ECONOMICS 121A

INDUSTRIAL ORGANIZATION
SPRING QUARTER 2009
PROFESSOR REQUENA

PROBLEM SET 2

DUE: APRIL 17TH

PROBLEM 1
A food co-op sells a homogenous good, called groceries, with the quantity sold denoted by q.
The co-op´s cost function is described by C (q ) = F + cq , where F denotes fixed costs and c is
the constant per-unit variable cost. At the meeting of the co-op board, a young economist
proposes the following marketing strategy for the co-op: Set a fixed membership fee, M, and a
price per unit groceries, p M , that members pay. In addition, set a price per unit of groceries, p N ,
higher than p M at which the co-op will sell groceries to non-members.

a. What must be true about the demand of different customers for this strategy to work?
The consumers who join must have a higher demand for groceries than those who do not.
Since they are willing to buy more groceries as a given price, the co-op would like to give
them a quantity discount.

b. What kinds of price discrimination does this strategy employ?

This is an example of second price discrimination.

PROBLEM 2
A night club owner has both student and adult customers. The demand for drinks by a typical
student is Q S = 18 − 3P . The demand for drinks by a typical adults is Q A = 10 − 2 P . There are
equal number of students and adults. The marginal cost of each drink is $2.

a. What price will the owner set if she cannot discriminate between the two groups? What
will her total profit be at this price?

Aggregate demand is Q S + A = (18 − 3P ) + (10 − 2 P ) = 28 − 5 P , inverse demand is

P = 28 / 5 − 1 / 5Q S + A and marginal revenue is MR = 28 / 5 − 2 / 5Q S + A

MR=MC, that is , 28 / 5 − 2 / 5Q S + A = 2 → Q S + A = 9
Her profits without price discrimination: π = ( P − 2)Q = 16.2
 b. If the club owner could separate the groups and practice third-degree price discrimination
what price per drink would have charged to members of each group? What would be
club´s owner profits?

If the club owner can price discriminate, she will equate marginal revenue and marginal
cost for each group. That is,
6 − 2 / 3Q S = 2 → QS = 6 → PS = 4
5−QA = 2 →QA = 3 → P A = 3 .5
Hence, total profit with price discrimination is
π S + π A = (4 − 2)(6) + (3.5 − 2)(3) = 12 + 4.5 = 16.5

c. If the owner can “card” patrons and determine who among them is a student and who is
not and , in turn, can serve each market by offering a cover charge and a number of drink
tokens to each group, what will be the cover charge and the number of tokens given to
students be? What will be the cover charge and the number of tokens given to adults?
What is the club owner´s profit under this regime?

In this scenario, the owner club can practice two-part pricing. For each group, the number
of token will be equal to quantity demanded at price $2, which is the marginal cost of a
drink.
Number of tokens for students = 18 − 3(2) = 12
Number of tokens for the adults = 10 − 2(2) = 6

Now for each group, the cover charge should equal the consumer surplus received at the
given number of tokens. That is,
1
Cover charge for students = (6 − 2)(12) + 2(12) = 48
2
1
Cover charge for an adult = (5 − 2)(6) + 2(6) = 21
2
Therefore, her profits = Total revenue – total cost of drinks =
1 1
(6 − 2)(12) + 2(12) + (5 − 2)(6) + 2(6) − 2(12) − 2(6) = 33
2 2

PROBLEM 3
A country club knows that all of its customers have a (inverse) demand curve for golf rounds of
P = 500 – Q, per year. Furthermore, because it is so exclusive and there are not many members,
the marginal cost of a round of golf is essentially zero.

(a) Suppose the management of the country club charged just one uniform price. Calculate the
optimal price and the per member profit that the country club earns.
 ∂π
Profit maximization: π = 500Q − Q 2 → = 500 − 2Q = 0 → Q U = 250 → P U = 250
∂Q
Total profits: 250*250
Per member profits= 250

(b) Now suppose the management took 121A and is interested in designing a two-part tariff (a
fixed fee and a per golf round fee). What would be the fixed fee? What would be the per round
fee? What would per member profits be?

1
Calculate the consumer surplus: CS = (500 − 0) 2 = $125000
2
Golf round fee=0 → Profit per round = 0 → Consequence: max demand = 500

Q = 500 members

Per member fee = $125000/500 = $250

Monopoly gets the entire consumer surplus.

PROBLEM 4
A university has determined that its students fall into two categories when it comes to room and
board demand. University planners call these two types Sleepers and Eaters. The reservation
prices for a dormitory room and the basic meal plan of the two types are as follows:

SLEEPERS EATERS
DORM ROOM $5,500 $3,000
MEAL PLAN $2,500 $6,000

Currently, the university offers students the option of selecting just the dorm room at $3,000, just
the meal plan at $2,500, or both for a total price of $5,500. An economic consultant advises the
university to stop offering the two goods separately and, instead, to sell them only as a single,
combined room and board package. Explain the consultant´s strategy and determine what price
the university should set for the combined product.

Answer:
By allowing the student to pick and choose rather than buying a bundle, each group is
getting one of the items at a price well below their reservation price.

While the sleepers get no consumer surplus from the meal plan price of $2500, they get
$2500 in consumer surplus from the dorm price of $3000 or the package price of $5500.
Similarly, the eaters get surplus $3500 from the meal plan price of $2500 or the package
price of $5500. By creating a bundle the university can capture a large amount of this
consumer surplus.
Assuming all students need to sleep and eat, a package price of $8000 would significantly
raise revenue. This would exhaust all the surplus of the sleepers and all but $1000 of the
surplus of the eaters.