Pricing Policy & Strategic Thinking MBA NCCU Managerial Economics Jack Wu

Pricing Policy

Case: Emirates Airline, Dubai-Mumbai, Economy class, May 2004 Fare Restrictions Price Year KRTAE1 None AED 2250 (US$ 613) Special Excursion QEE4MAE1 Min. 7 days, max. 4 mths stay AED 1900 Basic Season Special Excursion LLE4MAE1 Low season; min. 7 days, max. 4 mths stay AED 1550 Basic Season Special Excursion VLE4MAE1 AED 1200

Emirates Airline, Mumbai-Dubai, Economy class, May 2004 Fare Restrictions Price Economy unrestricted LRT None INR 25,600 (US$ 557) Economy restricted LRTIN1 INR 22,700 Regular Excursion LEE3M1 Min. 7 days, max. 3 mths stay INR 20,100 Special Excursion VEE3MIN1 Max. 3 mths stay. INR 17,000

Emirates Airline Why does Emirates charge lower fare for passengers originating from Mumbai? How is this discrimination possible?

Pricing Policy uniform pricing complete price discrimination direct segment discrimination indirect segment discrimination bundling

UNIFORM PRICING marginal cost demand marginal revenue 80 Price (Thousand Yen per unit) 55 marginal cost 30 demand marginal revenue 2500 5000 Quantity (Units a year)

Uniform Pricing: Profit Maximum MR = MC Equivalently, set the incremental margin percentage equal to the inverse of absolute value of price elasticity of demand, (price - MC) / price = -1/e

Price Elasticity e = -1.5  IM% = 2/3 always set price so that demand is elastic if demand more elastic, then lower incremental margin percentage (IM%) e = -2  IM% = 1/2 e = -1.5  IM% = 2/3

Pricing Private-Label Cola Suppose that WalMart learns that demand for private-label cola is less elastic than the demand for Coca Cola. Should WalMart set a higher price for private-label cola?

Uniform Pricing: Shortcomings marginal cost price buyer surplus potential buyers $ quantity leaves buyers with a lot of surplus does not sell to every potential buyer A new picture from IP’s presentation

Complete Price Discrimination price each unit at buyer’s benefit and sell quantity where MB = MC maximum profit -- theoretical ideal different from MR = MC implementation: must know entire marginal benefit and marginal cost curves

Complete Price Discrimination: Practice bargaining auctions

Direct Segment Discrimination, I price by segment implementation fixed identifiable characteristic --- basic for segmentation no re-sale

Direct Segment Discrimination, II simple case: uniform price within each segment within each segment IM% = -1/e for segment with more elastic demand, then lower incremental margin percentage (IM%)

DIRECT SEGMENT DISCRIMINATION, III (a) Men’s demand (b) Women’s demand demand 80 Price (Thousand Yen per unit) Price (Thousand Yen per unit) 55 50 marginal revenue marginal cost 40 marg. cost 30 30 demand marginal revenue 2500 3000 1000 Quantity (Units a year) Quantity (Units a year)

NYNEX Telephone Service New York City residential -- $16/month business -- $23/month How is discrimination possible?

Asian Wall Street Journal Price for annual subscription, May 2006 Print: Hong Kong (HK$ 2,700) US$ 348 Print: Singapore (S$ 525) US$ 331 Print: Tokyo (Yen 94,500) US$ 845 Interactive: Worldwide US$ 99 p.241, IP Why different prices for print edition but not interactive edition?

Indirect Segment Discrimination structure choice to earn different incremental margins from each segment implementation seller controls some variable to which segments are differentially sensitive buyers cannot circumvent the variable

AIR TRAVEL: BENEFITS Air Travel: Indirect Segment Discrimination

AIR TRAVEL: INDIRECT SEGMENT DISCRIMINATION *MC=200

Chinese Embassy: Visa Fees Application period 1 day 3 days 7 days Single entry $75 $60 $25 Double entry $85 $70 $35 Source: Chinese Embassy, Singapore, September 2000

