CHAPTER 11 • Pricing with Market Power 435

EXERCISES
1. Price discrimination requires the ability to sort cus- Coast and Midwest). Demand and marginal revenue
tomers and the ability to prevent arbitrage. Explain for the two markets are
how the following can function as price discrimination
schemes and discuss both sorting and arbitrage: P1 = 15 - Q1 MR1 = 15 - 2Q1
a. Requiring airline travelers to spend at least one
Saturday night away from home to qualify for a P2 = 25 - 2Q2 MR2 = 25 - 4Q2
low fare.
b. Insisting on delivering cement to buyers and basing The monopolist’s total cost is C  5  3(Q1  Q2).
prices on buyers’ locations. What are price, output, profits, marginal revenues,
c. Selling food processors along with coupons that and deadweight loss (i) if the monopolist can price dis-
can be sent to the manufacturer for a $10 rebate. criminate? (ii) if the law prohibits charging different
d. Offering temporary price cuts on bathroom tissue. prices in the two regions?
e. Charging high-income patients more than low- *6. Elizabeth Airlines (EA) flies only one route: Chicago–
income patients for plastic surgery. Honolulu. The demand for each flight is Q  500 − P.
2. If the demand for drive-in movies is more elastic for EA’s cost of running each flight is $30,000 plus $100
couples than for single individuals, it will be optimal per passenger.
for theaters to charge one admission fee for the driver a. What is the profit-maximizing price that EA will
of the car and an extra fee for passengers. True or false? charge? How many people will be on each flight?
Explain. What is EA’s profit for each flight?
3. In Example 11.1 (page 408), we saw how producers of b. EA learns that the fixed costs per flight are in fact
processed foods and related consumer goods use cou- $41,000 instead of $30,000. Will the airline stay in
pons as a means of price discrimination. Although cou- business for long? Illustrate your answer using a
pons are widely used in the United States, that is not the graph of the demand curve that EA faces, EA’s aver-
case in other countries. In Germany, coupons are illegal. age cost curve when fixed costs are $30,000, and EA’s
a. Does prohibiting the use of coupons in Germany average cost curve when fixed costs are $41,000.
make German consumers better off or worse off? c. Wait! EA finds out that two different types of people
b. Does prohibiting the use of coupons make German fly to Honolulu. Type A consists of business people
producers better off or worse off? with a demand of QA  260 − 0.4P. Type B consists
4. Suppose that BMW can produce any quantity of cars of students whose total demand is QB  240 − 0.6P.
at a constant marginal cost equal to $20,000 and a fixed Because the students are easy to spot, EA decides to
cost of $10 billion. You are asked to advise the CEO as charge them different prices. Graph each of these
to what prices and quantities BMW should set for sales demand curves and their horizontal sum. What
in Europe and in the United States. The demand for price does EA charge the students? What price does
BMWs in each market is given by it charge other customers? How many of each type
are on each flight?
QE = 4,000,000 - 100PE d. What would EA’s profit be for each flight? Would
the airline stay in business? Calculate the consumer
surplus of each consumer group. What is the total
and
consumer surplus?
e. Before EA started price discriminating, how much
QU = 1,000,000 - 20PU
consumer surplus was the Type A demand getting
from air travel to Honolulu? Type B? Why did total
where the subscript E denotes Europe, the subscript consumer surplus decline with price discrimina-
U denotes the United States. Assume that BMW can tion, even though total quantity sold remained
restrict U.S. sales to authorized BMW dealers only. unchanged?
a. What quantity of BMWs should the firm sell in each 7. Many retail video stores offer two alternative plans for
market, and what should the price be in each mar- renting films:
ket? What should the total profit be?
b. If BMW were forced to charge the same price in • A two-part tariff: Pay an annual membership fee
each market, what would be the quantity sold in (e.g., $40) and then pay a small fee for the daily
each market, the equilibrium price, and the com- rental of each film (e.g., $2 per film per day).
pany’s profit? • A straight rental fee: Pay no membership fee, but
5. A monopolist is deciding how to allocate output pay a higher daily rental fee (e.g., $4 per film per
between two geographically separated markets (East day).
 436 PART 3 • Market Structure and Competitive Strategy

