Economic
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LectureNotesTopic5Pricing.pptxLecture Notes
Pricing
Agenda
Simple (Monopoly) Pricing (Chapter 6)
Cost-Plus Pricing (Chapter 6)
Price Discrimination (Chapter 13-14)
Other Pricing Practices (Chapter 13-14)
Value Added Pricing
Pricing in General
Strongly affected by the Market Structure
Some (perfectly competitive) firms are price takers
Interplay of supply and demand which determines the market price is not the only factor affecting a firm’s pricing decision
Firms with “market power” have some control or influence over prices
These firms can raise prices without losing significant amount of customers
Optimal pricing decisions will vary according to:
Underlying market structure or degree of competition of the industry
How many firms in the industry?
Are there close substitutes in other industries? (product differentiation)
Ease of entry and exit
In short, what is the power of the firm to change its price without losing a lot of its revenues (demand)?
Instruments and measures available to the firm
Advertising
Use of coupons
Two things to Know Before We Discuss Pricing
Consumer Surplus: Difference between what a buyer is willing to pay (willingness to pay) and what he does pay (price)
People have a maximum willingness to pay for every good
If this maximum willingness to pay is greater than price, a rational consumer will buy the good
Since consumer surplus = willingness to pay – price
If consumer surplus >= $0, a rational person will buy the good
If consumer surplus < $0, a rational person will not buy the good
As people buy more and more of the same good, the additional value they get from consuming additional quantities decreases
You value the 1st cup of coffee more than you value the 2nd cup
You value the 3rd cup of coffee more than you value the 3rd cup, etc.
This is the law of diminishing marginal value discussed in the book in Chapter 6 (also called the law of diminishing marginal utility)
Simple Pricing for a Firm with Market Power with 1 Product
A firm selling just 1 product with Market Power will face a downward sloping demand curve for its product
If it sells at a high price, it will earn more profits for each unit sold but it will sell less of the good
If it sells at a low price, it will earn less profits for each unit sold but the firm will sell more of the good.
Incremental Analysis for a Profit Maximizing Firm:
Reduce Price (Sell More) if Increm. Rev. > Increm. Costs
Increase Price (Sell Less) if Increm. Rev. < Increm. Costs
OR
Reduce Price (Sell More) if Marginal Revenues (MR) > Marginal Costs (MC)
Increase Price (Sell Less) if MR < MC
Where MR = Incremental costs of selling 1 more unit
MC= Incremental costs of selling 1 more unit
Example #1: Pricing using Incremental Analysis
| $2.25 per customer | ||||
| Expected Number | Total | Incremental | Incremental | |
| Price | of Customers | Revenues | Revenues | Costs |
| $10 | 100 | $1,000 | ||
| $9 | 115 | $1,035 | $35 | 34 |
| $8 | 150 | $1,200 | $165 | 79 |
| $7 | 225 | $1,575 | $375 | 169 |
| $6 | 325 | $1,950 | $375 | 225 |
| $5 | 475 | $2,375 | $425 | 338 |
| $4 | 650 | $2,600 | $225 | 394 |
| $3 | 1000 | $3,000 | $400 | 788 |
Profit maximizing firm will lower price as long as incremental revenues > incremental costs
Profit Maximizing Price = $5
Why? If incremental revenues > incremental costs, profits increase and we assume that firms are
profit maximizers.
Example #2: Incremental Analysis for Pricing
Jack’s tours has been selling 80,000 tickets each year at $7 each.
Management is considering raising the selling price to $8 per unit, but this will likely cause the sales volume to drop to 76,000 units.
Identify incremental revenues from the Price Change
Since both units and the selling price will change, you must consider both changes as part of the incremental revenue. The incremental approach determines the difference between old and new revenue:
Incremental Revenues: New revenue - Original revenue
= (76,000 x $8) - (80,000 x $7)
= $48,000
Changing prices from $7 to $8 will increase revenues by $48,000
Example #2: Incremental Analysis for Pricing
2. Identify and compare the costs under both alternatives---both fixed and variable costs.
Assume that the variable cost of each ticket is $4 and the fixed costs are $100,000.
The fixed costs remain the same no matter how many tickets are sold; and are irrelevant
All that matters is the variable costs of $4 per ticket
There will be cost savings since the number of tickets sold goes down.
Incremental Costs = new costs – original costs
= (76,000 - 80,000) x $4
= -$16,000
Costs go down by $16,000 since fewer tours are being sold at the lower price
Example #2: Incremental Analysis for Pricing
3. Determine the impact on profits (Revenues Less costs).
Incremental Revenues = Change in Revenues = $48,000
LESS
Incremental Costs = Change in Costs = -$16,000
EQUALS
Incremental Profits = Change in Profits $64,000
In this case, increasing the selling price increases profits by $64,000 and a profit maximizing firm should go ahead and increase price
Incremental analysis will point you in the right direction, but it does not tell you how far to go
Would prices greater than $8 increase profits even more?
