Pricing in Theory and Practice

1. Pricing in Theory and Practice

2. Learning Outcomes 1) To review the knowledge about concept of equilibrium price. 2) To give basic idea about the supply lag and cob-web theory. 3) To remind the pricing practices in different market structures. 4) To give basic idea about various pricing strategies. 5) To give basic idea about price discrimination.

3. Basic Determinants of Price 1) The demand and elasticity for the good or services. 2) Cost of production. 3) Objective of its producers and managers. 4) Market structure. 5) Government policy (tax/subsidy). 6) Nature of the goods. 7) Company reputation. 8) Seasons.

4. Pricing Strategies in Practice • pricing strategies depend on managerial goals • the usual economic assumption is the goal of profit maximisation • but other goals might include… • achieve a target return on investment • match competitors’ performance • maintain / expand market share • maximise corporate growth • maximise sales revenue • satisfy managers’ sense of well-being

5. Three General Bases of Pricing Decisions • Cost-based pricing • marginal cost pricing • incremental pricing • break-even pricing • mark-up pricing • Demand-based pricing • based on demand in the market segments • extraction of consumer surplus • Competition-based pricing Entry preventing pricing

6. Pricing Strategies in Practice • Marginal cost pricing • Entry preventing price • Incremental pricing • Breakeven pricing • Mark-up pricing • Multi Product/Plant Pricing • Transfer Pricing • Peak-load Pricing

7. Consumer Surplus Pricing : The Classical View : Equilibrium price (Qd = Qs) Price is the key determinant of demand and supply theory. In determination of market equilibrium, price is going to be a key factor. Qs > Qd (excess supply) price is going down Qd > Qs (excess demand) price is going up Qs = Qd (market clearing price) price (£) supply p* E Revenue 0 demand quantity q*

8. Elasticity also play a very important role in determination of price. (for inelastic products always high price can be fixed and elastic products low price has to be fixed). In competitive markets, price takers and non-competitive markets price makers. In competitive markets price is always changing (fluctuating) and tendency to equilibrium (Ex: foreign exchange) and in non-competitive markets price is sticky.

9. Supply Lags and Cob-web Theory In some markets adjustment process for changing supply and demand is slow or sometime it may not going to happen. Ex: Agricultural products and skilled labour markets. Unstable Cobweb Situation (prices do not converge towards an equilibrium and instead becomes increasingly unstable, oscillating from high to low). Agricultural products: Demand curve shift to right while supply stable due to some reasons then prices are going up. But supply can not increase immediately. It has lags. This year production is a function of last year price: S =f (Pt-1). All the farmers are going to cultivate this high price product then supply curve is shifting to right while demand stable then prices are going down. Then next year farmers are not producing this crop. Then supply curve shift to left while demand stable. This is happening again and again. (See figure)

10. Price per unit Price per unit St=f(Pt-1) P2 P4 P3 p1 P2 P4 P3 p1 b a D’t=f(Pt) Dt=f(Pt) O Q1 Q3 Q2 O t1 t2 t3 t4 Quantity per unit of time (b) (a) Time period

11. Price per unit Price per unit St=f(Pt-1) P2 P4 P3 p1 P2 P4 P3 p1 b a D’t=f(Pt) Dt=f(Pt) O Q1 Q3 Q2 O t1 t2 t3 t4 Quantity per unit of time Time period (b) (a) Stable Cobweb Situation Price fluctuation become smaller and smaller, converging towards an equilibrium where the amount placed on the market equals the amount consumers are willing to buy at the price which existed in the last period. This situation occurs due to inelastic supply and elastic demand. (See figure)

12. Price per ticket D D’ a P2 p1 b D D’ O Q1 Q2 Stadium attendance (a) (90,000) Black Market Price (alternative markets appear when there is an impediments to running the free markets.)Sometime prices are fixing looking at the excess demand situation and shortage of supply. This price is fixed above the equilibrium price. Example: Famous sports events(See figure) or essential goods. Some manufactures are deliberately set price and production levels that the consumer has difficulty in obtaining the good. Ex: UK Morgan sports car.

13. Mini Case - Setting Price by Auction UK Mobile Phone Licences • Equilibrium price can be achieved through auction. • This is an efficient method to determine price when the seller is unsure about market value of the good. • Various auction methods: • a) Ascending price auction (bidders offer higher bids until the good is sold to the highest bidder). • b) Descending price auction (prices start at high and falls until a buyer is found - Dutch method). • c) Sealed bid auction (tendering - each bidder makes on bid without knowledge of other competitors bids). • Limitations: • 1) Winners curse - bidding for high price without imperfect knowledge about future. • 2) Collusion between bidders in sealed bid auctions.

