Pricing Practices

CHAPTER 15
KEY CONCEPTS
competitive market pricing market segment
rule-of-thumb
first-degree price
imperfectly competitive pricing discrimination
rule-of-thumb
second-degree price
markup on cost discrimination
profit margin third-degree price
discrimination
optimal markup on cost
two-part pricing
markup on price
bundle pricing
optimal markup on price
by-product
Lerner Index of Monopoly
Power joint products
price discrimination common costs
Pricing Rules-of-Thumb
Competitive Markets
◦ Profit maximization always requires setting Mπ = MR - MC = 0, or
MR=MC, to maximize profits.
◦ In competitive markets, P=MR, so profit maximization
requires setting P=MR= MC.
Examples:
◦ Agricultural markets
◦ Free software
◦ Street food vendors
Pricing Rules-of-Thumb
Imperfectly Competitive Markets
◦ With imperfect competition, P > MR, so profit
maximization requires setting MR=MC.
◦ MR = P[1 + (1/εP)]
◦ Optimal P* = MC/[1 + (1/εP)]

Examples:
• Power Company (Meralco)
• Telecom (PLDT, Globe)
• Beer (San Miguel)
Markup Pricing And Profit
Maximization
Optimal Markup on Cost
◦ Markup on cost uses cost as a basis.
◦ Markup on Cost = (P-MC)/MC
◦ Markup pricing is an efficient means for achieving the profit maximization
objective.
◦ Optimal markup on cost = -1/(εP + 1)

Example:
◦ Assume a catalog retailer pays a wholesale price of
$25 per pair for Birkenstock sandals, and markets
them at a regular price of $75 per pair.
This typical $50 profit margin implies a standard
markup on cost of 200%
Markup Pricing And Profit
Maximization
Optimal Markup on Price
◦ Markup on price uses price as a basis.
◦ Markup on Price = (P-MC)/P
◦ Optimal markup on price = -1/εP

Example:
◦ The catalog retailer pays a wholesale price of $25 per pair, has a regular price
of $75 per pair, and the arc price elasticity of demand εP = -1.5. This typical
$50 profit margin implies a standard markup on price of 66.7%
Why do optimal markups
vary?
Differences in relevant marginal costs
◦ Peak periods vs Off-peak periods

Differences in the price elasticity of demand

◦ P=MC (competitive market)
◦ P>MC (monopoly markets)

Lerner Index of Monopoly Power

◦ Lerner Index = (P-MC)/P = -1/εP
Price Discrimination
Profit-Making Criteria
◦ Price discrimination exists if P1/P2 ≠ MC1/MC2.
◦ Ability to segment the market.
◦ Multiple markets with no reselling.
◦ Price elasticity of demand differs across submarkets.

Market segment is a fragment of the overall market with unique demand or

cost characteristics.
Price Discrimination
Degrees of Price Discrimination
◦ First degree: Different prices for each consumer.
◦ Creates maximum profits for sellers.
◦ Second degree: Block-rates or quantity discounts.
◦ Third degree: Different prices by customer age, sex,
income, etc. (most common).
Price Discrimination
Example
Price/Output Determination
◦ Maximizes profits by setting MR=MC in each market segment.
Example:
◦ Suppose that MSU wants to reduce the athletic department’s operating deficit and
increase student attendance at home football games. To achieve these objectives, a
new two-tier pricing structure for season tickets is being considered in light of the
following demand and marginal revenue relations:

◦ The resulting total cost and marginal cost functions are:

Price Discrimination
Example
One-Price Alternative
◦ If tickets are offered to students and the general public at the same price, the total
amount of ticket demand equals the sum of student plus the general public demand.
◦ The student and general public market demand curves are:
Two-Part Pricing
A per unit fee equal to marginal cost plus a fixed fee equal to the
amount of consumer surplus generated at that unit fee

Bundle pricing
When significant consumer surplus exists, profits can be enhanced if
products are purchased together as a single bundle of goods.

Examples:
 "membership discount retailers" such as shopping clubs that charge an
annual fee for admission to the point of sale and also charge for your
purchases
 amusement parks where there are admission fees and also per-ride fees
 cover charge for bars combined with per drink fees
 credit cards which charge an annual fee plus a per-transaction fee
 loyalty cards or clubs
Multiple-product Pricing
Demand Interrelations
◦ Cross-marginal revenue terms indicate how product revenues are related to
another.

Production Interrelations
◦ Joint products may compete for resources or be complementary.
◦ A by-product is any output customarily produced as a direct result of an
increase in the production of some other output.
A by-product is any output that is customarily produced
as a direct result of an increase in the production of
some other output.

Example:
 Crude oil – gasoline - diesel fuel - heating oil
 Lumber – scrap bark – sawdust
 Paper – residual chemicals – water pollution
Joint Products
Joint Products in Variable Proportions
◦ If products are produced in variable proportions, treat as distinct products.
◦ For joint products produced in variable proportions, set MRA=MCA and
MRB=MCB.
◦ Common costs are joint product expenses.
◦ Allocation of common costs is wrong and arbitrary.

Joint Products in Fixed Proportions

◦ Some products are produced in a fixed ratio.
◦ If Q=QA=QB, set MRQ=MRA+MRB=MCQ.
Joint Product Pricing Example
Joint Products Without Excess By-product
◦ Profit-maximization requires setting MRQ=MRA+MRB=MCQ.
◦ Marginal revenue from each byproduct makes a contribution toward
covering MCQ.

Joint Production With Excess By-product (Dumping)

◦ Profit-maximization requires setting MRQ=MRA+MRB=MCQ.
◦ Primary product marginal revenue covers MCQ.
◦ Byproduct MR=MC=0.
Joint Product Pricing Example
The Vancouver Paper Company, located in Vancouver, British Columbia, produces newsprint
and packaging materials in a fixed 1:1 ratio, or 1 ton of packaging materials per 1 ton of
newsprint. These two products, A (newsprint) and B (packaging materials), are produced in equal
quantities because newsprint production leaves scrap by-product that is useful only in the
production of lower-grade packaging materials.

The total and marginal cost functions for Vancouver can be written

TC = $2,000,000 + $50Q + $0.01Q2

MC = ΔTC/ΔQ = $50 + $0.02Q
where Q is a composite package or bundle of output consisting of 1 ton of product A and 1 ton of
product B. Given current market conditions, demand and marginal revenue curves for each
product are as follows:
Newsprint Packaging Materials
PA = $400 – $0.01QA PB = $350 – $0.015QB
MRA = ΔTRA/ΔQA = $400 – $0.02QA MRB = ΔTRB/ΔQB = $350 – $0.03QB
Vancouver should produce 10,000 units of output and sell the resulting 10,000 units of
product A at a price of $300 per ton and 10,000 units of product B at a price of $200 per ton. An
optimum total profit of $1.5 million is earned at this activity level.