PRICING POLICIES: RANKING

Bundling strategy pure bundling mixed bundling

Cable Television: Benefits

Pure or Mixed Bundling What is the profit-maximizing pricing policy if marginal cost per channel = 0 marginal cost per channel = $5 Generally, if item is costless, no loss from giving it to every consumer --> pure bundling; if item is costly, then should avoid providing it to low-benefit users --> use mixed bundling to screen out low-benefit users. Mixed bundling is form of indirect segment discrimination structured choice between bundle and separates

Pure or Mixed Bundling Generally, if item is costless, no loss from giving it to every consumer --> pure bundling; if item is costly, then should avoid providing it to low-benefit users --> use mixed bundling to screen out low-benefit users. Mixed bundling is form of indirect segment discrimination structured choice between bundle and separates

Strategic Thinking

Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9% Case: Coke vs. Pepsi, 1999 Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9% “Coke and Pepsi will move now from price-based competition to marketing-based competition”, Andrew Conway, Morgan Stanley 2

What should Coke do? Competitive Dilemma 5 Nash equilibrium: for both parties, “raise price” is dominated by “discount”. but discounting is bad for both -- if only they could agree somehow to raise price. Coke and Pepsi stuck in this situation for four years until November 1999. What should Coke do? 5

Strategic Situations parties actively consider the interactions with one another in making decisions game theory -- set of ideas and principles to guide strategic thinking simultaneous actions: strategic form sequential actions: extensive form

Dominated Strategy generates worse consequences than another strategy, regardless of the choices of the other parties never use dominated strategy

Nash Equilibrium Given that the other players choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy No one is willing to deviate unilaterally from a Nash equilibrium

Solving for Nash Equilibrium eliminate dominated strategies, then check remaining cells “arrow” technique

Nash equilibrium: Competitive dilemma Pepsi Raise price Discount Coke C: 3, P: 3 C: 0, P: 5 C: 5, P: 0 C: 1, P: 1 From [IP] 10strt-ap-wo What should Coke do?

Coke and Pepsi Game Nash equilibrium: for both parties, “raise price” is dominated by “discount”. but discounting is bad for both -- if only they could agree somehow to raise price. Coke and Pepsi stuck in this situation for four years until November 1999.

Nash equilibrium: Prisoners’ dilemma Sam Do not confess Confess Ian Do not confess I: 0, S: 0 I: -10, S: -10 I: -5, S: -5 From [IP] 10strt-ap-wo What should Sam do?

No Nash equilibrium in pure strategies WHERE TO ADVERTISE? No Nash equilibrium in pure strategies 8

Randomized Strategies choose among pure strategies according to probabilities must be unpredictable Example: where to advertise _ We.com: ½ NBA and ½ NHL _ Competitor.com: ½ NBA and ½ NHL

Randomized strategies: Retail price competition Pricing trade-off: high price to extract buyer surplus of loyal customers low price to get store switchers Solution: randomized discounts From [IP] 10strt-ap-wo

Coordination/competition: Evening news Delta 7.30pm 8.00pm Zeta A: 1, B: 1 A: 3, B: 4 A: 4, B: 3 A: 2.5, B: 2.5 From [IP] 10strt-ap-wo

Coordination and Competition Prime time for news is 8:0pm; second best is 7:30pm; since audience is limited, get maximum viewership if two channels schedule at different times. Question: which station gets 8:0pm? Situation has elements of coordination -- avoiding same time slot competition -- getting the 8:0pm slot

Zero/Positive Sum zero-sum games: pure competition -- one party better off only if other is worse off positive-sum games: coordination -- both can be better off or both worse off co-opetition: competition and coordination

Coordination/competition: Future DVD standard Consumers Blu-ray HD-DVD DVD player manuf- acturers M: 1, C: 1 M: -1, C: -1 Similar problem in mid-1990s: adoption of new 56kbps modem for data communications. New technology assumed that ISP connected to exchange by digital circuit; economized on conversion, so offers higher speed; Market was frozen: for technology to work, both IAP (Internet access provider) and end-user must acquire matching modems; IAP and end-users daren’t buy modems for fear of buying the wrong technology – needed to coordinate Eventually settled: 3Com (belonging to Rockwell alliance) bought US Robotics; Two standards harmonized as ITU standard

