Module 5 – Competition and Differentiation

Question 1

A monopolistic coffee producer discovers that 30% of the people in the region are willing to pay $15 for a pound of coffee, another 25% are willing to pay $20, and the remaining 45% are only willing to pay $12. The cost of producing each pound of coffee is $10. How much should the monopolist charge for each pound of coffee?

• $10
• $12
• $15
• $20

Answer 1

$10

At a price of $10, the monopolist will sell coffee to everyone in the region, but will not make any profit since the cost of each pound of coffee sold is also $10.

$12

At a price of $12, the monopolist will sell coffee to everyone in the region. Since the cost of each pound of coffee is $10, the monopolist will make $2 on every pound it sells. Thus profit will be equal to $2 multiplied by the number of people in the region.

$15

At a price of $15, the monopolist will not sell coffee to the 45% of people who are only willing to pay $12, so 55% of people in the region will buy coffee. Since the cost of each pound of coffee is $10, the monopolist will make $5 on every pound it sells. Thus profit will be equal to $5 multiplied by 55% multiplied by the number of people in the region. This is equal to $2.75 multiplied by the number of people in the region. This is the greatest amount of profit.

$20

At a price of $20, the monopolist will only sell coffee to 25% of the region. Since the cost of each pound of coffee is $10, the monopolist will make $10 on every pound it sells. Thus profit will be equal to $10 multiplied by 25% multiplied by the number of people in the region. Thus profit will be equal to $2.50 multiplied by the number of people in the region.

Question 2

The monopolistic coffee producer runs a very effective advertisement promoting its coffee and discovers that everyone in the region is now willing to pay double what they were before! Thus, 30% of the people in the region are willing to pay $30 for a pound of coffee, another 25% are willing to pay $40, and the remaining 45% are only willing to pay $24. The cost of producing each pound of coffee is still $10. How much should the monopolist charge for each pound of coffee?

• $10
• $24
• $30
• $40

Answer 2

$10

At a price of $10, the monopolist will sell coffee to everyone in the region, but will not make any profit since the cost of each pound of coffee sold is also $10.

$24

At a price of $24, the monopolist will sell coffee to everyone in the region. Since the cost of each pound of coffee is $10, the monopolist will make $14 on every pound it sells. Thus profit will be equal to $14 multiplied by the number of people in the region. This is the greatest amount of profit.

$30

At a price of $30, the monopolist will not sell coffee to the 45% of people who are only willing to pay $24, so 55% of people in the region will buy coffee. Since the cost of each pound of coffee is $10, the monopolist will make $20 on every pound it sells. Thus profit will be equal to $20 multiplied by 55% multiplied by the number of people in the region. This is equal to $11 multiplied by the number of people in the region.

$40

At a price of $40, the monopolist will only sell coffee to 25% of the region. Since the cost of each pound of coffee is $10, the monopolist will make $30 on every pound it sells. Thus profit will be equal to $30 multiplied by 25% multiplied by the number of people in the region. Thus profit will be equal to $7.50 multiplied by the number of people in the region.

Question 3

A dairy farmer is a monopolist in the milk industry and is currently selling milk at the profit maximizing price. As a result of a terrible storm, the dairy farmer sees an increase in cost of feed for the cows. At the same time, the dairy farm receives an insurance check which effectively lowers the fixed costs of the farm. What effect will this cost change have on the optimal price of milk the farmer sets?

• The change in costs does not impact the profit maximizing price and quantity sold for the dairy farmer.
• The increase in variable costs will decrease the optimal price that should be set by the farmer.
• The increase in variable costs will increase the optimal price that should be set by the farmer.
• The impact on price cannot be determined due to some costs increasing, and other costs decreasing.

Answer 3

The change in costs does not impact the profit maximizing price and quantity sold for the dairy farmer.

A monopolist should set prices to where marginal revenue is equal to marginal cost. If marginal cost changes, then the monopolist will no longer be pricing where marginal revenue equals marginal cost.

The increase in variable costs will decrease the optimal price that should be set by the farmer.

If variable (marginal) costs increase, marginal revenue will now be lower than marginal cost. By lowering the price, the monopolist is further decreasing marginal revenue and thus marginal revenue will still be lower than marginal cost.

The increase in variable costs will increase the optimal price that should be set by the farmer.

If variable (marginal) costs increase, marginal revenue will now be lower than marginal cost. Thus the monopolist must increase the price it charges until marginal revenue is equal to marginal cost.

The impact on price cannot be determined due to some costs increasing, and other costs decreasing.

A monopolist should set prices so that marginal revenue is equal to marginal cost. If marginal cost changes, then the monopolist will no longer be pricing where marginal revenue equals marginal cost. Fixed costs play no role in determining how a business should price once it is already in the industry.

Question 4

Suppose a firm faces the demand and marginal cost shown below, and has incurred a fixed cost of $10,000. What is the profit maximizing price?

