GECO 6410 Week Eight

Pricing Strategies: Creating & Sustaining CA

Source: Boyes Ch 8
Pindyck and Rubinfeld Ch. 11) (short loans on line)
Outline
1. Pricing in context
2. Price Discrimination
3. Intertemporal Price Discrimination and Peak-
Load Pricing
4. Two-Part Tariff
5. Bundling
6. Mark-up pricing
7. Summary
Par t 1 Pricing in
context
 It is one of the issues managers are most
concerned with.
 Pricing strategies (i.e. charging different
prices to different customers for similar
goods & services) are a way that
producers capture consumer surplus.
Seeking Competitive Advantage:
Pricing Strategies
◆Pricing is an important strategic tool,
acknowledge by managers across industries.
◆Part of the broad pursuit of sustaining c.a.
through barriers to entry.
◆However, a small percentage of managers
know much about consumer's response to
price
Seeking Competitive Advantage:
Pricing Strategies
◆Key Questions: Have Internet buying/selling and auctions
turned all businesses into price takers? ( i.e. a perfectly
competitive outcome)?
◆How prices are determined on the Internet?
➤P = MC ( no differentiation)
➤P >MR=MC (some differentiation)
◆See Boyes pp. 163 -166
 Seeking Competitive Advantage:
Pricing Strategies
◆ While MC =MR is the fundamental approach to pricing, firms
face numerous complications while setting prices.
◆ Firms selling more than one product (super markets,
department and discount stores)
◆There is more than one market segment

◆Different selling environment and market structures

◆ Link between price and quality and consumers’ perception

◆Different customers have different capacity to pay for the same

good or service
 Most Important
Marketing Issues (Source: Dolan and Simon 1996 cited
in Boyes 2004: 163)
Management Knowledge (Source: Clancy and
Shulman 1994 cited in Boyes 2004: 163)
 The challenge

◆ The challenge is to capture as much of

the consumer surplus as possible. It is the
prices which are above MC. It can only
work if a firm has some market power.
 Consumer Surplus
Willingness to pay
The maximum amount that a buyer will pay for a good

Consumer surplus
A buyer’s willingness to pay less the amount the buyer actually pays
Price Price
A A
Initial Consumer Surplus
Consumer
Surplus
P1 B C
P1 B C Consumer surplus to
B
New consumers
P2 F
D E
Demand Additional Demand
consumer
Surplus to
initial consumer

Q1 Quantity Q1 Q2 Quantity
Capturing Consumer Surplus
Between 0 and Q*, consumers
will pay more than
$/Q Pmax A P*--consumer surplus (A).

P1
PC is the price
that would exist in
P* B a perfectly competitive
market.
P2
MC If price is raised above
PC P*, the firm will lose
sales and reduce profit.

D
Beyond Q*, price will
have to fall to create a
consumer surplus (B).
MR
Q* Quantity
Capturing Consumer Surplus
Question
$/Q Pmax A How can the firm
capture the consumer surplus
P1 in A and sell profitably in B?
P* B
Answer
P2 Price discrimination
Two-part tariffs
MC
PC Bundling

MR
Q* Quantity
Par t 2 Price
Discrimination
 First degree
 Second degree
 Third degree
 Price Discrimination

Price discrimination is the practice

of selling the same good at different
prices to different customers, even
though the costs for producing for
the two customers are the same
 Price Discrimination

Price discrimination is not possible

when a good is sold in a competitive
market since there are many firms all
selling at the market price. In order
to price discriminate, the firm must
have some market power
 Forms of Price Discriminations
◆ First-Degree or Perfect discrimination
Each consumer is charged according to
his/her maximum willingness to pay (e.g.
bargaining, auctions)
◆ Second-Degree Price discrimination
Different price for different quantity (e.g.
1 Pizza for $6.95 and 2 for $12.95)
◆ Third-Degree Price discrimination
Dividing consumers into 2 or more groups
with separate demand curves (e.g.
discounted prices for students or senior
citizens). Separation by different
elasticities of demand.
 First-Degree Price
Discrimination and Personalized
Pricing
◆ Technology, the Internet and personalized
pricing  firms are able to learn more about
customers’ likings and disliking.
◆ Pricing based upon postal code ( rich
suburbs pay more for an identical
product)
◆ Pricing based upon an individual’s price
elasticity of demand
◆ One-to-one marketing”  perfect price
discrimination to extract maximum
consumer surplus
 Price Discrimination
◆ First Degree Price Discrimination
➤ Charge a separate price to each customer:
the maximum or reservation price they are
willing to pay.
 Deadweight Loss
(e.g. how tax affects welfare)
Price Tax reduces consumer surplus by
(B+C) and producer surplus by
Price (D+E)
buyer
Tax revenue = (B+D)
s A Supply
pay = PB
B
Price C
withou = P1 Deadweight Loss =
t tax D E (C+E)
Price = PS
sellers F
receiv Demand
e

