Strategic Pricing:

Theory, Practice and Policy

Professor John W. Mayo

mayoj@georgetown.edu

Pricing Project Presentations

• Logistics - Rest of Course• Friday: Pricing project presentations, the logistics

• Affirmative presentations (Power point) 15-20 minutes• Q&A 10 minutes• Student questions encouraged• Professor Borner will help judge

• Today:• Pricing and “The Sound of Music”• Pricing in Vertical Settings

• Tomorrow:• The Psychology of Pricing

2

• Question: What should the price paid by TV stations (radio stations) be for music they play?

3

Industry Structure

4

Composers

PROs BMI ASCAPI

TV Stations InternetMedia

Retail consumers

$

Some options

• TV (radio) stations are losing customers to alternative (internet) media. With fewer customers and reduced advertising $, the price should fall.

• What is the value added to TV & Radio stations caused by the demand for music?

• The alternative? Individual contracting

• The competitive benchmark: Marginal cost• The “reasonable bounds”

• MC ≤ P ≤ Stand Alone Cost

• Practical: Price Cap

• Pt+1 = Pt + CPI – Productivity Change5

Vertical relations

• Review of Vertical Relations

• Transfer Pricing

Vertical relations

• Retail• Demand: Q= Q (Price, advertising, Sales outlets, etc)

• Wholesale• Demand: Q = Q (wholesale price, downstream demand)

retail

wholesale Upstream

Downstream

Double Marginalization

Q

P

mr

AC=MC

Pm

qm

Pr

Insufficient vertical control can diminish profits

This creates incentive for coordination/control across vertical stages

Two-part tariff Pw= πm +mc(Q)

qr

Alternatively, could set maximum retail price

Pricing and Competition in Vertical Markets

Q

P

mr

AC=MC

Pm

qm

Pr

qr

What is the relationship between the extent of downstream competition and the optimal upstream price?

Vertical relations, Retail competition and externalities

• Assume downstream competition• Assume that consumers receive valuable (but

costly to deliver) information at the retail stage • Free-rider problem • Possible solution: Resale price maintenance

• What about “generic” advertising?• Possible solution: Territorial restrictions

• What about generic manufacturer investments in retail stage (e.g. Training staff)

• Possible solution Exclusive dealing

Vertical restraints and the Law

• Resale price maintenance – • per se illegal until Leegin v. PSKS (2007), now Rule of

Reason

• Territorial restriction – Rule of Reason• Exclusive Dealing – Rule of reason• In Europe, Article 85 (1) – vertical restraints are

‘incompatible with the common market.” (but there is exception for technically or economically justified restrictions where consumers receive fair share of benefits.

Transfer Pricing

• Consider FedEX Office (aka Kinkos).• What price should FedEX Express Charge

FedEX Office for delivering an overnight package?

Office

FedEX

Should FedEX Office buy Express services at retail?

Transfer Pricing

• With no outside market

• With a competitive outside market

• With a non-competitive outside market

Transfer Pricing with no Outside Market

• Set transfer price of the input equal to the marginal cost of the upstream input

• A little economic manipulation shows that that with prices set equal to marginal cost, the incentives of decentralized, vertically related profit-centers are aligned.

Transfer Pricing

D

MRNMRu

MCu

MCd

To maximize profits, set the Transfer price equalTo the Net Marginal Revenue of the upstream input

P

Pu

Quantity

Transfer pricing with a competitive outside market

• Either buy upstream inputs from the market or sell upstream inputs into the competitive market depending on the relationship of the market price and your firm’s marginal input cost

Transfer Pricing with Competitive market

D

MRNMRu

MCu

MCd

Assuming a competitive world price of Pu, to maximize profits, produce qu and then purchase inputs out to Pu = NMRu)

P

Pu

Quantityqu Q*q1

Transfer Pricing Competitive market & high price

D

MRNMRu

MCu

MCd

Assuming a competitive world price of Pu, to maximize profits, produce qu and sell (qu –Q) in open marketP

Pu

QuantityquQ*

Why equate Pu and NMRu?

Efficient Component Pricing

Pricing with a non-competitive outside market: Efficient Component Pricing Rule

At what price should Verizon provide loops to a Competitive retail provider?

VerizonTelephone loops

Verizon RetailCompetitive

Local Exchange Company(CLEC)

The Critical Role of Economic Costs in Strategic Decision-making

At what price should Verizon provide loops to the CLEC?

Verizon Loops

VerizonRetail

CLECRetail:( R )

Wholesale: (W)

Suppose:PR = $15ICW = $4ICR = $5

Efficient Component Pricing Rule :

PW = ICW + (PR – ICW – ICR)