Lecture 8 PSB Tri 3 09 Pricing GECO6410

GECO 6410 Week Eight Pricing Strategies: Creating & Sustaining CA

Source: Boyes Ch 8 Pindyck and Rubinfeld Ch. 11) (short loans on line)

Outline1. Pricing in context2. Price Discrimination3. Intertemporal Price Discrimination and Peak-

Load Pricing 4. Two-Part Tariff5. Bundling 6. Mark-up pricing7. Summary

Part 1 Pricing in contextPart 1 Pricing in context

It is one of the issues managers are most It is one of the issues managers are most concerned with.concerned with.

Pricing strategies (i.e. charging different Pricing strategies (i.e. charging different prices to different customers for similar prices to different customers for similar goods & services) are a way that goods & services) are a way that producers capture consumer surplus.producers capture consumer surplus.

Seeking Competitive Advantage: Pricing Strategies

Pricing is an important strategic tool, acknowledge by managers across industries.Part of the broad pursuit of sustaining c.a. through barriers to entry. However, a small percentage of managers know much about consumer's response to price


Key Questions: Have Internet buying/selling and auctions turned all businesses into price takers? ( i.e. a perfectly competitive outcome)? How prices are determined on the Internet?

P = MC ( no differentiation)P >MR=MC (some differentiation)

See Boyes pp. 163 -166


While MC =MR is the fundamental approach to pricing, firms face numerous complications while setting prices. Firms selling more than one product (super markets, department and discount stores) There is more than one market segmentDifferent selling environment and market structures Link between price and quality and consumers’ perceptionDifferent customers have different capacity to pay for the same good or service

Most Important Marketing Issues (Source: Dolan and Simon 1996 cited

in Boyes 2004: 163)

Management Knowledge (Source: Clancy and

Shulman 1994 cited in Boyes 2004: 163)

The challenge

The challenge is to capture as much of the consumer surplus as possible. It is the prices which are above MC. It can only work if a firm has some market power.

Consumer Surplus

Quantity Quantity

Price Price

Demand Demand

A

B BC

ConsumerSurplus

Initial Consumer Surplus

Consumer surplus toNew consumers

Additional consumerSurplus to initial consumer

P1 P1

P2

Q1 Q1 Q2

A

B C

D EF

Willingness to pay The maximum amount that a buyer will pay for a good

Consumer surplusA buyer’s willingness to pay less the amount the buyer actually pays

Capturing Consumer Surplus

Quantity

$/Q

D

MR

Pmax

MC If price is raised above P*, the firm will lose

sales and reduce profit.

PC

PC is the pricethat would exist in

a perfectly competitivemarket.

A

P*

Q*

P1

Between 0 and Q*, consumerswill pay more than

P*--consumer surplus (A).

B

P2

Beyond Q*, price willhave to fall to create a consumer surplus (B).

Capturing Consumer Surplus

Quantity

$/Q

D

MR

Pmax

MCPC

A

P*

Q*

P1

B

P2

QuestionHow can the firm

capture the consumer surplusin A and sell profitably in B?

AnswerPrice discrimination

Two-part tariffsBundling

Part 2 Price Part 2 Price DiscriminationDiscrimination

First degree First degree Second degreeSecond degree Third degreeThird degree

Price Discrimination

Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same


Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power

Forms of Price Discriminations First-Degree or Perfect discrimination

Each consumer is charged according to his/her maximum willingness to pay (e.g. bargaining, auctions)

Second-Degree Price discriminationDifferent price for different quantity (e.g.

1 Pizza for $6.95 and 2 for $12.95) Third-Degree Price discrimination

Dividing consumers into 2 or more groups with separate demand curves (e.g. discounted prices for students or senior citizens). Separation by different elasticities of demand.

First-Degree Price Discrimination and Personalized

Pricing Technology, the Internet and personalized

pricing firms are able to learn more about customers’ likings and disliking. Pricing based upon postal code ( rich

suburbs pay more for an identical product)

Pricing based upon an individual’s price elasticity of demand

One-to-one marketing” perfect price discrimination to extract maximum consumer surplus


First Degree Price Discrimination Charge a separate price to each customer:

the maximum or reservation price they are willing to pay.

