CH-13-14 Monopoly – Modern Principles: Microeconomics : Book Guide

This Document Contains Chapters 13 to 14 CHAPTER 13 Modern Principles of Economics: Monopoly Facts and Tools 1. In the following diagram, label the marginal revenue curve, the profit-maximizing price, the profit-maximizing quantity, the profit, and the deadweight loss. Solution 1. 2. a. Consider a market like the one illustrated in Figure 13.5, where all firms have the same average cost curve. If a competitive firm in this market tried to set price above the minimum point on its average cost curve, how many units would it sell? b. If a monopoly did the same thing, raising its price above average cost, what would happen to the number of units it sells: Does it rise, fall, or remain unchanged? c. What accounts for the difference between your answers to parts a and b? Solution 2. a. It would sell zero units: In competitive markets, when one firm alone raises its prices, everyone switches to a competitor. b. It would lose some business, but not all of its business. c. A competitive firm loses all of its business when it sets a price only a little bit higher than its competitors because there are many substitutes for its product; on the other hand, since a monopolist has few competitors (there are few substitutes for its product), it loses some but not all of its business when it raises prices. 3. a. In the textbook The Applied Theory of Price, D. N. McCloskey refers to the equation MR = MC as the rule of rational life. Who follows this rule: monopolies, competitive firms, or both? b. Rapido, the shoe company, is so popular that it has monopoly power. It’s sell¬ing 20 million shoes per year, and it’s highly profitable. The marginal cost of making extra shoes is quite low, and it doesn’t change much if they produce more shoes. Rapido’s marketing experts tell the CEO of Rapido that if it de¬creased prices by 20%, it would sell so many more shoes that profits would rise. If the expert is correct, at its current output, is MC > MR, is MC = MR, or is MR > MC? c. If Rapido’s CEO follows the experts’ advice, what will this do to marginal revenue: Will it rise, fall, or will it be unchanged? Will Rapido’s total revenue rise, fall, or be unchanged? d. Apollo, another highly profitable shoe company, also has market power. It’s selling 15 million shoes per year, and it faces marginal costs quite similar to Rapido’s. Apollo’s marketing experts conclude that if they increased prices by 20%, profits would rise. For Apollo, is MC > MR, is MC = MR, or is MR > MC? Solution 3. a. Both follow this rule. For competitive firms, MR = MC. Of course, for competitive firms, price equals marginal revenue, so this fact is somewhat hidden: We usually emphasize P = MC under competition. With monopoly firms, this fact is much more blatant: MR = MC is stated many times in this chapter. b. If the experts are correct and a price decrease increases profits, MR must be greater than MC (MR > MC) at the current level of output. c. Cutting the price means cutting marginal revenue as well: Just look at any of the paired demand/MR curves in this chapter. This process will increase total revenue: Any time marginal revenue is positive, it means that a price cut will increase total revenue. d. If a price increase raises profits, MC > MR at the current level of output. The price is inefficiently low, and the firm is selling too many pairs of shoes to profit maximize. 4. a. When selling e-books, music on iTunes, and downloadable software, the marginal cost of producing and selling one more unit of output is essentially zero: MC = 0. Let’s think about a monopoly in this kind of market. If the monopolist is doing its best to maximize profits, what will marginal revenue equal at a firm like this? b. All firms are trying to maximize their profits (TR – TC). The rule from part a tells us that in the special case in which marginal cost is zero, “profit maximization” is equivalent to which of the following statements? “Maximize total revenue.” “Minimize total cost.” “Minimize average cost.” “Maximize average revenue.” Solution 4. a. For monopolies, as elsewhere in life, you’re doing your best if MR = MC. So, if MC = 0, then MR should equal zero, as well. b. “Maximize total revenue” is the right answer: You want the highest dollar sales possible. You don’t want to minimize total cost (if MC = 0, any level of output does that); you don’t want to minimize average cost (if MC = 0, that would mean infinite output, which probably isn’t revenue maximizing); you don’t want to maximize average revenue (average revenue is another word for “price” in any one-price market, and you don’t want to charge the highest price). 5. a. What’s the rule: Monopolists charge a higher markup when demand is highly elastic or when it’s highly inelastic? b. What’s the rule: Monopolists charge a higher markup when customers have many good substitutes or when they have few good substitutes? c. For the following pairs of goods, which producer is more likely to charge a bigger markup? Why? i. Someone selling new trendy shoes, or someone selling ordinary tennis shoes? ii. A movie theater selling popcorn or a New York City street vendor selling popcorn? iii. A pharmaceutical company selling a new powerful antibiotic or a firm selling a new powerful cure for dandruff? Solution 5. a. As we stated in the chapter, inelastic demand causes higher markups. b. Inelastic demand is the same as “fewer substitutes,” so fewer substitutes mean higher markups. c. Trendy shoes, theater popcorn, and new antibiotics probably have higher mark¬ups. People care about dandruff but a hat is a substitute for a good shampoo; Also, “you can’t take it with you” is a force pushing people to have an inelastic demand for life-saving antibiotics. 6. In 1996, the X Prize Foundation created what became known as the Ansari X Prize—a $10 million prize for the first nongovernment group to send a reusable manned spacecraft into space twice within two weeks. In 2004, it was won by the Tier One project, financed by Microsoft cofounder Paul Allen. a. An answer you can find on the Internet: How high did SpaceShipOne fly when it won the Ansari X Prize? b. How much did it cost to develop SpaceShipOne? Was the $10 million prize enough to cover the costs? Why do you think Microsoft cofounder Paul Allen invested so much money to win the prize? Do Allen’s motivations show up in our monopoly model? Solution 6. a. In its two flights, it flew 103 km and 112 km above the earth. Those on board could see stars during the daytime. b. There are various reports, ranging from $25 million to $100 million: Either way, Paul Allen lost money on the deal. However, he reaped fame and honor as the sponsor of the first privately funded manned spacecraft. It’s possible that he also helped Microsoft’s public image, and since he’s still a major shareholder in Microsoft, a small rise in Microsoft’s share price could be worth much more than $100 million to him. Neither of these ideas fit into the typical monopoly model. But if SpaceShipOne is just the fixed cost of starting up a space tourism com¬pany, then that would fit into our model. The first firm in this industry could reap monopoly profits for years if it built on the trust and reputation created by SpaceShipOne’s success. 7. Which of the following is true when a monopoly is producing the profit-maximizing quantity of output? More than one may be true. Marginal revenue = Average cost Total cost = Total revenue Price = Marginal cost Marginal revenue = Marginal cost Solution 7. Marginal revenue = Marginal cost: The rule of rational life 8. a. Consider a typical monopoly firm like that in Figure 13.3. If a monopolist finds a way to cut marginal costs, what will happen: Will it pass along some of the savings to the consumer in the form of lower prices, will it paradoxically raise prices to take advantage of these fatter profit margins, or will it keep the price steady? b. Is this what happens when marginal costs fall in a competitive industry, or do competitive markets and monopolies respond differently to a fall in costs? Solution 8. a. Some of the reduction in costs gets passed along in lower consumer prices. Remember that MR = MC if the monopolist is rationally greedy. So if MC falls, then the mo¬nopolist wants to push down MR, as well. The only way to do this is to cut the price of the good. The advertising cliché, “We’re passing the savings along to you!” is true in monopolies—at least when it’s a decrease in marginal costs. (Aside: If it’s just a decrease in the monopoly’s fixed costs, then there is no incentive to change the price.) b. Yes. In competitive markets, a decrease in marginal cost causes a decrease in price. In both monopoly and competition, declines in MC cause declines in equilibrium price. 