14. Pricing in different Market Structures In general, firms are maximizing their profits at MR = MC. Accordingly we can obtain the price. Perfect Competition MR = MC = P = AR = D - Short run (Demand curve is perfectly elastic and a price taker) Monopolistic competition MR = MC < P = AR = D (demand curve is downward slopping. But product differentiation and branding help them to have elastic demand then price can move up) Monopoly MR = MC < AR = P = D (Demand curve is downward slopping but price is very high to average cost due to monopoly situation). Oligopoly MR = MC < P downward downward slopping). (demand curve is kinked and downward slopping but price wars or sticky prices can be seen).

15. SRMC SRTC SRVC Short-run Profits Maximization in Perfect Competition Figure 1 P,C Profits maximising Condition: MR = MC (MR = MC = P = AR) B MR=P P1 A MR=P P2 o Q Q1 Output

16. Long run Profits Maximization in Perfect Competition LRAC P, C Figure 2 LRMC P = AR = MR = LRAC A AR=MR=D P Q 0 Q1

17. Monopolist’s Profits Maximization Profits maximizing output for monopoly (MR=MC) Price MC AC P1 0 Output AR Q MR P

18. AC Profits Maximization in Monopolistic Competition P In the short run the monopolistic competitor faces demand curve AR and Sets MR =MC to produce Q0 (K) at a price P0. Profits are Q0. (P0 – AC0). Profits attract new entrants and shift each firm’s demand curve to the left. When the demand curve reaches AR1they reach long run tangency equilibrium at F. The firm sets MR1=MC to produce Q1 at which P1 equals AC1. Firms are breaking even and there is no further entry. MC E P0 F AC1 AC0 K AR 0 Q1 Q0 MR Q MR AR1 MR1

19. Profits Maximization in Oilgopoly Demand curve depends on competitors reactions. Firms reacts only for price cuts but not for the price rises. P, MR, MC Oligopolist’s demand curve kinked at A. Price rises lead to a large loss of market share, but price cuts increase quantity only by increasing industry sales. MR is discontinuous at Q0. Produces Q0 at the point MR=MC A P0 MC MR DD 0 Qd Q0 MR In oligopoly price is sticky at p0 due to explicit or implicit collusion.

20. Marginal cost pricing Marginal cost pricing involves setting prices, and therefore determining the amount produced, according to the marginal cost of production, and is normally associated with a profit - maximizing objectives (MR = MC). Entry Preventing Price Normally in non-competitive markets, firms are setting low prices to prevent new comers to entry. Established firms can do it because they are enjoying economies of scales due to many factors.

21. Incremental pricing Incremental pricing deals with the relationship between larger changes in revenues and costs associated with managerial decisions. Proper use of incremental analysis requires a wide ranging examination of the total effect of any decision rather than simply the effect at the margin. Ex: Continental Airline in the US

22. Breakeven pricing Breakeven pricing requires that the price of the product is set so that total revenue earned equals the total costs of production. TC At breakeven : TR = TC Profits is zero but covers the cost. TR PM

23. Mark-up Pricing Mark-up pricing (cost-plus pricing, full - cost pricing or target- profit pricing) = Cost + profits margin This is the most widely used pricing method in business. Method: Estimate average variable cost of production and marketing, adding cost of overheads and profit margin. Profits margin depends on the many factors: market structure, demand elasticity, firms objectives, nature of the good, time, etc… Limitations: Considers only accounting cost side not the demand or market sides and no place for managerial decisions and optimal decision making. Some argues that while they are are adding profit margin they consider competition and elasticities.

24. Multi- Product or Full Range Pricing When producing and pricing a product, the multi-product firm has to take into consideration not only the impact on the demand for that product of a price change (Its own price elasticity of demand) but the impact on the demand for the other products in the firm’s range (the relevant cross price elasticities). In other words, pricing now involves obtaining the desired rate of return from the full product range rather than individual products. Some product may loss leaders but attract consumers to high profits margin products : ex: Supermarkets strategy. But it can be ended up with cherry pickers. Demand interdependencies and product interdependencies they should be considered while pricing.

25. Multi-Plant Pricing Where a firm’s output of the same product is produced on more than one site, the profit maximising output rule, that marginal supply costs must equal marginal revenue, is unchanged, but in this case marginal cost is the sum of the separate plants’ marginal costs and production must be allocated between the plants so that the marginal supply cost at each plant is identical.

26. Transfer Pricing This relates with the transfer of various products between different sections of the same company. Ex: Multi-nationals and Conglomerates transfer various intermediate and inputs between different branches in various countries for very low prices to avoid taxes. Three Possibilities: 1) Transfer pricing without an external market : When transferred products can not be soled in external market then marginal cost will be the optimal transfer price. 2) Transfer pricing of a product with a competitive market : When transferred products can be soled in external competitive market then external market price is the optimal price. 3) Transfer pricing with an imperfect external market: When transferred products can be soled in external imperfect external market then optimal price is determined by the MR = MC condition.

27. Peak-load Pricing This is the price which charge according to changes in demand in various seasons. During season – Price is high During off-season – Low price Reasons for high price during the season: Higher costs More expensive inputs Externalities Examples: Public transport, posts, electricity, water, gas and hotels, etc. Consumers adjust their demand pattern to face this season high price.

