Chapter 4

Product and Pricing Strategies

for the
Multiproduct Monopolist

Industrial Organization: Chapter 4 1

 Introduction

• A monopolist can offer goods of different varieties

– multiproduct firms
• The “big” issues:
– pricing
– product variety: how many?
– product bundling:
• how to bundle
• how to price
• whether to tie the sales of one product to sales of another
• Price discrimination

Industrial Organization: Chapter 4 2

4-1
 Price Discrimination
• This is a natural phenomenon with multiproduct firms
– restaurant meals: table d’hôte or à la carte
– different varieties of the same car
– airline travel
• “goods” of different quality are offered at very different prices
• Note the constraints
– arbitrage
• ensuring that consumers buy the “appropriate” good
– identification
• How to price goods of different quality?

Industrial Organization: Chapter 4 3

 Price discrimination and quality
• Extract all consumer surplus from the low quality good
• Use screening devices
– Set the prices of higher quality goods
• to meet incentive compatibility constraint
• to meet the constraint that higher price is justified by higher quality
• One interesting type of screening: crimping the product
– offer a product of reasonably high quality
– produce lower quality by damaging the higher quality good
• student version of Mathematica
• different versions of Matlab
• the “slow” 486SX produced by damaging the higher speed 486DX
– why?
• for cost reasons

Industrial Organization: Chapter 4 4

 A Spatial Approach to Product Variety
• Approach to product quality in Chapter 3 is an example of
vertical product differentiation
– products differ in quality
– consumers have similar attitudes to quality: value high quality
• An alternative approach
– consumers differ in their tastes
– firm has to decide how best to serve different types of consumer
– offer products with different characteristics but similar qualities
• This is horizontal product differentiation

Industrial Organization: Chapter 4 5

 A Spatial Approach to Product Variety (cont.)
• The spatial model (Hotelling) is useful to consider
– pricing
– design
– variety
• Has a much richer application as a model of product
differentiation
– “location” can be thought of in
• space (geography)
• time (departure times of planes, buses, trains)
• product characteristics (design and variety)

Industrial Organization: Chapter 4 6

 A Spatial Approach to Product Variety (cont.)
• Assume N consumers living equally spaced along Main
Street – 1 mile long.
• Monopolist must decide how best to supply these
consumers
• Consumers buy exactly one unit provided that price plus
transport costs is less than V.
• Consumers incur there-and-back transport costs of t per
unit
• The monopolist operates one shop
– reasonable to expect that this is located at the center of Main Street

Industrial Organization: Chapter 4 7

 The spatial model
Suppose
Supposethat
thatthe
themonopolist
monopolist Price
Price p1 + t.x sets
setsaaprice ofppp111+ t.x
priceof

V V

All
Allconsumers
consumerswithin
within t t
distance
distancexx11totothe
theleft
left p1
What
Whatdetermines
determines
and
andright
rightof
ofthe
theshop
shop xx1??
will
willby
bythe
theproduct
product 1

x=0 x1 1/2 x1 x=1

Shop 1
p1 + t.x1 = V, so x1 = (V – p1)/t

Industrial Organization: Chapter 4 8

 The spatial model
Price p1 + t.x p1 + t.x
Price
Suppose
Supposethethefirm
firm
V
reduces
reducesthe
theprice
price V
totopp2??
2

Then
Thenallallconsumers
consumers p1
within
withindistance
distancexx22 p2
of
ofthe
theshop
shopwill
willbuy
buy
from
fromthethefirm
firm

x=0 x2 x1 1/2 x1 x2 x=1

Shop 1

Industrial Organization: Chapter 4 9

 The spatial model
• Suppose that all consumers are to be served at price p.
– The highest price is that charged to the consumers at the ends of
the market
– Their transport costs are t/2 : since they travel ½ mile to the shop
– So they pay p + t/2 which must be no greater than V.
– So p = V – t/2.
• Suppose that marginal costs are c per unit.
• Suppose also that a shop has set-up costs of F.
• Then profit is (N, 1) = N(V – t/2 – c) – F.