What is the logic behind the two-part tariff in this profits? Explain why price would not be equal to
case? Why offer the customer a choice of two plans marginal cost.
rather than simply a two-part tariff? 10. As the owner of the only tennis club in an isolated
8. Sal’s satellite company broadcasts TV to subscribers in wealthy community, you must decide on membership
Los Angeles and New York. The demand functions for dues and fees for court time. There are two types of
each of these two groups are tennis players. “Serious” players have demand

QNY = 60 - 0.25PNY Q1 = 10 - P
QLA = 100 - 0.50PLA
where Q1 is court hours per week and P is the fee per
where Q is in thousands of subscriptions per year and hour for each individual player. There are also “occa-
P is the subscription price per year. The cost of provid- sional” players with demand
ing Q units of service is given by
Q2 = 4 - 0.25P
C = 1000 + 40Q
Assume that there are 1000 players of each type.
where Q  QNY  QLA. Because you have plenty of courts, the marginal cost
a. What are the profit-maximizing prices and quanti- of court time is zero. You have fixed costs of $10,000
ties for the New York and Los Angeles markets? per week. Serious and occasional players look alike, so
b. As a consequence of a new satellite that the you must charge them the same prices.
Pentagon recently deployed, people in Los Angeles a. Suppose that to maintain a “professional” atmos-
receive Sal’s New York broadcasts and people in phere, you want to limit membership to serious
New York receive Sal’s Los Angeles broadcasts. As players. How should you set the annual member-
a result, anyone in New York or Los Angeles can ship dues and court fees (assume 52 weeks per
receive Sal’s broadcasts by subscribing in either year) to maximize profits, keeping in mind the
city. Thus Sal can charge only a single price. What constraint that only serious players choose to join?
price should he charge, and what quantities will he What would profits be (per week)?
sell in New York and Los Angeles? b. A friend tells you that you could make greater prof-
c. In which of the above situations, (a) or (b), is Sal its by encouraging both types of players to join. Is
better off? In terms of consumer surplus, which sit- your friend right? What annual dues and court fees
uation do people in New York prefer and which do would maximize weekly profits? What would these
people in Los Angeles prefer? Why? profits be?
*9. You are an executive for Super Computer, Inc. (SC), c. Suppose that over the years, young, upwardly
which rents out super computers. SC receives a fixed mobile professionals move to your community,
rental payment per time period in exchange for the all of whom are serious players. You believe there
right to unlimited computing at a rate of P cents per sec- are now 3000 serious players and 1000 occasional
ond. SC has two types of potential customers of equal players. Would it still be profitable to cater to the
number—10 businesses and 10 academic institutions. occasional player? What would be the profit-
Each business customer has the demand function maximizing annual dues and court fees? What
Q  10 − P, where Q is in millions of seconds per would profits be per week?
month; each academic institution has the demand 11. Look again at Figure 11.12 (p. 420), which shows the
Q  8 − P. The marginal cost to SC of additional com- reservation prices of three consumers for two goods.
puting is 2 cents per second, regardless of volume. Assuming that marginal production cost is zero for
a. Suppose that you could separate business and aca- both goods, can the producer make the most money by
demic customers. What rental fee and usage fee selling the goods separately, by using pure bundling,
would you charge each group? What would be or by using mixed bundling? What prices should be
your profits? charged?
b. Suppose you were unable to keep the two types 12. Look again at Figure 11.17 (p. 424). Suppose that
of customers separate and charged a zero rental the marginal costs c1 and c2 were zero. Show that in
fee. What usage fee would maximize your profits? this case, pure bundling, not mixed bundling, is the
What would be your profits? most profitable pricing strategy. What price should
c. Suppose you set up one two-part tariff—that is, be charged for the bundle? What will the firm’s
you set one rental and one usage fee that both busi- profit be?
ness and academic customers pay. What usage and 13. Some years ago, an article appeared in the New York
rental fees would you set? What would be your Times about IBM’s pricing policy. The previous day,
 CHAPTER 11 • Pricing with Market Power 437