Effect of Elasticity on Profit Maximizing Price
In most Managerial Econ. Classes, you will see this formula for profit maximizing Price; set your price where
(P – MC)/P = 1/ |e|
where e is the price elasticity of demand
You do not have to memorize or know the formula!!!!!
What you have to know from this formula:
Markup is the amount that price is above costs:
Markup = P – MC
(1a) Since many firms do not know their MC or incremental costs, many markups are expressed versus average costs:
Markup = P – AC
The Greater the Markup, the greater the profit (holding everything else constant)
% Markup = m = (P –MC)/MC
Example: If MC =$2.00 and Price is $2.20
Markup = $2.20 - $2.00 = $0.20
% Markup = ($2.20 - $2.00)/$2.00 = 10%
P = (1 + m) * MC where m = % markup
(4) The optimal markup and therefore the optimal price for profit maximization depends upon the price elasticity of demand
Effect of Elasticity on the Optimal Price
Incremental Analysis for a Profit Maximizing Firm:
Reduce Price (Sell More) if Increm. Rev. > Increm. Costs
Increase Price (Sell Less) if Increm. Rev. < Increm. Costs
If demand is elastic, reducing price will increase revenues
Incremental revenues will be higher as price is lowered, the greater the elasticity
More likely that lowering the price will increase profits, the greater the elasticity (more elastic demand)
If demand is inelastic, increasing price will increase revenues
Incremental revenues will be higher as price is raised, the lower the elasticity
More likely that increasing the price will increase profits, the lower the elasticity (more inelastic demand)
Profit Maximizing Price will be lower (and the markup will be lower) the more elastic demand – because lowering price increases revenues and profits
Profit Maximizing Price will be higher (and the markup will be higher), the more inelastic demand – because increasing price increases revenues and profits
Real Life Implications of Effect of Elasticity on Profit Maximizing Price
Remember that the greater the number of substitutes, the more elastic demand
Implies that the greater the number of firms (competition) in the market, more elastic demand.
The greater the competition more elastic demand profit maximizing price should be lower
Greater the number of competitors, harder for an individual firm to have high markups or higher price, because customers will switch to other firms in the market
Think 3-4 gasoline stations at a busy intersection
The smaller the competition less elastic demand profit maximizing price should be higher
Think of a gasoline station near an airport
More competitive markets will have smaller markups and lower prices
Conclusions from Simple (Monopoly) Pricing
More elastic demand, the lower the profit maximizing price
Products with lots of substitutes, lots of competitionj will have a lower markup over costs
The more competitive the market, the lower the market price
Higher the incremental costs (or MC), the higher the profit-maximizing price (everything else the same)
All you need to determine the profit maximizing price is a numerical estimate of the elasticity of demand and an estimate of the firm’s incremental costs (or MC)
Pricing in Reality: No Easy Formula to Use
Most profit maximizing firms:
Do not have precise knowledge of their demand and cost curves they face
Do not know their price elasticity of demand for the firm’s products
Do not have just one product
Sell products in more than one market
Pricing in Practice: Cost-Based Pricing
In the real world, Firms do not know where incremental revenues = incremental costs or where MR=MC
most firms do not know their price elasticity of demand
Many firms do not know their incremental costs/MC
In place of MC, many firms use “fully allocated costs”, which allocate fixed costs to each product plus variable costs
So, firms ignore any demand considerations (i.e., ignore the elasticity of demand) and place an arbitrary markup over cost
Firms pick an arbitrary markup to cover costs and a return on capital
Easy and simple to use
Results in relatively stable pricing if costs do not vary significantly over time or over the amount of output
Cost Plus Pricing
Cost-Plus Pricing: P = (1 +m) * C where m is the % markup
C is some measure of cost per unit
Most commonly used measure of C is Fully Allocated Average Costs
Estimate average variable costs (AVC)
In many industries, AVC is constant and a good substitute for MC
Add fixed costs or overhead charges per unit of output
Usually allocated across products based on revenues of the product
Fully Allocated Average Costs per Unit = AVC + Allocated FC per unit
Firms choose (guess) % markup (m) to add onto these costs:
m = (P – C)/C where C = fully allocated average costs per unit
Markup is often based on a target return on investment or ROI
Relatively easy to utilize, requires little information
Simple Example of Cost Plus Pricing with 1 Product
Suppose you own a restaurant and serve an average of 1000 meals a month
Your average costs per month are the following:
Chefs and Cooks: $5000 variable cost
Waiter and Busboys: $2000 variable cost
Food: $3000 variable cost
Rent: $2000 fixed cost
Utilities/Prop. Taxes: $1,000 fixed cost
Average Variable Cost or Variable Cost per Meal = $10000/1000 = $10 per Meal
Allocate Fixed Cost per Meal: $3,000/1000 = $3 per meal
Total Cost per Meal: $13 per meal
You choose (guess) a markup of 20%
Price for each meal = (1 + m) * C
= (1 + .2) * $13
= $15.60
The price you set for each meal has nothing to do with demand or elasticity of demand
Simple Example of Cost Plus Pricing with More than 1 Product
Suppose you own a dog food manufacturing company with 2 products: premium and generic dog food
You calculate the following average monthly revenues and costs for the 2 products:
Note that your “overhead” or fixed costs cannot be attributed to either kind of dog food
The overhead might be the rent of the factory where both kinds of dog food are made, the salaries of the accounting/finance staff, the salary of managers, etc.