Deadweight Loss(e.g. how tax affects welfare)

Quantity0

Price

Demand

Supply

Q1

A

BC

F

D E

Q2

Tax reduces consumer surplus by (B+C) and producer surplus by (D+E)

Tax revenue = (B+D)

Deadweight Loss = (C+E)

Price buyerspay = PB

P1

Price without tax

=

PSPrice sellers receive

=

Deadweightloss

Consumersurplus

Welfare Without Price Discrimination... (Note welfare here is used in an economic context)

Price

0 Quantity

Profit

Demand

Marginal cost

Marginalrevenue

Quantity sold

Monopolyprice

(a) Monopolist with Single Price

Welfare With Price Discrimination...

Price

0 Quantity

Demand

Marginal cost

Quantity sold

(b) Monopolist with Perfect Price Discrimination

Profit

Perfect Price Discrimination

Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each consumer and can charge each consumer a different price.


Two important effects of price discrimination: It can increase the monopolist’s profits It can reduce deadweight loss

Question Why would a producer have difficulty in

achieving first-degree price discrimination?

Answer

1) Too many customers (impractical)

2) Could not estimate the reservation price for each customer

Additional Profit From Perfect First-Degree Price Discrimination


First Degree Price Discrimination The model does demonstrate the potential

profit (incentive) of practicing price discrimination to some degree.

Price Discrimination First Degree Price Discrimination

The following are examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product:• Lawyers, doctors, accountants

• Car salesperson (15% profit margin)

• Colleges and universities

First-Degree PriceDiscrimination in Practice

Quantity

D

MR

MC

$/Q

P2

P3

P*4

P5

P6

P1

Six prices exist resultingin higher profits. With a single priceP*4, there are fewer consumers and

those who pay P5 or P6 may have a surplus.

Q

Second-Degree Price Discrimination

Quantity

$/Q

D

MR

MC

AC

P0

Q0

Without discrimination: P = P0 and Q = Q0. With second-degree

discrimination there are threeprices P1, P2, and P3.(e.g. electric utilities)

P1

Q1

1st Block

P2

Q2

P3

Q3

2nd Block 3rd Block

Second-degree pricediscrimination is pricing

according to quantityconsumed--or in blocks.

Second-Degree Price Discrimination

Quantity

$/Q

D

MR

MC

AC

P0

Q0

P1

Q1

1st Block

P2

Q2

P3

Q3

2nd Block 3rd Block

Economies of scale permit:•Increase consumer welfare•Higher profits

Note: MC should cross over AC at some point but not here for the purposes of clarity


Third Degree Price Discrimination

1) Divides the market into two-groups.

2) Each group has its own demand function.



3) Most common type of pricediscrimination.

• Examples: airlines, discounts to students and senior citizens.



4) Third-degree price discrimination is feasible when the seller can separate his/her market into groups who have different price elasticities of demand (e.g. business air

travelers versus vacation air travelers)

Examples of Price Discrimination

Movie tickets (Tuesdays) Train fares (Peak, off-peak,

concessions, passes) Discount coupons (Elastic demand) Financial aid (Concession cards) Quantity discounts (Small vs large

packaging)

Airline Fares

Differences in elasticities imply that some customers will pay a higher fare than others.

Business travelers have few choices and their demand is less elastic.

Casual travelers have choices and are more price sensitive.

Airlines have two distinct profits which when summed, are greater than if just one price was charged.

MCATC

D:adultsMR:adults

Quantity

Re

ven

ue

an

d C

os

ts (

$)

D:students

MR:students

Q:adults

P:adults

Q:studs

P:studs

Under price discrimination, profit is maximised where MC = MR for each category of customer.

Note: Economy passengers are assumed to have a higher price elasticity of demand because of lower incomes or simply less urgent travel requirements.

