Special Pricing Policies

OverviewCartel arrangementsPrice leadershipRevenue maximizationPrice discriminationNonmarginal pricingMultiproduct pricingTransfer pricing

Learning objectives

analyze cartel pricing

illustrate price leadership

see how price discrimination affects output and prices

Learning objectives

• distinguish between marginal pricing and ‘cost-plus’ pricing

• discuss the various types of multiproduct pricing

• explain how a company can use transfer pricing

OverviewI. Basic Pricing Strategies

– Monopoly & Monopolistic Competition – Cournot Oligopoly

II. Extracting Consumer Surplus– Price Discrimination Two-Part Pricing– Block Pricing Commodity Bundling

III. Pricing for Special Cost and Demand Structures– Peak-Load Pricing Price Matching– Cross Subsidies Brand Loyalty– Transfer Pricing Randomized Pricing

IV. Pricing in Markets with Intense Price Competition

Cartel

Agreement among competing firms to fix prices, output and marketing.

Occurs in oligopoly marketsCan be explicit or ImplicitLegal or illegal• illegal in the US: Sherman

Antitrust Act, 1890• examples: OPEC, IATA

Cartel arrangements• In order to maximize profits, the cartel as a

whole should behave as a ‘monopolist’ the cartel determines the output which

equates MR = MC of the cartel as a whole the MC of the cartel as a whole is the

horizontal summation of the members’ marginal cost curves

price is set in the normal monopoly way, by determining quantity demanded where MC=MR and deriving P from the demand curve at that Q

Pricing StrategiesPrice leadership

• Barometric price leadership

– one firm in an industry will initiate a price change in response to economic conditions

– the other firms may or may not follow this leader

– leader may vary

Price leadership• Dominant price leadership

– one firm is the industry leader– dominant firm sets price with the realization

that the smaller firms will follow and charge the same price

– can force competitors out of business or buy them out under favorable terms

– could result in investigation under Sherman Anti-Trust Act

PRICE ELASTICITY AND PROFIT MAXIMIZING PRICE

Raise price you will lose sales? Not necessarily if you

know your price elasticity of demand

UNIFORM PRICING: - Seller charges same price for every unit of the product.

Lerner index = p-mc/pTo maximize profits, firm should charge a price

such that the LI = -1/price elasticity.

Suppose the MC = 800.And firms price elasticity is -1.5Then to maximize profits (MR=MC),

firm should charge (p-800/p) = -1/-1.5= 2/3 p = 2400

Shortcomings of uniform pricing

Only the marginal buyer has a benefit = price.All other (inframarginal) buyers, have benefits

that exceed price = buyer surplusFirm can increase profits by exploiting these

surpluses

Price discrimination• Price discrimination: products with

identical costs are sold in different markets at different prices

the ratio of price to marginal cost differs for similar products

Conditions for price discrimination– the markets in which the products are sold must

by separated (no resale between markets)– the demand curves in the market must have

different elasticities

Price discrimination

• First degree (or perfect) price discrimination– seller can identify where each

consumer lies on the demand curve and charges each consumer the highest price the consumer is willing to pay

– allows the seller to extract the greatest amount of profits

– requires a considerable amount of information

• Implication: Charge different price for each additional unit in each market

• In practice, transactions costs and information constraints make this difficult to implement perfectly (but car dealers and some professionals come close).

Price discrimination• Second degree price

discrimination

– differential prices charged by blocks of services

– requires metering of services consumed by buyers

• Implication:- block or quantity discounts

• Different prices for different incremental units in each market

• Third degree (or simple) price discrimination

– customers are segregated into different markets and charged different prices in each

– segmentation can be based on any characteristic such as age, location, gender, income, etc

Implication:- Multi-market price discriminationDifferent prices in each market

• Examples of 3rd degree price discrimination

• doctors

• telephone calls

• theaters

• hotel industry

Price discrimination

• Examples of price discrimination

• doctors

• telephone calls

• theaters

• hotel industry

More on Simple Price Discrimination

• Two conditions are necessary:1. Separable markets2. Different substitutability (price elasticity of

demand)If demand is less elastic in market A but more

elastic in market B, for profit maximization MRa = MRb =MC

Price-cost markup is higher in A than in B price is higher in A than in B

Price Discrimination comes in Many Variations

- Product is tied to sale of complements –tying arrangement

- Some customers receive reimbursements- Different products sold to different

customers (Versioning)- A higher price for a specified low

quantity, a lower price for a specified higher quantity

- Different prices to different customers screened by qualification

Price Discrimination comes in Many Variations (2)

- Different prices of x over time (inter-temporal price discrimination)

- Same price, but changing attributes over time (product sequencing)

Nonmarginal pricing

• Cost-plus pricing: price is set by first calculating the variable cost, adding an allocation for fixed costs, and then adding a profit percentage or markup

Problems with cost-plus pricing•calculation of average variable cost•allocation of fixed cost•size of the markup

Other pricing practices• Price skimming

– the first firm to introduce a product may have a temporary monopoly and may be able to charge high prices and obtain high profits until competition enters

• Penetration pricing– selling at a low price in order to obtain

market share

Other pricing practices• Prestige pricing

– demand for a product may be higher at a higher price because of the prestige that ownership bestows on the owner

• Psychological pricing– demand for a product may be quite inelastic

over a certain range but will become rather elastic at one specific higher or lower price

Two-Part Pricing

• When it isn’t feasible to charge different prices for different units sold, but demand information is known, two-part pricing may permit you to extract all surplus from consumers.

• Two-part pricing consists of a fixed fee and a per unit charge.– Example: Athletic club memberships.

How Two-Part Pricing Works

1. Set price at marginal cost.2. Compute consumer

surplus.3. Charge a fixed-fee equal

to consumer surplus.

Quantity

D

10

8

6

4

2

1 2 3 4 5

MC

Fixed Fee = Profits = $16

Price

Per UnitCharge

Block Pricing• The practice of packaging multiple

units of an identical product together and selling them as one package.

• Examples– Paper.– Six-packs of soda.– Different sized of cans of green

beans.

Commodity Bundling• The practice of bundling two or more

products together and charging one price for the bundle.

• Examples– Vacation packages.– Computers and software.– Film and developing.– Cable television – MTV and Learning

Channel

Peak-Load Pricing• When demand during

peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing.

• Charge a higher price (PH) during peak times (DH).

• Charge a lower price (PL) during off-peak times (DL).

Quantity

Price MC

MRL

PL

QL QH

DH

MRH

DL

PH

Cross-Subsidies

• Prices charged for one product are subsidized by the sale of another product.

• May be profitable when there are significant demand complementarities effects.

• Examples– Browser and server software.– Drinks and meals at restaurants.

Pricing in Markets with Intense Price Competition

• Price Matching– Advertising a price and a promise to match any lower

price offered by a competitor.– No firm has an incentive to lower their prices.– Each firm charges the monopoly price and shares the

market.

• Randomized Pricing– A strategy of constantly changing prices.– Decreases consumers’ incentive to shop around as

they cannot learn from experience which firm charges the lowest price.

– Reduces the ability of rival firms to undercut a firm’s prices.

Cannibalization

Occurs when sale of one product reduces the demand for another product with a higher incremental margin

e.g. business travelers flying on restricted economy class fareswealthy families buying basic sedans instead of high end luxury cars

• Fundamental reason for cannibalization is that seller cannot discriminate directly.

• The discriminating variable does not perfectly separate the buyer segments.