Pricing - University of Victoria - Web.UVic.caweb.uvic.ca/~pcourty/Chap 9-11.pdf · Emirates...

Pricing Pricing

Emirates AirlinesEmirates Airlines

Source: Emirates Airline, Reproduced with permission

Emirates Airline, Dubai-Mumbai, Economy class, May 2004

Fare Restrictions Price

Year KRTAE1 None AED 2250

(US$ 613)

Special Excursion QEE4MAE1

Min. 7 days, max. 4 mths stay

AED 1900QEE4MAE1 stay

Basic Season Special Excursion LLE4MAE1

Low season; min. 7 days, max 4 mths stay

AED 1550Excursion LLE4MAE1 max. 4 mths stay

Basic Season Special Excursion VLE4MAE1

Low season; min. 7 days, max. 4 mths stay

AED 1200

3(c) 2000-2007, I.P.L. Png & D.E. Lehman

y

Emirates Airline, Mumbai-Dubai, Economy class, May 2004

Fare Restrictions Price

Economy unrestricted None INR 25,600LRT (US$ 557)

Economy restricted LRTIN1

None INR 22,700LRTIN1

Regular Excursion LEE3M1

Min. 7 days, max. 3 mths stay

INR 20,100LEE3M1 mths stay

Special Excursion VEE3MIN1

Max. 3 mths stay. INR 17,000


Emirates AirlineEmirates Airline

Why does Emirates charge lower fare for passengers originating from Mumbai?

How is this discrimination possible?


VW Passat

Audi A6

What’s wrong ith d twith product

design?

OutlineOutlineOutlineOutline

if i i uniform pricing complete price

discriminationdiscrimination direct segment

discriminationdiscrimination indirect segment

discrimination bundling selecting the pricing


policy

Uniform PricingUniform Pricing


Uniform Pricing: Profit MaximumProfit Maximum

MR = MC

Equivalently, set the incremental margin percentage equal to the inverse of absolutepercentage equal to the inverse of absolute value of price elasticity of demand,

(price - MC) / price = -1/e(price MC) / price = 1/e


Uniform Pricing:Price ElasticityPrice Elasticity

always set price so that demand is elastic

if demand more elastic, then lower incremental margin percentage (IM%) g p g ( )

e = -2 IM% = 1/2e = -1.5 IM% = 2/3/


Uniform Pricing:PrivatePrivate--Label ColaLabel Cola

Suppose that WalMart learns that demand for private-label cola is less elastic than theprivate label cola is less elastic than the demand for Coca Cola. Should WalMart set a higher price for private-label

cola? Elasticity IM% Price = cost + margin Price = cost + margin


Contribution MarginContribution Margin

contribution margin % = (price - average variable cost) / price

if constant returns to scale: MC = AVC and IM% = CM%


Against Cost-PlusAgainst Cost-Plus

Impractical: How to determine mark-up?pWhat if production cost is almost zero?

Doesn’t maximize profit.p


Uniform Pricing: ShortcomingsShortcomings

leaves buyers with a lot of surplus

does not sell to everyb

$

does not sell to every potential buyer

buyer surplus

potential buyers

price

potential buyers

marginal cost


0 quantity

O tlineO tlineOutlineOutline

uniform pricing complete price discriminationp p direct segment discrimination indirect segment discrimination indirect segment discrimination bundling selecting the pricing policy selecting the pricing policy


Complete Price DiscriminationComplete Price Discrimination

Price each unit at buyer’s benefit and sell quantity where MB MCquantity where MB = MC

maximum profit - theoretical idealdifferent from MR = MC

I l t ti k l Implementation: must know entire marginal benefit and marginal cost curves


Complete Price Discrimination:PracticePractice

bargaining auctions


Complete Price Discrimination:Hong Kong Jockey ClubHong Kong Jockey Club

Club has monopoly over horse racing and betting in Hong Kongbetting in Hong Kong.

Rents 60 race-track boxes on seasonal basis to institutional clientsto institutional clients Box locations vary – clients prefer boxes

closer to finish line. “Rental” is minimum monthly F&B charge

based on seating capacity.


