Slide 12005 South-Western Publishing

• Value-based more than cost-based pricing often helps build profits.

• Firms charge different customers different prices, which is known as price discrimination.

• This chapter also looks at pricing within a firm called transfer pricing.

• Pricing techniques that are used by many multi-product firms, such as full-cost pricing and target return pricing.

Pricing Techniques and Analysis Pricing Techniques and Analysis Chapter 10Chapter 10

Slide 2

Proactive Value-based Pricing• If the price doesn’t fit what customers are willing to pay,

then the product may not be profitable.• Customer value is the focus for pricing, not just the costs

associated with the product. • Apple Computer lost market share by ignoring customer

value.• The Ford Mustang was a success, as Ford found that

people wanted a sports car, but didn’t want it to be too expensive. The started with a price and designed the product.

• The Mustang used value-based, not cost-plus pricing

Slide 3

Intertemporal Pricing

• If at peak rush hour, the toll is higher than at the off-peak, we are using different prices at different time periods.

• The peak toll can encourage shifting travel patterns to off-peak times or discourage some commuting altogether.

• Intertemporal pricing appears more frequently than one thinks. This is just one variety of what is called price discrimination.

Slide 4

Figure 14.1 Page 605

• If the price at off-peak is POP is the same price as the peak, the traffic volume varies from QOP to QPEAK.

• If the price at the peak is P’P, the traffic volume varies less, from QOP to QC. DPEAKDOFF-PEAK

POP

QOP QC QPEAK

P’P

shift

Slide 5

Price DiscriminationPrice Discrimination Price Discrimination -- Goods which are

NOT priced in proportion to their marginal cost, even though technically similar

Some Necessary Conditions:1. Some Monopoly Power

• Otherwise, in pure competition, P = MC

2. Ability to Arbitrage• Separate customers and prevent reselling

Slide 6

Arbitrage - Buy Low to Sell Higher

• Arbitrage of Goods is Easy» Price discrimination of goods is ineffective

» Little price discrimination of grocery items

• Arbitrage of Services is Difficult» Price discrimination of services is effective

» Price discrimination at restaurants by age, as restaurant food is a service

» Lawyers charge different prices for wills, based on ability to pay

Slide 7

Ways to Separate Customers for Price Discrimination

1. Geography as when the price in the East-side and West-side differ

2. Income as the American Econ Association charges more to professors than students

3. Gender as when jeans for women are priced higher than similar jeans for men

4. Age as when kids get in at lower prices for movies

5. Time of day or season

6. Race as when shampoos targeted for African-American hair are priced differently that other shampoos, though technically the same.

7. Language as when products printed in Spanish are priced differently than those in English

8. Transient/Resident as when contracts pay less at hardware stores than other customers

9. Ability to Haggle when those how ask for a lower price get it

Slide 8

Why Price Discriminate?

• In Simple Monopoly, there is only one price

• Consumers receive a consumer surplus

• In Price Discrimination, monopolists can SCOOP OUT all consumer surplus

Q

D

MC

PSM

QSM

CS

Simple Monopoly

Slide 9

Perfect Price Discrimination(or 1st Degree Price Discrimination)

• Charge the MOST that a person is willing to pay for each good

• Zero consumer surplus• Produce MORE than

in Simple Monopoly• Output the same as in

Competition

QD

MC

Price Discriminating Monopoly

Q1st

Slide 10

Perfect Price Discrimination Does it Work for Car Dealers?

“How much do you plan to pay a

month?”

you inadvertently reply:

“$232 per month, and have a $3,000 down payment!”

At 6%, that’s about $12,000 for 60 months,

plus $3,000

Here’s one for only$15,000. It’s swell.

Slide 11

Notice: Incentives to Understate One’s True Willingness to Pay

• The conditions for perfect price discrimination are seldom met

• Hence, some close approximations exist

• There are are a variety of ways to group units to attempt to scoop out consumer surplus

Second Degree Price Discrimination: Units are Grouped

Slide 12

Two-Part Pricing• A price for the privilege

of buying items PLUS a price per item

• Examples:» Car rental per day with

mileage charges per mile

» Amusement parks

» Country Club Dues and Greens Fees

» Cover Charge to Enter a Bar and a Price Per Drink

CoverCharge

P

Q

Second Degree Price Discrimination:

Car renters may not know howmuch they will use the car (D1 or D2). They may prefer a lower rental rate (cover charge) with a per mile charge, P*.

D2

D1

Figure 14.2Car rental per day is the ‘CoverCharge’, and mileagefee at P or P*

P*

Slide 13

Unlimited Access

A specified price for an unspecified quantity:

Example: AOL unlimited access for $19.95/monthExamples: Salad Bars, Legal Retainers, HMO’s

Ounces of Salad

The area under the demandcurves represent most

willing to pay.

P

Second Degree Price Discrimination:

Slide 14

BundlingOften the pricing arrangement includes purchasing groups of dissimilar products. The products are bundled or sold as a block, as in theatrical or sporting tickets: Movies A & B and Theaters 1 & 2.

Preferences are uncorrelated Preferences are correlated

1

2

A B A B

150150 100

80 190190

250

270

160 200 = 360 simple monopoly

500 80 100100

165 175175

180

340

165 200 = 365 simple monopoly

360

Second Degree Price Discrimination:

Bundlingis more

Profitable.

Slide 15

Bundling & Mixed Bundling

• McDonalds sells Extra Value Meals, as a bundle of sandwich, fries, and a soft drink for less than it sells them separately.

• Selling both bundles and items separately is mixed bundling.» If Bob would pay $3 for a burger and $1 for a soft drink, and if

Mary would pay $2 for a burger and $2 for a soft drink, a bundle of $4 for both a burger and soda will work for both customers as a bundle.

