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Advanced Pricing Strategies
Herbert Stocker
Institute of International Studies
University of Ramkhamhaeng
&
Department of Economics
University of Innsbruck
Pricing with Perfect Competition
Perfect Competition:Pricing without market power (perfectcompetition) is determined by market supplyand demand.Every supplier perceives demand for his ownproduct as perfectly elastic. Therefore, he hasto accept market prices as they are, he is aprice-taker.The individual producer must be able toforecast the market and then concentrate onmanaging production (cost) to maximizeprofits.On perfectly competitive markets you willrarely see advertisement. Why?
Pricing with Market Power
Pricing with market power (imperfectcompetition) requires the individual producerto know much more about the characteristicsof demand as well as manage production.
Monoplist is a price-searcher, he producesquantity where MR = MC and charges themaximum price that consumers are willing topay.
The same logic is essentially true for firms onmonopolistic competitive markets!
Under certain conditions, firms can catch evenhigher profits!
Markup Pricing
Remember: The condition for profitmaximizing MR = MC gave us
MR = P [1 − (1/|EQ,P|)] = MC
This can be rearranged to express price directlyas a markup over marginal cost
P =MC
[
1 − 1|EQ,P |
]
If e.g. |EQ,P | = 2 thenP = MC/(1 − 0.5) = 2 × MC,i.e. the monopolist charges double MC!
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Capturing Consumer Surplus
All pricing strategies we will examine are means ofcapturing consumer surplus and transferring it tothe producer:
ProducerSurplus
P
Q
D
MR
MCbc
bc
ProducerSurplus
P
Q
D
MR
MCbc
bc
A: The firm would like to charge higher price
to those consumers willing to pay it.
B: Firm would also like to sell to theseconsumers but without lowering
price to all consumers.
bc
bc
Both ways would allow
the firm to capture
more consumer surplus.
Price Discrimination
Price Discrimination
Price Discrimination: The practice ofcharging different prices to various customersthat are not based on differences in the costs ofproduction.The three requirements for successful pricediscrimination are that:
The firms possess some degree of market power.The firms have the ability to separate customersinto different groups that have different priceelasticities of demand.The firms have the ability to prevent resale amongthe different groups of customers.
Price Discrimination
Two important effects of price discrimination:It can increase the monopolist’s profits.It can reduce deadweight loss.
Price Discrimination can benefit someconsumers and hurt others.
Economists distinguish different kinds of pricediscrimination:
– First degree price discrimination– Second degree price discrimination– Third degree price discrimination
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First Degree Price Discrimination
First Degree Price Discrimination: Charge aseparate price to each customer: the maximumor reservation price they are willing to pay.
If the firm can price discriminate perfectly, eachconsumer is charged exactly what they arewilling to pay.
MR curve is no longer part of output decision.Incremental revenue is exactly the price atwhich each unit is sold – the demand curve
First Degree Price Discrimination
Perfect Price Discrimination:
firm can reap all the consumer surplus!
P
Q
D
MR
MC
ProducerSurplus(Profit)
First Degree Price Discrimination
In practice, perfect price discrimination isalmost never possible:
Impractical to charge every customer a differentprice (unless very few customers).Firms usually do not know reservation price of eachcustomer.
Sometimes, firms can discriminate imperfectly(e.g. lawyers, doctors, accountants).
Second Degree Price Discrimination
Assumes that firms charge maximum priceconsumers are willing to pay for differentblocks of output (non-linear pricing).
Each customer faces same price schedule, butpays different prices depending on quantitypurchased.
Example is quantity discounts.
Second-degree price discrimination increasesthe revenue and the profit for the firmcompared to charging a single price, but theseincreases are smaller than under first-degreediscrimination.
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Second Degree Price Discrimination
Second Degree Price Discrimination: Quantitydiscounts can increase producer surplus.
P
Q
D
MR
MC
P1
Q1
P2
Q2
P3
Q3
P4
Q4
bc
bc
bc
bc
Two-part pricing
Two-part pricing: charging customers a fixedfee for right to purchase product, then avariable fee that is a function of the number ofunits purchased.
A fee is charged upfront for right to use/buythe product; An additional fee is charged foreach unit the consumer wishes to consume.
Examples: amusement park, golf course,telephone service.
Pricing decision is setting the entry fee (A) andthe usage fee (f ).
Two-part pricing
Total Expenditure (TE) for Q units is
TE = A + fQ
Average price (P) is
P =TE
Q=
A + fQ
Q=
A
Q+ f
Average price decreases with quantity bought.
Two-part pricing
P =A
Q+ f
When consumers have identical demands,entire consumer surplus can be captured bysetting
f = MCA =consumer surplus (CS)
Optimal usage fee and access charge are moredifficult to determine with more groups ofbuyers with different demand.
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Two-part pricing Third Degree Price Discrimination
Third-Degree Price Discrimination: A pricingstrategy under which firms with market powerseparate markets according to the priceelasticity of demand and charge a higher price(relative to cost) in the market with the moreinelastic demand.
This is the most commonly used form of pricediscrimination.
A higher price is charged in the market withthe relatively more inelastic demand.
Examples: airlines, premium vs. non-premiumliquor, discounts to students and seniorcitizens, frozen vs. canned vegetables.
Third Degree Price Discrimination
$
0
Market 2 Market 1
QuantityMarket 2
QuantityMarket 1
MCD1MR1
P1
Q∗1
D2
MR2
P2
Q∗2
b
b
b b
(For simplicity we assume constant marginal cost!)