9. a. Where will profits be higher: When demand for a patented drug is highly inelastic or when demand for a patented drug is highly elastic? (Figure 13.4 might be helpful.) b. Which of those two drugs is more likely to be “important?” Why? c. Now, consider the lure of profits: If a pharmaceutical company is trying to decide what kind of drugs to research, will it be lured toward inventing drugs with few good substitutes or drugs with many good substitutes? d. Is your answer to part c similar to what an all-wise, benevolent government agency would do, or is it roughly the opposite of what an all-wise, benevolent government agency would do? Solution 9. a. Profits are higher when demand is inelastic. b. The important drug probably has more inelastic demand: Customers probably have fewer good substitutes. c. The pharmaceutical company will be lured toward the market with few good drug substitutes. That’s where the profits are. d. This is probably what a benevolent government would want to do: It would target scarce resources toward solving unsolved problems. This is yet another “invisible hand” result. Note, however, that a benevolent government would set a lower price once the drug was discovered, but to do so it would have to tax someone to fund research and development. 10. True or False? a. When a monopoly is maximizing its profits, price is greater than marginal cost. b. For a monopoly producing a certain amount of output, price is less than marginal revenue. c. When a monopoly is maximizing its profits, marginal revenue equals marginal cost. d. Ironically, if a government regulator sets a fixed price for a monopoly lower than the unregulated price, it is typically raising the marginal revenue of selling more output. e. In the United States, government regulation of cable TV cut the price of premium channels down to average cost. f. When consumers have many options, monopoly markup is lower. g. A patent is a government-created monopoly. Solution 10. a. True: For a monopoly, P > MR, and if it’s behaving optimally, MR = MC, so P > MC. b. False: P > MR on a monopoly demand curve. Extra output “spoils the market,” pushing MR below price. c. True: the rule of rational life seen throughout microeconomics d. True: Once the monopolist knows that there’s only one legal price for her output, she doesn’t worry about “spoiling the market” anymore. She no longer faces the cruel trade-off that monopolists typically face. Average revenue (i.e., price) and marginal revenue are again one and the same, as under competition. It’s the increase in marginal revenue that encourages the monopolist to produce more. e. False: Cable regulation only covered basic cable. It allowed cable companies to set monopoly prices on premium channels. These are the channels with the most innovative shows. Basic cable gives customers the equivalent of generic, off-patent drugs (more reruns), while premium cable provides the equivalent of new, patented drugs (innovative TV shows, some of which, like HBO’s expensive series Rome, fail to earn a good return). f. True: The flatter, more elastic is the demand curve, the lower the markup. As the demand curve becomes more elastic, equilibrium price gets ever closer to marginal cost. g. True: The government creates a monopoly by preventing other firms from offering competing patented goods. By law, only the patent holder may sell those goods. Thinking and Problem Solving 11. In addition to the clove monopoly discussed in the chapter, Tommy Suharto, the son of Indonesian President Suharto (in office from 1967 to 1998), owned a media conglom¬erate, Bimantara Citra. In their entertaining book Economic Gangsters (Princeton Uni¬versity Press, 2008), economists Raymond Fisman and Edward Miguel compared the stock price of Bimantara Citra with that of other firms on Indonesia’s stock exchange around July 4, 1996, when the government announced that President Suharto was traveling to Germany for a health checkup. What do you think happened to the price of Bimantara Citra shares relative to other shares on the Indonesian stock exchange? Why? What does this tell us about corruption and monopoly power in Indonesia? Solution 11. Shares of Tommy’s firm Bimantara Citra fell by significantly more than did shares in firms without such close connections to the president. The stock market’s reaction to President Suharto’s possible health problems was a signal that the market believed that Tommy’s firm was worth much less without his political connections than with the connections. The market was thus saying that corruption was rampant in Indonesia. Fisman and Miguel estimate that political connections were worth tens of billions of dollars. 12. a. Sometimes, our discussion of marginal cost and marginal revenue unintention¬ally hides the real issue: the entrepreneur’s quest to maximize total profits. Here is information on a firm: Demand: P = 50 − Q. Fixed cost = 100, marginal cost = 10. Using this information, calculate total profit for each of the values in the follow¬ing table, and then plot total profit in the figure below. Clearly label the amount of maximum profit and the optimum quantity that produces this level of profit. b. If the fixed cost increased from 100 to 200, would that change the shape of this curve at all? Also, would it shift the location of the curve to the left or right? Up or down? How does this explain why you can ignore fixed costs most of the time when thinking about a monopoly’s decision-making process? Solution 12. a. b. A rise in fixed costs would only shift the curve down—it would have no other effect. In terms of the graph, you’d only need to change the label from “300” to “200” and be done with it. Since the shape of the profit curve doesn’t change, it means that the best choice with low fixed costs is still the best choice with high fixed costs—as long as profits are positive. Therefore, what really matters is the firm’s marginal cost. 13. When a sports team hires an expensive new player or builds a new stadium, you often hear claims that ticket prices have to rise to cover the new, higher cost. Let’s see what monopoly theory says about that. It’s safe to treat these new expenses as fixed costs: something that doesn’t change if the number of customers rises or falls. You have to pay Miguel Cabrera the same salary whether people show up or not, you have to make the interest payments on the new Comerica Park whether the seats are filled or not. Treat the local sports team as a monopoly in this question, and, to keep it simple, let’s assume there is only one ticket price. a. As long as the sports team is profitable, will a mere rise in fixed costs raise the equilibrium ticket price, lower the equilibrium ticket price, or have no effect whatsoever on the equilibrium ticket price? Why? b. In fact, it seems common in real life for ticket prices to rise after a team raises its fixed costs by building a fancy new stadium or hiring a superstar player: In recent years, it’s happened in St. Louis and San Diego’s baseball stadiums. What’s probably shifting to make this happen? Name both curves, and state the direction of the shift. c. So, do sports teams spend a lot of money on superstars so that they can pass along the costs to the fans? Why do they spend a lot on superstars, according to monopoly theory? (Note: Books like Moneyball and The Baseball Economist apply economic models to the national pastime, and it’s common for sports managers to have solid training in economic methods.) Solution 13. a. This has no effect on the marginal cost curve, so it will have no effect on the monopolist’s optimal price. It won’t raise the price, it won’t lower the price. b. It’s probably an increase in demand. People are willing to pay more