You need to allocate the overhead costs to each of your products
The most common method of allocation is via per cent of revenues
Allocating overhead or fixed costs via per cent of revenues
In this case, Premium Dog Food has 20% ($25/$125) of revenues, so it gets 20% of overhead costs or .2 x $50 = $10
Generic Dog Food has 80% ($100/$125) of revenues , so it gets 80% of overhead costs or .8 x $50 = $40
| Premium | Generic | ||||
| Dog Food | Dog Food | Total | |||
| Revenues | $25 | $100 | $125 | ||
| Direct Costs | $10 | $40 | $50 | ||
| Overhead | $50 | ||||
| Total Costs | $100 |
Simple Example of Cost Plus Pricing with More than 1 Product (cont.)
You have now calculated Fully Allocated Cost for your products
Suppose you produce 100 bags of Premium Dog Food and 800 Bags of Generic Dog Food
You then calculate the Fully Allocated Cost per Unit (or per Bag):
| Premium | Generic | ||||
| Dog Food | Dog Food | Total | |||
| Revenues | $25 | $100 | $125 | ||
| Direct Costs | $10 | $40 | $50 | ||
| Overhead | $10 | $40 | $50 | ||
| Fully Allocated Costs | $20 | $80 | $100 |
Simple Example of Cost Plus Pricing with More than 1 Product (cont.)
Fully Allocated Cost per Unit:
You then arbitrarily choose a % markup, say 20%.
P = (1 + m) x Fully Allocated Cost per Unit
| Premium | Generic | ||||
| Dog Food | Dog Food | Total | |||
| Revenues | $25 | $100 | $125 | ||
| Direct Costs | $10 | $40 | $50 | ||
| Overhead | $10 | $40 | $50 | ||
| Fully Allocated Costs | $20 | $80 | $100 | ||
| Number of Bags | 100 | 800 | |||
| Fully Allocated Costs | $0.20 | $0.10 | |||
| Per Unit (per Bag) |
Simple Example of Cost Plus Pricing with More than 1 Product (cont.)
Calculating Price using Arbitrary % Markup with Cost Plus Pricing
| Premium | Generic | ||||
| Dog Food | Dog Food | Total | |||
| Revenues | $25 | $100 | $125 | ||
| Direct Costs | $10 | $40 | $50 | ||
| Overhead | $10 | $40 | $50 | ||
| Fully Allocated Costs | $20 | $80 | $100 | ||
| Number of Bags | 100 | 800 | |||
| Fully Allocated Costs | $0.20 | $0.10 | |||
| Per Unit (per Bag) | |||||
| 1 + Markup (m= 20%) | 1.2 | 1.2 | |||
| Price = (1 + m) x C | $0.24 | $0.12 |
Criticisms of Cost Based Pricing
Often based on accounting and sunk costs not economic costs and opportunity costs
Not based upon marginal costs, but average costs
Does not take into account customers’ willingness to pay or the prices of competitors
In practice, few firms follow rigid cost based pricing and do take into account other factors in pricing
Use trial and error and their experience to come up with the “best” markup
Pricing Strategies for Greater Profits
A firm can charge a single price to all consumers: Uniform Pricing
In some markets, charging different prices to different consumers can lead to greater profits
Extracting Consumer Surplus from Consumers
Price Discrimination
Two-Part Pricing
Block Pricing
Commodity Bundling
Special Cost and Demand Structures
Peak Load Pricing
Cross-Subsidies (substitutes and complements)
Problem with Uniform Pricing (One Price for All Customers)
Charging the same price to every customer creates consumer surplus:
With one price, in order to get more customers, you have to lower the price to all customers
But some customers may be willing to pay more than the uniform price
Consumer surplus is the difference between what the customer is willing to pay and what he/she actually pays
Existence of any consumer surplus is evidence of underpricing (charging too low of a price)
Object of the seller or firm is to take away the consumer surplus from the consumer and turn it into profit for the firm
Object of the seller or firm is to charge a price equal to each and every customer’s willingness to pay (so that consumer surplus =$0)
This will increase revenues and profits
Solution to Uniform Pricing
Strategy for increasing profit (and taking away consumer surplus from consumers) is to sell at different prices to different consumers
Sell at high price to consumers willing to pay more (or to customers who are NOT sensitive to price and are therefore price inelastic)
Sell at low prices to consumers willing to pay less (or to customers who ARE sensitive to price and are therefore price elastic)
Price Discrimination: selling same good at different prices to different customers based on differences in demand (willingness to pay) and not on costs
Consider a store selling just one product, such as shirts
The store could announce that the first 25 customers each day will pay $50 each, but the next customers pay only $40. Will that work?
