Economic Questions for Critical Thinking 6

Salvatore Chapter 12:

Question #7 (Discussion)

Quantity discounts are not a form of price discrimination because the firm saves on handling large orders. True or false? Explain.

A quantity discount is generally understood as an incentive, which is offered to a buyer, to increase the size of purchase of a good. The per-unit cost of a good diminishes as the size of the purchase (quantity of buying material/good) increases. With the decrease in the price of a good, because of the increase in the quantity of buying goods, the consumer surplus increases.

This selling strategy, which appears to be based on incentive, is considered a subtle form of price-discrimination, as the seller is charging more on smaller quantities (first bundle/batch) and less on larger quantities. Therefore, Quantity Discount is a form of price discrimination (second-degree).

Question #8 (Discussion)

(a) Why are first- and second-degree price discrimination less common than third-degree price discrimination?

(b) Are lower airline fares at midweek an example of third-degree price discrimination?

(c) Under what conditions would it not be useful to charge different prices in different markets (i. e., practice third-degree price discrimination) even if possible?

1. First-degree price discrimination is a sort of discrimination, in which a firm can charge a different price for every unit. It is possible, only when precise information is available regarding a consumer’s will to spend (how much a consumer is willing to spend to buy/consume a particular good). Therefore, first-degree discrimination is also called perfect price discrimination. As this price-discrimination requires perfect knowledge; therefore, it is quite difficult to exercise this sort of price discrimination. Second-degree price discrimination is based on selling different quantities of goods at different prices. There are numerous examples of second-degree price discrimination, which includes quantity discount. The most common, of all three types of price-discrimination, is third-degree price discrimination. This kind/type of discrimination is based on selling a product at different prices in different markets. It only requires knowledge-based segmentation of markets or identification of various types of markets (determining of price-elasticity of demand in different markets).
2. Price-discrimination is directly associated with the elasticity of demand. For instance, in third-degree price discrimination, the price elasticity of demand of a consumer group (of a particular market) is determined before setting a price. Those, who travel at mid-week, would probably be business travelers, who usually have the relatively low elasticity of demand (response mildly to changes in the price of a good/commodity). Therefore, the lower airline fares, at midweek, are not third-degree price discrimination. However, if the airline had increased the fares on mid-week, it would have been considered as third-degree price discrimination.
3. Firms can charge different prices in different markets only if they know that consumer-groups, of different markets have different demand elasticities. If demand elasticity, in various markets, is identical, then a firm will not be able to exercise third-degree price discrimination.

Question #13 (Discussion)

What are (a) the advantages and (b) the disadvantages of cost- plus pricing? (c) Why is incremental cost pricing the correct pricing method? Why is full- cost pricing equal to it?

Cost-plus pricing is a method developed to determine the price of a good or a service. This method requires the direct addition of material, labor, and overhead costs. After adding these fundamental costs, markup percentage is added to derive price of a good or service. This approach has several advantages and some disadvantages.

a-Advantages of Cost-plus Pricing Approach

• The mechanism of deriving price from this approach is quite simple.
• It requires fewer resources, such as time and finance, to determine price through this method.
• Constant costs allow deriving stable prices, which is beneficial for the firm and overall corporate system.
• It provides a sound rationale to increase the price of a product or service.
• This method takes into account demand if marginal cost is constant. Also, this method can incorporate profit maximization rule, which is that at profit maximization Marginal Revenue equals Marginal Cost.

b-Disadvantages of Cost-plus Pricing Approach

• Generally, it is difficult to determine and compute overhead costs.
• The derived cost is primarily based on accounting and historical costs, rather than on opportunity and replacement costs, which affects the size of profit.
• The method of pricing is considered flawed as it does not consider all sorts of costs.
• This method does not consider marginal cost. (Note: studies reveal that marginal cost becomes constant in long-run; however, they are still important in any arithmetic about)

c-Demand directly and strongly influences prices. However, this approach of determining price does not consider demand.Incremental pricing is understood as such a pricing method, in which the cost of a product is based on variable costs. A firm which adopts this method considers alterations in cost and revenue caused by changes in prices. Also, if a change(s) in price(s) swells profit, then price(s) must change. Another advantage of this approach is that it covers overhead costs during the computation. However, if a firm decides to change prices that may also affect overhead costs, then in fresh computation new overhead costs will be included.

Chapter 12; Part B (Problem)

Problem-5:

The Dairy Farm Company, a small producer of milk and cheese, has estimated the quantities of milk and cheese that it can produce with three levels of total expenditures or total costs. These are indicated in the following table. If the price of milk (product A) and the price of cheese (product B) that the firm receives are $ 1 each per unit of the products, draw a figure showing the maximum total profit (p) that the firm can earn at each level of TC and the overall maximum profit that the firm can earn for the three different levels of TC.