to go to a nicer, newer stadium with better views; better TV screens; bigger, cleaner restrooms; more food choices. This rise in demand also causes a rise in the marginal revenue curve: Both shift to the right, raising the equilibrium ticket price. c. They don’t spend a lot of money so they can pass the costs along. They spend the money to raise demand. Note that if they only raise demand by a little, they might lose money on the deal. The rise in demand has to be large enough to compensate for the higher average costs—a tough calculation to make. 14. Earlier we mentioned the special case of a monopoly where MC = 0. Let’s find the firm’s best choice when more goods can be produced at no extra cost. Since so much e-commerce is close to this model—where the fixed cost of inventing the product and satisfying government regulators is the only cost that matters—the MC = 0 case will be more important in the future than it was in the past. In each case, be sure to see whether profits are positive! If the “optimal” level of profit is negative, then the monopoly should never start up in the first place; that’s the only way they can avoid paying the fixed cost. a. P = 100 − Q. Fixed cost = 1,000. b. P = 2,000 − Q. Fixed cost = 900,000. (Driving the point home from part a.) c. P = 120 − 12Q. Fixed cost = 1,000. Solution 14. a. MR = 100 − 2Q, so Q = 50. TR = $50 × 50 = $2,500, so profit = TR − TC = $2,500 − 1,000 = $1,500. The company should go into business. b. MR = 2,000 − 2Q, so Q = 1,000. TR = $1 million, so profit = $100,000. Again, the company should go into business. c. MR = 120 − 24Q, so Q = 5. TR = $60 × 5 = $300, so profit = TR − TC = $300 − $1,000 = −$700. This is a losing proposition. This company should never start up in the first place. 15. a. Just based on self-interest, who is more likely to support strong patents on pharmaceuticals: young people or old people? Why? b. Who is more likely to support strong patent and copyright protection on video games: people who really like old-fashioned video games or people who want to play the best, most advanced video games? c. How are parts a and b really the same question? Solution 15. a. Young people: They have a longer time horizon, so they want more drugs to be invented. Older people are less likely to be around when new drugs are invented, so they’re more willing to support weaker patents that make existing drugs cheaper. They aren’t as worried about what will happen to drug innova¬tion 10 or 20 years down the road. b. People who want to play the best video games will support strong patents and copyrights. Strong intellectual property laws will encourage more companies to invest millions in inventing new games. People happy with old games are happy to cripple patent and copyright law, since they just want to play old games at lower prices. c. People who want innovation tend to support stronger intellectual property rights; they want a lot of people working in these industries trying to make new and better products. 16. Common sense might say that a monopolist would produce more output than a competitive firm facing the same marginal costs. After all, if you’re making a profit, you want to sell as much as you can, don’t you? What’s wrong with this line of reasoning? Why do monopolistic industries sell less than competitive industries? Solution 16. If a monopolist tried to sell more, he would push down the price of the good—in other words, he would “spoil the market.” This force is very strong, so that’s why monopoly markets sell less than competitive markets. Let’s look at it the other way. In competitive markets, every new firm that enters the market pushes down the price just a little, so each entry makes life a little worse for all the other firms. By contrast, a monopolist is so big that he takes this “spoilage” effect into account when he makes the decision of how much to make. He’s like a polluting fisherman who has to drink his own lake water. 17. In the early part of the twentieth century, it was cheaper to travel by rail from New York to San Francisco than it was to travel from New York to Denver, even though the train to San Francisco would stop in Denver on the way. a. Denver is a city in the mountains. Suggest alternate ways to get there from New York without taking the train. b. San Francisco is a city on the Pacific Ocean. Suggest alternate ways to get there from New York without taking the train. c. Why was San Francisco cheaper? d. How is this story similar to the one told in this chapter about prices for flights from Washington, D.C., to either Dallas or San Francisco? Solution 17. a. Taking a car, plane, or horse. b. Taking a car, plane, horse, or ship. c. Because there was additional competition from ship travel. d. In both cases, competition reduces prices. 18. This chapter told the story of how the 2000 California energy shortage was aggravated by price deregulation. a. Suppose you are an entrepreneur who is interested in building a power plant to take advantage of the high prices for energy. Seeing rising energy costs, would price deregulation make it more or less likely you would build a new power plant? Why? b. It’s very difficult to build and operate a new power plant, largely because new plants have to comply with a long list of environmental and safety regulations. Compared with a world with fewer such regulations, how do these rules change the average total cost of building and operating a power plant? Why? c. Do these regulations make it more or less likely that you will build a new power plant? Why? d. Do these regulations increase or decrease the market power of power plants that already exist? Solution 18. a. It would make it more likely, because the potential profits are higher. b. It increases the average total cost because complying with the laws requires additional expense. c. They will make it less likely, because the additional costs reduce profits and thus incentives. d. The regulations increase market power because these expenses were a barrier to entry that prevented the reduction of high profits; big barriers to entry create market power. 19. The lure of spices during the medieval period wasn’t driven merely by the desire to improve the taste of food (Europe produced saffron, thyme, bay leaves, oregano, and other spices for that). The lure of nutmeg, mace, and cloves came from their mystique. Spices became a symbol of prestige (just as Louis Vuitton and Ferrari are today). Most Europeans didn’t even know that they grew in the tiny chain of islands called the Spice Islands today. a. Suppose you grow much of the spices in the Spice Islands. Knowing that few people could compete with you, how would you adjust your production to maximize your profits? b. Suppose you heard rumors that the Europeans to whom you often sell are also becoming fascinated by the mechanical clock, a new invention that was spreading across Europe as a new novelty and as yet another symbol of prestige. How would this change your optimal production? Why? c. Once Europeans made contact with the Americas, a new, high-status novelty arose: chocolate. Was this good news or bad news for you, the monopolist in the Spice Islands? Solution 19. a. You would reduce quantity to increase profits. b. You would increase quantity because you have competition in the novelty market. c. This is bad news: there will be more competition for high-status goods. 