Slide 1  2002 South-Western Publishing Value-based more than cost-based pricing often helps build profits. Firms charge different customers different prices, which is known as price discrimination. This chapter also looks at pricing within a firm called transfer pricing. Pricing techniques that are used by many multi- product firms, such as full-cost pricing and target return pricing. Pricing Techniques and Analysis Chapter 16

Slide 2 Proactive Value-based Pricing If the price doesn’t fit what customers are willing to pay, then the product may not be profitable. »Customer value is the focus for pricing, not just the costs associated with the product. »Apple Computer lost market share by ignoring this. »The Ford Mustang was a success, as Ford found that people wanted a sports car, but didn’t want it to be too expensive. The started with a price and designed the product. The Mustang used value-based, not cost-plus pricing

Slide 3 Differential Pricing If at peak rush hour, the toll is higher than at the off-peak, we are using different prices at different time periods. The peak toll can encourage shifting travel patterns to off-peak times or discourage some commuting altogether. Differential pricing appears more frequently than one thinks. This we call price discrimination.

Slide 4 Price Discrimination l Price Discrimination -- Goods which are NOT priced in proportion to their marginal cost, even though technically similar l Some Necessary Conditions: 1.Some Monopoly Power In Perfect Competition, P = MC 2.Ability to Arbitrage Separate Customers and Prevent Reselling

Slide 5 Arbitrage - Buy Low to Sell Higher Arbitrage of Goods is Easy »Price discrimination of goods is ineffective »Little price discrimination of grocery items Arbitrage of Services is Difficult »Price discrimination of services is effective »Price discrimination at restaurants by age, a service »Lawyers charge different prices for wills, based on ability to pay

Slide 6 Many Ways to Separate Customers for Price Discrimination 1. Geography 2. Income 3. Gender 4. Age 5. Time 6. Race 7. Language 8. Transient / Resident 9. Ability to Haggle

Slide 7 Why Practice Price Discrimination? In Simple Monopoly, there is only one price Consumers receive a consumer surplus In Price Discrimination, monopolists can SCOOP OUT all consumer surplus Q D MC P SM Q SM CS Simple Monopoly

Slide 8 First Degree Price Discrimination Charge the MOST that a person is willing to pay for each good Zero consumer surplus Produce MORE than in Simple Monopoly Output the same as in Competition Q D MC Price Discriminating Monopoly Q 1st

Slide 9 Car Sales as First Degree Price Discrimination “How much do you plan to pay a month?” you inadvertently reply: “Only $200 per month, but I have $3,000 down payment!” Ahh, that is $9,887 for 60 months at our 7.9% financing, plus $3,000 Here’s one for only $12,887. It’s swell.

Slide 10 Notice: Incentives to Understate One’s True Willingness to Pay The conditions for First Degree price discrimination are seldom met Hence, some close approximations exist There are are a variety of ways to group units to attempt to scoop out consumer surplus Second Degree Price Discrimination: Units are Grouped

Slide 11 Second Degree Price Discrimination Methods Block rate setting Two part pricing Unlimited access Bundling methods We look at four examples:

Slide 12 Block Rate Pricing Price declines as the quantity purchased increased Examples: » Tri-State Gas Company example (page 632) » TJ Maxx, second pair half price » telephone charges » foreign film festivals Price declines similar to the demand curve Q P D Second Degree Price Discrimination:

Slide 13 Two-Part Pricing: A price for the privilege of buying items And a price per item Examples: »Country Club Dues and Greens Fees »Cover Charge to Enter and a Price Per Drink Cover Charge MC Q Another Second Degree Price Discrimination:

Slide 14 If P = Q and MC =.50 Find Optimal Cover Charge At P = $.50, he/she buys 4 mugs of root beer Biggest cover charge is the area of a triangle »Height is 4 »Base is 4 »(1/2)HeightBase Max cover charge is $8.00 Cover Charge $8 $.50 Q 4 $4.50 Monopoly: Q M = 2 & P M = $2.50 QMQM P M =$2.50 Cover Charge $8.00

Slide 15 Unlimited Access or All-You-Can-Eat Pricing A specified price for an unspecified quantity: Example: AOL unlimited access for $19.95/month Examples: Salad Bars, Legal Retainers, HMO’s ounces Area under demand curves represent most willing to pay for an AYCE offer P Second Degree Price Discrimination:

