Chapter 10 Special Pricing Policies

1. Chapter 10Special PricingPolicies

2. Outline • Cartel arrangements • Price leadership • Revenue maximization • Price discrimination • Nonmarginal pricing • Multiproduct pricing • Transfer pricing

3. Learning Objectives • Analyze cartel pricing • Illustrate price leadership • Understand price discrimination, and its effects • Distinguish between marginal pricing and “cost-plus” pricing • Discuss the various types of multiproduct pricing • Explain the meaning of “transfer pricing,” and explain how a company should price products that pass from one operating division to another

4. Cartel Arrangements • A cartel is an arrangement where firms in an industry cooperate and act together as if they were a monopoly • Cartel arrangements may be informal or formal • Illegal in the U.S.: Sherman Antitrust Act, 1890 • Examples: OPEC, IATA

5. Cartel Arrangements • Conditions that influence the formation of cartels • most common in oligopoly market structures • small number of large firms in the industry • geographical proximity of the firms • homogeneous products that do not allow differentiation • stage of the business cycle • difficult entry into industry • uniform cost conditions, usually defined by product homogeneity

6. Cartel Arrangements • Pricing and Profit Decisions • in order to maximize profits, the cartel as a whole should behave as a ‘monopolist’ • the cartel determines the output which equates MR = MC of the cartel as a whole • the MC of the cartel as a whole is the horizontal summation of the members’ marginal cost curves • price is set in the normal monopoly way, by determining quantity demanded where MC=MR and deriving P from the demand curve at that Q

7. Cartel Arrangements 1. MCT is the horizontal sum of MCI and MCII 2. QT is found at the intersection of MRT and MCT  price is found from the demand curve at QT … this is the price that maximizes total industry profits

8. Cartel Arrangements • To determine how much each firm should produce, draw a horizontal line back from the MRT/MCT intersection • Where this line intersects each individual firm’s MC determines that firm’s output, QI and QII. Note that the firms may produce different outputs • Key point: the MC of the last unit produced is equated across both firms

9. Cartel Arrangements 7. Profits for each firm are shown as rectangles in blue 8. Firms may earn different levels of profit, though combined profits are maximized

10. Cartel Arrangements • There may be an incentive for firms to cheat on agreements, thus cartels are unstable • There are additional costs facing a cartel • Formation costs • Monitoring costs • Enforcement costs • Potential cost of punishment by authorities

11. Cartel Arrangements • Discussion examples: price fixing by cartels • GE, Westinghouse • Archer Daniels Midland Company • Sotheby’s, Christie’s • Roche Holding AG, BASF AG • Foreign firms doing business in the U.S.--electronics, auto parts

12. Price Leadership • Barometric price leadership • One firm in an industry decides to initiate a price change in response to economic conditions. • The other firms may or may not follow this leader. • The leader may change.

13. Price Leadership • Dominant price leadership • One firm is the industry leader--normally the most efficient, lowest cost producer. • This dominant firm sets price with the realization that the smaller firms will follow and charge the same price. • This may force some competitors out of business or allow the dominant firm to buy them out under favorable terms. • This could result in investigation under the Sherman Anti-Trust Act.

14. Price Leadership DT = demand curve for entire industry MCD = marginal cost of the dominant firm MCR = summation of MC of follower firms In setting price, dominant firm must consider the amount supplied by all firms

15. Price Leadership • Demand curve facing the dominant firm is found by subtracting MCR from DT • Dominant firm equates its MC with MR from its ‘residual demand curve’ DD • The dominant firm sells A units and the rest of the demand (QT – A) is supplied by the follower firms

16. Revenue Maximization • Baumol model: firms maximize revenue (not profit) subject to maintaining a specific level of profits Rationale • a firm will become more competitive when it achieves a large size • management renumeration may be related to revenue not profits Implication: unlike the profit maximization case, a change in fixed costs will alter price and output (by raising the cost curve and lowering the profit line)

17. Revenue Maximization

18. Price Discrimination Price discrimination: • Products with identical costs are sold in different markets at different prices, or • The ratio of price to marginal cost differs for similar products. • Conditions for price discrimination: • the markets sold must be separate (no resale between markets) • the demand curves must have different elasticities

19. Price Discrimination First degree price discrimination • Seller can identify where each consumer lies on the demand curve and charges each consumer the highest price the consumer is willing to pay. • It allows the seller to extract the greatest amount of profits. • It requires a considerable amount of information about the consumer.

20. Price Discrimination Second degree price discrimination • Differential prices are charged by blocks of services • It requires metering of services consumed by buyers.

21. Price Discrimination Third degree price discrimination • Customers are segregated into different markets and charged different prices in each. • The market segmentation can be based on any characteristic such as age, location, gender, income, etc.