20. China developed gunpowder, paper, the compass, water-driven spinning machines, and many other inventions long before their European counterparts. Yet they did not adopt cannons, industrialization, and many other applications until after the West did. a. Suppose you are an inventor in ancient China and suddenly realize that the fire¬works used for celebration could be enlarged into a functioning weapon. It would take time and money to develop, but you could easily sell the cutting-edge result to the government. If there is a strong patent system, would you put a big invest¬ment into developing this technology? Why or why not? b. Suppose there were no patent system, but you could still sell your inventions to the government. Compared with a world with a good patent law, would you be more inclined, less inclined, or about equally inclined to invest in technological development? Why? Solution 20. a. Yes, because the benefits are high and the patent system secures those rewards. b. If all you could sell were the cannons, profits would be smaller (possibly zero) because other inventors could copy the invention as soon as you sell your idea to the government: They would make the market competitive. One important exception: The government could pay an extra-high price as a reward for your innovation. This would then work like the Ansari X Prize, giving you an incentive to work extra hard to innovate. The British government gave a similar prize for the first device to measure a ship’s longitude. The enjoyable best-seller Longitude tells this story. China, however, did not have a patent system. It had the opposite. Sinologist Etienne Balazs, in La bureaucratie céleste, explains: “The atmosphere of routine, of traditionalism, and of immobility, which makes any innovation suspect, any initiative that is not commanded and sanctioned in advance, is unfavorable to the spirit of free inquiry.” Challenges 21. a. For the following three cases, calculate i. The marginal revenue curve ii. The level of output where MR = MC (i.e., set the equation from item i equal to marginal cost and solve for Q) iii. The profit-maximizing price (i.e., plug your answer from equation ii into the demand curve) iv. Total revenue and total cost at this level of output (something you learned in Chapter 11) v. What entrepreneurs really care about—total profit Case A: Demand: P = 50 − Q Fixed cost = 100 Marginal cost = 10 Case B: Demand: P = 100 − 2Q Fixed cost = 100 Marginal cost = 10 Case C: Demand: P = 100 − 2Q Fixed cost = 100 Marginal cost = 20. b. What’s the markup in each case? Measure it two ways: first in dollars, as price minus marginal cost, and then as a percentage markup [100 × (P – MC)/MC, reported as a percent]. c. If you solved part b correctly, you found that when costs rose from Case B to Case C, the monopolist’s optimal price increased. Why didn’t the monopolist charge that same higher price when costs were lower? After all, they’re a monopolist, so they can charge what price they want. Explain in language that your grandmother could understand. Solution 21. a. Case A: i. MR = 50 – 2Q. ii. Optimal Q = 20. iii. Optimal P = $30. iv. Optimal TR = $600, optimal TC = $300. v. Profit = $300. Case B: i. MR = 100 24Q. ii. Optimal Q = 22.5. iii. Optimal P = $55. iv. Optimal TR = $1,237.5, optimal TC = $325. v. Profit = $912.5. Case C: i. MR = 100 24Q. ii. Optimal Q = 20. iii. Optimal P = $60. iv. Optimal TR = $1,200, optimal TC = $500. v. Profit = $700. b. A: $20 and 200%. B: $45 and 450%. C: $40 and 200%. c. A monopolist still loses customers when it raises its price: That’s the main idea. A little background: When costs rise, the monopolist decides that those last few units of output are adding more to costs than to revenue; that is, selling these units actually hurts company profits. As a result, the monopolist cuts back her production. By cutting back production, she can sell the rest of her products at a higher price. When there’s less to sell, there’s more of a bidding war between customers. Now, to the answer: If the company in Case B had raised its price while costs stayed low, it would have lost so many customers that the company would have seen its profits fall. But in Case C, it’s okay to lose some of those extra customers: MC > MR after costs rise, so losing a few customers (and therefore pushing up the price) is actually a good idea. Even monopolists have to worry about trade-offs. 22. In Challenges question 21, what was the deadweight loss of monopoly in each of the three cases? (Hint: Where does the marginal cost curve cross the demand curve? The same place it does under competition.) Is this number measured in dollars, in units of the good, or in some other way? Solution 22. The answer is measured in dollars. It represents the total amount that people who can’t buy the good under monopoly would be willing to pay for the good. To calculate the deadweight loss, you need to calculate the price and quantity under competition and use those facts to measure the size of the deadweight loss triangle. In Case A, P = 10, Q = 40. In Case B, P = 10, Q = 80. In Case C, P = 20, Q = 60. The area of each triangle is just one-half of base times height. Case A: 0.5 × 20 × $20 = $200 Case B: 0.5 × 57.5 × $45 = $1,293.75 Case C: 0.5 × 40 × $40 = $800 23. a. In 2006, Medicare Part D was created to subsidize spending on prescription drugs. What effect would you expect this expansion to have on pharmaceutical prices? What principle in the chapter would explain this result? b. Given your answer in part a, what effect on pharmaceutical research and development would you predict? c. Whatever answer you gave in part a, can you think of an argument for the opposite prediction? Hint: In writing the Part D law Congress said that subsidized drug plans must cover all pharmaceuticals in some “protected” classes, such as AIDS drugs, but in other areas subsidized plans could pick and choose which drugs to offer. Understanding this difference may lead to different predictions. Solution 23. a. Medicare Part D means that fewer prescription drug expenses are paid out-of-pocket and more are paid using insurance or “other people’s money.” The other people’s money effect from the chapter suggests that the demand for pharmaceuticals will become less elastic, that is, less sensitive to price, when pay¬ments are subsidized through insurance. When the demand curve facing a firm with market power becomes less elastic, it pays that firm to raise the price, thus we would expect that Medicare Part D will raise prescription drug prices. b. Higher prices mean higher profits for the pharmaceutical firms and thus a greater incentive to invest in R&D. This could be a beneficial side effect of subsidization, although it is possible to invest too much in R&D as well as too little, so we should not necessarily assume the effect is beneficial. (See Acemoglu, Daron, David Cutler, Amy Finkelstein, and Joshua Linn. 2006. Did Medicare induce pharmaceutical innovation? American Economic Review 96(2): 103–107 for evi¬dence that the earlier expansion of Medicare increased innovation in health care.) c. Under the Medicare Part D plan, more pharmaceuticals are purchased by insur¬ance firms rather than by individuals. An insurance firm has greater bargaining power with a pharmaceutical manufacturer than an individual does, so the firm may be able to use its power to push prices down. The bargaining power can only work, however, if the insurance firm can threaten to not buy the pharma¬ceutical firms’ drugs. As noted in the question, Congress said that an insurance firm had to offer all drugs in some protected classes; thus for these classes the firms have no bargaining power. For other drugs, however, the insurance firms might be able to lower prices using bargaining. For some evidence that Medicare Part D raised prices in protected classes and lowered them in unprotected classes, see Duggan, Mark and Morton, Fiona Scott. The effect of Medicare Part D on pharmaceutical prices and utilization. (April, 2008). NBER Working Paper No. 13917. 