Part 3 Intertemporal Part 3 Intertemporal Price Discrimination and Price Discrimination and Peak-Load PricingPeak-Load Pricing

Two related forms of Price Discrimination

Intertemporal Price DiscriminationCharge a high price at first to capture the

consumer surplus of high demand groupLower the price later to capture the mass marketExample: hardcover vs paperback releases

Peak-Load PricingCharge higher price during peak and lower price

during off-peak periodThis is more efficient because MC is higher

during peak periodsExample: Electricity charges

Intertemporal Price Discrimination and Peak-Load Pricing

Separating the Market With Time Initial release of a product, the demand is

inelastic• Book

• Movie

• Computer

Airline Fares

The airlines separate the market by setting various restrictions on the tickets. Less expensive: advance purchase, stay over

the weekend, no refund Most expensive: no restrictions

Separating the Market With Time Once this market has yielded a maximum

profit, firms lower the price to appeal to a general market with a more elastic demand • Paper back books

• Dollar Movies

• Discount computers

Intertemporal PriceDiscrimination and Peak-Load Pricing

Intertemporal Price Discrimination

Quantity

AC = MC

$/Q

Over time, demand becomesmore elastic and price

is reduced to appeal to the mass market.

Q2

MR2

D2 = AR2

P2

D1 = AR1MR1

P1

Q1

Consumers are dividedinto groups over time.

Initially, demand is lesselastic resulting in a

price of P1 .

Demand for some products may peak at particular times. Rush hour traffic Electricity - late summer afternoons Ski resorts on weekends


Peak-Load PricingPeak-Load Pricing

Capacity restraints will also increase MC.

Increased MR and MC would indicate a higher price.



MR is not equal for each market because one market does not impact the other market.

Different from 3rd degree p-d . With 3rd degree p-d, MR must be equal for each group of consumers, and equal to MC.

Peak-load pricing: price and sales can be determined independently by setting MC = MR for each period.



MR1

D1 = AR1

MC

P1

Q1

Peak-load price = P1 .

Peak-Load Pricing

Quantity

$/Q

MR2

D2 = AR2

Off- load price = P2 .

Q2

P2

Part 4 Two-Part TariffPart 4 Two-Part Tariff

The Two-Part Tariff

The purchase of some products and services can be separated into two decisions, and therefore, two prices.

The Two-Part Tariff

Examples

1) Amusement Park• Pay to enter

• Pay for rides and food within the park

2) Tennis Club• Pay to join

• Pay to play

The Two-Part Tariff Examples

3) Rental of Mainframe Computers• Flat Fee

• Processing Time

4) Polaroid Film• Pay for the camera

• Pay for the film

The Two-Part Tariff

Pricing decision is setting the entry fee (T) and the usage fee (P).

Choosing the trade-off between free-entry and high use prices or high-entry and zero use prices.

Two-Part Tariff Another means of extracting

consumer surplus It is a form of pricing in which

consumers are charged both an entry and a usage fee

The problem is to pick the profit maximising entry fee (T) and usage fee (P) combination

Firm must have some market power

Usage price P*is set whereMC = D. Entry price T* is equal to the entire consumer surplus.

T*

Two-Part Tariff with a Single Consumer

Quantity

$/Q

MCP*

D

Two-Part Tariff (Single Consumer)

D

MC

Quantity

P*

Pri

ce

Usage fee P*=MC

Entry Fee = Consumer Surplus

This is efficient because Price = MC but the firm takes all the consumer surplus

The Two-Part Tariff

The Two-Part Tariff With Many Different Consumers No exact way to determine P* and T*. Must consider the trade-off between the

entry fee T* and the use fee P*.• Low entry fee: High sales and falling profit with

lower price and more entrants.

The Two-Part Tariff

The Two-Part Tariff With Many Different Consumers To find optimum combination, choose

several combinations of P,T. Choose the combination that maximizes

profit.

The Two-Part Tariff

Two-Part Tariff With A Twist Entry price (T) entitles the buyer to a certain

number of free units• Gillette razors with several blades

• Amusement parks with some tokens

• On-line with free time

Pricing Cellular Phone Service

QuestionWhy do cellular (i.e. mobile) phone

providers offer several different plans instead of a single two-part tariff with an access fee and per-unit charge?