Or the store could try to sell at a higher price to well-dressed customers, on the belief that they are richer and are willing to pay more. Will that work?
Problems for Potential Price Discriminators
Distinguishing customers who will buy goods at high prices from those who will not
Preventing resale: stopping the customers who buy at the low price from reselling to customers at a higher price
This is why price discrimination is often observed for goods consumed on the premises (such as movies, amusement parks)
Need to have market power: the ability to control or influence prices
Firms in a competitive market (many firms selling similar products) will find that price discrimination is impossible
If one firm sells at higher price (than market price) to customers with higher willingness to pay, another firm will find it profitable to lure these customers away with lower price
3 Types of Price Discrimination
Perfect Price Discrimination: charging each and every customer a different price
Group Price Discrimination: charging groups of customers a different price
Direct Group Price Discrimination: groups are identified based on observable characteristics
Indirect Group Price Discrimination: customers self-select into groups
Volume Discounts: charging customers different prices based upon the quantity the customers purchase
In all cases, the firm needs to be able to identify the customers which have greater (or less) willingness to pay or have different price elasticities
Perfect Price Discrimination
Perfect Direct Price Discrimination: selling each unit of the product and charging the highest possible price for each unit sold according to each customers willingness to pay
Extremely difficult to implement since firms must know precisely the maximum price each consumer is willing and able to pay
Too difficult or costly to gather information about each customer’s willingness to pay
Although these costs have been lowered due to the internet and data mining
Allows hotels, airlines, cruise lines, etc. to try to practice perfect price discrimination
How Price Discrimination Increases Profits: An Example
George’s Photography is a profit maximizing business specializing in kid’s photography and faces absolutely no competition in his small town. George, who owns and runs the business, expects to encounter an average of 8 customers per day with the following demand and costs:
There is 1 customer willing to pay at most $50 for a photograph
There are 2 customers willing to pay at most $46 for a photograph. One of these customers is the person willing to pay at most $50.
There are 3 customers willing to pay at most $42 for a photograph. One of these customers is the person willing to pay at most $50 and one is the person willing to pay at most $46 for the photograph, Etc.
If George just charges one price, he will decrease price (increase number of customers) as long as Increm. Rev.> Increm. Costs
The profit maximizing number of customer is 3 customers at a price of $42 each for a profit of $39
Charging a price of $38 and getting 1 more customer will cause incremental revenues to be less than incremental costs and profits decline (see Total Profits column)
| Number of | Price | Incremental | Incremental | Total | |||||
| Customers | ($ per Photo) | TR | Revenues | TC | Costs | Profits | |||
| 1 | $50 | $50 | $50 | $29.00 | $29.00 | $21.00 | |||
| 2 | $46 | $92 | $42 | $58.00 | $29.00 | $34.00 | |||
| 3 | $42 | $126 | $34 | $87.00 | $29.00 | $39.00 | |||
| 4 | $38 | $152 | $26 | $116.00 | $29.00 | $36.00 | |||
| 5 | $34 | $170 | $18 | $145.00 | $29.00 | $25.00 | |||
| 6 | $30 | $180 | $10 | $174.00 | $29.00 | $6.00 | |||
| 7 | $26 | $182 | $2 | $203.00 | $29.00 | -$21.00 | |||
| 8 | $22 | $176 | -$6 | $232.00 | $29.00 | -$56.00 |
How Price Discrimination Increases Profits: An Example (cont.)
So, George maximizes profit by charging a price of $42 and 3 customers are willing to pay such a price to get a photograph
But one customer is willing to pay $50 and George is only charging $42
another customer is willing to pay $46 and George is only charging $42
The difference between what a customer is willing to pay and the price the customer does pay is consumer surplus
By charging one price of $42, there is positive consumer surplus of $12
1 customer willing to pay $50 and being charged $42: consumer surplus = $8
1 customer willing to pay $46 and being charged $42: consumer surplus = $4
Total Consumer Surplus = $12
This is at least $12 in revenues that George could have if each customer is charged his/her willingness to pay
If George could charge more than 1 price, there is a possibility of getting more revenues by charging each customer his/her willingness to pay
How Perfect Price Discrimination Increases Profits
In order to maximize profits, George would like to charge each customer exactly what he/she is willing to pay
Charge the 1st customer $50 price, 2nd customer $46 price, 3rd customer $42 price, etc.
George would only serve an individual customer if that customer’s incremental revenues are greater than incremental costs
George would serve 6 customer as long as the customer’s willingness to pay is greater than incremental costs of $29
7th customer has willingness to pay of $26, but it costs George $29 to provide the photograph.