Price $:

Answer 4

$15

Monopolists maximize profit by pricing where marginal revenue equals marginal cost. This occurs on the graph above where the blue line (MR) intersects the black line (MC) at a quantity of 1,000. To find the profit-maximizing price, find the price at which 1,000 will be the quantity demanded. This price is $15 and is the profit-maximizing price.

Question 5

The profit-maximizing price is $15 from the previous example. What is the profit of the monopolist given that the firm incurred a fixed cost of $10,000?

Price $:

Answer 5

$0

Profit is equal to revenue minus costs. Revenue here is equal to $15 * 1,000 = $15,000. Costs are equal to $5 * 1,000 = $5,000 in variable costs, plus $10,000 in fixed costs, totaling $15,000 in costs. Thus profit is equal to $15,000 - $15,000 = $0.

Question 6

The following table shows two HBS Online participants’ WTP for Taylor Swift tickets, Patriots tickets, and monthly Facebook access. It also shows the cost for each item:

A company, BuyMore, has bought the Patriots, Facebook, and Taylor Swift’s concert agency. If Nisha and Andrew are the only two consumers, what do you think is the profit-maximizing pricing strategy for BuyMore to implement for these three products? (Take your best guess, the calculations will be done out in the following exercises.)

• A fixed price for each good
• A bundle of goods
• A two-part tariff
• By the revenue equivalence theorem, all three of the above pricing strategies will achieve the same profit.

Answer 6

A fixed price for each good

A fixed price will leave a lot of surplus to the consumer when consumers have very different willingness to pay.

A bundle of goods

Bundles are most effective when consumer willingness to pay is very different across different goods, as is the case here.

A two-part tariff

A two-part tariff is generally for a single good which is bought at various quantities, as opposed to many different goods with different costs.

By the revenue equivalence theorem, all three of the above pricing strategies will achieve the same profit.

The revenue equivalence theorem applies to different auction formats, not pricing strategies.

Question 7

Consider the previous example:

What bundling strategy should BuyMore implement?

• Sell all three products in a bundle for $265.
• Sell all three products in a bundle for $260.
• Sell the tickets together for $255 and sell Facebook access for a fixed price of $10.
• Sell the tickets together for $245 and sell Facebook access for a fixed price of $10.

Answer 7

Sell all three products in a bundle for $265.

At a price of $265, Nisha will not buy the bundle because her willingness to pay is only $260. This would leave her $260 of uncaptured surplus.

Sell all three products in a bundle for $260.

At this price, both customers will buy the bundle and only $5 of surplus is not captured by BuyMore. This is the $5 extra that Andrew would have been willing to pay for the bundle.

Sell the tickets together for $255 and sell Facebook access for a fixed price of $10.

At a price of $255, Nisha will not buy the ticket bundle because her willingness to pay is only $245. This would leave her $245 of surplus uncaptured. An additional $5 of Nisha’s surplus would not be captured due to the fixed price of $10 for Facebook access, since she is willing to pay $15.

Sell the tickets together for $245 and sell Facebook access for a fixed price of $10.

At a price of $245, both customers will buy the bundle and only $10 of surplus is not captured from that bundle. This is the $10 extra that Andrew would have been willing to pay for the bundle. An additional $5 of Nisha’s surplus would not be captured due to the fixed price of $10 for Facebook access, since she is willing to pay $15.

Question 8

Consider the previous example:

If BuyMore sells all three products in a bundle for $260, what will be their profit?

Price $:

Answer 8

$430

At a price of $260, BuyMore will sell two bundles. BuyMore will also incur the cost for each item twice, one for each bundle. Thus profits are: $260 * 2 – ($20 + $25 + $0) * 2 = $520 - $90 = $430

Question 9

Consider the previous example:

If BuyMore sells each product separately, what prices should it use?

• $35 for Taylor Swift Tickets, $85 for Patriots Tickets, and $10 for Facebook Access.
• $160 for Taylor Swift Tickets, $85 for Patriots Tickets, and $10 for Facebook Access.
• $160 for Taylor Swift Tickets, $85 for Patriots Tickets, and $15 for Facebook Access.
• $160 for Taylor Swift Tickets, $220 for Patriots Tickets, and $10 for Facebook Access.
• $160 for Taylor Swift Tickets, $220 for Patriots Tickets, and $15 for Facebook Access.

Answer 9

$35 for Taylor Swift Tickets, $85 for Patriots Tickets, and $10 for Facebook Access.

Profits will be ($35 * 2 - $20 * 2) + ($85 * 2 - $25 * 2) + ($10 * 2 - $0 * 2) = $170

$160 for Taylor Swift Tickets, $85 for Patriots Tickets, and $10 for Facebook Access.

Profits will be ($160 - $20) + ($85 * 2 - $25 * 2) + ($10 * 2 - $0 * 2) = $280

$160 for Taylor Swift Tickets, $85 for Patriots Tickets, and $15 for Facebook Access.

