Session 4

Pricing StrategyPricing Strategy

Managerial Economics

Professor Changqi Wu

Pricing Slide 21

Topics for Today

Uniform pricing

Price discrimination

Durable good pricing

Bundling

Auction

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1. Uniform pricing

Profit maximizing pricing strategy: Setting the incremental margin equal to the

inverse of absolute value of the price elasticity of demand

A seller sets the same price for every unit of his product.

Optimal pricing depends on both price elasticity of demand and marginal cost

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Cost-Based Pricing

Average cost plus a fixed profit margin

ProcedureTo estimate the average cost

To add a markup to the average cost

Cost based pricing is widely practised. It has pros and cons.

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Why Cost-Plus Pricing is Popular?

It’s simple!

Cost-base pricing may be a profit-maximizing one if average cost approximates marginal cost

P = (1- 1/(ep+1)) MC

It costs money and time to calculate the right price and to work out how price should respond to changing market conditions, particularly for small firms

It is costly to change prices.

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Why Cost-Plus Pricing Can Go Wrong?

Demand side factor is not explicitly taken into consideration.

It is difficult to estimate true average cost because of the existence of indirect cost and joint cost

Average cost pricing is influenced by accounting rules

As a remedy, one can use variable markup rule instead of fixed markup

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2. Price Discrimination is ...

Two or more similar goods are sold at different net pricesPrices may differ due to quality and cost

differences.

Motives for price discrimination: earning more from existing customersselling to new customers without sacrificing

the current profit margin

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Capturing Consumer Surplus

Quantity

$/Q

D

MR

Pmax

MC If price is raised above P*, the firm will lose

sales and reduce profit.

PC

PC is the pricethat would exist in

a perfectly competitivemarket.

A

P*

Q*

P1

Between 0 and Q*, consumerswill pay more than

P*--consumer surplus (A).

B

P2

Beyond Q*, price willhave to fall to create a consumer surplus (B).

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Conditions of Price Discrimination

A seller must have market power

A seller is able to identify customers with different demand elasticities

Resale is impossible

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Practicing Price Discrimination

Complete price discrimination

Direct segment discrimination

Indirect segment discrimination

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Complete Price Discrimination

A seller charges each and every buyer her reservation price

It can be used for tailor-made products/services

Using price negotiation to find the buyer’s reservation price

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Incomplete Price Discrimination

Quantity

AC = MC

$/Q

Price is lower to appeal toConsumers with more elastic demand.

Q2

MR2

D2 = AR2

P2

D1 = AR1MR1

P1

Q1

Consumers are dividedinto groups.

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Direct Segment Discrimination

A seller charges different prices using directly observable signals relating a consumer with her price elasticity

Example: What’s in the name?

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Indirect Segment Discrimination

A seller use self-selection devices to distinguish customers.

Two-part tariffConsumers pay a fee up front for the right

to buy a product and then, pay additional fee for each unit of the product they wish to consume

Peak load pricing

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Methods to Prevent Resale

Refuse to deal with resellers

Bundling with services

Issuing warranties

Degrading the quality of product

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3. Durable Goods Pricing

Durable goods sold by a seller are their own substitutes

Ways to solve the durable goods pricing problemMaking goods less durable: planned obsolescence

Limiting the production in the future

Buy-back provisions

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4. Bundling

Bundling Scenario: Two different goods and many consumers Many consumers with different reservation price

combinations for two goods

Mixed Bundling Selling both as a bundle and separately

Pure Bundling Selling only a package

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Mixed Versus Pure Bundling

r2

r110 20 30 40 50 60 70 80 90 100

10

20

30

40

50

60

70

80

90

100

C2 = MC2

C2 = 30

Consumer A, for example, has a reservation price for good 1 that is below marginal cost c1.

With mixed bundling, consumer A is induced to buy only good 2, while

consumer D is induced to buy only good 1,reducing the firm’s cost.

A

B

D

C

C1 = MC1

C1 = 20 With positive marginalcosts, mixed bundling may be more profitable

than pure bundling.

Pricing Slide 19

The Complete Dinner Versus a la Carte:A Restaurant’s Pricing Problem

Pricing to match consumer preferences for various selections

Mixed bundling allows the customer to get maximum utility from a given expenditure by allowing a greater number of choices.

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5. Auctions

Auction Formats

Traditional English (oral)

Dutch auction

Sealed-bid

First price

Second price

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Auctions

How to choose an auction format

Private-value auction: bidders uncertain about the other bidders reservation price

Common-value auction: bidders uncertain what the value is

Valuation and InformationValuation and Information

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Auctions

Second-price sealed auction: bid your reservation price

English auction: Bid in small increments until you reach your reservation price

The winning bids in both auctions is the reservation price of the second highest bidder

Private Value AuctionPrivate Value Auction

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Auctions

Sealed-bid auction

First-price auction: lowers the bid

Second-price auction: bid just above the second highest reservation price

Both yield the same revenue

Private Value AuctionPrivate Value Auction

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Auctions

Winner’s Curse

The winner is worse off than those who did not win

Examples

Bidding on a construction job

Bidding on 3G mobile service licenses

Question

How can you avoid the winner’s curse?

Common Value AuctionCommon Value Auction

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Key Takeaway Points

Profit maximizing uniform pricing depends on marginal cost as well as price elasticity of demand

Depending on the information available, a seller can adopt different price discrimination schemes.

There are many ways to set the prices to reduce inefficiencies and raise the level of profit.