1. Reservation Price
• If a company has market power (like a monopoly), knows exactly how much every individual is willing to pay, and can This is basically the maximum amount someone is willing to pay for
prevent resale, it can charge each customer their reservation price. This is perfect price discrimination. something. Think of it like your personal limit on spending. For example, if
• When a firm does this, it captures all consumer surplus—meaning consumers don’t get any extra benefit. The firm takes you’re buying concert tickets and you’d never pay more than $100, then
it all. $100 is your reservation price.
• Example: The Suez Canal managers adjust tolls based on factors like weather and a ship’s alternative routes. That’s a
form of personalized pricing.
2. Perfect Price Discrimination
This is when a company knows exactly how much you’re willing to pay and
Why Perfect Price Discrimination is Rare: charges you that exact amount. So you get zero deals or savings. Imagine if
• It's rare because firms usually don’t know exactly how much every customer will pay. your favorite coffee shop knew you’d pay $8 for a latte and charged you $8,
• But it’s a useful concept because it shows the most efficient way price discrimination could work and acts as a while they only charged someone else $5 because that’s their limit. That’s
benchmark to compare other pricing strategies. perfect price discrimination in action!

How a Firm Does It (Perfect Price Discrimination in Action): 3. Market Power

• Imagine a monopoly that knows each customer’s reservation price and can block resale. Market power means a company can set prices without losing customers.
• The firm sells each unit at the highest price someone is willing to pay. It’s like climbing down the demand curve—first They don’t have to follow what everyone else is charging because they have
unit for $6, second for $5, third for $4, and so on. something special (think Apple with iPhones or a monopoly utility
• Marginal revenue (MR) for each unit is the same as the price they sell it for. company).
• If their marginal cost (MC) is $3 per unit, they’ll stop selling when MR = MC, which in this case is at 4 units.
• Profit is calculated by total revenue minus total cost. In this example, they make $18 revenue, $12 costs, so $6 profit.
4. Consumer Surplus
This is the “feel-good” gap between what you’re willing to pay and what
Real-Life Example - Google Ads: you actually pay. If you would have paid $100 for those concert tickets but
• Google uses auctions for ad space. Businesses bid for spots next to search results. got them for $70, you feel like you saved $30. That $30 is your consumer
• Ads are targeted. A lawyer specializing in toxic mold can reach exactly the right people. No “wasted eyeballs” like TV or surplus.
print ads.
• Lawyers pay more when it’s harder to find clients. For instance, personal injury lawyers pay more in states where direct
contact is restricted after an accident. 5. Marginal Revenue Curve
• Google is basically price discriminating, tailoring prices based on advertisers’ willingness to pay. This shows how much extra money the company makes from selling one
more unit. In perfect price discrimination, this marginal revenue line is the
same as the demand curve because they get the most they can from each
Efficiency & Who Wins: person.
• Perfect price discrimination is efficient: it maximizes total surplus (combined consumer + producer surplus).
• But! The entire surplus goes to the firm. Consumers get nothing.
• In perfect competition, consumers and producers share the surplus. 6. Marginal Cost
How much it costs a company to make one more item. If it costs $3 to make
one more latte, that’s the marginal cost. A smart company sells more lattes
Different Market Outcomes: only if they make more money than it costs to make them.
1. Competitive Market:
○ Price = marginal cost (MC).
○ Consumers get a lot of surplus. 7. Deadweight Loss
○ No deadweight loss (no wasted opportunity). This is the wasted opportunity when stuff doesn’t get sold because prices

