Special Pricing Policies
Overview
Cartel arrangements
Price leadership
Revenue maximization
Price discrimination
Nonmarginal pricing
Multiproduct pricing
Transfer 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
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
Agreement among competing firms to
fix prices, output and marketing.
Occurs in oligopoly markets
Can be explicit or Implicit
Legal 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 Strategies
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 (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 discrimination
Different 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 markets
2. 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 (intertemporal 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
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.