First law of demand : consumer demand increase as price fall.

Downward demand curve

Agreegate demand curve—add up all individual demand

As price decrease quatity demanded increase.

If something other than price caused increase in demand demand shift ot the right or demand
increase. Consumers purchase more at the same price.

If MR > MC  sell more, you do this by reducing price

Reduce price (Sell more) if MR> MC. Increase price (sell less) if MR<, MC

As long as price is greater than average cost, it appears that an increase in quantity would increase
profit.Footnote However, this reasoning is incorrect because you cannot sell more without reducing the
price on all goods, and not just on the extra units your boss wants to sell.
Given the importance of price elasticity to pricing—the more
elastic is demand, the lower is the profit-maximizing price—it’s
worthwhile to understand what makes demand more or less
elastic.
Products with close substitutes have more elastic demand.
Demand for an individual brand is more elastic than industry
aggregate demand.
Products with many complements have less elastic demand.
Another factor affecting elasticity is time.

the long run, demand curves become more elastic.

As price increases, demand becomes more elastic.
price is only one of many factors that affect demand. Income,
prices of substitutes and complements, advertising, and tastes all
affect demand
If the predicted quantity is less than the stay-even quantity, then the
price increase will likely be profitable, and vice versa.
Before you owned the rival brand, you didn’t care where your
additional sales came from, but now that you own both brands,
you don’t want to steal sales from a brand that you already own.
This is sometimes called “cannibalizing” the sales of one product
with increased sales of the other. After the acquisition, you will
find it profitable to eliminate such cannibalization. You do this by
raising price on each brand.
After acquiring a substitute good, raise price on both goods.
After acquiring a complementary product, reduce price on both
products to increase profit.
 In an oral auction or english auction, bidders
submit increasing bids until only one bidder
remains. The item is awarded to this last remaining
bidder.
Since every bidder is willing to bid up to his value,
but no higher, the high-value bidder wins the item
as soon as the second-highest-value bidder drops
out.
Stronger losing bidders lead to higher winning bids.
A vickrey auction or second-price auction is a type of sealed-
bid auction in which bidders submit their bids without knowing
the bids of other participants. The item is awarded to the highest
bidder, but the winner pays the second-highest bid.

In a sealed-bid first-price auction, the highest bidder wins the

item at a price equal to the highest bid.
Collusion is more likely in small, frequent auctions than in big,
infrequent ones.
Collusion is more likely in oral auctions than in sealed-bid auctions.
To avoid the winner’s curse, you bid as if everyone else thinks the
value is less than your estimate.
To avoid the winners’ curse, you bid less aggressively as the number
of bidders increases.
Oral auctions return higher prices in a common-value setting than
sealed-bid auctions.

price discrimination is the practice of charging different prices to

different buyers or groups of buyers based on differences in demand.
nder direct price discrimination, we can identify members of
the low-value group, charge them a lower price, and prevent them
from reselling their lower-priced goods to the higher-value group
(arbitrage). Under indirect price discrimination, we cannot
perfectly identify the two groups or cannot prevent arbitrage, so
we must find indirect methods of setting different prices to the
two different groups
Charge all customers the same price, unless the cost of serving them
varies. But feel free to cut price to any customer to meet the lower
price of a competitor.

This indirect price discrimination differs from the direct price

discrimination of Chapter 13 because high-value
customers could clip coupons if they wanted. If too many high-
value customers (those with a low elasticity of demand) clip
coupons, then the attempt at price discrimination becomes
unprofitable.

