Chapter Eight Price Strategies. Copyright © Houghton Mifflin Company.All rights reserved....

Chapter Eight

Price Strategies

Copyright © Houghton Mifflin Company.All rights reserved. 8–2

Importance of Pricing

• A survey of hundreds of executives about what marketing function was most important rated from 0 to 5 showed the following:


Importance of Pricing

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

Rating

Price

Product Differentiation

New Product Introduction

Selling Costs

New Competition

Market Saturation

Government Regulation

Internal Staff ing

Distribution

Environment

Advertising


Price Decisions

• Set MR = MC to maximize profit.


Price Discrimination

• Suppose the seller is able to separate customers in terms of their willingness and ability to purchase a product.

• For instance, suppose there are two identifiable sets of customers?


If Motorola is able to separate business customers from individual

customers:

• Then, it makes sense to charge a higher price to business customers.

• Another example---airline flights. Business customers and tourist customers are willing to pay different prices.

• Another example---movie theaters. Some customers might choose the cheaper matinee vs. the full-priced evening show.

• International differences -- dumping. Different nations are charged different prices for the same product.


Product-Line Extension

• Procter Silex sells its top of the line iron for $55 and its next best for $49.

• Yet there is only a $1 difference in manufacturing cost.

• Why the different prices?

• Because there are two sets of customers.


Product-Line Extension

• One type of customer: Wants the “best.”

• The other type: Wants good value.

• But Procter Silex is not able to separate (differentiate) the customers.

• Thus, it allows the customers to separate themselves.


Peak-Load Pricing

• A company using the same plant or facility to supply a good or service whose demand varies at different points in time might want to charge different prices at different times.


Peak-Load Pricing

Examples:

• Electricity

• Telephone use

• Bus services


D

P

Q

Charge each customer a different price

Perfect Price Discrimination


Perfect Price Discrimination

Examples:

• Transactions throughout China, since face-to-face individual negotiations lead to buyers paying different prices for the same product.

• Similarly, negotiating automobile deals in the U.S. leads to different prices for different buyers.

• The same occurs with housing purchases.


Cost Plus

• Firm knows costs.

• So firms should set a margin and then set the price to generate that margin.

P

Q

MC ATC

Margin

P

Q

MC ATC

Margin

Is cost-plus the same as profit maximizing?

DMR

Only under a rare circumstance.


Price Complexities

Consider a cable TV firm.

• It has 2 channels to sell, 1 and 2, and 2 groups of customers, A and B.

• Group A: • won’t pay more than $12 for Channel 1.

• won’t pay more than $12 for Channel 2.

• Group B: • won’t pay more than $20 for Channel 1.

• won’t pay more than $4 for Channel 2.

• WHAT DOES THE CABLE TV FIRM DO?


BUNDLING

• Suppose the marginal cost is zero. Then equating marginal revenue and marginal cost means that revenue maximization is the same as profit maximization.

• If the channels are sold separately, the most the firm, Cox Cable, could get for the channels would be the sum of the prices each segment was willing to pay.


BUNDLING

• If Cox set a price of $20 for channel 1, it would sell only to Group A.

• To get Group B to purchase channel 1, Cox has to set a price of no more than $12 for channel 1.

• Since Cox is not able to distinguish between Groups A and B, it has to set the same price for all customers.

• Thus, total revenue from channel 1 is:TR = (QA + QB)$12.


Bundling

• Similarly, Cox can charge only $4 to get Group A to purchase channel 2, so it can not charge more than $4 for channel 2.

• The total revenue from channel 2 is: TR = (QA + QB)$4.


Bundling

• Now, consider what would happen if Cox sold the two channels as a package – bundled the two channels together.

• Cox could set a price of $24, the lowest price that would attract the two groups to the bundle of channels 1 and 2.

• TR = (QA + QB)$24.


Bundling

• Compare the two schemes, first, pricing independently:TR = (QA + QB)$12 and TR = (QA + QB)$4.

• Now, bundle the two channels together:TR = (QA + QB)$24.

Bundling (Example 2)• Bundling involves tying products together and

selling them as a package.

