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Chapter 11: Q16. (page 451)

A cable TV company offers, in addition to its basic service, two products: a Sports Channel (Product 1) and a Movie Channel (Product 2). Subscribers to the basic service can subscribe to these additional services individually at the monthly prices P1 and P2, respectively, or they can buy the two as a bundle for the price PB, where PB 6 P1 + P2. They can also forgo the additional services and simply buy the basic service. The company’s marginal cost for these additional services is zero. Through market research, the cable company has estimated the reservation prices for these two services for a representative group of consumers in the company’s service area. These reservation prices are plotted (as x’s) in Figure 11.21, as are the prices P1, P2, and PB that the cable company is currently charging. The graph is divided into regions I, II, III, and IV.

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.

b. Note that as drawn in the figure, the reservation prices for the Sports Channel and the Movie Channel are negatively correlated. Why would you, or why would you not, expect consumers’ reservation prices for cable TV channels to be negatively correlated?

c. The company’s vice president has said: “Because the marginal cost of providing an additional channel is zero, mixed bundling offers no advantage over pure bundling. Our profits would be just as high if we offered the Sports Channel and the

Movie Channel together as a bundle, and only as a bundle.” Do you agree or disagree? Explain why.

d. Suppose the cable company continues to use mixed bundling to sell these two services. Based on the distribution of reservation prices shown in Figure 11.21, do you think the cable company should alter any of the prices that it is now charging? If so, how?

Short Answer

Expert verified

  1. The consumers of region I will not buy any of the products because the reservation price for the goods will be lower than the optimal prices set by the cable company. The consumers of region II will buy Movie Channel only they are have a greater reservation price (equal to or higher than the optimal price) for it but very lower price (less than the optimal price) for Sports Channel. The consumers of region III will buy Sports Channel only because they have a greater reservation price (equal to or higher than the optimal price) for it but very lower price (less than the optimal price) for Movie Channel. The consumers of region IV will buy both the goods as a bundle because they are offering a similar price for both the goods.

  2. The consumer’s reservation prices for cable TV channels are negatively correlated because a person cannot enjoy both the channels at a time.

  3. Agree with the statement. Charging separate pricing for channels from some consumers will not provide any additional profit level to the company because the marginal cost of providing one more channel is zero.

  4. The company should charge pure bundle price from consumers instead of mixed bundle prices.

Step by step solution

01

Step 1. Deciding the type of consumers for both the goods.

The figure depicts the reservation price of different customers for both the goods. Good 1 is placed on x-axis and good 2 is placed on Y-axis.

Region Idepicts those consumers whose reservation prices for Good 1 and Good 2 is less than the optimal price or bundle price set by the producer for both the goods. These consumers will not be able to buy any of the products (Movie channels or Sports channel). They want to enjoy the basic services of the cable.

Region IIdepicts those consumers whose reservation price for Good 1 is very large compared to Good 2. Their reservation price for Good 1 is equal to or above the optimal price set by the producer. But their reservation price for Good 2 is very low compared to the optimal for it. It shows ynthey are more interested in Sports Channel compared to Movie Channel.

Region IIIdepicts those consumers whose reservation price for Good 2 is very large compared to Good 1. Their reservation price for Good 2 is equal to or above the optimal price set by the producer. But their reservation price for Good 1 is very low compared to the optimal for it. It shows they are more interested in Movie Channel compared to Sports Channel.

Region IV depicts those consumers whose gap between the reservation prices for both the goods is less compared to the consumers of region I and region II. It shows that they are ready to pay same level of reservation prices for both the channels unlike consumers of region II and III that are ready to pay more for one good and less for other.

02

Step 2. Argument for option ‘b’.

Suppose a person wants to enjoy both TV channels (Sports and Movie). He is ready to pay equal amount of reservation prices for it. In the leisure time, if he wishes to enjoy both the channels at a time, it is impossible for him to do so. It concludes that a person can watch a single channel at a time. And he will spent more time on watching those channel which he prefers most and other will give less time to other channels.

That’s why he will offer more money for his favorite channels and less for others.This is the reason why reservation prices for Good 1 (Movie Channels) and Good 2 (Sports Channels) are negatively correlated.

03

Step 3. Argument in favor of statement in ‘c’.

One would agree with the statement of company’s vice president. The marginal cost of providing additional channel is zero. It means that the ‘separate pricing policy’ is not providing any extra profit to the company. If the company decides to sell both the channels under pure bundling strategy, their profit won’t reduce.