Industrial Organization: Chapter 4 10

 Monopoly Pricing in the Spatial Model
• What if there are two shops?
• The monopolist will coordinate prices at the two shops
• With identical costs and symmetric locations, these prices
will be equal: p1 = p2 = p
– Where should they be located?
– What is the optimal price p*?

Industrial Organization: Chapter 4 11

 Location with Two Shops
Delivered
Deliveredprice
pricetoto
Suppose
Supposethat
thatthetheentire
entiremarket
marketisisto
to be
be served
consumers
served
consumers atatthe
the
market
marketcenter
centerequals
equals
Price their
theirreservation
reservationprice
price Price
IfIfthere
thereare
aretwotwoshops
shops
they
theywill
willbe belocated
located V V
symmetrically
symmetricallyaa
distance
distanceddfrom fromthe the
p(d) p(d)
The
The maximum
end-points
maximum
end-points ofprice
of the
price
the
the
thefirm can
cancharge
market
firmmarket charge What
Whatdetermines
determines
isisdetermined
determined bythethe
Now
Nowraiseraisebythethe
price
price p(d)?
p(d)?
consumers
consumers at
atateach the
at shop
each the
shop
center Start
of
Start with
the
with aa lowprice
low
market price
center of the market
at each shop
at each shop x=0 d 1/2 1-d x=1
Shop 1 Shop 2
Suppose
Supposethat
that The
Theshops
shopsshould
shouldbe
be
dd<<1/4
1/4 moved
movedinwards
inwards
Industrial Organization: Chapter 4 12
 Location with Twoprice
Delivered
Delivered Shops
pricetoto
consumers
consumersatatthe
the
The end-points
end-pointsequals
equals
Themaximum
maximumprice
price their
the theirreservation
reservationprice
price
thefirmfirmcan
cancharge
charge Price Price
isisnow
nowdetermined
determined
bybythetheconsumers
consumers
atatthe V V
theend-points
end-points
of
ofthe
themarket
market
p(d) p(d)

Now
Nowwhat
what
Now
Nowraise
raisethe
theprice determines
price determinesp(d)?
p(d)?
atateach
each shop
shop
Start with a low price
Start with a low price
atateach
eachshop
shop d 1/2 1-d
x=0 x=1
Shop 1 Shop 2
Now
Nowsuppose
supposethat
that The
Theshops
shopsshould
shouldbe
be
dd>>1/4
1/4 moved
movedoutwards
outwards
Industrial Organization: Chapter 4 13
ItItfollows Location with Two Shops
followsthat
that
shop
shop11should
should Price
Priceatateach
each
bebelocated
locatedatat shop
shopisisthen
then
Price Price
1/4
1/4and
andshop
shop22 p*
p*==VV--t/4t/4
atat3/4
3/4 V V

V - t/4 V - t/4
Profit
Profitatateach
eachshop
shop
isisgiven
givenby
bythe
the
shaded c c
shadedarea
area

x=0 1/4 1/2 3/4 x=1

Shop 1 Shop 2

Profit now(N,
Profitisisnow (N,2)
2)==N(V
N(V--t/4
t/4--c)
c)––2F
2F
Industrial Organization: Chapter 4 14
 By
Bythethesame
sameargument
argument
Three Shops they
theyshould
shouldbebelocated
located
What
Whatififthere
there atat1/6,
1/6,1/2
1/2and
and5/6
5/6
are
arethree
threeshops?
shops?
Price Price

V V
Price
Priceatateach
each V - t/6 V - t/6
shop
shopisisnow
now
VV--t/6
t/6

x=0 1/6 1/2 5/6 x=1

Shop 1 Shop 2 Shop 3

Profit now(N,
Profitisisnow (N,3)
3)==N(V
N(V--t/6
t/6--c)
c)––3F
3F
Industrial Organization: Chapter 4 15
 Optimal Number of Shops
• A consistent pattern is emerging.
Assume that there are n shops.
They will be symmetrically located distance 1/n apart.
We have already considered n = 2 and n = 3. How Howmany
many
When n = 2 we have p(N, 2) = V - t/4 shops
shopsshould
should
there
therebe?
be?
When n = 3 we have p(N, 3) = V - t/6
It follows that p(N, n) = V - t/2n
Aggregate profit is then (N, n) = N(V - t/2n - c) – n.F

