Pricing Techniques and Analysis Chapter 16

1. Pricing Techniques and Analysis Chapter 16 • Value-based more than cost-based pricing often helps build profits. • Firms charge different customers different prices, which is known as price discrimination. • This chapter also looks at pricing within a firm called transfer pricing. • Pricing techniques that are used by many multi-product firms, such as full-cost pricing and target return pricing. 2002 South-Western Publishing

2. Proactive Value-based Pricing • If the price doesn’t fit what customers are willing to pay, then the product may not be profitable. • Customer value is the focus for pricing, not just the costs associated with the product. • Apple Computer lost market share by ignoring this. • The Ford Mustang was a success, as Ford found that people wanted a sports car, but didn’t want it to be too expensive. The started with a price and designed the product. • The Mustang used value-based, not cost-plus pricing

3. Differential Pricing • 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. • Differential pricing appears more frequently than one thinks. This we call price discrimination.

4. Price Discrimination • Price Discrimination -- Goods which areNOT priced in proportion to their marginal cost, even though technically similar • Some Necessary Conditions: • 1. Some Monopoly Power • In Perfect Competition, P = MC • 2. Ability to Arbitrage • Separate Customers and Prevent Reselling

5. Arbitrage - Buy Low to Sell Higher • Arbitrage of Goodsis 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, a service • Lawyers charge different prices for wills, based on ability to pay

6. 1. Geography 2. Income 3. Gender 4. Age 5. Time 6. Race 7. Language 8. Transient / Resident 9. Ability to Haggle Many Ways to Separate Customers for Price Discrimination

7. In Simple Monopoly, there is only one price Consumers receive a consumer surplus In Price Discrimination, monopolists can SCOOP OUT all consumer surplus Why Practice Price Discrimination? MC Simple Monopoly CS PSM D Q QSM

8. Charge the MOST that a person is willing to pay for each good Zero consumer surplus Produce MORE than in Simple Monopoly Output the same as in Competition First Degree Price Discrimination Price Discriminating Monopoly MC D Q Q1st

9. Car Sales as First Degree Price Discrimination Ahh, that is $9,887 for 60 months at our 7.9% financing, plus $3,000 “How much do you plan to pay a month?” you inadvertently reply: “Only $200 per month, but I have $3,000 down payment!” Here’s one for only $12,887. It’s swell.

10. The conditions for First Degree price discrimination are seldom met Hence, some close approximations exist There are are a variety of ways to group units to attempt to scoop out consumer surplus Notice: Incentives to Understate One’s True Willingness to Pay Second Degree Price Discrimination: Units are Grouped

11. Second Degree Price Discrimination Methods • Block rate setting • Two part pricing • Unlimited access • Bundling methods We look at four examples:

12. Second Degree Price Discrimination: Block Rate Pricing • Price declines as the quantity purchased increased • Examples: • Tri-State Gas Company example (page 632) • TJ Maxx, second pair half price • telephone charges • foreign film festivals • Price declines similar to the demand curve D P Q

13. Another Second Degree Price Discrimination: Two-Part Pricing: • A price for the privilege of buying items • And a price per item • Examples: • Country Club Dues and Greens Fees • Cover Charge to Enter and a Price Per Drink Cover Charge MC Q

14. If P = 4.50 - Q and MC = .50Find Optimal Cover Charge Cover Charge $8.00 • At P = $.50, he/she buys 4 mugs of root beer • 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 PM=$2.50 Cover Charge $8 $.50 Q 4 QM Monopoly: QM = 2 & PM = $2.50

15. Second Degree Price Discrimination: Unlimited AccessorAll-You-Can-Eat Pricing A specified price for an unspecified quantity: Example: AOL unlimited access for $19.95/month Examples: Salad Bars, Legal Retainers, HMO’s Area under demand curves represent most willing to pay for an AYCE offer P ounces

16. Second Degree Price Discrimination: Bundling (or 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 80 100 165 175 180 340 500 360 165 200 = 365 simple monopoly 160 200 = 360 simple monopoly

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

18. Third Degree Price Discrimination East West Market PE PM PW MC MR MR MR Example with DifferentPrices in Each Market

19. 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 P ( 1 + 1/ EQ•P ) = MC Suppose MC = $100 in 2 markets and E1 = - 3 and E2 = - 6 Why are haircuts for kids cheaper than for adults?

20. Pricing of Multiple Product • Products are INDEPENDENT when changes in price and quantity of one product do not alter revenues or cost in the others • Products are INTERDEPENDENT, when changes DO affect other products • Ex: Procter & Gamble makes both Luvs and Pampers • TR = TRA + TRB

21. Substitutes & Complements • Look for interdependencies in marginal revenues: • MRA = TRA / QA +TRB / QA • MRB = TRA / QB+ TRB / QB • Substitutes when cross terms arenegative • Erosion or Cannibalism are terms used • Complementswhen cross terms are positive • BASE sells tapes and tape head cleaners

22. Decision Rule for Multiple Product Firms • Do NOTuse the rule to produce where MR=MC, as in MRA = MCA • INSTEAD: • Produce where the FULL MR =FULL MC • For a Two Product Firm of A & B • Produce where: TRA /QA + TRB /QA= TCA /QA + TCB /QA Include all relevant revenue and cost effects

23. Pricing Example in Supermarkets • Turkey prices fall during Thanksgiving • Yet we would expect DEMAND to be greatest?! • Loss Leader Pricing • Consider T as turkey • and A as all other food • TRstore = TRT + TRA MRstore for turkey = TRT /QT+ TRA /QT • Complementarity with other food explains the apparent conundrum

