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Chapter 7: Pricing with Market Power. Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture , 4th ed. Pricing with market power learning objectives. Students should be able to Explain the role of elasticity in optimal pricing
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Chapter 7: Pricing with Market Power Brickley, Smith, and Zimmerman, Managerial Economics and Organizational Architecture, 4th ed.
Pricing with market powerlearning objectives • Students should be able to • Explain the role of elasticity in optimal pricing • Identify circumstances appropriate for price discrimination • Apply selected pricing techniques consistent with maximum profit
Pricing objective A firm has market power if… it faces a downsloping demand curve. The firm’s pricing objective is… to maximize shareholder value. The demand curve reflects… consumer willingness and ability to buy.
Other single pricing issues • Relevant costs • sunk costs are irrelevant • current opportunity costs are relevant • Price sensitivity • price elasticity, , is a measure of price sensitivity • Optimal price is P*=MC*/[1-1/ *] • A firm with market power should never operate on the inelastic portion of the demand curve
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. • But they must reflect awareness of price sensitivity!
Cost-plus pricing • Add a markup to average total cost to yield target return • Does this ignore incremental costs and price sensitivity? • not if managers have a fundamental understanding of their markets • consistently bad pricing policies are not good for the firm’s long-term fiscal health
Mark-up pricing • Optimal mark-up rule of thumb: P*=MC*/(1-1/*) where * indicates estimated value • Requires some knowledge or awareness of both marginal costs and elasticity
Homogenous consumer demand • Block pricing • declining price on subsequent blocks of product • 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
Price discriminationheterogeneous consumer demands • Price discrimination occurs when firm charges different prices to different groups of customers for the same product • not related to cost differences • Necessary conditions • different price elasticities of demand • no transfers across submarkets
Using information about individuals • Personalized pricing • “first degree” price discrimination • possible only with small number of buyers • Group pricing • “third degree” price discrimination • very common (utilities, theaters, airlines…)
Using information about the distribution of demands • Menu pricing • “second degree” price discrimination • consumers select preferred package • Coupons and rebates • users likely more price sensitive • users who are new customers may stick with product
Bundling and other concerns • Bundling may yield a higher price than if each component is sold separately • theater season tickets • restaurant fixed price meals • Multiperiod pricing • low initial price can “lock-in” customers • Strategic considerations • low price may be barrier to entry