Industrial Organization: Chapter 4 16

 Optimal number of shops (cont.)
Profit from n shops is (N, n) = (V - t/2n - c)N - n.F

and the profit from having n + 1 shops is:

*(N, n+1) = (V - t/2(n + 1)-c)N - (n + 1)F

Adding the (n +1)th shop is profitable if (N,n+1) - (N,n) > 0

This requires tN/2n - tN/2(n + 1) > F

which requires that n(n + 1) < tN/2F.

Industrial Organization: Chapter 4 17

 An example
Suppose that F = $50,000 , N = 5 million and t = $1
Then t.N/2F = 50
So we need n(n + 1) < 50. This gives n = 6
There should be no more than seven shops in this case: if
n = 6 then adding one more shop is profitable.

But if n = 7 then adding another shop is unprofitable.

Industrial Organization: Chapter 4 18

 Some Intuition
• What does the condition on n tell us?
• Simply, we should expect to find greater product variety
when:
• there are many consumers.
• set-up costs of increasing product variety are low.
• consumers have strong preferences over product
characteristics and differ in these.

Industrial Organization: Chapter 4 19

 How Much of the Market to Supply
• Should the whole market be served?
– Suppose not. Then each shop has a local monopoly
– Each shop sells to consumers within distance r
– How is r determined?
• it must be that p + tr = V so r = (V – p)/t
• so total demand is 2N(V – p)/t
• profit to each shop is then  = 2N(p – c)(V – p)/t – F
• differentiate with respect to p and set to zero:
• d/dp = 2N(V – 2p + c)/t = 0
– So the optimal price at each shop is p* = (V + c)/2
– If all consumers are to be served then price is p(N,n) = V – t/2n
• Only part of the market should be served if p(N,n) > p*
• This implies that V > c + t/n.
Industrial Organization: Chapter 4 20
 Partial Market Supply
• If c + t/n > V supply only part of the market and set price
p* = (V + c)/2
• If c + t/n < V supply the whole market and set price
p(N,n) = V – t/2n
• Supply only part of the market:
– if the consumer reservation price is low relative to marginal
production costs and transport costs
– if there are very few outlets

Industrial Organization: Chapter 4 21

 Are
Are there
theretoo
too
Social Optimum
many
manyshops
shopsoror
What number of shops maximizes total surplus? too
too few?
few?
What number of shops maximizes total surplus?
Total surplus is consumer surplus plus profit
Consumer surplus is total willingness to pay minus total revenue
Profit is total revenue minus total cost
Total
Totalsurplus
surplusisisthen
thentotal
totalwillingness
willingnessto
topay
payminus
minustotal
totalcosts
costs
Total willingness to pay by consumers is N.V

Total
Totalsurplus
surplusisistherefore
thereforeN.V
N.V--Total
TotalCost
Cost

So
Sowhat
whatisisTotal
TotalCost?
Cost?

Industrial Organization: Chapter 4 22

 Social optimum (cont.)
Assume
Assumethat
that
there
there
are
arennshops
shops Price Price

V Transport
Transportcost
costforV
for
Consider
Considershop
shop each
eachshop
shopisisthe
thearea
area
ii of
ofthese
thesetwo
twotriangles
triangles
multiplied
multipliedby by
consumer
consumerdensity
density
Total
Totalcost
costisis t/2n t/2n
total
totaltransport
transport
cost
costplus
plusset-up
set-up x=0 1/2n 1/2n x=1
costs
costs Shop i
This
Thisarea
areaisist/4n
2
t/4n2

Industrial Organization: Chapter 4 23

 Social optimum (cont.)
Total cost with n shops is, therefore: C(N,n) = n(t/4n2)N + n.F