Coordination/Competition: Focal Point Single Nash equilibrium - clear focal point Multiple Nash equilibria - look for focal point to see which one to play *

nodes branches outcomes Sequencing Game in extensive form – sequence of moves: nodes branches outcomes In some strategic situations, players act in sequence; examples: takeover bidding; tennis; Sotheby’s bidding; tic-tac-toe; use different model to analyze sequential moves -- game in extensive form: explicitly shows timing of moves node -- where party must choose an action branches leading from a node represent the possible choices outcome after each move

Extensive Form: Equilibrium backward induction final nodes  intermediate nodes  initial node

Sequencing: Extensive Form - TV News Fig.2 17

Strategic Move credibility first mover advantage Action to influence beliefs or actions of other parties in a favorable way credibility first mover advantage second mover advantage

Examples Examples: Evening TV news -- both stations want to move first: which one can? Use strategic move, eg, contracts with advertisers to deliver news at 8pm. Famous Chinese general: after crossing a river, burnt his ships -- strategic move to force soldiers to fight harder. Issue: Is the move credible? Will it convince the other players? Advantage doesn’t always go to first mover; In war, better to see opponent’s move, and then take action, eg is enemy moving south or north? new product category -- let competitor test the market and educate the customers

(2) destroying the plate (3) other solution? Lithographer Make more prints Buy Litho Make prints consumer Do not Do not Litho (1) serial number (2) destroying the plate (3) other solution? Do not 20

Conditional Strategic Moves Threats – if it succeeds, then it needn’t be carried out Promises – if it succeeds, then it needn’t be carried out Ideal strategic move doesn’t impose costs Strategic move may be very costly, eg, upon arriving in Mexico, Cortes dismantled his ships; similar example in Chinese history lithographer destroys plates Ideal -- strategic move that doesn’t impose costs: threat: if it succeeds, then needn’t be carried out promise: if it succeeds, then needn’t be carried out Examples of promises: Lithographer: put money in escrow, and offer to buy back prints from dissatisfied customers. If successful, then no buybacks. United States Federal Deposit Insurance Corporation (FDIC) guarantees deposits of up to $100,000 at participating banks. FDIC’s promise aims to forestall bank runs. If successful, then FDIC doesn’t spend anything. 22

MORGAN STANLEY: “SHAREHOLDER RIGHTS PLAN” If any party acquires 10% or more of company’s shares, other shareholders get right to buy additional shares at 50% discount. Impact on hostile bidder? 23

Shareholder Rights Plan This shareholder rights plan is a threat to potential bidders: most hostile bidders begin with small stake; with shareholder rights plan, if bidder acquires more than 10%, then rights triggered, and bidder will be diluted. Nickname: poison pill. Actually works against shareholder rights -- by entrenching existing management.

Poison Pill Hilda loses on initial stake + cost of takeover rises activates rights acquires 100,000 shares Sharon Hilda does not doesn’t bid 25

American professional football? Strike Lose current wage and possibly gain in future wage strike reject union demand Union do not Maintain current wage Employer accept Why are strikes rare in American professional football? 27

Conditional strategic move: Without deposit insurance bank insolvent bank remains solvent principal + interest zero depositor depositor maintains deposit withdraws deposit principal bank remains solvent bank insolvent For depositor, no dominant strategy: maintain deposit benefit -- small amount of interest risk – lose entire principal withdraw deposit – no interest, but safety of principal critical factor– perceived probability that bank will become insolvent if probability sufficiently high, depositor would withdraw immediately on hearing rumors Next transparency: deposit insurance if there is a bank run, depositor will only suffer inconvenience working back to initial node, depositor would not withdraw immediately on hearing rumors

Conditional strategic move: With deposit insurance bank insolvent bank remains solvent principal + interest principal depositor depositor maintains deposit withdraws deposit principal bank remains solvent bank insolvent With deposit insurance if there is a bank run, depositor will only suffer inconvenience working back to initial node, maintaining deposit is dominant strategy depositor would not withdraw immediately on hearing rumors Good example of promise U.S. Federal Deposit Insurance Corporation (FDIC) guarantees deposits of up to $100,000 at participating banks. FDIC’s promise aims to forestall bank runs. If successful, then FDIC doesn’t spend anything.