Pricing Strategy

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Session 4
Managerial Economics

• Pricing Strategy

Professor Changqi Wu
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Topics for Today

• Uniform pricing
• Price discrimination
• Durable good pricing
• Bundling
• Auction

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1. Uniform pricing

• Profit maximizing pricing strategy
• Setting the incremental margin equal to the
  inverse of absolute value of the price elasticity
  of demand
• A seller sets the same price for every unit of
  his product.
• Optimal pricing depends on both price elasticity
  of demand and marginal cost

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Cost-Based Pricing

• Average cost plus a fixed profit margin
• Procedure
• To estimate the average cost
• To add a markup to the average cost
• Cost based pricing is widely practised. It has
  pros and cons.

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Why Cost-Plus Pricing is Popular?

• Its simple!
• Cost-base pricing may be a profit-maximizing one
  if average cost approximates marginal cost
• P (1- 1/(ep1)) MC
• It costs money and time to calculate the right
  price and to work out how price should respond to
  changing market conditions, particularly for
  small firms
• It is costly to change prices.

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Why Cost-Plus Pricing Can Go Wrong?

• Demand side factor is not explicitly taken into
  consideration.
• It is difficult to estimate true average cost
  because of the existence of indirect cost and
  joint cost
• Average cost pricing is influenced by accounting
  rules
• As a remedy, one can use variable markup rule
  instead of fixed markup

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2. Price Discrimination is ...

• Two or more similar goods are sold at different
  net prices
• Prices may differ due to quality and cost
  differences.
• Motives for price discrimination
• earning more from existing customers
• selling to new customers without sacrificing the
  current profit margin

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Capturing Consumer Surplus
/Q
If price is raised above P, the firm will lose
sales and reduce profit.
Quantity
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Conditions of Price Discrimination

• A seller must have market power
• A seller is able to identify customers with
  different demand elasticities
• Resale is impossible

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Practicing Price Discrimination

• Complete price discrimination
• Direct segment discrimination
• Indirect segment discrimination

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Complete Price Discrimination

• A seller charges each and every buyer her
  reservation price
• It can be used for tailor-made products/services
• Using price negotiation to find the buyers
  reservation price

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Incomplete Price Discrimination
/Q
Quantity
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Direct Segment Discrimination

• A seller charges different prices using directly
  observable signals relating a consumer with her
  price elasticity
• Example Whats in the name?

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Indirect Segment Discrimination

• A seller use self-selection devices to
  distinguish customers.
• Two-part tariff
• Consumers pay a fee up front for the right to buy
  a product and then, pay additional fee for each
  unit of the product they wish to consume
• Peak load pricing

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Methods to Prevent Resale

• Refuse to deal with resellers
• Bundling with services
• Issuing warranties
• Degrading the quality of product

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3. Durable Goods Pricing

• Durable goods sold by a seller are their own
  substitutes
• Ways to solve the durable goods pricing problem
• Making goods less durable planned obsolescence
• Limiting the production in the future
• Buy-back provisions

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4. Bundling

• Bundling Scenario Two different goods and many
  consumers
• Many consumers with different reservation price
  combinations for two goods
• Mixed Bundling
• Selling both as a bundle and separately
• Pure Bundling
• Selling only a package

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Mixed Versus Pure Bundling
r2
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r1
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The Complete Dinner Versus a la CarteA
Restaurants Pricing Problem

• Pricing to match consumer preferences for various
  selections
• Mixed bundling allows the customer to get maximum
  utility from a given expenditure by allowing a
  greater number of choices.

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5. Auctions

• Auction Formats
• Traditional English (oral)
• Dutch auction
• Sealed-bid
• First price
• Second price

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Auctions
Valuation and Information

• How to choose an auction format
• Private-value auction bidders uncertain about
  the other bidders reservation price
• Common-value auction bidders uncertain what the
  value is

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Auctions
Private Value Auction

• Second-price sealed auction bid your reservation
  price
• English auction Bid in small increments until
  you reach your reservation price
• The winning bids in both auctions is the
  reservation price of the second highest bidder

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Auctions
Private Value Auction

• Sealed-bid auction
• First-price auction lowers the bid
• Second-price auction bid just above the second
  highest reservation price
• Both yield the same revenue

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Auctions
Common Value Auction

• Winners Curse
• The winner is worse off than those who did not
  win
• Examples
• Bidding on a construction job
• Bidding on 3G mobile service licenses
• Question
• How can you avoid the winners curse?

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Key Takeaway Points

• Profit maximizing uniform pricing depends on
  marginal cost as well as price elasticity of
  demand
• Depending on the information available, a seller
  can adopt different price discrimination schemes.
• There are many ways to set the prices to reduce
  inefficiencies and raise the level of profit.