How to increase profit?

Direct Segment Discrimination IDirect Segment Discrimination, I

Price by segment

Implementationfixed identifiable characteristic - basic for

segmentationAge, gender, nationality, location

lno re-sale


Direct Segment Discrimination IIDirect Segment Discrimination, II

simple case: uniform price within each segment

within each segment IM% = -1/efor segment with more elastic demand,

then lower incremental margin percentage (IM%)


Direct Segment Discrimination IIIDirect Segment Discrimination, III


Direct Segment Discrimination:“Not for Retail Sale”“Not for Retail Sale”

Heinz serves

• institutional customers (food service, restaurants) directly

• retail customers indirectly through supermarkets and g pgrocery stores


Internet ServicesInternet Services

residential -- $30-50/month business – over $100/month

How is discrimination possible?


Direct Segment Discrimination:LocationLocation

Free on board (FOB) price - does not include deliveryinclude delivery

Cost including freight (CF) price - includes d lidelivery

conventional productsdigital productsdigital products


Direct price discrimination: Gray MarketsGray Markets

Price differential parallel imports Retailers: Hong Kong music stores source music CDs g g

through parallel imports Consumers: 2 million U.S. consumers buy drugs from

Canadian pharmacies (on-line)

Managing the gray market packaging packaging warranty service technical differentiation


Asian Wall Street JournalAsian Wall Street Journal

Price for annual subscription, May 2006

Print: Hong Kong (HK$ 2 700) US$ 348Print: Hong Kong (HK$ 2,700) US$ 348

Print: Singapore (S$ 525) US$ 331

k ( ) $Print: Tokyo (Yen 94,500) US$ 845

Interactive: Worldwide US$ 99

Why different prices for print edition but not interactive


y p pedition?

Indirect Segment DiscriminationIndirect Segment Discrimination

Structure choice to earn different incremental margins from each segmentmargins from each segment

Implementationp seller controls some variable to which segments

are differentially sensitive buyers cannot circumvent the variable


Air Travel: Air Travel: BenefitsBenefits

Unrestricted Restricted Traveler Segment

UnrestrictedTravel ($)

RestrictedTravel ($)

Maria Business 1000 200Tom Business 900 180 R bi V ti 500 400Robin Vacation 500 400Leslie Vacation 280 224


Air Travel: Air Travel: Indirect Segment DiscriminationIndirect Segment Discrimination

P d t

F S lTotal R

Total C t

P fitProduct Fare

($) Sales Rev.

($) Cost($)

Profit($)

U t i t d 900 2 1 800 400 1 400Unrestricted 900 2 1,800 400 1,400

Restricted 399 1 399 200 199

*MC=200


Chinese Embassy: Visa FeesChinese Embassy: Visa Fees

Application periodpp p

1 day 3 days 7 days

Single entry $75 $60 $25

Double entry $85 $70 $35Double entry $85 $70 $35


Pricing Policies: RankingRanking

Profitability Policy Information Requirementq

Highest Complete price discrimination

Highest

Di t t Direct segment discrimination

Indirect segment Indirect segment discrimination

Lowest Uniform pricing Lowest


OutlineOutline



BundlingBundling

strategy pure bundlingmixed bundling

implementationd d ff b f f segments derive different benefits from

separate products negatively correlated preferences negatively correlated preferences low marginal cost


Cable Television: Cable Television: BenefitsBenefits

“if every segment … was wild about one thing and hated the rest, they have done thei job” (Economist)their job” (Economist) Segment Education MusicSegment Education

channel Musicchannel

Conservatives $20 $ 2

Middle of road $11 $11


Pure or Mixed BundlingPure or Mixed Bundling

What is the profit-maximizing pricing policy if marginal cost per channel = 0g p marginal cost per channel = $5


Ace RentAce Rent--aa--Car of Perth,Car of Perth,,,Western Australia (2004)Western Australia (2004)

Toyota Camry rental

unlimited mileage – A$ 288 for four days

time and mileage rate – A$ 216 for four days including 400 free kilometers plus additional mileage g p gcharge 25c per kilometer


