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Pricing Strategy
Quantity
$
0 5 10 15 20
100
150
200
300
400
50
R
Profits = R - C
t
t'
c
c’
Example of Profit Maximization
C
Slope of R curve is MR
Slope of C curve is MC
Profit (Q) = Revenue - Cost = R(Q) - C(Q)
Maximum when = 0, i.e., =
Here:
= MR = marginal revenue
= MC = marginal cost
ddQ
dR dCdQ dQ
dR dQ
dC dQ
Profit Maximization
So profits are maximized at the price/output level at which
marginal revenue = marginal cost
P1
Q1
Lostprofit from loweroutput
MC
AC
Quantity
$ perunit ofoutput
D = AR
MR
P*
Q*
Maximizing Profit When Marginal Revenue Equals Marginal Cost
P2
Q2
Monopoly
An Example
CMC
QQCCost
2
50)( 2
The Monopolist’s Output DecisionThe Monopolist’s Output Decision
Note – here fixed cost = 50
Monopoly
An Example
RMR
QQQQPQR
QQPDemand
240
40)()(
40)(2
The Monopolist’s Output DecisionThe Monopolist’s Output Decision
Monopoly
An Example
30 10,When
10
2240
P Q
Q
QQorMCMR
The Monopolist’s Output DecisionThe Monopolist’s Output Decision
Monopoly
An Example By setting marginal revenue equal to marginal
cost, profit is maximized at P = $30 and Q = 10. This can be seen graphically:
The Monopolist’s Output DecisionThe Monopolist’s Output Decision
Quantity
$
0 5 10 15 20
100
150
200
300
400
50
R
Profits
t
t'
c
c’
Example of Profit Maximization
C
Fixed cost is $50. Changing fixed cost changes the intercept only.
All costs above $50 are variable.
Question – how does a change in fixed costs affect the best price?
Example of Profit Maximization
Observations Slope of rr’ = slope cc’
and they are parallel at 10 units
Profits are maximized at 10 units
P = $30, Q = 10, TR = P x Q = $300
AC = $15, Q = 10, TC = AC x Q = 150
Profit = TR - TC– $150 = $300 - $150
Quantity
$
0 5 10 15 20
100
150
200
300
400
50
R
C
Profits
t
t'
c
c
Profit
AR
MR
MC
AC
Illustration of Profit Maximization
Quantity
$/Q
0 5 10 15 20
10
20
30
40
15
Illustration of Profit Maximization
Observations AC = $15, Q = 10,
TC = AC x Q = 150 Profit = TR = TC = $300 -
$150 = $150 or Profit = (P - AC) x Q =
($30 - $15)(10) = $150
Quantity
$/Q
0 5 10 15 20
10
20
30
40
15
MC
AR
MR
ACProfit
Markup Rules
Two models of pricing – Markup over costs and What the market will bear. In fact they come together in a demand-
based approach to markup pricing. How should price relate to cost to maximize
profits?
PED = Ep =
Revenue = R = P(Q)Q
Marginal Revenue = MR = = [P(Q)Q]MR = Q + P
MR = P [ + 1]
MR = P [ + 1]
dQ PdP Q
dR dQ
d dQ
dP dQ
dP QdQ P
1 Ep
For maximum profits, MR = MC so
P + P = MC
Or
1 Ep
P - MC = - 1 P Ep
Another way of saying the same
thing:
P - MC = - P Ep
Plot the ratio of price to marginal cost as a
function of the demand elasticity:
Ep p/MC
- 1
- 2 2
- 3 3/2
- 4 4/3
- 5 5/4
- 6 6/5
1
Elasticity of Demand and Price Markup
$/Q $/Q
Quantity Quantity
AR
MR
MR
AR
MC MC
Q* Q*
P*
P*
P*-MC
The more elastic isdemand, the less the
markup.
Summary
This is a model of price setting as a markup over costs with the markup reflecting what the market will bear.
