Slide 1  2005 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 10

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 customer value. 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 Intertemporal 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. Intertemporal pricing appears more frequently than one thinks. This is just one variety of what is called price discrimination.

Slide 4 Figure 14.1 Page 605 If the price at off-peak is P OP is the same price as the peak, the traffic volume varies from Q OP to Q PEAK. If the price at the peak is P’ P, the traffic volume varies less, from Q OP to Q C. D PEAK D OFF-PEAK P OP Q OP Q C Q PEAK P’ P shift

Slide 5 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 Otherwise, in pure competition, P = MC 2.Ability to Arbitrage Separate customers and prevent reselling

Slide 6 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, as restaurant food is a service »Lawyers charge different prices for wills, based on ability to pay

Slide 7 Ways to Separate Customers for Price Discrimination 1. Geography as when the price in the East-side and West-side differ 2. Income as the American Econ Association charges more to professors than students 3. Gender as when jeans for women are priced higher than similar jeans for men 4. Age as when kids get in at lower prices for movies 5. Time of day or season 6. Race as when shampoos targeted for African-American hair are priced differently that other shampoos, though technically the same. 7. Language as when products printed in Spanish are priced differently than those in English 8. Transient/Resident as when contracts pay less at hardware stores than other customers 9. Ability to Haggle when those how ask for a lower price get it

Slide 8 Why Price Discriminate? 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 9 Perfect Price Discrimination (or 1 st 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 10 Perfect Price Discrimination Does it Work for Car Dealers? “How much do you plan to pay a month?” you inadvertently reply: “ $232 per month, and have a $3,000 down payment!” At 6%, that’s about $12,000 for 60 months, plus $3,000 Here’s one for only $15,000. It’s swell.

Slide 11 Notice: Incentives to Understate One’s True Willingness to Pay The conditions for perfect 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 12 Two-Part Pricing A price for the privilege of buying items PLUS a price per item Examples: »Car rental per day with mileage charges per mile »Amusement parks »Country Club Dues and Greens Fees »Cover Charge to Enter a Bar and a Price Per Drink Cover Charge P Q Second Degree Price Discrimination: Car renters may not know how much they will use the car (D1 or D2). They may prefer a lower rental rate (cover charge) with a per mile charge, P*. D2 D1 Figure 14.2 Car rental per day is the ‘Cover Charge’, and mileage fee at P or P* P*

Slide 13 Unlimited Access A specified price for an unspecified quantity: Example: AOL unlimited access for $19.95/month Examples: Salad Bars, Legal Retainers, HMO’s Ounces of Salad The area under the demand curves represent most willing to pay. P Second Degree Price Discrimination:

Slide 14 Bundling 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: Movies A & B and Theaters 1 & 2. Preferences are uncorrelated Preferences are correlated 1212 A B = 360 simple monopoly = 365 simple monopoly 360 Second Degree Price Discrimination: Bundling is more Profitable.

Slide 15 Bundling & Mixed Bundling McDonalds sells Extra Value Meals, as a bundle of sandwich, fries, and a soft drink for less than it sells them separately. Selling both bundles and items separately is mixed bundling. »If Bob would pay $3 for a burger and $1 for a soft drink, and if Mary would pay $2 for a burger and $2 for a soft drink, a bundle of $4 for both a burger and soda will work for both customers as a bundle. »But if the price of a burger individually were $2.5 and a soft drink $1.50, then Bob would buy only a burger and Mary only a soft drink. Not everyone is alike, so mixed bundles succeeds with more customers.

Slide 16 One Price for All Regions East West Market MC MR PMPM Example with a Simple Monopoly Price (P M ) in both markets

Slide 17 East West Market MC MR PMPM Example with Different Prices in Each Market PE PE PWPW MR Third Degree Price Discrimination

Slide 18 Mathematics of Price Discrimination Using elasticities P( 1 + 1/ E D ) = MC In two regions: P 1 ( 1 + 1/ E 1 ) = P 2 ( 1 + 1/ E 2 ) = MC or: P 1 / P 2 = ( 1 + 1/ E 2 )/( 1 + 1/ E 1 ) If the elasticities in region 1 and region 2 are and -2.5 respectively, then P 1 / P 2 = (1+1/ -2.5)/(1+1/-1.25 ) = 3. Hence, P 1 = 3P 2. The price is three times higher in region 1, which less elastic.

Slide 19 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 20 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, such as Pampers & Luvs. Complements when cross terms are positive »Mitsubishi Electric sells DVD Players and blank DVDs

Slide 21 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 22 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 3 ¢ / lb. with $10 purchase

Slide 23 Pricing in Practice In practice, pricing strategy involves the whole life-cycle pricing 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 24 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 25 Full Cost Pricing Full Cost- - »Covers all Costs at the standard or normal output »Plus a return on the investment P = VC l + VC m + F/Q +  K / Q »Where VC l and VC m are unit labor cost and unit material cost respectively (which is average variable cost). »where  K is the target amount of profit »and  is the desired profit rate and K is gross operating assets »Q is the number of units expected to be produced over this time horizon.

Slide 26 Example: Low Tech Security Start a firm with F = 200,000, Q = 3000, total labor cost is $40,000 and total material cost is $50,000  = 20% and K=$500,000. Find Full Cost Price! Answer »P = VC l + VC m + F/C + (.20)(500,000)/Q »P = = $130 Also, suppose a 35% markup on average cost »P = [ AC] (1.35) »P = [ ](1.35) »P = $130.50

Slide 27 Advantages & Disadvantages 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 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 of cost-plus pricing

Slide 28  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 29  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 30  1999 South-Western College Publishing Skimming 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, and PDAs. TIME P D

Slide 31 Prestige Pricing Some products distinguish themselves by being noticeably expensive. »Mercedes, Audi, or BMW »Cartier jewelry The price is itself a way to distinguish the product from others Prestige Pricing is the practice of charging a high price to enhance its perceived value. »However, the firms typically have to spend a great deal in promotional activities to convince customers that the product is prestigious.