PRICING PRACTICES

Prepared by: Marsha C. Radam

PRICING PRACTICES
Pricing practices used to advertise products and
services to consumers such as 3 for P100, 50% off
or 3-Day Sale are highly prevalent in todays society
indicating that they are beneficial for businesses.
There are now price consultants who advise retailers
on how to price their products and brands. Rooted in
behavioral decision theory the new psychology of
pricing dictates the design of price tags, rebates, sale
adverts, cell phone plans, bundle offers, and more.
Choosing a price is one of the most important
decisions that a business makes for its product line.
Ahmetoglu et al.

Price Setting Behavior Market Power

Price Setters
: a firm can set the price of its products
above its MC of production

: a special case is that of a monopoly

Price Setting Behavior Market Power

Price Takers
: the market price is determined by the
market supply and demand
: with an established price, a producer is a
price taker or someone who takes the
market price as given

Foundations of Price Setting

If a firm decreases the price per unit then quantity
demanded increases, holding the price of all other
close substitutes constant.
The firms profit is defined as the difference between
total revenue of the firm and the total cost of
production.
With revenue and cost information, a firm will
produce output at levels that yield the highest
profits.
To induce consumers to purchase the profitmaximizing output, the firm will use demand
information to price its products.

Example

What pricing and output decisions will maximize profits?

www.mbs.edu

The MR = MC Pricing Rule

In Perfect Competition, price is determined by
the market forces of demand and supply.
A company can use demand and cost data to
maximize its profits by applying the Marginal
Revenue (MR) = Marginal Cost (MC)
Pricing Rule whereby the profit maximizing
price (P) and quantity (Q) will be when
MR=MC.
Profit maximization requires setting
P = MR = MC.

Competitive Market Pricing

Competition among
buyers forces the
market price up to
the maximum
demand price on the
demand curve.
Competition among
the sellers forces
the market price
down to the
minimum supply
price on the supply
curve.

Imperfect Market
An imperfect market is a situation where individual firms
have some measure of control or discretion over the
price of the commodity in an industry
This imperfect competition does not necessarily mean that
a firm can arbitrarily put any price on its commodity
an imperfect competitor does not have absolute power
over price

Aside from discretion over price, imperfect competitors

may or may not have product differentiation/variation

Elasticity and Pricing

In reality, firms have only a limited knowledge of
their demand and marginal revenue curves.
Thus, it is difficult to apply the rule of MR=MC to
determine the optimal level of production and the
price per unit.
However, if the firm knows its MC of production
and the elasticity of demand (e) then it can use
the following rule for setting its pricing policy
P = MC / [ 1 + ( 1 / e )

Imperfectly Competitive Pricing

Pricing under Monopoly
-It is true that a firm with monopoly has pricesetting power and will look to earn high levels of
profit.
-However the firm is constrained by the position
of the demand curve. Ultimately a monopoly
cannot charge a price that the consumers in the
market will not bear.
-The position and elasticity of the demand curve
acts as a constraint on the pricing behavior of
the monopolist.

Imperfectly Competitive Pricing

Pricing under Oligopoly
-A market structure characterized by
competition among a small number of
large firms that have market power, but
that must take their rivals actions into
consideration when developing their
competitive strategies.

How Prices are Determined

Interdependent Pricing
Each firm keeps a close eye on the activities
of other firms in the industry. Because firms
engage in competition among the few,
decisions made by one firm affect others.

How Prices are Determined

Price Wars
Assumes that oligopolistic is able to predict
the counter moves of his rivals and they
provide a determinant solution to the price
and output problem.
The objective of price wars:
To seize major part of total sales
To expand towards monopoly
To threaten rivals to accept leadership

How Prices are Determined

Price Leadership
Firms in an oligopoly would accept one firm as
a leader and would follow in setting prices.
Such a leader firm may be dominant or lowcost firm producing a very large proportion of
the total production and having a great
influence over the market.

