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Special Pricing Policies

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Title: Special Pricing Policies


1
  • Special Pricing Policies

2
Overview
  • Cartel arrangements
  • Price leadership
  • Revenue maximization
  • Price discrimination
  • Nonmarginal pricing
  • Multiproduct pricing
  • Transfer pricing

3
Learning objectives
  • analyze cartel pricing
  • illustrate price leadership
  • see how price discrimination affects output and
    prices

4
Learning objectives
  • distinguish between marginal pricing and
    cost-plus pricing
  • discuss the various types of multiproduct pricing
  • explain how a company can use transfer pricing

5
Overview
  • I. Basic Pricing Strategies
  • Monopoly Monopolistic Competition
  • Cournot Oligopoly
  • II. Extracting Consumer Surplus
  • Price Discrimination ? Two-Part Pricing
  • Block Pricing ? Commodity Bundling
  • III. Pricing for Special Cost and Demand
    Structures
  • Peak-Load Pricing ? Price Matching
  • Cross Subsidies ? Brand Loyalty
  • Transfer Pricing ? Randomized Pricing
  • IV. Pricing in Markets with Intense Price
    Competition

6
Cartel
  • Agreement among competing firms to fix prices,
    output and marketing.
  • Occurs in oligopoly markets
  • Can be explicit or Implicit
  • Legal or illegal
  • illegal in the US Sherman Antitrust Act, 1890
  • examples OPEC, IATA

7
Cartel arrangements
  • In order to maximize profits, the cartel as a
    whole should behave as a monopolist
  • ? the cartel determines the output which equates
    MR MC of the cartel as a whole
  • ? the MC of the cartel as a whole is the
    horizontal summation of the members marginal
    cost curves
  • ? price is set in the normal monopoly way, by
    determining quantity demanded where MCMR and
    deriving P from the demand curve at that Q

8
Pricing StrategiesPrice leadership
  • Barometric price leadership
  • one firm in an industry will initiate a price
    change in response to economic conditions
  • the other firms may or may not follow this leader
  • leader may vary

9
Price leadership
  • Dominant price leadership
  • one firm is the industry leader
  • dominant firm sets price with the realization
    that the smaller firms will follow and charge the
    same price
  • can force competitors out of business or buy them
    out under favorable terms
  • could result in investigation under Sherman
    Anti-Trust Act

10
PRICE ELASTICITY AND PROFIT MAXIMIZING PRICE
  • Raise price you will lose sales? Not necessarily
    if you
  • know your price elasticity of demand
  • UNIFORM PRICING - Seller charges same price for
    every unit of the product.
  • Lerner index p-mc/p
  • To maximize profits, firm should charge a price
    such that the LI -1/price elasticity.

11
  • Suppose the MC 800.
  • And firms price elasticity is -1.5
  • Then to maximize profits (MRMC), firm should
    charge
  • (p-800/p) -1/-1.5 2/3
  • p 2400

12
Shortcomings of uniform pricing
  • Only the marginal buyer has a benefit price.
  • All other (inframarginal) buyers, have benefits
    that exceed price buyer surplus
  • Firm can increase profits by exploiting these
    surpluses

13
Price discrimination
  • Price discrimination products with identical
    costs are sold in different markets at different
    prices
  • ? the ratio of price to marginal cost differs
    for similar products
  • Conditions for price discrimination
  • the markets in which the products are sold must
    by separated (no resale between markets)
  • the demand curves in the market must have
    different elasticities

14
Price discrimination
  • First degree (or perfect) price discrimination
  • seller can identify where each consumer lies on
    the demand curve and charges each consumer the
    highest price the consumer is willing to pay
  • allows the seller to extract the greatest amount
    of profits
  • requires a considerable amount of information

15
  • Implication Charge different price for each
    additional unit in each market
  • In practice, transactions costs and information
    constraints make this difficult to implement
    perfectly (but car dealers and some professionals
    come close).

