Chapter 12 Pricing Copyright 2015 Health Administration Press

After mastering this material, students will be able to  explain why pricing is important,  apply the marginal cost pricing model,  link the model to profit maximization, and  explain price discrimination. Copyright 2015 Health Administration Press2

PRICING IS IMPORTANT Copyright 2015 Health Administration Press3

Pricing is important.  Prices that are too high will cut profits.  Prices that are too low will cut profits.  Pricing systems that are too – simple may give up profits, and – complex will annoy customers. Copyright 2015 Health Administration Press4

What is the profit at $110? At $90? PQRevenueCostProfitMR $110150$16,500$7,500$9,000 $105325$34,125$16,250$17,875$ $100500$50,000$25,000 $90.71 $95675$64,125$33,750$30,375$80.71 $90850$76,500$42,500$34,000$70.71 Assume that AC = MC = $50. Copyright 2015 Health Administration Press5

Prices that are too high will reduce profits. PQRevenueCostProfitMR $110150$16,500$7,500$9,000 $105325$34,125$16,250$17,875$ $100500$50,000$25,000 $90.71 $95675$64,125$33,750$30,375$80.71 $90850$76,500$42,500$34,000$70.71 Assume that AC = MC = $50. Copyright 2015 Health Administration Press6

What’s the profit at $65? At $45? PQRevenueCostProfitMR $651,725$112,125$86,250$25,875$20.71 $601,900$114,000$95,000$19,000$10.71 $552,075$114,125$103,750$10,375$0.71 $502,250$112,500 $0-$9.29 $452,425$109,125$121,250-$12,125-$19.29 Assume that AC = MC = $50. Copyright 2015 Health Administration Press7

Prices that are too low will reduce profits. PQRevenueCostProfitMR $651,725$112,125$86,250$25,875$20.71 $601,900$114,000$95,000$19,000$10.71 $552,075$114,125$103,750$10,375$0.71 $502,250$112,500 $0-$9.29 $452,425$109,125$121,250-$12,125-$19.29 Assume that AC = MC = $50. Copyright 2015 Health Administration Press8

Getting the price right matters. PQRevenueCostProfitMR $841,060$89,040$53,000$36,040$54.71 $831,095$90,885$54,750$36,135$52.71 $821,130$92,660$56,500$36,160$50.71 $811,165$94,365$58,250$36,115$48.71 $801,200$96,000$60,000$36,000$46.71 Assume that AC = MC = $50. Copyright 2015 Health Administration Press9

The Economic Pricing Model  Find your incremental costs.  Estimate the price elasticity of demand that your organization faces.  Calculate the appropriate price. Copyright 2015 Health Administration Press10

Profit-maximizing prices are markups over marginal cost.  Marginal cost is the basis.  Price elasticity determines the markup.  P = MC ×ε ⁄ (1 + ε) – Elasticity is represented by ε Copyright 2015 Health Administration Press11

P = MC × e ⁄ (1 + e)  Example 1: (MC = $10) – Price elasticity of demand = -6.4 – P = 10 × (-6.4) ⁄ (1-6.4) = $11.85  Example 2: (MC = $10) – Price elasticity of demand = -3.2 – P = 10 × (-3.2) ⁄ (1-3.2) = $14.55 Copyright 2015 Health Administration Press12

What pattern do you see?  Example 1: (MC = $10) – Price elasticity of demand = -6.4 – P = 10 × (-6.4) ⁄ (1-6.4) = $11.85  Example 2: (MC = $10) – Price elasticity of demand = -3.2 – P = 10 × (-3.2) ⁄ (1-3.2) = $14.55 Copyright 2015 Health Administration Press13

Less elastic demand results in bigger markups.  Example 1: (MC = $10) – Price elasticity of demand = -6.4 – P = 10 × (-6.4) ⁄ (1-6.4) = $11.85  Example 2: (MC = $10) – Price elasticity of demand = -3.2 – P = 10 × (-3.2) ⁄ (1-3.2) = $14.55 Copyright 2015 Health Administration Press14

The pricing model is not new.  It restates the profit-maximization rule: Set price so that MR = MC. – Profit: P × (1 + ε) ⁄ ε = MC – Pricing: P = MC × ε ⁄ (1 + ε) Copyright 2015 Health Administration Press15

