EF3442 – Homework 3

Not For Distribution Beyond the Class

Yunan Li
February 20, 2025

This homework is designed to test understanding of price discrimination.

No submission is required.

Question 1
The two main cities of the Republic of Ruritania are Streslau and Zenda.1 The population of each
city is 100,000. Citizens of the Republic consume Brawndo (the thirst mutilator) as if it were
water.2 The inverse demand curve of each inhabitant of Zenda is given by pZ = 120 − 2qZ . Here
pZ is the unit price of Brawndo (the unit of currency is called a florin) paid by a resident of Zenda
and qZ is the quantity supplied. Similarly, the inverse demand of each inhabitant of Streslau is
pS = 30 − 0.5qS .
The Brawndo Corporation is the monopoly supplier of Brawndo in Ruritania. It enjoys a constant
marginal cost of production of 0. It is trying to determine the best pricing strategy under a variety
of different scenarios. In each case assume there is no resale market for Brawndo, i.e., Brawndo
is purchased for personal consumption only. Assume, unless stated otherwise, that citizens in
Streslau cannot purchase Brawndo from Zenda, and vice versa.
1. If Brawndo can charge different unit prices in the different cities, what unit price should it
charge in each city to maximize total profit?

2. The Republic is contemplating regulation that would guarantee that all citizens of the Re-
public should pay the same price per unit for Brawndo. Were such a restriction in place,
what price should Brawndo set to maximize total profit? Brawndo is not obliged to serve
any particular city.

3. Are the citizens better off, as measured by consumer surplus, under this regulation compared
to part (1) above?

4. Now suppose that residents of Streslau can purchase Brawndo from Zenda by incuring a
total travel cost of 10 florin per unit and vice-versa. Under this condition how should the
1
Formerly a monarchy, the deposed king now serves as the doorman of Barribault’s Hotel.
2
It isn’t, but plants crave it. In fact, visitors to Ruritania who ask for water will frequently be shown the toilet.

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 Brawndo Corporation set the price of Brawndo in Zenda and Streslau? For this part it can
set a different price in each city. Brawndo is not obliged to serve any particular city but it
cannot prevent residents of one city from traveling to the other to purchase Brawndo.

Solution:

1. Answer: p∗Z = 60 and p∗S = 15.

Justification: The profit maximization problems are

Zenda: Π∗Z = max(120 − 2qZ )qZ · 105

qZ

Streslau: Π∗S = max(30 − 0.5qS )qS · 105

qS

By solving these optimization problems, we obtain the following optimal values: p∗Z = 60,
qZ∗ = 30, πZ∗ = 1800 · 105 = 1.8 × 108 and p∗S = 15, qS∗ = 30, πS∗ = 450 · 105 = 4.5 × 107 .
Hence, total profit is 2.25 × 108 . The SOC condition holds for each.

2. Answer: p∗ = 60.

Justification: The choke prices of the two cities are 120 and 30, respectively. Sup-
pose the firm is to sell in both cities. Then, provided the price in each city is at most
30, total demand of the two cities is

D(p) = 105 · (qS + qZ ) = 105 [(60 − 2p) + (60 − 0.5p)] = 105 (120 − 2.5p)

The profit maximization problem is

Π∗both = max 105 (120 − 2.5p)p

p≤30

Ignoring the constraint p ≤ 30, the optimal solution is p∗ = 24, q ∗ = 105 · 60 = 6 × 106 ,
Π∗both = 105 · 1440 = 1.44 × 108 (the SOC condition checks out). Since the price is
below the choke price 30, this price is profit maximizing even when including the omited
constraint.
Suppose on the other hand, the firm ignores Streslau and only serves the citizens in
Zenda. This can be interpreted as not selling in Streslau or setting a price above the
choke price in Streslau.
From part (1), the profit is Π∗Z = 1.8 × 108 > 1.44 × 108 . So Brawndo won’t charge
p = 24 and won’t sell in both cities. Instead, p∗ = 60, the monopoly price in Zenda, is
the optimal price.

3. Answer: Citizens in Zenda are indifferent; those in Streslau are worse off. As a whole,
citizens of the Republic are worse off.

