Managerial Economics and Organizational Architecture, 5e
Managerial Economics and
Organizational Architecture, 5e
Chapter 7: Pricing with
Market Power
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Managerial Economics and Organizational Architecture, 5e
Pricing Objective
• Pricing is key to managerial decision
making
• Firms with market power can raise prices
without losing all customers to competitors
• A firm has market power when it faces a
downward sloping demand curve
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Managerial Economics and Organizational Architecture, 5e
Pricing
• Assume profit maximization
– Implies single period pricing strategies
• Firms wish to capture as much consumer
surplus as possible
• Consumer surplus is the difference
between what the consumer is willing to
pay and what the consumer actually pays
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Managerial Economics and Organizational Architecture, 5e
Pricing with Market Power
$
Price (in dollars)
Consumer surplus
Demand
MC
Q
Quantity
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Managerial Economics and Organizational Architecture, 5e
The Benchmark Case:
single price per unit
Intuit data:
• Purchases software from manufacturer for $10
• Demand curve is P = 85 - 0.5Q (Q in 1000s of
units)
• What is the profit-maximizing price?
• Set MR = MC
• 85-Q=10
• Q=75, P= $47.50
• Profit is $2,812.50 (000s)
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Managerial Economics and Organizational Architecture, 5e
Single Price per Unit
$
Checkware
With MC=10,
the optimal output is 75
with a price of $47.50
Price (in dollars)
85.00
P*=
47.50
Demand
MC
10.00
MR
Q* = 75
Quantity of Checkware
Q
170
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Managerial Economics and Organizational Architecture, 5e
Cost Issues
• Relevant costs
– sunk costs are irrelevant
– current opportunity costs are relevant
– historical costs are irrelevant
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Managerial Economics and Organizational Architecture, 5e
Pricing Strategy
• price elasticity, , is a measure of price
sensitivity
• Optimal price is P=MC/[1-1/ ]
• For MC = 10, if  = 2, then
• P = 10/[1 – ½] = 20
• For MC = 10, if  = 3, then
• P = 10/[1 – 1/3] = 15
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Managerial Economics and Organizational Architecture, 5e
Price Sensitivity and Optimal Markup
Price (in dollars)
$
$
85.00
85.00
P*=
47.50
10.00
The optimal markup
is higher for the less
elastic demand
42.50
Demand
MR
Q* = 75
MC
170
Quantity of Checkware
Less elastic demand
P*=
26.25
10.00
Q
Demand
MC
MR
Q* = 65
Q
170
Quantity of Illustrator
More elastic demand
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Managerial Economics and Organizational Architecture, 5e
Price Sensitivity
•
•
•
•
In the original example  = 1.267
P = 10/[1 – 1/1.267] = 47.5
For Illustrator,  = 1.615
P = 10/[1 – 1/1.615] = 26.25
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Managerial Economics and Organizational Architecture, 5e
Estimating Profit-Maximizing Price
• In theory, MC=MR, but in practice,
manager may not know demand curve and
therefore MR.
• Cost-plus or mark-up pricing may be
useful approximations.
• Such pricing should be product specific
and based on awareness of price
sensitivity.
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Managerial Economics and Organizational Architecture, 5e
Linear Approximation
• Suppose firm currently sells 30 units at
$70
• Firm estimates that by lowering price to
$65 it will sell 40 units
• This information can be used to
approximate a linear demand curve
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Managerial Economics and Organizational Architecture, 5e
Linear Approximation
•
•
•
•
•
•
•
•
Slope = (65-70)/(40-30) = -0.5
the intercept is calculated using
P = a - 0.5Q
When price is $70, the intercept is
$70 = a - 0.5(30)
a = 85
Demand is estimated as:
P=85 – 0.5Q
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Managerial Economics and Organizational Architecture, 5e
Cost-Plus Pricing
• Add a markup to average total cost to yield
target return
• Must account for price sensitivity
• Consistently bad pricing policies are not
good for the firm’s long-term fiscal health
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Managerial Economics and Organizational Architecture, 5e
Mark-Up Pricing
• Optimal mark-up rule of thumb:
• P*=MC*/(1-1/*)
• where * indicates estimated value
• Requires some knowledge or awareness
of both marginal costs and elasticity
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Managerial Economics and Organizational Architecture, 5e
Potential for Higher Profits
$
Consumer surplus
b
Price (in dollars)
Firm profits
P*
a
Unrealized gains from trade
c
e
Demand
d
f
MC
MR
Q*
Quantity of Checkware
Q
170
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Managerial Economics and Organizational Architecture, 5e
Block Pricing
• Declining price on subsequent blocks of
product
• Takes advantage of consumers’ lower
marginal value for additional units
• Seen in product packaging
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Managerial Economics and Organizational Architecture, 5e
Two-Part Tariffs
• Up-front fee for the right to purchase
• Additional fee per unit purchased
• Best when customers have relatively
homogenous demand for product
• Used at country clubs, health clubs,
college football
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Managerial Economics and Organizational Architecture, 5e
Two-Part Tariff
$
capturing consumer surplus
$10
Price (in dollars)
Charge an upfront fee equal to consumer surplus
Profits will equal the area of the consumer surplus, $42.50
Demand
Charge a price of $1 per unit and
sell 9 units
MC
$1
Q
Quantity
Q*=9
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Managerial Economics and Organizational Architecture, 5e
Price Discrimination
heterogeneous consumer demands
• Price discrimination occurs when firm
charges different prices to different groups
of customers
– not related to cost differences
• Necessary conditions
– different price elasticities of demand
– no transfers across submarkets
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Managerial Economics and Organizational Architecture, 5e
Using Information About Individuals
• Personalized pricing
– “first degree” price discrimination
– Extract maximum amount each customer is
willing to pay
– possible only with small number of buyers
• Group pricing
– “third degree” price discrimination
– very common (utilities, theaters, airlines…)
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Managerial Economics and Organizational Architecture, 5e
Group Pricing
• If two groups have different elasticities of
demand, the charge a higher price to the
group with the more inelastic demand.
• Us the markup rule: P*=MC*/(1-1/*)
• Apply it for each elasticity to get the
different prices
• If the elasticities are 2.33 and 1.55 and
MC=$10, then markup the price to $17.50
and $30, respectively.
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Managerial Economics and Organizational Architecture, 5e
Optimal Pricing at Snowfish
different demand elasticities
Price (in dollars)
$
50.00
50.00
η* = 1.50
P*=
30.00
25.00
η* = 2.33
P*=17.50
10.00
MC
MR
Q* = 200
Quantity of passes
for out-of-town skiers
MC
10.00
MR
Q* = 150
Quantity of passes
for local skiers
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Managerial Economics and Organizational Architecture, 5e
Using Information About the
Distribution of Demands
• Menu pricing
– “second degree” price discrimination
– consumers select preferred package
– Companies often use different versions of
their product – deluxe, basic, etc.
• Coupons and rebates
– users likely more price sensitive
– users who are new customers may stick with
product
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Managerial Economics and Organizational Architecture, 5e
Bundling and Other Concerns
• Bundling may yield a higher price than if
each component is sold separately
– theater season tickets
– restaurant fixed price meals
• Multiperiod pricing
– low initial price can “lock-in” customers
• Strategic considerations
– low price may be barrier to entry
7-25