APPLIED PRICING

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 customer value.

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

Type of pricing

1. Cartel arrangement

2. Price leadership

3. Price discrimination

4. Cost-plus pricing

5. Pricing of multiple products

6. Other types of pricing

1. Cartel Arrangment

It may be advisable for companies in the Oligopoly industry to act together as if they were a monopoly.

In other words, they all agree to cooperate with one another; they form a cartel.

“Unofficial” cartels were mostly illegal. Thus, “official” cartels are found in the organization such as OPEC (Organization of Petroleum Exporting Countries), IATA (International Air Transport Association).

The ideal cartel will be powerful enough to establish monopoly prices and earn maximum monopoly profits for all the members combined.

2. Price Leadership

A price movement initiated by one of the firms, provided others will follow, then this firm will be the price leader

Barometric Price Leadership

One firm in the industry - and it does not always have to be the same one - will initiate a price change in response to economic conditions, and the other firms may or may not follow the leader

Dominant Price Leadership

When an industry contains one company distinguished by its size and economic power relative to other firms, the dominant price leadership model emerges. The dominant company may well be the most efficient (i.e., lowest-cost) firm. It initiates to set the price at the point where it will maximize its profits, and up to the smaller companies whether they will follow or not.

3. Price 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• Otherwise, in pure competition, P = MC

2. Ability to Arbitrage• Separate customers and prevent reselling

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, as restaurant food is a service

Lawyers charge different prices for wills, based on ability to pay

To Separate Customers

1. Geography

2. Income

3. Gender

4. Age

5. Time of day or season

6. Race.

7. Language

8. Transient/Resident

9. Ability to Haggle

Why Price Discriminate?

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

Perfect Price Discrimination(or 1st 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

CompetitionQ

D

MC

Price Discriminating

Monopoly

Q1st

Perfect Price Discrimination Does it Work for Car Dealers?

“How much do you

plan to pay a month?”

you inadvertently reply:

“$232 per month, and have a $3,000 down

payment!”

At 6%, that’s about $12,000 for 60 months,

plus $3,000

Here’s one for only$15,000. It’s swell.

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

The conditions for

perfect 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

Two-Part Pricing A price for the privilege

of buying items PLUS a

price per item

Examples:

Car rental per day with

mileage charges per mile

Amusement parks

Country Club Dues and

Greens Fees

CoverCharge

P

Q

Second Degree Price Discrimination:

Car renters may not know how

much they will use the car (D1 or

D2). They may prefer a lower rental

rate (cover charge) with a per mile

charge, P*.

D2

D1

Figure 14.2Car rental per day is the ‘CoverCharge’, and mileagefee at P or P*

P*

McDonalds sells Extra Value Meals, as a bundle of sandwich, fries, and a soft drink for less than it sells them separately.

Selling both bundles and items separately is mixed bundling.

If Bob would pay $3 for a burger and $1 for a soft drink, and if Mary would pay $2 for a burger and $2 for a soft drink, a bundle of $4 for both a burger and soda will work for both customers as a bundle.

But if the price of a burger individually were $2.5 and a soft drink $1.50, then Bob would buy only a burger and Mary only a soft drink. Not everyone is alike, so mixed bundles succeeds with more customers.

BundlingSecond Degree Price Discrimination:

East West Market

MCMR

PM

Example with Different Prices in Each Market

PE

PW

MR

MR

Third Degree Price Discrimination

Mathematics of Price Discrimination

Using elasticities P( 1 + 1/ ED ) = MC

In two regions:P1( 1 + 1/ E1 ) = P2( 1 + 1/ E2 ) = MC

or: P1/ P2 = ( 1 + 1/ E2 )/( 1 + 1/ E1 )

If the elasticities in region 1 and region 2 are -1.25 and -2.5 respectively, then P1/ P2 = (1+1/ -2.5)/(1+1/-1.25 ) = 3.

Hence, P1 = 3P2.

