1. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 15 Pricing Strategy

2. 2 of 24 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Getting into Walt Disney World: One Price Does Not Fit All 15.1Define the law of one price and explain the role of arbitrage. 15.2Explain how a firm can increase its profits through price discrimination. 15.3Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. Learning Objectives In this chapter, we will study some common pricing strategies, and we will see how Disney and other firms use these strategies to increase their profits.

3. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 24 Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. Pricing Strategy, the Law of One Price, and Arbitrage Learning Objective 15.1 Arbitrage

4. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 24 Solved Problem 15-1 Is Arbitrage Just a Rip-off? Learning Objective 15-1 Does eBay serve a useful economic purpose? Economists would say that it does.

5. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 24 Pricing Strategy, the Law of One Price, and Arbitrage Learning Objective 15.1 Why Don’t All Firms Charge the Same Price? Table 15-1 Which Internet Bookseller Would You Buy From? PRODUCT: HARRY POTTER AND THE DEATHLY HALLOWS COMPANYPRICE Amazon.com$18.89 BarnesandNoble.com18.89 WaitForeverForYourOrder.com 17.50 JustStartedinBusinessLastWednesday.com 16.75

6. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 24 Price discrimination Charging different prices to different customers for the same product when the price differences are not due to differences in cost. Price Discrimination: Charging Different Prices for the Same Product Learning Objective 15.2 Don’t Let This Happen to YOU! Don’t Confuse Price Discrimination with Other Types of Discrimination

7. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 24 1 A firm must possess market power. 2 Some consumers must have a greater willingness to pay for the product than other consumers, and the firm must be able to know what prices customers are willing to pay. 3 The firm must be able to divide up—or segment— the market for the product so that consumers who buy the product at a low price are not able to resell it at a high price. In other words, price discrimination will not work if arbitrage is possible. Learning Objective 15.2 The Requirements for Successful Price Discrimination A successful strategy of price discrimination has three requirements: Price Discrimination: Charging Different Prices for the Same Product

8. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 24 Learning Objective 15.2 The Requirements for Successful Price Discrimination FIGURE 15-1 Price Discrimination by a Movie Theater Price Discrimination: Charging Different Prices for the Same Product

9. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 24 Solved Problem 15-2 How Dell Computer Uses Price Discrimination to Increase Profits Learning Objective 15-2

10. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 24 Learning Objective 15.2 FIGURE 15-2 33 Customers and 27 Different Prices Price Discrimination: Charging Different Prices for the Same Product Airlines: The Kings of Price Discrimination

11. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 24 Learning Objective 15.2 How Colleges Use Yield Management Making the Connection Some colleges use yield management techniques to determine financial aid.

12. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 24 Learning Objective 15.2 FIGURE 15-3 Perfect Price Discrimination Price Discrimination: Charging Different Prices for the Same Product Perfect Price Discrimination

13. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 24 Learning Objective 15.2 FIGURE 15-4 Price Discrimination across Time Price Discrimination: Charging Different Prices for the Same Product Price Discrimination across Time

14. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 24 Learning Objective 15.2 In 1936, Congress passed the Robinson– Patman Act, which outlawed price discrimination that reduced competition, but which also contained language that could be interpreted as making illegal all price discrimination not based on differences in cost. Price Discrimination: Charging Different Prices for the Same Product Can Price Discrimination Be Illegal?

15. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 24 Learning Objective 15.2 Price Discrimination with a Twist at Netflix Making the Connection Why does renting only a few movies get you better service on Netflix?

16. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 24 Many firms use what is called odd pricing—for example, charging $4.95 instead of $5.00, or $199 instead of $200. Other Pricing Strategies Learning Objective 15.3 Odd Pricing: Why Is the Price $2.99 Instead of $3.00? Do consumers have an illusion that a price of $9.99 is significantly cheaper than $10.00? There is some evidence that using odd prices makes economic sense.

17. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 24 1 When marginal cost and average cost are roughly equal 2 When the firm has difficulty estimating its demand curve Other Pricing Strategies Learning Objective 15.3 Why Do Firms Use Cost-Plus Pricing? Economists conclude that cost-plus pricing may be the best way to determine the optimal price in two situations:

18. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 24 Learning Objective 15.3 Cost-Plus Pricing in the Publishing Industry Making the Connection PLANT COST Typesetting$3,500 Other plant costs 2,000 MANUFACTURING COST Printing$5,750 Paper 6,250 Binding 5,000 TOTAL PRODUCTION COST $22,500

19. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 24 Learning Objective 15.3 Two-part tariff A situation in which consumers pay one price (or tariff) for the right to buy as much of a related good as they want at a second price. Other Pricing Strategies Pricing with Two-Part Tariffs

20. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 24 Learning Objective 15.3 FIGURE 15-5 A Two-Part Tariff at Disney World Other Pricing Strategies Pricing with Two-Part Tariffs

21. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 24 Learning Objective 15.3 Table 15-2 Disney’s Profits per Day from Different Pricing Strategies MONOPOLY PRICE FOR RIDES COMPETITIVE PRICE FOR RIDES PROFITS FROM ADMISSION TICKETS$240,000$960,000 PROFITS FROM RIDE TICKETS 480,000 0 TOTAL PROFIT720,000960,000 Other Pricing Strategies Pricing with Two-Part Tariffs

22. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 24 Learning Objective 15.3 1 Because price equals marginal cost at the level of output supplied, the outcome is economically efficient. 2 All of consumer surplus is transformed into profit. The rides at Disney World are free—once you have paid to get into the park. Other Pricing Strategies Pricing with Two-Part Tariffs It is important to note the following about the outcome of a firm using an optimal two-part tariff:

23. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 24 An Inside LOOK College Tuition: One Price Does Not Fit All Amid Rising Costs and Criticism, Some Colleges Cut Back Merit Aid

24. Chapter 15: Pricing Strategy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 24 Price discrimination Transactions costs Two-part tariff K e y T e r m s