MANAGERIAL ECONOMICS 12th Edition By Mark Hirschey

Pricing Practices Chapter 15

Chapter 15 OVERVIEW Pricing Rules-of-thumb Markup Pricing And Profit Maximization Price Discrimination Price Discrimination Example Two-part Pricing Multiple-product Pricing Joint Products Joint Product Pricing Example

Chapter 15 KEY CONCEPTS competitive market pricing rule-of-thumb imperfectly competitive pricing rule-of-thumb markup on cost profit margin optimal markup on cost markup on price optimal markup on price Lerner Index of Monopoly Power peak periods off peak periods price discrimination market segment first-degree price discrimination second-degree price discrimination third-degree price discrimination two-part pricing bundle pricing by-product common costs vertical relation vertical integration transfer pricing

Pricing Rules-of-thumb Competitive Markets Profit maximization always requires setting Mπ = MR - MC = 0, or MR=MC, to maximize profits. In competitive markets, P=MR, so profit maximization requires setting P=MR= MC. Imperfectly Competitive Markets With imperfect competition, P > MR, so profit maximization requires setting MR=MC. MR = P[1 + (1/εP)] Optimal P* = MC/[1 + (1/εP)]

Markup Pricing and Profit Maximization Optimal Markup on Cost Markup pricing is an efficient means for achieving profit maximization. Markup on cost uses cost as a basis. Optimal markup on cost = -1/(εP + 1). Optimal Markup on Price Markup on price uses price as a basis. Optimal markup on price = -1/εP

Price Discrimination Profit-Making Criteria Price elasticity of demand must differ in submarkets. Must have ability to prevent reselling. Price discrimination exists if P1/P2 ≠ MC1/MC2. Degrees of Price Discrimination First degree creates different prices for each customer (maximum profits). Second degree gives quantity discounts. Third degree assigns different prices by customer age, sex, income, etc. (most common).

Price Discrimination Example Price/Output Determination To maximize profits, set MR=MC in each market. One-price Alternative Without price discrimination, MR=MC for all customers as a group. With price discrimination, MR=MC for each customer or customer group. Profitable price discrimination benefits sellers at the expense of some customers.

Two-Part Pricing One-price Policy and Consumer Surplus A single price policy creates bargains for avid buyers; they enjoy consumer surplus. Consumer surplus reflects unpaid benefit. Capturing Consumer Surplus With Two-part Pricing Lump-sum prices plus user fees capture consumer surplus for producers, e.g., club memberships. Consumer Surplus and Bundle Pricing When significant consumer surplus exists, profits can be enhanced if products are purchased together.

Multiple-product Pricing Demand Interrelations Cross‑marginal revenue terms indicate how product revenues are related to another. Production Interrelations Joint products may compete for resources or be complementary. A by-product is any output customarily produced as a direct result of an increase in the production of some other output.

Joint Products Joint Products in Variable Proportions If products are produced in variable proportions, they are distinct outputs. For joint products produced in variable proportions, set MRA= MCA and MRB= MCB. Allocation of common costs is wrong and arbitrary. Joint Products in Fixed Proportions Some products are produced in a fixed ratio. If Q = QA= QB, set MRQ= MRA+ MRB = MCQ.

Joint Product Pricing Example Joint Products Without Excess By-product Profit-maximization requires setting MRQ= MRA+MRB = MCQ. Marginal revenue from each byproduct makes a contribution toward covering MCQ. Joint Production With Excess By-product (Dumping) Profit-maximization requires setting MRQ= MRA+MRB= MCQ. Primary product marginal revenue covers MCQ. Byproduct MR=MC=0.