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Managerial Economics and Organizational Architecture, Chapter 7

Pricing with market power


Pricing with market power learning objectives

Students should be able to

• Explain the role of elasticity in optimal pricing

• Identify circumstances appropriate for price discrimination

• Apply slected pricing techniques consistent with maximum profit


Pricing objective

A firm has market power if…

...it faces a downsloping demand curve.

The firm’s pricing objective is…

…to maximize shareholder value.

The demand curve reflects…

…consumer willingness and ability to buy.


Pricing with market power


The benchmark case:single price per unit

Beyond.com data:• Purchases software from manufacturer for $10• Demand curve is P = 85-.5Q (Q in 000s of units)

What is the profit-maximizing price?• Set MR = MC• 85-Q=10• Q=75, p=$47.50• Profit is $2,812.50 (000s)


Single price per unitCheckware


Other single pricing issues• Relevant costs

– sunk costs are irrelevant– current opportunity costs are relevant

• Price sensitivity– price elasticity, , is a measure of price

sensitivity– Optimal price is P*=MC*/[1-1/ *]– A firm with market power should never operate

on the inelastic portion of the demand curve


Price sensitivity and optimal markup


Estimating profit-maximizing price

• In theory, MC=MR, but in practice, manager may not know demand curve and therefore MR.

• Cost-plus or mark-up pricing may be useful approximations.

• But they must reflect fundamentals!


Linear approximation

Requirements: estimates of current price (P1), quantity sold (Q1), possible new price (P2), quantity sold with price change (Q2), and marginal cost

A linear demand curve is approximated by

P1=a-(P2-P1/Q2-Q1)Q1; solve for a

More generally, P=a-bQ


Cost-plus pricing

• Add a markup to average total cost to yield target return

• Does this ignore incremental costs and price sensitivity?– not if managers have a fundamental

understanding of their markets– consistently bad pricing policies are not good

for the firm’s long term fiscal health


Mark-up pricing

• Optimal mark-up rule of thumb:

P*=MC*/(1-1/*)

where * indicates estimated value

• Requires some knowledge or awareness of both marginal costs and elasticity


Potential for higher profits


Homogenous consumer demand

• Block pricing– declining price on subsequent blocks of product– product packaging

• Two-part tariffs– up-front fee for the right to purchase– additional fee per unit purchased– best when customers have relatively

homogenous demand for product


Two-part tariffcapturing consumer surplus


Price discriminationheterogeneous consumer demands

• Price discrimination occurs when firm charges different prices to different groups of customers– not related to cost differences

• Necessary conditions– different price elasticities of demand– no transfers across submarkets


Using information about individuals• Personalized pricing

– “first degree” price discrimination– possible only with small number of buyers

• Group pricing– “third degree” price discrimination– very common (utilities, theaters, airlines…)


Group pricingexample

Snowfish Ski Resort demand curves

Out of town: Qo=500-10P

Local: Ql=500-20P

Total: Q=1000-30P

One-price profit: P*=$21.66, Q*=350, Qo*=283, Ql*=67, Profit=$4,081

Two-price profit: Po*=$30, Qo*=200, Pl*=17.50, Ql*=150, Profit=$5,125


Optimal pricing at Snowfishdifferent demand elasticities


Using information about the distribution of demands

• Menu pricing– “second degree” price discrimination– consumers select preferred package

• Coupons and rebates– users likely more price sensitive– users who are new customers may stick with

product


Bundling and other concerns• Bundling may yield a higher price than if

each component is sold separately– theater season tickets– restaurant fixed price meals

• Multiperiod pricing– low initial price can “lock-in” customers

• Strategic considerations– low price may be barrier to entry