Pricing Strategies
Managerial Economics – Econ 340
Lecture 9
Christopher Michael
Trent University
© 2006 by Nelson, a division of Thomson Canada Limited
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Topics
•
•
•
•
•
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Proactive Value-Based Pricing
Intertemporal Pricing
Price Discrimination
Pricing of Multiple Products
Pricing in Practice
Transfer Pricing
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Proactive Value-Based Pricing
• If the price doesn’t fit what customers are willing to pay,
then the product may not be profitable.
• Customer value is the focus for pricing, not just the
costs associated with the product.
• Apple Computer lost market share by ignoring
customer value.
• The Ford Mustang was a success, as Ford found that
people wanted a sports car, but didn’t want it to be too
expensive. The started with a price and designed the
product.
• The Mustang used value-based, not cost-plus pricing
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Intertemporal
Pricing
• If at peak rush hour, the toll is higher than at
the off-peak, we are using different prices at
different time periods.
• The peak toll can encourage shifting travel
patterns to off-peak times or discourage some
commuting altogether.
• Intertemporal pricing appears more
frequently than one thinks. This is just one
variety of what is called price discrimination.
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Congestion Tolls
• If the price at
off-peak is POP
is the same
price as the
peak, the traffic
volume varies
from QOP to
QPEAK.
• If the price at
the peak is P’P,
the traffic
volume varies
less, from QOP
to QC.
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P’P
POP
DPEAK
DOFF-PEAK
QOP
QC
QPEAK
shift
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Price Discrimination
 Price Discrimination — Goods which are
NOT priced in proportion to their marginal cost,
even though technically similar
 Some
Necessary Conditions:
1. Some Monopoly Power
• Otherwise, in pure competition, P = MC
2. Limited Ability to Arbitrage
• Separate customers and prevent reselling
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Arbitage – Buy Low to Sell Higher
• Arbitrage of Goods is Easy
» Price discrimination of goods is not effective
» Little price discrimination of grocery items
• Arbitrage of Services is Difficult
» Price discrimination of services is effective
» Price discrimination at restaurants by age,
as restaurant food is a service
» Lawyers charge different prices for wills,
based on ability to pay
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Ways to Separate Customers
for Price Discrimination
1. Geography as when the
price in the East-side and
West-side differ
2. Income as the Canadian
Econ Association charges
more to professors than
students
3. Gender as when jeans for
women are priced higher
than similar jeans for men
4. Age as when kids get in at
lower prices for movies
5. Time of day or season
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6. Race as when shampoos targeted
for Afro-Canadian hair are priced
differently that other shampoos,
though technically the same.
7. Language as when products
printed in Spanish are priced
differently than those in
English/French
8. Transient/Resident as when
contractors pay less at hardware
stores than other customers
9. Ability to Haggle when those
who ask for a lower price get it
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Why Price Discriminate?
• In Simple Monopoly,
there is only one price
• Consumers receive a
consumer surplus
• In Price
Discrimination,
monopolists can
SCOOP OUT all
consumer surplus
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MC
Simple
Monopoly
PSM CS
D
QSM
Q
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Perfect Price Discrimination
(or 1st Degree Price Discrimination)
• Charge the MOST
that a person is
willing to pay for
each good
• Zero consumer
surplus
• Produce MORE than
in Simple Monopoly
• Output the same as in
Competition
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Price Discriminating
Monopoly
MC
D
Q
Q1st
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Perfect Price Discrimination
Does it Work for Car Dealers?
“How much do you
plan to pay a
month?”
you inadvertently reply:
“$232 per month,
and have a $3,000
down payment!”
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At 6%, that’s
about $12,000
for 60 months,
plus $3,000
Here’s one for only
$15,000. It’s swell.