Since incremental costs of $29 > incremental revenues of $26, George’s profits would go down if he provided a photograph to the 7th customer
If George could charge each customer a different price, note that the number of customers served would increase from 3 to 6 and his profits would increase from $39 to $66
Also note that charging each customer his/her willingness to pay will cause consumer surplus to go to $0
Charging customers more than 1 price has the potential to increase revenues and profits by taking away some (or all) of the buyer’s consumer surplus and allowing the firm to serve more customers
| Price = | Incremental | Incremental | Total | |||||
| Willingness to Pay | TR | Revenues | TC | Costs | Profits | |||
| Customer 1 | $50 | $50 | $50 | $29.00 | $29.00 | $21.00 | ||
| Customer 2 | $46 | $96 | $46 | $58.00 | $29.00 | $38.00 | ||
| Customer 3 | $42 | $138 | $42 | $87.00 | $29.00 | $51.00 | ||
| Customer 4 | $38 | $176 | $38 | $116.00 | $29.00 | $60.00 | ||
| Customer 5 | $34 | $210 | $34 | $145.00 | $29.00 | $65.00 | ||
| Customer 6 | $30 | $240 | $30 | $174.00 | $29.00 | $66.00 | ||
| Customer 7 | $26 | $266 | $26 | $203.00 | $29.00 | $63.00 | ||
| Customer 8 | $22 | $288 | $22 | $232.00 | $29.00 | $56.00 |
Identifying Groups with Different Willingness to Pay
Perfect Price Discrimination is very difficult to implement: the firm needs to know the willingness to pay of each customer.
Instead, may firms practice one of the following 2 ways to divide customers into groups based on their different willingness to pay
Direct Price Discrimination: divide customers into groups based on observable characteristics that firms believe are associated with unusually high or low willingness to pay or demand elasticities
Geography
Gender
Age
Transient/Resident
Time: sales by departments stores, new products
Indirect Price Discrimination: divide customers into groups based on the basis of their actions.
Customers self-select the group to which they belong
Firms generally use:
Differences in the value customers place on their time
Firms assume that people who value time less than others will be more price sensitive
Differences in product design and features
Examples:
Coupons and Rebates
Broadway Discount tickets
First Class/Business vs. Coach airfare
Direct Price Discrimination: An Example
Let’s go back to George the photographer with the following revenues and costs:
Recall that if George can only charge one price, he will serve 3 customers at a price $42 and make a profit of $39
Suppose George is permitted to charge two prices. He knows from experience that
senior citizens form the bulk of his customers with a willingness to pay $34 or below, whereas
everyone else (non-senior citizens) are willing to pay above $34.
What should George’s two prices be?
| Number of | Price | Incremental | Incremental | Total | |||||
| Customers | ($ per Photo) | TR | Revenues | TC | Costs | Profits | |||
| 1 | $50 | $50 | $50 | $29.00 | $29.00 | $21.00 | |||
| 2 | $46 | $92 | $42 | $58.00 | $29.00 | $34.00 | |||
| 3 | $42 | $126 | $34 | $87.00 | $29.00 | $39.00 | |||
| 4 | $38 | $152 | $26 | $116.00 | $29.00 | $36.00 | |||
| 5 | $34 | $170 | $18 | $145.00 | $29.00 | $25.00 | |||
| 6 | $30 | $180 | $10 | $174.00 | $29.00 | $6.00 | |||
| 7 | $26 | $182 | $2 | $203.00 | $29.00 | -$21.00 | |||
| 8 | $22 | $176 | -$6 | $232.00 | $29.00 | -$56.00 |
Direct Price Discrimination: An Example
The knowledge that senior citizens are the ones paying $34 or below allows George to divide his market into 2 subgroups – each with 1 price.
High Value Sub-Group (willing to pay above $34):
George should set the price at $42 and sell 3 photos a day (as long as Increm. Rev.>Increm. Costs)
2. Low Value Sub-Group (Senior Citizens willing to pay $34 or below)
George should set the senior citizen discount price at $34 and sell 1 senior citizen’s tickets a day (as long as Incremental Rev. > Increm Costs.)
| Willingness to Pay | TR | Incremental Revenues | TC | Incremental Costs | Total Profits | |||
| Customer 1 | $50 | $50 | $50 | $29.00 | $29.00 | $21.00 | ||
| Customer 2 | $46 | $92 | $42 | $58.00 | $29.00 | $34.00 | ||
| Customer 3 | $42 | $126 | $34 | $87.00 | $29.00 | $39.00 | ||
| Customer 4 | $38 | $152 | $26 | $116.00 | $29.00 | $36.00 |
| Willingness to Pay | TR | Incremental Revenues | TC | Incremental Costs | Total Profits | |||
| Customer 5 | $34 | $34 | $34 | $29.00 | $29.00 | $5.00 | ||
| Customer 6 | $30 | $60 | $26 | $58.00 | $29.00 | $2.00 | ||
| Customer 7 | $26 | $78 | $18 | $87.00 | $29.00 | ($9.00) | ||
| Customer 8 | $22 | $100 | $14 | $116.00 | $29.00 | ($16.00) |
Direct Price Discrimination: An Example (continued)
With 2 prices instead of 1:
The number of customers served has risen from 3 to 4
Profits have increased from $39 to $44
Direct Price Discrimination, under the right circumstances, can increase profits!
