Strategic Pricing: Theory, Practice and Policy Professor John W. Mayo

Pricing Project Presentations Logistics - Rest of Course Friday: Pricing project presentations, the logistics Affirmative presentations (Power point) minutes Q&A 10 minutes Student questions encouraged Professor Borner will help judge Today: Pricing and “The Sound of Music” Pricing in Vertical Settings Tomorrow: The Psychology of Pricing 2

Question: What should the price paid by TV stations (radio stations) be for music they play? 3

Industry Structure 4 Composers PROsBMIASCAP I TV StationsInternet Media Retail consumers $

Some options TV (radio) stations are losing customers to alternative (internet) media. With fewer customers and reduced advertising $, the price should fall. What is the value added to TV & Radio stations caused by the demand for music? The alternative? Individual contracting The competitive benchmark: Marginal cost The “reasonable bounds” MC ≤ P ≤ Stand Alone Cost Practical: Price Cap P t+1 = P t + CPI – Productivity Change 5

Vertical relations Review of Vertical Relations Transfer Pricing

Vertical relations Retail Demand: Q= Q (Price, advertising, Sales outlets, etc) Wholesale Demand: Q = Q (wholesale price, downstream demand) retail wholesale Upstream Downstream

Double Marginalization Q P mr AC=MC Pm qmqm Pr Insufficient vertical control can diminish profits This creates incentive for coordination/control across vertical stages Two-part tariff P w = π m +mc(Q) qrqr Alternatively, could set maximum retail price

Pricing and Competition in Vertical Markets Q P mr AC=MC Pm qmqm Pr qrqr What is the relationship between the extent of downstream competition and the optimal upstream price?

Vertical relations, Retail competition and externalities Assume downstream competition Assume that consumers receive valuable (but costly to deliver) information at the retail stage Free-rider problem Possible solution: Resale price maintenance What about “generic” advertising? Possible solution: Territorial restrictions What about generic manufacturer investments in retail stage (e.g. Training staff) Possible solution Exclusive dealing

Vertical restraints and the Law Resale price maintenance – per se illegal until Leegin v. PSKS (2007), now Rule of Reason Territorial restriction – Rule of Reason Exclusive Dealing – Rule of reason In Europe, Article 85 (1) – vertical restraints are ‘incompatible with the common market.” (but there is exception for technically or economically justified restrictions where consumers receive fair share of benefits.

Transfer Pricing Consider FedEX Office (aka Kinkos). What price should FedEX Express Charge FedEX Office for delivering an overnight package? Office FedEX Should FedEX Office buy Express services at retail?

Transfer Pricing With no outside market With a competitive outside market With a non-competitive outside market

Transfer Pricing with no Outside Market Set transfer price of the input equal to the marginal cost of the upstream input A little economic manipulation shows that that with prices set equal to marginal cost, the incentives of decentralized, vertically related profit-centers are aligned.

Transfer Pricing D MR NMRu MCu MCd To maximize profits, set the Transfer price equal To the Net Marginal Revenue of the upstream input P Pu Quantity

Transfer pricing with a competitive outside market Either buy upstream inputs from the market or sell upstream inputs into the competitive market depending on the relationship of the market price and your firm’s marginal input cost

Transfer Pricing with Competitive market D MR NMRu MCu MCd Assuming a competitive world price of Pu, to maximize profits, produce q u and then purchase inputs out to Pu = NMRu) P Pu Quantity ququ Q* q1q1

Transfer Pricing Competitive market & high price D MR NMRu MCu MCd Assuming a competitive world price of Pu, to maximize profits, produce q u and sell (qu –Q) in open market P Pu Quantity ququ Q* Why equate Pu and NMRu?

Efficient Component Pricing

Pricing with a non-competitive outside market: Efficient Component Pricing Rule At what price should Verizon provide loops to a Competitive retail provider? Verizon Telephone loops Verizon Retail Competitive Local Exchange Company (CLEC)

The Critical Role of Economic Costs in Strategic Decision-making At what price should Verizon provide loops to the CLEC? Verizon Loops Verizon Retail CLEC Retail: ( R ) Wholesale: (W) Suppose: P R = $15 IC W = $4 IC R = $5 Efficient Component Pricing Rule : P W = IC W + (P R – IC W – IC R )