Pricing with market power McGraw-Hill/Irwin

Pricing with market power learning objectives Students should be able to Explain the role of elasticity in optimal pricing Identify circumstances appropriate for price discrimination Apply selected pricing techniques consistent with maximum profit McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Pricing objective A firm has market power if…...it faces a downsloping demand curve. The firm’s pricing objective is… …to maximize shareholder value. The demand curve reflects… …consumer willingness and ability to buy. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Pricing with market power McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

The benchmark case: single price per unit Beyond.com data: Purchases software from manufacturer for $10 Demand curve is P = 85-.5Q (Q in 000s of units) What is the profit-maximizing price? Set MR = MC 85-Q=10 Q=75, P=$47.50 Profit is $2, (000s) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Single price per unit Checkware McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Other single pricing issues Relevant costs –sunk costs are irrelevant –current opportunity costs are relevant Price sensitivity –price elasticity, , is a measure of price sensitivity –Optimal price is P*=MC*/[1-1/  *] –A firm with market power should never operate on the inelastic portion of the demand curve McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Price sensitivity and optimal markup McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Estimating profit-maximizing price In theory, MC=MR, but in practice, manager may not know demand curve and therefore MR. Cost-plus or mark-up pricing may be useful approximations. But they must reflect fundamentals! McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Linear approximation Requirements: estimates of current price (P 1 ), quantity sold (Q 1 ), possible new price (P 2 ), quantity sold with price change (Q 2 ), and marginal cost A linear demand curve is approximated by P 1 =a-(P 2 -P 1 /Q 2 -Q 1 )Q 1 ; solve for a More generally, P=a-bQ McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Cost-plus pricing Add a markup to average total cost to yield target return Does this ignore incremental costs and price sensitivity? –not if managers have a fundamental understanding of their markets –consistently bad pricing policies are not good for the firm’s long term fiscal health McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Mark-up pricing Optimal mark-up rule of thumb: P*=MC*/(1-1/  *) where * indicates estimated value Requires some knowledge or awareness of both marginal costs and elasticity McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Potential for higher profits McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Homogenous consumer demand Block pricing –declining price on subsequent blocks of product –product packaging Two-part tariffs –up-front fee for the right to purchase –additional fee per unit purchased –best when customers have relatively homogenous demand for product McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Two-part tariff capturing consumer surplus McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Price discrimination heterogeneous consumer demands Price discrimination occurs when firm charges different prices to different groups of customers –not related to cost differences Necessary conditions –different price elasticities of demand –no transfers across submarkets McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Using information about individuals Personalized pricing –“first degree” price discrimination –possible only with small number of buyers Group pricing –“third degree” price discrimination –very common (utilities, theaters, airlines…) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Group pricing example Snowfish Ski Resort demand curves Out of town: Q o =500-10P Local: Q l =500-20P Total: Q= P One-price profit: P*=$21.66, Q*=350, Q o *=283, Q l *=67, Profit=$4,081 Two-price profit: P o *=$30, Q o *=200, P l *=17.50, Q l *=150, Profit=$5,125 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Optimal pricing at Snowfish different demand elasticities McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Using information about the distribution of demands Menu pricing –“second degree” price discrimination –consumers select preferred package Coupons and rebates –users likely more price sensitive –users who are new customers may stick with product McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Bundling and other concerns Bundling may yield a higher price than if each component is sold separately –theater season tickets –restaurant fixed price meals Multiperiod pricing –low initial price can “lock-in” customers Strategic considerations –low price may be barrier to entry McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.