1. 1 © 2006 by Nelson, a division of Thomson Canada Limited Christopher Michael Trent University Managerial Economics – Econ 340 Lecture 9 Pricing Strategies

2. 2 © 2006 by Nelson, a division of Thomson Canada Limited Proactive Value-Based Pricing Intertemporal Pricing Price Discrimination Pricing of Multiple Products Pricing in Practice Transfer Pricing Topics

3. 3 © 2006 by Nelson, a division of Thomson Canada Limited 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

4. 4 © 2006 by Nelson, a division of Thomson Canada Limited 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. Intertemporal Pricing

5. 5 © 2006 by Nelson, a division of Thomson Canada Limited 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 Congestion Tolls

6. 6 © 2006 by Nelson, a division of Thomson Canada Limited 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.Limited Ability to Arbitrage Separate customers and prevent reselling Price Discrimination

7. 7 © 2006 by Nelson, a division of Thomson Canada Limited Arbitrage of Goods is Easy »Price discrimination of goods is not effective »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 Arbitage – Buy Low to Sell Higher

8. 8 © 2006 by Nelson, a division of Thomson Canada Limited 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 Canadian 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 Afro-Canadian 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/French 8. Transient/Resident as when contractors pay less at hardware stores than other customers 9. Ability to Haggle when those who ask for a lower price get it

9. 9 © 2006 by Nelson, a division of Thomson Canada Limited 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 Why Price Discriminate?

10. 10 © 2006 by Nelson, a division of Thomson Canada Limited 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

11. 11 © 2006 by Nelson, a division of Thomson Canada Limited 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.

12. 12 © 2006 by Nelson, a division of Thomson Canada Limited 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

13. 13 © 2006 by Nelson, a division of Thomson Canada Limited A price for the privilege of buying items PLUS a price per item Examples: »Car rental per day with per kilometre charges Car renters may not know how much they will use the car. They may prefer a lower rental rate (cover charge) with a per mile charge. »Amusement parks »Country Club Dues and Greens Fees »Cover Charge to Enter a Bar and a Price Per Drink Second Degree Price Discrimination: Two Part-Pricing

14. 14 © 2006 by Nelson, a division of Thomson Canada Limited Second Degree Price Discrimination at McDonalds (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.

15. 15 © 2006 by Nelson, a division of Thomson Canada Limited »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 $3.00 and a soft drink $2.00, then Bob would buy only a burger and Mary only a soft drink. Not everyone is alike, so mixed bundles succeeds with more customers. Bundling & Mixed Bundling

16. 16 © 2006 by Nelson, a division of Thomson Canada Limited East West Market MC MR PMPM Example with a Simple Monopoly Price (P M ) in both markets One Price for All Regions

17. 17 © 2006 by Nelson, a division of Thomson Canada Limited East West Market MC MR PMPM Example with Different Prices in Each Market PE PE PWPW MR Third Degree Price Discrimination

18. 18 © 2006 by Nelson, a division of Thomson Canada Limited 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 -1.25 and -2.5 respectively, then P 1 / P 2 = (1+1/ -2.5)/(1+1/-1.25 ) = 3. Hence, P 1 = 3P 2. Price is 3 times higher in region 1, which is less elastic. Mathematics of Price Discrimination

19. 19 © 2006 by Nelson, a division of Thomson Canada Limited 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 Products

20. 20 © 2006 by Nelson, a division of Thomson Canada Limited 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 »Sony sells DVD Players and blank DVDs Substitutes and Complements

21. 21 © 2006 by Nelson, a division of Thomson Canada Limited 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 Decision Rules for Multiple Product Firms

22. 22 © 2006 by Nelson, a division of Thomson Canada Limited 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 30¢ / kilo with $100 purchase Pricing Example in Supermarkets

23. 23 © 2006 by Nelson, a division of Thomson Canada Limited 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 products Pricing in Practice

24. 24 © 2006 by Nelson, a division of Thomson Canada Limited 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 D ) = MC Cost-Plus and Full-Cost Pricing

25. 25 © 2006 by Nelson, a division of Thomson Canada Limited 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 labour 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. Full-Cost Pricing

26. 26 © 2006 by Nelson, a division of Thomson Canada Limited Start a firm with F = 200,000, Q = 3,000, total labour 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/Q + (0.20)(500,000)/Q »P = 13.33 + 16.67 + 66.67 + 33.33 = $130 Also, suppose a 35% markup on average cost »P = [ AC] (1.35) »P = [ 13.33 + 16.67 + 66.67 ](1.35) »P = $130.50 Example: Low-Tech Security

27. 27 © 2006 by Nelson, a division of Thomson Canada Limited Cost-plus is simple 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 Advantages and Disadvantages of Cost-Plus Pricing

28. 28 © 2006 by Nelson, a division of Thomson Canada Limited 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 Optimal Markups in Practice

29. 29 © 2006 by Nelson, a division of Thomson Canada Limited Jewellery markups are known to be large Difficult to make comparisons across jewellery stores Little repeat purchases, so knowledge about prices is low Consequently, lower price elasticity for jewellery The optimal markup is larger Markups on Jewellery

30. 30 © 2006 by Nelson, a division of Thomson Canada Limited Price declines over time Those who wish to get it first pay the highest price, others are willing to wait Examples: »Hardcover & Paperback Books »New electronic, computer products, and PDAs. TIME P D Skimming

31. 31 © 2006 by Nelson, a division of Thomson Canada Limited Some products distinguish themselves by being noticeably expensive. »Mercedes, Rolls Royce, or BMW »Cartier jewellery Price is a way to distinguish the product Prestige Pricing is the practice of charging a high price to enhance its perceived value. »However, firms spend much on promotional activities to convince customers that the product is prestigious. Prestige Pricing

32. 32 © 2006 by Nelson, a division of Thomson Canada Limited When no external markets exist, use the MC of the transferred good. Often, however, the MC is a function of output. Marketing and Production steps (M & P) Transfer price is P T = MC P on following figure Transfer Pricing with No External Markets

33. 33 © 2006 by Nelson, a division of Thomson Canada Limited Find Where MC M+P = MR D MC M MC P MC M+P MR P PTPT Q 0 MC M + P T

34. 34 © 2006 by Nelson, a division of Thomson Canada Limited Once a firm uses the optimal transfer price, P T, the whole firm maximizes profits. Suppose a firm uses a higher price than P T, call it P Higher to make the production group happier. The sum of the MC M plus P Higher is given at the next slide, creating the appearance of a cost increase. Quantity declines from Q 0 to Q 1 and price is artificially increased from P 0 to P 1. Transfer Pricing and Profit Maximization

35. 35 © 2006 by Nelson, a division of Thomson Canada Limited Using a HIGHER TRANSFER PRICE hurts profits as quantity declines and price rises D MC M MC P MC M+P MR P0P0 PTPT P Higher P Higher + MC M P T + MC M Q 1 Q 0 P1P1

36. 36 © 2006 by Nelson, a division of Thomson Canada Limited External Market Market Structure Optimal Transfer Price NoNot ApplicableMC P = P T Yes: Q P > Q M Perfectly competitive MC P = P T = P EXT Yes: Q P < Q M Perfectly competitive MC P = P T = P EXT Yes: Q P > Q M Imperfectly competitive MC P = P T < P EXT Yes: Q P < Q M Imperfectly competitive MC P = P T > P EXT Optimal Transfer Pricing