Topic 6: Mass Market Pricing

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Topic 6 Mass Market Pricing

• How to set prices in mass markets
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Posted versus negotiated prices

• In mass markets, it is more convenient to simply
  post a price
• Consumers whose willingness-to-pay is above that
  price will purchase from you
• Consumers will lower their own demand and just
  purchase units for which their WTP for that unit
  exceeds price

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Looking forward ...

• Mass market demand
• Relationship between revenue and demand
• Elasticity of demand
• Profit-maximising price levels
• Price discrimination

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Mass Market Demand

• The monopolist faces a demand schedule or curve
• This describes the number of units the monopolist
  will sell for any given price
• The market demand curve is found by summing up
  the willingness-to-pay curves of all potential
  consumers

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Puzzle Luxury Boxes

• Among the many decisions made by sports stadium
  designers is the number of luxury boxes to build
• Suppose that, for a particular stadium under
  construction, luxury boxes will be sold outright
  to local businesses and can be constructed at a
  cost of 300,000 apiece. The stadium designer
  plans to build 25 boxes and expects, at this
  number, to sell each for 1 million, for a net
  profit of 700,000 x 25 17.5m
• An associate asserts that this is crazy. Since
  the boxed can be build for 300,000 and sold for
  around 1m apiece, building only 25 leaves money
  on the table, even if a small price reduction is
  needed if more are built
• Is the associate correct? What if the price to
  sell 26 is 950,000?

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Demand curves

• When a seller faces a mass market then we can
  summarise their information about the market by a
  demand curve
• A demand curve is the sellers best prediction as
  to how many units of the product he can sell for
  any specific posted price

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Example

• Your firm produces a small motor scooter which it
  sells to the mass consumer market. Your market
  research people tell you that you
• You will make no sales at a price above about
  1000. At that price, you are simply not
  competitive.
• Every reduction in price by 200 should increase
  sales by about 200,000.
• Even if the price is very low, you will not sell
  more than about 1,000,000 motor scooters as this
  is the total size of the market for these
  machines.

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Example (cont)

• The market information about customers can be
  summarised in a table (as above) or in a diagram
  (next page) a graph that shows the expected
  unit sales associated with each price

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Example (cont)
Price
Demand curve for motor scooters
1000
800
600
400
Expected unit sales (000s)
200
0
400
600
800
1,000
0
200
10
What does a demand curve look like?

• It slopes down
• Why common sense!
• Other than this, it can be pretty much any shape!
• Note it does not have to be a straight line!
• Note it does not have to be smooth

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Demand curves and WTP

• Note that the height of the demand curve at any
  quantity represents the WTP of the marginal
  consumer at that level of output
• If we read the demand curve from price to
  quantity then it tells us how much we will sell
  in total at a given price
• If we read the demand curve from quantity to
  price then it tells us what is the
  willingness-to-pay for the consumer who just buys
  the last unit given the total number of units
  sold?

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Demand curves and WTP example
Suppose we are selling tickets to a concert.
There are five people interested in potentially
buying one ticket each
To draw the demand curve we need to order the
individuals in terms of their willingness-to-pay,
from highest to lowest
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Demand curves and WTP example

• To draw the demand curve we need to consider how
  many tickets we will sell at any price
• If we price the tickets at 9 we sell three
  tickets, one each to Toby, Claudia and Abbey
• If we price the tickets at 4 we sell 4 tickets,
  one each to Toby, Claudia and Abbey and Jed
• And so on

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Demand curves and WTP example
Price
Demand curve for concert tickets
25
20
12
10
7
3
Tickets sold
0
0
1
2
3
4
5
15
Demand curves and WTP example
Price
25
Note that at any price the demand curve tells us
how many tickets we will sell at that price
20
At 15, sell 1 ticket
12
10
7
At 5, sell 4 tickets
3
0
Tickets sold
0
1
2
3
4
5
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Demand curves and WTP example
Price
And at any quantity, the height of the demand
curve tells us the WTP of the last or marginal
buyer
25
20
At 2 units, the marginal WTP is 12
12
10
At 4 units, the marginal WTP is 7
7
3
0
Tickets sold
0
1
2
3
4
5
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So

• The demand curve is also a marginal
  willingness-to-pay curve when read the other
  way
• Remember that the WTP represents the value of the
  product to a buyer (the maximum that the buyer
  would pay)
• So for a given quantity the area under a demand
  curve represents the total consumer value from
  that quantity of the product