Hence the company should follow pure bundling pricing strategy as mixed bundling is not proving any extra benefit to the company’s profit.

04

Step 4. Argument for option ‘d’.

The figure shows that most of the consumers (including Consumers of region II and region III) lie on the right side of the diagonal line (bundle price). If the TV Company applies pure bundling pricing strategy for channels, it will receive more revenue. Since marginal cost for adding more channels is zero for the company, there profit would be equal to the amount received as revenue.

If Company switches from mixed bundling to pure bundling pricing strategy for channels, it might be possible that the profit of the Company will increase.

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Most popular questions from this chapter

Some years ago, an article appeared in the New York Times about IBM’s pricing policy. The previous day,IBM had announced major price cuts on most of itssmall and medium-sized computers. The article said:

IBM probably has no choice but to cut prices periodicallyto get its customers to purchase moreand lease less. If they succeed, this could makelife more difficult for IBM’s major competitors.Outright purchases of computers are needed for ever larger IBM revenues and profits, says Morgan Stanley’s Ulric Weil in his new book, InformationSystems in the 80’s. Mr. Weil declares that IBM cannot revert to an emphasis on leasing.

a. Provide a brief but clear argument in support of the claim that IBM should try “to get its customers to purchase more and lease less.”

b. Provide a brief but clear argument against this claim.

c. What factors determine whether leasing or selling is preferable for a company like IBM? Explain briefly.

Consider a firm with monopoly power that faces the demand curve

P= 100 - 3Q+ 4A1/2

and has the total cost function

C= 4Q2 + 10Q+ A

where Ais the level of advertising expenditures, and Pand Qare price and output.

a.Find the values of A, Q, and Pthat maximize the firm’s profit.

b.Calculate the Lerner index, L = (P - MC)/P, for this firm at its profit-maximizing levels of A, Q, and P.

Sal’s satellite company broadcasts TV to subscribers in Los Angeles and New York. The demand functions for each of these two groups are

QNY = 60 - 0.25PNY

QLA = 100 - 0.50PLA

where Q is in thousands of subscriptions per year and P is the subscription price per year. The cost of providing Q units of service is given by

C = 1000 + 40Q

where Q = QNY + QLA.

  1. What are the profit-maximizing prices and quantities for the New York and Los Angeles markets?
  2. As a consequence of a new satellite that the Pentagon recently deployed, people in Los Angeles receive Sal’s New York broadcasts and people in New York receive Sal’s Los Angeles broadcasts. As a result, anyone in New York or Los Angeles can receive Sal’s broadcasts by subscribing in either city. Thus Sal can charge only a single price. What price should he charge, and what quantities will he sell in New York and Los Angeles?
  3. In which of the above situations, (a) or (b), is Sal better off? In terms of consumer surplus, which situation do people in New York prefer and which do people in Los Angeles prefer? Why?

Price discrimination requires the ability to sort customers and the ability to prevent arbitrage. Explain how the following can function as price discrimination schemes and discuss both sorting and arbitrage:

  1. Requiring airline travelers to spend at least one Saturday night away from home to qualify for a low fare.

  2. Insisting on delivering cement to buyers and basing prices on buyers’ locations.

  3. Selling food processors along with coupons that can be sent to the manufacturer for a $10 rebate.

  4. Offering temporary price cuts on bathroom tissue.

  5. Charging high-income patients more than low-income patients for plastic surgery

You are an executive for Super Computer, Inc. (SC), which rents out supercomputers. SC receives a fixed rental payment per time period in exchange for the right to unlimited computing at a rate of P cents per second. SC has two types of potential customers of equal number—10 businesses and 10 academic institutions. Each business customer has the demand function Q = 10 - P, where Q is in millions of seconds per month; each academic institution has the demand Q = 8 - P. The marginal cost to SC of additional computing is 2 cents per second, regardless of volume.

  1. Suppose that you could separate business and academic customers. What rental fee and usage fee would you charge each group? What would be your profits?
  2. Suppose you were unable to keep the two types of customers separate and charged a zero rental fee. What usage fee would maximize your profits? What would be your profits?
  3. Suppose you set up one two-part tariff—that is, you set one rental and one usage fee that both business and academic customers pay. What usage and rental fees would you set? What would be your profits? Explain why the price would not be equal to marginal cost.
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