Microsoft Office 2007Microsoft Office, 2007

Home and student Standard Profession

al Ultimate

Regular price $149.99 $399.99 $499.99 $699.99

Academic price $139.85 $134.85 $169.85 $249.85


OutlineOutline



CannibalizationCannibalization

“business travelers were contorting their schedules to .. qualify for fares with leisure travel restrictions”

Northwest VP Tom Bach

degrade low-end item upgrade high-end item


CannibalizationCannibalization

d Low-margin item draws customers away from higher-margin product.P ibl l ti Possible solutions: Limit availability of low-end item

S d b h l Separate distribution channels Product design

D d l d itDegrade low-end itemUpgrade high-end item


VW Passat

Audi A6

What’s wrong ith d twith product

design?

Information technologyInformation technology

More discrimination more data on

More price competition (less

more data on buyers

easier to

discrimination) easier to

icustomize products

online auctions

compare prices

online auctions


Information ProductsInformation Products

music, computer software, novel: once content is created, marginal cost is almost zero

offer multiple versions on-line stock prices: real-time/delayed computer software: Pro/Regular novels: hard cover/paperback


Strategic Thinking

Coke vs Pepsi 1999Coke vs. Pepsi, 1999

Nov. 16: Coca-Cola raised price 7%

Nov. 22: Pepsi raised price 6.9%

“Coke and Pepsi will move now from price-based competition to marketing-based

i i ”competition”,Andrew Conway, Morgan Stanley


Strategic SituationsStrategic Situations

parties actively consider the interactions with one another in making decisions

game theory -- set of ideas and principles to guide strategic thinking simultaneous actions: strategic form sequential actions: extensive form



Nash equilibrium randomized strategiesg coordination / competition sequencing sequencing strategic moves


Radio FormatsRadio Formats

Merkur

Lite AC no change

JupiterHot AC J: 60,

M: 40J: 60,

M: 40p

no change J: 70,M: 30

J: 50,M: 50


M: 30 M: 50

Nash EquilibriumNash Equilibrium

Given that the other players choose their Nash p yequilibrium strategies, each party prefers its own Nash equilibrium strategy

No one is willing to deviate unilaterally from a h l bNash equilibrium


Nash Equilibrium:Dominated StrategyDominated Strategy

Generates worse consequences than another strategy, regardless of the choices of the otherstrategy, regardless of the choices of the other parties

d i t d t t never use dominated strategy


Nash Equilibrium:SolutionSolution

eliminate dominated strategies, then check remaining cells

“arrow” technique


Nash equilibrium:Radio formatsRadio formats

Merkur

Lite AC no change

J: 60 J: 60

Jupiter

Hot ACJ: 60,

M: 40J: 60,

M: 40

J: 70 J: 50Jupiterno change

J: 70,M: 30

J: 50,M: 50


Nash equilibrium:Prisoners’ dilemmaPrisoners’ dilemma

Samsung

Do not confess ConfessDo not confess Confess

Do not I: 0, I: -10,Infine

on

Do not confess S: 0 S: 0

I: 0 I: -5Confess

I: 0,S: -10

I: 5,S: -5


What should Samsung do?

Nash equilibrium:Competitive dilemmaCompetitive dilemma

Pepsi

Raise price DiscountRaise price Discount

Raise priceC: 3,

P: 3C: 0,

P: 5

Coke

Raise price P: 3 P: 5

DiscountC: 5, C: 1,

Discount P: 0 P: 1

What should Coke do?


What should Coke do?

OPEC: Oil CartelOPEC: Oil Cartel

June 1998: Saudi Oil Minister Naimi, “I don’t think anybody expects 100% y y pcompliance… Once the price goes up, there will be cheating”gMarch 1999: Algerian Oil Minister Youcef Yousfi “OPEC is still able to actYoucef Yousfi, OPEC is still able to act collectively and restore market stability”


Resolving Competitive DilemmaResolving Competitive Dilemma

repetition -- using punishment strategy Saudi Arabia is low-cost producerp

commitment to raise price / not to cut price Pepsi separated franchisor / bottlep p / price-matching