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 Justification: Since under the uniform price policy, citizens in Streslau buy nothing
and citizens in Zenda each buy the same amount as in part (a). Thus, citizens in Zenda
are indifferent and those in Streslau are strictly worse off. Citizens as a whole are worse
off.
FYI: The consumer surplus in part (b) is
Z 120 Z 120
CSpart b = D(p)dp = 105 (60 − 0.5p)dp = 9 × 107
60 60

Consumer surplus in part (a) is

Z 120 Z 30
5
CSpart a = CSZ + CSS = 10 (60 − 0.5p)dp + 105 (60 − 2p)dp = 11.25 × 107
60 15

Hence, CSpart a > CSpart b

4. Answer: p∗Z = 60, p∗S ≥ 50, in other words Brawndo chooses not to sell in Streslau.

Justification: Brawndo has two cases it must consider.

Case 1: If the difference in prices between the two cities exceeds 10 florins, then, the
residents in the city with the higher price will travel to the city with the lower price. In
this case, Brawndo is essentially serving all demand either via Zenda or via Streslau.
Case 2: The difference in prices between the two cities is at most 10 florins. In this case,
no resident in one city will travel to the other to purchase Brawndo.

Let us examine case 1. Suppose Brawndo decides to serve all demand via Streslau.
Brawndo can choose not to sell in Zenda or set a Zenda price so high that no one buys
in Zenda.
Let p be the unit price charged in Streslau. The price that residents of Zenda will ‘see’
is p + 10, because they must incur a travel cost to purchase in Streslau.
The demand curve in Zenda is 120−p−10
2
while in Streslau it is 60 − 2p. Thus combined
profits will be:
120 − (p + 10)
Π∗both = max p( ) + p(60 − 2p)
p 2
The optimal solution is p = 23. In words, the price in Streslau is 23 florin a unit. Any
resident of Zenda who travels to Streslau will end up spending 33 florins for a unit of
Brawndo. Total profit is 1.3225 × 108 .

Or Brawndo could choose to sell via Zenda. In which case it is interested in

120 − p
Π∗both = max p( ) + p(60 − 2(p + 10))
p 2
The profit maximizing price is p = 20. This makes the demand from Streslau zero and
only residents of Zenda purchase. Total profit is 1 × 108 . This is less than previous

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 possibility.

Now, we turn to case 2. The optimization problem the firm must solve is:
120 − pZ
max pZ + pS (60 − 2pS )
pZ ,pS 2
s.t. |pZ − pS | ≤ 10
If we ignore the constraint |pZ − pS | ≤ 10 (in words: the difference in prices is at most
10), then we have solved this problem already in part 1. The difference in prices was
60 − 15 = 45 which exceeds 10. So, in the optimal solution the difference in prices must
be exactly 10. But we have already examined this possibility in case 1.

Question 2
Suppose Cyberdyne Systems creates a Professional version of its machine learning software. By
disabling some of the features in the Professional version it can create a Home version. Both
versions have zero marginal cost.
Cyberdyne Systems faces two customer segments each interested in buying at most one version.
The RPs of each segments for each version are displayed below.

Professional Version Home Version Segment Size

Business $100 $0 20
Home Buyers $20 $5 80
Each customer will choose the software that gives her the highest surplus.

1. If Cyberdyne Systems offers only the Professional version, what price should it charge in
order to maximize revenue?

2. If it offers both versions, what prices should it set to maximize revenue.

3. Now suppose that instead of valuing the Home version at $0, each Business buyer values the
Home version at $80. Keep all other RPs the same as before. Show that at the prices you
chose in (2), Business buyers would actually prefer to buy the Home version instead of the
Professional version. Is this better or worse for Cyberdyne Systems than the single-product
strategy identified in (1)?

4. Assume Business buyers value the products as in part (3). Keep the Home version at the
same price as in part (2), but lowering the price of Professional version until the Business
buyers will be willing to buy the Professional version instead of the Home version. What
pair of prices will Cyberdyne Systems now be charging? What profits will it make? Is this
better or worse for the company than the single-product strategy described in (1)?

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Solution:

1. Answer: Cyberdyne Systems is indifferent between charging $100 and $20.

Justification: Since, we see that:

• Π(100) = 100 × 20 = 2000.