0 Q2 Q1 Quantity
 Welfare Without Price Discrimination...
(Note welfare here is used in an economic
context)

Price (a) Monopolist with

Single Price
Consumer
surplus

Monopoly Deadweight
price loss
Profit
Marginal cost

Marginal Demand
revenue

0 Quantity sold Quantity

Welfare With Price
Discrimination...
Price (b) Monopolist with Perfect
Price Discrimination

Profi
t Marginal cost

Demand

0 Quantity sold Quantity

Perfect Price Discrimination
Perfect price discrimination
refers to the situation when the
monopolist knows exactly the
willingness to pay of each
consumer and can charge each
consumer a different price.
 Price Discrimination

◆ Two important effects of price

discrimination:
◆ It can increase the monopolist’s profits
◆ It can reduce deadweight loss
 Additional Profit From Perfect First-Degree
Price Discrimination

◆ Question
➤ Why would a producer have difficulty in
achieving first-degree price discrimination?

◆ Answer
1) Too many customers (impractical)
2) Could not estimate the reservation
price for each customer
 Price Discrimination
◆ First Degree Price Discrimination
➤ The model does demonstrate the potential
profit (incentive) of practicing price
discrimination to some degree.
 Price Discrimination
◆ First Degree Price Discrimination
➤ The following are examples of imperfect
price discrimination where the seller has the
ability to segregate the market to some
extent and charge different prices for the
same product:
• Lawyers, doctors, accountants
• Car salesperson (15% profit margin)
• Colleges and universities
 First-Degree Price
Discrimination in Practice

Six prices exist resulting

$/Q in higher profits. With a single price
P1 P*4, there are fewer consumers and
those who pay P5 or P6 may have a surplus.
P2
P3
P*4 MC

P5
P6

MR

Q Quantity
Second-Degree Price Discrimination
Second-degree price
discrimination is pricing
$/Q according to quantity
consumed--or in blocks.
P1
Without discrimination: P = P0
P0 and Q = Q0. With second-degree
discrimination there are three
prices P1, P2, and P3.
(e.g. electric utilities)
P2
AC
P3 MC

MR
Q1 Q0 Q2 Q3 Quantity

1st Block 2nd Block 3rd Block

Second-Degree Price Discrimination
$/Q
Economies of scale permit:
P1
•Increase consumer welfare
P0 •Higher profits

P2
AC
P3 MC Note: MC
should
cross
over AC
D at some
point but
MR not here
Q1 Q0 Q2 Q3 for the
Quantity purposes
of clarity
1st Block 2nd Block 3rd Block
 Price Discrimination

◆ Third Degree Price Discrimination

1) Divides the market into two-groups.

2) Each group has its own demand

function.
 Price Discrimination

◆ Third Degree Price Discrimination

3) Most common type of price

discrimination.
• Examples: airlines, discounts to students and
senior citizens.
 Price Discrimination
◆ Third Degree Price Discrimination

4) Third-degree price discrimination is

feasible when the seller can
separate his/her market into groups who
have different price elasticities of demand
(e.g. business air travelers
versus vacation air travelers)
 Examples of Price
Discrimination
◆ Movie tickets (Tuesdays)
◆ Train fares (Peak, off-peak,
concessions, passes)
◆ Discount coupons (Elastic demand)

◆ Financial aid (Concession cards)

◆ Quantity discounts (Small vs large

packaging)
 Airline Fares
◆ Differences in elasticities imply that some
customers will pay a higher fare than others.
◆ Business travelers have few choices and their
demand is less elastic.
◆ Casual travelers have choices and are more price
sensitive.
◆ Airlines have two distinct profits which when
summed, are greater than if just one price was
charged.
Under price discrimination, profit is maximised where MC = MR for
each category of customer.
Note: Economy passengers are
assumed to have a higher price elasticity
of demand because of lower incomes or
simply less urgent travel requirements.
MC
Revenue and Costs ($)

ATC
P:adults

P:studs
D:students

MR:students
MR:adults D:adults

Q:adults Q:studs Quantity

Par t 3 Inter tempor al
Price Discrimination
and Peak-Load Pricing
Two related forms of Price
Discrimination
◆ Intertemporal Price Discrimination
 Charge a high price at first to capture the
consumer surplus of high demand group
 Lower the price later to capture the mass market
 Example: hardcover vs paperback releases
◆ Peak-Load Pricing
 Charge higher price during peak and lower price
during off-peak period
 This is more efficient because MC is higher
during peak periods
 Example: Electricity charges
 Intertemporal Price
Discrimination and Peak-Load Pricing

