Managerial economics and organizational architecture 5e ch007

Pricing Objective• Pricing is key to managerial decision making • Firms with market power can raise prices without losing all customers to competitors • A firm has market power when it f

Managerial Economics and Organizational Architecture, 5e

Chapter 7: Pricing with

Market Power

Pricing Objective

• Pricing is key to managerial decision

making

• Firms with market power can raise prices

without losing all customers to competitors

• A firm has market power when it faces a

downward sloping demand curve

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• Assume profit maximization

– Implies single period pricing strategies

• Firms wish to capture as much consumer

surplus as possible

• Consumer surplus is the difference

between what the consumer is willing to

pay and what the consumer actually pays

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Pricing with Market Power

The Benchmark Case:

single price per unit

Single Price per Unit

$

7-6

Cost Issues

• Relevant costs

– sunk costs are irrelevant

– current opportunity costs are relevant

– historical costs are irrelevant

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Price Sensitivity and Optimal Markup

The optimal markup

is higher for the less elastic demand

Estimating Profit-Maximizing Price

• In theory, MC=MR, but in practice,

manager may not know demand curve

and therefore MR

• Cost-plus or mark-up pricing may be

useful approximations

• Such pricing should be product specific

and based on awareness of price

Linear Approximation

• Suppose firm currently sells 30 units at

$70

• Firm estimates that by lowering price to

$65 it will sell 40 units

• This information can be used to

approximate a linear demand curve

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Cost-Plus Pricing

• Add a markup to average total cost to yield target return

• Must account for price sensitivity

• Consistently bad pricing policies are not

good for the firm’s long-term fiscal health

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Mark-Up Pricing

• Optimal mark-up rule of thumb:

• P*=MC*/(1-1/η*)

• Requires some knowledge or awareness

of both marginal costs and elasticity

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Potential for Higher Profits

Block Pricing

• Declining price on subsequent blocks of

product

• Takes advantage of consumers’ lower

marginal value for additional units

• Seen in product packaging

Two-Part Tariffs

• Up-front fee for the right to purchase

• Additional fee per unit purchased

• Best when customers have relatively

homogenous demand for product

• Used at country clubs, health clubs,

college football

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Price Discrimination

heterogeneous consumer demands

• Price discrimination occurs when firm

charges different prices to different groups

of customers

– not related to cost differences

• Necessary conditions

– different price elasticities of demand

– no transfers across submarkets

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Using Information About Individuals

• Personalized pricing

– “first degree” price discrimination – Extract maximum amount each customer is willing to pay

– possible only with small number of buyers

• Group pricing

– “third degree” price discrimination – very common (utilities, theaters, airlines…)

Group Pricing

• If two groups have different elasticities of

demand, the charge a higher price to the

group with the more inelastic demand

• Apply it for each elasticity to get the

different prices

• If the elasticities are 2.33 and 1.55 and

MC=$10, then markup the price to $17.50

and $30, respectively

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Optimal Pricing at Snowfish

different demand elasticities

Quantity of passes for local skiers

P*=

30.00

50.00

P*=17.50 MR

Using Information About the

Distribution of Demands

• Menu pricing

– “second degree” price discrimination

– consumers select preferred package

– Companies often use different versions of

their product – deluxe, basic, etc.

• Coupons and rebates

– users likely more price sensitive

– users who are new customers may stick with

product

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Bundling and Other Concerns

• Bundling may yield a higher price than if

each component is sold separately

– theater season tickets

– restaurant fixed price meals