Switching costs ( “lock-in”)
These are the costs to consumers of switching from one producer or brand to another
They make demand for the first brand less elastic - less responsive to lower prices by competitors
Switching costs associated with your competitors’ brands make your selling costs higher
Examples of switching costs:
Frequent flier bonuses and other rewards for loyalty
Emphasis on “relationships” rather than “transactions”. Valid for banking, computer systems (custom jobs vs. off-the-shelf software), consulting, legal services
Emphasis on “uniqueness” of product
Examples of Switching Costs
IBM with mainframes
ATT with PBXs
Microsoft with Windows
Switching Costs
Can be high for widely-used software because of need to retrain, modify file formats, maintain links to other applications, etc.
Hence incoming products will attempt to maintain compatibility and reduce these costs.
In general, a major role of marketing
strategy and image building is to increase
the costs of switching from your product, so
as to make demand less elastic.
Switching costs are reflected in the PED.
Being an industry standard raises
switching costs.
Consumer Surplus
With a downward sloping demand curve, and uniform price for all buyers, some buyers will be paying less than they are willing to pay for the good (for example, the buyers at the top left hand end of the demand curve)
The difference between what a buyer is
willing to pay for the units of a good which
she buys, and the amount she actually pays, is
called the buyer’s consumer surplus
One of the main aims of pricing strategy is to
find a way of charging for goods which brings
this consumer surplus to the seller. To quote
the marketing SVP of American Airlines,
“Why sell a seat for $200 to someone who is
willing to pay $500 for it?”
Buyer #: Will Pay: Revenue: Price:1 10 10 102 9 18 93 8 24 84 7 28 75 6 30 66 5 30 57 4 28 48 3 24 39 2 18 2
10 1 10 1
Total 55
Revenue:
0
5
10
15
20
25
30
35
1 2 3 4 5 6 7 8 9 10
Price
Reve
nue
Revenue:
Consumer surplus & demand curve
Buyer’s consumer surplus is area beneath her demand curve and above horizontal line whose height is the price.
Example - buyer is willing to pay $10 for 1st unit, $9 for 2nd, $8 for 3rd, $7 for 4th, etc.
Construct demand curve.
W-T-P, $
0
2
4
6
8
10
12
1 2 3 4 5 6 7 8 9 10
# of unit
W-T-P, $
Demand curve Area under D curve here is about 55, = total willingness to pay.
Consumer Surplus
Suppose price is zero. She will buy 10 units and consumer surplus is $(10+9+8+7+6 … ) which is $55.
Area beneath demand curve and above P=0 is 1/2x10.5x10.5 which is 55.125.
Try second example: price is just less than $6, so she buys 5 units. Pays $5x6 = $30.
W-T-P, $
0
2
4
6
8
10
12
1 2 3 4 5 6 7 8 9 10
# of unit
W-T-P, $
Demand curve Area under D curve here is about 55, = total willingness to pay.
Consumer surplus
Area beneath demand curve and above P=6 is 1/2x4.5x4.5 = 10.125.
Total value attributed to first 5 units is $(10+9+8+7+6) = $40. Subtract payment of $30 and consumer surplus is $10.
So - CS is area beneath D curve and above horizontal line with vertical coordinate of price.
Tools of pricing strategy
Three main tools:
Price discrimination, two-part pricing and bundling
(1) Price discrimination: charging different prices for essentially the same good to different buyers. Charge each what they are willing to pay.
Different types of price discrimination
Charging a different price to every buyer. Examples: Reuters Info Services, car sales
Segmenting the market. Airlines with business vs. vacation travel, railroads with time-of-day pricing, phone companies with time-of-day pricing, retail stores pricing by location.
price discrimination over time: introduce a product at a high price and reduce the price over time. Sell at a high price to the aficionados - e.g. high fi systems, new and more powerful computers
Two market segments, with demand curves
P1 = P1 (Q1) and P2 = (Q2)
Marginal cost curve is
MC = MC (Q1 + Q2)
Market Segmentation
Choose price, output so that MR same in each segment
Common MR should equal MC
Third-Degree Price Discrimination
Quantity
D2 = AR2
MR2
$/Q
D1 = AR1MR1
Consumers are divided intotwo groups, with separate
demand curves for each group.
