Chapter 14: Advanced Pricing Techniques

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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Advanced Pricing Techniques

• Price discrimination

• Multiple products

• Cost-plus pricing

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Capturing Consumer Surplus

• Uniform pricing• Charging the same price for every unit of the

product

• Price discrimination• More profitable alternative to uniform pricing• Market conditions must allow this practice to

be profitably executed• Technique of charging different prices for the

same product• Used to capture consumer surplus (turning

consumer surplus into profit)

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The Trouble with Uniform Pricing (Figure 14.1)

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Price Discrimination

• Exists when the price-to-marginal cost ratio differs between two products:

A B

A B

P P

MC MC

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Three conditions necessary to practice price discrimination profitably:

1) Firm must possess some degree of market power

2) A cost-effective means of preventing resale between lower- and higher-price buyers (consumer arbitrage) must be implemented

3) Price elasticities must differ between individual buyers or groups of buyers

Price Discrimination

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First-Degree (Perfect) Price Discrimination

• Every unit is sold for the maximum price each consumer is willing to pay• Allows the firm to capture entire consumer

surplus

• Difficulties• Requires precise knowledge about every

buyer’s demand for the good

• Seller must negotiate a different price for every unit sold to every buyer

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First-Degree (Perfect) Price Discrimination (Figure 14.2)

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Second-Degree Price Discrimination

• Lower prices are offered for larger quantities and buyers can self-select the price by choosing how much to buy

• When the same consumer buys more than one unit of a good or service at a time, the marginal value placed on additional units declines as more units are consumed

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Second-Degree Price Discrimination

• Two-part pricing• Charges buyers a fixed access charge (A) to

purchase as many units as they wish for a constant fee (f) per unit

• Total expenditure (TE) for q units is: TE A fq

A

fq

Average price ( ) is:

TE A fq

p pq q

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• When consumers have identical demands, entire consumer surplus can be captured by:• Setting f *= MC• Setting A* = consumer surplus (CS)

• Optimal usage fee when two groups of buyers have identical demands is the level for which MRf = MCf

Second-Degree Price Discrimination

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Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14.3)

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Demand at Northvale Golf Club (Figure 14.4)

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• Declining block pricing• Offers quantity discounts over successive

discrete blocks of quantities purchased

Second-Degree Price Discrimination

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Block Pricing with Five Blocks (Figure 14.5)

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Third-Degree Price Discrimination

• If a firm sells in two markets, 1 & 2

• Allocate output (sales) so MR1 = MR2

• Optimal total output is that for which MRT = MC

• For profit-maximization, allocate sales of total output so that

MRT = MC = MR1 = MR2

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• Equal-marginal-revenue principle

• Allocating output (sales) so MR1 = MR2

which will maximize total revenue for the firm (TR1 + TR2)

• More elastic market gets lower price• Less elastic market gets higher price

Third-Degree Price Discrimination

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Allocating Sales Between Markets (Figure 14.6)

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Constructing the Marginal Revenue Curve (Figure 14.7)

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Profit-Maximization Under Third-Degree Price Discrimination (Figure 14.8)

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Multiple Products

• Related in consumption• For two products, X & Y, produce & sell

levels of output for which

MRX = MCX and MRY = MCY

• MRX is a function not only of QX but also

of QY (as is MRY) – conditions must be

satisfied simultaneously

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• When price discrimination is not possible, bundling multiple goods and charging a single price can be more profitable than charging individual prices for multiple goods

• Two conditions for profitable bundling• Consumers must have different demand

prices for each good in the bundle• Demand prices must be negatively correlated

across consumer types

Bundling Multiple Products

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Cost-Plus Pricing

• Common technique for pricing when firms do not wish to estimate demand & cost conditions to apply the MR = MC rule for profit-maximization

• Price charged represents a markup (margin) over average cost:

P = (1 + m) ATC Where m is the markup on unit cost

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• Does not generally produce profit-maximizing price• Fails to incorporate information on demand

& marginal revenue• Uses average, not marginal, cost

Cost-Plus Pricing

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Practical Problems with Cost-Plus Pricing (Figure 14.13)