= tN/4n + n.F
IfIftt==$1,
$1,FF==$50,000,
$50,000,
Total cost with n + 1 shops is: C(N,n+1)N=There
tN/4(n+1)+
should (n+1).F
be
= 5
N There million then
shouldthen
= 5 million befive
this
five
this
Adding another shop is socially efficientshops:
shops: with
ifcondition+ n1)
with
condition
C(N,n ==<44C(N,n)
tells
ntells adding
usadding
us
another
that shop
shopisis
thatn(n+1)
another n(n+1) <<efficient
25
efficient
25
This requires that tN/4n - tN/4(n+1) > F
which implies that n(n + 1) < tN/4F

The
Themonopolist
monopolistoperates
operatestoo
toomany
manyshops
shopsand,
and,more
more
generally,
generally,provides
providestoo
toomuch
muchproduct
productvariety
variety

Industrial Organization: Chapter 4 24

Monopoly, Product Variety and Price Discrimination
• Suppose that the monopolist delivers the product.
– then it is possible to price discriminate
• What pricing policy to adopt?
– charge every consumer his reservation price V
– the firm pays the transport costs
– this is uniform delivered pricing
– it is discriminatory because price does not reflect costs
• Should every consumer be supplied?
– suppose that there are n shops evenly spaced on Main Street
– cost to the most distant consumer is c + t/2n
– supply this consumer so long as V (revenue) > c + t/2n
– This is a weaker condition than without price discrimination.
– Price discrimination allows more consumers to be served.

Industrial Organization: Chapter 4 25

 Price Discrimination and Product Variety
• How many shops should the monopolist operate now?
Suppose that the monopolist has n shops and is supplying
the entire market.
Total revenue minus production costs is N.V – N.c
Total transport costs plus set-up costs is C(N, n)=tN/4n + n.F
So profit is (N,n) = N.V – N.c – C(N,n)
But then maximizing profit means minimizing C(N, n)
The discriminating monopolist operates the socially
optimal number of shops.

Industrial Organization: Chapter 4 26

 Bundling
• Firms sell goods as bundles
– selling two or more goods in a single package
– complete stereo systems
– fixed-price meals in restaurants
• Firms also use tie-in sales: less restrictive than bundling
– tie the sale of one good to the purchase of another
– computer printers and printer cartridges
– constraining the use of spare parts
• Why?
• Because it is profitable to do so!

Industrial Organization: Chapter 4 27

 Bundling: an example
• Two television stations offered two oldHow How much
Hollywood
much can
films
can
How much can
– Casablanca and Son of GodzillaHow much be
be
can
charged
chargedfor
for
be
If the films are sold charged for
be charged Godzilla?
for
• Arbitrage is possible between the stations Godzilla?
Casablanca?
separately total Casablanca?
• Willingness revenue
to pay is:is $19,000
$7,000
Willingness to Willingness to
pay for pay for $2,500
Casablanca Godzilla

Station A $8,000 $2,500

Station B $7,000 $3,000

Industrial Organization: Chapter 4 28

 How
How much
much can
can
Bundling: an example
be
be charged for
chargedis
Bundling for
profitable
Now suppose the
the package?
package?
because it exploits
Now suppose
that
thatthe
thetwo
two films
films are
are aggregate willingness
bundledIf and
the films
Willingness
sold are
to sold
Willingness
pay to Total
bundledasand
a sold total
package
as pay for pay for Willingness
asaapackage
package
revenue is $20,000Godzilla
Casablanca to pay

Station A $8,000 $2,500 $10,500

Station B $7,000 $3,000 $10,000

$10,000

Industrial Organization: Chapter 4 29

 Bundling (cont.)
• Extend this example to allow for
– costs
– mixed bundling: offering products in a bundle and separately

