ECO 6301 V

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit V At the end of this unit, you should be able to:

3. Analyze how price and output influence profit maximization under different market structures. 3.2 Explain how market power affects different types of pricing strategies.

4. Evaluate strategic pricing decisions.

4.1 Explain the conditions necessary to price discriminate. Required Unit Resources Chapter 12: More Realistic and Complex Pricing (ULO 3.2) Chapter 13: Direct Price Discrimination (ULO 4.1) Chapter 14: Indirect Price Discrimination (ULO 4.1) Article: Public Subsidies and the Location and Pricing of Sports This article discusses sports subsidies and pricing by analyzing how sports teams make decisions. Unit Lesson Lesson: Pricing and Greater Profit (ULOs 3.2, 4.1) This lesson introduces you to the topics covered in this unit. Firms have to answer two important questions: How much of their product should they produce, and how much should they charge for their product? The two are certainly linked, but the pricing decision is generally more complicated and drives the production decision. In basic economics, price is determined by the intersection of supply and demand, with price (P) determined on output determined by marginal revenue (MR) equals marginal cost (MC). A pricing strategy given earlier in the course is to set price such that the following equation holds:

In practice, however, pricing strategies often deviate from this standard theory. Sometimes, for example, firms have multiple products and this affects their pricing strategies. A firm might want to lower prices to sell more of a product, but if the increase in sales in one product simply comes from “stealing” sales from another of their products, then this is not really a net gain to the company. Also, owning more brands in a market gives the firm more market power, which means raising prices is more profitable. A potential problem with raising prices based on newfound market power is that it could attract the attention of the Antitrust Division of the Justice Department. The question is what to do strategically. A profit improving approach would be to raise the price on whichever product has a lower profit margin. With the lower margin product now being relatively more expensive, consumers will be more likely to purchase the higher profit margin. The preceding strategy is based on the goods being substitutes. If a single producer yields two products that are complements, then the profit maximizing action is to reduce the price on both products. By reducing the

UNIT V STUDY GUIDE Pricing and Greater Profit

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

price, the producer increases quantity demanded for one good, but as a result, increases demand for the other good. Increasing sales of both products increases total profit. Another pricing situation of interest is when producers have fixed capacity (think a cruise ship or concert). In these cases, lowering prices to sell more product does not necessarily work because there might not be the ability to provide more product. The result might be a situation where MR > MC, contrary to the standard profit maximizing rule that MR = MC. Promotional pricing is another instance where firms might deviate from the standard pricing rule. Advertising can serve two broad goals: promote based on price or promote based on quality. The type of advertising will determine the appropriate price strategy. If the advertising focuses on promoting products based on price, demand will become more elastic, so lowering price makes sense. If the advertising focuses on promoting product quality, the demand will become more inelastic so raising price makes sense. This second point is important because price can often convey information about product quality. Promoting product quality and lowering price can send conflicting messages to consumers. Following in a similar vein of consumers inferring information about a product based on price, consumers sometimes have price expectations. Managing price expectations is why businesses will sometimes set a “suggested retail price” and then give the price of the product they are selling. The goal is to set a high price in the customer’s mind so that they will be happy about the lower price. You might also see producers set a low price but end up selling at a higher price or generating revenue some other way. Musicians might set low concert prices but then hold back tickets to sell themselves on the secondary market. Sports teams might set low prices to build up a fan base but then leverage that popularity to receive government subsidies for stadiums. If you would like to learn more about sports subsidies and pricing, you can read the article “Public Subsidies and the Location and Pricing of Sports” by Porter and Thomas.