New Section 1 Page 2

 one more latte, that’s the marginal cost. A smart company sells more lattes
Different Market Outcomes: only if they make more money than it costs to make them.
1. Competitive Market:
○ Price = marginal cost (MC).
○ Consumers get a lot of surplus. 7. Deadweight Loss
○ No deadweight loss (no wasted opportunity). This is the wasted opportunity when stuff doesn’t get sold because prices
2. Single-Price Monopoly: are too high. In monopoly pricing, people who would have bought the
○ Charges one price for everyone. product at a lower price don’t get to. That loss in total welfare is
○ Less is sold compared to competition. deadweight loss. It’s like extra seats at a concert going empty because
○ There’s deadweight loss (lost surplus that neither side gets). tickets were overpriced.
○ Consumers keep some surplus.
3. Perfect Price Discrimination: 8. Efficiency
○ Everyone pays their reservation price. This is when resources are used in the best way possible—no waste, no
○ Firm gets all the surplus. missed opportunities. Perfect competition and perfect price discrimination
○ No deadweight loss, but consumers get nothing. are both efficient because they maximize the total benefit (but under
perfect price discrimination, the company keeps it all).
Who’s Better Off?
• Consumers do best in competition. 9. Single-Price Monopoly
• Some consumers do better under single-price monopoly because they still get a bit of surplus. This is when the company charges everyone the same price, regardless of
• Consumers do worst under perfect price discrimination—no surplus left for them. how much you might have been willing to pay. Like movie tickets costing
$10 for everyone, even if some folks would’ve paid $20 and others only $5.
Botox Example:
• Allergan (the company selling Botox): 10. Perfect Competition
○ If competitive, price = $25, big consumer surplus. In this dreamy world, there are lots of sellers and buyers, and no one
○ As a single-price monopoly, sells at $400 per vial, less surplus for consumers, some deadweight loss. controls the price. Prices are low, everyone pays the same, and consumer
○ If it could perfectly price discriminate, it could double its profit. Consumers get no surplus, but no deadweight surplus is high because the price equals marginal cost.
loss.
• In numbers: 11. Group Price Discrimination
○ Competition: Consumer surplus = $750M, Producer surplus = $0, Total welfare = $750M. This is when companies split people into groups based on something like
○ Single-price monopoly: CS = $187.5M, PS = $375M, Deadweight loss = $187.5M. age or student status and charge different prices. Think student discounts
○ Perfect price discrimination: CS = $0, PS = $750M, No deadweight loss. or senior prices at the movies. They don’t know your exact reservation
price, but they’re making educated guesses by grouping.
Movie Theater Example (Solved Problem 12.1):
• Panel A: Theater sells 30 tickets at $5. 12. Nonlinear Price Discrimination
○ Seniors pay $5, college students have reservation prices of $10 (so they get $50 in consumer surplus). This is about offering different prices based on how much you buy. Think
○ Firm makes $150 in profit. “buy one, get one 50% off” or bulk discounts at Costco. The price per unit
○ Welfare = $200 (profit + consumer surplus). changes depending on how many you buy.
• With perfect price discrimination, no consumer surplus, but firm profit = $200. Same welfare.
• Panel B: Single price of $10.
○ Only college students attend.
○ Firm makes $100, no CS.
• With perfect price discrimination, profit rises to $125, no CS.
○ Welfare improves because output increased (more tickets sold).

Transaction Costs Get in the Way:

• It’s expensive and hard to collect data on everyone’s reservation price.
• But tech improvements are making it easier (think airlines, hotels, car rentals adjusting prices in real time).
• Private colleges often come close to perfect price discrimination by using financial aid as a way to charge different
students different prices.

Key Points Summary:

1. Perfect Price Discrimination:
○ Charges each person exactly what they’re willing to pay.
○ Firm captures all consumer surplus.
○ Efficient, but consumers lose out.
2. Efficiency Comparison:
○ Perfect competition: Consumer + producer share surplus.
○ Single-price monopoly: Firm gets more, consumers get less, deadweight loss exists.
○ Perfect price discrimination: Firm gets everything, no deadweight loss, consumers get nothing.
3. Real-World Examples:
○ Google Ads: Auctions and targeting = modern price discrimination.
○ Botox: More profit if Allergan could price discriminate perfectly.
○ Movie theater: Welfare increases if more people are served with price discrimination.
4. Challenges:
○ High transaction costs make perfect price discrimination tough.
○ Technology is lowering these barriers (e.g., airlines, colleges)

12.3 Group price discrimination

Group Price Discrimination (aka 3rd Degree Price Discrimination)

So, here’s the deal: Most companies can’t figure out the exact maximum price each customer is willing to pay
(that’s called their reservation price). But what they can often figure out is which groups of people are
generally willing to pay more or less.
For example:
• Students and seniors usually have tighter budgets, so businesses often charge them less.
• People in different countries might be willing to pay more or less depending on income levels, tastes, or
other factors.
When a company splits customers into groups and charges each group a different price, that’s Group Price
Discrimination.

Key Conditions for This to Work

For a firm to successfully pull this off, they need to:
1. Have market power – They can’t be in a super competitive market where prices are driven down to
costs.
2. Be able to separate groups clearly – Like asking for an ID to prove you’re a senior or a student.

New Section 1 Page 3

 2. Be able to separate groups clearly – Like asking for an ID to prove you’re a senior or a student.
3. Prevent resale – Otherwise, the cheap group could just buy and resell to the expensive group.

