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Pricing Strategies for Firms with Market Power & Price Discrimination Chapter 11 in Baye

Pricing Strategies for Firms with Market Power & Price Discrimination Chapter 11 in Baye. Product Life Cycle & Pricing : Pricing strategy involves the whole life-cycle of the product. Managers report wide use of C ost-plus pricing & rule of thumb markups:

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Pricing Strategies for Firms with Market Power & Price Discrimination Chapter 11 in Baye

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  1. Pricing Strategies for Firmswith Market Power &Price DiscriminationChapter 11 in Baye • Product Life Cycle & Pricing: • Pricing strategy involves the whole life-cycle of the product. • Managers report wide use of Cost-plus pricing & rule of thumb markups: • Streamlines pricing of multiple products • Streamlines pricing of retail prices

  2. Profit-Maximizing Markups & cost-plus pricing OPTIMAL: MR ≡ P( 1 + 1/EF ) = MC, where EF = firm’s price elasticity for its own products, or P = (EF/(EF+1)) MC = K·MC, where the optimal markup K is (EF/(EF+1)). see pages 400- 401 If E = -4, then K = -4/-3 = 1.33 or a 33% markup on cost. In Practice:P = ACn + Markupis cost-plus pricing orP = ACn(1 + m) where ACnis average cost at a normal output and m is a percentage markup, or Markup Pricing, m = -1/(E+1). If E = -4, m = 33%.

  3. Cost-Plus Pricing: Illustrated Manufacturing pricing illustrated: One Good P } markup ATC ACn AVC AFC Qn Qcapacity

  4. Cost-Plus Pricing: Illustrated quantity varies as demand varies D1 D2 P } markup ACn AVC AFC Qn Qcapacity

  5. Cost-Plus Pricing: Illustrated quantity varies as demand varies D1 D2 P } markup ACn AVC AFC Q2 Qn Qcapacity Q1

  6. Markup Pricing • Example:Door Manufacturer FC = 200,000, Qn = 3000, VC = 90,000 p= 20% and K=$500,000. Find markup price,with a 35% markup on AC. • Answer • ACN = AVC + AFC = 66.67 + 30 = 96.67 • with 35% markup on average cost • P = [ ACn] (1.35) = 96.67 (1.35) = $130.50

  7. Cournot Oligopoly – first mention • We’ll work on oligopoly on March 28 (Chapter 9), but we find what happens to the profit maximizing markup as N, the number of firms increases. • P = {N·EM /(1 + N·EM) } MC (cf: page 402) • As N rises, the markup gets closer to 0%.

  8. Coupons & Rebates Professionals with multiple locations Ticketron vs. Tickets sold at the theater box office BOGO – buy one, get one free Standby airline tickets Twilight movie tickets Volume discounts Pricing of daily car rentals with per mileage charges Bundling of orchestra tickets vs. selling them separately Premium gasvs. regular gas, even though difference in cost is tiny Pricing and Price Discrimination

  9. Price Discrimination Price Discrimination occurs when: goods are NOT priced in proportion to their marginal cost, even though technically similar Necessary Conditions: 1. Some Monopoly Power In Perfect Competition, P = MC 2. Ability to Arbitrage Separate Customers and Prevent Reselling

  10. 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

  11. Geographyas when the price in the East-side and West-side differ Incomeas the American Econ Association charges more to professors than students Genderas when jeans for women are priced higher than similar jeans for men Ageas when kids get in at lower prices for movies Timeof day or season Transient/Residentas when contractors pay less at hardware stores than other customers Ability to Hagglewhen those who ask for a lower price get it Ways to Separate Customers for Price Discrimination

  12. In Simple Monopoly, there is only one price Consumers receive a consumer surplus But in Price Discrimination, monopolists can Extractconsumer surplus Why Price Discriminate? MC Simple Monopoly CS PSM D Q QSM

  13. Charge the MOST that a person is willing to pay for each good Consumer Surplus is Zero Produce MORE than in Simple Monopoly Output the same as in Perfect Competition Examples: Hospital emergencies and car deals First Degree Price Discrimination:a.k.a. = perfect price discrimination Price Discriminating Monopoly MC D Q Different prices for each unit Q1st

  14. First Degree Price Discrimination Does it Work for Car Dealers? At 6%, that’s about $12,000 for 60 months, plus $3,000 “How much do you plan to pay a month?” you inadvertently reply: “$232 per month, and have a $3,000 down payment!” Here’s one for only $15,000. It’s swell.

  15. Second Degree Price Discrimination Units are Grouped All or Nothing Price Discrimination or Block Pricing (page 412-414) • Buy a group of items, but CANNOT buy them individually • Four Light Bulbs, but not individual bulbs • Candy bars in Movie Theaters -- large size 1. Not permitted to bring FOOD into a movie theater: Why?

  16. Willing to pay $2.20 for a 4-once chocolate bar At 50¢ per ounce, would buy only 2 bars All or Nothinggets one off of the demand curve at, say, $2.00 for a 4-ounce bar Demand for Ounces of Chocolate all or nothing 50¢ 90¢ 60¢ 40¢ 30¢ 1 2 3 4 Oz.