These examples show that indirect price discrimination is not only

a pricing issue, but also a product design issue. We avoid
cannibalization by making the lower-priced version as
unattractive as possible to commercial users by disabling the
features most important to them
Do not tie the sale of one product to another. Such arrangements
are only legal in a few rare instances—to ensure effective
functioning of complicated equipment, to name one. But they are
generally against the law.
When bargaining with a customer, do not bargain over unit price;
instead, bargain over the bundled price.
Bundled pricing allows a seller to extract more consumer surplus
if willingness to pay for the bundle is more homogeneous than
willingness to pay for the separate items in the bundle
 When a seller cannot identify low- and high-value
consumers or cannot prevent arbitrage between
two groups, it can still discriminate indirectly by
designing products or services that appeal to groups
with different price elasticities of demand.
 If you offer a low-value product that is attractive to
high-value consumers, you may cannibalize sales of
your high-price product.
 Metering is a type of indirect discrimination that
identifies high-value consumers by how intensely
they use a product (e.g., by how many cartridges
they buy). In this case, charge a big markup on the
cartridges and a lower markup on the printer.
 When pricing for an individual customer, do not
bargain over unit price. Instead, you should
 offer volume discounts;
 use two-part pricing; or
 offer a bundle containing a number of units.
 Bundling different goods together can allow a seller to

extract more consumer surplus if willingness to pay
for the bundle is more homogeneous than
willingness to pay for the separate items in the
bundle.
The Nash equilibrium of a prisoners’ dilemma represents an
unconsummated wealth-creating transaction between players.
o not discuss prices with your competitors. That is one of those
black-and-white areas. The enforcement authorities can be counted
on to bring a criminal prosecution if they learn that you have met
with your competitors to fix prices or any other terms of sale. Jail
time is increasingly common.
As a general matter, it is easier to get out of a prisoners’ dilemma
when the game is repeated
 In sequential-move games, players observe all prior
decisions of the rival before deciding on a strategy.
 In simultaneous-move games, players do not
observe the rival’s decision before deciding on their
own strategies.
 A Nash equilibrium is a pair of strategies, one for
each player, in which each strategy is a best
response to the other. These represent the likely
outcomes of games.
 When the rules of the game are flexible, change them
to your advantage.
 In sequential games, players can change the outcome
by committing to a future course of action. Credible
commitments are difficult to make because they
may require players to threaten to act against their
own self-interest.
  In the prisoners’ dilemma, conflict and cooperation
are in tension—self-interest leads the players to
outcomes that no one likes. Studying the games can
help you find a way to avoid these bad outcomes.
 In repeated games, it is much easier to get out of bad
situations. Here are some general rules of thumb:
 Be nice: No first strikes.
 Be easily provoked: Respond immediately to rivals.
 Be forgiving: Don’t try to punish other players too
much.
 Don’t be envious: Focus on your own slice of the
profit pie, not on your competitor’s.
 Be clear: Make sure your competitors can easily
interpret your actions.
The best threat is one you never have to use.
To summarize: the strategic view of bargaining suggests that if
you can commit to a position, you can capture a bigger share of
the gains from agreement. But committing to a position is difficult
because it requires you to act against your self-interest. If your
rival doesn’t believe your commitment, she will test you and you
may go through a period of no agreement.
The games just described take a strategic view of bargaining, in
which the outcome depends on who moves first and who can
commit to a position.
To improve your own bargaining position, improve your outside
option, or decrease that of your opponent.

This nonstrategic view of bargaining tells you that if you

can decrease your own gain to reaching agreement
by improving your outside option, you become a tougher
bargainer because you have less to gain by reaching agreement

