Pricing strategies 2

Peak-Load PricingWhen demand is not evenly distributed, a firm needs to have

facilities to accommodate periods of high demand.Even with large facilities, the firm may experience times when

the demand is greater than can be handled. Then the firm may experience costly computer system crashes.

During off-peak times (periods of lower demand), there is excess capacity.

The firm charges less at off-peak times.Example: More phone calls are made during business hours

than in the evenings and on weekends. So the phone companies charge more during business hours.

Peak load pricing• The effect of peak-load pricing is to induce some

consumption to shift, away from the times of• peak demand, and toward times of lower

demand. Consumers are rewarded -- in the sense that they pay

• less -- for using the service when there is ample unutilised capacity, rather than when demand takes up

• or even exceeds all the capacity. This makes for more efficient use of existing capacity.

Peak load pricing

• Telephone service providers, for instance, charges a lower call rate from 11:00 pm to 6:00am. Long distance calls made during off-peak periods also cost less. Some “decongestion” results from this practice.

• The same outcome happens when airlines charge higher fares during the tourist season.

Peak load pricing

• This shifting of consumption creates what economists call “efficiency gains.” If airfares were kept uniform, airlines would forego profits because they have to turn away passengers when flights are fully booked, while other flights take off with a lot of empty seats.

• The “average” price has the effect of encouraging higher consumption during peak periods and lower consumption during off-peak periods -- which producers and consumers don’t really want.

Peak load pricing

• The high demand at certain hours would compel the producers to install additional capacity. Producers would have to pump in additional capital, and pass the cost on to consumers. However, the increased capacity becomes even more under-utilized during the off-peak hours.

Peak load pricing

• The effect of peak-load pricing is to induce some consumption to shift, away from the times of

peak demand, and toward times of lower demand. Consumers are rewarded -- in the sense that they pay less -- for using the service when there is ample unutilised capacity, rather than when demand takes up or even exceeds all the capacity. This makes for more efficient use of existing capacity.

Two- Part Tariffs

• Two- Part Tariffs Consumers pay a one-time access fee (T) for the right to buy a product, and a per-unit price (P) for each unit they consume.

• Examples: Amusement parks, Golf Clubs, T-passes,• Necessary conditions for Two-Part Tariff implementation: • Firm must have market power • Firm must be able to control access • Homogeneous consumer demand (all the consumers

within the same segment have the same demand curve)

Example

• Some video game stores offer customers two ways to rent cds:

• (i) Pay an annual membership fee (e.g., $40), and then pay a small fee for the daily rental of each film (e.g., $2 per film per day) (Two part Tariff)

• (ii) Pay no membership fee, but pay a higher daily rental fee (e.g., $4 per game per day) (Simple rental fee) Why might it be more profitable to offer consumers a choice of two plans, rather than a single plan for all customers?

•

Example

• A classic price discrimination example. The store has created a menu of choices where each plan appeals to a different group of consumers that will self select into the option designed for them. The high demand consumer will probably choose the two-part tariff, while the casual consumer will prefer the simple rental fee.

• Profits will be greater with price discrimination than with a single pricing scheme for all customers

The “Two-Part Tariff”

• There are two components to the price: a unit price (P) for each unit consumed, & a “tariff” (T) for entry into the market.

• Examples include telephone service, health clubs, etc.

• The tariff enables the firm to capture some consumer surplus.

Suppose that a firm has constant average and marginal costs as shown.

P

D

ATC=MC

Q

P*

Q*

Also, each customer has the indicated demand curve.

Suppose that the firm charges price P* per unit.

Based on the per unit charge, the firm earns revenues equal to the area of the blue box.

The firm can also pick up the consumer surplus,

• P

D

ATC=MC

Q

P*

Q*

if it charges a membership fee equal to the area of the green triangle.

Bundling

• Bundling is packaging two or more products to gain a pricing advantage.

• Conditions necessary for bundling to be the appropriate pricing alternative:

• Customers are heterogeneous. • Price discrimination is not possible.• Demands for the two products are negatively

correlated.

Bundling

• Bundling Bundling refers to selling more than one product at a single price.

• When is bundling applicable: • The firm has market power • Price discrimination is not possible (inability to offer

different prices to different customers or segments) • Demand for two or more goods to be sold is

negatively correlated (the more consumers demand one good, the less they will demand of the other good)

Types of bundling

• Pure Bundling: Consumers must buy both goods together; the choice of buying one good without buying the other is NOT given.

• Mixed Bundling: Consumers have the choice of buying both goods or buying one good without the other.

Consider the following reservations prices, for two buyers: Alan and Beth

Stereo TVSum of

reservation prices

Alan $225 $375 $600

Beth $325 $275 $600

Maximum price for both to buy the good $225 $275

To get both people to buy both goods without bundling, you can only charge $225 + $275 = $500, & each person would have consumer surplus of $600 – $500 = $100. If you bundle, you can charge $600 & consumer surplus = 0.

