Pricing Techniques and Analysis

Chapter 14
Valuebasedmorethancostbasedpricingoften
helpsbuildprofits.
Firmschargedifferentcustomersdifferentprices,
whichisknownaspricediscrimination.
Thischapteralsolooksatpricingwithinafirm
calledtransferpricing.
Pricingtechniquesthatareusedbymanymulti
productfirms,suchasfullcostpricingandtarget
returnpricing.
2005 South-Western Publishing

Slide 1

Proactive Value-based Pricing

Ifthepricedoesntfitwhatcustomersarewillingtopay,
thentheproductmaynotbeprofitable.
Customervalueisthefocusforpricing,notjustthecosts
associatedwiththeproduct.
AppleComputerlostmarketsharebyignoringcustomer
value.
TheFordMustangwasasuccess,asFordfoundthat
peoplewantedasportscar,butdidntwantittobetoo
expensive.Thestartedwithapriceanddesignedthe
product.
TheMustangusedvaluebased,notcostpluspricing
Slide 2

Intertemporal
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.
Intertemporal pricing appears more frequently
than one thinks. This is just one variety of
what is called price discrimination.
Slide 3

Figure 14.1 Page 605

If the price at
off-peak is POP is
the same price as
the peak, the
traffic volume
varies from QOP
to QPEAK.
If the price at the
peak is PP, the
traffic volume
varies less, from
QOP to QC.

PP

POP
DPEAK

DOFF-PEAK
QOP

QC

QPEAK
shift

Slide 4

Price Discrimination
Price

Discrimination -- Goods which are

NOT priced in proportion to their marginal cost,

even though technically similar
Some

Necessary Conditions:

1. Some Monopoly Power

Otherwise, in pure competition, P = MC

2. Ability to Arbitrage
Separate customers and prevent reselling

Slide 5

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
Slide 6

Ways to Separate Customers

for Price Discrimination
1. Geography as when the price in6.
the East-side and West-side
differ
2. Income as the American Econ
Association charges more to 7.
professors than students
3. Gender as when jeans for
8.
women are priced higher than
similar jeans for men
4. Age as when kids get in at
9.
lower prices for movies
5. Time of day or season

Race as when shampoos targeted for

African-American hair are priced
differently that other shampoos, though
technically the same.
Language as when products printed in
Spanish are priced differently than
those in English
Transient/Resident as when contracts
pay less at hardware stores than other
customers
Ability to Haggle when those how ask
for a lower price get it

Slide 7

Why Price Discriminate?

In Simple Monopoly,
there is only one price
Consumers receive a
consumer surplus
In Price
Discrimination,
monopolists can
SCOOP OUT all
consumer surplus

Simple
Monopoly

MC

PSM CS

D
QSM

Q
Slide 8

Perfect Price Discrimination

(or 1st Degree Price Discrimination)

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

Price Discriminating
Monopoly

MC

D
Q1st

Q
Slide 9

Perfect Price Discrimination

Does it Work for Car Dealers?

How much do you

plan to pay a
month?
you inadvertently reply:

$232 per month,

and have a $3,000
down payment!

At 6%, thats
about $12,000
for 60 months,
plus $3,000

Heres one for only

$15,000. Its swell.

Slide 10

Notice: Incentives to Understate

Ones True Willingness to Pay

The conditions
for perfect price
discrimination
are seldom met
Hence, some
close
approximations
exist

Second Degree Price

Discrimination:

Units are Grouped

There are are a variety
of ways to group units
to attempt to scoop out
consumer surplus
Slide 11

Second Degree Price Discrimination:

Two-Part Pricing
A price for the privilege
of buying items PLUS a
price per item
Examples:
Car rental per day with
mileage charges per mile
Amusement parks
Country Club Dues and
Greens Fees
Cover Charge to Enter a
Bar and a Price Per
Drink

Figure 14.2

Car rental per

day is the Cover
Charge, and mileage
fee at P or P*

P*

Cover
Charge

D2
D1
Q

Car renters may not know how

much they will use the car (D1 or D2).
They may prefer a lower rental rate (cover
charge) with a per mile charge, P*.
Slide 12

Second Degree Price Discrimination:

Unlimited Access
A specified price for an unspecified quantity:
Example: AOL unlimited access for $19.95/month

Examples: Salad Bars, Legal Retainers, HMOs

P

The area under the demand

curves represent most
willing to pay.