MRT = MR1 + MR2
Third-Degree Price Discrimination
Quantity
D2 = AR2
MR2
$/Q
D1 = AR1MR1
MC
Q2
P2
QT=Q1+Q2
•QT: MC = MRT
•Group 1: P1Q1 ; more elastic•Group 2: P2Q2; more inelastic•MR1 = MR2 = MC•QT control MC
Q1
P1
MC = MR1 at Q1 and P1
MR
Third-Degree Price Discrimination
Quantity
MR2
$/Q
MR1
MC
Q1 Q2 QT=Q1+Q2
Market Segmentation
Choose price, output so that MR same in each segment
Common MR should equal MC
Sales, Coupons, Random Discounts
All of these are frequently forms of price discrimination.
People who won’t pay the full price wait for sales.
Coupon users typically have low incomes.
Price Elasticities of Demand for Users Versus Nonusers of Coupons
Toilet tissue -0.60 -0.66
Stuffing/dressing -0.71 -0.96
Shampoo -0.84 -1.04
Cooking/salad oil -1.22 -1.32
Dry mix dinner -0.88 -1.09
Cake mix -0.21 -0.43
Price Elasticity
Product Nonusers Users
Cat food -0.49 -1.13
Frozen entrée -0.60 -0.95
Gelatin -0.97 -1.25
Spaghetti sauce -1.65 -1.81
Crème rinse/conditioner -0.82 -1.12
Soup -1.05 -1.22
Hot dogs -0.59 -0.77
Price Elasticity
Product Nonusers Users
Price Elasticities of Demand for Users Versus Nonusers of Coupons
Cost Structure
Consulting studies: costs are 12 cents/available passenger mile (a.p.m.).
Is this AC or MC? Focus on AC vs. MC distinction and on SR vs. LR MC
12 cents/a.p.m. is AC
LR MC is AC
SR MC is close to zero
Airlines
PED for Business Class = -1.25
PED for Economy in range -1.5 to -5 depending on category
Demand
# passengers
0
10
20
30
40
50
60
Price
# passengers
Passengers and fares on UAL # 815
Markup is PED/(1+PED)
Business: Markup = -1.25/(-.25) = 5
So price = 5 times MC
Should be LR MC
Take NY - SFO - NY round trip, about 5800 miles.
Price = 5800 x .12 x 5 = $3480. (actual $3628)
Pricing
Economy:
Markup range -1.5/(-0.5) = 3 to -5/(-4) = 1.25
Price range: 5800 x .12 x 3 = $2088
to 5800 x .12 x 1.25 = $870
These are prices based on LR MC.(Actual range $326 to $2344)
Actual prices go lower - may be based on lower PED estimates, or on SR MC.
What about situations where SR MC applies?
Standby, bucket-shops, end-of-week specials.
Examples of “Yield Management” - see also hotels, car rentals, etc.
Also adjust prices for “load factor”. If this is 75%, actual revenues will be only 75% of that predicted by these prices so gross up price to allow for this.
NYNEX Case
Price Net Price # Lines Net Rev Lost to ATT From ATT Net ATT Rev from W. County Profit
$215 $175 24,250 $4,243,750 $5,600,000 $3,000,000 -$2,600,000 $3,500,000 $5,143,750$230 $190 23,000 $4,370,000 $5,200,000 $3,000,000 -$2,200,000 $3,800,000 $5,970,000$245 $205 19,950 $4,089,750 $4,400,000 $2,700,000 -$1,700,000 $4,100,000 $6,489,750$260 $220 16,250 $3,575,000 $3,200,000 $2,100,000 -$1,100,000 $4,400,000 $6,875,000$275 $235 11,500 $2,702,500 $2,000,000 $1,400,000 -$600,000 $4,700,000 $6,802,500$290 $250 8,500 $2,125,000 $0 $0 $0 $5,000,000 $7,125,000$305 $265 5,500 $1,457,500 $0 $0 $0 $5,300,000 $6,757,500
NYNEX profits & Revenues
-4000000
-2000000
0
2000000
4000000
6000000
8000000
$215 $230 $245 $260 $275 $290 $305
Price
$$
Operating Rev
Net ATT
Rev from W. County
Profit
The Two-Part Tariff
The purchase of some products and services can be separated into two decisions, and therefore, two prices
Decision to enter market and decision about how much to buy
The Two-Part Tariff
Examples
1) Amusement Park– Pay to enter
– Pay for rides and food within the park
2) Tennis Club– Pay to join
– Pay to play
The Two-Part Tariff
Examples
3) Rental of Mainframe Computers– Flat Fee
– Processing Time
4) Safety Razor– Pay for razor
– Pay for blades
The Two-Part Tariff
Examples
5) Polaroid Film– Pay for the camera
– Pay for the film
The Two-Part Tariff
Pricing decision is setting the entry fee (T) and the usage fee (P)
Choosing the trade-off between free-entry and high user charges or high-entry and zero user charges
User price P* is set atMC. Entry price T*
is equal to the entire consumer surplus.