24. In 1983, Congress passed the Orphan Drug Act, which gave firms that developed pharmaceuticals to treat rare diseases (diseases with U.S. patient populations of 200,000 people or fewer) the exclusive rights to sell their pharmaceutical for seven years, basically an extended patent life. In other words, the act gave greater market power to pharmaceutical firms who developed drugs for rare diseases. Per¬haps surprisingly, a patient organization, the National Organization for Rare Disorders (NORD), lobbied for the act. Why would a patient group lobby for an act that would increase the price of pharmaceuticals to their members? Why do you think the act was specifically for rare diseases? Solution 24. NORD understood that there is a trade-off between higher prices and greater incentives to research and develop new drugs. NORD reasoned that the most press¬ing needs of the patients that it represented were more new drugs and treatment choices; high prices are bad, but even worse is not having any treatment choices at all (a drug that doesn’t exist has a price of infinity!). The costs of developing a new pharmaceutical are about the same whether the pharmaceutical is intended to treat a patient population of 100,000 or 100,000,000, but the revenues are much greater in the latter case. Thus, there are greater incen¬tives to develop pharmaceuticals to treat common diseases (especially common diseases among rich people!) than to treat rare diseases. Extending the patent life for drugs meant to treat common diseases would also increase the incentive to spend on R&D for common diseases, but these incentives are already quite strong, and the increase in price might not be worth the extra R&D. The Orphan Drug Act, therefore, targeted the extra incentives where they would do the most good. Lichtenberg and Waldfogel found that the number of new drugs to treat rare diseases increased after the act (more than expected had the act not passed) and mortality rates for these diseases declined. See Lichtenberg, Frank R. and Waldfogel, Joel. Does misery love company? Evidence from pharmaceutical markets before and after the Orphan Drug Act. (June, 2003.) NBER Working Paper No. W9750. Available at SSRN: http://ssrn.com/abstract=414248. 25. For Kremer’s patent buyout proposal (mentioned in the chapter) to work, the government needs to pay a price that’s high enough to encourage pharmaceuti¬cal companies to develop new drugs. How can the government find out the right price? Through an auction, of course. In Kremer’s plan, it works roughly like this: The government announces that it will hold an auction the next time a com¬pany invents a powerful anti-AIDS drug. Once the drug has been invented and thoroughly tested, the government holds the auction. Many firms compete in the auction—just like on eBay—and the highest bid wins. Now comes the twist: After the auction ends, a government employee rolls a six-sided die. If it comes up “1,” then the highest bidder gets the patent, it pays off the inventor, and it’s free to charge the monopoly price. If the die comes up “2” through “6,” then the government pays the inventor whatever the highest bid was, and then it tears up the patent. The auction had to be held to figure out how much to pay, but most of the time it’s the government that does the paying. Similarly, most of the time, citizens get to pay the marginal cost for the drug, but one-sixth of all new drugs will still charge the monopoly price. a. In your opinion, would taxpayers be willing to pay for this? b. Using Figure 13.5 to guide your answer, what polygon(s) would these firms’ bid be equal to? c. If the government wins the die roll, what net benefits do consumers get, using Figure 13.5’s polygons as your answer? (Be sure to subtract the cost of the auction!) Solution 25. a. This is a matter of opinion. But many taxpayers might object to paying for drugs that already exist. It’s not like they’re paying a company to invent a new drug: They’re paying for what’s already there. The opposite argument might go like this: Taxpayers don’t think of government spending as being “real money,” but if they get drugs at marginal cost, they’ll be very happy. They’ll notice every time they go to the pharmacy and pay 50 cents for a cutting-edge drug. In that case, it might be very popular! Taxpayers might also object that pharmaceuticals should be paid for by sick people rather than by taxpayers. b. The bid would be equal to the profit rectangle—whoever wins the lottery, they’re just taking the drug company’s place as a monopolist. c. Consumers would get the two smaller triangles: the consumer surplus under monopoly plus the recovered deadweight loss of monopoly. Consumers (as taxpayers) have to pay the profit rectangle to the drug manufacturer, so we can’t count the whole big triangle as a benefit to consumers. 26. a. Let’s imagine that the firm with cost curves illustrated in the left panel of the following figure is a large cable TV provider. Assuming that the firm is free to maximize profit, find the profit-maximizing price, quantity, and the firm’s profit. b. Now assume that the firm is regulated and that the regulator sets the price so that the firm earns a normal (zero) profit. What price does the regulator set and what quantity does the firm sell? (Label this price and quantity on the diagram.) c. Which price and quantity pair do consumers prefer, that in part a or in part b? Do consumers benefit from price regulation? d. Imagine that the cable TV provider can invest in fiber-optic cable (high defini¬tion), better programming, movie downloading, or some other service that increases the demand for the product as shown in the right panel. If the firm were regulated as in part b, do you think it would be more or less likely to make these investments? e. Given your answer in part d, revisit the question of price regulation and make an argument that price regulation could harm consumers once you take into account dynamic factors. Would this argument apply to all consumers or just some? If so, which ones? Solution 26. a. The profit-maximizing price and quantity are P*, Q* and the profit is illustrated. b. The regulated price and quantity are Pr, Qr. At this price P = AC so the firm makes normal profit. c. Consumers are better off under price regulation as the price is lower and the quantity is higher. Consumer surplus, for example, increases from triangle abP* to triangle acPr. d. A firm that is free to profit-maximize can increase its profits by investing in new technologies that shift the demand curve out (notice that profit is larger in the right panel). A regulated firm doesn’t earn excess profits when it invests in new tech-nologies and so is less likely to make investments that expand the demand curve. (In theory, a firm that was guaranteed to recover its costs would be willing to make new investments, but in practice it’s reasonable to assume that when the profits from investment decline, the probability that the investment happens will also decline.) e. Under price regulation, you are less likely to see investments in new technolo¬gies that increase demand. But notice that in the right panel, depending on how big the rise in demand turns out to be, consumer surplus could be even larger than in the left panel, where the government regulated the market. Thus, if price regulation impedes new investment and dynamism, then it may reduce consum¬er surplus in the long run. Not all consumers appreciate dynamism! Consumers of cable TV who just want to watch reruns of Law and Order and ER may be better off under price regulation. Consumers who appreciate new shows, high definition, movie down¬loading, and so forth may be better off with higher prices but greater dynamism. CHAPTER 14 Modern Principles of Economics: Price Discrimination and Pricing Strategy Facts and Tools 1. True or false? A business that price-discriminates will generally charge some cus¬tomers more than marginal cost, and it will generally charge other customers less than marginal cost. Solution 1. False: Price discrimination has little to do with charging less than marginal cost. The goal is to charge some customers a little more than MC and others a lot more than MC. 2. Two customers, Fred and Lamont, walk into a Grady’s Used Pickups. Who probably has a more inelastic demand for one of Grady’s pickups: people like Lamont, who are good at shopping around, or people like Fred, who know what they like and just buy it? Solution People like Fred, who make quick, impulsive decisions, have inelastic demand: They don’t shop around much and aren’t very sensitive to price. Customers like Fred are every business owner’s dream. 3. Who probably has more elastic demand for a Hertz rental car: Someone who reserves a car online weeks before a trip, or someone who walks up to a Hertz counter after he walks off an airplane following a 4-hour flight? Who probably gets charged more? Solution The person who shops in advance probably has a more elastic demand: If Hertz charges too much, it’s easy to go to another car rental website and quickly check other prices. But after a long flight, few people are willing to wait in the Hertz line, find out the price is high, and then jump into the National or Enterprise line. This second person probably gets charged more as a result. 