214ECN Managerial Economics

Seminar 6

Q1. You are the manager of a firm that produces products X and Y at zero cost. You
know that different types of consumers value your two products differently., but you
are unable to identify these consumers individually at the time of the sale. In
particular, you know there are three types of consumers (1,000 of each type) with the
following valuations for the two products:

Consumer Type Product X Product Y

1 60$ 50$
2 50 125
3 25 140

a. What are your firm’s profits if you charge $25 for product X and $50 for product
Y?
b. What are your profits if you charge $60 for product X and $140 for product Y?
c. What are your profits if you charge $110 for a bundle containing one unit of
product X and one unit of product of Y?
d. What are your firm’s profit if you charge $175 for a bundle of containing one unit
of X and one unit of Y, but also sell the products individually at price of $60 for
product X and $140 for product Y?

Answers:
a. $225,000 (since all consumers purchase each product, you earn $75,000 on sales of good
X and $150,000 on sales of good Y).
b. $200,000 (since only the highest valuation type purchases each product, you earn $60,000
on sales of good X and $140,000 on sales of good Y).
c. Since all consumers receive at least $110 in value from the bundle, all types buy the
bundle. Profits are thus $330,000.
d. Type 2 consumers will purchase the bundle. Type 1 consumers will purchase good X only,
and type 3 consumers will purchase product Y only. Total profits are thus $175,000 +
$60,000 + $140,000 = $375,000.

2. You are a pricing analyst for QuantCrunch Corporation, a company that

recently spent $10,000 to develop a statistical software package. To date, you only
have one client. A recent internal study revealed that this client’s demand for your
software is Qd=100-0.1P and that it would cost you $500 per unit to install and
maintain software at this client’s site. The CEO of your company recently asked you
to construct a report that compares (1) the profit results from charging this client a
single-unit price with (2) the profit that results from charging $900 for the first 10 unit
and $700 for each additional unit of software purchased. Construct this report,
including in it a recommendation that would result in even higher profits.

1
Answers:
With a simple per-unit pricing strategy, the optimal per-unit price is determined by MR = MC. Here,
the inverse demand function is P  1, 000  10Q , so MR  1, 000  20Q . Also, MC = $500 and
fixed costs are $10,000. Equating MR and MC yields 1, 000  20Q  $500 . Solving, Q = 25 and P
= 1,000 – 10(25) = $750. Profits at this price are ($750 - $500)(25) – $10,000 = -$3,750. Under the
second-degree price discrimination strategy, 10 units (computed as 100 – 0.1($900) = 10) are
purchased at $900 and an additional 20 units are purchased at a price of $700 (total quantity demanded
at a price of $700 is 30 units, but 10 of these will be sold at $900). Profits from the second-degree price
discrimination scheme are thus ($900 –$500)(10) + ($700 – $500)(20) – $10,000 = -$2,000. A
profitable and feasible recommendation would be two-part pricing. Under this proposal, the client
would pay a fixed “license fee” plus a per-unit fee for each unit of the software installed and
maintained. The optimal two-part price sets the per-unit fee at $500 per unit (marginal cost). At this
price, the client will purchase 50 units of the software. The optimal fixed fee is $12,500 (computed as
(.5)($1000 - $500)(50) = $12,500). Profits under two-part pricing are $12,500 - $10,000 = $2,500.

3. As a manager of a chain of movie theaters that are monopolies in their

respective markets, you have noticed much higher demand on weekends than
during the week. You therefore conducted a study that has revealed two different
demand curves at your movie theatres. On weekends, the inverse demand function
is P=15-0.001Q; on weekdays, it is P=10-0.001Q. You acquire legal rights from
movie producers to show their films at a cost of $20,000 per movie, plus a $2
“royalty” for each movie-goer entering your theatres (the average moviegoer in your
market watches a movie only once). Devise a pricing strategy to maximize your
firm’s profits.

Answers:
Probably the best you can do in this instance is charge different per-unit prices on weekends and
weekdays. The optimal decision on weekends is determined by 15  .002Q  2 (MR = MC).
Solving yields Q = 6,500. The optimal price on weekends is thus P = 15 – .001(6500) = $8.50. The
optimal decision for weekdays is determined by 10  .002Q  2 . Solving yields Q = 4,000. The
optimal weekday price is thus P = 10 –.001(4000) = $6.

4. Magazines are distributed through both newsstands and subscriptions. They

derive revenue from both selling the publication and advertising. Many also publish
their content through the World Wide Web.

a. The larger a title's circulation, the more its publisher can charge for advertising.
How should a publisher take account of this factor in setting the cover price of a
magazine?
b. From the reader's standpoint, what are the differences between buying at a
newsstand and through subscription? How should a publisher price subscriptions
relative to newsstand sales?
c. The Web edition is particularly beneficial to business executives who travel
frequently and subscribers in locations that are poorly served by mail delivery from
the magazine printers. Should a magazine provide the Web edition free to
subscribers or levy an additional charge for it?

2
Answers:

(a) The publisher should consider marginal revenue in two forms -- magazine sales and advertising. In
setting the cover price, the publisher should balance the marginal revenue from both sales and
advertising with the marginal cost of producing and delivering the publication.
(b) For the reader, subscription is more convenient as it includes delivery. On the other hand, a
subscription locks in the reader so that he cannot pick and choose according to the content of particular
issues. These two factors have conflicting effects on the reader’s willingness to pay for subscriptions
vis-à-vis newsstand purchases.
(c) There appear to be several segments in the demand for the Web edition: (i) business executives who
travel frequently; (ii) subscribers in locations that are poorly served by mail delivery from the magazine
printers; and (iii) non-business subscribers in locations well-served by mail delivery. The magazine can
directly identify segment (ii) and offer them the Web edition at no charge. However, the magazine
cannot directly identify segment (i). It can indirectly discriminate by levying a charge for the Web
edition.