28. Pricing policy and the role of government 1) Taxes and subsidies (In some cases the price consumers are willing to pay may not accurately represents true social cost and benefits of the consumption due to externalities. Then the price Can alters using taxes and subsidies. Taxes on products affect for prices and output which depends on elasticity. Subsidy affect for price reduction). 2) Direct price controls (regulations such as anti-monopoly and restrictive practices legislations. Licensing such as public utility services ). 3) Pricing in the public sector (objective of public sector to maximize social profits rather private profits but now a days they are moving to cost-effectiveness. Public sector should set prices equals to marginal social benefits to marginal social cost).

29. Maturity (saturation) Launch Growth The Product Life Cycle Decline Sales (units sold) 0 Time Products and branding usually undergone life cycle covering the period from their inception in the market to their eventual withdrawal. Therefore, firms must know different and appropriate pricing strategies to each stages. The length of the cycle and its stages depends on nature of products.

30. Appropriate and different Pricing strategies in Product Life • Decide on the best pricing strategy for each stage in the product life cycle Tips : • remember the phases : launch, growth, maturity, decline • focus on a specific product : e.g. DVDs, chocolate, widescreen televisions, mobile phones… • consider the factors affecting pricing : e.g. demand elasticities, costs of production, market segments...

31. Two General strategies can be identified: Promotional/penetration pricing: Price is set low to enter market and attract customers and to gain more market share through branding: Launch stage low price, growth stage high, maturity stage high and decline stage low. This strategy is good for competitive market structures. Skimming pricing: Price is set high at launch to cover larger unit cost and gaining high profits. This is good to a monopoly and oligopoly situation and to quality concern consumers. Launch high price, growth stage low, maturity stage low and decline stage low.

32. Maturity (saturation) Launch Growth “skimming” high lower low low “promotional” low higher higher low Pricing Over The Product Life Cycle Decline Sales 0 Time

33. Price Discrimination You produce the goods or services bearing in the same unit cost but sell in different markets and for different customers for different prices. Through price discrimination you can operate most profitable scale and profitable mix (Ex: Airline behaviour with respect to business and holiday customers). Service industry is subject to more price discrimination compared with goods market. Generally price discrimination helps to low incomes groups to purchase goods and to maximize profits to producer. Three possible price discriminations can be identified First degree, Second-degree and Third-degree.

34. First Degree Price Discrimination (Perfect price discrimination) • Charge a different (maximum) price to every consumer which reflects their “demand value” or “marginal utility” • Captures all “consumer surplus” To effective this type of P.D. sub markets should be isolated. price (£) consumer surplus captured by producer p* demand 0 q* qty

35. consumer surplus captured p2 q2 Second Degree Price Discrimination • Charge different prices based on specific quantities or blocks of output • p1 for q1, p2 for q2 etc. • Captures some consumer surplus e.g.1. metered electricity, water and gas e.g.2. bulk buying discount e.g.3. Renting of capital goods price (£) Supply p1 demand 0 q1 qty

36. Third-degree Price Discrimination Charging different prices for the same product in different segments of the market. This market separation can be: By geography By type of demand By time By the nature of product

37. Third Degree Price Discrimination Market 1 Market 2 price (£) price (£) A B p p D2 D1 0 0 q1 quantity quantity q4 • Two markets with different price elasticities of demand • Charge same price, p : revenue = 0pAq1 + 0pBq4 • But, can take advantage of different elasticities….

38. C E p2 q3 q2 Third Degree Price Discrimination Market 1 Market 2 price (£) price (£) p3 A B p1 p D2 D1 0 0 q1 quantity quantity q4 • Charge higher price, p1 in inelastic demand market 1 • Charge lower price, p2 in elastic demand market 2 • Can now earn more revenue : 0p3Cq3 + 0p2Eq2

39. Conditions for Successful Price Discrimination 1) possible to divide the market into mutually exclusive segments • e.g. by price elasticity of demand, wealth / status of customers, time of day, geographical boundaries…. 2) consumers can’t move between segments 3) Any costs incurred in pursuing price discrimination must be exceeded by the potential return. 4) not possible for different groups of consumers to trade • i.e. products can’t move groups 5) firm has control over its own prices • i.e. firm has some monopoly or oligopoly power

40. Some Potential Criteria for Price Discrimination season quantity bought type of customer packaging location of customer whether original equipment or replacement part time of day quality of after sales service type of product brand of product geographical market Age, Sex and income

41. Price Discrimination in Practice: • Bring examples of price discrimination in practice • Idea is to challenge others to discuss the applied price discrimination example you have brought... • own experience

42. Question for the discussion • What are the basic determinants of price. • Explain various pricing strategies with respect to their limitations. • Explain pricing with respect to various market structures. • Explain price discrimination. • Pricing explain with respect to product life cycle.