Profits will be ($160 - $20) + ($85 * 2 - $25 * 2) + ($15 - $0) = $275

$160 for Taylor Swift Tickets, $220 for Patriots Tickets, and $10 for Facebook Access.

Profits will be ($160 - $20) + ($220 - $25) + ($10 * 2 - $0 * 2) = $355

$160 for Taylor Swift Tickets, $220 for Patriots Tickets, and $15 for Facebook Access.

Profits will be ($160 - $20) + ($220 - $25) + ($15 - $0) = $350

Question 10

Consider the previous example:

For which pricing system was profit greater?

• The fixed price system
• The bundled pricing system

Answer 10

The fixed price system

See correct answer for explanation.

The bundled pricing system

Total profit was $430, more than the $355 from the fixed pricing system.

Question 11

In a major city, there is currently only one health insurance provider, CityHealth. CityHealth’s insurance network covers two-thirds of the city’s hospitals and private health practices. (Insurance networks are a network of healthcare providers that offer discounted rates to patients with a specific insurance.) A new insurance company, HealthWay, is considering entering the city. If both insurance companies are able to adjust prices, which of the following is HealthWay’s best strategy?

• Imitate CityHealth’s insurance network and charge a slightly lower price to capture the entire market.
• Differentiate by creating a network that covers the third of the city’s healthcare providers that are not covered by CityHealth.

Answer 11

Imitate CityHealth’s insurance network and charge a slightly lower price to capture the entire market.

If CityHealth is able to adjust prices, then they will simply lower their price slightly below HealthWay’s price. Since the companies are so similar, this price lowering will continue until both companies are pricing at their variable costs. This will result in zero profits for both companies and potential losses due to fixed costs.

Differentiate by creating a network that covers the third of the city’s healthcare providers that are not covered by CityHealth.

By differentiating, HealthWay is targeting a different segment of consumers and will not be directly competing with CityHealth in price. As a result, a price war is less likely to occur and profits can be sustained.

Question 12

Consider the previous example of CityHealth and HealthWay. Suppose insurance companies are unable to adjust prices easily due to government regulation and long-term plans with fixed prices. Does this new information change the optimal strategy for HealthWay?

• Yes, HealthWay should now imitate CityHealth’s insurance network and charge a slightly lower price to capture the entire market.
• No, HealthWay should still differentiate by creating a network that covers the third of the city’s healthcare providers that are not covered by CityHealth.

Answer 12

Yes, HealthWay should now imitate CityHealth’s insurance network and charge a slightly lower price to capture the entire market.

If CityHealth is unable to adjust prices, then they will not be able to lower prices to compete with HealthWay. Since the companies are so similar, this price lowering will result HealthWay capturing the entire market.

No, HealthWay should still differentiate by creating a network that covers the third of the city’s healthcare providers that are not covered by CityHealth.

While it is still true that by differentiating, a price war is less likely to occur and profits can be sustained, these profits will be less than the expected profits of capturing the entire market via imitation.

Question 13

Consider the previous example of CityHealth and HealthWay. Suppose HealthWay imitated CityHealth and captured the market by offering a lower price. Now suppose CityHealth has developed the ability to adjust their prices, resulting in a price war between the two companies. Which of the following could allow CityHealth to be profitable? Select all that apply.

• Customers feel a connection with and have a long history with CityHealth.
• CityHealth has established connections with healthcare providers in the city that allow them to negotiate better rates and lower their costs.
• CityHealth paid less for the construction of their headquarters in the city than HealthWay did.
• The majority of CityHealth customers are not willing to switch insurance providers for minor cost-savings.

Answer 13

Customers feel a connection with and have a long history with CityHealth.

This could raise the willingness to pay for CityHealth insurance, allowing CityHealth to win in a price war.

CityHealth has established connections with healthcare providers in the city that allow them to negotiate better rates and lower their costs.

Having lower variable costs allows CityHealth to price lower than HealthWay in a price war and thus remain profitable.

CityHealth paid less for the construction of their headquarters in the city than HealthWay did.

Fixed costs have no impact on the pricing strategies of the two companies. Thus having lower fixed costs will not allow CityHealth to win a price war and remain profitable.

The majority of CityHealth customers are not willing to switch insurance providers for minor cost-savings.

If this is true, CityHealth will be able to retain a portion of its customers through its incumbent advantage.

Question 14

A monopolist bakery is currently selling its cupcakes for $10 and the quantity demanded is 50. If the monopolist lowers its price to $9, it will have a quantity demanded of 80. Which of the following could be the marginal cost of producing a cupcake if the monopolist is maximizing profits at a price of $10?

• $3
• $7
• $8
• $11

Answer 14

$3

If the marginal cost of producing a cupcake is $3, then the monopolist would make gross margin of $9*80 - $3*80 = $480 selling at $9. This is greater than the gross margin made selling at $10, which are $10*50 - $3*50 = $350. Thus selling at $9 would be better for the monopolist.