4. When arbitrage is easy in a market of would-be price discriminators, who is more likely to get priced out of the market: those with elastic demand or those with inelastic demand? Solution 4. When arbitrage is easy, it’s the person with the elastic demand who is likely to get priced out. Arbitrage turns this back into a normal monopoly market, and at the higher monopoly price, the price might rise above the elastic person’s cutoff level. 5. There are people who absolutely must have the latest fashions. Can you classify them as probably having elastic or inelastic demand? Solution 5. They are inelastic. 6. Why would a firm hand out coupons for its products rather than just lowering the price? (Hint: At your school, what kind of students use coupons to buy their pizza? What kind of students never use coupons to buy their pizza?) Solution 6. The careful, price-conscious students (elastic demand) probably use coupons to buy pizza. Students with impaired judgment, a lot of money, or little time on their hands (inelastic demand) probably never use coupons. So lowering the price will result in the loss of profits from those students who do not use coupons. 7. Where will you see more price discrimination: In monopoly-type markets with just a few firms or in competitive markets with many firms? Why? Solution 7. In monopoly-type markets: In these markets, individual firms face downward-sloping demand curves, and they want to pick off the customers at different price levels, if possible. But in a competitive market, like for socks or fast food, if one firm tried to price-discriminate, another firm would just jump in and offer a lower-but-still-profitable price. The power of free entry—key to a competitive market—makes it much harder to lump customers into different price-discrimination categories. 8. When will a monopoly create more output: When it is allowed to and can perfectly price-discriminate or when the government bans price discrimination? Solution 8. It will create more output when it can perfectly price-discriminate. (The answer is more ambiguous when the company can only carve out two categories, as in the pharmaceutical example in the chapter.) 9. Some razors, like Gillette’s Fusion and Venus razors, have disposable heads. The razor comes with an initial pack with a razor handle plus three or four heads; after that, you need to buy refills separately. a. Where do you think Gillette gets more revenue: By selling the initial pack or by selling the refills? b. The next time you buy a new razor, are you going to spend more time looking at the price of the razor or at the price of the refills? Solution 9. a. By selling the refills. A typical person will spend much more money on refills than on the original razor handle. b. You should certainly spend more time looking at the price of the refills, just as you should spend more time looking at the cost of printer cartridges before you buy a new printer. You may even want to ask your car dealer how much they charge to replace a transmis¬sion before you buy a new car there: That’s another form of tying. Thinking and Problem Solving 10. Subway, the fast-food chain, sells foot-long sandwiches for $5 each. However, Subway still sells 6-inch sandwiches for more than $2.50 each, that is, at a higher price per inch of sub. a. Can you think of a way that in theory you could make money from Subway’s pricing practices? Would this method work in practice? What does this tell you about the limits of arbitrage? b. In many of our price-discrimination examples, we think that businesses try to break customers into two groups: more price-sensitive and less price-sensitive. What kinds of Subway customers fit into the first group? Into the second? Busy lawyers with 20-minute lunches College students Health-conscious soccer moms Long-haul truck drivers Solution 10. a. Subway’s pricing strategy is not an unreasonable idea, at first glance. You might be able to sell 50 or 60 sandwiches out in front of a busy store during a lunch rush, making $25 to $60 an hour. But, it’s probably illegal to sell food on the street in most towns. Plus, people go to Subway to order sandwiches with custom toppings, and you’d have a tough time offering that kind of variety. Product customization is one way to make arbitrage difficult. Of course, you might do a decent business carrying the sandwiches back to your dorm and selling them there, but since even college students value freshness, you’d have to move them very quickly. It’s a tough business proposition. b. Busy lawyers and soccer moms probably are less price-sensitive. Lawyers are richer, and value convenience above all else. The soccer moms are there to get just the right healthy toppings and may be richer, as well. College students and truck drivers want to eat as cheaply as possible; truck drivers especially may pass many suitable substitutes for Subway on the highway. 11. A dry cleaner has a sign in its window: “Free Internet Coupons.” The dry cleaner lists its Web site, and indeed there are good discounts available with the coupons. Most customers don’t use the coupons. a. What probably would be the main difference between customers who use the coupons and those who don’t? b. Some people might think “The dry cleaner offers the coupons to get people in the door to try the place out, but then the customers will pay the normal high price afterward.” But the coupons are always there, so even repeat customers can keep using the coupons. Is this a mistake on the business owner’s part? (Hint: Think about marginal cost.) Solution 11. a. Those who use the coupons are probably more price-sensitive: They’re the kind of people who worry about saving a little on dry cleaning. (Those who use the coupons may also be poorer, on average, but that’s probably not as important as being price-sensitive. Many poor people pay full price, and lots of non-poor people use coupons.) Overall message: The kind of people who can’t be both¬ered to carry around coupons probably have pretty inelastic demand for dry cleaning. b. This chapter emphasized that as long as the product’s price is above the marginal cost of producing the product, it’s good to sell more. The coupon price is prob¬ably above marginal cost (just like the price of the drug Combivir in Africa): The impulse shop¬pers pay the high price, and the careful shoppers pay the low price. As long as both prices are above marginal cost, this is a reasonable business decision. 12. a. When will a firm find it easier to price-discriminate: before the existence of eBay or afterward? b. Which of the two “principles of price discrimination” does this invoke? Solution 12. a. Before: eBay makes it easy for people who “buy cheap” to resell their products anonymously. b. Arbitrage must be difficult for price discrimination to work. 13. As we saw in this chapter, drug companies often charge much more for the same drug in the United States than in other countries. Congress often consid¬ers passing laws to make it easier to import drugs from these low-price countries (it also considers passing laws to make it illegal to import these drugs, but that’s another story). If one of these laws passes, and it becomes effortless to buy AIDS drugs from Africa or antibiotics from Latin America—drugs that are made by the same compa¬nies and have essentially the same quality controls as the drugs here in the United States—how will drug companies change the prices they charge in Latin America and Africa? Why? Solution 13. The equilibrium price will rise in Latin America and Africa, because the drug companies will know that much of what they send there will wind up back in the United States. 