Out of Nash EquilibriumOut of Nash Equilibrium

What if another player doesn’t play Nash equilibrium strategy? Nash equilibrium strategy may not be best still don’t use dominated strategygy


OutlineOutline

Nash equilibrium Randomized strategiesg Coordination / competition Sequencing Sequencing Strategic move


Randomized StrategiesRandomized Strategies

choose among pure strategies according to probabilities

must be unpredictable


Randomized strategies:Retail price competitionRetail price competition

Two competing retailers – Jaya and Ming Three segments Three segments

captive (loyal) to Ming captive (loyal) to Jaya captive (loyal) to Jaya switchers



Ming

Hi h i L iHigh price Low price

High price J: 60, J: 40,Jaya M: 40 M: 50

Low price J: 50, J: 50,Low price J: 50,M: 40

J: 50,M: 30



Pricing trade-off:hi h i t t t b l f l l high price to extract buyer surplus of loyal customers

low price to get store switchers low price to get store switchers Solution: randomized discounts


OutlineOutline



Coordination/competition:Evening newsEvening news

Delta

7.30pm 8.00pm

7 30A: 1, A: 3,

Zeta

7.30pmB: 1 B: 4

8 00pmA: 4, A: 2.5,

8.00pmB: 3 B: 2.5


Coordination/Competition:Zero/Positive SumZero/Positive Sum

zero-sum games: pure competition -- one party better off only if other is worse off

positive-sum games: coordination -- both can be better off or both worse off

co-opetition: competition and coordination


Coordination/Competition: Instant Messaging TechnologiesInstant Messaging Technologies

Venus Inc.

Orange Green

Sol Corp.Orange S: 1.5

V: 1.5S: 1

V: 1p

Green S: 1V: 1

S: 1.5V: 1.5


V: 1 V: 1.5

Coordination/competition:Future DVD standard

Consumers

Blu-ray HD-DVD

M: 1 M: -1

DVD player manuf-

Blu-rayM: 1,

C: 1M: 1,

C: -1

M: -1 M: 1manufacturers HD-DVD

M: 1,C: -1

M: 1,C: 1


Coordination/Competition: Focal PointFocal Point

Single Nash equilibrium - clear focal point

Multiple Nash equilibria - look for focal point to see which one to play


OutlineOutline



SequencingSequencing

Game in extensive form – sequence of moves:

nodes odesbranchesoutcomesoutcomes


Sequencing:Extensive FormExtensive Form

backward induction final nodes intermediate nodes initial

node


Sequencing:Extensive FormExtensive Form -- TV NewsTV News



Nash equilibrium randomized strategiesg coordination / competition sequencing sequencing strategic moves


Strategic MoveStrategic Move

Action to influence beliefs or actions of other parties in a favorable way

• Credibility- irreversible commitment

• First mover advantage• Second mover advantage• Second mover advantage


Strategic Move:LithographerLithographer

(1) serial number (2) destroying the plate


(2) destroying the plate(3) other solution?

Strategic Move:LockLock--InIn

sunk costs – learning, complementary hardware – become switching costs

lock-in strategy initially, price low/free to lock in buyer exploit later

counter lock-in competitive upgrade


Strategic Move:LockLock--Out Verizon WirelessOut Verizon Wireless

Los Angeles wireless market dominant: Verizon and Cingular dominant: Verizon and Cingular entrants: AT&T and Sprint

Verizon Digital Plus 200: 1000 free minutes of Verizon Digital Plus 200: 1000 free minutes of calls to/from another Verizon customer


Pepsi’s Strategic MovePepsi s Strategic Move

1995-99: intense price war Nov. 99:

Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9% “C k d P i ill f i b d “Coke and Pepsi will move now from price-based

competition to marketing-based competition” (Andrew Conway, Morgan Stanley)

How did they get out of price war? Mar. 99: Pepsi spun off Pepsi Bottling Group (PBG)


C di i l S i MConditional Strategic Moves

Threats – if it succeeds, then it needn’t be carried outcarried out

Promises – if it succeeds, then it needn’t be carried out

Ideal strategic move doesn’t impose costs


Morgan Stanley:“Shareholder rights plan”“Shareholder rights plan”

If any party acquires 15% or more of company’s shares other shareholders getcompany’s shares, other shareholders get right to buy additional shares at 50% discount.discount. Impact on hostile bidder?Good or bad for shareholders?Good or bad for shareholders?