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Notice: Incentives to Understate
One’s True Willingness to Pay
• The conditions
for perfect price
discrimination
are seldom met
• Hence, some
close
approximations
exist
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Second Degree Price
Discrimination:
Units are Grouped
• There are are a variety
of ways to group units
to attempt to scoop out
consumer surplus
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Second Degree Price
Discrimination:
Two Part-Pricing
• A price for the privilege of buying items PLUS a price
per item
• Examples:
» Car rental per day with per kilometre charges
• Car renters may not know how much they will use the car.
• They may prefer a lower rental rate (cover charge) with a per mile
charge.
» Amusement parks
» Country Club Dues and Greens Fees
» Cover Charge to Enter a Bar and a Price Per Drink
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Second Degree Price
Discrimination at McDonalds
(Bundling)
• McDonalds sells Extra Value Meals, as a bundle of
sandwich, fries, and a soft drink for less than it
sells them separately.
• Selling both bundles and items separately is mixed
bundling.
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Bundling & Mixed Bundling
» If Bob would pay $3 for a burger and $1 for a soft
drink, and if Mary would pay $2 for a burger and
$2 for a soft drink, a bundle of $4 for both a
burger and soda will work for both customers as a
bundle.
» But if the price of a burger individually were
$3.00 and a soft drink $2.00, then Bob would buy
only a burger and Mary only a soft drink.
• Not everyone is alike, so mixed bundles succeeds with
more customers.
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One Price for All Regions
East
West
Market
PM
MC
MR
Example with a Simple Monopoly Price (PM) in both markets
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Third Degree Price Discrimination
East
West
Market
PE
PM
PW
MC
MR
MR
MR
Example with Different Prices in Each Market
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Mathematics of Price
Discrimination
•
•
Using elasticities P( 1 + 1/ ED ) = MC
In two regions:
P1( 1 + 1/ E1 ) = P2( 1 + 1/ E2 ) = MC
or: P1/ P2 = ( 1 + 1/ E2 )/( 1 + 1/ E1 )
•
•
•
If the elasticities in region 1 and region 2 are -1.25 and
-2.5 respectively, then P1/ P2 = (1+1/ -2.5)/(1+1/-1.25 ) = 3.
Hence, P1 = 3P2.
Price is 3 times higher in region 1, which is less elastic.
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Pricing of Multiple Products
• Products are INDEPENDENT when
changes in price and quantity of one product
do NOT alter revenues or cost in the others
• Products are INTERDEPENDENT, when
changes DO affect other products
• Ex: Procter & Gamble makes both Luvs and
Pampers
» TR = TRA + TRB
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Substitutes and Complements
• Look for interdependencies in marginal
revenues:
» MRA = TRA / QA + TRB / QA
» MRB = TRA / QB + TRB / QB
• Substitutes when cross terms are negative
» Erosion or Cannibalism are terms used, such
as Pampers & Luvs.
• Complements when cross terms are positive
» Sony sells DVD Players and blank DVDs
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Decision Rules for Multiple
Product Firms
• Do NOT use the rule to produce where
MR=MC, as in MRA = MCA
• INSTEAD:
» Produce where the FULL MR = FULL MC
» For a Two Product Firm of A & B
» Produce where:
TRA /QA + TRB /QA = TCA /QA + TCB /QA
Include all relevant revenue and cost effects
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Pricing Example in Supermarkets
• Turkey prices fall during Thanksgiving
» Yet we would expect DEMAND to be greatest?!
• Loss-Leader Pricing
» Consider T as turkey
» and A as all other food
30¢ / kilo with
$100 purchase
• TRstore = TRT + TRA
MRstore for turkey = TRT /QT + TRA /QT
• Complementarity with other food explains the
apparent conundrum
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Pricing in Practice
• In practice, pricing strategy involves the
whole life-cycle pricing of the product.
• Managers report wide use of cost-plus
pricing methods because it:
» Streamlines pricing of multiple products
» Streamlines pricing of retail products
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Cost-Plus and Full-Cost
Pricing
P = ACn + Markup
or
P = ACn(1 + m)
where ACn is average cost at a normal output
and m is a percentage markup
• Notice: Little reliance on MC pricing or use of
elasticities, as in: P( 1 + 1/ED ) = MC
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Full-Cost Pricing
• Full Cost
» Covers all Costs at the standard or normal output
» Plus a return on the investment
• P = VCl + VCm + F/Q + p K / Q
» Where VCl and VCm are unit labour cost and unit material
cost respectively (which is average variable cost).