14. Some people think that businesses create monopolies by destroying their competition, and there is certainly some truth to that. But as we learned from Obi-Wan Kenobi, “[Y]ou will find that many of the truths we cling to depend greatly on our own point of view.” For instance, some people (Convenience Shop¬pers) love shopping at one particular store and will switch stores only when a prod¬uct is outrageously expensive, while other people (Bargain Shoppers) will gladly spend hours looking through newspaper advertisements searching for the best deal. a. When both kinds of people, the Convenience Shoppers and the Bargain Shoppers, are shopping at the same Walmart, who is more likely to stick to their prearranged shopping list, and who is more likely to splurge on a little some¬thing? b. Which group does Walmart have monopoly power over? Which group does Walmart have no monopoly power over? c. Does this mean that the same shop can simultaneously be a “monopolist” to some customers and a “competitive firm” to other customers? Why or why not? d. Does this mean that Darth Vader really did kill Anakin Skywalker? Solution 14. a. The Bargain Shoppers will stick to their prearranged, low-price shopping list. The Convenience Shoppers will splurge. b. Walmart has monopoly power over Convenience Shoppers: They will buy whatever looks good. Walmart will have little power over the Bargain Shoppers: When these shoppers walk into Walmart, they only “see” the good with the competitive price. c. Yes. If you shop around carefully, Walmart is a “competitive firm” to you. If you buy whatever looks best, Walmart often charges you higher, “monopoly” prices. d. It “depends on your own point of view.” 15. Where are you more likely to see businesses “bundling” a lot of goods into one package: In industries with high fixed costs and low marginal costs (like computer games or moviemaking), or in industries with low fixed costs and high marginal costs (like doctor visits, where the doctor’s time is expensive)? Solution 15. You tend to see bundling in low-marginal-cost industries, when the business has a big incentive to add a little bit more value to the product, since for little extra cost the business can charge a much higher price. 16. Isn’t it surprising that movies, with tickets that cost around $10, often use vastly more economic resources than stage plays, where tickets can easily cost $100? Compare, for example, a live stage performance of Shakespeare’s Hamlet with a movie of Hamlet. a. In which field is the marginal cost of one more showing lower: on stage or on screen? b. “Bundling” in a movie or stage performance might show up in the form of add¬ing special effects, expensive actors, or fancy costumes: Some customers might not be too interested in an Elizabethan revenge drama, but they show up to see Liam Neeson waving an authentic medieval dagger. Is it better to think of these extra expenses as “fixed costs” or “marginal costs?” c. In which setting will it be easier for a business to cover its total costs: In a “bundled” stage production or in a “bundled” movie production? Solution 16. a. On screen: Once you’ve made the film, making extra copies is easy, and show¬ing the movie one extra time per week is even easier. If you want to show a play one more time, though, you have to pay all of the performers and all of the stage hands for a few more hours of labor—and that adds up. b. These are more like fixed costs: You pay them regardless of how many people see the play or movie. c. In a bundled movie production: A moviemaker can spread the fixed cost over millions of movie viewers. 17. When is a pharmaceutical company more likely to spend $100 million to research a new drug: when it knows it will be able to charge different prices in different coun¬tries or when it knows that it will be required to charge the same price in different countries? Why? Solution 17. When it can charge different prices in different countries. This is because price dis¬crimination always offers the promise of higher profits than a one-price-for-all rule. And the lure of high profits is what brings forth the drug research. 18. True or false? A price-discriminating business will be willing to spend money to make a product worse. Solution 18. True: The HP printer story in the chapter is a good example. A car dealer might buy cars that all have good stereo systems and then pay workers to take them out and put in cheap AM radios in order to price-discriminate, as well. 19. Let’s calculate the profit from price discrimination. The average daily demand for dinners at Paradise Grille, an upscale casual restaurant, is as follows: Demand for dinners by senior citizens: P = 50 − 0.5Q MR = 50 − Q Demand for dinners by others: P = 100 − Q MR = 100 − 2Q Marginal cost = 10 in both cases. a. What is the profit-maximizing price for each group? b. Translate this into real-world jargon: If you owned this restaurant, what “senior citizen discount” would you offer, in percent? c. Ignoring fixed costs, how much profit would Paradise Grille make if it did this? d. If it became illegal to discriminate on the basis of age, you would face only one demand curve. Adding up these two demand curves turns out to yield: P = 67 − (1/3)Q MR = 67 − (2/3)Q What is the optimal price and quantity in this unified market? Are the total meals sold in this discrimination-free market higher or lower than in part a? e. What is the profit in this discrimination-free market? Solution 19. a. Set MC = MR in each case, and solve. Seniors: Q = 40; 50 − 0.5(40) = 30 = P Others: Q = 45; 100 − 45 = 55 = P P(senior) = $30, P(others) = $55. b. You’d offer a ($55 − $30)/$55 = 45 percent discount to seniors. c. Profit = Total revenue − Total variable costs = $30 × 40 + $55 × 45 − $10 × 85 = $2,825 d. P = $38.50, Q = 86. In this case, the price is somewhere in between the two prices, and the quantity is actually slightly higher (a possibility noted in the chapter). e. Profit = $2,436.75 per night, which is almost $400 per night less than before, or more than $140,000 less per year. 20. At the Kennedy Center for the Performing Arts in Washington, D.C., if you make a $120 donation per year, you are allowed to go to a small room before the concert and drink free coffee and eat free cookies. If you make a donation of $1,200 per year, you are allowed to go to a different small room before the concert and drink the same free coffee and eat the same free cookies. There are always a lot of people in both rooms be¬fore the concert: Why doesn’t everybody just pay the $120 instead of the higher price? Solution 20. There’s more than one answer here. One reason is probably because some people want to show that they are able to pay $1,200 per year, and showing up in the special room is an easy way to prove it. Also, some people like to show that they care about music enough to pay $1,200 per year to support the Kennedy Center. So demonstrating that you are “rich” and that you “care” are worth enough for people to spend an extra $1,080 per year. Note that most charities and political campaigns have various “donor levels” in order to price-discriminate: The higher up you go, the bigger they print your name at the entrance. Challenges 21. In the following table, we consider how Alex, Tyler, and Monique would fare under à la carte pricing and under bundling for cable TV when there are two channels: Lifetime and the Food Network. Alex and Tyler like to watch Project Runway so they each place a higher value on Lifetime than on the Food Network. Monique is practicing to be an Iron Chef in her second life and so she places a higher value on the Food Network than on Lifetime. a. If the channels are priced individually, the most profitable prices for the cable operator turn out to be 10 for Lifetime and 7 for the Food Network. At these prices, who buys what channel and how much profit is there? b. Let’s just check to see if these prices really are profit-maximizing. What would profit be if the cable company raised Lifetime to a price of 11 and Food Net¬work to a price of 8? c. At the profit-maximizing prices, how much total consumer surplus would there be for the three of them? (Recall that consumer surplus is just each customer’s willingness to pay minus the amount each person actually paid.) d. Now consider what happens under bundling: Customers get a take-it-or-leave-it offer of both channels or nothing at all. The profit-maximizing bundle price turns out to be 12, and at that price, Alex, Tyler, and Monique all subscribe. How much consumer surplus is there at this price? How much profit? And, most important, what would profit equal if the cable company raised the price to 13 instead? Solution 21. a. At these prices, Alex and Tyler subscribe to Lifetime and Alex and Monique subscribe to the Food Network. Monique misses Project Runway and Tyler misses Flay v. Morimoto on Iron Chef. Since marginal cost is zero, total profits for the cable operator are $34 = $10 × 2 + $7 × 2. b. Tyler would be the only customer for Lifetime, yielding a profit of $11, and Mo¬nique would be the only customer buying Food Network, yielding an additional profit of $8. The total profit would be $19, far less than $34. Price hikes lose some customers, something you really want to avoid when the marginal cost of serving one more customer is zero. c. Total consumer surplus is $7 = $5 + $2. Alex values Lifetime at $10 and pays $10, Tyler values Lifetime at $15 and pays $10, giving a consumer surplus of $5. The $2 comes from Monique: She pays $7 but would have been willing to pay $9; Alex pays exactly as much as he’d be willing to pay to get the Food Network: $7, so he experiences no consumer surplus. d. Profit increases to $36 and so does consumer surplus, which increases to $10 = $3 + $7. If the cable company raised the price to $13, they’d lose Monique, and only earn a profit of $26. 