Slide 16 Bundling (or Block Booking) Often the pricing arrangement includes purchasing groups of dissimilar products. The products are bundled or sold as a block, as in theatrical or sporting tickets. Preferences are uncorrelated Preferences are correlated 1212 A B = 360 simple monopoly = 365 simple monopoly 360 Second Degree Price Discrimination:

Slide 17 Third Degree Price Discrimination East West Market MC MR PMPM Example with a Simple Monopoly Price in both markets

Slide 18 Third Degree Price Discrimination East West Market MC MR PMPM Example with Different Prices in Each Market PE PE PWPW MR

Slide 19 Pricing In Segmented Markets Segment markets by price sensitivity Charge higher prices in the markets that are the most inelastic Then P 1 = $150 and P 2 = $120 P ( 1 + 1/ E QP ) = MC Suppose MC = $100 in 2 markets and E 1 = - 3 and E 2 = - 6 Why are haircuts for kids cheaper than for adults?

Slide 20 Products are INDEPENDENT when changes in price and quantity of one product do not alter revenues or cost in the others Products are INTERDEPENDENT, when changes DO affect other products Ex: Procter & Gamble makes both Luvs and Pampers »TR = TR A + TR B Pricing of Multiple Product

Slide 21 Substitutes & Complements Look for interdependencies in marginal revenues: »MR A =  TR A /  Q A +  TR B /  Q A »MR B =  TR A /  Q B +  TR B /  Q B Substitutes when cross terms are negative »Erosion or Cannibalism are terms used Complements when cross terms are positive »BASE sells tapes and tape head cleaners

Slide 22 Decision Rule for Multiple Product Firms Do NOT use the rule to produce where MR=MC, as in MR A = MC A INSTEAD: » Produce where the FULL MR = FULL MC »For a Two Product Firm of A & B »Produce where:  TR A /  Q A +  TR B /  Q A =  TC A /  Q A +  TC B /  Q A Include all relevant revenue and cost effects

Slide 23 Pricing Example in Supermarkets Turkey prices fall during Thanksgiving »Yet we would expect DEMAND to be greatest?! Loss Leader Pricing »Consider T as turkey »and A as all other food TR store = TR T + TR A MR store for turkey =  TR T /  Q T +  TR A /  Q T Complementarity with other food explains the apparent conundrum

Slide 24 Pricing of Joint Products Interdependencies in costs occur in products that are produced simultaneously E.g., Beef & Hides; Wool & Mutton; Natural Gas & Crude Oil Suppose FIXED PROPORTIONS in production: 500 lbs. of Beef + 10 sq. yards of Hide for 1 steer. Two cases: No Excess of Hides, and Excess Hides case

Slide 25 Steers: No Excess Case steers (T) DHDH DBDB MR H MR B Two Demand Curves: Hides & Beef Two MR Curves: Hides & Beef

Slide 26 Steers: No Excess Case 2 steers (T) DHDH DBDB MC T MR H MR T Find where MR T = MC T to find the optimal of steers.

Slide 27 Steers: No Excess Case 3 steers (T) DHDH DBDB MC T MR H MR T At the optimal number of steers, find the prices of beef & hides on their respective demand curves T PBPHPBPH if demand for beef rises, the price of hides will fall !

Slide 28 Excess of One of the Joint Products Excess means the price would be ZERO The solution is to hold back some of the excess to reach the Unit Elastic Point on the Demand Curve. This Maximizes Total Revenue.

Slide 29 Multi-Divisional Firms and the Economics of Transfer Pricing Transfer Pricing serves two functions: 1.Measure of the marginal value of the resource 2.Provides a performance measures of resources used For international firms, transfer pricing may assist in reducing worldwide taxation, but the ability to reduce taxation is limited because the IRS requires arm’s length prices.

