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Firms with Market Power Pricing Strategies

Sam's Auto's faces a strategic managerial decision. The firm can sell cars by simply posting a price. If the customer is willing to buy, clerk's fill-out paperwork and the sale is complete. Alternatively, it can hire commissioned sales reps to probe customer's willingness and ability to pay. (These reps are trained to ask customers where they live and work and often directly ask customers what they intend to spend!).

Under the former strategy, the firm's MC is $2 (thousand) per unit (which is also the AVC). The latter strategy increases MC and AVC by $1 thousand per car (to $3) but FC are $5 per month regardless. Under this approach, each customer essentially pays their full reservation price (willingness to pay).

With a demand curve of P = 12 - Q, which strategy should Honest Sam's use and why?

Solution Preview

Total Revenue = PxQ = 12xQ - Q^2
Marginal Revenue = 12 - 2Q

Profit is Maximized when Marginal Cost equals Marginal Revenue
Under strategy 1, marginal cost is $2. So ...

Solution Summary

The solution evaluates the two business strategy and determines the best one based on marginal cost and marginal revenue concepts. Profit maximization happens when Marginal cost equals marginal revenue.