Industrial Organization: Chapter 4 30

 Consumer
ConsumeryyEach has
Each
has consumerconsumer
Bundling: another example
reservation
reservation
Suppose price
price
that ppy1the firm
Suppose that there are
All
Suppose that thereAll consumers
areconsumers in Suppose
in buys
buysthat y1exactly
the firm one
exactly one
for
forgood
good 11and
sets
sets price
All
and
priceppy2pp1 for
consumers foraagoodinin
two goods and that
two goods and that region
region B
B buy
buy All unity2 1 of
consumers
unit of good
R2 only good 2 for
for good
goodgood
good 2region
11and price
2region
and priceAAbuy
pbuy
p22 price
consumers differ in
consumers differ in onlyConsumer
good
Consumer2 xx has provided
provided
has both goods
that
that price
reservation pricefor good
both
ppx1 good
for 2 goods
2 than her
their reservation
B prices
their reservation prices A reservation price is less
is less than her
x1
for good 1 and p reservationprice price
for
forthese goods y for for
thesegoods good 1 and px2x2 reservation
py2 All
Allconsumersforgood
consumers inin 22
good All
Allconsumers
consumersinin
p2 region
regionCCbuy buy region
regionDDbuy
Consumers buy
x Consumers
neither
neithergood only good
px2 good only
split goodinto11
split into
D fourgroups
four groups
C

px1 p1 py1 R1

Industrial Organization: Chapter 4 31

 Bundling: the example (cont.)
Now
Nowconsider
considerpure pure
R2 bundling
bundling at
atsome
some
All
All consumersinin
consumers
Consumers price
theseprice
Consumersininthese two ppB E buy
regions
region
two regions
regionB E buy
pB can
canbuy
buyeach
eachgood
goodeven though
the
even bundle
though
the bundle
their
theirreservation
reservationprice
pricefor
forone
oneof of
Ethe
thegoods
goodsisisless
lessthan
thanits
its Consumers
marginal
marginal cost
cost
Consumers
All consumers
All consumers inin
nowsplit
now splitinto
into
region F do not
region F do not
buy the bundle twogroups
two groups
c2 F buy the bundle

c1 pB R1

Industrial Organization: Chapter 4 32

 Mixed Bundling
In
Inthis
thisregion
region Now
Nowconsider
considermixed mixed
consumers
Consumers
consumers buy
ininGood
this
buy11isissold bundling
Consumers
either the
this
Good
bundle sold bundling
R2 region
region buy
either the
buy onlybundle
onlyatatprice pp1
or product 22 price 1
pB good 2 ConsumersinGood
good
or 2
product Consumers this2Consumers
this
inGood isissold
2Consumers
sold
ininthis
this
region
regionalso region
alsoatatprice
region pp2 are
are willing
willing toto
price
This leaves
buy the bundle
buy the bundle buyThis
buy both
both
2
leaves
goods.
goods. TheyThey
p2 two
two buyregions
buy regions
the
the bundle
Consumers
bundle split split
Consumers
In
In thisregion
this region
Consumers
Consumersininthis this into fourgroups:
consumers
into four
consumers groups:
buy
buy
region
regionbuy buy
The nothing
Consumers
nothing
bundle
Consumers isinin this
sold buythe
either
buy
either
this thebundle
the
the bundle
bundle
bundle
pB - p 1 The bundle is sold or product 11
region
atatprice
region p buy
<
buyp only
+
only
price pBB < p11 + p22 p buy
buy or only
product
only good
good 11
good
good11 buy buyonlyonlygood good22
buynothing
buy nothing
pB - p 2 p1 pB R1

Industrial Organization: Chapter 4 33

 Mixed Bundling (cont.)
Similarly,
Similarly,all
all
consumers
consumersinin
R2 this
thisregion
regionbuy
buy
only Theconsumer
consumer
pB onlyproduct
product22 The
xxwill
willbuy buyonlyonly
product11
product
Consider
Considerconsumerconsumerxxwith with
p2 reservation Allprices pp1x for
consumers in
Which is reservation
this Allprices
consumers 1x for in
Consumer
Which surplus
is Consumer
Consumerthis
productsurplus 1 from
surplus
this
andfrom region
pregionfrombuy
measure Consumer
product
Her 1
aggregate surplus
this
and 2x for
p from
for buy
willingness
buying
measure Her
product
buyingbuying
productaggregate
1
the is
1 bundle
only willingness
isbundle
2x
isis 11
buying
to product
pay the
product
foronlythe22product
product
bundle
pB - p 1 pp1x to--ppay
pp1 +for
p the
- p bundleisis
1x p 1x1 + p 2x - p
1x p 2x
p1x1x++pp2x2xB
B
p2x x

pB - p 2 p1 pB p1x R1
p1x+p2x

Industrial Organization: Chapter 4 34

 Mixed Bundling (cont.)
• What should a firm actually do?
• There is no simple answer
– mixed bundling is generally better than pure bundling
– but bundling is not always the best strategy
• Each case needs to be worked out on its merits

