Pricing Strategies INTRODUCTION In this research we deal with pricing strategies of firms that have some market power: firms in monopoly, oligopoly and monopolistic competition. Firms in perfect competition are price takers and they don’t have a pricing strategy of their own. This research goes as far as providing practical advice on implementing pricing strategies for those firms with market power, typically using information that is readily available to managers, including publicly available information such as the price elasticity of demand. The optimal pricing strategies for firms with market power vary depending on the underlying market structure and the instruments (e.g., advertising) available & the nature of product whether it has elastic or inelastic demand (i.e. whether it is luxury or necessary good). To account for that, this research presents some sophisticated pricing strategies that enable a manger to extract greater profits from the consumers. BASIC PRICING STRATEGIES We will first look at the very basic pricing strategy which relies on single or uniform pricing. This strategy uses the profit- maximizing rule: MR=MC to derive the optimal price. This rule is then mathematically manipulated to provide a rule of thumb that makes use of the markup to arrive at the price. 1
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Pricing Strategies
INTRODUCTION
In this research we deal with pricing strategies of firms that have some market power:
firms in monopoly, oligopoly and monopolistic competition. Firms in perfect competition
are price takers and they don’t have a pricing strategy of their own. This research goes as
far as providing practical advice on implementing pricing strategies for those firms with
market power, typically using information that is readily available to managers, including
publicly available information such as the price elasticity of demand.
The optimal pricing strategies for firms with market power vary depending on the
underlying market structure and the instruments (e.g., advertising) available & the nature
of product whether it has elastic or inelastic demand (i.e. whether it is luxury or necessary
good). To account for that, this research presents some sophisticated pricing strategies
that enable a manger to extract greater profits from the consumers.
BASIC PRICING STRATEGIES
We will first look at the very basic pricing strategy which relies on single or uniform
pricing. This strategy uses the profit-maximizing rule: MR=MC to derive the optimal
price. This rule is then mathematically manipulated to provide a rule of thumb that makes
use of the markup to arrive at the price.
Review of the Basic Rule of Profit Maximization
Firms with market power can restrict output to charge a higher price; thus they have a
downward-sloping demand curve. In this case the price is different from marginal
revenue. The profit-maximizing rule for firms with market power is given by
MR = MC.
This rule is first solved for the equilibrium output which in turn is substituted in the
inverse demand equation to solve for the optimal or equilibrium price. Managers of large
firms may have research department that have economists who can estimate demand and
cost functions and apply this rule and to solve for optimal price and output
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Demonstration 1:
Suppose the inverse demand equation is given by
P=10−2Q(downward sloping demand=market)
and the cost function is
C (Q )=2Q
Determine the profit-maximizing output and price.
Answer: Recall MR has twice the slope of the price in this case.
Then
MR=10−4 Q
Set MR=M C
10−4Q¿=2
Solve for Q*. Then Q* = 2 units. Plug Q* into the inverse demand equation
P¿=10−2Q¿=$ 6
A Simple Pricing Rule for Monopoly and Monopolistic Competition
Some small firms such as retail clothing stores do not hire economists to estimate their
demand and cost functions. They can, however, rely on publicly available information
such as information on price elasticity of demand. We can derive a rule of thumb from
the profit-maximization rule and estimate the price with minimal or crude information
and still be consistent with profit-maximization.
Formula: Marginal Revenue for a firm with Market Power (Monopoly and Monopolistic
Competition):
MR=P[ (1+ Ef )E f
]where E f=%∆ Q%∆ P
=(∆ Q
∆ P )∗P
Q
where Ef is the firm’s own direct price elasticity of demand. Substitute this in the profit-
maximization rule
P[ (1+ Ef )E f
]=MC
Solve for the price:
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P=[ (1+E f )E f
]MC
or
P=(K )MC
where K=[ E f
(1+E f ) ]can be viewed as the profit maximization (optimal factor)
markup factor.
Example: The clothing store’s best estimate of elasticity is -4.1 and this is known. Thus,
the optimal markup is
K = -4.1/(1- 4.1) = 1.32.
Then the optimal price
P = (K)MC = 1.32*MC
(That is, 1.32 times marginal cost).
The manger should note two things about this price elasticity: First, the more
elastic the price is, the lower the markup factor and the price (if Ef = -infinity, then K= 1
and P = MC as is the case in perfect competition); the lower MC is, lower the price.
Demonstration 2:
Suppose the manger of a convenience store competes in a monopolistically competitive
market and buys Soda at a price of $1.25 per liter. The price elasticity of demand for the
typical grocery is -3.8. The manger of this convenience store believes that demand is
slightly more elastic than -3.8. Let the price elasticity of the convenience store is -4. What
is the profit maximizing price for this store?
P = [-4/(1-4)]MC = 1.3 MC
A Simple Pricing Rule for Cournot Oligopoly
Strategic interaction is an important issue in Cournot oligopoly. Each firm maximizes
profit taking into account of the output of the rival firms in the industry. It believes that
the output of the rivals will stay constant. The maximization rule is the same as in the
monopoly case,
MR = MC.
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But under Cournot monopoly, MR depends on the firm’s output and on the rivals’ output
as well. Each oligopolistic firm uses this rule to derive its interaction functions in which
its own output depends on the rivals’ outputs. Then the interaction functions are used to
determine the profit-maximizing outputs (Q1*, Q2*)
Fortunately and similar to monopoly, a simple markup pricing rule can be used in
Cournot oligopoly when the oligopolistic firms have identical cost structures and
producing similar products. Suppose the industry consists of N firms with each firm
having identical cost structures and produces similar products. In this case we can use
the markup pricing rule for monopoly and monopolistic competition to derive a pricing
formula for a firm in a Cournot Oligopoly. First, it can be shown that if products are
similar then
Ef = N*EM
Where Ef is the price elasticity of demand for the typical firm, EM is the industry’s price
elasticity of demand and N is the number of firms in the industry. Recall that the markup
pricing rule under monopoly and monopolistic competition is given by
P = [Ef /(1+Ef)]MC
where MC is the individual firm’s marginal cost. Upon substitution for Ef from above, the
profit maximizing price for a firm under Cournot is given by:
P = [NEM /(1+NEM)]*MC (rule of thumb pricing under Cournot)
Demonstration 3:
Suppose a Cournot industry has three firms, with market elasticity Em equal -2 and the
individual firm’s MC is $50. What is the firm’s profit maximizing price under Cournot
oligopoly
P = {(3)(-2)/[1+(3)(-2)] }*$50 = $60
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STRATGIES THAT YIELD EVEN GREATER PROFITS
These are strategies that can be implemented under monopoly, monopolistic competition
and oligopoly by which the manager can earn a profit greater that it can get using the
single pricing rule (MR = MC) whether directly or through a pricing formula. These
strategies which include: price discrimination, two–part pricing, block pricing and
commodity bundling, are appropriate for firms with various cost structures and degrees of
market interdependence.
Extracting Surplus from Consumers
All the above four strategies aim at extracting consumer surplus and turn it into profit for
the producers.
I. Price Discrimination
Price discrimination is the practice of charging different prices to different consumers for
the same good or service sold. There are three types of discrimination; each requires that
the manager have different types of information about consumers.