It allows suppliers to combine 3rd degree price discrimination with

the two-part tariff. Consumers sort themselves into groups on the basis

of which plan they want. These different groups have different

elasticities of demand.

Part 5 BundlingPart 5 Bundling

Bundling

Bundling is practice of selling multiple products in a package

Aimed at extracting maximum consumer surplus

Bundling can be: Pure: Practice of selling products only as a package.

Mixed: Practice of selling two or more goods both as a package and individually.

Bundling

Bundling in Practice Automobile option packages Vacation travel Cable television

Examples of Mixed Bundling

McDonalds (Value meals) Accommodation bundled with

meals Clothing (shirt bundled with tie) Microsoft products (e.g. you can

buy Word separately or choose a bundle)

Bundling

Mixed Bundling in Practice Use of market surveys to determine reservation

prices Design a pricing strategy from the survey results

Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.

Bundling

Tying Practice of requiring a customer to purchase

one good in order to purchase another. Examples• Xerox machines and the paper

• IBM mainframe and computer cards

• Mobil may require its service stations to sell only Mobil Oil

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.

Part 6 Part 6 Mark-up pricingMark-up pricing

Mark-up or cost-plus pricing

Percentage contribution margin( PCM): PCM = (Price-Marginal Cost)/ PricePCM= 1/ elasticity

%markup profit margin; desired rate of return on investment

Inelastic demand higher markup

Elastic demand lower markup

Part 7 SummaryPart 7 Summary

Summary

Firms with market power are in an enviable position because they have the potential to earn large profits, but realizing that potential may depend critically on the firm’s pricing strategy.

A pricing strategy aims to enlarge the customer base that the firm can sell to, and capture as much consumer surplus as possible.

Summary

Ideally, the firm would like to perfectly price discriminate.

The two-part tariff is another means of capturing consumer surplus.

Bundling can increase profits.

In-class revision exercises

What do you understand by 3rd degree price discrimination?

Two or more customer groups with different price elasticities – and therefore different demand curves - are charged different prices. These groups can be distinguished such as with concession passes (e.g. working people and pensioners), or eagerness or reluctance to pay a higher price (e.g. holiday travelers and business class travelers.). Use diagram. Can also draw a simpler diagram, assuming constant ATC and MC.

Discuss three different pricing strategies that an airline may use.

Airlines use an array of different pricing strategies, often simultaneously. These include:

third degree price discrimination (e.g. holiday travelers and business travelers);

peak load pricing when elasticities are lower, demand is higher, and running costs are higher due to capacity constraints (e.g. Sydney airport on Monday morning);

intertemporal pricing (e.g. advanced bookings are cheaper because the consumer is more flexible with schedules and likely to be more price sensitive, whereas if the consumer desperately needs to fly to a destination the next day, then demand is less elastic and be more willing to pay a higher price);

bundling (e.g. if you book hotel accommodation, multiple flight destinations and car hire, then each flight is relatively cheaper than if you just booked a single flight);

marginal cost pricing (e.g. as take-off time approaches, seats that remain empty, after the other pricing strategies have been exhausted, are sold off at ‘rock- bottom’ prices as the mc of each extra passenger is very low. Better to have seats at $50 than empty seats).

There are other strategies such as two part tariffs (e.g. frequent flyers club members pay a joining fee but then each flight [i.e. usage] is cheaper).

The objective of airline companies has been to discriminate more finely among travelers with different reservation prices. Over the past decade, Internet booking patterns and ‘data mining’ is making this easier for airlines than previously.

As one industry executive put it: “ You don’t want to sell a seat to a guy for $69 when he is willing to pay $400. At the same time, you would rather sell a seat for $69 than leave it empty” (cited Pindyck and Rubinfeld 2005: 393).

The End

Lecture 8 PSB Tri 3 09 Pricing GECO6410

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Transcript of Lecture 8 PSB Tri 3 09 Pricing GECO6410