$7

If the marginal cost of producing a cupcake is $7, then the monopolist would make gross margin of $9*80 - $7*80 = $160 selling at $9. This is greater than the gross margin made selling at $10, which are $10*50 - $7*50 = $150. Thus selling at $9 would be better for the monopolist.

$8

If the marginal cost of producing a cupcake is $8, then the monopolist would make gross margin of $9*80 - $8*80 = $80 selling at $9. This is less than the gross margin made selling at $10, which are $10*50 - $8*50 = $100. Thus selling at $10 is better for the monopolist.

$11

If the marginal cost of producing a cupcake is $11, then the monopolist would make gross margin of $10*50 - $11*50 = a loss of $50. Thus selling at $10 cannot be best for the monopolist because it is selling below marginal cost.

Question 15

Consider the following table which shows the willingness to pay of HBS Online staff for successive quantities of cake slices.

The variable cost to produce a slice of cake is $1. The bakery wants to implement a two-part tariff. What per-unit-price should the bakery charge?

Price $:

Answer 15

The per-unit charge should be equal to the per-unit cost, which in this case is $1.

Question 16

Consider the same example:

The variable cost to produce a slice of cake is still $1. The bakery wants to implement a two-part tariff. What fee should the bakery charge?

Price $:

Answer 16

$7

The fee should cover the rest of the surplus that is not covered by the per-unit charge. In this case Ben and Katherine both have surpluses of $7. This is calculated by adding up their willingness to pay beyond the per-unit charge. So for Ben, surplus is: $4 + $2 + $1 + $0 = $7. And for Katherine, surplus is: $6 + $1 = $7.

Question 17

Consider the same example:

If the variable cost to produce a slice of cake is still $1, and the bakery charges the optimal $7 fee and $1 per-unit-price, what will be the profit of the bakery?

Price $:

Answer 17

$14

Profit is calculated by taking the revenue earned ($7 * 2 + $1 * 6 = $20) and subtracting the total costs ($1* 6 = $6), thus giving $14 in profit.

Question 18

Consider the previous example:

Let’s say the bakery does not know about two-part tariffs. If the variable cost to produce a slice of cake is still $1, which of the following fixed prices should the bakery charge?

• $5
• $4
• $3
• $2

Answer 18

$5

A fixed price of $5 would result in profits of $5 * 2 - $1 * 2 = $8.

$4

A fixed price of $4 would result in profits of $4 * 2 - $1 * 2 = $6

$3

A fixed price of $3 would result in profits of $3 * 3 - $1 * 3 = $6.

$2

A fixed price of $2 would result in profits of $2 * 5 - $1 * 5 = $5.

Question 19

Consider the previous example:

For which pricing system was the profit to the bakery greater?

• The fixed price
• The two-part tariff

Answer 19

The fixed price

See correct answer for explanation.

The two-part tariff

Correct, the two-part tariff had profits of $14, compared to the $8 profits from the fixed price.

Question 20

A monopolist’s profits are maximized when:

• The average revenue is lower than the average cost.
• The average revenue equals the average cost.
• The marginal revenue exceeds the marginal cost.
• The marginal revenue equals the marginal cost.

Answer 20

The average revenue is lower than the average cost.

See correct answer for explanation.

The average revenue equals the average cost.

See correct answer for explanation.

The marginal revenue exceeds the marginal cost.

See correct answer for explanation.

The marginal revenue equals the marginal cost.

The monopolist’s revenue is maximized when marginal revenue is equal to the marginal cost.

Question 21

Suppose that when a monopolistic car manufacturer raised its prices, it lost half of its customer base, but reported higher profits than before. Which of the following can be concluded?

• Consumer willingness to pay decreased.
• The demand curve was upward sloping.
• The firm was originally pricing where marginal revenue was greater than marginal cost.
• The firm was originally pricing where marginal revenue was lower than marginal cost.

Answer 21

Consumer willingness to pay decreased.

See correct answer for explanation.

The demand curve was upward sloping.

See correct answer for explanation.

The firm was originally pricing where marginal revenue was greater than marginal cost.

See correct answer for explanation.

The firm was originally pricing where marginal revenue was lower than marginal cost.

The fact that the manufacturer could increase its revenues by raising prices and narrowing the client base indicated that the WTP of the high-type consumers was sufficiently higher than the WTP of the low-type consumers to make it inefficient to serve the low-type consumers.

Question 22

A monopolistic seller of rare oriental rugs discovers that 60% of the population is willing to pay $1,000 for a rug. The remaining 40% of the population is willing to pay $2000. Each rug costs $600 to produce. How much should the monopolist charge for each rug?

• $600
• $1000
• $1500
• $2000

Answer 22

$600

Charging $600 would lead to zero profits.

$1000

Charging $1000 would lead to everyone purchasing the rug, at $400 of profit each. If there are 100 customers, that would lead to profits of $40,000.

$1500

At $1500, only 40% of the population would purchase a rug, in which case you might as well charge $2000.