Slide 30 Create Transfer Prices Similar to Competitive Market Prices Disagreements across divisions are common »“Selling” Division wants a HIGH transfer price »“Buying” Division wants a LOW transfer price When External Markets exists, use those prices for transfer (a market-based competitive price) motor assembly final car assembly sell to “P” purchase motors from “P”

Slide 31 Transfer Pricing With No External Markets When no external markets exist, use the MC of the transferred good. Often, however, the MC is a function of output. Marketing and Production steps (M & P) Transfer price is P T = MC P on following figure

Slide 32 Find Where MC M+P = MR D MC M MC P MC M+P MR P PTPT

Slide 33 Pricing in Practice In practice, pricing strategy involves the whole life-cycle of the product. Managers report wide use of cost-plus pricing methods because it: »Streamlines pricing of multiple products »Streamlines pricing of retail prices

Slide 34 Cost-Plus and Full Cost Pricing P = AC n + Markup or P = AC n (1 + m) where AC n is average cost at a normal output and m is a percentage markup Notice: Little reliance on MC pricing or use of elasticities, as in: P( 1 + 1/E p ) = MC

Slide 35 Cost-Plus Pricing : Illustrated Manufacturing pricing illustrated: One Good AFC AVC QnQn Q capacity AC n } markup P ATC

Slide 36 Cost-Plus Pricing : Illustrated AFC AVC QnQn Q capacity AC n } markup P D 1 D 2 quantity varies as demand varies

Slide 37 Cost-Plus Pricing : Illustrated AFC AVC QnQn Q capacity AC n } markup P D 1 D 2 quantity varies as demand varies Q1Q1 Q2Q2

Slide 38 Full Cost Pricing Full Cost- - »Covers all Costs at the standard or normal output »Plus a return on the investment P = AFC n + AVC n +  K / Q n »where  K is the target amount of profit »and  is the desired profit rate and K is gross operating assets Example: Low Tech Security FC = 200,000, Q n = 3000, VC = 90,000  = 20% and K=$500,000. Find Full Cost Price!

Slide 39 Full Cost Pricing Answer »P = AVC + AFC + (.20)(500,000)/Q »P = = $130 Also, suppose a 35% markup on cost »P = [ AC n ] (1.35) »P = [ ](1.35) »P = $130.50

Slide 40 Advantages Cost-plus is simple It is easy to delegate to others Easy to apply to thousands of items »Can use categories of markups for different classes of products Disadvantages But cost-plus ignores demand changes Pricing may be based on poor cost data Output varies in business cycle Hybrid Method: Variable Cost-Plus Pricing -- the markup can vary over the season or business cycle Cost-Plus Pricing

Slide 41  1999 South-Western College Publishing Optimal Markups in Practice Grocery stores have low markups Many close substitutes -- at other grocery stores (bread varieties and qualities are standardized) Frequent purchase, so customers are knowledgeable about prices & quality Demand is therefore highly elastic Optimal markup would consequently be small

Slide 42  1999 South-Western College Publishing Markups on Jewelry Jewelry Markups are known to be large Difficult to make comparisons across jewelry stores Little repeat purchases, so knowledge about prices is low Consequently, lower price elasticity for jewelry The optimal markup is larger

Slide 43  1999 South-Western College Publishing Skimming a form of block rate pricing over time Price declines over time Those who wish to get it first pays the highest price, others are willing to wait Examples: »Hardcover & Paperback Books »New electrical & Computer Products TIME P D

Slide 44 Revenue Management: Appendix 16A Revenue Management is the problem of the disappearing inventory. Managers must be flexible to change their predicted sales by market segment as information arrives. Airlines price discriminates between business and non-business travelers. If too few business travelers have booked tickets compared to the amount expected, then more non-business tickets should be released.

Slide 45 Optimal Overbooking Managers may authorize reservation clerks to sell more seats (rooms) than are available. The greater the overbooking, the lower are the costs of spoilage. Spoilage is an inventory NOT sold. If capacity is large, an airline or hotel will have high spoilage. The greater the overbooking, the greater are the costs of spillage, making customers unhappy by finding that they have no seat or reservation.

Slide 46 Spillage Spillage is the excess demand that cannot be met. If the service industry has low capacity, the spillage will be great Customers leave the hotel or airline unable to get a room or an airplane seat.

Slide 47 Optimal Overbooking Spillage and spoilage costs go in opposite directions, the sum of these costs has a minimum with the optimal amount of overbooking. Since business travelers tend to a large extent to be repeat customers, the cost of spillage (oversells) may be very high. The optimal amount of overbooking for this market segment may well be lower than for non-business clients. 100% 110% 120%... Percent Overbooked Spoilage Spillage Total Cost optimal