The price is three times higher in region 1, which less elastic.

5. Pricing of multiple products

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

Products areINTERDEPENDENT, when changes DO affect other products

Ex: Procter & Gamble makes both Luvs and PampersTR = TRA + TRB

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, such as

Pampers & Luvs.

Complements when cross terms are positive Mitsubishi Electric sells DVD Players and blank DVDs

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 /Q

A+ TRB /Q

A= TC

A /QA

+ TCB /QA

Include all relevant revenue and cost effects

4. Pricing in Practice

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

► Cost-plus pricing involves a mark-up over the cost of acquiring or producing a product.

► The mark-up used in cost-plus pricing is determined by demand elasticity and competition. Mark-ups are lower where demand is more elastic and competition is intense (vice-versa).

►For example, if the variable cost of a product is RM8, its allocated overhead is RM6, and the desired mark-up is 25%, the price of the product will be:

►Total cost = 6 + 8 = RM 14, with a mark up of 25%, thus 25% x 14 = RM 3.50, then the price of the product will be RM 14 + RM 3.50 = RM 17.50.

Cost-Plus

P = ACn + Markup

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

normal output and m is a percentage

markup

Full Cost Pricing

Full Cost-- Covers all Costs at the standard or normal output

Plus a return on the investment

P = VCl + VCm + F/Q + p K / Q Where VCl and VCm are unit labor cost and unit

material cost respectively (which is average variable cost).

where p K is the target amount of profit

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

Q is the number of units expected to be produced over this time horizon.

Example: Low Tech Security

Start a firm with F = 200,000, Q = 3000, total labor cost is $40,000 and total material cost is $50,000

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

Answer P = VCl + VCm + F/C + (.20)(500,000)/Q

P = 13.33 +16.67+ 30 + 66.67 + 33.33

= $130

Also, suppose a 35% markup on average cost P = [ AC] (1.35)

P = [ 30 + 66.67 ](1.35)

P = $130.50

Example 1

► An automobile manufacturer estimates that total variable costs will be RM500 million and total fixed costs will be RM1 billion in the next year. In setting prices it is assumed that sales will be 80% of the firm's 125,000 vehicle per year capacity, or 100,000 units. The target rate of return is 10% out of its RM2 billion investment. If prices are set on a cost-plus basis, what price should be charged for each automobile?

►Company X buy leather shoes from the manufacturer for RM 30 per pair. Given the point price elasticity of demand (Ed) = - 1.8, What price should the company X charge in the retail market?

►The mark-up formula:► (1 + M) = Ed / Ed + 1, where M is the

mark-up and Ed is price elasticity of demand.

Advantages & Disadvantages

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

But cost-plus ignores

demand changes

Pricing may be based

on poor cost data

Output varies in

business cycle

of cost-plus pricing

1999 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

1999 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

6. Transfer Pricing Vertically integrated firms “sell” intermediate

goods from one division to the other. The

internal price used is called the transfer

price.

Fisher Body automobile

Frames (a division of GM)

sells to Chevrolet (another

division of GM)

Car Frames

Transfer prices

paid

GM

Chevy

Division

Fisher

Body

GM Chevrolet Division

Buys Fisher Body Car Frames

1999 South-Western College

Publishing

7. Price Skimming 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, and PDAs.

TIME

P D

8. Prestige Pricing

Some products distinguish themselves by being noticeably expensive.

Mercedes, Audi, or BMW

Cartier jewelry

The price is itself a way to distinguish the product from others

Prestige Pricing is the practice of charging a high price to enhance its perceived value.

However, the firms typically have to spend a great deal in promotional activities to convince customers that the product is prestigious.

9. Penetration Pricing The company charges a lower price in order to

gain a foothold in the market.

10. Psychological Pricing The practice of charging, for example, $9.95 or

$9.99 rather than $10 for a product in the belief

that such pricing will create the illusion of

significantly lower price to the consumer.