• Case 1

• The firm can’t sell the goods except at the lowest prices:Pu=250 PT = 150

• So, each customer pays the lowest prices and total revenue is:TR =2*(250+150) = 800

Willingness to pay for:Uniform Trousers

Customer A 300 150

Customer B 250 200


Bundling (Example 2)

• Bundling involves tying products together and selling them as a package.

• If they are bundled, then customer A pays $450 for the bundle, as does customer B.

• PB =450 TR = 900


Bundling

• Case 2

• Pu=250 PT = 120

• TR =2*(250+120) = 740

• Bundling requires the lowest bundled price:

• PB =370 TR = 740

Willingness to pay for:Uniform Trousers

Customer A 300 150

Customer B 250 120


Bundling

• Idea: When customers have heterogeneous demand and the firm can not price discriminate, the firm may earn more by bundling.

• Examples: • Cable TV

• Furniture

• Vacations

• restaurants


Transfer Pricing

• When one division provides a product to another division within the firm, what price should be charged?


Transfer Pricing

• Divisions are told to maximize their own profits.

• Division managers’ compensation is based on division profits.

• When one division sells to another, profits of each division depend on the “transfer price.”

• Transfer price can matter because it affects the incentives faced by each division.


Transfer Pricing

• Decisions affected by transfer price:

• Computer division’s price, output, and advertising.

• Computer division’s choice of internal vs. external supply.

• Microprocessor division’s willingness to supply the product.

Microprocessor Division

Computer Division


The “Market” Is Entirely Internal

• The correct transfer price is one that maximizes company profits. • The computer division’s MC equals total

company MC.

• But the MC depends on the costs of the products from the microprocessor division.

• MR = MC for the computer division, and it maximizes the company’s profits.


P

0 Q

The “Market” Is Entirely Internal

MC

D=AR

MR

Q

P

MCmPm

So transfer price is Pm

The computer division faces D=AR.

The marginal cost is the sum of the marginal costs of the microprocessing and computer divisions:MC = MCm+ MCc

Set price P and quantity Q.

To produce Q requires a marginal cost for microprocessing of MCm(Q).


Competitive Market for Microprocessors

Result:

• Use the market price for the transfer price.

Consequence:

• The microprocessor division produces up to point where the market price equals MC.

• The computer division makes market purchases if its needs exceed the microprocessor division’s output.

• The microprocessor division sells input if its production exceeds the computer division’s needs.

Review of Pricing TacticsPricing Method When to Use How to Use

MR=MC

Learning Curves

1st Degree Price Discrimination

2nd Degree Price Discrimination

3rd Degree Price Discrimination

Two Part Tariffs

Bundling (Pure)

Bundling Mixed

General monopoly power

Cost function of cumulative output

Excellent information about consumer preferences

Quantity purchased varies greatly across / within customers

Can segment customers by willingness to pay

Cannot price discriminate effectively; homogenous demand, quantity varies for individuals

Multiple products, heterogeneous demand,

May be better than pure bundling

Find MR and MC. Set MR=MC. Get P from Demand curveSet MR=MC after learning, unless discount rate is very high.

Set P at reservation level for each customer.

Set different P for different levels of Q purchased.

Set MR1=MR2=MC across segments.

Choose P to maximize profit function with entry fee component. Entry fee= consumer surplus of group valuing product least. If all consumers are identical, P=MC and entry fee=consumer surplus at P.

Set MR=MC for bundle OR solve numerically for simple problems. Solve by trial and error if demand is unknown.

Find P1, P2, Pb, compare mixed bundling solution to pure bundling to see which is better.


When Firms Don’t Interact

Current Price



Expected sales if we raise price.



Expected sales if we lower price.



This generates our normal- looking demand curve.


When Firms Interact

Expected sales if we lower price and rivals also lower theirs.


When Firms Interact

Expected sales if we raise price and rivals do not raise theirs.


Expected sales if we raise price and rivals do not raise theirs.

When Firms Interact


Firm vs. Firm

• A real life example involves the newspaper owned by Robert Murdoch, the Australian media mogul.

• Murdoch’s paper and a rival were trying to set a price.


Firm vs. Firm

Dai

ly N

ews

$.50 $.40

$.50Good Best

Good Worst

$.40Worst Bad

Best Bad

New York Post


Firm vs. Firm

• Does one strategy for the Daily News exceed the other options?