Price Discrimination Up until now, the assumption has been that firms can only charge one price to all of their customers, but sometimes firms can charge different prices to different customers. This is called price discrimination. Examples of price discrimination are matinee ticket prices for movies and discounts for seniors and military members. Several criteria must be met for firms to successfully price discriminate. There must be consumers with different elasticities, that is different price sensitivity, and firms must be able to identify those different customers (consumers with more inelastic demands pay higher prices). As part of that identification, they must be able to implement different prices for those customers. Finally, firms must be able to prevent resale. If consumers who can buy at low prices are able to turn around and sell to the consumers willing to pay a high price, then firms lose their ability to sell to the high price consumers. Price discrimination comes in three different categories. First-degree price discrimination, also called perfect price discrimination, is when firms are able to charge each consumer their maximum willingness to pay. Car sales that involve negotiation are an attempt at first-degree price discrimination. Data mining is a growing tool to help firms toward first-degree price discrimination. Second-degree price discrimination involves things like volume discounts or frequent customer cards. The idea is not to charge different prices to every customer but to allow customers to self-select into different price points for the producer to increase profit. Third degree price discrimination alters prices based on demographics or other group characteristics. This is the category of price discrimination with student or military discounts or movie theaters changing prices by time of day. Firms can use a variety of ways to identify customers based on their elasticity. Take airline tickets, for example. There are certain days of the week to travel when ticket prices are lower, and people can often get tickets at a lower price if they purchase their tickets a few weeks in advance. Why? Because airlines are attempting to separate the elastic buyers (vacation travelers) from the inelastic buyers (business travelers). Who likely plans a trip at least a few weeks in advance? Vacation travelers. Who is more likely to need a

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

ticket on short notice? Business travelers. Who is unlikely to travel over a weekend? Business travelers. Who can afford to pay more for their ticket? Business travelers. Firms can also sell different versions of a product. Consumers with a high value for a product will likely need all of the bells and whistles of the product, but consumers with a low value for a product might only need the basic. That is why you might see a “pro” version of software or a “student” or “home” version. Sometimes, businesses can separate high use customers, such as printers and ink or razors and razor blades. The cost to buy the printer or the razor might be low, but to continue using the product requires ink or razor blades and those are sold at a higher markup. Firms can also use bundling to extract extra revenue. This strategy led to the value meals at McDonald’s or computers with preloaded software. Bundling increases the value of the base product, allowing producers to sell the product for a higher price. Customers might also be more inclined to pay a higher price for an all- inclusive deal than to pay small amounts to continually add features or products. A similar approach is taken with all-inclusive resorts and wrist bands at fairs. There is comfort in knowing that you can pay one price and be done with paying. Price discrimination sounds bad, largely because of the word discrimination, but it can be beneficial to society. When people hear about price discrimination, they often think of charging higher prices to certain consumers, but in many cases, it is about lowering prices (coupons, student discounts, matinees, etc.). Since some consumers can pay a lower price, that brings them into the market and allows them to benefit from the exchange. When looking at value to society, economists generally look at the total amount of exchange that occurs. How much the consumer benefits and how much the producer benefits are certainly interesting, but ultimately it is the amount of exchange that occurs. With price discrimination, the amount of exchange certainly increases, though it does come with more benefit going to producers and less going to consumers. Just because producers benefit at the expense of consumers does not mean consumers cannot benefit from price discrimination. Take Uber’s surge pricing, for example. Surge pricing is a type of price discrimination. People who are going to use an Uber on a busy night, such as Friday or Saturday night are going to pay more for an Uber. However, by charging more, Uber also attracts more Uber drivers to work on those busy nights. Without these additional drivers, Uber customers looking for an Uber on Friday or Saturday night would likely have long waits for an Uber or may not be able to get an Uber at all. Similarly, hotels charging higher prices during conferences, sporting events, and even natural disasters discourages demand and encourages consumers to be efficient in their consumption. By encouraging efficient consumption, there will be more rooms available for other people. Without the higher prices, more people would be left out. Certainly, this all works to the benefit of the producers, but it also works to the benefit of the consumer, and that is an important feature of price discrimination that should not be overlooked. It is another benefit of a free market system. Even if producers are acting in their own best interest, the benefits of those self-interested actions help other people.

Reference Porter, P. K., & Thomas, C. R. (2010). Public subsidies and the location and pricing of sports. Southern

Economic Journal, 76(3), 693–710. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=47776241&site=ehost-live&scope=site

ECO 6301, Economics for Managers 1

Course Learning Outcomes for Unit V At the end of this unit, you should be able to:

3. Analyze how price and output influence profit maximization under different market structures. 3.2 Explain how market power affects different types of pricing strategies.