Example: Movie Theaters

• They charge seniors less because seniors aren’t willing to pay as much as younger adults.
• They check your ID when you buy the ticket, which stops you from reselling it to someone else.

Warner Bros & Harry Potter DVDs

Warner Bros had the legal right (thanks to copyright laws) to sell Harry Potter DVDs, and they charged
different prices in different countries.
• In the U.S., the DVD sold for $29, and they sold 5.8 million copies.
• In the U.K., it sold for $39 (which is about £25), and they sold 2 million copies.
They could do this because the DVDs for each country had different formats, which made resale pretty much
impossible.

How Warner Set Their Prices

They wanted to maximize profits in each country, so they did this:
• Checked how many DVDs they could sell at different prices in each country (based on demand curves).
• Their cost of making a DVD was $1 everywhere.
• They kept raising prices up to the point where marginal revenue (extra revenue from selling one more
DVD) equaled marginal cost ($1).
In the U.S.:
• They sold 5.8 million DVDs at $29.
In the U.K.:
• They sold 2 million DVDs at $39.
Key Rule: They equated marginal revenue (MR) to marginal cost (MC) in each country:

ini
CopyEdit
MRA = MC = MRB
Which basically means: “We’re making the most money we can without overpricing or underpricing.”

Elasticity Stuff (How Sensitive People Are to Price)

Warner figured that:
• U.S. customers were a little more sensitive to price changes (their demand was more elastic).
• British customers were less sensitive (more inelastic), so they were okay paying more.
This is why:
• British folks paid 34% more than Americans.
Later on, Amazon dropped prices everywhere (like to $7 in the U.S. and $9.50 in the U.K.), but they still kept
the U.K. price higher by about the same percentage. Old habits die hard!

Reselling Textbooks Example

Here’s a fun story:
• A Thai student named Supap Kirtsaeng was studying in the U.S.
• He noticed textbooks were way cheaper in Thailand.
• He had his friends ship him books, and he resold them in the U.S. for a nice profit—he made hundreds
of thousands!
But the publisher, Wiley, got mad and sued him for copyright infringement. After a legal battle, the U.S.
Supreme Court ruled in 2013 that the First-Sale Doctrine applied—meaning once you buy something, you can
resell it. So Kirtsaeng won.
Impact?
• It got harder for publishers to keep big price gaps between countries.
• If people can resell easily, prices tend to level out across countries.
• Publishers might respond by making the books way different in each country or moving to digital
rentals (no reselling possible!).

Monopoly Example: Selling a Novel in 2 Countries

Let’s say a publisher sells a novel in:
• Country 1: Demand curve is p1 = 6 - 0.5Q1
• Country 2: Demand curve is p2 = 9 - Q2
• Cost per book = $1
If Resale is Banned (Price Discrimination Possible):
• Country 1:
○ Find where MR = MC
○ MR curve: MR1 = 6 - Q1
○ Set MR1 = 1 → Q1 = 5
○ Plug into demand: p1 = 6 - 0.5(5) = 3.5
• Country 2:
○ MR curve: MR2 = 9 - 2Q2
○ Set MR2 = 1 → Q2 = 4
○ Plug into demand: p2 = 9 - 4 = 5
So, they charge $3.50 in Country 1 and $5 in Country 2.
If Resale is Allowed (Single Price):
• Combine both countries’ demand curves.
• Price discrimination isn’t possible, so they pick a single price.
• After some math (which we can totally dig into if you want), they’d charge $4 and sell 9 books total.
This price is between the two separate prices from before.

The Big Picture

• Group Price Discrimination works when companies can separate groups and prevent resale.
• Prices depend on how sensitive each group is to price.
• If people can resell, prices tend to equalize.
• Digital goods and rentals are making it easier for companies to control resale and keep price
differences.

This excerpt lays out group price discrimination—where firms segment consumers based on characteristics
or behaviors and charge different prices. Let's break down the key ideas, then I can help summarize or

New Section 1 Page 4

or behaviors and charge different prices. Let's break down the key ideas, then I can help summarize or
clarify anything you want.
Two Main Ways Firms Segment Consumers:
1. Observable Characteristics
○ Age (e.g., cheaper movie tickets for kids and seniors).
○ Geography (e.g., Windows 8 Pro sold at very different prices worldwide—US: $95, UK: $125,
France: $70, Japan: $77).
2. Consumer Behavior (Self-Selection)
○ Consumers reveal how price-sensitive they are by their actions (e.g., waiting in line, clipping
coupons, booking early).