16
Price discrimination
  • Second degree price discrimination
  • differential prices charged by blocks of services
  • requires metering of services consumed by buyers

17
  • Implication- block or quantity discounts
  • Different prices for different incremental units
    in each market

18
  • Third degree (or simple) price discrimination
  • customers are segregated into different markets
    and charged different prices in each
  • segmentation can be based on any characteristic
    such as age, location, gender, income, etc

19
  • Implication-
  • Multi-market price discrimination
  • Different prices in each market
  • Examples of 3rd degree price discrimination
  • doctors
  • telephone calls
  • theaters
  • hotel industry

20
More on Simple Price Discrimination
  • Two conditions are necessary
  • Separable markets
  • Different substitutability (price elasticity of
    demand)
  • If demand is less elastic in market A but more
    elastic in market B, for profit maximization
    MRa MRb MC
  • Price-cost markup is higher in A than in B? price
    is higher in A than in B

21
Price Discrimination comes in Many Variations
  • Product is tied to sale of complements tying
    arrangement
  • Some customers receive reimbursements
  • Different products sold to different customers
    (Versioning)
  • A higher price for a specified low quantity, a
    lower price for a specified higher quantity
  • Different prices to different customers screened
    by qualification

22
Price Discrimination comes in Many Variations (2)
  • Different prices of x over time (inter-temporal
    price discrimination)
  • Same price, but changing attributes over time
    (product sequencing)

23
Versioning
  • One product for 2 markets Barrier for the
    separation of markets must be identified to avoid
    resale
  • Different products sell for different prices (two
    markets)- customers do not have to be identified.
    Customers self-sort and product versions
    create barriers.

24
Nonmarginal pricing
  • Cost-plus pricing price is set by first
    calculating the variable cost, adding an
    allocation for fixed costs, and then adding a
    profit percentage or markup
  • Problems with cost-plus pricing
  • calculation of average variable cost
  • allocation of fixed cost
  • size of the markup

25
Other pricing practices
  • Price skimming
  • the first firm to introduce a product may have a
    temporary monopoly and may be able to charge high
    prices and obtain high profits until competition
    enters
  • Penetration pricing
  • selling at a low price in order to obtain market
    share

26
Other pricing practices
  • Prestige pricing
  • demand for a product may be higher at a higher
    price because of the prestige that ownership
    bestows on the owner
  • Psychological pricing
  • demand for a product may be quite inelastic over
    a certain range but will become rather elastic at
    one specific higher or lower price

27
(Mixed) Two-Part Pricing
  • When it isnt feasible to charge different prices
    for different units sold, but demand information
    is known, two-part pricing may permit you to
    extract all surplus from consumers.
  • Two-part pricing consists of a fixed fee and a
    per unit charge.
  • Example Athletic club memberships.

28
How Two-Part Pricing Works
  • 1. Set price at marginal cost.
  • 2. Compute consumer surplus.
  • 3. Charge a fixed-fee equal to consumer surplus.

Price
10
8
6
Fixed Fee Profits 16
Per Unit Charge
4
MC
2
D
1 2 3 4 5
Quantity
29
Block Pricing
  • The practice of packaging multiple units of an
    identical product together and selling them as
    one package.
  • Examples
  • Paper.
  • Six-packs of soda.
  • Different sized of cans of green beans.

30
Commodity Bundling
  • The practice of bundling two or more products
    together and charging one price for the bundle.
  • Examples
  • Vacation packages.
  • Computers and software.
  • Film and developing.
  • Cable television MTV and Learning Channel

31
Bundling as a bribe
  • Can of soda with free bubble gum
  • Paper with free pen
  • Distinguish between buyer (customer) and consumer.

32
Peak-Load Pricing
Price
  • When demand during peak times is higher than the
    capacity of the firm, the firm should engage in
    peak-load pricing.
  • Charge a higher price (PH) during peak times
    (DH).
  • Charge a lower price (PL) during off-peak times
    (DL).

Quantity
33
Cross-Subsidies
  • Prices charged for one product are subsidized by
    the sale of another product.
  • May be profitable when there are significant
    demand complementarities effects.
  • Examples
  • Browser and server software.
  • Drinks and meals at restaurants.

34
Pricing in Markets with Intense Price Competition
  • Price Matching
  • Advertising a price and a promise to match any
    lower price offered by a competitor.
  • No firm has an incentive to lower their prices.
  • Each firm charges the monopoly price and shares
    the market.
  • Randomized Pricing
  • A strategy of constantly changing prices.
  • Decreases consumers incentive to shop around as
    they cannot learn from experience which firm
    charges the lowest price.
  • Reduces the ability of rival firms to undercut a
    firms prices.

35
Cannibalization
  • Occurs when sale of one product reduces the
    demand for another product with a higher
    incremental margin
  • e.g. business travelers flying on restricted
    economy class fares
  • wealthy families buying basic sedans instead of
    high end luxury cars

36
  • Fundamental reason for cannibalization is that
    seller cannot discriminate directly.
  • The discriminating variable does not perfectly
    separate the buyer segments.
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