22. Consider the following seating arrangement for a concert hall: The front row seats only two people. Rows B–H, about 50 feet back from the front row, seat 20 people per row. a. Would these front-row seats sell for more or for less than the front-row seats at a typical concert hall? Why? b. Why don’t we see concert halls set up like this? Solution 22. a. They would sell for much more. There are only two really good seats in the house, creating more competition between the same number of patrons. Cer¬tainly, somebody in town would be willing to pay quite a lot for these seats. b. Because the “real estate” is worth too much in the concert hall: The marginal cost of putting in some more chairs is quite low, and you can fill them up with a lot of folks. Sure, you lose the ability to charge a massive amount for just two seats, but the concert hall makes it up on volume. And there are other, cheaper ways to make concertgoers feel special. Giving just a few excellent seats isn’t the best way. 23. a. In competitive markets in the long run, if there are two kinds of steaks, “regular” and “high-quality Angus beef,” and the regular beef sells at a lower price, is this an example of price discrimination? b. How is this different from the HP printer story in this chapter? Solution 23. a. In a competitive market, we know that Price = Average cost in the long run. So the Angus beef must cost more to produce. b. In the HP market, HP presumably is not competitive enough for P = AC to be true. Instead, it’s a monopoly-type market, one in which you might actually spend more to make a worse product. 24. Amanda and Yvonne are thinking of going out to the movies. Amanda likes action flicks more, but Yvonne likes a little bit of romance. Warner Bros. is trying to decide what kind of movies to make this year. Should it make one movie for release this summer, an action flick with a romantic subplot, or should it make two movies for release this summer: an action flick and a romantic drama? Here’s the two friends’ willingness to pay for the separate kinds of movies. As you can see, both Amanda and Yvonne are annoyed by the idea of a hybrid movie: Each would rather see her favorite kind of movie. Now, let’s look at this from Warner Bros. point of view. You’re the midlevel execu¬tive who has to decide which project to green light. Your marketing people have figured out that there are 5 million people like Amanda and 5 million people like Yvonne in the United States, and they’ll only see one film per summer. To make things simple, assume that the marginal cost of showing the movie one more time is zero, and that ticket prices are fixed at $8. a. If the cost of producing any of the three films is $30 million, what should it do: Make the two films or just the one hybrid film? Of course, the right way to find the answer is to figure out which choice would generate the most profit for Warner Bros. b. Of course, the hybrid might cost a bit more to make. What if the hybrid costs $40 million to make, the pure action flick $30 million, and the romance a mere $15 million? What’s the best choice now: one hybrid or two pure films? c. Let’s see how much prices would have to change for the answer to this question to change. Holding all else equal, how low would the cost of the pure romance film have to fall before the two-movie deal would get the green light? d. (Hard) There’s an underlying principle here: The “unbundled” two-movie deal won’t get the green light unless its total cost is less than what? The answer is not a number—it’s an idea. Is this likely to happen in the real world? Why or why not? Solution 24. a. It should make the hybrid film. If it made both films, it would have to pay the fixed cost twice but get the same number of customers. b. It’s still the same: Just make the hybrid. $45 million is more than $40 million. c. The cost of the romance would have to fall below $10 million before both movies would get produced. d. The two-movie deal will get made if and only if its total cost is less than the cost of the hybrid film. This is unlikely to happen in the real world very often, since movies have high fixed costs. 25. Think about the kind of 40-year-old who pulls out a faded, obviously expired student ID to get a discount ticket at a movie theater: What can you predict about his or her willingness to pay for a full-price movie? Is the movie theater making a mistake when it lets him or her pay the student price? Solution 25. This person probably has a low willingness to pay: He or she has no shame. This kind of person probably wouldn’t go to the movies if it weren’t for the low student price, so the theater is happy to have a little extra revenue from him or her. It’s bet¬ter than no revenue at all. 26. We mentioned that airlines charge much more for flights booked at the last minute than for flights booked well in advance, even for exactly the same flight. This is because people who tend to book at the last minute tend to have inelastic demand. Think of other characteristics that airlines use to vary their pricing: Do you think these characteristics are correlated with business travel or any other sort of inelastic demand? (If you don’t fly too often, just ask someone who does: “What’s the key to getting the lowest possible airfare?”) Solution 26. Airlines charge more if the traveler does not want to stay over the weekend, they charge more for travelers to be able to change their flights, and they charge more for a combination of one-way trips than for return flights. Each of these characteristics is plausibly correlated with business travel or inelastic demand. Business travelers are less likely than vacationers, for example, to want to stay over a weekend, more likely to want to change flights at the last minute, and more likely to want to travel on a circuit of cities rather than from one city to another and back. 27. Apple’s iTunes music service sells music by the song. Other services, such as Spotify and Pandora, sell subscriptions to a library of music. Using the material in this chapter, which type of service do you think is most likely to succeed in the marketplace and why? Solution 27. Spotify and Pandora are selling music as a bundle. The lessons in this chapter suggest that bundling will be more profitable than selling music on a song-by-song basis. To see why, substitute Rap and Classical for Word and Excel in Table 14.3. The argument works even better for music than for software because if a consumer values one type of music highly, then they probably value other types of music less highly. It’s the rare person who likes both Kanye and Mozart. (Moreover, there is only a limited amount of time in a day, so listening more to one type of music means listening less to other types). However, the Mozart lover may occasionally want to listen to a little Kanye, and vice-versa. By bundling, Spotify and Pandora can appeal to both types of listeners and more efficiently price discriminate. In addition, as with cable TV, there are high fixed costs to putting the bundle together but low marginal costs, so it costs very little for the bundle owner to make the entire bundle of millions of songs available to everyone. Solution Manual for Modern Principles: Microeconomics Tyler Cowen, Alex Tabarrok 9781319098766