Problem-5 Solution

Scenario A
	Milk	Cheese	Combined Revenue	Total Cost = 70	Profit (Revenue -Total Cost)
1	80	0	80	70	10
2	70	40	110	70	40
3	50	70	120	70	50
4	20	90	110	70	40
5	0	95	95	70	25
Scenario B
	Milk	Cheese	Combined Revenue	Total Cost = 90	Profit (Revenue -Total Cost)
1	100	0	100	90	10
2	90	60	150	90	60
3	70	90	160	90	70
4	30	120	150	90	60
5	0	130	130	90	40
Scenario C
	Milk	Cheese	Combined Revenue	Total Cost = 140	Profit (Revenue -Total Cost)
1	130	0	130	140	-10
2	110	70	180	140	40
3	80	120	200	140	60
4	40	150	190	140	50
5	0	160	160	140	20

 

TC	Profit
70	50
90	70
140	60

 

Problem-12

1. Will a monopolist’s total revenue be larger with second- degree price discrimination when the batches on which it charges a uniform price are larger or smaller? Why?

2. How does a two- part tariff differ from bundling?

Solution/Answer Problem-12

1. A monopolist earns large revenue when he/she produces goods/services in small quantities. As the quantity of a product or service increases, the size of revenue diminishes. The small batches or quantities of production allows the monopolist to charge each unit at a different price (first-degree price discrimination).
2. Bundling is selling two or more products at a single price; whereas a two-part tariff splits the price into two parts; 1^st part is a fee paid to gain the right to buy the product, and 2^nd part is the amount paid to purchase the product.

Froeb et al. Chapter 14

Problem 14.1

Why might Mattel set a much lower contribution margin on its Barbie dolls than on the accessories for the dolls?

This strategy, of the set price of accessorized Barbie doll higher than normal/non-accessorized Barbie doll, is, in fact, an instrument to identify customers, who prefer accessorized Barbie doll and are willing to pay more for that product. Therefore, this strategy of Mattel is a form of price discrimination (indirect price discrimination). If the difference in price, between accessorized and non-accessorized Barbie, had been marginal, it would not have been considered price discrimination. The fact remains that Mattel sells non-accessorized Barbie at near-cost and there is a high markup on Barbie doll with accessories.

Problem 4.4

A manufacturer of microwaves has discovered that male shoppers have little value for micro-waves and attribute almost no extra value to an auto- defrost feature. Female shoppers generally value microwaves more than men and attribute greater value to the auto- defrost feature. There is a little additional cost to incorporating an auto-defrost feature. Since men and women cannot be charged different prices for the same product, the manufacturer is considering introducing two different models. The manufacturer has determined that men value a simple microwave at $ 70 and one with auto- defrost at $ 80 while women value a simple microwave at $ 80 and one with auto-defrost at $ 150.

If there is an equal number of men and women, what pricing strategy will yield the greatest revenue? What if women compromise the bulk of microwave shoppers?

Solution/Answer problem 4.4

As per information, there are equal numbers of men and women that intend to buy a microwave oven. Therefore, the firm should charge men $70 for the microwave oven, which does not have auto-defrost feature. This strategy will increase consumer surplus for women (around $10), which will positively affect sales of the simple microwave oven. As the surplus from a simple microwave oven is $10; therefore, the surplus from auto-defrost feature must be more than $11. The price of a microwave oven with defrost features should not be more than $139.

If most of the customers are women, the firm should stop manufacturing simple microwave oven and produce only those microwave ovens that have to defrost feature, and the price of that microwave should be $150, as women are willing to pay $150 for a microwave oven with defrost feature.

Salvatore Chapter 13

Question 8 (Discussion)

What is the basic difference between using a subsidy to induce producers to install antipollution equipment and a tax on producers who pollute?

In the given scenario, the subsidy will be considered as an incentive and tax will be seen as a punitive action. The subsidy may not push producers who produce pollution to install the equipment, as they would still be bearing some cost (unless it is full subsidy). Tax, which is a kind of cost, reflects price and if a firm is operating in the competitive market, it would not be pleased to see an increase in price/cost because of tax, as it may affect market share and profit. It would attempt to eliminate or reduce tax to keep the price stable and maintain its market share.

Question 10 (Discussion)

Given the difficulties that the regulation of public utility faces, would it not be better to nationalize public utilities, as some European countries have done? Explain your answer.