The pricing model is not complex.  You need estimates of MC anyway.  You can approximate the price elasticity of demand easily. Copyright 2015 Health Administration Press16

Estimating Your Elasticity  Experiment  Hire a consultant  Approximate using market share Copyright 2015 Health Administration Press17

Experiment: A 5 Percent Price Cut Price ChangeQuantity ChangeElasticity Estimate -5%15% %12% %10%-2.00 Copyright 2015 Health Administration Press18

You do the math. Price ChangeQuantity ChangeElasticity Estimate -5%18%? -5%1%? Copyright 2015 Health Administration Press19

You do the math. Price ChangeQuantity ChangeElasticity Estimate -5%18% %1%-0.20 Copyright 2015 Health Administration Press20

What should you do now? Price ChangeQuantity ChangeElasticity Estimate -5%1%-0.20 Copyright 2015 Health Administration Press21

You should raise your price. Price ChangeQuantity ChangeElasticity Estimate -5%1%-0.20 Copyright 2015 Health Administration Press22

Approximating your price elasticity.  The market price elasticity is usually between and  Your price elasticity usually equals the market elasticity divided by your market share. Copyright 2015 Health Administration Press23

Approximating your price elasticity. Your Market ShareMarket ElasticityYour Elasticity 2% % % Copyright 2015 Health Administration Press24

Which leads to the higher price? Your Market ShareMarket ElasticityYour Elasticity 2% % % Copyright 2015 Health Administration Press25

Your turn.  The market price elasticity =  Your market share is – 12 percent – 24 percent  Your marginal cost is $100.  Find your elasticity and set your price. Copyright 2015 Health Administration Press26

Which market share do you prefer?  Your market share is 12 percent. – Your elasticity is ⁄ 0.12 = – Price should = $100 × ⁄ (1-3.33) = $  Your market share is 24 percent. – Your elasticity is ⁄ 0.12 = – Price should = $100 × ⁄ (1-1.67) = $250 Copyright 2015 Health Administration Press27

Your prices should make demand for your product elastic.  If not, higher prices will increase profits.  This is an issue for firms with – significant market shares, and – prices that are too low. Copyright 2015 Health Administration Press28

PRICE DISCRIMINATION Copyright 2015 Health Administration Press29

Price discrimination is common in healthcare.  Some pay different prices. – Medicare versus Medicaid – PPO versus FFS workers’ compensation  Often called “cost shifting” for PR reasons  Part of profit maximization  May alienate customers Examples in healthcare? Copyright 2015 Health Administration Press30

How do price discrimination and cost shifting differ?  Price discrimination – is an active strategy for managers, and – says prices differ because submarkets differ.  Cost shifting – is a reactive strategy, and – says prices differ because of indigent care or low prices paid by some payers. Copyright 2015 Health Administration Press31

Would prices rise or fall if  Medicare cut its prices by 10 percent? – Fall: price discrimination – Rise: cost shifting  Evidence says Medicare cuts lead to lower private prices. Copyright 2015 Health Administration Press32

Price discrimination makes sense  when groups have different elasticities, and  when you can prevent resale.  Examples? Copyright 2015 Health Administration Press33

Profits Without Price Discrimination GroupPriceQuantityMC = ACProfit Insured$ $5.00$2,000 Uninsured$25.000$5.00$0 Total$2,000 Copyright 2015 Health Administration Press34

Profits with Price Discrimination GroupPriceQuantityMC = ACProfit Insured$ $5.00$2,000 Uninsured$ $5.00$1,000 Total$3,000 Copyright 2015 Health Administration Press35

Contracting usually involves price discrimination.  Insurers seek the lowest flat fee possible.  Insurers seek the biggest discount possible.  Providers need to assess whether – a fee is greater than MC, – a fee is the best they can negotiate, and – a product line is profitable. Copyright 2015 Health Administration Press36

CONCLUSIONS Copyright 2015 Health Administration Press37

Pricing  is important,  is simpler than you may think,  is a continuing issue, and  requires data on – marginal costs, and – price elasticities. Copyright 2015 Health Administration Press38

The profit-maximizing price  depends on – marginal costs, and – elasticities of demand; and  equals MC × e ⁄ (1 + e). Copyright 2015 Health Administration Press39

Price discrimination  is common,  should be used with caution, and  can increase profits. Copyright 2015 Health Administration Press40