Pricing Strategies for the Firm Chapter 10

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Markup Pricing Calculating the price of a product by determining the average cost of producing the product and then setting the price a given percentage above that cost. In some cases, the markup is based on industry tradition. Firms estimate first their cost of production (AVC) and then markup. Markup pricing is a profit-maximizing strategy for managers. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

EQUATION 10.1-10.7 Marginal Revenue and the Price Elasticity of Demand

TABLE 10.1 Marginal Revenue and Price Elasticity of Demand

EQUATION 10.7-10.8 Profit Maximization and Markup Pricing

EQUATION 10.9-10.11 Profit Maximization and Markup Pricing

EQUATION 10.12-10.13 Profit Maximization and Markup Pricing

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Markup Pricing Calculating the price of a product by determining the average cost of producing the product and then setting the price a given percentage above that cost. Optimal markup: m = -1 ÷ (1 + ep), where, m = markup and ep = price elasticity of demand Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Optimal Markups Elasticity Calculation Markup -2.0 m = -[1/(1 - 2)] = +1.00 1.00 or 100% -5.0 m = -[1/(1 – 5)] = +.25 0.25 or 25% -11.0 m = -[1/(1 - 11)] = +0.10 0.10 or 10% ∞ m = -[1/(1 - ∞)] = 0 0.00 (no markup) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Studies of Markup Pricing The 1958 Lanzillotti study concluded that the goal of the companies studied was to earn a predetermined target rate of return on their investment. In 1988, Kenneth Elzinga updated the Lanzillotti study and found that most of the 20 original firms earned a lower rate of return in subsequent years compared with the original study period. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Markup Pricing Examples Restaurant Industry. The divergence between the prices restaurants charge and the costs of producing the menu items are much greater than what would be expected. Even though one might not consider one particular type of food as highly inelastic, the markups can often be extremely high such as the one on mussels which is 650 percent, while those on salmon can exceed 900 percent. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Price Discrimination Price discrimination is the practice of charging different prices to various groups of customers that are not based on differences in the costs of production. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Requirements for Successful Price Discrimination Firms must possess some degree of monopoly or market power that enables them to charge a price in excess of the costs of production. Firms must be able to separate customers into different groups that have varying price elasticities of demand. Firms must be able to prevent resale among the different groups of customers. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Best Example Airline industry These firms are limited in number, thus, they have a market power. They have customers with different elasticities, i.e., business men, pleasure travelers. Resale cannot occur once the flight left. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Price Discrimination We will present three models of price discriminations: first, second and third degrees. Before this, we should describe the consumer willingness to pay to provide a rationale for price discrimination. Total Willingness to pay = total revenue (spending) + Consumer Surplus. Consumer surplus: the difference between the max amount to pay and actual payments. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Price Discrimination The goal of managers is to increase profits by turning some or all of the consumer surplus to the firm revenues. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

First Degree Price Discrimination (FDPD) A pricing strategy under which firms with market power are able to charge individuals the maximum amount they are willing to pay for each unit of the product. The Internet offers many opportunities for first degree price discrimination. Amazon.com tracks the purchases of its customers, adjusts prices, and recommends additional related books in subsequent sessions. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

FIGURE 10.2 Profit Maximization and First-Degree Price Discrimination

First Degree Price Discrimination (FDPD) In a perfectly competitive market, we produce where D=S (MC), thus we will produce 10 units at P=2. The total revenue = 2*10 =20, Profit =0 Consumer surplus (CS) = 0.5*10*10 = 50 In a monopoly case, the manager is trying to extract more of the consumer surplus. P=7, Q=5, thus TR= 35, Profit=25. CS = 0.5*5*5= 12.5. FDPD will charge the higher price =12, thus total revenue will go to 47.5 and profit =37.5 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Second Degree Price Discrimination A pricing strategy under which firms with market power charge different prices for different blocks of output. Small convenient store around the corner vs carrefour Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

FIGURE 10.3 Second-Degree Price Discrimination

Second Degree Price Discrimination The firm can sell Q1 and the TR=0PBQ1. The firm can divide this into blocks; the first Q3 will be sold at P3, thus, TR=0P3CQ3. The second Block Q3Q2 at P2, TR =Q3EDQ2. The last block Q2Q5 at P1, TR =Q2FBQ1. 0P3CQ3 + Q3EDQ2+ Q2FBQ1 is bigger than 0PBQ1. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

TABLE 10.4 Numerical Example of Profit Maximization with a Single Price and First- and Second-Degree Price Discrimination

Third Degree Price Discrimination A pricing strategy under which firms with market power separate markets according to the price elasticity of demand and charge a higher price (relative to cost) in the market with the more inelastic demand. Dell Computer Corporation has made extensive use of this pricing strategy. In June 2001, its Latitude L400 ultralight laptop was listed at $2,307 on the company’s Web page directed to small businesses, at $2,228 for sales to health care companies, and at $2,072 for sales to state and local governments. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

FIGURE 10.6 Profit Maximization and Third-Degree Price Discrimination

TABLE 10.5 Numerical Example of Profit Maximization and Third-Degree Price Discrimination

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Summary First degree price discrimination - charging what ever the market will bear, Second degree price discrimination - quantity discounts or versioning, Third degree price discrimination - separate markets and customer groups. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination - Versioning Offering different versions of a product to different groups of customers at various prices, with the versions designed to meet the needs of the specific groups. Book publishers have long used versioning when they publish a hardcover edition of a book and then wait a number of months before the cheaper paperback edition is released. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination - Bundling Bundling involves selling multiple products as a bundle where the price of the bundle is less than the sum of the prices of the individual products or where the bundle reduces the dispersion in willingness to pay. Microsoft Office bundles its products together, but also sells them separately. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination - Bundling Customer Computer Printer 1 1000 250 2 800 300 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination - Bundling The table shows the consumers willingness to pay. If the firm charged the products 1250 for both, just only one consumer will by them. The firm will bundle them and charge 1100. Thus, both consumer will purchase. Bundling reduces the dispersion in the willingness to pay. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination: Coupons and Sales - Promotional Pricing Using coupons and sales to lower the price of the product for those customers willing to incur the costs of using these devices as opposed to lowering the price of the product for all customers. Those individuals who clip coupons or watch newspaper advertisements for sales are more price sensitive than consumers who do not engage in these activities, and they are also willing to pay the additional costs of the time and inconvenience of clipping the coupons and monitoring the sale periods. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination: Two - Part Pricing Charging consumers a fixed fee for the right to purchase a product and then a variable fee that is a function of the number of units purchased. This is a pricing strategy used by buyers clubs, athletic facilities, and travel resorts where customers pay a membership or admission fee and then a per-unit charge for the various products, services, or activities as members. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall