Lecture 9_Pricing Techniques_Topic 10.ppt

Chapter 10
Special Pricing
Practices
Managerial Economics: Economic
Tools for Today’s Decision Makers, 5/e
By Paul Keat and Philip Young
Pricing
Techniques
and Analysis
Topic 10
Ahmed Munawar
MANAGERIAL ECONOMICS (ECO501)
MNU Business School

2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young
Content
• Cost-Plus Pricing
• Price Discrimination
• Nonmarginal Pricing
• Multiproduct Pricing
• Transfer Pricing
• Other Pricing Practices
MNU Business School Managerial Economics (ECO501) Ahmed Munawar

Pricing in Practice
• In practice, pricing strategy involves the
whole life-cycle pricing of the product.
• Managers report wide use of cost-plus
pricing methods because it:
• Streamlines pricing of multiple products
• Streamlines pricing of retail prices
• In Topic 8 and 9, the product pricing is cost-
based. The optimal output is when MR = MC.

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

• Suppose the elasticity of demand for the firm’s
product is ED.
• MR = P[1 + ED]/ ED
• Since MR = P[1 + ED]/ ED, setting MR = MC and
simplifying yields the standard markup rule:
• P = [ED /(1+ ED)] x MC.
• The optimal price is a simple markup over marginal
cost
• More elastic the demand, lower markup.
• Less elastic the demand, higher markup
Markup Rule

An Example
• Elasticity of demand for Kodak film is -2.
• P = [ED /(1+ ED)]  MC
• P = [-2/(1 - 2)]  MC
• P = 2  MC
• Price is twice marginal cost.
• Fifty percent of Kodak’s price is margin
above manufacturing costs.

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.

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: Low Tech Security

Advantages & disadvantages of cost-plus
pricing
• 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
Hybrid Method: Variable
Cost-Plus Pricing -- the
markup can vary over the
season, or business cycle
Advantages Disadvantages

Price Discrimination
• Products with identical costs are sold in
different markets at different prices.
• The ratio of price to marginal cost differs for
similar products.
• Exists when the price-to-marginal cost ratio
differs between two products:

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

Ways to Separate Customers
for Price Discrimination
1. Geography as when the
price in the East-side and
West-side differ
2. Income as the American
Econ Association charges
more to professors than
students
3. Gender as when jeans for
women are priced higher
than similar jeans for men
4. Age as when kids get in at
lower prices for movies
5. Time of day or season
6. Race as when shampoos targeted
for African-American hair are
priced differently that other
shampoos, though technically the
same.
7. Language as when products
printed in Spanish are priced
differently than those in English
8. Transient/Resident as when
contracts pay less at hardware
stores than other customers
9. Ability to Haggle when those
how ask for a lower price get it

First Degree Price Discrimination
• Seller can identify where each consumer lies on the
demand curve and charges each consumer the
highest price the consumer is willing to pay.
• Allows the seller to extract the greatest amount of
profits.
• Requires a considerable amount of information.
• 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

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

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

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
• Cover Charge to Enter a
Bar and a Price Per
Drink
Cover
Charge
P
Q
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 14.2
Car rental per
day is the ‘Cover
Charge’, and mileage
fee at P or P*
P*

Unlimited Access
A specified price for an unspecified quantity:
Example: AOL unlimited access for $19.95/month
Examples: Salad Bars, Legal Retainers, HMO’s
Ounces of Salad
The area under the demand
curves represent most
willing to pay.
P

Bundling
Often the pricing arrangement includes purchasing groups of
dissimilar products. The products are bundled or sold as a block, as
in theatrical or sporting tickets: Movies A & B and Theaters 1 & 2.
Preferences are uncorrelated Preferences are correlated
1
2
A B A B
150 100
80 190
250
270
160 200 = 360
simple monopoly
500
80 100
165 175
180
340
165 200 = 365
simple monopoly
360
Bundling
is more
Profitable.

Bundling & Mixed Bundling
• 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.

Block Rate Setting
• Another example of second-degree price
discrimination is "block rate setting".
• The price for the first group is greater than
the next group. Some telephone companies
charge a different price for the first few
minutes and subsequent minutes of long
distance calling

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

Third-Degree Price Discrimination
• 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

Allocating Sales Between Markets

Constructing the Marginal Revenue
Curve

Profit-Maximization Under Third-
Degree Price Discrimination

Third Degree Price Discrimination
• Assume the firm operates in two markets, A and B.
• The demand in market A is less elastic than the demand in
market B.
• The entire market faced by the firm is described by the horizontal
sum of the demand and marginal revenue curves.

• The firm finds the total amount to produce by equating the
marginal revenue and marginal cost in the market as a whole: QT.
• If the firm were forced to charge a uniform price, it would find
the price by examining the aggregate demand DT at the output
level QT.
• The firm can increase its profits by charging a different price in
each market.

• In order to find the optimum price to charge in each market, draw
a horizontal line back from the MRT/MCT intersection.
• Where this horizontal line intersects each submarket’s MR curve
determines the amount that should be sold in each market; QA
and QB.
• These quantities are then used to determine the price in each
market using the demand curves DA and DB.

• Tying Arrangement: a buyer of one product is
obligated to also by a related product from the
same supplier.
• Illegal in some cases.
• One explanation: a device to “meter” demand for
tied product.
• Other explanations of tying
• Quality control
• Efficiencies in distribution
• Evasion of price controls

Nonmarginal Pricing
• Cost-Plus Pricing
• Price is set by first calculating the variable
cost, adding an allocation for fixed costs, and
then adding a profit percentage or markup.
• Problems with Cost-Plus Pricing
• Calculation of Average Variable Cost
• Allocation of Fixed Cost
• Size of the Markup

Nonmarginal Pricing
• Incremental Pricing and Costing Analysis
• Similar to marginal analysis.
• Incremental analysis deals with changes in total
revenue and total cost resulting from a decision to
change prices, introduce a new product, discontinue
an existing product, improve a product, or acquire
additional capital equipment.
• Only the revenues and costs that will change due to
the decision are considered.

Multiproduct Pricing
• Products are complements in terms of demand
• An increase in the quantity sold of one will bring
about an increase in the quantity sold of the other.
• Products are substitutes in terms of demand
• An increase in the quantity sold of one will bring
about an decrease in the quantity sold of the other.
• Products are joined in production
• Products produced from one set of inputs
• Products compete for resources
• Using resources to produce one product takes those
resources away from producing other 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

• Related in production as substitutes
• For two products, X & Y, allocate
production facility so that
MRPX = MRPY
• Optimal level of facility usage in the long
run is where MRPT = MC
• For profit-maximization:
MRPT = MC = MRPX = MRPY

• Related in production as complements
• To maximize profit, set joint marginal
revenue equal to marginal cost:
MRJ = MC
• If profit-maximizing level of joint
production exceeds output where MRJ
kinks, units beyond zero MR are disposed of
rather than sold
• Profit-maximizing prices are found using
demand functions for the two goods

Transfer Pricing
• Modern companies are subdivided into several
groups or divisions, each of which may be
charged with a profit objective.
• As the product moves through these divisions on
the way to the consumer it is “sold” or
transferred from one division to another at a
“transfer price.”
• If each division is allowed to choose its own
transfer price without any coordination, the final
price of the product to consumers may not
maximize profits for the firm as a whole.

Transfer Pricing
• Firms must pay special attention to designing
a transfer pricing mechanism that is geared
toward maximizing total company profit.
• Design of the optimal transfer pricing
mechanism is complicated by the fact that
• each division may be able to sell its product in
external markets as well as internally.
• each division may be able to procure inputs from
external markets as well as internally.

Transfer Pricing
• No External Markets
• No division can buy from or sell to an external
market.
• The divisions must deal with equal quantities.
• The selling division will produce exactly the number
of components that will be used by the purchasing
division.
• One demand curve and two marginal cost curves.
• Marginal cost curves are summed vertically.
• Set production where MR = Total MC.

Transfer Pricing
• External Markets
• Divisions have the opportunity to buy or sell its
inputs/products in a competitive market.
• If selling division prices above the external market
price, the buying division will buy from the external
market.
• If selling division cannot produce enough to satisfy
buying division demand, the buying division will
buy additional units from the external market.

Other Pricing Practices
• Price Skimming
• The first firm to introduce a product may have
a temporary monopoly and may be able to
charge high prices and obtain high profits
until competition enters
• Penetration Pricing
• Selling at a low price in order to obtain market
share

Other Pricing Practices
• Prestige Pricing
• Demand for a product may be higher at a
higher price because of the prestige that
ownership bestows on the owner.
• Psychological Pricing
• Demand for a product may be quite inelastic
over a certain range but will become rather
elastic at one specific higher or lower price.

Lecture 9_Pricing Techniques_Topic 10.ppt

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