• Π(20) = 20 × 100 = 2000.

2. Answer: Charge $100 for the Professional version and $5 for the Home version.

Justification: Charge $5 for the Home version so that the Home users are willing to
buy the Home version. The Business buyers value the Home version at $0, so they will
not buy the Home version. Charge $100 for the Professional version so that the Business
users are willing to buy the Professional version.
The profit associated with this pricing strategy is

Π(100, 5) = 100 × 20 + 5 × 80 = 2400

3. Answer: Option (1) would be better compared to using the prices in (2).

Justification: At prices chosen in (2), a Business user get a surplus of (100 − 100 = 0)
if he purchases the Professional version, and (80 − 5 = 75) if he purchases the Home
version. The latter is higher, so he would actually prefer to buy the Home version instead
of the Professional version.
To determine which pricing strategy is better, we can compare the profit associated with
each option.

• Pricing strategy (1) gives a profit of Π(100) = 2000 = Π(20).

• Pricing strategy (2) gives a profit of Π(100, 5) = 100 × 0 + 5 × 100 = 500.

4. Answer: They are going to price the Professional version at $25, and the Home one at $5.
They will make a profit of $900, and they would prefer (1) to (4).

Justification: To make the Business users willing to buy the Professional version, the
Professional price should satisfy 100 − p ≥ 80 − 5. Thus the highest price we can set is
$25 (Recall that we can break even in favor of the seller).
The profit associated with this pricing strategy is

Π(25, 5) = 25(20) + 5(80) = 900

which is lower than 2000, the profit from (1). Hence they would prefer (1) over (4).

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Question 3
The University of Ruritania bookstore is the monopoly seller of two types of books: one in eco-
nomics and another in mathematics. It acquires the books from suppliers for $35 each. Three
types of students are considering purchasing the books: students only majoring in math (M),
students only majoring in economics (E), and ones obtaining a double major (M & E). There are
an equal number of students of each type. Each student is interested in purchasing at most one
copy of each book. The RPs of each student of each type for each kind of book are displayed in
the table below.

math textbooks econ textbooks

M 60 10
E 10 60
M&E 46 46

1. What is the optimal price if the bookstore chooses individual pricing?

2. What is the optimal price if the bookstore chooses pure bundling? The RP of a bundle is the
sum of the individual RPs. Compared to individual pricing, which one will the bookstore
prefer?
3. What is the optimal mixed bundling strategy? The RP of a bundle is the sum of the
individual RPs. Which pricing strategy maximizes the bookstore’s profits?

Solution:

1. Answer: The optimal price for each book is $60.

Justification: No book will be priced below $35 or above $60. So, we have only
two prices to consider for each book: $46 and $60. (Any other price between $35 and
$60 leaves money on the table and so is suboptimal.) Let’s focus on the mathematics
textbook. We have two cases.

• Case 1: The price of the mathematics book is pM = 60. In this case profit on the
book is 60 − 35 = 25.
• Case 2: The price of the mathematics book is pM = 46. In this case profit on the
book is (46 − 35) × 2 = 22.

Therefore, the optimal price for the mathematics books is $60. A similar argument
applies to the economics textbook. The bookstore’s profit is 25+25=50.

2. Answer: The optimal price for a pure bundle is $92.

The bookstore prefers individual pricing.

Justification: The RPs of each student of each type for a bundle are displayed in the
table below.

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 math textbooks econ textbooks bundle
M 60 10 70
E 10 60 70
M&E 46 46 92

There are only two possible prices for a pure bundle: $92 or $70.

• Case 1: At a bundle price of $92 the bookstore serves only the M&E students.
Profit will be 92 − 70 = 22.
• Case 2: At a bundle price of $70 the bookstore chooses to serve all the students.
The profit is 70 × 3 − 70 × 3 = 0. (Note that the cost of a bundle is 35 × 2 = 70.)

Therefore, the bookstore will price the bundle at $92 and only serve the M &E students.
Since 50 > 22, the bookstore prefers individual pricing compared to bundling.