Ounces of Salad

Slide 13

Second Degree Price Discrimination:

Bundling

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: Movies A & B and Theaters 1 & 2.
Preferences are uncorrelated

1
2

Preferences are correlated

150
80

100

190

A
250
270

160
200 = 360
simple monopoly

500
Bundling
is more
Profitable.

80

100 180
360

165

175 340

165
200 = 365
simple monopolySlide 14

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.
Slide 15

One Price for All Regions

East

West

Market

PM

MC

MR

Example with a Simple Monopoly Price (PM) in both markets

Slide 16

Third Degree Price Discrimination

East

West

Market

PE
PM

PW
MC

MR
MR
MR

Example with

Different Prices in Each Market

Slide 17

Mathematics of Price
Discrimination

Using elasticities P( 1 + 1/ ED ) = MC
In two regions:
P1( 1 + 1/ E1 ) = P2( 1 + 1/ E2 ) = MC
or: P1/ P2 = ( 1 + 1/ E2 )/( 1 + 1/ E1 )

If the elasticities in region 1 and region 2 are -1.25 and

-2.5 respectively, then P1/ P2 = (1+1/ -2.5)/(1+1/-1.25 ) = 3.

Hence, P1 = 3P2.
The price is three times higher in region 1, which less
elastic.
Slide 18

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
Slide 19

Substitutes & Complements

Look for interdependencies in marginal

revenues:
MRA = TRA / QA + TRB / QA
MRB = TRA / QB + TRB / QB
Substitutes when cross terms are negative
Erosion or Cannibalism are terms used, such as
Pampers & Luvs.

Complements when cross terms are positive

Mitsubishi Electric sells DVD Players and blank DVDs
Slide 20

Decision Rule for Multiple Product Firms

Do NOT use the rule to produce where MR=MC, as in MR A =
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

Slide 21

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

3 / lb.
with $10 purchase

TRstore = TRT + TRA

MRstore for turkey = TRT /QT + TRA /QT

Complementarity with other food explains the
apparent conundrum
Slide 22

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

Slide 23

Cost-Plus and Full Cost Pricing

P = ACn + Markup
or

P = 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

Slide 24

Full Cost Pricing

Full Cost--

Covers all Costs at the standard or normal output

Plus a return on the investment

P = VCl + VCm + F/Q + K / Q

Where VCl and VCm are unit labor cost and unit material cost
respectively (which is average variable cost).
where K is the target amount of profit
and is the desired profit rate and K is gross operating assets
Q is the number of units expected to be produced over this time
horizon.

Slide 25

Example: Low Tech Security

Start a firm with F = 200,000, Q = 3000, total labor cost is $40,000
and total material cost is $50,000
= 20% and K=$500,000. Find Full Cost Price!

Answer
P = VCl + VCm + F/C + (.20)(500,000)/Q
P = 13.33 +16.67+ 30 + 66.67 + 33.33
= $130

Also, suppose a 35% markup on average cost

P = [ AC] (1.35)
P = [ 30 + 66.67 ](1.35)
P = $130.50

Slide 26

Advantages & Disadvantages

of cost-plus pricing

Cost-plus is simple
But cost-plus ignores
It is easy to delegate to
demand changes
others
Pricing may be based on
Easy to apply to
poor cost data
thousands of items
Output varies in business
Can use categories
cycle
of markups for
different classes of Hybrid Method: Variable
products
Cost-Plus Pricing -- the
markup can vary over the
season, or business cycle
Slide 27

Optimal Markups in Practice

Grocery stores have low
markups
Many close substitutes -- at
other grocery stores (bread
varieties and qualities are
standardized)
Frequent purchase, so
customers are
knowledgeable about prices
& quality

1999 South-Western College Publishing

Demand is therefore

highly elastic
Optimal markup would
consequently be small

Slide 28

Markups on Jewelry
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
1999 South-Western College Publishing

Slide 29

Skimming
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, and PDAs.

1999 South-Western College Publishing

TIME
Slide 30

Prestige Pricing
Some products distinguish themselves by being
noticeably expensive.
Mercedes, Audi, or BMW
Cartier jewelry

The price is itself a way to distinguish the product from

others
Prestige Pricing is the practice of charging a high price
to enhance its perceived value.
However, the firms typically have to spend a great deal in
promotional activities to convince customers that the product
is prestigious.
Slide 31