Managerial Economics & Business Strategy

Chapter 11Pricing Strategies for Firms with

Market Power

Standard Pricing and Profits

Price

Quantity

P = 10 - 2Q

10

8

6

4

2

1 2 3 4 5

MC=AC

MR = 10 - 4Q

Profits from standard pricing= $8

Price Discrimination

• Defined as: the practice of charging different prices to consumers

for the same good or service

• Purpose: to extract consumer surplus and increase firm profits.

• Caveat: in order for price discrimination to work consumers

who pay a lower price are not able to resell the good to consumers willing to pay a higher price (i.e., no arbitrage possibilities)

First-Degree or Perfect Price Discrimination

• Practice of charging each consumer their maximum willlingness-to-pay

Permits a firm to extract all surplus from consumers Nearly impossible Examples: car salesman who is able to “perfectly size

up” his customers

Perfect Price Discrimination

Price

Quantity

D

10

8

6

4

2

1 2 3 4 5

Profits:.5(4)(10 - 2)

= $16

Total Cost

MC

Second Degree Price Discrimination

• The practice of charging different prices for different quantities of the same good.

• Examples: soup, electricity, items sold in bulk, and block pricing which is encouraged when scale economies exist

Price

MC

D

$5

$10

4Quantity

$8

2

AC

MR

$3

Third Degree Price Discrimination• The practice of charging different groups

of consumers different prices for the same product

Based on Time, Consumer Characteristics, or geographic location

• Examples include student discounts, senior citizen’s discounts, coupons, rebates, matinees, long-distance telephone service, best-selling novels (hard vs. soft), new technologies (e.g., DVD players)

Third Degree PD

• To maximize profits, the firm should equate MR from selling Q to each group to MC

MR1=MC and MR2=MC; thus firm should allocate Q among the 2 groups such that MR1=MR2=MC.

• Suppose E1 < E2

• Thus, group 1 will be charged a lower price than group 2.

Senior citizen or student discounts Those who clip coupons Matinees

An ExampleBMW can produce any quantity of cars at a constant MC equal to $15,000, and a FC of $20 million. You are asked to advise the CEO as to what prices and quantities BMW should set for sales in Europe and in the US. The demand for BMW’s in each market is given by

QE=18,000 – 400PE

QU=5500 – 100PU

Assume that BMW can restrict US sales to authorized dealers only.

Two-Part Pricing

• Two-part pricing consists of a fixed fee and a per unit charge.

• Works well when consumer demands are relatively homogeneous.

Examples: golf club memberships, Costco, cell phone services, Gillette razors.

How Two-Part Pricing Works

1. Set price at marginal cost.

2. Compute consumer surplus.

3. Charge a fixed-fee equal to consumer surplus.

Quantity

D

10

8

6

4

2

1 2 3 4 5

MC

Fixed Fee = Profits = $16

Price

Per UnitCharge

An Example

As the owner of the only tennis club in an isolated wealthy community, you must decide on membership dues and fees for court time. There are 2 types of tennis players (serious and occasional) with the following demands

QS = 6 – PS

QO = 3 – 0.5PO

where Q is court hours per week, and P is the fee per hour for each individual player. Assume that there are 1000 players of each type, the MC of court time is zero, FC are $5000 per week, and serious and occasional players look alike so you must charge the same price.

You only want S players. What should you charge for annual dues and court fees? Could you increase profits by selling to both types?

Commodity Bundling• The practice of bundling two or more products

together and charging one price for the bundle. Mixed Bundling the practice of selling goods separately or as a bundle

• Good when: Heterogeneous consumer demands Can’t PD Consumer demands are negatively correlated

• Examples Vacation packages Computers and software Film and developing McDonald’s

An Example that Illustrates Kodak’s Moment

• Total market size is 4 million consumers• Four types of consumers

25% will use only Kodak film 25% will use only Kodak developing 25% will use only Kodak film and use only Kodak

developing 25% have no preference

• Zero costs (for simplicity)• Maximum price each type of consumer will

pay is as follows:

Reservation Prices for Kodak Film and Developing by Type of

Consumer

Type Film DevelopingF $8 $3

FD $8 $4B $4 $6N $3 $2

Optimal Film Price?

Type Film DevelopingF $8 $3

FD $8 $4B $4 $6N $3 $2

Optimal Price is $8, to earn profits of $8 x 2 million = $16 Million

At a price of $4, only first three types will buy (profits of $12 Million)

At a price of $3, all will types will buy (profits of $12 Million)

Optimal Price for Developing?

Type Film DevelopingF $8 $3

FD $8 $4B $4 $6N $3 $2

Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million

At a price of $6, only “B” type buys (profits of $6 Million)

At a price of $4, only “B” and “FD” types buy (profits of $8 Million)

At a price of $2, all types buy (profits of $8 Million)

Total Profits by Pricing Each Item Separately?Type Film Developing

F $8 $3FD $8 $4B $4 $6N $3 $2

$16 Million Film Profits + $9 Million Development Profits =$25 Million

Let’s see if the firm can earn even greater profits by bundling

Consumer Valuations of a Bundle

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

What’s the Optimal Price for a Bundle?

Type Film Developing Value of BundleF $8 $3 $11

FD $8 $4 $12D $4 $6 $10N $3 $2 $5

Optimal Bundle Price = $10 (for profits of $30 million)

Cross-Subsidies

• Prices charged for one product are subsidized by the sale of another product

• May be profitable when there are significant demand complementarities

• Example Adobe Reader and Adobe Acrobat

Pricing in Markets with Intense Price Competition

• Price Matching Advertising a price and a promise to match any lower price offered

by a competitor. Such strategies weaken the incentives for rivals to undercut any

given store’s price, thus Each firm charges the monopoly price and shares the market.

• Randomized Pricing A strategy of constantly changing prices. Decreases consumers’ incentive to shop around as they cannot

learn from experience which firm charges the lowest price. Reduces the ability of rival firms to undercut a firm’s prices.