Chapter five
Pricing and Business strategy
April 2020
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Pricing strategies
• What is a price strategy?
Price strategy refers to the firm’s plan or discretion of price fixation in a
manner such that it may successfully adjust to attain the objective
profit maximization.
• Pricing is key to managerial decision making.
• If the price doesn’t fit what customers are willing to pay, then the
product may not be profitable.
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• Price directly relates to firm’s profitability.
• Firm’s profitability can be affected by internal and external factors
(1) Competitive advantage (internal factors)
(2) Market conditions (external factors)
April 2020
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5.1 Mark-up pricing
• Most businesses set prices in ‘relation to costs’, but not demand.
Two steps
• The firm estimates the cost per unit of output of the product , usually
marginal cost (average cost).
• The firm adds a mark-up to the estimated average cost.
April 2020
Yordanos G. (Mulungushi Univ.)
Mark-up on cost/cost plus pricing
=
(
−
Where the numerator, price – cost, is the profit margin.
If the cost of a book is $4 and its price is $6
(6 − 4)
=
= 0.50
4
Or 50 percent.
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)
• If we solve the above equation for price, the result is
=
1+
Which is the pricing formula for the firm.
−
= 4 1 + 0.5 = 6
April 2020
Yordanos G. (Mulungushi Univ.)
Mark-up on price
• It is a measure of profit margin that is expressed as a percentage of
price.
(
−
)
=
• The mark-up on cost and mark-up on price formulas are simply
alternative means for expressing the relative size of profit margins.
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•
•
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=
=
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Example
• Sam is a project coordinator at Sam & Associates Ltd. Sam has asked
you to complete an analysis of profit margins earned on a number of
recent projects. Unfortunately, your predecessor on this project was
abruptly transferred, leaving you with only sketchy information on the
firm’s pricing practices.
• Use the available data to complete the following table:
April 2020
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Price ($)
100
240
680
750
2,800
Marginal cost ($)
25
72
272
Markup on cost (%)
300
Markup on price (%)
75
150
100
60
40
2,700
3,360
5,800
6,250
33.3
20
10
5.3
1,000
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0
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5.2 Price discrimination
• In some situations it is possible to charge different prices for different
units of the output:
- Price discrimination
Examples of price discrimination
- suppliers offer quantity discount
- Airlines charge different prices
- Price of Phone/electricity consumption vary in time
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• Price discrimination is a device to increase profit. Charging different
prices for different clients allows for an increase in profit.
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When is price discrimination possible?
• Existence of monopoly power
• Separate market
- there must be two or more separate markets.
- Transferring a commodity from low-priced market to highpriced market should be expensive.
• Difference in the elasticity of demand
- elasticity of demand should be different in different markets.
April 2020
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Price discrimination and profits
Example: suppose a firm sell its product in two markets and has
constant marginal costs of production equal to $2 per unit. The
demand equations for the two markets are as follows:
Market 1
Market 2
= 14 − 2
= 10 −
What are the profit maximizing prices and quantities in each market?
Show that profit from price discrimination is greater than a uniform
price.
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Solution:
With price discrimination, the condition for profit maximization is
=
=
= 3;
= 4;
= 8;
= 34
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=6
• To compute profits in the absence of price discrimination, the
combined demand and marginal revenue equations must be
computed.
• The first step is to express the demand equations in terms of
quantities. Thus,
=7−
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2
= 10 −
Yordanos G. (Mulungushi Univ.)
Note that the subscript has been dropped from price because the same
price is to be charged in each market. Adding to two demand curves
gives
3
= 17 −
2
The corresponding marginal revenue equation is calculated by solving
for P and using the principle that marginal revenue function for a linear
demand curve has the same intercept and twice the slope. Thus,
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Yordanos G. (Mulungushi Univ.)
1 2
= 11 −
3 3
and
1 4
= 11 −
3 3
Equating marginal revenue to marginal cost
=7
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2
=6
3
2
= 32
3
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Degrees of Price Discrimination
• Under first-degree price discrimination, the firm extracts the
maximum amount each customer is willing to pay for its products.
Such pricing precision is rare because it requires that sellers know the
maximum price each buyer is willing to pay for each unit of output.
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• Second-degree price discrimination, a more frequently employed type
of price discrimination, involves setting prices on the basis of the
quantity purchased.
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• The most commonly observed form of price discrimination, thirddegree price discrimination, results when a firm separates its
customers into several classes and sets a different price for each
customer class.
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5.3 Peak-load Pricing
Peak-load pricing is the practice of charging a higher price for a service
when demand is high and capacity is fully utilized and a lower price when
demand is low and capacity is underutilized.
• The demand for airline travel is greater during holiday seasons than at
other times.
• The demand for electric power, for example, is higher during the day than
at night
Peak-load pricing rule:
Charge a higher price during peak times than is charged during off-peak
times so that MR=MC during each period.
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Peak-load pricing may be suitable only if three conditions are met in
producing a product.
1. The product cannot be storable. Eg. Electricity
2. The same facilities must be used to provide the service during
different periods of time.
3. There must be variation in demand characteristics of consumers at
different periods of time.
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Example of peak-load pricing
• The Gotham Bridge and Tunnel Authority (GBTA) has
estimated the following demand equations for peak
and off-peak automobile users of the Frog’s Neck
Bridge:
=
−
= 10 − 0.02
=
= 5 − 0.05
Where T is the toll charged for a one-minute trip (Q)
across the bridge.
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• The marginal cost of operating the bridge has been estimated at $2
per automobile bridge crossing. The peak capacity of the Frog’s Neck
Bridge has been estimated at 50 automobiles per minute. What toll
should the GBTA charge peak and off-peak users of the bridge?
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• With assume that the firm wants to maximize profit
•
=
= 5 − 0.05
=5
The marginal revenue equation is
= 5 − 0.1
.
Then,
5 − 0.1
=2
= 30
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− 0.05
Substituting this result into the off-peak demand equation
yields the toll charged to off-peak automobile users of the
bridge:
= 5 − 0.05
= 5 − 0.05 30 = $3.50
At a bridge capacity of 50 automobiles per minute, the
marginal cost curve is vertical. Substituting bridge capacity
into the peak demand equation yields the toll that should
be charged to peak automobile users of the bridge:
= 10 − 0.02 50 = $9
Peak users of the bridge should be charged $9 per crossing.
April 2020
Yordanos G. (Mulungushi Univ.)