Pricing Strategies

Managerial Economics Econ 340 Lecture 9

Christopher Michael

Trent University

2006 by Nelson, a division of Thomson Canada Limited

Topics
Proactive Value-Based Pricing Intertemporal Pricing Price Discrimination Pricing of Multiple Products Pricing in Practice Transfer Pricing

2006 by Nelson, a division of Thomson Canada Limited

Proactive Value-Based Pricing

If the price doesnt 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 didnt want it to be too expensive. The started with a price and designed the product.
The Mustang used value-based, not cost-plus pricing
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Intertemporal Pricing
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.
2006 by Nelson, a division of Thomson Canada Limited

 2006 by Nelson, a division of Thomson Canada Limited

If the price at off-peak is POP is the same price as the peak, the traffic volume varies from QOP to QPEAK. If the price at the peak is PP, the traffic volume varies less, from QOP to QC.

Congestion Tolls

PP

POP
DOFF-PEAK QOP QC
shift

DPEAK QPEAK
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Price Discrimination
Price Discrimination Goods which are NOT priced in proportion to their marginal cost, even though technically similar Some

Necessary Conditions:

1. Some Monopoly Power

Otherwise, in pure competition, P = MC

2. Limited Ability to Arbitrage

Separate customers and prevent reselling

2006 by Nelson, a division of Thomson Canada Limited

Arbitage Buy Low to Sell Higher

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
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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
2006 by Nelson, a division of Thomson Canada Limited

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
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Why Price Discriminate?

In Simple Monopoly, there is only one price Consumers receive a consumer surplus In Price Discrimination, monopolists can SCOOP OUT all consumer surplus
2006 by Nelson, a division of Thomson Canada Limited

MC
Simple Monopoly

PSM CS

D
QSM

Perfect Price Discrimination

(or 1st 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
2006 by Nelson, a division of Thomson Canada Limited

Price Discriminating Monopoly

MC

D
Q

Q1st

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Perfect Price Discrimination

Does it Work for Car Dealers?
How much do you plan to pay a month?
you inadvertently reply:
At 6%, thats about $12,000 for 60 months, plus $3,000

$232 per month, and have a $3,000 down payment!

2006 by Nelson, a division of Thomson Canada Limited

Heres one for only $15,000. Its swell.

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Notice: Incentives to Understate

Ones True Willingness to Pay

The conditions for perfect price discrimination are seldom met Hence, some close approximations exist
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Second Degree Price Discrimination:

Units are Grouped

There are are a variety of ways to group units to attempt to scoop out consumer surplus
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Second Degree Price Discrimination: Two Part-Pricing

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
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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.
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Bundling & Mixed Bundling

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.
2006 by Nelson, a division of Thomson Canada Limited

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One Price for All Regions

East West Market

PM

MC

MR

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Example with a Simple Monopoly Price (PM) in both markets

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Third Degree Price Discrimination

East West Market

PE
PM

PW
MC

MR
MR MR
Example with Different Prices in Each Market
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Mathematics of Price Discrimination

Using elasticities P( 1 + 1/ ED ) = MC In two regions:
P1( 1 + 1/ E1 ) = P2( 1 + 1/ E2 ) = MC or: P1/ P2 = ( 1 + 1/ E2 )/( 1 + 1/ E1 ) If the elasticities in region 1 and region 2 are -1.25 and -2.5 respectively, then P1/ P2 = (1+1/ -2.5)/(1+1/-1.25 ) = 3. Hence, P1 = 3P2. Price is 3 times higher in region 1, which is less elastic.
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2006 by Nelson, a division of Thomson Canada Limited

Pricing of Multiple Products

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 = TRA + TRB
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Substitutes and Complements

Look for interdependencies in marginal revenues: MRA = TRA / QA + TRB / QA MRB = TRA / QB + TRB / QB 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
2006 by Nelson, a division of Thomson Canada Limited

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Decision Rules for Multiple Product Firms

Do NOT use the rule to produce where MR=MC, as in MRA = MCA INSTEAD:
Produce where the FULL MR = FULL MC For a Two Product Firm of A & B Produce where: TRA /QA + TRB /QA = TCA /QA + TCB /QA Include all relevant revenue and cost effects

2006 by Nelson, a division of Thomson Canada Limited

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Pricing Example in Supermarkets

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

30 / kilo with $100 purchase

TRstore = TRT + TRA

MRstore for turkey = TRT /QT + TRA /QT

Complementarity with other food explains the apparent conundrum
2006 by Nelson, a division of Thomson Canada Limited

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Pricing in Practice
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
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Cost-Plus and Full-Cost Pricing

P = ACn + Markup
or

P = ACn(1 + m)

where ACn 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/ED ) = MC

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Full-Cost Pricing
Full Cost
Covers all Costs at the standard or normal output Plus a return on the investment

P = VCl + VCm + F/Q + p K / Q

Where VCl and VCm are unit labour cost and unit material cost respectively (which is average variable cost). where p

K is the target amount of profit

and p 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.
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Example: Low-Tech Security

Start a firm with F = 200,000, Q = 3,000, total labour cost is $40,000 and total material cost is $50,000 p = 20% and K=$500,000. Find Full Cost Price!

Answer
P = VCl + VCm + 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
2006 by Nelson, a division of Thomson Canada Limited

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Advantages and Disadvantages of Cost-Plus Pricing

Cost-plus is simple But cost-plus ignores demand changes Easy to delegate to others Pricing may be based on poor cost data Easy to apply to thousands of items Output varies in business cycle Can use categories of markups for Hybrid Method: Variable different classes of Cost-Plus Pricing the products markup can vary over the season or business cycle
2006 by Nelson, a division of Thomson Canada Limited

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Optimal Markups in Practice

Grocery stores have
Demand is therefore low markups highly elastic Many close substitutes -- Optimal markup would at other grocery stores consequently be small (bread varieties and qualities are standardized) Frequent purchase, so customers are knowledgeable about prices & quality
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2006 by Nelson, a division of Thomson Canada Limited

Markups on Jewellery
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
2006 by Nelson, a division of Thomson Canada Limited

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Skimming
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
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Prestige Pricing
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.
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Transfer Pricing with No External Markets

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 PT = MCP on following figure
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Find Where MCM+P = MR

MCM+P P
MCM + PT MCP

MCM

PT
Q

D
MR

0 Limited 2006 by Nelson, a division of Thomson Canada

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Transfer Pricing and Profit Maximization

Once a firm uses the optimal transfer price, PT, the whole firm maximizes profits. Suppose a firm uses a higher price than PT, call it PHigher to make the production group happier. The sum of the MCM plus PHigher is given at the next slide, creating the appearance of a cost increase. Quantity declines from Q0 to Q1 and price is artificially increased from P0 to P1.
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Using a HIGHER TRANSFER PRICE hurts profits as quantity declines and price rises PHigher + MCM MCM+P
P1 P0 PT + MCM MCP

MCM

PHigher

PT
Q Q

D
MR

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Optimal Transfer Pricing

External Market
No

Market Structure
Not Applicable

Optimal Transfer Price

MCP = PT

Yes: QP > QM
Yes: QP < QM Yes: QP > QM Yes: QP < QM

Perfectly competitive Perfectly competitive Imperfectly competitive Imperfectly competitive

MCP = PT = PEXT
MCP = PT = PEXT MCP = PT < PEXT MCP = PT > PEXT
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2006 by Nelson, a division of Thomson Canada Limited