Flaws in market/capitalist systems justify government intervention and provide a rationale to regulate markets and utilities. Public utilities, such as electricity and natural gas, are regulated by governments to provide relief to the public; however, regulating public utilities is a cumbersome process and requires various kinds of resources (financial/time). Therefore, sometimes it is suggested that it is better to nationalize public utilities. This suggestion is hard to act upon, as nationalization may aggravate the problem. For instance, for a state profit is not a prime concern, which is why the incentive to reduce cost is absent in nationalized schemes.

The advantage of nationalization is that its concern is efficiency. Studies reveal that regulations adversely affect efficiency, as it leads to under or over investment (most of the time). Therefore, nationalization may effectively address efficiency factors, which is hard to achieve, as an objective, during a regulation.

Problem 12

Determine whether the Justice Department would challenge a merger between two fi rms in an industry with 10 equal- sized firms, based on its 1984 Herfi ndahl- index guidelines only.

Solution/Answer

As per the guidelines, about 1984 Herfi ndahl- index, if the HI is between 1000 to 1800 after the merger and the merger of firms have increased the HI more than 100 points, then such merger can be challenged.

As per information two firms merged in an industry with 10 equal sized firms. This information will aid us in calculating HI before and after the merger.

HI before the merger.

102*10 = 1000

Hi after the merger.

202+102*8 =1200

It is apparent from the arithmetic that HI has increased more than 100 points, which is why the Justice Department must challenge this merger.

Problem 13

(a) in what way the U. S. trucking industry exemplified the capture theory hypothesis of government regulation prior to the passage of the Motor Carrier Act of 1980 and

(b) the result of the passage of the Motor Carrier Act in 1980.

1. The Motor Carrier Act of 1935 had increased the role of the regulator to the point that it started to affect the market by diluting/diminishing competition adversely. For instance, Regulator, the Interstate Commerce Commission, had to issue a certificate to the new trucking company to operate. This certificate could be challenged by rates the new company intended to charge. Most of the time, regulators favored the trucking company that was already operating.
2. In 1980, the Motor Carrier Act was amended, which allowed more competition, as it removed barriers to entry.

Problem 15

Integrating Problem From the following figure referring to a natural monopolist, indicate ( a) the best level of output, price, and profits per unit and in total for the monopolist, ( b) the best level of output and price with a lump sum tax that would eliminate all the monopolist’s profits, ( c) the best level of output, price, and profits per unit and in total with a $ 3 per unit tax collected from the monopolist, and ( d) the best level of output and profit per unit and in total if the government sets the price of the product or service at $ 10. (e) Which is the best method of controlling monopoly power? Why? (See Figure 13- 5.)

(a)-It is a known economic fact that profit-maximizing output is where Marginal Cost equals Marginal Revenue (MC = MR). For the monopolist, the profit-maximizing output is 6 million units, which sets the price at $12. The average cost is $8. This information allows us to compute per unit cost. To compute per unit cost, we will subtract Average Cost (AC) from Price (P).

(P-AC) = $12-$8=$4

(b)-Lump-sum tax is viewed as Fixed Cost (FC). Therefore, we will treat it as Fixed Cost (FC) for this calculation. Fixed Cost (FC) directly affects average cost; however, it does not affect Marginal Cost. As the Fixed Cost does not affect Marginal Cost; therefore, it does not influence the decision pertaining to profit maximization. Firm will continue to produce 6 million units, where MC=MR. However, as the size of cost has increased, therefore, size of profit will reduce (reduces to zero).

(c)-The introduction of $3 on each unit will expand both Marginal Cost and Average Cost exactly by $3 (apparent in the graph). Marginal Cost’s upward push of $3, now it interacts with Marginal Revenue at 5 million units, which sets the price of $13 for each unit. As the average cost of each unit is also $13, the firm will earn zero profit.

(d)-The firm will opt for the quantity where price equals marginal cost (P=MC), in case government sets the price of $10. At P=MC, the firm will produce 8 million units, and average cost will be $8. Therefore, the profit per unit will be $2.

Profit =P-AC

$10-$8 =$2

(e)-Which of these considered is best considered?

The scenario which is described in (a) demonstrates the inherent inefficiency of monopoly. For instance, the last unit produced by the monopolist has a price greater than Marginal Cost. Therefore, monopolist produces small quantities to keep the margin of profit large.

The optimal quantity is where Marginal Cost curve cuts Demand from below (P=MC). The point where MC=P, price per unit is $10 and quantity is 8 million units.

Required Textbooks:

Froeb, L. M., McCann, B. T., Ward, M. R., & Shor, M. (2016). Managerial economics: A problem solving approach (4th ed.). Boston, MA: Cengage Learning. ISBN: 9781305259331.

Salvatore, D. (2015). Managerial economics in a global economy (8th ed.). New York, NY: Oxford University Press. ISBN: 9780199397129.