Examples of Behavioral-Based Price Discrimination:

• Coupons: People willing to spend time clipping coupons are likely more price-sensitive.
○ E.g., 2009 study: 20 minutes per week could save $1,000 a year.
○ Shift to digital coupons lowered the "cost" (time/effort) of coupon use, so more people use
them.
• Airline Tickets:
○ Business travelers = less price-sensitive, often book late, pay higher prices.
○ Vacationers = more price-sensitive, book early, get cheaper fares.
• Reverse Auctions (e.g., Priceline):
○ Price-sensitive consumers bid low and accept restrictions (e.g., odd flight times, multiple
connections).
• Rebates:
○ Requires effort to claim.
○ Those who value money over time are more likely to apply for rebates.

Welfare Effects of Group Price Discrimination:

• Compared to perfect competition:
○ Consumer surplus and output are lower.
○ Firms gain profit by capturing consumer surplus.
○ There’s a deadweight loss (inefficiency).
• Compared to a single-price monopoly:
○ Welfare could be higher or lower.
○ If discrimination results in higher output, welfare may increase.
○ If output decreases, total surplus falls.

Key Takeaways:
• Firms try to extract more profit by targeting groups with different price sensitivities.
• Price discrimination can sometimes increase output and welfare, but usually reduces consumer
surplus.
• The closer a firm gets to perfect price discrimination, the less inefficiency, but consumer surplus
keeps shrinking.

12.4 Nonlinear price discrimination

This section dives into Nonlinear Price Discrimination, also called second-degree price discrimination or
quantity discrimination. It's all about charging different prices based on the quantity purchased, rather
than who the customer is. Here's the breakdown:

What is Nonlinear Price Discrimination?

• Firms don’t know exactly who is willing to pay more.
• But they do know that most customers:
○ Will pay more for their first unit.
○ Will only buy more if the price drops for additional units.
• So, the price varies with the quantity purchased (hence nonlinear).
Key:
• Same pricing schedule for everyone, but customers self-select how much they buy at each price
level.
• Firm must have market power (to set prices above marginal cost) and prevent resale between
consumers.

Real-Life Example: V8 Juice

• 64 oz. bottle: $4.39 → 6.8¢ per oz.
• 12 oz. bottle: $2.79 → 23¢ per oz.
• Larger buyers get a discounted price per unit. This is quantity discrimination—unless the price
difference is due to actual cost savings (like packaging or service costs).

Block Pricing (A Common Nonlinear Strategy)

• Prices are charged per block of units purchased.
• Declining-Block Pricing: Price decreases after a certain quantity (common for utilities: electricity,
water, gas).
• Increasing-Block Pricing: Price increases after a certain threshold (used to discourage overuse, like
water in droughts).

Figure 12.4 Example:

(Imagine two scenarios—a monopoly with block pricing vs. a single-price monopoly.)
Block Pricing Scenario (Panel a):
• Demand curve starts at $90 (high reservation price for first unit) and drops to $0 at 90 units.
• The firm charges:
○ $70 per unit for the first 20 units.
○ $50 per unit for the next 20 units.
• The marginal cost is $30.
• Consumer buys 40 units:

New Section 1 Page 5

 • Consumer buys 40 units:
○ Pays $1,400 for the first block (20 units × $70).
○ Pays $1,000 for the second block (20 units × $50).
Outcomes:
• Consumer Surplus = A + C = $400.
• Firm Profit (Producer Surplus) = B = $1,200.
• Welfare (CS + PS) = $1,600.
• Deadweight Loss = D = $200 (since the price on the last unit sold is still above marginal cost).

Single-Price Monopoly (Panel b):

• Sets one price: $60.
• Sells 30 units where MR = MC.
Outcomes:
• Consumer Surplus = E = $450.
• Firm Profit = F = $900.
• Welfare = $1,350.
• Deadweight Loss = G = $450.

Key Takeaways:
1. Quantity Discounts (Nonlinear Pricing):
○ Increase profit for the firm.
○ Often increase total welfare by selling more units than single pricing.
○ Can lower consumer surplus because consumers pay more for earlier units and only get savings
on extra units.
2. Block Pricing Can Approach Perfect Price Discrimination:
○ The more blocks/prices, the closer to perfect price discrimination.
○ Firm captures all consumer surplus as profit.
○ Total welfare is maximized (no deadweight loss) if the last unit sells at marginal cost.
○ Consumers, however, may end up worse off, as they lose surplus to the firm.

