Session 4 Pricing Strategy Managerial Economics Professor Changqi Wu

PricingSlide 2 1 Topics for Today Uniform pricing Price discrimination Durable good pricing Bundling Auction

PricingSlide Uniform pricing Profit maximizing pricing strategy: Setting the incremental margin equal to the inverse of absolute value of the price elasticity of demand A seller sets the same price for every unit of his product. Optimal pricing depends on both price elasticity of demand and marginal cost

PricingSlide 4 3 Cost-Based Pricing Average cost plus a fixed profit margin Procedure To estimate the average cost To add a markup to the average cost Cost based pricing is widely practised. It has pros and cons.

PricingSlide 5 Why Cost-Plus Pricing is Popular? It’s simple! Cost-base pricing may be a profit-maximizing one if average cost approximates marginal cost P = (1- 1/(e p +1)) MC It costs money and time to calculate the right price and to work out how price should respond to changing market conditions, particularly for small firms It is costly to change prices.

PricingSlide 6 Why Cost-Plus Pricing Can Go Wrong? Demand side factor is not explicitly taken into consideration. It is difficult to estimate true average cost because of the existence of indirect cost and joint cost Average cost pricing is influenced by accounting rules As a remedy, one can use variable markup rule instead of fixed markup

PricingSlide Price Discrimination is... Two or more similar goods are sold at different net prices Prices may differ due to quality and cost differences. Motives for price discrimination: earning more from existing customers selling to new customers without sacrificing the current profit margin

PricingSlide 8 Capturing Consumer Surplus Quantity $/Q D MR P max MC If price is raised above P*, the firm will lose sales and reduce profit. PCPC P C is the price that would exist in a perfectly competitive market. A P* Q* P1P1 Between 0 and Q*, consumers will pay more than P*--consumer surplus (A). B P2P2 Beyond Q*, price will have to fall to create a consumer surplus (B).

PricingSlide 9 5 Conditions of Price Discrimination A seller must have market power A seller is able to identify customers with different demand elasticities Resale is impossible

PricingSlide 10 6 Practicing Price Discrimination Complete price discrimination Direct segment discrimination Indirect segment discrimination

PricingSlide 11 Complete Price Discrimination A seller charges each and every buyer her reservation price It can be used for tailor-made products/services Using price negotiation to find the buyer’s reservation price

PricingSlide 12 Incomplete Price Discrimination Quantity AC = MC $/Q Price is lower to appeal to Consumers with more elastic demand. Q2Q2 MR 2 D 2 = AR 2 P2P2 D 1 = AR 1 MR 1 P1P1 Q1Q1 Consumers are divided into groups.

PricingSlide 13 7 Direct Segment Discrimination A seller charges different prices using directly observable signals relating a consumer with her price elasticity Example: What’s in the name?

PricingSlide 14 8 Indirect Segment Discrimination A seller use self-selection devices to distinguish customers. Two-part tariff Consumers pay a fee up front for the right to buy a product and then, pay additional fee for each unit of the product they wish to consume Peak load pricing

PricingSlide 15 9 Methods to Prevent Resale Refuse to deal with resellers Bundling with services Issuing warranties Degrading the quality of product

PricingSlide Durable Goods Pricing Durable goods sold by a seller are their own substitutes Ways to solve the durable goods pricing problem Making goods less durable: planned obsolescence Limiting the production in the future Buy-back provisions

PricingSlide Bundling Bundling Scenario: Two different goods and many consumers Many consumers with different reservation price combinations for two goods Mixed Bundling Selling both as a bundle and separately Pure Bundling Selling only a package

PricingSlide 18 Mixed Versus Pure Bundling r2r2 r1r C 2 = MC 2 C 2 = 30 Consumer A, for example, has a reservation price for good 1 that is below marginal cost c 1. With mixed bundling, consumer A is induced to buy only good 2, while consumer D is induced to buy only good 1, reducing the firm’s cost. A B D C C 1 = MC 1 C 1 = 20 With positive marginal costs, mixed bundling may be more profitable than pure bundling.

PricingSlide 19 The Complete Dinner Versus a la Carte: A Restaurant’s Pricing Problem Pricing to match consumer preferences for various selections Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.

PricingSlide Auctions Auction Formats Traditional English (oral) Dutch auction Sealed-bid  First price  Second price

PricingSlide 21 Auctions How to choose an auction format Private-value auction: bidders uncertain about the other bidders reservation price Common-value auction: bidders uncertain what the value is Valuation and Information

PricingSlide 22 Auctions Second-price sealed auction: bid your reservation price English auction: Bid in small increments until you reach your reservation price The winning bids in both auctions is the reservation price of the second highest bidder Private Value Auction

PricingSlide 23 Auctions Sealed-bid auction First-price auction: lowers the bid Second-price auction: bid just above the second highest reservation price Both yield the same revenue Private Value Auction

PricingSlide 24 Auctions Winner’s Curse The winner is worse off than those who did not win Examples Bidding on a construction job Bidding on 3G mobile service licenses Question How can you avoid the winner’s curse? Common Value Auction

PricingSlide 25 Key Takeaway Points Profit maximizing uniform pricing depends on marginal cost as well as price elasticity of demand Depending on the information available, a seller can adopt different price discrimination schemes. There are many ways to set the prices to reduce inefficiencies and raise the level of profit.