22. Price Discrimination Third degree discrimination: • Assume the firm operates in two markets, A and B • The demand in market A is less elastic than the demand in market B • The entire market faced by the firm is described by the horizontal sum of the demand and marginal revenue curves …

23. Price Discrimination • The firm finds the total amount to produce by equating the marginal revenue and marginal cost in the market as a whole: QT • If the firm were forced to charge a uniform price, it would find the price by examining the aggregate demand DT at the output level QT • The firm can increase its profits by charging a different price in each market …

24. Price Discrimination • In order to find the optimum price to charge in each market, draw a horizontal line back from the MRT/MCT intersection • Where this line intersects each submarket’s MR curve determines the amount that should be sold in each market: QA and QB • These quantities are then used to determine the price in each market using the demand curves DA and DB

25. Price Discrimination Examples of price discrimination • doctors • telephone calls • theaters • hotel industry

26. Price Discrimination Tying arrangement: a firm will use its existing market power in the first (tying) product to suppress previously existing competition in the second (tied) product. • Price discrimination is a plausible explanation of firms using tying arrangements • Other explanations: • quality control • efficiencies in distribution • evasion of price controls • Example: Hardware and software

27. Price Discrimination • Welfare Implications • U.S. antitrust laws look unfavorably at the practice of price discrimination, which is said to lead to a lessening of competition. • Often, the welfare implications are uncertain because it is difficult to weigh the benefits bestowed on consumers with lower prices compared with the costs imposed on consumers paying higher prices.

28. Non-marginal Pricing Cost-plus pricing: price is set by first calculating the variable cost, adding an allocation for fixed costs, and then adding a profit percentage or markup Problems with cost-plus pricing • calculation of average variable cost • allocation of fixed cost • size of the markup

29. Non-marginal Pricing Incremental pricing (and costing) analysis: deals with changes in total revenue and total cost resulting from a decision to change prices or product. • incremental, similar to marginal analysis • only revenues and costs that will change due to the decision are considered • examples of product change: new product, discontinue old product, improve a product, capital equipment

30. Multiproduct Pricing When the firm produces two or more products • Case 1 Fixed proportions: products are complements in terms of demand, an increase in the quantity sold of one will bring about an increase in the quantity sold of the other • Case 2 Variable proportions: products are substitutes in terms of demand, an increase in the quantity sold of one will bring about a decrease in the quantity sold of the other

31. Multiproduct Pricing When the firm produces two or more products • Case 3: products are joined in production, • products produced from one set of inputs • Case 4: products compete for resources, using resources to produce one product takes those resources away from producing other products

32. Transfer Pricing Internal pricing: as the product moves through these divisions on the way to the consumer it is ‘sold’ or transferred from one division to another at a ‘transfer price’ Rationale: • firm subdivided into divisions, each may be charged with a profit objective

33. Transfer Pricing • Without any coordination, the final price of the product to consumers may not maximize profits for the firm as a whole

34. Transfer Pricing • The design of the transfer pricing mechanism must be geared toward maximizing total company profit; therefore, the final pricing policy may be dictated centrally from the top of the corporation.

35. Transfer Pricing Case A: no external markets • no division can buy from or sell to an external market • the selling division will produce exactly the number of components that will be used by the purchasing division • one demand curve and two MC curves • MC curves are summed vertically • set production where MR = Total MC

36. Transfer Pricing Case B: external markets • divisions have the opportunity to buy or sell in outside competitive markets • if selling division prices above the external market price, the buying division will buy from outside • if selling division cannot produce enough to satisfy buying division demand, the buying division will buy additional units from the external market

37. Other Pricing Practices • Price skimming • the first firm to introduce a product may have a temporary monopoly and may be able to charge high prices and obtain high profits until competition enters • Penetration pricing • selling at a low price in order to obtain market share

38. Other Pricing Practices • Limit pricing • A monopolist will set price below MR = MC to prevent potential customers from entering the market. • Predatory pricing • Setting price below marginal cost to drive competitors out of the market

39. Other Pricing Practices • Prestige pricing • demand for a product may be higher at a higher price because of the prestige that ownership bestows on the owner • Psychological pricing • demand for a product may be quite inelastic over a certain range but will become rather elastic at one specific higher or lower price

40. Global Application • Example: decline of European cartels • carton-board • vitamin • copper pipe • elevator operators

41. Summary • Cartels are formed to avoid market competition and maximize profits. However, as history shows, such arrangements are not always stable. • Price leadership exists when one company establishes a price and others follow. Two types of price leadership were discussed: barometric and dominant. • Baumol’s model describes the actions of a company whose objective is to maximize revenue.

42. Summary • Price discrimination (or differential pricing) exists when a product is sold in different markets at different prices. Third-degree price discrimination is the most common. • A firm can increase its profits over what they would be if a uniform price were charged by price discrimination. • Cost-plus pricing appears to be a very common method but often ignores marginal principles and demand curve effects.

43. Summary • Multiproduct pricing was examined, because most firms and plants produce more than one product at the same time. • Multiple products produced by one firm can be complements or substitutes, both on the demand side and the supply side. • Transfer pricing is used to determine the price of a product that progresses through several stages of production within a firm.