Industrial Organization: Chapter 4 35

 An Example
Four consumers; two products; MC1 = $100, MC2 = $150

Reservation Reservation Sum of

Consumer Price for Price for Reservation
Good 1 Good 2 Prices

A $50 $450 $500

B $250 $275 $525

C $300 $220 $520

D $450 $50 $500

Industrial Organization: Chapter 4 36

 The example (cont.)
Good 1: Marginal Cost $100
Price Quantity TotalConsider
revenue simple
Consider simple
Profit
$450 1 monopoly
monopolypricing
$450 pricing
$350
$300 2 $600 $400
$250
Good 1 should
3 Good 1 should $750
be
besold
sold $450
at $250 and good
good22at
$50 4 at $250 and $200 at -$200
$450.
$450. Total
Totalprofit
profit
isis$450
Good 2: Marginal Cost +
$450 +$300
$150
$300
Price Quantity ==Total
$750
$750revenue Profit
$450 1 $450 $300
$275 2 $550 $200
$220 3 $660 $210
$50 4 $200 -$400

Industrial Organization: Chapter 4 37

 The example (cont.)
Now
Nowconsider
considerpure
pure
bundling
bundling

Reservation Reservation Sum of

Consumer Price forThe highest
Price for
The highest bundle Reservation
bundle
Good 1 price that
Good 2 be
can Prices
price that can be
All considered
considered isisbuy
$500
$500
A Allfour
four
$50consumers
consumers will
will
$450 buy $500
the
thebundle
bundleand
andprofit
profitisis
B 4x$500
$250--4x($150
4x$500 4x($150+ +$100)
$100)
$275 $525
==$1,000
$1,000
C $300 $220 $520

D $450 $50 $500

Industrial Organization: Chapter 4 38

 The example (cont.)
Now
Nowconsider
considermixed
mixed
Take the monopoly prices p1 = $250; p2 = $450 and a bundle price pB = $500
bundling
bundling
All
Allfour
fourconsumers
consumersbuy buy
something
something and
andprofit
Reservation profit isis
Reservation Sum of
Consumer $250x2
Price + $150x2
for Price for Reservation
Can the $250x2
seller
Can the seller + $150x2
improve
improve
Good
= 1
$800 Good 2 Prices
on =
onthis?
this? $800
A $50 $450 $500

B $250 $275 $525

$500

C $300
$250 $220 $520

D $450
$250 $50 $500

Industrial Organization: Chapter 4 39

 The example (cont.)
Try instead the prices p1 = $450; p2 = $450 and a bundle price pB = $520
This is actually
All four consumers the best Reservation
Reservation
buy that the Sum of
All four consumers buyfirm can do
Consumer
and profit is Price+for
$300 Price for Reservation
and profit is $300
Good+1 Good 2 Prices
$270x2 + $350
$270x2 + $350
= $1,190
A = $1,190 $50 $450
$450 $500

B $250 $275 $525

$520

C $300 $220 $520

D $450
$450 $50 $500

Industrial Organization: Chapter 4 40

 Bundling (cont.)
• Bundling does not always work
• Requires that there are reasonably large differences in
consumer valuations of the goods
• What about tie-in sales?
– “like” bundling but proportions vary
– allows the monopolist to make supernormal profits on the tied
good
– different users charged different effective prices depending upon
usage
– facilitates price discrimination by making buyers reveal their
demands