IBM had announced major price cuts on most of its b. Now suppose that the production of each good
small and medium-sized computers. The article said: entails a marginal cost of $30. How does this
IBM probably has no choice but to cut prices peri- information change your answers to (a)? Why is the
odically to get its customers to purchase more and optimal strategy now different?
lease less. If they succeed, this could make life more 16. A cable TV company offers, in addition to its basic
difficult for IBM’s major competitors. Outright service, two products: a Sports Channel (Product 1)
purchases of computers are needed for ever larger and a Movie Channel (Product 2). Subscribers to the
IBM revenues and profits, says Morgan Stanley’s basic service can subscribe to these additional serv-
Ulric Weil in his new book, Information Systems in ices individually at the monthly prices P1 and P2,
the 80’s. Mr. Weil declares that IBM cannot revert to respectively, or they can buy the two as a bundle for
an emphasis on leasing. the price PB, where PB < P1  P2. They can also forgo
a. Provide a brief but clear argument in support of the the additional services and simply buy the basic serv-
claim that IBM should try “to get its customers to ice. The company’s marginal cost for these additional
purchase more and lease less.” services is zero. Through market research, the cable
b. Provide a brief but clear argument against this company has estimated the reservation prices for these
claim. two services for a representative group of consumers
c. What factors determine whether leasing or selling is in the company’s service area. These reservation prices
preferable for a company like IBM? Explain briefly. are plotted (as x’s) in Figure 11.21, as are the prices P1,
14. You are selling two goods, 1 and 2, to a market con- P2, and PB that the cable company is currently charg-
sisting of three consumers with reservation prices as ing. The graph is divided into regions I, II, III, and IV.
follows: a. Which products, if any, will be purchased by the
consumers in region I? In region II? In region III? In
region IV? Explain briefly.
RESERVATION PRICE ($)
b. Note that as drawn in the figure, the reservation
prices for the Sports Channel and the Movie Channel
CONSUMER FOR 1 FOR 2 are negatively correlated. Why would you, or why
A 20 100 would you not, expect consumers’ reservation prices
for cable TV channels to be negatively correlated?
B 60 60 c. The company’s vice president has said: “Because
the marginal cost of providing an additional chan-
C 100 20
nel is zero, mixed bundling offers no advantage
over pure bundling. Our profits would be just
The unit cost of each product is $30.
a. Compute the optimal prices and profits for (i) sell-
ing the goods separately, (ii) pure bundling, and
r1
(iii) mixed bundling. X II
b. Which strategy would be most profitable? Why? X X
PB X
X X
15. Your firm produces two products, the demands for X X
which are independent. Both products are produced X X
X X
X
X
IV
X X
at zero marginal cost. You face four consumers (or X X X
X X X
groups of consumers) with the following reservation X X X X
P1 X X X
prices: X
X X
X
X X X
X X
X X
CONSUMER GOOD 1($) GOOD 2($) X
X
X X
X X X
A 25 100 X X
X X X
B 40 80 X
I X
X X
C 80 40 PB–P2 X

X X X III
D 100 25
X
X X
X X X X X
a. Consider three alternative pricing strategies:
(i) selling the goods separately; (ii) pure bundling; PB–P1 P2 PB r2
(iii) mixed bundling. For each strategy, determine
the optimal prices to be charged and the resulting F IGURE 11.21
profits. Which strategy would be best? FIGURE FOR EXERCISE 16
 438 PART 3 • Market Structure and Competitive Strategy

as high if we offered the Sports Channel and the and has the total cost function
Movie Channel together as a bundle, and only as a
bundle.” Do you agree or disagree? Explain why. C = 4Q2 + 10Q + A
d. Suppose the cable company continues to use mixed
bundling to sell these two services. Based on the dis- where A is the level of advertising expenditures, and P
tribution of reservation prices shown in Figure 11.21, and Q are price and output.
do you think the cable company should alter any of a. Find the values of A, Q, and P that maximize the
the prices that it is now charging? If so, how? firm’s profit.
*17. Consider a firm with monopoly power that faces the b. Calculate the Lerner index, L  (P − MC)/P, for this
demand curve firm at its profit-maximizing levels of A, Q, and P.

P = 100 - 3Q + 4A1/2