◆ Separating the Market With Time

➤ Initialrelease of a product, the demand is
inelastic
• Book
• Movie
• Computer
 Airline Fares
◆ The airlines separate the market by
setting various restrictions on the tickets.
➤ Less expensive: advance purchase, stay over
the weekend, no refund
➤ Most expensive: no restrictions
 Intertemporal Price
Discrimination and Peak-Load Pricing

◆ Separating the Market With Time

➤ Once this market has yielded a maximum
profit, firms lower the price to appeal to a
general market with a more elastic demand
• Paper back books
• Dollar Movies
• Discount computers
Intertemporal Price Discrimination
Consumers are divided
$/Q into groups over time.
Initially, demand is less
P1 elastic resulting in a
price of P1 . Over time, demand becomes
more elastic and price
is reduced to appeal to the
mass market.
P2
D2 = AR2

AC = MC

MR2
MR1 D1 = AR1

Q1 Q2 Quantity
 Intertemporal Price
Discrimination and Peak-Load Pricing

Peak-Load
Peak-Load Pricing
Pricing

◆ Demand for some products may peak at

particular times.
➤ Rush hour traffic
➤ Electricity - late summer afternoons
➤ Ski resorts on weekends
 Intertemporal Price
Discrimination and Peak-Load Pricing

Peak-Load
Peak-Load Pricing
Pricing

◆ Capacity restraints will also increase

MC.
◆ Increased MR and MC would indicate a
higher price.
 Intertemporal Price
Discrimination and Peak-Load Pricing

Peak-Load
Peak-Load Pricing
Pricing

◆ MR is not equal for each market because one market does

not impact the other market.
◆ Different from 3rd degree p-d . With 3rd degree p-d, MR
must be equal for each group of consumers, and equal to
MC.
◆ Peak-load pricing: price and sales can be determined
independently by setting MC = MR for each period.
 Peak-Load Pricing
$/Q MC
Peak-load
price = P1 .
P1

D1 = AR1

Off- load
price = P2 . P2

MR1

D2 = AR2
MR2
Q2 Q1 Quantity
Par t 4 Two-Par t Tarif f
 The Two-Part Tariff
◆ The purchase of some products and
services can be separated into two
decisions, and therefore, two prices.
 The Two-Part Tariff
◆ Examples
1) Amusement Park
• Pay to enter
• Pay for rides and food within the park

2) Tennis Club
• Pay to join
• Pay to play
 The Two-Part Tariff
◆ Examples
3) Rental of Mainframe Computers
• Flat Fee
• Processing Time

4) Polaroid Film
• Pay for the camera
• Pay for the film
 The Two-Part Tariff
◆ Pricing decision is setting the entry fee
(T) and the usage fee (P).
◆ Choosing the trade-off between free-
entry and high use prices or high-entry
and zero use prices.
 Two-Part Tariff
◆ Another means of extracting
consumer surplus
◆ It is a form of pricing in which
consumers are charged both an
entry and a usage fee
◆ The problem is to pick the profit
maximising entry fee (T) and usage
fee (P) combination
◆ Firm must have some market power
Two-Part Tariff with a Single Consumer

$/Q
Usage price P*is set where
MC = D. Entry price T*
T* is equal to the entire
consumer surplus.

MC
P*

Quantity
 Two-Part Tariff (Single Consumer)
Entry Fee =
Consumer
Surplus
Price

P* M
C
Usage fee
P*=MC

Quantit
This is efficient because Price = MC but y
the firm takes all the consumer surplus
 The Two-Part Tariff
◆ The Two-Part Tariff With Many
Different Consumers
➤ No exact way to determine P* and T*.
➤ Must consider the trade-off between the
entry fee T* and the use fee P*.
• Low entry fee: High sales and falling profit with
lower price and more entrants.
 The Two-Part Tariff
◆ The Two-Part Tariff With Many
Different Consumers
➤ To find optimum combination, choose
several combinations of P,T.
➤ Choose the combination that maximizes
profit.
 The Two-Part Tariff
◆ Two-Part Tariff With A Twist
➤ Entryprice (T) entitles the buyer to a certain
number of free units
• Gillette razors with several blades
• Amusement parks with some tokens
• On-line with free time
 Pricing Cellular Phone Service