$2000

Charging $2000 would lead to 40% of the population purchasing at $1400 profit each. If there are 100 customers, that would be total profits of $56,000.

Question 23

A monopolistic seller of sports cars has traced out the following demand curve: 10 customers have willingness to pay (WTP) of $100K each, another 10 customers have WTP of $150K each, another 10 customers have WTP of $200K each; and a further 15 customers have WTP of $250K. Each sports car costs $50K to produce, but the production process requires a fixed machinery investment of $1.5M as well. The seller is considering setting one of the following prices:

I. A price of $150K
II. A price of $200K
III. A price of $250K

What is the order of the profits, from greatest to least, generated by these three pricing schemes?

• II > I > III
• III > I > II
• I > II > III
• II > III > I

Answer 23

II > I > III

Pricing scheme I would generate a profit of ($150K-$50K) * 35 - $1.5M = $2M. Pricing scheme II would generate ($200-$50K) * 25 - $1.5M =$2.25M. Pricing scheme III would generate ($250K-$50K) * 15 - $1.5M = $1.5M.

III > I > II

See correct answer for explanation.

I > II > III

See correct answer for explanation.

II > III > I

See correct answer for explanation.

Question 24

A monopolist faces the demand curve shown below, and incurs a cost of $20 for each unit it sells. What will be the price and quantity sold?

• The price will be $20 and the quantity sold will be 15
• The price will be $50 and the quantity sold will be 15
• The price will be $40 and the quantity sold will be 20
• The price will be $20 and the quantity sold will be 30

Answer 24

The price will be $20 and the quantity sold will be 15

At a quantity of 15, the monopolist could charge $50 per unit.

The price will be $50 and the quantity sold will be 15

Marginal cost = marginal revenue at a quantity of 15. The monopolist will sell 15 cars, and determine price based on the demand curve.

The price will be $40 and the quantity sold will be 20

The monopolist will sell the quantity of cars where marginal revenue = marginal cost.

The price will be $20 and the quantity sold will be 30

The monopolist will sell the quantity of cars where marginal revenue = marginal cost.

Question 25

A monopolistic producer of caviar has historically sold all of its caviar to 10 distributors. Recently, one of the distributors has acquired all of its competitors, becoming the caviar producer’s sole customer. How are the caviar producer’s prices and profits likely to change as a result of this downstream consolidation?

• Prices and profits will not change
• Prices and profits will decrease
• Prices and profits will increase
• Prices will decrease and profits will not change

Answer 25

Prices and profits will not change

See correct answer for explanation.

Prices and profits will decrease

The customer now has the power to negotiate price with the seller, and prices will likely fall as a result. Profit will decrease as the customer captures an increased share of the surplus.

Prices and profits will increase

See correct answer for explanation.

Prices will decrease and profits will not change

See correct answer for explanation.

Question 26

A fan of classical music would like to attend the symphony multiple times in a given month, but her willingness to pay for each subsequent performance decreases with the number of performances she has already attended. In particular, she is willing to pay $150 for the first performance, $100 for the second, and $60 for the third. The cost of each ticket to the symphony amounts to roughly $40. Which of the two-part tariff schemes listed below yields the highest profit to the symphony from the given fan?

• Charge $100 monthly membership fee, and $60 per ticket
• Charge a $190 monthly membership fee, and $40 per ticket
• Charge only a $300 monthly membership
• Charge no monthly membership, and $100 per ticket

Answer 26

Charge $100 monthly membership fee, and $60 per ticket

At these prices, the customer would attend all three performances, and would pay a total of $280, resulting in $160 in profits for the symphony.

Charge a $190 monthly membership fee, and $40 per ticket

At these prices, the customer would attend all three performances, and would pay her total WTP of $310, resulting in $190 in profits for the symphony.

Charge only a $300 monthly membership

At these prices, the customer would attend all three performances, and the symphony would earn $180 in profits.

Charge no monthly membership, and $100 per ticket

At these prices, the customer would attend only 2 performances, and would pay a total of $200, resulting in $120 in profits for the symphony.

Question 27

An opera house is offering three performances, and has two types of consumers. The performances are “Carmen,” “Madama Butterfly,” and “Eugene Onegin.” Consumer 1 has WTP of $100 for a ticket to “Carmen,” $200 for “Madama Butterfly,” and $70 for “Eugene Onegin.” Consumer 2 has WTP of $120 for “Carmen,” $100 for “Madama Butterfly,” and $150 for “Eugene Onegin.” Each ticket costs the opera house $40. How should the opera house bundle the goods?

• Bundle the three operas together.
• Bundle “Madama Butterfly” and “Eugene Onegin,” and sell “Carmen” separately.
• Bundle “Carmen” and “Eugene Onegin,” and sell “Madama Butterfly” separately.
• Sell each opera separately.

Answer 27

Bundle the three operas together.

A bundle of the three operas would be priced at $370, and the opera would earn a total of $740 in revenues, or $500 in profits.

