1 MANAGERIAL ECONOMICS An Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall

2 Chapter 14: Pricing in Theory Objectives: To examine theoretical aspects of the pricing decision, including basic rules for optimal pricing pricing and market structures pricing and entry conditions - the pre-game theory approach price discrimination pricing and the product life cycle

3 The Basic Rule for Profit- Maximization n (Price - Marginal Cost)/Price = 1/-E d n Not an operational decision rule - a statement of the condition required for maximum profit n Can be re-stated in an “average cost plus margin” format - see p.292

4 Pricing and Market Structures n Review Chapter 10 n Under perfect competition, firms are price- takers n Under monopoly, firms are price-makers (but still constrained by the requirement to make maximum profit) n Under monopolistic competition, prices settle at the ‘excess capacity’ level where P=AC

5 Pricing in Oligopoly n Review Chapter 13 on Cournot, Bertrand and von Stackelberg competition n The ‘conjectural variation’ approach –P - MC = (-) s i (1+a) P E d n Where s i = firm’s market share; a =conjectural variation

6 Entry Conditions and Pricing n Entry may be ‘blockaded’, ‘effectively impeded’ or ‘uneffectively impeded’ n Entry barriers are advantages held by incumbent firms, arising from: –absolute cost advantages –economies of scale –product differentiation

7 Limit Pricing n The ‘limit price’ is the highest price that can be charged without inducing new entry n Can it be determined? n Game theory is the current approach - review Chapter 13 n The traditional, pre-game theory approach was based on the Bain-Sylos-Labini- Modigliani model

8 Limit Pricing n The Bain-Sylos-Labini-Modigliani model n Entry will take place if the entrant believes that the post-entry situation will be profitable n Entrants believe that if entry takes place, incumbents will keep their output constant –(a rather restrictive assumption)

9 Limit Pricing n Figure 14.2: Demand for an Entrant’s product Price Quantity X X P1P1 P2P2 Q 1 Q 2 D industry D entrant

10 Limit Pricing n Figure 14.3: The Case of Absolute Cost Advantages Quantity PHPH PLPL D entry encouraged D entry deterred ATC entrant ATC incumbent

11 Limit Pricing n If the limit price is known, should incumbent firms set that price or not? n Limit pricing might mean less profit in short term but less erosion of profit in the long term n Therefore depends upon: –how much extra profit can be made in the short run by setting price above the limit price –how long can that extra profit be enjoyed before entry takes place –what is the firm’s discount rate?

12 Price Discrimination n Price discrimination exists when the same product is sold for different prices, that are not attributable to differences in the cost of supply n Two conditions are needed: –the market must be divisible into sub-markets between which there cannot be any arbitrage –demand conditions (elasticity) must be different in the sub-markets

13 Third Degree Price Discrimination n A number of sub-markets, each containing a number of potential customers n These markets may be separated by: –distance ( car prices differ between Europe and the UK - but is it really price discrimination?) –time (for non-storable commodities) - peak versus off-peak journeys –age and status - Student Railcards, Old Person Railcards n See p 304 for a graphical analysis

14 First Degree Price Discrimination n Every buyer is charged the maximum they are willing to pay (the demand curve becomes the marginal revenue curve) n Can be difficult to evaluate willingness to pay but first degree discrimination may be possible in personal, household or commercial services n Note that the socially optimal level of output will be produced but all the surplus accrues to the producer

15 Second Degree Price Discrimination n Customers are charged one price for the first block of units they purchase, then a different price for the second block –electricity, water, gas tariffs –the producer appropriates part of the consumer surplus

16 Pricing and the Product Life Cycle n Given; –the basic formula linking Price, Marginal Cost and Elasticity –the likelihood that Elasticity rises and Marginal Cost falls throughout the PLC n The most straightforward prediction is that price falls continuously n But is the PLC really valid?

17 Pricing and the Product Life Cycle n.n. Introduction Growth Maturity Decline Time Sales Volume

18 What Happens to Elasticity of Demand and Marginal Cost Over the Product Life Cycle? n Introduction - product is new. Elasticity may be low because there are no substitutes or high if buyers need to be persuaded to try the new product. Marginal cost is relatively high. Appropriate price will reflect high MC combined with high/low elasticity n Growth - imitation begins, and learning takes place. Elasticity rises, MC falls. Price falls? n Maturity - competition from many locations, substitutes and next-generation products have been invented, elasticity high, MC low n Decline - fierce competition for a declining market, very low margins n BEWARE THE POTENTIALLY SELF-FULFILLING NATURE OF THE PLC THEORY!!!!!

19 Pricing New Products n For new products, there is a significant amount of uncertainty about demand conditions. Two strategies have been suggested (Dean 1950) n SKIMMING - set an initially high price. IF that produces a high level of profits, leave the price high until conditions change and demand becomes more elastic. Do this when: –there is a significant group of buyers prepared to pay high prices –when demand is inelastic –when the high price will not induce entry –when the cost penalty for low volume is small n PENETRATION - set a low price from the beginning in order to build a large market share quickly. Do this when: –demand is elastic –low volume is very high cost –entry is a major danger

20 Is Skimming v Penetration Just an Application of the Simple Model? n YES - set a high price when elasticity is low and MC is high, set a low price when the opposite is true n BUT - –skimming may have another benefit. If experience shows it is the wrong strategy, the price can be cut without much customer resistance. If the penetration approach is used but it becomes clear that skimming would be better, it is more difficult to raise price than to lower it –skimming may provide a means of price discrimination through time. If a market contains a group of ‘trendsetters’ or ‘first-adopters’ who must have, or like to have, a product first and are willing to pay more for it. Skimming allows them to be charged a higher price. –E.g new major dictionaries, new types of mobile phone