Industrial Organization: Chapter 4 41

 Tie-in Sales
• Suppose that a firm offers a specialized product – a
camera? – that uses highly specialized film cartridges
• Then it has effectively tied the sales of film cartridges to
the purchase of the camera
– this is actually what has happened with computer printers and ink
cartridges
• How should it price the camera and film?
– suppose that marginal costs of the film and of making the camera
are zero (to keep things simple)
– suppose also that there are two types of consumer: high-demand
and low-demand

Industrial Organization: Chapter 4 42

 Tie-In Sales:
Suppose anthe
that Example
Profit
Profitisis$72
$72from
fromeach
each
Suppose that the
firm leases the type
type of
of consumer
consumer
High-Demand firm leases the Low-Demand
Consumers product
product for
for$72
$72 per
perSo
So this
thisgives
Consumers givesprofit
profitof
of
Is this the best
period
period $144
$144perperpair
pairof ofhigh-
high-
Demand: P = that
16 - Q Demand: P = 12 - Q
Demand: P = 16 - Q Demand:
and P = 12 - Q
low-demand
the firm can do? and low-demand
$ $ consumers
consumers
$16
$12 Low-demand
Low-demand
consumers
consumersareare
High-demand willing
High-demand willingtotobuy
buy12
12
consumers
consumersbuy
buy16
16 units
units
$128 units
units
$72

16 12
Quantity Quantity
Industrial Organization: Chapter 4 43
 Tie-In Sales: an Example
Suppose that Profit
Profit isis$70
$70 from
from each
each
Suppose that
High-Demandthe low-demand
Low-Demand
low-demand consumer:
consumer:
thefirm
firmsetssetsaa
So
Sothethe firm
firm can set a $50
$50++$20
Consumersprice
price of
of$2$2 percan set aConsumers
per $20
lease
lease
unit charge
chargeof of$50
$50and
and $78 $78from
fromeach each
Demand: P = 16 -
Demand: P = 16 - Q Q unit Demand:
Demand: P = 12 - Q
P = surplus
12 -Q
to
toeach
eachtype
typeof Consumer
ofhigh-demand
Consumer
high-demand consumer:
surplus
consumer:
$ consumer: it cannot for low-demand
$50
for ++$28
low-demand
consumer:
Consumer surplus
it $cannot $50
consumers $28
is $50
$16 Consumer surplus
discriminate consumers
giving $148 is
per $50
pair of
for discriminate
high-demand
for high-demand $12
giving $148 per pair of
consumers
consumersis $98
High-demand
is $98
high-demand
high-demand and
and
Low-demand
Low-demand
low-
low-
High-demand
consumers demand
consumers
consumersbuy
demand buy10
consumersbuy buy14
14 10
units units
units
$98 units
$50

$2 $2

14 16 10 12
Quantity Quantity
Industrial Organization: Chapter 4 44
 Tie-In Sales:
Suppose that an Example
Suppose that
the firm can Profit
Profitisis$72
$72from
fromeach
each
High-Demand the firm can Low-Demand
bundle the two low-demand
low-demandconsumer
consumer
Consumersbundle the two Consumers
goods instead and
and $80
$80 from
from each
each
Produce
Produce goods
a
So bundled instead
produce
a -bundled
So produce a second
a second
Demand: P = 16of Qtie them high-demand
high-demand
Demand: consumer
consumer
PP==12 --QQ
Demand: P
product = 16
of of- Qtie
ofcamera
productbundle of
camera
bundle them
ofcamera
cameraplusplus
Demand: 12
giving
giving $150
$150 per
per pair
pairof
of
$ plus 12-shot
plus 12-shot cartridge
16-shot
cartridge
16-shot cartridge
$
cartridgehigh-demand
$16 High-demand
High-demand
High-demand high-demandand andlow-
low-
consumersHigh-demand
get $48 demand
consumers
consumers getwill
$48$12
pay demand
consumers will pay
consumer surplus Low-demand
consumer
$80 for surplus
this Low-demand
$80
from for thisitbundled
buying bundled consumers
from buying
camera it consumerscancanbe
be
camera($128
($128--$48)
$48) sold
$48 soldthis
thisbundled
bundled
product
productfor
for$72
$72
$72 $72
$8
12 16 12
Quantity Quantity
Industrial Organization: Chapter 4 45
 Complementary Goods
• Complementary goods are goods that are consumed
together
– nuts and bolts
– PC monitors and computer processors
• How should these goods be produced?
• How should they be priced?
• Take the example of nuts and bolts
– these are perfect complements: need one of each!
• Assume that demand for nut/bolt pairs is:
Q = A - (PB + PN)