3. Answer: The price should be $60 for each book and $92 for the bundle. Among all
options considered this yields the largest profit for the bookstore.
Justification: If the bookstore wants mixed bundling to generate a profit that beats the
best option so far (selling individually) it must find some unserved segment or capture
more surplus from a segment already catered to, or both. When selling individually, the
M&E segment buys nothing. Therefore, it is natural to target the bundle to this segment
and single books to the other two segments.
To make the M&E segment willing to purchase the bundle, its price should be pB = 92
(anything less leaves money on the table). Now, we need to make sure that segments M
and E do not purchase the bundle. Given their RPs, this is clearly the case. So, we set
the individual price atpM = pE = 60.
There is no other combination that will yield a higher profit. To see why, observed that it
never makes sense to sell the math textbook to segment E and the econ book to segment
M. Why? Their RP for these books is below the marginal cost of these books. Given this,
mixed bundling has extracted all the available surplus from the buyers and therefore, is
the best option.
The profit under mixed bundling is 60 + 60 + 92 − 35 × 4 = 72. Since 72 > 50, the
bookstore prefers mixed bundling.

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Question 4
The Soylent corporation is in charge of dining options at the University of Ruritania. There are
two types of students, with demands given as follows:

eaters: q = 14 − p
p
grazers: q = 7 −
2
Here, p denotes the per meal price and q denotes the number of meals a month that a student will
purchase. The marginal cost of a meal is zero because it consists entirely of Soylent Green. There
are no capacity constraints. Soylent cannot identify a student’s type.
1. If Soylent can only sell meals individually, what price should it charge per meal to maximize
revenue?

2. A consultant suggests that Soylent should switch to a monthly meal plan instead of selling
by the meal. In a monthly plan, students pay a fee for the month and are free to consume
as many meals as they wish at no cost. Should they follow this advice? For this and all
subsequent parts, assume that there are 10,000 potential customers: 3,000 eaters, and 7,000
grazers.

3. Another consultant suggests that Soylent should offer a monthly meal plan in addition to a
per meal option at the rate determined in part 1. Should Soylent follow this advice?

Solution:

1. Answer: The daily fee for both student types is p∗ = 7. Eaters eat 7 times a month,
and grazers 3.5 times a month.

Justification: When demand takes the form q = a − bp and marginal costs are constant
at c, the monopolist’s problem is:

max Π(p) = (p − c)(a − bp)

dΠ
= a + bc − 2bp = 0
dp
a + bc
p∗ =
2b
By plugging in the appropriate numbers, we find that p∗ = 7 for each type. The frequency
of eating is found by plugging this price back into the type-specific demand functions.

2. Answer: p∗ = 7.

Justification: If the discriminating prices are all equal to some p, then the common
optimal price must be the p∗ = 7 found in part (1).

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3. Answer: Yes.

Justification: As consumer surplus of those two types, at any given price, is unam-
biguously ordered (CSeater > CSgrazer ), the flat monthly fee should be equal to the
surplus of the grazers. When demand takes the form q = a − bp, consumer surplus is:
Z a/b
CS(p) = (a − bx)dx.
p

If using inverse demand curve, the CS at price p:

Z a−bp
a−q (a − bp)2
CS(p) = ( )dq − p(a − bp) =
0 b 2b
As the per meal price is zero, consumer surplus is:

142 72
CSeater = = 98 CSgrazer = = 49
2 2 × 0.5
The relevant pricing options are summarized in the following table:

Fee Quantity Revenues

$49 10,000 $490,000
$98 3,000 $294,000

Maximum revenue under the monthly fee achieves $490, 000. Under the per meal scheme,
one sells 3000 × 7 + 7000 × 3.5 = 45, 500 meals each month at a price of $7, for a total
of $318, 500 in revenue. Conclude that the consultant is correct.

4. Answer: No.

Justification: When both daily and monthly plans are available, customers will self-
select by comparing their surplus under the two options. When purchasing daily plan at
$7 each, consumer surplus is:

CSeater = 24.5 CSgrazer = 12.25

To get the ‘eaters’ buying the monthly plan instead have to set it at a value F such that
98 − F = 24.5, i.e. F = 73.5. The grazers will not get the monthly plan. Profit will be

73.5 × 3, 000 + 7 × 3.5 × 7, 000 = 392, 000.

This generates less revenue than part (3).

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