  17. 2. Two-Part Pricing:Another 2nd Degree Form (see page 410-12) • A price for the privilege of buying items • PLUS a price per item • Examples: • Country Club Dues and Greens Fees • Cover Charge to Enter and a Price Per Drink Cover Charge MC Q

  18. If P = 4.50 - Q and MC = .50Find Optimal Cover Charge Monopoly: QM = 2 & PM = 2.50 • At P = $.50, he/she buys 4 beer mugs • Biggest cover charge is the area of a triangle • Height is 4 • Base is 4 • (1/2)Height•Base • Max cover charge is $8.00 $4.50 Cover Charge of $8.00 is area of the triangle PM Cover Charge $8 $.50 Q 4 QM

  19. 3. Declining Block Pricing • Price declines as the quantity purchased increased • Examples: • TJ Maxx, second pair half price • telephone charges • foreign film festivals • Price declines similar to the demand curve D P Q

  20. 4. Skimming or Declining Block Pricing Over Time P • Price declines over time • The avant garde wish to get it first, others are willing to wait • Examples: • Hardcover & Paperback Books • Electrical & Computer Products D TIME

  21. 5. Bundling (Block Booking) 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. Preferences are uncorrelated Preferences are correlated A B A B 1 2 250 270 150 100 80190 80 100 165 175 180 340 500 360 160 + 200 = 360 in simple monopoly 165 + 200= 365 simple monopoly

  22. 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.

  23. 6. All You Can Eat Pricing AYCE Pricing -- A specified price for an unspecified quantity. Examples: Salad Bars, Legal Retainers, HMO’s Area under demand curves represent most willing to pay for an AYCE offer P ounces

  24. Third Degree Price Discrimination East West Market PM MC MR Example with a Simple Monopoly Price in both markets

  25. Third Degree Price Discrimination East West Market PE PM PW MC MR MR MR Example with a Different Prices in Each Market

  26. Segment markets by price sensitivity Charge higher prices in the markets that are the most inelastic Then P1 = $150 and P2 = $120 Pricing In Segmented Markets Why are haircuts for kids cheaper than for adults? P ( 1 + 1/ EP ) = MC Suppose MC = $100 in 2 markets and E1 = -3 and E2 = -6, find prices

  27. How can the full time tuition be the same for all students and still use price discrimination? If the firm were a “price taker,” could it price discriminate? The group with the higher price elasticity pays the lower price. Is price discrimination ‘fair’? Yield Management in airlines: the price as a function of time. Do you think that your kid will get a “better aid package” if she applies early? Are prices in the various college fields identical? Why does the EMBA cost more than a regular MBA program? Coffee, Tea, or Tuition Free?MBN Chapter 18

  28. Peak Load Pricing (page 417-419) • If at peak rush hour, the toll is higher than at the off-peak, we are using different prices at different time periods. • The peak toll can encourage shifting travel patterns to off-peak times or discourage some commuting altogether.

  29. Cross-Subsidization(page 419-421) • Firms with multiple products have the ability to price products so as to subsidize one at the expense of the other. • Loss leaders, are such a case • Low price for razors, and high price for complementary products, blades • Free Acrobat Reader, but charge for Adobe Acrobat

  30. Transfer Pricing • Multidivisional firms, with vertical integration • Chevy and Fisher Body; Stride Rite Shoes and Stride Rite Shoe Stores for kids. • Disagreements are sure to be present • Can price products at one division low or high, and impacts the profit of the whole enterprise • Standard costing methods uses average cost with markups in transfer prices • Optimal, however, is the price of each division up to the final division as if it were “arm’s length” competitive prices, P = MC.

  31. The optimal Price is where MR = MCThis is the Profit Max Price. Two-division firm with MC1 as TP (transfer price). MC1 + MC2 (the true cost of the combinedoperation) MC2 of second division of firm Profit Max Price Demand Curve MC1 of the first division of he firm TP TP MR Profit Max Quantity

  32. Suppose Division 1 gets a markup For firms with some market power, transfer prices with markups lead to higher imputed costs at the final stage than would be optimal for the firm. MC1 + MC2 + markup MC1 + MC2 (the true cost of the combined operation) MC2 of second division of firm Higher Price Profit Max Price Demand Curve TP+ MC1 +markup MC1 of the first division of the firm M R Profit Max Quantity MC1 + markup is the TP. MC1 + markup is the TP+.

  33. I am not a lawyer! Consult an attorney for specific issues. Clearly, price fixing agreements are illegal. PENALTIES $10 million under Sherman Antitrust for corporation $350,000 for individuals jail sentences were given in the Electrical Price Conspiracy Antitrust damages of double the harm (or gain). Most cases brought to the attention of the Department of Justice or the FTC by other firms, not those affected by it. New price fixing agreements are more likely to be prosecuted than old established ones. Laws and Price Discrimination

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