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b: $10,125 = $67,500 .15; $12,150 = $81,000 .15. c: $11,250 = 37,500 .30; $15,750 = 37,500 1.40 .30.d: $5,625 = 37,500 .15; $7,875 = 37,500 1.40 .15.Notice that the cost of the bus, office operating expenses, and advertising costs areall fixed. Since these costs do not vary across Cody’s decision, they are not relevant. For a similar reason, the fixed cost associated with insurance also is not Balakrishnan, Sivaramakrishnan, & Sprinkle – 2eFOR INSTRUCTOR USE ONLY6-52
relevant. (Absent information to the contrary, we are assuming that the additionalmileage will not decrease the bus’s salvage value. Any such decrease would diminish the attractiveness of slashing off-peak fares.)Assuming the friend’s numbers are accurate, we see that Cody’s overall business and personal income will increase to $69,525, which represents a $69,525 – $60,750 = $8,775increase in overall income compared to his current pricing strategy. In terms of evaluating the advice, we would first need to consider whether Cody actually would want to be this much busier during the off-peak season – perhaps Cody enjoys the free time and having a more relaxed schedule for half of the year.At another level, we see that such differential pricing strategies (also known as peak-load pricing) are widely followed. Ready examples are utility firms that offer different rates based on time-of-use, airlines offering summer specials, hotels offering “deals” for weekend getaways, and golf courses offering reduced rates for winter or mid-week play. The pricing strategy makes sense when fixed costs are relatively high, implying that capacity utilization is key for maximizing profit.While this strategy may work well for airlines and hotels, it probably will not work well for Cadillac Cody. Stated simply, the strategy works well for airlines, hotels, and golf courses because the size of the overall market changes (it increases) when these organizations cut prices. In other words, spurred by a low airfare or a low green fee, more people will travel or play golf. The increase in themarket size is the source for the incremental revenue. For Cadillac Cody, however, his actions are likely to have minimal impact on market size. After all, people do not plan a vacation, costing thousands of dollars, based on the prices of local transportation. The number of people traveling to the Keys will be the same regardless of whether Cody keeps his prices the same or slashes them (similarly, arelatively small change in shuttle-bus fees are unlikely to affect the number of car rentals). If Cody were to cut his prices, it also is likely that other shuttle-bus operators will cut their prices. Since market size and market share are likely to stay the same, everyone will make a lower profit. In other words, the friend’s calculation assumes that all other persons would stay put, which is not a good assumption in the real world. Given this insight and the fact that lowering prices will not affect the overall size of the market, Cody would be well advised not to lower his off-peak prices.