Bundle “Madama Butterfly” and “Eugene Onegin,” and sell “Carmen” separately.

The bundle would be sold for $250, and “Carmen” would be sold for $100. Cost would be the same as in the optimal scenario, but revenues would be only $700.

Bundle “Carmen” and “Eugene Onegin,” and sell “Madama Butterfly” separately.

The bundle would be priced at $270 (only Customer 2 would purchase it), and “Madama Butterfly” would be priced at $200 (only Customer 1 would purchase it). Costs would be $120, and revenues would be $470, resulting in profits of $350.

Sell each opera separately.

“Carmen” would be sold for $100, “Madama Butterfly” would be sold for $200, and “Eugene Onegin” would be sold for $150. Total revenues would be $550, and total costs would be $160, resulting in profits of $390.

Question 28

The round-trip business class airfare from Boston to Amsterdam (from August 18 through August 21) is $6,000. The round-trip business class airfare from Boston to Amsterdam to Athens and then returning to Boston (from August 18 through August 31) is $4,000. What is the most likely explanation for this price difference?

• The multi-city travelers probably care more about the comfort of their seats, whereas the Boston-Amsterdam travelers might be willing to buy coach seats since they will spend less total time in flight.
• The Boston-Amsterdam travelers are probably more flexible to choose their dates of travel than the multi-city travelers, since they only need to spend a few days overseas.
• The Boston-Amsterdam roundtrip travelers are more likely to be on business, whereas the multi-city travelers going to Greece are likely to be on vacation, and therefore more price-sensitive.
• The Boston-Amsterdam flights must be more costly for the airline than the three flights in the multi-city trip combined.

Answer 28

The multi-city travelers probably care more about the comfort of their seats, whereas the Boston-Amsterdam travelers might be willing to buy coach seats since they will spend less total time in flight.

This would be a reason for the airline to set a higher price for the multi-city flight.

The Boston-Amsterdam travelers are probably more flexible to choose their dates of travel than the multi-city travelers, since they only need to spend a few days overseas.

If this were true, it should lead to a lower price for the Boston-Amsterdam flight.

The Boston-Amsterdam roundtrip travelers are more likely to be on business, whereas the multi-city travelers going to Greece are likely to be on vacation, and therefore more price-sensitive.

A 3-day trip to Amsterdam (during weekdays) is more likely to be a business trip than a longer trip, including weekends, to multiple destinations. Vacation travelers are typically more flexible in their dates and destinations, and more price-conscious, since they are actually paying the bill.

The Boston-Amsterdam flights must be more costly for the airline than the three flights in the multi-city trip combined.

An airline’s cost grow significantly with increased time in the air (and therefore more fuel burned) and with more take-offs and landings.

Question 29

“Marginal revenue” refers to the:

• revenue earned on the last unit sold.
• variable cost to produce an extra unit.
• total revenue divided by the total number of units sold.
• change in total revenue that results from selling an extra unit.

Answer 29

revenue earned on the last unit sold.

To calculate marginal revenue, you would need to subtract lost revenue on inframarginal customers from this number.

variable cost to produce an extra unit.

This is the marginal cost.

total revenue divided by the total number of units sold.

This is price.

change in total revenue that results from selling an extra unit.

Marginal revenue takes into account both the extra revenue from selling one more unit to a customer and the lost revenue from lowering the price that will be charged to customers that would have bought the product already.

Question 30

Suppose that a museum of modern art discovers the following: adults are willing to pay $20 per ticket to see a Monet exhibit. Students are willing to pay less; 60% of students have WTP of $15, and 40% are willing to pay up to $10. There are no marginal costs to allowing more viewers into the museum. The museum manager decides to set the regular price at $20, and offer a student discount. What discount should it offer?

• 10%
• 25%
• 33%
• 50%

Answer 30

10%

No student would purchase the ticket for $18.

25%

60% of the students would purchase the ticket at $15, but the museum could earn more by lowering the price enough to attract the lower-WTP students.

33%

At a price of $13.33, the museum will only attract the high-WTP students, and might as well charge their full WTP of $15.

50%

At $10, all of the students will be willing to purchase a ticket. Imagine there are 100 students total: this would lead to revenue (and profits) of $1000, compared to $900 at a price of $15.

Question 31

A chocolatier produces truffles and sells each 1 pound box of truffles for $20. However, the chocolatier knows that some consumers would be willing to pay more than the cost of the chocolate, but less than $20 per pound, and wishes to sell truffles to these consumers as well. Which of the following price discrimination methods relies on the chocolatier knowing which types of consumers are likely to have a lower willingness to pay?

• Offering one free box of truffles to anyone who purchases two boxes
• Selling misshaped truffles in bulk at a price of $12 per pound
• Offering a discount to students and seniors
• Offering a 20% off sale on a single type of truffle each week

Answer 31

Offering one free box of truffles to anyone who purchases two boxes

The chocolatier does not need to know which consumers would be interested in buying larger quantities at a discount in order to offer the deal.