How Prices are Determined

Formal Agreement: Cartel
A group of firms that collude to limit
competition in a market by negotiating and
accepting agreed-upon price and market
shares.
Two models of imperfect cartels:
Joint-Profit Maximizing Cartels
Market-sharing cartels

Kinked Demand Curve

According to the kinked demand curve
hypothesis, the demand curve facing the
oligopolistic has a kink at the level of the
prevailing price.
The kink is formed because the segment
of the demand curve above the prevailing
price level is highly elastic and the
segment of the demand curve below the
price level is inelastic.

Optimal Pricing of Multiple Products

We have considered pricing by the firms of
a single product. In reality firms produce
multiple products.
Such multiple products create 4 different
kinds of relationships.
Demand relationships
Cost relationships
Production relationships
Capacity relationships

Optimal Pricing of Multiple Products

4 different kinds of relationships.
Demand relationships: products are complements
or substitutes
Cost relationships: multiple products produced in
some facility. Cost sharing results.
Production relationships: more than one product
results from a single production process.
Capacity relationships: firms can use excess or idle
capacity to produce one or more additional
products.

Pricing Products with Interrelated Demands

For a two product (A and B) firm, marginal
revenue functions of the firms are:

!If the 2nd term on the right hand side of each equation
is > 0, the two products are complementary
!If the 2nd term on the right hand side of each equation
is < 0, the two products are substitutes.

Plant Capacity Utilization and Optimal

Product Pricing
Firms produce more than one product to
make fuller use of their plant and
production capacities.
Example:

Plant Capacity Utilization and Optimal

Product Pricing

JOINT PRODUCTS
Joint Products in Fixed Proportions
Products should be thought of as a single
production package.
Jointly produced products may have
independent demands and marginal
revenues.
If Q=QA=QB, set MRQ =MRA + MRB = MCQ

Joint Products in Fixed Proportions

JOINT PRODUCTS
Joint Products in Variable Proportions
If products are produced in variable
proportions, treat as distinct products.
For joint products produced in variable
proportions, set MRA=MCA and MRB=MCB.
Common costs are joint product expenses.

Joint Products in Variable

Proportions

PRICE DISCRIMINATION
The situation where a firm sells identical
products in two or more markets at
different prices.
3 degrees of price discrimination
First-degree price discrimination
Occurs when a firm charges each buyer in the
market a different price based on what the
consumer is willing to pay.

Price discrimination
Second-degree price discrimination
Involves charging different prices for different
blocks of units or bundling different products and
sold at a package price
Often referred to as volume discounting

Third-degree price discrimination

Firms segment the market for a particular good or
service into easily identifiable groups and then
charging each group a different price.
Market segregation may be based on factors like
geography, age, product use, income, etc.

First-Degree
Price Discrimination
If a firm that practices first-degree price discrimination charges $2
and sells 40 units, then total revenue will be equal to $160 and
consumers surplus will be zero.

Bahan Kuliah

Second-Degree
Price Discrimination
If a firm that practices second-degree price discrimination charges $4
per unit for the first 20 units and $2 per unit for the next 20 units, then
total revenue will be equal to $120 and consumers surplus will be $40.

Bahan Kuliah

Third-Degree
Price Discrimination

Examples of Price Discrimination

business vs. tourist airfares
business vs. residential
telephone service
and senior discounts.

International Price
Discrimination & Dumping
Dumping is defined as the act of a
firm in one country exporting a
product to another country at a
price which is either below the
price it charges in its home
market or is below its costs of
production.

Other forms of Dumping

Predatory Dumping the practice of
cutting prices abroad in an attempt to drive
a rival out of business
Strategic Dumping if a firm has a
monopoly in its home market but has
strong competition in a foreign market, it
charges a higher price in the home market

Other forms of Dumping

Sporadic Dumping selling at low price
because of over capacity due to downturn
in demand
Market Expansion Dumping selling at
lower price for export than domestically in
order to gain market share