Chap 16

Slide 12002 South-Western Publishing

• Value-based more than cost-based pricing often helps build profits.

• Firms charge different customers different prices, which is known as price discrimination.

• This chapter also looks at pricing within a firm called transfer pricing.

• Pricing techniques that are used by many multi-product firms, such as full-cost pricing and target return pricing.

Pricing Techniques and Analysis Pricing Techniques and Analysis Chapter 16Chapter 16

Slide 2

Proactive Value-based Pricing• If the price doesn’t fit what customers are willing to

pay, then the product may not be profitable.» Customer value is the focus for pricing, not just the costs

associated with the product. » Apple Computer lost market share by ignoring this.» The Ford Mustang was a success, as Ford found that

people wanted a sports car, but didn’t want it to be too expensive. The started with a price and designed the product.

• The Mustang used value-based, not cost-plus pricing

Slide 3

Differential Pricing

• If at peak rush hour, the toll is higher than at the off-peak, we are using different prices at different time periods.

• The peak toll can encourage shifting travel patterns to off-peak times or discourage some commuting altogether.

• Differential pricing appears more frequently than one thinks. This we call price discrimination.

Slide 4

Price DiscriminationPrice Discrimination Price Discrimination -- Goods which are

NOT priced in proportion to their marginal cost, even though technically similar

Some Necessary Conditions:1. Some Monopoly Power

• In Perfect Competition, P = MC

2. Ability to Arbitrage• Separate Customers and Prevent Reselling

Slide 5

Arbitrage - Buy Low to Sell Higher

• Arbitrage of Goods is Easy» Price discrimination of goods is ineffective» Little price discrimination of grocery items

• Arbitrage of Services is Difficult» Price discrimination of services is effective» Price discrimination at restaurants by age, a service» Lawyers charge different prices for wills, based on

ability to pay

Slide 6

Many Ways to Separate Customers for Price Discrimination

1. Geography

2. Income

3. Gender

4. Age

5. Time

6. Race

7. Language

8. Transient / Resident

9. Ability to Haggle

Slide 7

Why Practice Price Discrimination?Why Practice Price Discrimination?

• In Simple Monopoly, there is only one price

• Consumers receive a consumer surplus

• In Price Discrimination, monopolists can SCOOP OUT all consumer surplus

Q

D

MC

PSM

QSM

CS

Simple Monopoly

Slide 8

First Degree Price Discrimination

• Charge the MOST that a person is willing to pay for each good

• Zero consumer surplus• Produce MORE than

in Simple Monopoly• Output the same as in

Competition

QD

MCPrice Discriminating Monopoly

Q1st

Slide 9

Car Sales as First Degree Price Discrimination

“How much do you plan to pay a month?”

you inadvertently reply:

“Only $200 per month, but I have $3,000 down payment!”

Ahh, that is $9,887 for 60 months at our 7.9% financing, plus $3,000

Here’s one for only$12,887. It’s swell.

Slide 10

Notice: Incentives to Understate One’s True Willingness to Pay

• The conditions for First Degree price discrimination are seldom met

• Hence, some close approximations exist

• There are are a variety of ways to group units to attempt to scoop out consumer surplus

Second Degree Price Discrimination: Units are Grouped

Slide 11

Second Degree Price Discrimination Methods

• Block rate setting

• Two part pricing

• Unlimited access

• Bundling methods

We look at four examples:

Slide 12

Block Rate Pricing• Price declines as the quantity purchased

increased• Examples:

» Tri-State Gas Company example (page 632)

» TJ Maxx, second pair half price» telephone charges» foreign film festivals

• Price declines similar to the demand curve Q

P D

Second Degree Price Discrimination:

Slide 13

Two-Part Pricing:

• A price for the privilege of buying items

• And a price per item

• Examples:» Country Club Dues

and Greens Fees» Cover Charge to

Enter and a Price Per Drink

CoverCharge

MC

Q

Another Second Degree Price Discrimination:

Slide 14

If P = 4.50 - Q and MC = .50Find Optimal Cover Charge

• At P = $.50, he/she buys 4 mugs of root beer

• Biggest cover charge is the area of a triangle» Height is 4» Base is 4» (1/2)Height•Base

• Max cover charge is $8.00

CoverCharge $8

$.50

Q4

$4.50

Monopoly: QM = 2 & PM = $2.50

QM

PM=$2.50

CoverCharge$8.00

Slide 15

Unlimited Accessor All-You-Can-Eat Pricing

A specified price for an unspecified quantity:

Example: AOL unlimited access for $19.95/monthExamples: Salad Bars, Legal Retainers, HMO’s

ounces

Area under demandcurves represent mostwilling to pay for an AYCE offer

P

Second Degree Price Discrimination:

Slide 16

Bundling (or Block Booking)Often the pricing arrangement includes purchasing groups of dissimilar products. The products are bundled or sold as a block, as in theatrical or sporting tickets.