 he strategic view of bargaining envisions bargaining

as a game of chicken where the ability to commit to
a position allows a player to capture the lion’s share
of the gains from trade.
 However, credible commitments are difficult to make
because they require players to commit to a course
of action against their self-interest.
 The nonstrategic view of bargaining does not focus
on the explicit rules of the game to understand the
likely outcome of the bargaining. Rather, it is the
alternatives to agreement that determine the terms
of any agreement.
 Anything you can do to increase your opponent’s
gains from reaching agreement or to decrease your
own will improve your bargaining position.
A principal wants an agent to act on her behalf. But agents often
have different goals and preferences than do principals.
The problem the principal faces is that the agent has different
incentives than does the principal, which we call an incentive
conflict
The principal has to decide which agent to hire (a problem of
adverse selection). Once the agent is hired, the principal has to
figure out how to motivate the agent (moral hazard).
In fact, the costs associated with moral hazard and adverse
selection are called agency costs because we analyze them using
principal–agent models. A well-run firm will find ways to reduce
agency costs; poorly run firms often blindly incur agency costs or
unwittingly make decisions that increase them.
A principal can reduce agency costs if she gathers information
about the agent’s type (adverse selection) or about the agent’s
actions (moral hazard).
Incentive compensation imposes risk on the agent for which he must
be compensated.
Either move information to those who are making decisions or move
decision-making authority to those who have information.
When you centralize decision-making authority, you should also
figure out how to transfer information to the decision-make
When you decentralize decision-making authority, you should also
strengthen incentive-compensation schemes.
The logic is clear. Once you give an agent authority to make
decisions, you want to make sure that he is motivated to make
choices in the firm’s best interest
he conflict between the art experts and their employer is fairly
typical of the general incentive conflict that arises in organizations
with separate sales and marketing divisions. The two divisions
rarely get along, and this is often due to the different incentives
that they are provided. Marketing managers generally receive
profitability bonuses as compensation, whereas salespeople
receive commissions based on revenue. They disagree about what
price to charge because the marketing principal wants to
maximize profit—that is, by making sales where MR > MC. In
contrast, the sales agent wants to maximize revenue by making
sales where MR > 0. This means that the salesperson prefers more
sales or, equivalently, lower prices.
 ummary of Main Points
 Principals want agents to work in the principals’
best interests, but agents typically have different
goals from those of principals. This is
called incentive conflict.
 Incentive conflict and asymmetric information lead
to moral hazard and adverse selection.
 The costs of controlling incentive conflict (agency
costs) go down if the principal can gather
information about the agent’s productivity (adverse
selection) and about his actions (moral hazard).
 Three alternatives for controlling principal–agent
conflicts are
1. reassigning decision rights,
2. transferring information, and
3. changing incentives.
 In a well-run organization, decision-makers have

o (1)
the information necessary to make good decisions
and
o (2)
the incentive to do so.
3. If you decentralize decision-making authority, you
should strengthen incentive-compensation schemes.
4. If you centralize decision-making authority, you
should make sure to transfer needed information to
the decision-makers.
 Agents may try to “game” incentives, maximizing their
own profit at the expense of the principal.
  Three approaches to controlling incentive conflicts
are
0. a fixed payment to the agent (akin to company-
owned stores with salaried managers, giving rise to
agency costs, and requiring monitoring costs to
overcome them),
1. incentive pay (akin to franchising, requiring no
monitoring but requiring agents to be compensated
for bearing risk), or
2. sharing contracts, which blend the above two
approaches (requiring some monitoring, some
agency costs, and some risk compensation).
 To analyze principal–agent conflicts, focus on three
questions:
0. Who is making the (bad) decision?
1. Does the decision-maker have enough information
to make good decisions?
2. Does the decision-maker have the incentive to make
good decisions?
ith two simple modifications, we can apply the framework set up
in Chapter 21 to make sure that the incentives of the various
divisions are aligned with the goals of the parent company. The
first is to “personify” the division as being controlled by a division
manager. So when we ask the three questions, we are really
talking about the division manager’s decision rights, information,
and incentives.
The second modification relates to the first question asked in the
framework. A complicating feature of applying our method to
problems created by conflict between divisions is how to reduce
the problem to a simple decision. F
 Companies are principals trying to get their divisions
(agents) to work profitably in the interests of the
parent company.
 Transfer pricing does not merely transfer profit from
one division to another; it can stop assets from
moving to higher-valued use. Efficient transfer
prices are set equal to the opportunity cost of the
asset being transferred.
 A profit center on top of another profit center can
result in too few goods’ being sold; one common
way of addressing this problem is to change one of
the profit centers into a cost center. This eliminates
the incentive conflict (about price) between the
divisions.
 Companies with functional divisions share functional
expertise within a division and can more easily
evaluate and reward division employees. However,
senior management must often coordinate the
activities of the various divisions.
 An M-form or multidivisional structure has divisions
that perform all the functional tasks to serve specific
customer types or geographic areas.
 When divisions are rewarded for reaching a budget
threshold, they have an incentive to lie to make the
threshold as low as possible, thus ensuring they get
their bonuses. In addition, they will often pull sales
into the present, and push costs into the future, to
 make sure they reach the threshold level. A simple
linear compensation scheme solves this problem.
Individual Problems
 22-1Transfer Pricing
Suppose that a paper mill “feeds” a downstream box
mill. For the downstream mill, the marginal
profitability of producing boxes declines with
volume. For example, the first unit of boxes
increases earnings by $10, the second by $9, the
third by $8, and so on, until the tenth unit increases
profit by just $1. The cost the upstream mill incurs
for producing enough paper to make one unit of
boxes is $3.50.
1. If the two companies are separate profit centers,
and the upstream paper mill sets a single transfer
price (the price the box company pays the paper
mill), what price will it set, and how much money
will the company make?
2. If the paper mill were forced to transfer at marginal
cost, how much money would the company make?
22-2Transfer Prices Set by Headquarters
List three reasons why it might be a bad idea to have
corporate headquarters set transfer prices.