T*
Two-Part Tariff with a Single Type of Consumer
Quantity
$/Q
MCP*
D
Two-part tariffs with varied consumers:
Consumer surplus of the lowest demand curve limits what you can charge as the fixed charge. If you charge more than this you lose this group of consumers.
Try to devise ways of differentiating the fixed charges- see below about cell phones.
D2 = consumer 2
D1 = consumer 1
Q1Q2
The price, P*, will be greater than MC. Set T* at the surplus value of D2.
T*
Two-Part Tariff with Two Types of Consumers
Quantity
$/Q
MC
A
BC
ABC e than twicmore
)()(2 21**
QQxMCPT
The Two-Part Tariff
The Two-Part Tariff With Many Different Consumers No exact way to determine P* and T*. Must consider the trade-off between the entry
fee T* and the use fee P*.– Low entry fee: High sales and falling profit with
lower price and more entrants.
The Two-Part Tariff
The Two-Part Tariff With Many Different Consumers To find optimum combination, choose several
combinations of P,T. Choose the combination that maximizes profit.
The Two-Part Tariff
Rule of Thumb Similar demand: Choose P close to MC and
high T Dissimilar demand: Choose high P and low T.
The Two-Part Tariff
Two-Part Tariff With A Twist Entry price (T) entitles the buyer to a certain
number of free units– Gillette razors with several blades
– Amusement parks with some tokens
– On-line with free time
Selling several goods in one bundle
Hardware and software
Software suites
Auto accessories
Bundling
A will pay $9.25 for the bundle and B, $11.50. To sell 1 and 2 separately and get both customers to buy both, cannot charge more than $3.25 for either good. Gives revenue of 4x$3.25 = $13. Bundling gets $2x$9.25 = $18.50. Selling only to customer willing to pay most gets $6 + $8.25 = $14.25. Selling 1 for $8.25 and
2 for $3.25 gets $8.25 + $6.50 = $14.75.
A & B are individuals described by the amounts they are willing to pay for each good.
Consumption Decisions WhenProducts are Sold Separately
r2
r1
P2
II
Consumers buyonly good 2
22
11
PR
PR
P1
Consumers fall intofour categories basedon their reservation
price.I
Consumers buyboth goods
22
11
PR
PR
III
Consumers buyneither good
22
11
PR
PR
IV
Consumers buyonly Good 1
22
11
PR
PR
R = reservation price = willingness to pay
Consumption DecisionsWhen Products are Bundled
r2
r1
Consumers buy the bundlewhen r1 + r2 > PB
(PB = bundle price).PB = r1 + r2 or r2 = PB - r1
Region 1: r > PB
Region 2: r < PB
r2 = PB - r1
I
II
Consumersbuy bundle
(r > PB)
Consumers donot buy bundle
(r < PB)
Reservation Pricesr2
r1
P2
P1
If the demands are perfectly positivelycorrelated, the firm
will not gain by bundling.It would earn the same
profit by selling the goods separately.
Reservation Pricesr2
r1
If the demands are perfectly negatively
correlated bundling is the ideal strategy--all the
consumer surplus canbe extracted and a higher
profit results.
Mixed Versus Pure Bundlingr2
r110 20 30 40 50 60 70 80 90 100
10
20
30
40
50
60
70
80
90
100
C2 = MC2
C2 = 30
Consumer A, for example, has a reservation price for good 1 that is below marginal cost c1.
With mixed bundling, consumer A is induced to buy only good 2, while
consumer D is induced to buy only good 1,reducing the firm’s cost.
A
B
D
C
C1 = MC1
C1 = 20 With positive marginalcosts, mixed bundling may be more profitable
than pure bundling.
Bundle at $100
A,B,C,D all buy
1. Revenue is $400
2. Costs are 4 x 30 + 4 x 20 = $200
3. Profits are $200
Mixed bundle at $100, $89, $89
B,C buy bundle
1. Revenue $2002. Costs 2 x 30 + 2 x 20 = $1003. Profits are $100
A buys 2: profit is $89 - $30 = $59
D buys 1: profit is $89 - $20 = $69
Total for mixed bundling is $100 + $59 + $69 = $228
Sell separately
Sell 1 at $50, 2 at $90
B, C, D all buy 1
1. Revenue is $1502. Costs are $603. Profit is $90
A buys 2
1. Revenue is $902. Cost $303. Profit $60
Total for separate sales is $150
Mixed Bundlingwith Zero Marginal Costs
r2
r120 40 60 80 100
20
40
60
80
100
120
120
In this example, consumers B and C are willing to pay $20 more for the bundle
than are consumers A and D. With mixed bundling, the price of the bundle
can be increased to $120.A & D can be charged $90 for a single good.
C
10 90
10
90A
B
D
Sell separately $80 $80 ---- $320
Pure bundling ---- ---- $100 $400
Mixed bundling $90 $90 $120 $420
P1 P2 PB Profit
Mixed Bundlingwith Zero Marginal Costs
Bundling by Pricing
Willing to pay: Word Processor SpreadsheetJack $120 $100Jill $100 $120
In this case, try the following: $120 for thefirst application, and $100 for the second.
Pricing Cell-Phones
A mix of discrimination, bundling and two-part pricing
Buy the phone (connection/membership charge) & pay for service - like Polaroid, Gilette. Phones at different price points.
Then you have a choice between several two-part tariffs
Typically $40 per month with 400 minutes free and 40c/min additionally
or $60 per month with 600 minutes free and 30c/min additionally, etc.
Choice of two-part tariffs - intended to price discriminate. Heavy users - willing to pay a lot - will opt for high fixed charge to get the lower per unit price, and vice versa.
Different two-part tariffs
Cost of extra minute
# of minutes400 600 1000
0.50
0.25
0.20
$40/month
$60/month
$100/month
Supply curves under alternative tariffs.
“Free” minutes
These are the supply curves of cell-phone minutes you face as consumers. Each targets a different market segment.
Pricing policy
For each market segment try to estimate Maximum consumption if marginal
consumption cost is zero. Consumer surplus at this consumption level.
Use this surplus as a fixed monthly charge and then have a steep fee for going over the allotted number of minutes.
Demand curve.
Consumer surplus if service provided free.Charge this as fixed charge.
Maximum use if service free.Give this number of “free” minutes.
0
A
B
A TYPICAL MARKET SEGMENT
Cost of extra minute
# of minutes600 1000
0.50
0.25
0.20
$40/month
$60/month
$100/month
Different market segments
400
Key aspects of pricing policy
Compare giving 400 minutes for $40 ($0.10 per minute on
average) with charging $0.10 per minute for any number of
minutes. If demand curve is as Verizon policy
implies, then selling at $0.10/minute will sell 100 minutes (next slide) and give revenue of $20, rather than $40
400 minutes
20 cents
10 cents
200 minutes
400 minutes for $40 produces revenue of $40 and appropriates all consumer surplus. Selling @ $0.10/minute sells 200 minutes forrevenue of $20.
Key aspects
So selling 400 minutes for $40 is NOT the same as selling each minute at the average price, 40/400 = $0.10.
Selling the 400 minutes together is twice as profitable as selling each minute at $0.10. WHY?
Bundling earlier and later minutes together.
400 minutes
20 cents
10 cents
200 minutes
At 10 cents consumer gets first 200 units at lessthan she values them at. She has a positive consumer surplus on these.
At 10 cents consumer has negative CS on last 200 units.
Negative CS on last 200 units just offset by positive CS on first 200.
Bundling early and late minutes
Conclusions
Key aspect of pricing here is bundling early and late minutes. Positive CS on former offsets negative CS on latter.
Prices seem to be low - probably competition between different carriers and between cell phones and normal phones.
Carriers see market share as critical in growing market. Valued “per pop.”
Pricing of AIDS Drugs
Key issue – price discrimination by country is natural as country is a proxy for income and WTP.
Deal struck with SA and other poor countries is no more than extension of this principle.
Leads to situation where rich countries naturally contribute more to R&D expenses and so in effect subsidize others.
Pricing AIDS Drugs
May make economic sense to sell to poorest markets at less than average cost as long as price above marginal cost
Limiting Market Power: The U.S. Antitrust Laws
Antitrust Laws: Promote a competitive economy - competition
benefits consumers. Rules and regulations designed to promote a
competitive economy by:– Prohibiting actions that restrain or are likely to
restrain competition
– Restricting the forms of market structures that are allowable (e.g. excessive concentration).
Sherman Act (1890) Section 1
– Prohibits contracts, combinations, or conspiracies in restraint of trade
Explicit agreement to restrict output or fix prices Implicit collusion through parallel conduct
Limiting Market Power: The U.S. Antitrust Laws
1983 Six companies and six executives indicted for
price of copper tubing 1996
Archer Daniels Midland (ADM) pleaded guilty to price fixing for lysine -- three sentenced to prison in 1999
Limiting Market Power: The U.S. Antitrust Laws
Examples of Illegal CombinationsExamples of Illegal Combinations
1999 Roche A.G., BASF A.G., Rhone-Poulenc and
Takeda pleaded guilty to price fixing of vitamins -- fined more than $1 billion.
Limiting Market Power: The U.S. Antitrust Laws
Examples of Illegal CombinationsExamples of Illegal Combinations
Sherman Act (1890) Section 2
– Makes it illegal to monopolize or attempt to monopolize a market and prohibits conspiracies that result in monopolization.
Limiting Market Power: The U.S. Antitrust Laws
Clayton Act (1914)
1) Makes it unlawful to require a buyer or lessor not to buy from a competitor
2) Prohibits predatory pricing
Limiting Market Power: The U.S. Antitrust Laws
Clayton Act (1914)
Prohibits mergers and acquisitions if they “substantially lessen competition”or “tend to create a monopoly”
Proposed mergers have to be approved by the Justice Department.
Limiting Market Power: The U.S. Antitrust Laws
Robinson-Patman Act (1936) Prohibits price discrimination if it is likely to
injure the competition Also new case on Acuvue Contact Lenses 2002
Limiting Market Power: The U.S. Antitrust Laws
Federal Trade Commission Act (1914, amended 1938, 1973, 1975)
1) Created the Federal Trade Commission (FTC)
2) Prohibitions against deceptive advertising, labeling, agreements
with retailer to exclude competing brands
Limiting Market Power: The U.S. Antitrust Laws
Antitrust laws are enforced three ways:
1) Antitrust Division of the Department of Justice
– A part of the executive branch--the administration can influence enforcement
– Fines levied on businesses; fines and imprisonment levied on individuals
Limiting Market Power: The U.S. Antitrust Laws
Antitrust laws are enforced three ways:
2) Federal Trade Commission– Enforces through voluntary understanding or
formal commission order
Limiting Market Power: The U.S. Antitrust Laws
Antitrust laws are enforced three ways:
3) Private Proceedings– Lawsuits for damages– Plaintiff can receive treble damages
Limiting Market Power: The U.S. Antitrust Laws
Two Examples American Airlines -- Price fixing Microsoft
– Monopoly power
– Predatory actions
– Collusion
Limiting Market Power: The U.S. Antitrust Laws
Recent cases
GE and Honeywell United Airlines and US Airways Mergers blocked on grounds of restriction of
competition. Bundling an issue for Microsoft – but
because of its anti-competitive implications,