Price Discrimination with increasing MC
Y
X
MC
MC must equal total MR!
Total MR is the horizontalsum of individual MRs.
bc
MRtot = MC
bcbc
b
Q∗1
P∗1
b
Q∗2
P∗2
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Third Degree Price Discrimination
Examples:College students and senior citizens are notusually willing to pay as much as othersbecause of lower incomes.
These groups are easily distinguishable with ID’s.
Price reductions for locals in ski resortsLocals are easily distinguishable by their dialect.
Hardback vs. paperback books:Company divides consumers into two groups:Those willing to buy the more expensive hardbackand those willing to wait for the paperback.Publishers typically wait 12 to 18 months
Coupons and Rebates
Those consumers who are more price elasticwill tend to use the coupon/rebate more oftenwhen they purchase the product than thoseconsumers with a less elastic demand.
Coupons and rebate programs allow firms toprice discriminate.
About 20 – 30% of consumers in the USA usecoupons or rebates.
Firms can get those with higher elasticities ofdemand to purchase the good who would notnormally buy it.
Coupons and Rebates Airline Fares
Differences in elasticities imply that somecustomers will pay a higher fare than others.
Business travelers have few choices and theirdemand is less elastic.
Casual travelers and families are moreprice-sensitive and will therefore be choosier.
There are multiple fares for every route flownby airlines.They separate the market by setting variousrestrictions on the tickets:
Stay over weekend or return on same day.Most expensive: no restrictions – first class.
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Bundling
Bundling: where products are sold separatelybut also as a bundle which is less than the sumof prices as if they had been sold individually.Conditions necessary for bundling:
Heterogeneous customers.Price discrimination is not possible.Demands must be negatively correlated.
Examples: Microsoft, restaurants, carpurchasing, vacation travel, . . .
Bundling
Tying
Tying: The practice of requiring a customer topurchase one good in order to purchaseanother.Examples:
Xerox machines and the paper.IBM mainframe and computer cards.
Allows firm to meter demand and practice pricediscrimination more effectively.
Cost-Plus Pricing
Common technique for pricing when firms donot wish to estimate demand and costconditions to apply the
MR = MC
rule for profit-maximization.
Price charged represents a markup (margin)over average cost:
P = (1 + m)ATC
where m is the markup on unit cost.7
Cost-Plus Pricing
Cost-Plus Pricing does not generally produceprofit-maximizing price!
Fails to incorporate information on demand &marginal revenue.Uses average, not marginal, cost.
Pricing and Macroeconomics
Macroeconomic conditions can influence pricing:
Overall economic conditions influence markupand price discrimination.
Periods of long-run economic expansion makeconsumers less cost-conscious and morevalue-conscious (demand is more priceinelastic).
However, ability to raise prices differs amongsectors of the economy.
Firms become rigid when they think other firmswill not follow price increases.
Price Elasticity & Pricing inMarketing
Managerial Price Sensitivity Analysis
The price elasticity of demand (in marketingliterature often called price sensitivity) is one ofthe most important variables for managers.
A managerial analysis of price elasticity shouldbe a written document that can be criticizedand improved over time.
It should include some of the followingquestions:
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Reference Price
Substitutes and Reference Price:
Are there close substitutes to the product, and ifso, are the buyers (or a segment of buyers) usuallyaware thereof when making a purchase?To what extent can buyers price expectations beinfluenced by the positioning of one brand relativeto particular alternatives?Can buyers speed up or delay purchases based onexpectations of future prices?
Reference Price
How difficult is it for buyers to compare offersof different suppliers?
Can the attributes of the product be determined byobservation, or must the product be tested?Is the product highly complex, or are there fewreliable cues for ascertaining quality?Does the product need after-sale service, likepreventive maintenance or repairing, and how doesafter-sale service compare with competitors’?Have most consumers past experiences with thisproduct, or is it in it’s early stages of life-cycle?
Switching Cost Effect
To what extent have buyers already madeinvestments (monetary and/or psychological)that they would need to incur again if theyswitched suppliers?
For how long are buyers presumably ‘locked’ bythose expenditures?
Expenditure Share
How significant are buyers expenditures for theproduct?
For end consumers mainly the portion of income isimportant.For business customers also the absolute pricemight be important.
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End-Benefit
What end-benefit do buyers seek from theproduct? (e.g. fishing ↔ fishing rod).
How price sensitive are buyers to the cost ofthe end benefit?
What proportion of the end benefit does theprice of the product account for?
Does the customer pay the full cost of theproduct, or is it e.g. deductible from tax?
Fairness
Buyers are more sensitive to a product’s pricewhen it is outside the range that they perceiveas ‘fair’ or ‘reasonable’.
How does the current price compare with pricespeople have paid in the past?
What do buyers expect to pay for similarproducts?
Do customers perceive the product as‘necessity’ or as a discretionary purchase?
Framing Effect
Prospect Theory: (D. Kahneman & A.Tversky)Essential idea: people ‘frame’ purchasingdecisions in their minds as a bundle of gainsand losses.
Consumers tend to be more price sensitivewhen they perceive the price as a ‘loss’ ratherthan a foregone ‘gain’.
Additionally, they are more price sensitive whenthe price is paid separately rather than as partof a bundle.
Framing Effect
Example: (Prospect Theory)Gas station A sells gasoline for $1.20 and gives a$0.10 per liter discount if the buyer pays with cash.Gas station B sells gasoline for $1.10 and charges a$0.10 surcharge if the buyer pays with credit card.
Most people choose station A.
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