Note that you have to be able to separate out and identify the groups with different willingness to pay:
You can identify senior citizens by showing their age from a drivers license
You can identify students by requiring a student ID
Indirect Price Discrimination
Sometimes it is impossible to explicitly identify specific groups, such as students or senior citizens
Instead, firms identify certain features of the product or buying patterns and correlate these features to differences in elasticity
Ways to implicitly put customers into groups with different elasticities
People who clip coupons are more likely to be price elastic
Airlines differentiate between price elastic (leisure travelers) customers and price inelastic (business travelers) by their willingness to plan ahead and when they travel
Versioning: Differences in features and functions of the product
Product without options is priced low
Product with options and features is priced high
Need to watch out for “cannibalization”
People who wait on line to buy discount theater tickets are more likely to be price elastic
Principle is the same: charge price sensitive customers a lower price and price insensitive customers a higher price
Internet and Price Discrimination: Dynamic Pricing
Emergence of electronic commerce and online transactions have greatly expanded the opportunities for market segmentation and price discrimination
Advances in computer power, demand tracking and software with pricing algorithms (pricing intelligence software)
Dynamic Pricing: Price of the good can be changed minute by minute, customer by customer
E-tailers can obtain a lot of information about potential customers from their IP address
Where you live
Your buying history
What device you are using?
Are you a repeat customers?
What other websites have you visited?
How far are you from the closest store?
Examples of Dynamic Pricing
Airline ticket pricing adjusted based on seat availability, passenger demand and how far in advance customers make reservations
Disneyland pricing based on demand: 4% discount on low demand days to a 20% increase on busiest days
Peach Pass toll rates on I-85
Sports teams offer lower or higher prices for certain teams, seats, pitching matchups in baseball, weather and ticket demand
Mac Users can pay $20-30 more for booking hotel rooms (WSJ)
Users of Android devices pay more at Home Depot and Sears on line stores than desktop users (Northeastern University)
Frequent fliers are liable to pay more for flights
Amazon users are likely to be guided to products priced 20-30% higher – unless they are a Prime member
Prices are set according to elasticities: most price sensitive customers get the steepest discounted prices
Need to be aware that the pricing scheme is defensible to customers
Big Data and Price Discrimination
Big data refers to the ability to gather large volumes of data, often from multiple sources, and with it produce new kinds of observations, measurements and predictions.
Big data has lowered the costs of collecting customer-level information, making it easier for sellers to identify new customer segments and to practice price discrimination (dynamic pricing)
Real time information about inventory and customer demand
3 broad pricing strategies:
Running of experiments to see how pricing affects quantity demanded
Efforts to steer customers toward particular products without changing prices
Customized pricing for individuals
Price Discrimination with Volume Discounts
Many firms are unable to determine which of their customers have higher or lower willingness to pay
However, such firms know that most customers are willing to pay more for the first unit of a good than each successive units
Each additional unit of a good is worth less to the consumer and the consumer is willing to pay less
Firms know that:
People who buy small quantities place a high marginal value on additional quantities of the good
People who buy large quantities place a low marginal value on additional quantities of the good
Charge higher price to smaller less price sensitive buyers and lower price to larger more price sensitive buyers
Pure Volume Discounts: Practice price discrimination by charging higher price per unit to customers buying smaller quantities and lower price per unit to customers buying larger quantities
Best for the firm to sell additional units of the good without lowering the prices of the earlier units:
Block Pricing: offer discounts such as the first good at $7, the second at $6, etc.
Two-Part Pricing: charge a lump sum fee for the right to buy as many goods as the consumer wants at a per-unit price
Bundle the Goods together
Pure Volume Discounts
Volume Discounts are based on the belief that as customers consumer more and more of a good, they value additional quantities of the good less and less
Consumers are willing to pay less for additional quantities of the good
For example, consider Home Depot’s pricing decision for interior wall paint
Home Depot knows that some people are only planning to paint one or two rooms
These small buyers will highly value that 1st quart or gallon of paint because they are painting so little
And because they are buying so little paint, they are relatively insensitive to the price of paint
Home Depot also knows that some people will be painting a lot of rooms and need a lot of paint
These large buyers will value an additional quart or gallon of paint a lot less than the small buyers
Since they are spending more on paint, they will be more price sensitive
Since it is impossible for Home Depot employees to identify small and large paint buyers prior to the sales transaction, all paint buyers are offered the same price schedule:
Large buyers of paint (5 gallon buckets) face lower prices per gallon than smaller buyers (1 gallon pails)
Buyers self select themselves into lower and higher priced groups
Volume Discounts: Two-Part Pricing
Two Part Pricing is another Volume Discount scheme where prices decline as the amount purchased by the customer increases
Firm charges:
A lump sum fixed fee for the right to buy as many units of the good as the consumer wants at a per unit price
Examples:
Fitness clubs charge a yearly access fee and a price per session
Warehouse stores require an annual membership fee before being allowed to buy goods at relatively low prices
For increased profitability, the following conditions must be present:
How many units the customer purchases must be significantly price sensitive
Product cannot be resold or stored for later use
Two-Part Pricing (continued)
By charging a fixed fee, firm is able to extract (some) consumer surplus
Does not require different elasticities of demand
Consumers vary the amount they purchase according to their own demand for the product
Principle: Charge a per unit price equal to MC of serving 1 additional customer plus a fixed fee equal to the consumer surplus each consumer receives at this per-unit price
Note that if the MC of serving 1 additional customeris $0, there may just be a lump sum fee for the right to purchase the product
Disneyland: you pay a lump sum fee to enter the amusement park, but $0 for each ride
Two Part Pricing: an Example
Suppose Jane is a gym rat and will go to the gym a maximum of 20 times a month
Jane is willing to pay:
$1 for the first 10 visits to the gym for a total of $10 in revenues a month for 10 visits
$0.75 for the next 10 visits to the gym for a total of $17.50 in revenues a month for 20 visits
In order to induce Jane to visit more than 10 times, the gym has to lower the price per visit
Suppose the MC to the gym for each visit is $0
The gym could charge a price of $0.75 per visit, Jane will visit 20 times and the gym would get $15.00 in revenues.
