Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1 Chapter 10 Special Pricing Policies

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 Overview Cartel arrangements Price leadership Revenue maximization Price discrimination Nonmarginal pricing Multiproduct pricing Transfer pricing

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 3 Cartel arrangements  A cartel is an arrangement where firms in an industry cooperate and act together as if they were a monopoly cartel arrangements may be tacit or formal illegal in the US: Sherman Antitrust Act, 1890 examples: OPEC

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 4 Cartel arrangements  Conditions that influence the formation of cartels small number of large firms in the industry geographical proximity of the firms homogeneous products that do not allow differentiation stage of the business cycle difficult entry into industry uniform cost conditions, usually defined by product homogeneity

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 5 Cartel arrangements  In order to maximize profits, the cartel as a whole should behave as a ‘monopolist’  the cartel determines the output which equates MR = MC of the cartel as a whole  the MC of the cartel as a whole is the horizontal summation of the members’ marginal cost curves  price is set in the normal monopoly way, by determining quantity demanded where MC=MR and deriving P from the demand curve at that Q

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 6 Cartel arrangements MC T is the horizontal sum of MC I and MC II Q T is found at the intersection of MR T and MC T  price is found from the demand curve at Q T … this is the price that maximizes total industry profits

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 7 Cartel arrangements  to determine how much each firm should produce, draw a horizontal line back from the MR T /MC T intersection  where this line intersects each individual firm’s MC determines that firm’s output, QI and QII. Note that the firms may produce different outputs Key point: the MC of the last unit produced is equated across both firms

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8 Cartel arrangements Profits for each firm are shown as rectangles in blue Firms may earn different levels of profit, though combined profits are maximized

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9 Cartel arrangements  Problem: incentive for firms to cheat on agreement, thus cartels are unstable  Additional costs facing the cartel formation costs monitoring costs enforcement costs cost of punishment by authorities  weigh the benefits against these costs

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10 Cartel arrangements  Examples: price fixing by cartels GE, Westinghouse Archer Daniels Midland Company Sotheby’s, Christie’s Roche Holding AG, BASF AG

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 11 Price leadership  Barometric price leadership one firm in an industry will initiate a price change in response to economic conditions the other firms may or may not follow this leader leader may vary

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12 Price leadership  Dominant price leadership one firm is the industry leader dominant firm sets price with the realization that the smaller firms will follow and charge the same price can force competitors out of business or buy them out under favorable terms could result in investigation under Sherman Anti-Trust Act

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 13 Price leadership D T = demand curve for entire industry MC D = marginal cost of the dominant firm MC R = summation of MC of follower firms  in setting price, dominant firm must consider the amount supplied by all firms

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 14 Price leadership Demand curve facing the dominant firm is found by subtracting MC R from D T  dominant firm equates its MC with MR from its ‘residual demand curve’ D D  the dominant firm sells A units and the rest of the demand (Q T – A) is supplied by the follower firms

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 15 Revenue maximization  Baumol model: firms maximize revenue (not profit) subject to maintaining a specific level of profits Rationale  a firm will become more competitive when it achieves a large size  management remuneration may be related to revenue not profits Implication: unlike the profit maximization case, a change in fixed costs will alter price and output (by raising the cost curve and lowering the profit line)

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 16 Price discrimination  Price discrimination: products with identical costs are sold in different markets at different prices  the ratio of price to marginal cost differs for similar products Conditions for price discrimination the markets in which the products are sold must by separated (no resale between markets) the demand curves in the market must have different elasticities

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 17 Price discrimination  First degree price discrimination seller can identify where each consumer lies on the demand curve and charges each consumer the highest price the consumer is willing to pay allows the seller to extract the greatest amount of profits requires a considerable amount of information

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 18 Price discrimination  Second degree price discrimination differential prices charged by blocks of services requires metering of services consumed by buyers

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 19 Price discrimination  Third degree price discrimination customers are segregated into different markets and charged different prices in each segmentation can be based on any characteristic such as age, location, gender, income, etc

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 20 Price discrimination Third degree discrimination: assume the firm operates in two markets, A and B the demand in market A is less elastic than the demand in market B the entire market faced by the firm is described by the horizontal sum of the demand and marginal revenue curves …

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 21 Price discrimination the firm finds the total amount to produce by equating the marginal revenue and marginal cost in the market as a whole: Q T if the firm were forced to charge a uniform price, it would find the price by examining the aggregate demand D T at the output level Q T the firm can increase its profits by charging a different price in each market …

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 22 Price discrimination in order to find the optimum price to charge in each market, draw a horizontal line back from the MR T /MC T intersection where this line intersects each submarket’s MR curve determines the amount that should be sold in each market: Q A and Q B these quantities are then used to determine the price in each market using the demand curves D A and D B

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 23 Price discrimination  Examples of price discrimination doctors telephone calls theaters hotel industry

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 24 Price discrimination  Tying arrangement: a buyer of one product is obligated to also buy a related product from the same supplier illegal in some cases one explanation: a device to ‘meter’ demand for tied product other explanations of tying  quality control  efficiencies in distribution  evasion of price controls

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 25 Nonmarginal pricing  Cost-plus pricing: price is set by first calculating the variable cost, adding an allocation for fixed costs, and then adding a profit percentage or markup Problems with cost-plus pricing  calculation of average variable cost  allocation of fixed cost  size of the markup

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 26 Nonmarginal pricing  Incremental pricing (and costing) analysis: deals with changes in total revenue and total cost resulting from a decision to change prices or product Features: incremental, similar to marginal analysis only revenues and costs that will change due to the decision are considered examples of product change: new product, discontinue old product, improve a product, capital equipment

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 27 Multiproduct pricing  When the firm produces two or more products Case 1: products are complements in terms of demand  an increase in the quantity sold of one will bring about an increase in the quantity sold of the other Case 2: products are substitutes in terms of demand  an increase in the quantity sold of one will bring about a decrease in the quantity sold of the other

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 28 Multiproduct pricing  When the firm produces two or more products Case 3: products are joined in production  products produced from one set of inputs Case 4: products compete for resources  using resources to produce one product takes those resources away from producing other products

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 29 Transfer pricing  Internal pricing: as the product moves through these divisions on the way to the consumer it is ‘sold’ or transferred from one division to another at a ‘transfer price’ Rationale: firm subdivided into divisions, each may be charged with a profit objective without any coordination, the final price of the product to consumers may not maximize profits for the firm as a whole

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 30 Transfer pricing  Design of the optimal transfer pricing mechanism is complicated by the fact that each division may be able to sell its product in external markets as well as internally each division may be able to procure inputs from external markets as well as internally

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 31 Transfer pricing  Case A: no external markets no division can buy from or sell to an external market the selling division will produce exactly the number of components that will be used by the purchasing division one demand curve and two MC curves MC curves are summed vertically set production where MR = Total MC

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 32 Transfer pricing  Case B: external markets divisions have the opportunity to buy or sell in outside competitive markets if selling division prices above the external market price, the buying division will buy from outside if selling division cannot produce enough to satisfy buying division demand, the buying division will buy additional units from the external market

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 33 Other pricing practices  Price skimming the first firm to introduce a product may have a temporary monopoly and may be able to charge high prices and obtain high profits until competition enters  Penetration pricing selling at a low price in order to obtain market share

Chapter TenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 34 Other pricing practices  Prestige pricing demand for a product may be higher at a higher price because of the prestige that ownership bestows on the owner  Psychological pricing demand for a product may be quite inelastic over a certain range but will become rather elastic at one specific higher or lower price