Selling misshaped truffles in bulk at a price of $12 per pound

Consumers with lower WTP can self-select into buying the cheaper but uglier truffles.

Offering a discount to students and seniors

This method relies on the chocolatier knowing that students and seniors are the consumers who have a lower WTP.

Offering a 20% off sale on a single type of truffle each week

Consumers with a lower WTP could self-select buy choosing to buy only the truffles that were on sale.

Question 32

An artisan who creates customized furniture has a customer who is interested in purchasing several pieces of furniture. The artisan decides to sell the furniture via a two-part tariff, charging a fee to work with the customer and an additional price for each individual piece of furniture. How should the artisan determine the price of each piece of furniture?

• Estimate the customer’s willingness to pay and set the per-unit price equal to the average WTP.
• Set the price of each piece of furniture equal to the marginal cost of producing it.
• Set the price between the marginal cost of producing the most costly unit and the customer’s lowest estimated willingness to pay.
• Set the per-unit price to $0 and capture value through the fee instead.

Answer 32

Estimate the customer’s willingness to pay and set the per-unit price equal to the average WTP.

See correct answer for explanation.

Set the price of each piece of furniture equal to the marginal cost of producing it.

An optimal two-part tariff prices each unit at marginal cost, and charges a lump sum fee on top.

Set the price between the marginal cost of producing the most costly unit and the customer’s lowest estimated willingness to pay.

See correct answer for explanation.

Set the per-unit price to $0 and capture value through the fee instead.

See correct answer for explanation.

Question 33

In the situation of the artisan in the previous question, assume that the artisan has an accurate estimate of the customer’s willingness to pay for each unit, and sets the lump sum fee just low enough that the customer decides to pay it. Remember that we are only assessing the artisan’s transactions with one customer. In this case, what will be the deadweight loss and the distribution of surplus?

• There will be no deadweight loss, and most of the surplus will be captured by the artisan.
• There will be no deadweight loss, and the surplus will be close to evenly split between the customer and the artisan.
• There will be some deadweight loss, and most of the surplus will be captured by the artisan.
• There will be some deadweight loss, and the surplus will be close to evenly split between the customer and the artisan.

Answer 33

There will be no deadweight loss, and most of the surplus will be captured by the artisan.

Deadweight loss will be avoided since each piece of furniture is sold at its marginal cost. Once the customer has paid the lump sum fee, he will buy every piece of furniture for which his WTP is more than or equal to its cost. Since the lump sum fee is set barely low enough for the customer to pay it, most of the surplus is going to the artisan through the fee.

There will be no deadweight loss, and the surplus will be close to evenly split between the customer and the artisan.

See correct answer for explanation.

There will be some deadweight loss, and most of the surplus will be captured by the artisan.

See correct answer for explanation.

There will be some deadweight loss, and the surplus will be close to evenly split between the customer and the artisan.

See correct answer for explanation.

Question 34

The tiny town of Nemo has three neighborhoods located on a straight line: Neighborhood 1, Neighborhood 2, and Neighborhood 3, with Neighborhood 2 located equidistant between Neighborhood 1 and Neighborhood 3. There is one daycare center, located on Neighborhood 1. There are 10 families residing in each neighborhood, and each family has one child. Each family is willing to pay $70/day for daycare, and prefers daycare closest to its own neighborhood (though at current distances, families will purchase daycare services even if it’s two neighborhoods away). Families are indifferent between any two daycares in the same neighborhood. Suppose that daycare costs $30/day per child to provide. A new daycare center is thinking of opening in Nemo. If both daycares will keep their price at $70/day, which neighborhood should the new daycare open in?

• Neighborhood 1
• Neighborhood 2
• Neighborhood 3
• It does not matter

Answer 34

Neighborhood 1

Opening in Neighborhood 1 would make the new day care identical to the old one, capturing half the total surplus: 15 * ($70 - $30) = $600/day.

Neighborhood 2

Being located in Neighborhood 2 would attract all residents of Neighborhoods 2 and 3, and none of the residents of Neighborhood 1, for a surplus of: 20 * ($70 - $30) = $800/day.

Neighborhood 3

Being located in Neighborhood 3 would attract all residents of Neighborhood 3, and half the residents of Neighborhood 2, for a profit of: 15 * ($70 - $30) = $600/day.

It does not matter

See explanations above.

Question 35

A town has many fast food restaurants, which charge an average of $6 for a hamburger. However, one fast food restaurant charges $10 for a hamburger and remains very competitive. Which of the following situations could not, by itself, explain this restaurant’s ability to charge a higher price?

• The restaurant is in a convenient location near several schools and businesses.
• The restaurant pays higher monthly rent than its competitors.
• The restaurant has been around for many years and customers have a nostalgic preference for it.
• The restaurant offers its milkshakes and fries for a price below the market average.