If the Daily News Charges $.50 D

aily

New

s

$.50 $.40

$.50Good Best

Good Worst

$.40Worst Bad

Best Bad

New York Post


If the Daily News Charges $.40

Dai

ly N

ews

$.50 $.40

$.50Good Best

Good Worst

$.40Worst Bad

Best Bad

New York Post


Firm vs. Firm

• So when the New York Post chose $.50, the Daily News stayed at $.40.

• This is the worst situation for the Post.

• The Daily News won the most profit.


Dai

ly N

ews

$.50 $.40

$.50Good Best

Good Worst

$.40Worst Bad

Best Bad

New York Post

The Worst Situation for the Post


Firm vs. Firm

• The Post said “no way,” since this would be the worst scenario for it.

• The Post went back to $.40.


The Dilemma

Dai

ly N

ews

$.50 $.40

$.50Good Best

Good Worst

$.40Worst Bad

Best Bad

New York Post


Firm vs. Firm

• As the Post returns to its $.40, we have a dilemma.

• This “dilemma” would require both papers to remain at the lower price of $.40, even though both would be better off at $.50.

• How could they break out of the dilemma?


Firm vs. Firm

• So, when the New York Post raised its price to $.50, the Daily News stayed at $.40.

• The Post wanted to force the Daily News to go to $.50 as well.

• How could it do that?


Firm vs. Firm

Change the payoff:• The Post threatens a price war.

• The Post says its price will be $.25.

• This is a more serious lose-lose position for both firms.

• The Post actually cuts prices to $.25 but does so only in a portion of its market -- on Staten Island.


Firm vs. Firm

• So, when firms have to consider the reactions of other firms, they often fall into a Price war.

• Even though the price war makes everyone worse off than cooperating would.


Firm vs. Firm

• SWAir introduced its new service into Baltimore Washington International Airport by initiating a fare war.

• USAir and Continental were not equipped to engage in the war, since both had higher cost structures.

• Nevertheless -- both did -- in fact, for 15 months.

• USAir had its worst year in its history.


How to Avoid a Price War

Can firms call each other up and say: “Let’s agree not to lower price”?

• No. This is illegal in the United States.



Can they form a “cartel?”

• This is an organization of independent firms who agree to set prices and the quantities each sells. Examples include: • Oil (OPEC)

• Illicit Drugs

• Cartels also are usually illegal in the United States.


Facilitating Practices

• You are talking on the phone with an associate.

• The phone is cut off.

• Do you try calling back or does your associate?

• Circular reasoning says, “If I call and he calls, then we will both be calling each other at the same time and neither of us will get through.”

• There are two good solutions: • In one, you call, and your associate doesn’t.

• In the other, the associate calls, and you don’t.


Telephone Game

• What is required here is a preassigned operating rule:

• The person who initially made the call, calls again.

• This is called a convention.

• What are some “conventions” in business?• Hours of work -- typically 8 to 5?

• Dress codes?

• Structure of meetings?



Conventions or facilitating practices that lead to cooperation:

• “We will match any advertised price.”

• 5-year unconditional guarantee

• Low price every day

• Price leadership


When There Are Few Firms

• Firms must be VERY aware of what their rivals are doing.

• Before changing prices, for example, you’d want to know what your rivals will do.

• Firms will respond to rivals---often leading to price wars if firms are not careful.



• One way firms can avoid price wars is to announce to the other firms that it is willing and able to engage in a price war.

• The other firms knowing this, can avoid a price war by not cutting prices.

• For instance the “Low Price Guarantee” or “We will match any price on this product” campaign announces to all rivals that the firm will engage in any price war or price cuts other firms attempt.

• This is called a “meet the competition” policy.



• Similar to a meet the competition policy is the most-favored customer policy.

• This policy ensures that any customer who has purchased a product from the firm is guaranteed that it is at the lowest price the firm offers.

• If another customer gets a better price, then all customers are eligible for refunds at a matching lower price.

Chapter Eight Price Strategies. Copyright © Houghton Mifflin Company.All rights reserved....

Documents

Transcript of Chapter Eight Price Strategies. Copyright © Houghton Mifflin Company.All rights reserved....