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Strategic Pricing: Theory, Practice and Policy

Strategic Pricing: Theory, Practice and Policy. Professor John W. Mayo mayoj@georgetown.edu. Pricing Project Presentations. Logistics - Rest of Course Friday: Pricing project presentations, the logistics Affirmative presentations (Power point) 15-20 minutes Q&A 10 minutes

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Strategic Pricing: Theory, Practice and Policy

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  1. Strategic Pricing: Theory, Practice and Policy Professor John W. Mayo mayoj@georgetown.edu

  2. Pricing Project Presentations • Logistics - Rest of Course • Friday: Pricing project presentations, the logistics • Affirmative presentations (Power point) 15-20 minutes • Q&A 10 minutes • Student questions encouraged • Professor Borner will help judge • Today: • Pricing and “The Sound of Music” • Pricing in Vertical Settings • Tomorrow: • The Psychology of Pricing

  3. Question: What should the price paid by TV stations (radio stations) be for music they play?

  4. Industry Structure Retail consumers Media TV Stations Internet $ PROs BMI ASCAPI Composers

  5. Some options • TV (radio) stations are losing customers to alternative (internet) media. With fewer customers and reduced advertising $, the price should fall. • What is the value added to TV & Radio stations caused by the demand for music? • The alternative? Individual contracting • The competitive benchmark: Marginal cost • The “reasonable bounds” • MC ≤ P ≤ Stand Alone Cost • Practical: Price Cap • Pt+1 = Pt + CPI – Productivity Change

  6. Vertical relations • Review of Vertical Relations • Transfer Pricing

  7. Vertical relations • Retail • Demand: Q= Q (Price, advertising, Sales outlets, etc) • Wholesale • Demand: Q = Q (wholesale price, downstream demand) retail Downstream Upstream wholesale

  8. Double Marginalization P Insufficient vertical control can diminish profits Pr This creates incentive for coordination/control across vertical stages Pm Two-part tariff Pw= πm +mc(Q) Alternatively, could set maximum retail price AC=MC Q qm qr mr

  9. Pricing and Competition in Vertical Markets P What is the relationship between the extent of downstream competition and the optimal upstream price? Pr Pm AC=MC Q qm qr mr

  10. Vertical relations, Retail competition and externalities • Assume downstream competition • Assume that consumers receive valuable (but costly to deliver) information at the retail stage • Free-rider problem • Possible solution: Resale price maintenance • What about “generic” advertising? • Possible solution: Territorial restrictions • What about generic manufacturer investments in retail stage (e.g. Training staff) • Possible solution Exclusive dealing

  11. Vertical restraints and the Law • Resale price maintenance – • per se illegal until Leegin v. PSKS (2007), now Rule of Reason • Territorial restriction – Rule of Reason • Exclusive Dealing – Rule of reason • In Europe, Article 85 (1) – vertical restraints are ‘incompatible with the common market.” (but there is exception for technically or economically justified restrictions where consumers receive fair share of benefits.

  12. Transfer Pricing • Consider FedEX Office (aka Kinkos). • What price should FedEX Express Charge FedEX Office for delivering an overnight package? Should FedEX Office buy Express services at retail? Office FedEX

  13. Transfer Pricing • With no outside market • With a competitive outside market • With a non-competitive outside market

  14. Transfer Pricing with no Outside Market • Set transfer price of the input equal to the marginal cost of the upstream input • A little economic manipulation shows that that with prices set equal to marginal cost, the incentives of decentralized, vertically related profit-centers are aligned.

  15. Transfer Pricing To maximize profits, set the Transfer price equal To the Net Marginal Revenue of the upstream input P MCu MCd Pu D MR Quantity NMRu

  16. Transfer pricing with a competitive outside market • Either buy upstream inputs from the market or sell upstream inputs into the competitive market depending on the relationship of the market price and your firm’s marginal input cost

  17. Transfer Pricing with Competitive market Assuming a competitive world price of Pu, to maximize profits, produce qu and then purchase inputs out to Pu = NMRu) P MCu Pu MCd D Quantity qu q1 Q* MR NMRu

  18. Transfer Pricing Competitive market & high price Assuming a competitive world price of Pu, to maximize profits, produce qu and sell (qu –Q) in open market P MCu Pu Why equate Pu and NMRu? MCd D Q* Quantity qu MR NMRu

  19. Efficient Component Pricing

  20. Pricing with a non-competitive outside market: Efficient Component Pricing Rule At what price should Verizon provide loops to a Competitive retail provider? Verizon Retail Competitive Local Exchange Company (CLEC) Verizon Telephone loops

  21. The Critical Role of Economic Costs in Strategic Decision-making At what price should Verizon provide loops to the CLEC? Suppose: PR = $15 ICW = $4 ICR = $5 Retail: ( R ) Verizon Retail CLEC Wholesale: (W) Efficient Component Pricing Rule : PW = ICW + (PR – ICW – ICR) Verizon Loops

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