Important Notes:
• Not all quantity discounts = price discrimination.
○ If a lower price per unit reflects lower costs, it's not discrimination.
○ Example: A larger soda cup costing less per ounce because the packaging and service costs are
less per unit.

12.5 two-part pricing

Key Concept: Two-Part Pricing

Two-part pricing is a strategy where a firm:
1. Charges a lump-sum access fee (A)—you pay to enter the club, store, or service.
2. Then charges a per-unit price (p) for each unit of the good or service you buy.
So, your total expenditure becomes:
E = A + p * q,
where q is the quantity you buy.
Why use two-part pricing?
• Increases profit: Firms can capture more of your consumer surplus.
• Efficient quantity sold: If the firm charges p = MC (price equals marginal cost), people buy
the efficient quantity.
• Examples: Warehouse clubs (Costco), fitness memberships, car rentals (daily fee + per mile).

Two-Part Pricing with Identical Consumers

If all customers are the same, the firm can:
• Charge per-unit price p = MC (e.g., $10).
• Then set an access fee A equal to all of the consumer’s potential surplus.
Example from the book:
• Demand curve: Q = 80 - p
• If p = 10, customer buys 70 units.
• The firm sets A = $2,450, which captures the entire consumer surplus.
• The firm’s total profit = $2,450 * number of customers.
If the firm raised p above MC (say p = 20):
• Consumer buys fewer units (60 instead of 70).
• Access fee (A) falls (because consumer surplus is lower).
• Total profit falls because of deadweight loss.
Takeaway:
Set p = MC and use A to capture surplus for maximum profit when consumers are identical.

Two-Part Pricing with Nonidentical Consumers

Gets trickier when customers have different demand curves (e.g., Valerie and Neal).
• Valerie: Q = 80 - p
• Neal: Q = 100 - p
If the firm can price discriminate between Valerie and Neal:
• Charge both p = MC = 10.
• Set A = 2,450 for Valerie (her total surplus at p = 10).
• Set A = 4,050 for Neal (his surplus at p = 10).
• Total profit = 2,450 + 4,050 = 6,500.
If the firm cannot charge different access fees:
• Has to balance between them.
• Sets p = 20.
• Access fee A = 1,800 (maximum Valerie can afford).
• Valerie buys 60, Neal buys 80.
• Firm earns per-unit profits on both and gets A fees.
• Total profit = 5,000.
Why raise price above MC?
• Helps extract more surplus from customers like Neal, even if it means less from Valerie.
• It’s a trade-off, but sometimes higher p leads to higher overall profit.

New Section 1 Page 6

 • It’s a trade-off, but sometimes higher p leads to higher overall profit.

iTunes Case Study

Before 2009: Uniform price of $0.99 per song.
After pressure and competition: Switched to variable pricing (different prices for different songs).
Researchers found:
• Uniform Pricing:
○ Producer Surplus (PS): 28%
○ Consumer Surplus (CS): 42%
○ Deadweight Loss (DWL): 29%
• Variable Pricing:
○ PS: 29%
○ CS: 45%
○ DWL: 26%
• Two-Part Pricing (hypothetical):
○ PS: 37%
○ CS: 43%
○ DWL: 20%
Insight:
Two-part pricing can maximize profit and reduce deadweight loss, making it better for firms and
sometimes for consumers (depends on the structure).

TL;DR Summary
• Two-part pricing splits charges into an access fee and a per-unit price.
• Works best when firms can differentiate between customers and prevent resale.
• Price = MC, access fee = entire surplus gives max profit when customers are identical.
• When customers differ, balancing per-unit price and access fees gets tricky.
• Real-life case (iTunes): Variable pricing improved things, but two-part pricing could have
been even better.

12.6 two-part pricing

Tie-In Sales
• Definition: Customers can buy one product only if they agree to buy another product as well.
Two Forms:
1. Requirement Tie-In Sale
Customers must buy all their purchases of another product from the same firm.
○ Example: Buy a printer, and you must buy all ink cartridges from the same company.
○ Benefit: Helps firms identify heavy users and charge them more over time.
2. Bundling (Package Tie-In Sale)
Multiple goods or services sold together for a single price.
○ Example: A combo meal at a restaurant or a software suite like Microsoft Works.