22-3Chargebacks
Your local fast-food chain with two dozen stores
uses the company’s internal corporate marketing
department to produce signage, print ads, in-store
displays, and so forth. When placing an order, store
managers are assessed a chargeback (transfer price)
that reduces store profitability but increases
marketing department profitability. Lately, the store
managers have been ordering more and more
marketing services; the marketing department is
swamped, and it cannot afford to hire more staff.
What does this indicate about the chargeback rates?

22-4Divisional Profit Measure

Discuss the advantages and disadvantages of using
divisional profit as the basis of incentive
compensation for division managers compared to
using company profit as the basis.

22-5Furniture Forecasting
Futura Furniture Products manufactures upscale
office furniture for the “Office of the Future.” The
sales division comprises regionally based sales
offices made up of sales representatives and
regional managers. Sales representatives—who
report to the regional managers—conduct direct
sales efforts with customers in their regions. As part
of the sales process, representatives gather
information about likely future orders and convey
that information back to the regional managers.
Regional managers use that information to create
sales forecasts, which are then used as the basis for
manufacturing schedules.
Sales representatives and regional managers are
both compensated on a salary plus commission
(percentage of revenue as pricing is centrally
controlled). However, a regional manager’s
commission is adjusted based on regional sales that
exceed the forecasted budget.
Corporate managers are concerned with one of
Futura’s key products, the “DeskPod.” They worry
that DeskPod forecasts are inaccurate, causing
extreme havoc in the manufacturing process. How
are the forecasts likely to be inaccurate? What do
you think is driving this inaccuracy? How might this
problem be solved?

22-6Jet Turbine Design

This problem is mentioned in the text (see the
section on “Organizational Alternatives”). Your task
is to propose an organizational solution. To briefly
recap, a manufacturer is trying to design the next
generation of turbine engines for jet airplanes. The
company is divided along functional lines.
Engineering designs the engine, production
manufactures it, and finance figures out how much
to charge for it. The engineers invented a radical
new design that used hollow fan blades. The award-
winning design used less fuel than conventional
engines, but the hollow fan blades were very
difficult to build. When the Finance Division
computed the marginal cost of an engine, it
discovered that the new engines were much more
expensive than rival engines, even accounting for
the expected fuel savings. No one purchased the
engine. How would you make sure that this problem
does not recur?

Group Problems
G22-1Transfer Pricing
Does your company use transfer pricing to “charge”
divisions for the cost of the products they consume?
Are these prices set equal to the opportunity cost of
the product? Why or why not? Can you think of a
better organizational architecture? Compute the
 profit consequences of changing the organizational
architecture.

G22-2Divisional Evaluation
Discuss a division or subunit of your organization
and how it is evaluated (revenue center, profit
center, cost center, etc.). How does the evaluation
scheme affect performance? If it is optimal, explain
why. Otherwise, explain why you think it is
suboptimal, and recommend what you would do if
you were free to change it. Compute the profit
consequences of the change.