Jane values the 20 visits at $10 for the first 10 visits and $0.75 for then next 10 visits for a total of $17.50 in value
Instead it could charge a monthly fee of $17.50 per month with $0 per visit.
Jane could go to the gym as many or as little times as she would like
Note that revenues have increased from $15.00 to $17.50
Other Pricing Strategies: Commodity Bundling
Commodity Bundling is selling multiple goods and services for a single price
Cable companies selling a package of TV, internet and phone services
Microsoft selling its Office package including Excel, Word, PowerPoint, etc.
Whether it pays to bundle or sell products separately depends on how the willingness to pay for each of the products vary across customers.
This assumes that you cannot identify the willingness to pay of the customers for the individual products (cannot price discriminate)
Let’s look at Microsoft’s decision to bundle.
For simplicity, assume that MC of producing 1 box of software = $0 so that profits are essentially equal to revenues
Bundling Example #1
Microsoft has two types of customers with the same number of customers in each group: Bobs and Alishas with the following willingness to pay (WTP).
Bundling allows seller to gain more profit (extract more consumer surplus) if:
Willingness to pay for the bundle is more homogenous (has less variability) than the willingness to pay for the individual products
| Word | |||
| Processor | Spreadsheet | Bundle | |
| Bobs WTP | $120 | $50 | $170 |
| Alishas WTP | $90 | $70 | $160 |
| Profit Maximizing Price | $90 | $50 | $160 |
| Nmber of Units Sold | 2 | 2 | 2 |
Bundling Example #2
If the variability of the bundle’s WTP is greater than the individual products, bundling would not increase profits
Only 1 spreadsheet would be sold because the incremental revenues of the second spreadsheet is -$10
Sell 1 spreadsheet at a price of $90 TR = $90
Sell 2 spreadsheets at a price of $40 TR goes down to $80
MR of selling second spreadsheet is $80 - $90 = $-10
Sold Separately: Revenues = 2 x $90 + $90 = $270
Sold as a Bundle: Revenues = 2 x $130 = $260
| Word | |||
| Processor | Spreadsheet | Bundle | |
| Bobs WTP | $100 | $90 | $190 |
| Alishas WTP | $90 | $40 | $130 |
| Profit Maximizing Price | $90 | $90 | $130 |
| Nmber of Units Sold | 2 | 1 | 2 |
Other Pricing Strategies: Cross Subsidies for Pricing for Firms with Multiple Products
Relevant if:
Costs of 2 or more products are shared
Demand for 2 or more products are interdependent
Pricing one product below cost can stimulate the demand for complementary products
Razors and blades
Loss leaders
Incremental revenues from the higher priced product must be greater than the incremental losses suffered from pricing the other product below cost
Principle: Whenever the demands for two products are interrelated through costs or demand, the firm may enhance profits by cross subsidization: selling one product at or below cost and the other product above cost
Other Pricing Strategies: Peak Load Pricing
Peak Load Pricing: charging higher price for a good or service during peak times than at off peak times
Product cannot be storable
Different prices are based on cost differences – not technically price discrimination
Operating costs are the same at all times
Capacity costs are the costs of purchasing resources to serve peak times
But, capacity costs are not just incurred at peak time, but at non-peak times too
Capacity is an incremental cost only for changes in demand during peak times
Charge higher prices for use during peak times to manage demand (and not incur even higher capacity costs)
Examples of industries charging different prices at different times: airlines, hotels, electric and gas utilities, toll bridges and parking garages.
Similar to “Surge” Pricing that Uber uses
Higher the demand for Uber at any time, the greater the price
These times also tend to be times of more inelastic demand (when its raining, New Years Eve, etc.)