◆ Question
➤Why do cellular (i.e. mobile) phone
providers offer several different plans
instead of a single two-part tariff with an
access fee and per-unit charge?
It allows suppliers to combine 3rd degree price discrimination with
the two-part tariff. Consumers sort themselves into groups on the basis
of which plan they want. These different groups have different
elasticities of demand.
Par t 5 Bundling
 Bundling
◆ Bundling is practice of selling multiple
products in a package
◆ Aimed at extracting maximum consumer
surplus
◆ Bundling can be:
 Pure: Practice of selling products only as a package.
 Mixed: Practice of selling two or more goods both as
a package and individually.
 Bundling
◆ Bundling in Practice
➤ Automobile option packages
➤ Vacation travel
➤ Cable television
 Examples of Mixed
Bundling

◆ McDonalds (Value meals)

◆ Accommodation bundled with
meals
◆ Clothing (shirt bundled with tie)
◆ Microsoft products (e.g. you can
buy Word separately or choose a
bundle)
 Bundling
◆ Mixed Bundling in Practice
➤ Use of market surveys to determine reservation
prices
➤ Design a pricing strategy from the survey results

◆ Mixed bundling allows the customer to get

maximum utility from a given expenditure by
allowing a greater number of choices.
 Bundling
◆ Tying
➤ Practiceof requiring a customer to purchase
one good in order to purchase another.
➤ Examples

• Xerox machines and the paper

• IBM mainframe and computer cards
• Mobil may require its service stations to sell only
Mobil Oil
 BUNDLING

◆ Suppose the marginal cost is zero. Then

equating marginal revenue and marginal cost
means that revenue maximization is the same
as profit maximization.
◆ If the channels are sold separately, the most the
firm, Cox Cable, could get for the channels
would be the sum of the prices each segment
was willing to pay.
Par t 6
Mar k-up pricing
Mark-up or cost-plus pricing

◆ Percentage contribution margin( PCM):

➤ PCM = (Price-Marginal Cost)/ Price
➤PCM= 1/ elasticity
◆ %markup  profit margin; desired rate
of return on investment
◆ Inelastic demand  higher markup
◆ Elastic demand  lower markup
Par t 7 Summar y
 Summary
◆ Firms with market power are in an enviable
position because they have the potential to earn
large profits, but realizing that potential may
depend critically on the firm’s pricing strategy.
◆ A pricing strategy aims to enlarge the customer
base that the firm can sell to, and capture as
much consumer surplus as possible.
 Summary
◆ Ideally, the firm would like to perfectly
price discriminate.
◆ The two-part tariff is another means of
capturing consumer surplus.
◆ Bundling can increase profits.
In-class revision exercises
What do you understand by 3rd degree
price discrimination?

◆ Two or more customer groups with different price

elasticities – and therefore different demand curves -
are charged different prices. These groups can be
distinguished such as with concession passes (e.g.
working people and pensioners), or eagerness or
reluctance to pay a higher price (e.g. holiday
travelers and business class travelers.). Use diagram.
Can also draw a simpler diagram, assuming constant
ATC and MC.
◆
 Discuss three different pricing strategies that an
airline may use.
◆ Airlines use an array of different pricing strategies, often
simultaneously. These include:
➤ third degree price discrimination (e.g. holiday travelers and business
travelers);
➤ peak load pricing when elasticities are lower, demand is higher, and
running costs are higher due to capacity constraints (e.g. Sydney airport on
Monday morning);
➤ intertemporal pricing (e.g. advanced bookings are cheaper because the
consumer is more flexible with schedules and likely to be more price
sensitive, whereas if the consumer desperately needs to fly to a destination
the next day, then demand is less elastic and be more willing to pay a higher
price);
➤ bundling (e.g. if you book hotel accommodation, multiple flight destinations
and car hire, then each flight is relatively cheaper than if you just booked a
single flight);
➤ marginal cost pricing (e.g. as take-off time approaches, seats that remain
empty, after the other pricing strategies have been exhausted, are sold off at
‘rock- bottom’ prices as the mc of each extra passenger is very low. Better
to have seats at $50 than empty seats).
◆ There are other strategies such as two part tariffs (e.g. frequent flyers
club members pay a joining fee but then each flight [i.e. usage] is
cheaper).
◆ The objective of airline companies has been to
discriminate more finely among travelers with
different reservation prices. Over the past decade,
Internet booking patterns and ‘data mining’ is
making this easier for airlines than previously.
◆ As one industry executive put it: “ You don’t want
to sell a seat to a guy for $69 when he is willing to
pay $400. At the same time, you would rather sell
a seat for $69 than leave it empty” (cited Pindyck
and Rubinfeld 2005: 393).
The End