Special Pricing Policies
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
Overview
I. Basic Pricing Strategies
– Monopoly & Monopolistic Competition
– Cournot Oligopoly
II. Extracting Consumer Surplus
– Price Discrimination
– Block Pricing
Two-Part Pricing
Commodity Bundling
III. Pricing for Special Cost and Demand
Structures
– Peak-Load Pricing
– Cross Subsidies
– Transfer Pricing
Price Matching
Brand Loyalty
Randomized Pricing
IV. Pricing in Markets with Intense Price
Competition
Cartel arrangements
• A cartel is an arrangement where
firms in an industry cooperate and
act together as if they were a
monopoly
• cartel arrangements may be tacit or
formal
• illegal in the US: Sherman Antitrust
Act, 1890
• examples: OPEC, IATA
Cartel arrangements
• Conditions that influence the
formation of cartels
– small number of large firms in the
industry
– geographical proximity of the firms
– homogeneous products that do not allow
differentiation
– stage of the business cycle
– difficult entry into industry
– uniform cost conditions, usually defined
by product homogeneity
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
Cartel arrangements
• Problem: incentive for firms to cheat
on agreement, thus cartels are
unstable
• Additional costs facing the cartel
–
–
–
–
formation costs
monitoring costs
enforcement costs
cost of punishment by authorities
 weigh the benefits against these
costs
Cartel arrangements
• Examples: price fixing by cartels
–
–
–
–
GE, Westinghouse
Archer Daniels Midland Company
Sotheby’s, Christie’s
Roche Holding AG, BASF AG
Price 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/p
To maximize profits, firm should charge a price such
that the LI = -1/price elasticity.
Suppose the MC = 800.
And firms price elasticity is -1.5
Then 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 surplus
Firm 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 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
Caveats:
• In practice, transactions costs and
information constraints make this difficult
to implement perfectly (but car dealers
and some professionals come close).
• Price discrimination won’t work if
consumers can resell the good.
Price discrimination
• Second degree price discrimination
– differential prices charged by blocks of
services
– requires metering of services consumed
by buyers
Price discrimination
• Third degree 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
Price discrimination
• Examples of price discrimination
• doctors
• telephone calls
• theaters
• hotel industry
Price discrimination
• Tying arrangement: a buyer of one
product is obligated to also buy a
related product from the same
supplier
– illegal in some cases
– one explanation: a device to ‘meter’
demand for tied product
– other explanations of tying
• quality control
• efficiencies in distribution
• evasion of price controls
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
Price
1. Set price at marginal
cost.
2. Compute consumer
surplus.
3. Charge a fixed-fee equal
to consumer surplus.
Fixed Fee = Profits = $16
10
8
6
Per Unit 4
Charge
MC
2
D
1
2
3
4
5
Quantity
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
Price
MC
PH
DH
PL
MRH
MRL
QL
DL
Q
H
Quantit
y
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 fares
wealthy 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.
Conclusion
• First degree price discrimination, block
pricing, and two part pricing permit a firm to
extract all consumer surplus.
• Commodity bundling, second-degree and third
degree price discrimination permit a firm to
extract some (but not all) consumer surplus.
• Simple markup rules are the easiest to
implement, but leave consumers with the
most surplus and may result in doublemarginalization.
• Different strategies require different
information.