Industrial Organization: Chapter 4 46

 Complementary goods (cont.)
This demand curve can be written individually for nuts and bolts
For bolts: QB = A - (PB + PN)
For nuts: QN = A - (PB + PN)
These give the inverse demands: PB = (A - PN) - QB
PN = (A - PB) - QN
These allow us to calculate profit maximizing prices
Assume that nuts and bolts are produced by independent firms
Each sets MR = MC to maximize profits
MRB = (A - PN) - 2QB
Assume MCB = MCN = 0
MRN = (A - PB) - 2QN
Industrial Organization: Chapter 4 47
 Complementary goods (cont.)
Therefore QB = (A - PN)/2
and PB = (A - PN) - QB = (A - PN)/2
by a symmetric argument PN = (A - PB)/2
The
Theprice
priceset
setby
byeach
eachfirm
firmisisaffected
affectedby
by
the
theprice
priceset
setby
bythe
theother
otherfirm
firm

In
Inequilibrium
equilibriumthe
theprice
priceset
setby
bythe
thetwo
two
firms
firmsmust
mustbe
beconsistent
consistent

Industrial Organization: Chapter 4 48

 Complementary goods (cont.)
PB = (A - PN)/2
PN = (A - PB)/2
PB Pricing
Pricingrulerulefor for  PN = A/2 - (A - PN)/4
the
theNutNut
A Equilibrium
Equilibrium
Producer: isis = A/4 + PN/4
Pricing
Producer:
Pricing rule
rule for
for
where
PPN =where
(A these
--Pthese
)/2 two
two  3PN/4 = A/4
= (A Pthe)/2
the
B Bolt
Bolt
N
pricing
pricing
B
rules
rules  PN = A/3
Producer:
Producer:
intersect  PB = A/3
A/2 PPintersect
BB==(A (A--PPNN)/2 )/2  PB + PN = 2A/3
A/3  Q = A - (PB+PN) = A/3
Profit of the Bolt Producer
= PBQB = A2/9
A/3 A/2 A PN
Profit of the Nut Producer
= PNQN = A2/9

Industrial Organization: Chapter 4 49

 Complementary goods (cont.)
What happens if the two goods are produced by the same firm?
Merger
The firm will set a price PNB of
forthe two firms
a nut/bolt pair.
Demand is now QNB =results
A - PNBinsoconsumers
that PNB = A - QNB
Why?
beingBecause
chargedthe
$
merged firm
 MRNB = A - 2QNBlower prices and is the
ablefirm
to
MR = MC = 0 coordinate
making the prices
greater profitsof
A
 Q = A /2 the two goods
NB

 PNB = A /2
A/2
Profit of the nut/bolt producer
is PNBQNB = A2/4 Demand
MR

A/2 A Quantity
Industrial Organization: Chapter 4 50
Industrial Organization: Chapter 4 51
 Product variety (cont.)

d < 1/4

We know that p(d) satisfies the following constraint:

p(d) + t(1/2 - d) = V
This gives: p(d) = V - t/2 + t.d
 p(d) = V - t/2 + t.d
Aggregate profit is then: (d) = (p(d) - c)N
= (V - t/2 + t.d - c)N

This is increasing in d so if d < 1/4 then d should be increased.

Industrial Organization: Chapter 4 52

 Product variety (cont.)

d > 1/4

We now know that p(d) satisfies the following constraint:

p(d) + t.d = V
This gives: p(d) = V - t.d
Aggregate profit is then: (d) = (p(d) - c)N
= (V - t.d - c)N

This is decreasing in d so if d > 1/4 then d should be decreased.

Industrial Organization: Chapter 4 53