Question

Merriwell Corporation has a virtual monopoly in the ultra high speed computer market. Merriwell has recently introduced a new computer that will be used by installations around the world. The installations have identical demands for the computers. Merriwell’s managers have decided to lease rather than sell the computers, but they have not yet decided whether to use a single hourly rental charge or a two-part tariff. Under the two-part tariff, users would be charged a monthly “access charge” plus an hourly rental rate. Merriwell’s staff has estimated the following demand and marginal revenue curves for each user:

Demand: P = 45 - .025Q

Marginal Revenue: MR = 45 - .05Q

Where P = price per hour of computer time, and Q = the number of hours of computer time leased per month. Merriwell offers their users extensive maintenance assistance and technical support. The firm’s engineers estimate that marginal cost is $30 per computer hour.

A. Assuming that Merriwell decides to set a single price, what will the firm’s price and output be?

B. Assuming that Merriwell uses a two-part tariff, what “access charge” and hourly rental fee should the firm set?

C. Which strategy would you advise for Merriwell, the single price, or the two-part tariff? Explain.

Answer 1

(A) A single price seller maximizes profit by equating MR and MC.

45 - 0.05Q = 30

0.05Q = 15

Q = 300

P = 45 - (0.025 x 300) = 45 - 7.5 = $37.5

(B) With two-part tariff, rental fee (P) equals MC and access charge equals consumer surplus (CS, equals profit).

P = MC

45 - 0.025Q = 30

0.025Q = 15

Q = 600

P = MC = $30

From demand function, when Q = 0,P = $45 (Reservation price)

Access charge = CS = Area between demand curve & market price = (1/2) x $(45 - 30) x 600 = 300 x $15 = $4,500

(C)

With single pricing, Profit = Q x (P - MC) = 300 x $(37.5 - 30) = 300 x $7.5 = $2,250

With two-part tariff, profit (CS) = $4,500

Since two-part tariff leads to higher profit, this strategy is advisable.