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Demand curves and WTP example
Price
The area under the demand curve represents the
total value to the buyers
25
20
If two units are sold then this area equals the
total buyer value 32
12
10
7
3
0
Tickets sold
0
1
2
3
4
5
19
Demand curves and WTP example
Price
The area under the demand curve represents the
total value to the buyers
25
20
If four units are sold then this area equals the
total buyer value 49
12
10
7
3
0
Tickets sold
0
1
2
3
4
5
20
Consumer surplus

• Also remember that the surplus to a buyer is
  the difference between the buyers WTP and the
  price the buyer pays.
• So, for any quantity the area between the demand
  curve and the price paid gives us the total
  surplus to all buyers
• We call this the consumer surplus

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Consumer surplus
Price
25
So if 3 units are sold at a price of 8 then the
consumer surplus is the shaded area. This is 18.
Tobey gets a surplus of 12, Claudia gets 4 and
Abbey gets 2
20
12
10
8
7
3
0
Tickets sold
0
1
2
3
4
5
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Consumer surplus and motor scooters
Price
If the price of motor scooters is set at 400
each, then 600,000 scooters will be sold.
Consumer surplus is the shaded area. This is
180m.
1000
800
600
400
200
Expected sales (000s)
0
400
600
800
1,000
0
200
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Consumer surplus and motor scooters
Price
But if the price dropped to 300, then 700,000
scooters will be sold. Consumer surplus is the
shaded area, which is now . This is 245m
1000
800
600
400
300
200
Expected sales (000s)
0
400
600
800
1,000
0
200
700
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Consumer surplus - measurement

• Consumer surplus is measured by the area under
  the demand curve, above the posted price paid by
  consumers, up to the quantity consumers purchase

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Changes in consumer surplus

• Obviously a lower price and more sales leads to a
  higher consumer surplus
• This increased surplus has two sources
• Increased benefit to existing buyers as the price
  drops
• Increased surplus as new buyers purchase and
  existing buyers purchase more

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Value maximisation for mass markets

• The value of trade is maximised if every unit
  where the buyers WTP exceeds the sellers WTS is
  sold
• What is the sellers willingness-to-sell?
• Remember it is the sellers next best option to
  selling an individual unit or the marginal cost
  of the unit
• So value is maximised if every unit where the WTP
  exceeds marginal cost is sold and no more

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Value maximisation example

• Lets return to the example of concert tickets
• Suppose that each ticket has a marginal cost of
  6 to the seller. Then to maximise value we want
  to have every buyer whose WTP exceeds 6 to buy a
  seat, and no-one else

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Demand curves and WTP example
Price
To maximise the value created we want tickets
sold until the demand curve intersects the
marginal cost curve. Total consumer surplus 25
25
20
Marginal cost 6 per ticket
12
10
7
Tickets sold
3
0
0
1
2
3
4
5
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But does value maximisation profit maximisation
?

• Remember that a monopoly has a trade-off between
  limiting supply (and reducing value) and
  increasing their share of the value
• This holds true in mass markets
• Consider the above example. If the seller set the
  price at 6 then their profit would be zero (or
  negative if there were any fixed costs)
• Each ticket costs them 6 and they just sell them
  for 6 each. From the sellers perspective this
  makes no sense

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Profit maximisation and restricting supply
In our ticket example what price maximises the
sellers profit? If set price at 20, sell one
ticket and make 20-6 14 If set price at 12,
sell two tickets and make (12-6)2 12 If set
price at 10, sell three tickets and make
(10-6) 312 If set price at 7, sell four
tickets and make (7-6) 44 If set price below
6 lose money on every ticket sold! So the
profit maximising price is 20 with only one
ticket sold. Consumer surplus is now 0 but
profit is 14 Note the seller destroys 11 in
value but raises profits (At price 6 there
were no profit for the seller and the consumer
surplus was 25)
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Summary

• In a mass market a seller just sells at a posted
  price
• The demand curve gives the predicted sales at
  each price
• It is also the marginal WTP curve
• The consumer surplus from a posted price is the
  area under the demand curve, above the price
  paid, up to the quantity sold
• A seller in a mass market wants to limit supply
  this destroys total value but raises profits