Managerial Economics
Session 4
Pricing Strategy
Professor Changqi Wu
Topics for Today

Uniform pricing

Price discrimination

Durable good pricing

Bundling

Auction
1
Pricing
Slide 2
1. Uniform pricing

Profit maximizing pricing strategy:
 Setting
the incremental margin equal to the
inverse of absolute value of the price
elasticity of demand

A seller sets the same price for every
unit of his product.

Optimal pricing depends on both price
elasticity of demand and marginal cost
2
Pricing
Slide 3
Cost-Based Pricing

Average cost plus a fixed profit margin

Procedure

 To
estimate the average cost
 To
add a markup to the average cost
Cost based pricing is widely practised. It
has pros and cons.
3
Pricing
Slide 4
Why Cost-Plus Pricing is Popular?

It’s simple!

Cost-base pricing may be a profit-maximizing
one if average cost approximates marginal
cost
P = (1- 1/(ep+1)) MC

It costs money and time to calculate the right
price and to work out how price should
respond to changing market conditions,
particularly for small firms

It is costly to change prices.
Pricing
Slide 5
Why Cost-Plus Pricing Can Go Wrong?

Demand side factor is not explicitly taken into
consideration.

It is difficult to estimate true average cost
because of the existence of indirect cost and
joint cost

Average cost pricing is influenced by
accounting rules

As a remedy, one can use variable markup
rule instead of fixed markup
Pricing
Slide 6
2. Price Discrimination is ...

Two or more similar goods are sold at
different net prices
 Prices
may differ due to quality and cost
differences.

Motives for price discrimination:
 earning
more from existing customers
 selling
to new customers without sacrificing
the current profit margin
4
Pricing
Slide 7
Capturing Consumer Surplus
$/Q
Pmax
Between 0 and Q*, consumers
will pay more than
P*--consumer surplus (A).
A
P1
P*
B
PC is the price
that would exist in
a perfectly competitive
market.
P2
MC
PC
If price is raised above
P*, the firm will lose
sales and reduce profit.
D
Beyond Q*, price will
have to fall to create a
consumer surplus (B).
MR
Q*
Pricing
Quantity
Slide 8
Conditions of Price Discrimination

A seller must have market power

A seller is able to identify customers
with different demand elasticities

Resale is impossible
5
Pricing
Slide 9
Practicing Price Discrimination

Complete price discrimination

Direct segment discrimination

Indirect segment discrimination
6
Pricing
Slide 10
Complete Price Discrimination

A seller charges each and every buyer
her reservation price

It can be used for tailor-made
products/services

Using price negotiation to find the
buyer’s reservation price
Pricing
Slide 11
Incomplete Price Discrimination
Consumers are divided
into groups.
$/Q
P1
Price is lower to appeal to
Consumers with
more elastic demand.
P2
D2 = AR2
AC = MC
MR1
Q1
Pricing
MR2
D1 = AR1
Q2
Quantity
Slide 12
Direct Segment Discrimination

A seller charges different prices using
directly observable signals relating a
consumer with her price elasticity

Example: What’s in the name?
7
Pricing
Slide 13
Indirect Segment Discrimination

A seller use self-selection devices to
distinguish customers.

Two-part tariff
 Consumers
pay a fee up front for the right
to buy a product and then, pay additional
fee for each unit of the product they wish to
consume

Peak load pricing
8
Pricing
Slide 14
Methods to Prevent Resale

Refuse to deal with resellers

Bundling with services

Issuing warranties

Degrading the quality of product
9
Pricing
Slide 15
3. Durable Goods Pricing

Durable goods sold by a seller are their own
substitutes

Ways to solve the durable goods pricing
problem

Making goods less durable: planned obsolescence

Limiting the production in the future

Buy-back provisions
11
Pricing
Slide 16
4. Bundling

Bundling Scenario: Two different goods and
many consumers


Mixed Bundling


Many consumers with different reservation price
combinations for two goods
Selling both as a bundle and separately
Pure Bundling

Pricing
Selling only a package
Slide 17
Mixed Versus Pure Bundling
r2
100
C1 = MC1
C1 = 20
A
With positive marginal
costs, mixed bundling
may be more profitable
than pure bundling.
90
80
70
60
50
B
C
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.
40
30
20
D
C2 = MC2
C2 = 30
10
10 20 30 40 50 60 70 80 90 100
Pricing
r1
Slide 18
The Complete Dinner Versus a la Carte:
A Restaurant’s Pricing Problem

Pricing to match consumer preferences
for various selections

Mixed bundling allows the customer to
get maximum utility from a given
expenditure by allowing a greater
number of choices.
Pricing
Slide 19
5. Auctions

Auction Formats
 Traditional
 Dutch
English (oral)
auction
 Sealed-bid
Pricing

First price

Second price
Slide 20
Auctions
Valuation and Information

How to choose an auction format
 Private-value
auction: bidders uncertain
about the other bidders reservation price
 Common-value
auction: bidders uncertain
what the value is
Pricing
Slide 21
Auctions
Private Value Auction

Second-price sealed auction: bid your
reservation price

English auction: Bid in small increments until
you reach your reservation price

The winning bids in both auctions is the
reservation price of the second highest bidder
Pricing
Slide 22
Auctions
Private Value Auction

Sealed-bid auction
 First-price
auction: lowers the bid
 Second-price
auction: bid just above the
second highest reservation price

Both yield the same revenue
Pricing
Slide 23
Auctions
Common Value Auction

Winner’s Curse



The winner is worse off than those who did not win
Examples

Bidding on a construction job

Bidding on 3G mobile service licenses
Question

Pricing
How can you avoid the winner’s curse?
Slide 24
Key Takeaway Points

Profit maximizing uniform pricing depends
on marginal cost as well as price elasticity
of demand

Depending on the information available, a
seller can adopt different price
discrimination schemes.

There are many ways to set the prices to
reduce inefficiencies and raise the level of
profit.
Pricing
Slide 25