Conditional Strategic Move:Poison PillPoison Pill


Conditional Strategic Move:TwoTwo--Tier Takeover BidTier Takeover Bid


Conditional Strategic Move:StrikeStrike


Why are strikes rarer in American professional football than in baseball?

Conditional strategic move: Without deposit insurance

b k idepositor

maintains

bank remains solvent

principal + interest

depositor

deposit bank insolvent zero

depositor

withdraws d it

principalbank remains solvent

deposit

principalbank insolvent


Conditional strategic move: With deposit insurance

b k idepositor

maintains

bank remains solvent

principal + interest

depositor

deposit bank insolvent principal

depositor

withdraws d it

principalbank remains solvent

deposit

principalbank insolvent


RepetitionRepetition

expanded strategies: condition actions on actions of other partiesp external events


Repeated CartelRepeated Cartel

tit-for-tat Axelrod’s rules

do not strike first reciprocate both good and badp g act simply and clearly do not be envious


Oli lOligopoly

U.S. Wireless Telecommunications Industry: does the Sprint/NEXTEL merger y p / g

increase or decrease competition?

• 62.0 million subscribers

illi b ib• 60.7 million subscribers

•• 53.6 million subscribers53.6 million subscribers


OligopolyOligopoly

Oligopoly is a market with a small number of sellers whose actions are interdependent

A duopoly is a market with two sellers



pricing capacity capacity price/capacity leadership t i i titi restraining competition antitrust (competition) policy


Pricing: MonopolyPricing: Monopoly


Homogenous ProductHomogenous Product

Bertrand model: sellers who produce at constant marginal cost with unlimited capacity compete on price

Suppose one of the two firms charges price p, above marginal pp g p p, gcost

The other firm has three choices: price > p: lose all customersprice p: lose all customersprice = p: split the market in halfprice < p: gain the whole market, even marginally below p P i i j t b l i t fit bl Th l i ld Pricing just below p is most profitable. The same logic would

apply to the other firm. So, the Nash equilibrium is for both firms to charge price = p.


Differentiated ProductsDifferentiated Products

Sellers compete partially on price, partially on product design/placement


Pricing: Differentiated ProductsDifferentiated Products

the Hotelling model of duopoly


Pricing: Differentiated ProductsDifferentiated Products


Differentiated sellers: best response price functions

Pricing:Product DesignProduct Design

Desire for market share leads firms to locate “close” to their customers

Desire to avoid direct competition leads firms to locate away from their competitor (less differentiation leads to more direct price competition)O ti l l ti i l t d ff Optimal solution is a complex tradeoff


Pricing:Strategic ComplementsStrategic Complements

Actions are strategic complements if an adjustment by one party leads other parties to adjust in the same direction

Example: if Ajax lowers price and Bacchus responds by lowering price, then prices are strategic complements


Capacity CompetitionCapacity Competition

Cournot model: sellers produce at constant marginal cost and compete on production capacity (homogeneous product)

Residual demand curve: market demand less the quantities supplied by other sellers

Best response functions show the best it h i f h ll f ticapacity choice for each seller as a function

of the other seller’s capacity choices


ExampleExample

Mars Cellular and Pluto Wireless compete on capacity

Market demand = 300 – 3p Marginal cost = $30/subscriber/monthg $ / /


Capacity CompetitionCapacity Competition

Residual Demand Curves


CapacityCapacity

Best Response Capacity Functions


Capacity:Cost DifferencesCost Differences

A decrease in marginal cost for one firm will lead to an increased market share for that firm and a decreased market share for thefirm and a decreased market share for the other firm

This is seen by shifting outward the best This is seen by shifting outward the best response function of the firm with the lower marginal cost

Changes in fixed costs do not shift the best response functions


Capacity:Multiple SellersMultiple Sellers

With multiple sellers with differing marginal cost, the incremental margin percentage in the industrypercentage in the industry can be represented by

