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Chapter 10 More Realistic and Complex Pricing COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 10 – Take Aways After acquiring a substitute product, raise price on both products to avoid each product cannibalizing the sales of the other product. After acquiring a substitute product, raise price more on the low-margin (more elastic demand) product. After acquiring a substitute product, reposition the products so that there is less substitutability between them.

Chapter 10 – Take Aways After acquiring a complementary product, reduce price on both products to increase demand for both products. If fixed costs are large relative to marginal costs, and capacity is fixed, price to fill available capacity. If the costs of underpricing are smaller than the costs of overpricing, then underprice, on average, and vice versa. If promotional expenditures make demand more elastic, then reduce price when you promote the product, and vice versa.

Review of Chapter 9 Competitive firm earns positive or negative profits only in the short- run  In long run, profits exhibit mean reversion Indifference principle  Compensating wage differentials  Risk premia on stocks Monopoly firms can earn positive profits for longer period of time  Entry and imitation eventually erode profits Strategy is plan to slow profit erosion  IO view focuses on industry; RBV focuses on firm resources Generic strategies  Cost reduction  Product differentiation  Control competition

Another Pricing Anecdote Las Vegas Casinos OOffer both rooms and gaming PPrices on rooms are often set at “sub-optimal” levels PPlan to more than make up room profit shortfall with gaming profits Similar to grocery store loss leader concept GGet people in the door Goal is to maximize total profit, not individual product profit

Pricing Commonly Owned Products First case to consider is when the products are substitutes for each other Use marginal analysis Discussion: Purchasing adjacent video store CCommon ownership makes analysis more complex RReducing price at one store steals sales from the other (reduces MR at both) With MR falling, raise price to maximize profits Consider your product portfolio as a bundle of goods DDemand for a bundle of substitutes is less elastic than demand for the individual products LLess elastic demand means raise price RRaise price more on the more elastic product (try to push price sensitive customers to higher margin product)

Pricing Commonly Owned Products (cont.) Next case to consider is when the products are complements of each other Use marginal analysis Discussion: Purchasing parking lot adjacent to video store CCommon ownership makes analysis more complex RReducing price at one increases demand at the other (increases MR at both) With MR rising, reduce price to maximize profits Consider your product portfolio as a bundle of goods DDemand for a bundle of complements is more elastic than demand for the individual products MMore elastic demand means reduce price

Revenue or Yield Management Example industries: cruise ships, hotels, stadiums, commercial parking lots, etc. CCosts of building capacity are mostly fixed or sunk FFirms face capacity constraints Initial decision is how much capacity to build KKeep adding capacity until LRMR = LRMC Once built, must decide on pricing RRelevant costs are now short-run MR and MC IIf MR>MC at capacity, price to fill available capacity

Revenue or Yield Management (cont.) When demand is difficult to predict, pricing to fill capacity is very challenging Balances the cost of over-pricing (lost profit on unsold capacity) against the cost of under pricing (lower margins on capacity sold) Optimal price minimizes the expected costs of these two mistakes. In general, if the lost profit from over-pricing (unused capacity) is bigger than the lost profit from under- pricing (lower margins), then price lower than would fill capacity, and vice-versa.

Advertising and Promotional Pricing Combines two of the Four P’s (Pricing and Promotion) Promotional spending affects demand in different ways Price-related promotions (coupons, end-of-aisle displays, etc.) tend to make demand more elastic IIf you are making demand more elastic, it makes sense to reduce price concurrently Product-related promotions (quality advertising, celebrity endorsements, etc.) tend to make demand less elastic IIf you are making demand less elastic, it makes sense to raise price concurrently Caveat: Prices can affect customer perception of quality

Alternate Intro Anecdote American Airlines pioneered the development of sophisticated reservation management systems, launching SABRE in 1968 Without overbooking practices like those instituted through SABRE, AA estimates that 15% of the seats on sold out flights would be unused. This overbooking process was the first element in developing a yield management system. With additional industry changes in the 1970’s, AA moved to develop a yield management system with the goal of "selling the right seat to the right customer at the right time."

Alternate Intro Anecdote (cont.) The yield management system helps determine  How many seats to allocate initially to each fare category  How to dynamically adjust this allocation as reservations come in and the date of the flight approaches.  Accurate forecast of demand and cancellations are critical The complexity of the problem eventually led to the development in 1988 of an automated system for yield management, DINAMO. The system's net impact was estimated be $1.4 billion in additional revenues over a three year period.