Transfer Pricing

• Sometimes firms are organized into separate divisions.

• One division may produce an intermediate product and supply it to another division to produce the final product.

• How does the firm determine the efficient price at which the intermediate product should be sold. That is, what is the transfer price?

The Simplest Case

• The firm has 2 divisions: E and A• Division E produces the intermediate product (engine) for

Division A which produces the final product (automobile).• Division E does not sell engines to anyone but division A,

and division A does not buy engines from anyone but division E.

• Each unit of output (automobile) requires one unit of the input (engine).

• The goal is to maximize the firm’s profit.

•First, find the company’s (total) marginal cost MCT, which is the marginal cost of division E’s producing an engine (MCE) plus the marginal cost of division A’s producing an auto (MCA).

•That is, MCT = MCA + MCE .

•Then, produce the amount of output (autos) so that the marginal revenue from selling an auto (MR) is equal to the marginal cost of production (MCT).

•The appropriate price of the auto for that quantity of output is determined from the demand curve for the firm’s autos.

How do we determine the optimal quantity & price for the final product (the auto)?

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Transfer pricing

Transfer Price is:the internal price charged by one segment of a firm for a product or service supplied to another segment of the same firm

Such as:• Internal charge paid by final assembly division for

components produced by other divisions• Service fees to operating departments for

telecommunications, maintenance, and services by support services departments

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Transfer Pricing

• The transfer price creates revenues for the selling subunit and purchase costs for the buying subunit, affecting each subunit’s operating income

• Intermediate Product – the product or service transferred between subunits of an organization

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Effects of Transfer Prices

Performance measurement: • Reallocate total company profits among business

segments• Influence decision making by purchasing, production,

marketing, and investment managers

Rewards and punishments:• Compensation for divisional managers

Partitioning decision rights:• Disputes over determining transfer prices

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Three Transfer Pricing Methods

1. Market-based Transfer Prices2. Cost-based Transfer Prices3. Negotiated Transfer Prices

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Market-Based Transfer Prices

• Top management chooses to use the price of a similar product or service that is publicly available. Sources of prices include trade associations, competitors, etc.

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Market-Based Transfer Prices

• Lead to optimal decision making when three conditions are satisfied:

1. The market for the intermediate product is perfectly competitive

2. Interdependencies of subunits are minimal3. There are no additional costs or benefits to the

company as a whole from buying or selling in the external market instead of transacting internally

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Market-Based Transfer Prices

• A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions

• Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomy

• Perhaps should not be used if the market is currently in a state of “distress pricing”

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Cost-Based Transfer Prices

• Top management chooses a transfer price based on the costs of producing the intermediate product. Examples include:– Variable Production Costs– Variable and Fixed Production Costs– Full Costs (including life-cycle costs)– One of the above, plus some markup

• Useful when market prices are unavailable, inappropriate, or too costly to obtain

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Negotiated Transfer Prices• Occasionally, subunits of a firm are free to negotiate the

transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties

• May or may not bear any resemblance to cost or market data

• Often used when market prices are volatile• Represent the outcome of a bargaining process between

the selling and buying subunits

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Comparison of Transfer-Pricing Methods

Criteria Market-Based

Cost- Based

Negotiated

Achieves Goal Congruence

Yes, when markets are competitive

Often, but not always

Yes

Useful for Evaluating Subunit

Performance

Yes, when markets are competitive

Difficult unless transfer price

exceeds full cost

Yes, but transfer prices are affected

by bargaining strengths of the

buying and selling divisions

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Comparison of Transfer-Pricing Methods

Criteria Market-Based

Cost- Based

Negotiated

Motivates Management

Effort

Yes Yes, when based on budgeted costs; less incentive to control costs if

transfers are based on actual costs

Yes

Preserves Subunit Autonomy

Yes, when markets are competitive

No, because it is rule-based

Yes, because it is based on

negotiations between subunits

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Comparison of Transfer-Pricing Methods

Criteria Market-Based

Cost- Based

Negotiated

Other Factors No market may exist or

markets may be imperfect or

in distress

Useful for determining full cost of

products; easy to implement

Bargaining and negotiations

take time and may need to be

reviewed repeatedly as

conditions change

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Minimum Transfer Price

• The minimum transfer price in many situations should be:

– Incremental cost is the additional cost of producing and transferring the product or service

– Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally

Minimum Transfer Price =

Incremental cost per unit incurred up to the point of

transfer +Opportunity Cost per unit

to the selling subunit

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Transfer Pricing for International Taxation

When products or services of a multinational firm are transferred between segments located in countries with different tax rates, the firm attempts to set a transfer price that minimizes total income tax liability.

Segment in higher tax country:Reduce taxable income in that country by charging high prices on imports and low prices on exports.

Segment in lower tax country:Increase taxable income in that country by charging low prices on imports and high prices on exports.