Answer 35

The restaurant is in a convenient location near several schools and businesses.

A convenient location can increase customers’ willingness to pay for the restaurant’s hamburgers.

The restaurant pays higher monthly rent than its competitors.

In a competitive market, higher costs alone cannot justify higher prices.

The restaurant has been around for many years and customers have a nostalgic preference for it.

In this case, customers might choose to buy the hamburgers in spite of their higher price.

The restaurant offers its milkshakes and fries for a price below the market average.

In this case, a customer might end up paying the same total amount for a meal at this restaurant as at another one.

Question 36

A town with a small airport is served by two competing airlines. Which of the following strategies would make the airlines more likely to compete on price?

• The airlines fly identical planes, with the same type of seat and the same amount of legroom for customers
• One airline offers meals on board every flight while the other serves no meals but has fewer delayed flights
• Each airline offers flights to a different set of other cities
• The airlines offer loyalty programs, motivating existing customers to continue to fly with them

Answer 36

The airlines fly identical planes, with the same type of seat and the same amount of legroom for customers

This makes the airlines more similar to each other in non-price ways, making it more likely that they will compete on price.

One airline offers meals on board every flight while the other serves no meals but has fewer delayed flights

Different passengers are likely to prefer one or the other of these approaches, and the variation should reduce price competition.

Each airline offers flights to a different set of other cities

Consumers will choose their airline based on where they need to go, making price competition unnecessary.

The airlines offer loyalty programs, motivating existing customers to continue to fly with them

Consumers who have already flown on one or the other of the airlines will have greater reason to fly with that airline again. This differentiates the airlines, and can reduce price competition.

Question 37

A telephone company offers two services: landlines and Internet. There are two types of customer demographics for these services. One customer demographic values the Internet service at $40/month, but only values landlines at $10/month. The other customer demographic values the Internet service less, at $30/month, but values the landline telephone service at $40/month. The two customer demographics are each comprised of 100 persons. Internet and landlines each cost $30/month to supply to each customer who purchases them (so the cost to supply both products to a customer is $60/month). Which pricing scheme should the telephone company adopt?

• Price Internet at $30/month and landlines at $40/month.
• Price Internet at $40/month and landlines at $40/month.
• Bundle the two goods at a combined price of $50/month.
• Bundle the two goods at a combined price of $70/month.

Answer 37

Price Internet at $30/month and landlines at $40/month.

All customers would purchase Internet, creating profits of $0 per month. 100 customers would purchase landlines, creating profits of $1000 per month. Total profits would be $1000 per month.

Price Internet at $40/month and landlines at $40/month.

100 customers would purchase only Internet, creating profits of $1000. The other 100 customers would only purchase landlines, creating profits of $1000. Total profits would be $2000 per month.

Bundle the two goods at a combined price of $50/month.

All customers would purchase the bundle, leading to losses of $2000 per month

Bundle the two goods at a combined price of $70/month.

Only 100 customers would purchase the bundle, leading to profits of $1000 per month.

Question 38

A real estate developer is offering identical houses for sale for $350,000 each, and has 20 willing customers. The developer is considering lowering the price to $300,000, since at that price there would be an additional 3 customers willing to purchase houses. What would be the developer’s change in revenue from lowering the price in this way?

• -$100,000
• $100,000
• $900,000
• $1,050,000

Answer 38

-$100,000

The current revenue is $350,000*20 = $7M. By lowering the price, the seller would get $300,000*23 = $6.9M, which is $100,000 less. Thus, the developer should not lower the price to $300,000.

$100,000

See correct answer for explanation.

$900,000

See correct answer for explanation.

$1,050,000

See correct answer for explanation.

Question 39

An entrepreneur is looking to open a restaurant in a town with only one other restaurant. The incumbent restaurant is very successful with high profits. Which of the following business strategies are most likely to allow the entrepreneur to start a profitable restaurant? Select all that apply.

• Offer the most popular dish served by the incumbent restaurant.
• Open the restaurant location near the incumbent restaurant.
• Use new technology and business practices to cut variable costs lower than the incumbent restaurant.
• Specialize in a type of cuisine not served by other restaurants in the region.
• Set prices lower than the incumbent restaurant to capture market share.

Answer 39

Offer the most popular dish served by the incumbent restaurant.

This would make the restaurant more similar to its competitors, making it more likely to have to compete on price.

Open the restaurant location near the incumbent restaurant.

This would make the restaurant more similar to its competitors, making it more likely to have to compete on price.

Use new technology and business practices to cut variable costs lower than the incumbent restaurant.

This would allow the restaurant to come out of a price war with profits since it has lower costs and thus can offer lower prices than the incumbent restaurant.

Specialize in a type of cuisine not served by other restaurants in the region.

This would differentiate the restaurant from its competitors, making it less likely to have to compete on price.

Set prices lower than the incumbent restaurant to capture market share.

Lowering prices will start a price war with the incumbent. This might not be profitable for the entrepreneur.