Example of Requirement Tie-In Sales

• HP sells printers super cheap ($34.99), but their ink cartridges are expensive ($20.99 color /
$14.99 black).
• To enforce the tie-in, HP warranties often warn that using non-HP cartridges may void the
warranty.
• Consumers end up buying ink from HP, even without a legal requirement, because of these
warranty warnings.

Bundling in Depth
• Efficiency Bundling: Reduces transaction or production costs.
○ Example: Buying a shirt with buttons already attached.
• Price Discrimination Bundling: Extracts more consumer surplus by tailoring bundles based on
consumers’ willingness to pay.
Types of Bundling:
1. Pure Bundling:
○ Goods sold only as a package (e.g., Microsoft Works).
2. Mixed Bundling:
○ Consumers can buy products separately or as a bundle (e.g., a soup and sandwich
combo and individually).

Why Bundling Works

• Firms can capture more consumer surplus, especially when consumers have negatively
correlated reservation prices.
○ Example:
▪ Alisha values a word processor at $120 but a spreadsheet at $50.
▪ Bob values the word processor at $90 but the spreadsheet at $70.
○ By bundling, the firm can charge $160 and sell to both, capturing more profit than
selling separately.
Negatively Correlated Reservation Prices:
• When one person values Product A highly but Product B less, and another person is the
opposite.
• Pure bundling often works well here.
Positively Correlated Reservation Prices:
• When one person values both products highly, and another values both less.
• Pure bundling may not work as well here—separate pricing might yield higher profits.

Solved Problem Example

New Section 1 Page 7

Solved Problem Example
• Four customers with varying reservation prices for a word processor and spreadsheet.
Separate Pricing:
• $90 per product, selling to three customers each → $540 total profit.
Pure Bundling:
• $150 bundle, selling to all four customers → $600 total profit.
Mixed Bundling:
• $200 for the bundle, $120 for each product individually.
• Some buy the bundle, others buy products individually → $640 total profit (the highest).

Key Takeaways
• Requirement tie-in sales lock customers into buying complementary products from the same
firm.
• Bundling can be used as a price discrimination strategy when firms can’t price individually
based on each consumer's willingness to pay.
• Whether pure or mixed bundling works best depends on the correlation between customers'
reservation prices for different products.

12.7 Advertising

Why Firms Advertise (Especially Monopolies)

• Monopolies advertise to shift their demand curve outward, which allows them to sell
more units at higher prices.
• A competitive firm, however, has no incentive to advertise because it can already sell all
it wants at the going market price.
• Advertising can:
○ Change consumer tastes (e.g., celebrity endorsements, targeting kids/teens).
○ Inform consumers about new uses for products (e.g., Heinz promoting beans on
toast in 1927).

Advertising in Practice
• Grocery stores strategically position products (child-oriented sugary cereals on lower
shelves) to promote sales subtly, an example of non-traditional promotion.
• Successful advertising makes the demand curve:
○ Shift to the right (higher quantity demanded).
○ Less elastic (consumers are less sensitive to price changes).

The Monopoly’s Advertising Decision

• A monopoly will only advertise if its net profit increases (gross profit minus the cost of
advertising).
• After advertising:
○ The demand curve shifts from D1 to D2.
○ The monopoly produces more output (Q2 instead of Q1) at a higher price (P2
instead of P1).
○ Gross profit rises from π1 to π1 + B.
○ If the cost of advertising is less than B, the monopoly gains and should advertise.

How Much to Advertise

• Marginal Analysis is key:
○ The monopoly should increase advertising as long as each additional $1 spent
increases gross profit by at least $1.
○ Optimal advertising happens when marginal benefit equals marginal cost (MB =
MC).

Infomercials Example
• Firms use this marginal principle when buying infomercial time:
○ They purchase up to the point where MB = MC.
○ If a special event (like the Super Bowl) lowers marginal benefit (viewers are
elsewhere), they buy less ad time.

Super Bowl Commercials

• They are extremely expensive, but firms are willing to pay because:
○ They get massive viewership.
○ Ads are more impactful and often go viral.
○ Investor confidence rises when firms air Super Bowl ads (stock prices go up).
○ For movies, Super Bowl ads boost ticket sales more than regular ads.

Key Takeaways
1. Advertising shifts the demand curve, increasing potential profit.
2. Monopolies use marginal analysis to determine how much to advertise.
3. Even expensive ads (like those during the Super Bowl) can be worth it, as long as they
increase net profits.

New Section 1 Page 8