» But if the price of a burger individually were $2.5 and a soft drink $1.50, then Bob would buy only a burger and Mary only a soft drink.

• Not everyone is alike, so mixed bundles succeeds with more customers.

Slide 16

One Price for All Regions

East West Market

MCMR

PM

Example with a Simple Monopoly Price (PM) in both markets

Slide 17

East West Market

MCMR

PM

Example with Different Prices in Each Market

PE

PW

MR

MR

Third Degree Price Discrimination

Slide 18

Mathematics of Price Discrimination

• Using elasticities P( 1 + 1/ ED ) = MC

• In two regions: P1( 1 + 1/ E1 ) = P2( 1 + 1/ E2 ) = MC

or: P1/ P2 = ( 1 + 1/ E2 )/( 1 + 1/ E1 )

• If the elasticities in region 1 and region 2 are -1.25 and -2.5 respectively, then P1/ P2 = (1+1/ -2.5)/(1+1/-1.25 ) = 3.

• Hence, P1 = 3P2.

• The price is three times higher in region 1, which less elastic.

Slide 19

• Products are INDEPENDENT when changes in price and quantity of one product do not alter revenues or cost in the others

• Products are INTERDEPENDENT, when changes DO affect other products

• Ex: Procter & Gamble makes both Luvs and Pampers» TR = TRA + TRB

Pricing of Multiple Product

Slide 20

Substitutes & Complements• Look for interdependencies in marginal

revenues:

» MRA = TRA / QA + TRB / QA

» MRB = TRA / QB + TRB / QB

• Substitutes when cross terms are negative» Erosion or Cannibalism are terms used, such as

Pampers & Luvs.

• Complements when cross terms are positive» Mitsubishi Electric sells DVD Players and blank DVDs

Slide 21

Decision Rule for Multiple Product Firms

• Do NOT use the rule to produce where MR=MC, as in MRA = MCA

• INSTEAD: » Produce where the FULL MR = FULL MC» For a Two Product Firm of A & B» Produce where:

TRA /QA + TRB /QA = TCA /QA + TCB /QA

Include all relevant revenue and cost effects

Slide 22

Pricing Example in Supermarkets

• Turkey prices fall during Thanksgiving» Yet we would expect DEMAND to be greatest?!

• Loss Leader Pricing» Consider T as turkey» and A as all other food

• TRstore = TRT + TRA

MRstore for turkey = TRT /QT + TRA /QT

• Complementarity with other food explains the apparent conundrum

3 ¢ / lb.with $10 purchase

Slide 23

Pricing in Practice

• In practice, pricing strategy involves the whole life-cycle pricing of the product.

• Managers report wide use of cost-plus pricing methods because it:» Streamlines pricing of multiple products

» Streamlines pricing of retail prices

Slide 24

Cost-Plus and Full Cost Pricing

P = ACn + Markup

or P = ACn(1 + m) where ACn is average cost at a normal output

and m is a percentage markup• Notice: Little reliance on MC pricing or use of

elasticities, as in: P( 1 + 1/Ep ) = MC

Slide 25

Full Cost Pricing• Full Cost--

» Covers all Costs at the standard or normal output » Plus a return on the investment

• P = VCl + VCm + F/Q + K / Q» Where VCl and VCm are unit labor cost and unit material cost

respectively (which is average variable cost).

» where K is the target amount of profit

» and is the desired profit rate and K is gross operating assets» Q is the number of units expected to be produced over this time

horizon.

Slide 26

Example: Low Tech SecurityStart a firm with F = 200,000, Q = 3000, total labor cost is $40,000 and total material cost is $50,000

= 20% and K=$500,000. Find Full Cost Price!

• Answer» P = VCl + VCm + F/C + (.20)(500,000)/Q

» P = 13.33 +16.67+ 30 + 66.67 + 33.33

= $130

• Also, suppose a 35% markup on average cost» P = [ AC] (1.35)

» P = [ 30 + 66.67 ](1.35)

» P = $130.50

Slide 27

Advantages & Disadvantages

• Cost-plus is simple• It is easy to delegate to

others• Easy to apply to

thousands of items» Can use categories

of markups for different classes of products

• But cost-plus ignores demand changes

• Pricing may be based on poor cost data

• Output varies in business cycle

Hybrid Method: VariableCost-Plus Pricing -- the markup can vary over the season, or business cycle

of cost-plus pricing

Slide 281999 South-Western College Publishing

Optimal Markups in Practice

• Grocery stores have low markups

• Many close substitutes -- at other grocery stores (bread varieties and qualities are standardized)

• Frequent purchase, so customers are knowledgeable about prices & quality

• Demand is therefore highly elastic

• Optimal markup would consequently be small

Slide 291999 South-Western College Publishing

Markups on Jewelry• Jewelry Markups are known to be large

• Difficult to make comparisons across jewelry stores

• Little repeat purchases, so knowledge about prices is low

• Consequently, lower price elasticity for jewelry

• The optimal markup is larger

Slide 301999 South-Western College Publishing

Skimming• Price declines over time• Those who wish to get it

first pays the highest price, others are willing to wait

• Examples:» Hardcover & Paperback

Books

» New electrical, computer products, and PDAs.

TIME

P D

Slide 31

Prestige Pricing

• Some products distinguish themselves by being noticeably expensive.» Mercedes, Audi, or BMW» Cartier jewelry

• The price is itself a way to distinguish the product from others

• Prestige Pricing is the practice of charging a high price to enhance its perceived value.» However, the firms typically have to spend a great deal in

promotional activities to convince customers that the product is prestigious.