Preferences are uncorrelated Preferences are correlated

1

2

A B A B

150150 100

80 190190

250

270

160 200 = 360 simple monopoly

500 80 100100

165 175175

180

340

165 200 = 365 simple monopoly

360

Second Degree Price Discrimination:

Slide 17

Third Degree Price Discrimination

East West Market

MCMR

PM

Example with a Simple Monopoly Price in both markets

Slide 18

Third Degree Price Discrimination

East West Market

MCMR

PM

Example with Different Prices in Each Market

PE

PW

MR

MR

Slide 19

Pricing In Segmented Markets• Segment markets by

price sensitivity

• Charge higher prices in the markets that are the most inelastic

• Then P1 = $150 and

• P2 = $120

P ( 1 + 1/ EQ•P ) = MC

Suppose MC = $100 in 2 marketsand E1 = - 3 and E2 = - 6

Why are haircuts forkids cheaperthan for adults?

Slide 20

• Products are INDEPENDENT when changes in price and quantity of one product do not alter revenues or cost in the others

• Products are INTERDEPENDENT, when changes DO affect other products

• Ex: Procter & Gamble makes both Luvs and Pampers

» TR = TRA + TRB

Pricing of Multiple Product

Slide 21

Substitutes & Complements• Look for interdependencies in marginal

revenues:

» MRA = TRA / QA + TRB / QA

» MRB = TRA / QB + TRB / QB

• Substitutes when cross terms are negative» Erosion or Cannibalism are terms used

• Complements when cross terms are positive» BASE sells tapes and tape head cleaners

Slide 22

Decision Rule for Multiple Product Firms

• Do NOT use the rule to produce where MR=MC, as in MRA = MCA

• INSTEAD: » Produce where the FULL MR = FULL MC» For a Two Product Firm of A & B» Produce where:

TRA /QA + TRB /QA = TCA /QA + TCB /QA

Include all relevant revenue and cost effects

Slide 23

Pricing Example in Supermarkets

• Turkey prices fall during Thanksgiving» Yet we would expect DEMAND to be greatest?!

• Loss Leader Pricing» Consider T as turkey» and A as all other food

• TRstore = TRT + TRA

MRstore for turkey = TRT /QT + TRA /QT

• Complementarity with other food explains the apparent conundrum

Slide 24

Pricing of Joint Products• Interdependencies in costs occur in products

that are produced simultaneously

• E.g., Beef & Hides; Wool & Mutton; Natural Gas & Crude Oil

• Suppose FIXED PROPORTIONS in production: 500 lbs. of Beef + 10 sq. yards of

Hide for 1 steer.

• Two cases: No Excess of Hides, and Excess Hides case

Slide 25

Steers: No Excess Case

steers (T)

DH DB

MRH

MRB

Two Demand Curves:Hides & Beef

Two MR Curves:Hides & Beef

Slide 26

Steers: No Excess Case 2

steers (T)

DH DB

MCT

MRH

MRTFind whereMRT = MCT

to find theoptimal ofsteers.

Slide 27

Steers: No Excess Case 3

steers (T)

DH DB

MCT

MRH

MRT At the optimal number of steers, findthe prices of beef & hides on theirrespective demand curves

T

PB

PH

if demand for beef rises, the price of hides will fall !

Slide 28

Excess of One of the Joint Products

• Excess means the price would be ZERO

• The solution is to hold back some of the excess to reach the Unit Elastic Point on the Demand Curve.

• This Maximizes Total Revenue.

Slide 29

Multi-Divisional Firms and the Economics of Transfer Pricing

Transfer Pricing serves two functions:

1. Measure of the marginal value of the resource

2. Provides a performance measures of resources used

For international firms, transfer pricing may assist in reducing worldwide taxation, but the ability to reducetaxation is limited because the IRS requires arm’s length prices.

Slide 30

Create Transfer Prices Similar to Competitive Market Prices

• Disagreements across divisions are common» “Selling” Division wants a HIGH transfer price

» “Buying” Division wants a LOW transfer price

• When External Markets exists, use those prices for transfer (a market-based competitive price)

motor assemblyfinal carassembly

sell to others @ “P”

purchase motors from others @ “P”

Slide 31

Transfer Pricing With No External Markets

• When no external markets exist, use the MC of the transferred good.

• Often, however, the MC is a function of output.