» where p
K is the target amount of profit
» and p is the desired profit rate and K is gross operating
assets
» Q is the number of units expected to be produced over this
time horizon.
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Example: Low-Tech Security
Start a firm with F = 200,000, Q = 3,000, total labour
cost is $40,000 and total material cost is $50,000
p = 20% and K=$500,000. Find Full Cost Price!
• Answer
» P = VCl + VCm + F/Q + (0.20)(500,000)/Q
» P = 13.33 + 16.67 + 66.67 + 33.33
= $130
• Also, suppose a 35% markup on average cost
» P = [ AC] (1.35)
» P = [ 13.33 + 16.67 + 66.67 ](1.35)
» P = $130.50
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Advantages and Disadvantages of
Cost-Plus Pricing
• Cost-plus is simple
• But cost-plus ignores
demand changes
• Easy to delegate to
others
• Pricing may be based on
poor cost data
• Easy to apply to
thousands of items
• Output varies in business
cycle
» Can use categories
of markups for
Hybrid Method: Variable
different classes of
Cost-Plus Pricing — the
products
markup can vary over the
season or business cycle
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Optimal Markups in Practice
• Grocery stores have
• Demand is therefore
low markups
highly elastic
• Many close substitutes -- • Optimal markup would
at other grocery stores
consequently be small
(bread varieties and
qualities are
standardized)
• Frequent purchase, so
customers are
knowledgeable about
prices & quality
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Markups on Jewellery
• Jewellery markups are known to be large
• Difficult to make comparisons across
jewellery stores
• Little repeat purchases, so knowledge
about prices is low
• Consequently, lower price elasticity for
jewellery
• The optimal markup is larger
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Skimming
• Price declines over time
• Those who wish to get it
first pay the highest price,
others are willing to wait
• Examples:
P
D
» Hardcover & Paperback
Books
» New electronic, computer
products, and PDAs.
TIME
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Prestige Pricing
• Some products distinguish themselves by being
noticeably expensive.
» Mercedes, Rolls Royce, or BMW
» Cartier jewellery
• Price is a way to distinguish the product
• Prestige Pricing is the practice of charging a high price
to enhance its perceived value.
» However, firms spend much on promotional activities to
convince customers that the product is prestigious.
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Transfer Pricing with
No External Markets
• When no external markets exist, use the
MC of the transferred good.
• Often, however, the MC is a function of
output.
• Marketing and Production steps (M & P)
• Transfer price is PT = MCP on following
figure
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Find Where MCM+P = MR
MCM+P
P
MCM + PT
MCP
MCM
PT
D
Q0
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MR
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Transfer Pricing and Profit
Maximization
• Once a firm uses the optimal transfer price, PT, the
whole firm maximizes profits.
• Suppose a firm uses a higher price than PT, call it
PHigher to make the production group happier.
• The sum of the MCM plus PHigher is given at the
next slide, creating the appearance of a cost
increase.
• Quantity declines from Q0 to Q1 and price is
artificially increased from P0 to P1.
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Using a HIGHER TRANSFER PRICE hurts
profits as quantity declines and
price rises
PHigher + MCM
MCM+P
P1
P0
PT + MCM
MCP
MCM
PHigher
PT
D
Q1 Q0
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MR
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Optimal Transfer Pricing
External
Market
Market
Structure
Optimal
Transfer Price
No
Not Applicable
MCP = PT
Yes: QP > QM
Perfectly
competitive
Perfectly
competitive
Imperfectly
competitive
Imperfectly
competitive
MCP = PT = PEXT
Yes: QP < QM
Yes: QP > QM
Yes: QP < QM
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MCP = PT = PEXT
MCP = PT < PEXT
MCP = PT > PEXT
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