4. Evaluate strategic pricing decisions.

4.1 Explain the conditions necessary to price discriminate. Required Unit Resources Chapter 12: More Realistic and Complex Pricing (ULO 3.2) Chapter 13: Direct Price Discrimination (ULO 4.1) Chapter 14: Indirect Price Discrimination (ULO 4.1) Article: Public Subsidies and the Location and Pricing of Sports This article discusses sports subsidies and pricing by analyzing how sports teams make decisions. Unit Lesson Lesson: Pricing and Greater Profit (ULOs 3.2, 4.1) This lesson introduces you to the topics covered in this unit. Firms have to answer two important questions: How much of their product should they produce, and how much should they charge for their product? The two are certainly linked, but the pricing decision is generally more complicated and drives the production decision. In basic economics, price is determined by the intersection of supply and demand, with price (P) determined on output determined by marginal revenue (MR) equals marginal cost (MC). A pricing strategy given earlier in the course is to set price such that the following equation holds:

In practice, however, pricing strategies often deviate from this standard theory. Sometimes, for example, firms have multiple products and this affects their pricing strategies. A firm might want to lower prices to sell more of a product, but if the increase in sales in one product simply comes from “stealing” sales from another of their products, then this is not really a net gain to the company. Also, owning more brands in a market gives the firm more market power, which means raising prices is more profitable. A potential problem with raising prices based on newfound market power is that it could attract the attention of the Antitrust Division of the Justice Department. The question is what to do strategically. A profit improving approach would be to raise the price on whichever product has a lower profit margin. With the lower margin product now being relatively more expensive, consumers will be more likely to purchase the higher profit margin. The preceding strategy is based on the goods being substitutes. If a single producer yields two products that are complements, then the profit maximizing action is to reduce the price on both products. By reducing the

UNIT V STUDY GUIDE Pricing and Greater Profit

ECO 6301, Economics for Managers 2

UNIT x STUDY GUIDE Title

price, the producer increases quantity demanded for one good, but as a result, increases demand for the other good. Increasing sales of both products increases total profit. Another pricing situation of interest is when producers have fixed capacity (think a cruise ship or concert). In these cases, lowering prices to sell more product does not necessarily work because there might not be the ability to provide more product. The result might be a situation where MR > MC, contrary to the standard profit maximizing rule that MR = MC. Promotional pricing is another instance where firms might deviate from the standard pricing rule. Advertising can serve two broad goals: promote based on price or promote based on quality. The type of advertising will determine the appropriate price strategy. If the advertising focuses on promoting products based on price, demand will become more elastic, so lowering price makes sense. If the advertising focuses on promoting product quality, the demand will become more inelastic so raising price makes sense. This second point is important because price can often convey information about product quality. Promoting product quality and lowering price can send conflicting messages to consumers. Following in a similar vein of consumers inferring information about a product based on price, consumers sometimes have price expectations. Managing price expectations is why businesses will sometimes set a “suggested retail price” and then give the price of the product they are selling. The goal is to set a high price in the customer’s mind so that they will be happy about the lower price. You might also see producers set a low price but end up selling at a higher price or generating revenue some other way. Musicians might set low concert prices but then hold back tickets to sell themselves on the secondary market. Sports teams might set low prices to build up a fan base but then leverage that popularity to receive government subsidies for stadiums. If you would like to learn more about sports subsidies and pricing, you can read the article “Public Subsidies and the Location and Pricing of Sports” by Porter and Thomas.

