Pricing Policy & Strategic Thinking

1. Pricing Policy & Strategic Thinking MBA NCCU Managerial Economics Jack Wu

2. Pricing Policy

3. Case: Emirates Airline, Dubai-Mumbai, Economy class, May 2004

4. Emirates Airline, Mumbai-Dubai, Economy class, May 2004

5. Emirates Airline • Why does Emirates charge lower fare for passengers originating from Mumbai? • How is this discrimination possible?

6. Pricing Policy • uniform pricing • complete price discrimination • direct segment discrimination • indirect segment discrimination • bundling

7. UNIFORM PRICING 80 Price (Thousand Yen per unit) 55 marginal cost 30 demand marginal revenue 0 2500 5000 Quantity (Units a year)

8. Uniform Pricing: Profit Maximum • MR = MC • Equivalently, set the incremental margin percentage equal to the inverse of absolute value of price elasticity of demand, (price - MC) / price = -1/e

9. Price Elasticity • always set price so that demand is elastic • if demand more elastic, then lower incremental margin percentage (IM%) e = -2  IM% = 1/2 • e = -1.5  IM% = 2/3

10. Pricing Private-Label Cola Suppose that WalMart learns that demand for private-label cola is less elastic than the demand for Coca Cola. Should WalMart set a higher price for private-label cola?

11. potential buyers $ buyer surplus price marginal cost 0 quantity Uniform Pricing: Shortcomings • leaves buyers with a lot of surplus • does not sell to every potential buyer

12. Complete Price Discrimination • price each unit at buyer’s benefit and sell quantity where MB = MC • maximum profit -- theoretical ideal • different from MR = MC • implementation: must know entire marginal benefit and marginal cost curves

13. Complete Price Discrimination: Practice • bargaining • auctions

14. Direct Segment Discrimination, I • price by segment • implementation • fixed identifiable characteristic --- basic for segmentation • no re-sale

15. Direct Segment Discrimination, II simple case: uniform price within each segment • within each segment IM% = -1/e • for segment with more elastic demand, then lower incremental margin percentage (IM%)

16. DIRECT SEGMENT DISCRIMINATION, III (a) Men’s demand (b) Women’s demand demand 80 Price (Thousand Yen per unit) Price (Thousand Yen per unit) 55 50 marginal revenue marginal cost 40 marg. cost 30 30 demand marginal revenue 0 2500 3000 0 1000 Quantity (Units a year) Quantity (Units a year)

17. NYNEX Telephone Service New York City • residential -- $16/month • business -- $23/month How is discrimination possible?

18. Asian Wall Street Journal • Why different prices for print edition but not interactive edition?

19. Indirect Segment Discrimination • structure choice to earn different incremental margins from each segment • implementation • seller controls some variable to which segments are differentially sensitive • buyers cannot circumvent the variable

20. AIR TRAVEL: BENEFITS

21. AIR TRAVEL: INDIRECT SEGMENT DISCRIMINATION *MC=200

22. Chinese Embassy: Visa Fees

23. PRICING POLICIES: RANKING

24. Bundling • strategy • pure bundling • mixed bundling

25. Cable Television: Benefits

26. Pure or Mixed Bundling What is the profit-maximizing pricing policy if • marginal cost per channel = 0 • marginal cost per channel = $5

27. Pure or Mixed Bundling • Generally, • if item is costless, no loss from giving it to every consumer --> pure bundling; • if item is costly, then should avoid providing it to low-benefit users --> use mixed bundling to screen out low-benefit users. • Mixed bundling is form of indirect segment discrimination • structured choice between bundle and separates

28. Strategic Thinking

29. Case: Coke vs. Pepsi, 1999 Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9% “Coke and Pepsi will move now from price-based competition to marketing-based competition”, Andrew Conway, Morgan Stanley

30. Competitive Dilemma What should Coke do?

31. Strategic Situations • parties actively consider the interactions with one another in making decisions • game theory -- set of ideas and principles to guide strategic thinking • simultaneous actions: strategic form • sequential actions: extensive form

32. Dominated Strategy generates worse consequences than another strategy, regardless of the choices of the other parties • never use dominated strategy

33. Nash Equilibrium Given that the other players choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy • No one is willing to deviate unilaterally from a Nash equilibrium

34. Solving for Nash Equilibrium • eliminate dominated strategies, then check remaining cells • “arrow” technique

35. Nash equilibrium:Competitive dilemma • What should Coke do?

36. Coke and Pepsi Game • Nash equilibrium: for both parties, “raise price” is dominated by “discount”. • but discounting is bad for both -- if only they could agree somehow to raise price. • Coke and Pepsi stuck in this situation for four years until November 1999.

37. Nash equilibrium:Prisoners’ dilemma • What should Sam do?

38. WHERE TO ADVERTISE? No Nash equilibrium in pure strategies

39. Randomized Strategies • choose among pure strategies according to probabilities • must be unpredictable • Example: where to advertise • _ We.com: ½ NBA and ½ NHL • _ Competitor.com: ½ NBA and ½ NHL

40. Randomized strategies: Retail price competition • Pricing trade-off: • high price to extract buyer surplus of loyal customers • low price to get store switchers • Solution: randomizeddiscounts

41. Coordination/competition:Evening news

42. Coordination and Competition • Prime time for news is 8:0pm; second best is 7:30pm; • since audience is limited, get maximum viewership if two channels schedule at different times. • Question: which station gets 8:0pm? Situation has elements of • coordination -- avoiding same time slot • competition -- getting the 8:0pm slot

43. Zero/Positive Sum • zero-sum games: pure competition -- one party better off only if other is worse off • positive-sum games: coordination -- both can be better off or both worse off • co-opetition: competition and coordination

44. Coordination/competition:Future DVD standard

45. Coordination/Competition: Focal Point • Single Nash equilibrium - clear focal point • Multiple Nash equilibria - look for focal point to see which one to play

46. Sequencing Game in extensive form – sequence of moves: • nodes • branches • outcomes

47. Extensive Form: Equilibrium backward induction • final nodes  intermediate nodes  initial node

48. Sequencing:Extensive Form- TV News

49. Strategic Move Action to influence beliefs or actions of other parties in a favorable way • credibility • first mover advantage • second mover advantage

50. Examples • Examples: • Evening TV news -- both stations want to move first: which one can? • Use strategic move, eg, contracts with advertisers to deliver news at 8pm. • Famous Chinese general: after crossing a river, burnt his ships -- strategic move to force soldiers to fight harder. • Issue: Is the move credible? Will it convince the other players? • Advantage doesn’t always go to first mover; • In war, better to see opponent’s move, and then take action, eg is enemy moving south or north? • new product category -- let competitor test the market and educate the customers