24. Pricing of Joint Products • Interdependencies in costs occur in products that are produced simultaneously • E.g., Beef & Hides; Wool & Mutton; Natural Gas & Crude Oil • Suppose FIXED PROPORTIONS in production: 500 lbs. of Beef + 10 sq. yards of Hide for 1 steer. • Two cases: No Excess of Hides, and Excess Hides case

25. Steers: No Excess Case Two Demand Curves: Hides & Beef Two MR Curves: Hides & Beef MRB DH DB steers (T) MRH

26. Steers: No Excess Case 2 MRT Find where MRT = MCT to find the optimal of steers. MCT DH DB steers (T) MRH

27. Steers: No Excess Case 3 MRT At the optimal number of steers, find the prices of beef & hides on their respective demand curves MCT PB PH if demand for beef rises, the price of hides will fall ! DH DB steers (T) MRH T

28. Excess of One of the Joint Products • Excess means the price would be ZERO • The solution is to hold back some of the excess to reach the Unit Elastic Point on the Demand Curve. • This Maximizes Total Revenue.

29. Multi-Divisional Firms and the Economics of Transfer Pricing Transfer Pricing serves two functions: 1. Measure of the marginal value of the resource 2. Provides a performance measures of resources used For international firms, transfer pricing may assist in reducing worldwide taxation, but the ability to reduce taxation is limited because the IRS requires arm’s length prices.

30. Create Transfer Prices Similar to Competitive Market Prices • Disagreementsacross divisions are common • “Selling” Division wants a HIGH transfer price • “Buying” Division wants a LOW transfer price • When External Markets exists, use those prices for transfer (a market-based competitive price) sell to others @ “P” final car assembly motor assembly purchase motors from others @ “P”

31. Transfer Pricing With No External Markets • When no external markets exist, use the MC of the transferred good. • Often, however, the MC is a function of output. • Marketing and Production steps (M & P) • Transfer price is PT = MC P on following figure

32. Find Where MCM+P = MR MCM+P MCP P MCM PT D MR

33. Pricing in Practice • In practice, pricing strategy involves the whole life-cycle of the product. • Managers report wide use of cost-pluspricing methods because it: • Streamlines pricing of multiple products • Streamlines pricing of retail prices

34. Cost-Plus and Full Cost Pricing P = ACn + Markup orP = ACn(1 + m) where ACn is average cost at a normal output and m is a percentage markup Notice: Little reliance on MC pricing or use of elasticities, as in: P( 1 + 1/Ep ) = MC

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

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

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

38. Full Cost Pricing • Full Cost-- • Covers all Costs at the standard or normal output • Plus a return on the investment • P = AFCn + AVCn + p K/ Qn • wherep Kis the target amount of profit • and p is the desired profit rate and K is gross operating assets • Example: Low Tech Security FC = 200,000, Qn = 3000, VC = 90,000 p= 20% and K=$500,000. Find Full Cost Price!

39. Full Cost Pricing • Answer • P = AVC + AFC + (.20)(500,000)/Q • P = 30 + 66.67 + 33.33 = $130 • Also, suppose a 35% markup on cost • P = [ ACn] (1.35) • P = [ 30 + 66.67 ](1.35) • P = $130.50

40. Advantages 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 Disadvantages But cost-plus ignores demand changes Pricing may be based on poor cost data Output varies in business cycle Cost-Plus Pricing Hybrid Method: Variable Cost-Plus Pricing --the markup can vary over the season or business cycle

41. Grocery storeshave low markups Many close substitutes -- at other grocery stores (bread varieties and qualities are standardized) Frequent purchase, so customers are knowledgeable about prices & quality Demand is therefore highly elastic Optimal markup would consequently be small Optimal Markups in Practice 1999 South-Western College Publishing

42. Jewelry Markups are known to be large Difficult to make comparisons across jewelry stores Little repeat purchases, so knowledge about prices is low Consequently, lower price elasticity for jewelry The optimal markup is larger Markups on Jewelry 1999 South-Western College Publishing

43. Skimminga form of block rate pricing over time • Price declines over time • Those who wish to get it first pays the highest price, others are willing to wait • Examples: • Hardcover & Paperback Books • New electrical & Computer Products D P TIME 1999 South-Western College Publishing

44. Revenue Management: Appendix 16A • Revenue Management is the problem of the disappearing inventory. • Managers must be flexible to change their predicted sales by market segment as information arrives. • Airlines price discriminates between business and non-business travelers. If too few business travelers have booked tickets compared to the amount expected, then more non-business tickets should be released.

45. Optimal Overbooking • Managers may authorize reservation clerks to sell more seats (rooms) than are available. • The greater the overbooking, the lower are the costs of spoilage. • Spoilageis an inventory NOT sold. If capacity is large, an airline or hotel will have high spoilage. • The greater the overbooking, the greater are the costs of spillage, making customers unhappy by finding that they have no seat or reservation.

46. Spillage • Spillage is the excess demand that cannot be met. • If the service industry has low capacity, the spillage will be great • Customers leave the hotel or airline unable to get a room or an airplane seat.

47. Optimal Overbooking Spillage • Spillage and spoilage costs go in opposite directions, the sum of these costs has a minimum with the optimal amount of overbooking. • Since business travelers tend to a large extent to be repeat customers, the cost of spillage (oversells) may be very high. • The optimal amount of overbooking for this market segment may well be lower than for non-business clients. Total Cost optimal Spoilage 100% 110% 120% ... Percent Overbooked