Other Pricing Strategies: Price Matching
Firm advertises a price and promises to “match” any lower price offered to a competitor or low-price guarantees
If all firms announce such a policy, they can set the price at a relatively high level and earn high profits.
No firm will have an incentive to charge a lower price to steal customers
If a firm lowers its price, the rivals would match the price triggering a potential price war
Firm does not have to monitor other firm’s prices
Even if customer found lower price, a firm with price matching strategy would get to price discriminate between customer who found such a price and those who did not.
Two things to consider:
Need to devise a mechanism that precludes customers from claiming they found a lower price when in fact they have not
Your firm can get into trouble with such a strategy if your competitors have lower costs
Other Pricing Strategies: Inducing Brand Loyalty
Brand Loyal customers will continue to buy a firms’ products even if another firm offers a (slightly) better price.
Reduces customer switching between firms
Makes the demand for the product more price inelastic
Ways to Induce Brand Loyalty:
Advertise that the firm’s product is better than others
Loyalty Discounts: the more you buy, you get 1 free (volume discount)
Buy 9, get the 10th free
Frequent flier programs
Pricing Strategies for New Products
Skimming: setting a high price when a product is introduced and gradually lowering its price
Usually done for durable goods such as refrigerators, personal computers, etc.
Often difficult to determine the strength of demand when a product is introduced
Starting with high price allows firm to sell product to customers who value it the most
Particularly useful if firm has limited production capacity.
Can be used if demand for new product is likely to be more price inelastic earlier in its life cycle
Cross elasticity of demand with other products should be low (so high price of new product does not decrease demand of related products)
May require high promotional expenditures to stimulate demand
Penetration Pricing: setting a low price when a product is introduced and gradually raising its price
Use when price elasticity of demand for then new product is high (elastic)
Costs decrease significantly with greater amounts of sales
Product is acceptable to a mass of consumers
Inappropriate if market is to remain small
Imminent threat of potential competition so that market share must be captured quickly
Long term pricing strategy with little changes in prices expected
Inappropriate if the firm needs to recover significant capital costs over a long time period
How to Set Prices: Value Added Pricing
What price can be justified by the customer’s perceived value of the product relative to other similar products?
Economic Value: Price of the customer’s best alternative (reference value) plus the value to the consumer of how your firm’s product differentiates itself from the alternative
Notice similarity to consumer surplus
Reference Value is the price that a competitor charges
For Samsung Galaxy, it might be the iPhone 6S
For Ford Fusion, it might be the Toyota Camry
Differentiation Value: net benefits that your product or service delivers to customers over and above those of your competitors reference value
Steps to Estimate Economic Value
Identify the cost of the competitive product or process (reference value)
Identify all factors that differentiate your product from the competitor
Determine the value to the customer of these differentiating factors (the differentiation value)
Customer surveys
Customer interviews
Sum the reference value and differentiation value to determine the total economic value
These values may be different for different user groups or market segments
Value Added Pricing: Examples
Greek Yogurt vs. Regular Yogurt:
Greek Yogurt price is about 40 cents more than regular yogurt
Difference in price is due, in part, to perceived higher value of Greek yogurt:
Preference for different texture
Higher amount of protein
Proctor & Gamble Tide Pods: premeasured detergent balls costing about $2.00 more than regular Tide
Eliminates measuring, saves time
When to Use Each Pricing Methodology
All of these assume that the firm has some market power (control over prices)
Simple Pricing
Some knowledge of magnitude of the firm’s price elasticity of demand and marginal costs
Cost Based Pricing
No knowledge of demand or cost functions
Intensely traded products (oil and other commodities)
Products sold to highly sophisticated customers (automotive industry)
Direct and Indirect Price Discrimination
Knowledge that price elasticities differ among different groups
Ability to separate and identify such groups
No ability for resale
Two Part Pricing: 2 scenarios
Popular product where the value to the customer is greater than just the use of it
Charge an up front fee – like Country Clubs
Frequently purchased product with some users who are heavy users and price sensitive
Charge an up front fee – like Amazon Prime
When to Use Each Pricing Methodology
Volume Discounts
Consumers use more than one unit of the product within a short time period
Product is storable, not perishable
Examples: toilet paper, soda
Value-Based Pricing:
Need to have specific competitor product customers can buy instead
Will not work with new products without any peers
Some idea of the differentiated value of your product vs. similar products
Depends upon how smartly competitors have priced their products
Useful in the following situations:
Niche markets (products applied to a specific segment)
Where products are similar to one another
Two Conclusions about Pricing
If possible, charge more than 1 price for the same good
Charge the more elastic customer a lower price
Charge the more inelastic customer a higher price
Students should be:
Understand the purpose of pricing
Understand what optimal (monopoly) pricing is and its limitations
Understand what cost based pricing is and its limitations
Understand the impact of differences in price elasticity on pricing
Understand the forms of price discrimination and when each can be used
Understand Value Added Pricing and its usefulness in determining the price of a product