G22-3Budget Games
Does your company tie compensation to meeting a
budget? If so, what kind of problems does this
practice cause? What can you do to fix these
problems? Compute the profit consequences of
changing the process.

G22-4Functional Silos versus Process Teams

Is your company organized around functional
divisions? If so, what kind of problems does this
cause? What can you do to fix these problems?
Compute the profit consequences of fixing the
problem.
If unrealized profit exists at one stage of the vertical supply chain,
firms can capture some of the unrealized profit by adopting a
variety of contractual or organizational forms.

 If unrealized profit exists at one stage of the vertical

supply chain—as often happens as a consequence of
 incentive conflict—a firm can capture some of the
unrealized profit by integrating vertically, tying,
bundling, or excluding competitors.
 Double marginalization problems occur in supply
chains because the same input is marked up
multiple times. Vertical integration or price
contracts that keep marginal input prices closer to
MC will raise total profit.
 Manufacturers typically want higher-quality, lower
retail prices, higher sales effort, and higher levels of
promotional activity than retailers want to provide.
Manufacturers and retailers use a variety of formal
and informal agreements to more closely align the
incentives of retailers with the profitability goals of
manufacturers.
 Vertical integration can facilitate downstream price
discrimination schemes.
 Most countries have antitrust laws that regulate
vertical relationships. To avoid running afoul of
these laws, remember that if you have significant
market power, you should consider the effect that
any planned action will have on competitors.
 Do not purchase a customer or supplier merely
because that customer or supplier is profitable.
There must be a synergy that makes it more
valuable to you than it is to its current owners. And
do not overpay.

23-1Local Phone Companies

State utility commissions typically regulate local
phone companies, but local phone companies also
offer long-distance service to their customers. Rival
long-distance carriers also connect to local phone
lines to provide long-distance service to customers.
Recently, the rival long-distance carriers have
complained that the local phone company repair
persons have put peanut butter on rival long-
distance carriers’ phone lines to encourage rats to
eat through the lines. If true, why is this a profitable
strategy?

23-2Integration of Physician Groups and Testing

Services
Under a proposed health-care reform, doctors’ fees
will be capped at 80% of their current rate, but
doctors can order blood tests that will be
reimbursed at 90% of the current rate. How does
vertical integration of physician groups into testing
services increase profits?

23-3Online Cosmetics
Australian cosmetics maker, Eternal Beauty
Products, pressures online retailers to either sell
goods at prices charged by brick and mortar stores
or risk being cutoff. If online retailers are paying the
same wholesale prices, why would Eternal not want
online retailers to charge lower prices?

23-4Wedding Dresses
Stores that sell wedding dresses do not typically
permit photos, and do not have tags in the dresses
that would identify the manufacturer and style type.
What is the purpose of these rules? Suggest one
other way of accomplishing the same objective.
23-5Herbicide Integration
Suppose the herbicide manufacturer mentioned in
the chapter can vertically integrate only into home
gardening retailing. Would this allow the
manufacturer to price discriminate?

23-6Loyalty Payments
Intel made large loyalty payments to HP in exchange
for HP buying most of their chips from Intel instead
of rival AMD. AMD sued Intel under the antitrust
laws, and Intel settled the case by paying $1.25
billion to AMD. What incentive conflict was being
controlled by these loyalty payments? What advice
did Intel ignore when they adopted this practice?

Group Problems
G23-1Managing Vertical Relationships
Identify a vertical relationship in your company and
determine whether it could be managed more
profitably by tying, bundling, exclusion, or vertical
integration. Clearly identify the source of the
profitability (e.g., regulatory evasion, elimination of
double markup, better goal alignment, or price
discrimination), and describe how to exploit it.
Estimate the change in profit.

G23-2Undoing Vertical Relationships

Identify a vertical relationship in your company, and
determine whether it could be managed more
profitably by outsourcing, untying, unbundling,
inclusion of rivals, or vertical disintegration. Clearly
identify the source of the profitability and describe
how to exploit it. Estimate the gain in profit from the
change.