• Marketing and Production steps (M & P)

• Transfer price is PT = MC P on following figure

Slide 32

Find Where MCM+P = MR

D

MCM

MCP

MCM+P

MR

P

PT

Slide 33

Pricing in Practice

• In practice, pricing strategy involves the whole life-cycle of the product.

• Managers report wide use of cost-plus pricing methods because it:» Streamlines pricing of multiple products

» Streamlines pricing of retail prices

Slide 34

Cost-Plus and Full Cost Pricing

P = ACn + Markup

or P = ACn(1 + m) where ACn is average cost at a normal output

and m is a percentage markup• Notice: Little reliance on MC pricing or use of

elasticities, as in: P( 1 + 1/Ep ) = MC

Slide 35

Cost-Plus Pricing: IllustratedManufacturing pricing illustrated: One Good

AFC

AVC

Qn Qcapacity

ACn

} markup

PATC

Slide 36

Cost-Plus Pricing: Illustrated

AFC

AVC

Qn Qcapacity

ACn

} markup

P

D1 D2

quantityvaries asdemandvaries

Slide 37

Cost-Plus Pricing: Illustrated

AFC

AVC

Qn Qcapacity

ACn

} markup

P

D1 D2

quantityvaries asdemandvaries

Q1Q2

Slide 38

Full Cost Pricing• Full Cost--

» Covers all Costs at the standard or normal output » Plus a return on the investment

• P = AFCn + AVCn + K / Qn

» where K is the target amount of profit

» and is the desired profit rate and K is gross operating assets

• Example: Low Tech SecurityFC = 200,000, Qn = 3000, VC = 90,000

= 20% and K=$500,000. Find Full Cost Price!

Slide 39

Full Cost Pricing• Answer

» P = AVC + AFC + (.20)(500,000)/Q

» P = 30 + 66.67 + 33.33

= $130

• Also, suppose a 35% markup on cost» P = [ ACn] (1.35)

» P = [ 30 + 66.67 ](1.35)

» P = $130.50

Slide 40

Advantages• Cost-plus is simple• It is easy to delegate to

others• Easy to apply to

thousands of items» Can use categories of

markups for different classes of products

Disadvantages• But cost-plus ignores demand

changes• Pricing may be based on poor

cost data• Output varies in business cycle

Hybrid Method: VariableCost-Plus Pricing -- the markup can vary over the season or business cycle

Cost-Plus Pricing

Slide 411999 South-Western College Publishing

Optimal Markups in Practice

• Grocery stores have low markups

• Many close substitutes -- at other grocery stores (bread varieties and qualities are standardized)

• Frequent purchase, so customers are knowledgeable about prices & quality

• Demand is therefore highly elastic

• Optimal markup would consequently be small

Slide 421999 South-Western College Publishing

Markups on Jewelry• Jewelry Markups are known to be large

• Difficult to make comparisons across jewelry stores

• Little repeat purchases, so knowledge about prices is low

• Consequently, lower price elasticity for jewelry

• The optimal markup is larger

Slide 431999 South-Western College Publishing

Skimminga form of block rate pricing over time

• Price declines over time

• Those who wish to get it first pays the highest price, others are willing to wait

• Examples:» Hardcover & Paperback

Books » New electrical & Computer

Products TIME

P D

Slide 44

Revenue Management: Appendix 16A

• Revenue Management is the problem of the disappearing inventory.

• Managers must be flexible to change their predicted sales by market segment as information arrives.

• Airlines price discriminates between business and non-business travelers. If too few business travelers have booked tickets compared to the amount expected, then more non-business tickets should be released.

Slide 45

Optimal Overbooking• Managers may authorize reservation clerks to sell

more seats (rooms) than are available.

• The greater the overbooking, the lower are the costs of spoilage.

• Spoilage is an inventory NOT sold. If capacity is large, an airline or hotel will have high spoilage.

• The greater the overbooking, the greater are the costs of spillage, making customers unhappy by finding that they have no seat or reservation.

Slide 46

Spillage

• Spillage is the excess demand that cannot be met.

• If the service industry has low capacity, the spillage will be great

• Customers leave the hotel or airline unable to get a room or an airplane seat.

Slide 47

Optimal Overbooking• Spillage and spoilage costs go in

opposite directions, the sum of these costs has a minimum with the optimal amount of overbooking.

• Since business travelers tend to a large extent to be repeat customers, the cost of spillage (oversells) may be very high.

• The optimal amount of overbooking for this market segment may well be lower than for non-business clients.

100% 110% 120% ...

Percent Overbooked

Spoilage

Spillage

TotalCost

optimal