Price Discrimination Up until now, the assumption has been that firms can only charge one price to all of their customers, but sometimes firms can charge different prices to different customers. This is called price discrimination. Examples of price discrimination are matinee ticket prices for movies and discounts for seniors and military members. Several criteria must be met for firms to successfully price discriminate. There must be consumers with different elasticities, that is different price sensitivity, and firms must be able to identify those different customers (consumers with more inelastic demands pay higher prices). As part of that identification, they must be able to implement different prices for those customers. Finally, firms must be able to prevent resale. If consumers who can buy at low prices are able to turn around and sell to the consumers willing to pay a high price, then firms lose their ability to sell to the high price consumers. Price discrimination comes in three different categories. First-degree price discrimination, also called perfect price discrimination, is when firms are able to charge each consumer their maximum willingness to pay. Car sales that involve negotiation are an attempt at first-degree price discrimination. Data mining is a growing tool to help firms toward first-degree price discrimination. Second-degree price discrimination involves things like volume discounts or frequent customer cards. The idea is not to charge different prices to every customer but to allow customers to self-select into different price points for the producer to increase profit. Third degree price discrimination alters prices based on demographics or other group characteristics. This is the category of price discrimination with student or military discounts or movie theaters changing prices by time of day. Firms can use a variety of ways to identify customers based on their elasticity. Take airline tickets, for example. There are certain days of the week to travel when ticket prices are lower, and people can often get tickets at a lower price if they purchase their tickets a few weeks in advance. Why? Because airlines are attempting to separate the elastic buyers (vacation travelers) from the inelastic buyers (business travelers). Who likely plans a trip at least a few weeks in advance? Vacation travelers. Who is more likely to need a

ECO 6301, Economics for Managers 3

UNIT x STUDY GUIDE Title

ticket on short notice? Business travelers. Who is unlikely to travel over a weekend? Business travelers. Who can afford to pay more for their ticket? Business travelers. Firms can also sell different versions of a product. Consumers with a high value for a product will likely need all of the bells and whistles of the product, but consumers with a low value for a product might only need the basic. That is why you might see a “pro” version of software or a “student” or “home” version. Sometimes, businesses can separate high use customers, such as printers and ink or razors and razor blades. The cost to buy the printer or the razor might be low, but to continue using the product requires ink or razor blades and those are sold at a higher markup. Firms can also use bundling to extract extra revenue. This strategy led to the value meals at McDonald’s or computers with preloaded software. Bundling increases the value of the base product, allowing producers to sell the product for a higher price. Customers might also be more inclined to pay a higher price for an all- inclusive deal than to pay small amounts to continually add features or products. A similar approach is taken with all-inclusive resorts and wrist bands at fairs. There is comfort in knowing that you can pay one price and be done with paying. Price discrimination sounds bad, largely because of the word discrimination, but it can be beneficial to society. When people hear about price discrimination, they often think of charging higher prices to certain consumers, but in many cases, it is about lowering prices (coupons, student discounts, matinees, etc.). Since some consumers can pay a lower price, that brings them into the market and allows them to benefit from the exchange. When looking at value to society, economists generally look at the total amount of exchange that occurs. How much the consumer benefits and how much the producer benefits are certainly interesting, but ultimately it is the amount of exchange that occurs. With price discrimination, the amount of exchange certainly increases, though it does come with more benefit going to producers and less going to consumers. Just because producers benefit at the expense of consumers does not mean consumers cannot benefit from price discrimination. Take Uber’s surge pricing, for example. Surge pricing is a type of price discrimination. People who are going to use an Uber on a busy night, such as Friday or Saturday night are going to pay more for an Uber. However, by charging more, Uber also attracts more Uber drivers to work on those busy nights. Without these additional drivers, Uber customers looking for an Uber on Friday or Saturday night would likely have long waits for an Uber or may not be able to get an Uber at all. Similarly, hotels charging higher prices during conferences, sporting events, and even natural disasters discourages demand and encourages consumers to be efficient in their consumption. By encouraging efficient consumption, there will be more rooms available for other people. Without the higher prices, more people would be left out. Certainly, this all works to the benefit of the producers, but it also works to the benefit of the consumer, and that is an important feature of price discrimination that should not be overlooked. It is another benefit of a free market system. Even if producers are acting in their own best interest, the benefits of those self-interested actions help other people.

Reference Porter, P. K., & Thomas, C. R. (2010). Public subsidies and the location and pricing of sports. Southern

Economic Journal, 76(3), 693–710. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=47776241&site=ehost-live&scope=site