HHI

pcp

)(

where HHI is the Herfindahl –Hirschman Index is the

p

cHirschman Index, is the industry weighted average cost, and is the elasticity of demand.

c


Capacity:Strategic SubstitutesStrategic Substitutes

Actions by various parties are strategic substitutes if an adjustment by one party leads other parties to adjust in the opposite direction

Capacity levels in the Cournot model are strategic substitutes


Las Vegas StripLas Vegas Strip

Group No. of hotels (1995)

Hotels added (1996-

Hotels added (1999-

Average occupancy

June 30, 200

Average occupancy

June 30, 200

Average daily room

1 –June 30,

Average daily roo m

1 –June 30, -97)

-2000)

Jan. 1 –04 Jan. 1 –05

m rate Jan. 2004

m rate Jan. 2005

MGM Mirage 1 (MGM Grand) 1 (New York, New York)

3 (Mirage, TI, Bellagio)

96.3% 97.6% $159 $173

Mandalay Resort Group

3 (Luxor, Circus-Circus, Excalibur)

1 (Monte Carlo ) 1 (Mandalay Bay) 92% 93% $121 $131

Other notables Caesar’s Palace, Aladdin

Stratosphere Venetian, Paris


Price LeadershipPrice Leadership

Consider and industry with fixed costs and a market leader

The leader can use a first mover advantage by choosing output and price to create a residual demand curve for a potential entrant that leaves no room for profitThi i k “li it i i ” This is known as “limit pricing”


Price/Capacity Leadership:PricePrice


Price/Capacity Leadership:CapacityCapacity

The Stackelberg Model: the leader commits to capacity before the followerh l d k h f ll ’ The leader takes into account the follower’s

subsequent choice of capacity The result is an industry production capacity greater The result is an industry production capacity greater

than in Cournot competition (with a lower price) The leader has a larger market share than the

follower (first mover advantage, even though the follower gets to observe the leader’s capacity before choosing its capacity)


choosing its capacity)


pricing capacity capacity price/capacity leadership e t i i o etitio restraining competition antitrust (competition) policy


Restraining Competition:CartelsCartels

Cartels are agreements among sellers (or buyers) to raise the price above (below, for a buyers’ cartel) the competitive levelbuyers cartel) the competitive level

Cartels are generally illegal Where legal their effectiveness will depend Where legal, their effectiveness will depend

on the number of sellers, the relation of industry capacity to market demand, the y p y ,extent of sunk costs, the extent of barriers to entry and exit, and the homogeneity of the product


product

Restraining Competition:Horizontal IntegrationHorizontal Integration

Horizontal integration is the combination of two entities in the same, or similar, businesses under a common ownership.

Vertical integration is the combination of the assets for two (or more) successive stages of production under a common ownership.H i t l i t ti h th t ti l t Horizontal integration has the potential to increase market power.


Antitrust (Competition) Policy:Competition LawsCompetition Laws

Prohibit collusion on price or other means Prohibit monopolies or monopsonies from p p

abusing market power Prohibit mergers or acquisitions that would g q

substantially lessen competition in the market.


Antitrust (Competition) Policy:Merger GuidelinesMerger Guidelines

Post-merger HHI

Increase in HHI

0 50 50 100 1000 - 50 50 - 100 > 100

> 1 800 safe suspect suspect> 1,800 safe suspect suspect

1,000 – safe safe suspect1,8000 – 1,000 safe safe safe


SummarySummarySummarySummary

Prices are strategic complements Production capacities are strategic substitutes Sellers who can commit to capacity before their Sellers who can commit to capacity before their

competitors may have a first mover advantage, potentially to the point of excluding all potential entrantsentrants

Restraining competition – either through agreement or horizontal integration – can increase profits for sellerssellers

Anti-trust (competition) authorities monitor industry behavior. The Herfindahl-Hirschman Index is a commonly used gauge for screening mergers


commonly used gauge for screening mergers

Pricing - University of Victoria - Web.UVic.caweb.uvic.ca/~pcourty/Chap 9-11.pdf · Emirates...

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