PRICING PRACTICES Prepared by: Marsha C. Radam

PRICING PRACTICES •  Pricing practices used to advertise products and

services to consumers such as ‘3 for P100’, ‘50% off’ or ‘3-Day Sale’ are highly prevalent in today’s society indicating that they are beneficial for businesses.

•  There are now price consultants who advise retailers on how to price their products and brands. Rooted in behavioral decision theory the new psychology of pricing dictates the design of price tags, rebates, sale adverts, cell phone plans, bundle offers, and more.

•  Choosing a price is one of the most important decisions that a business makes for its product line.

Ahmetoglu et al.

Price Setting Behavior Market Power Price Setters : a firm can set the price of its products

above its MC of production

: a special case is that of a monopoly

Price Takers : the market price is determined by the

market supply and demand : with an established price, a producer is a

price taker or someone who takes the market price as given

Price Setting Behavior Market Power

Foundations of Price Setting •  If a firm decreases the price per unit then quantity

demanded increases, holding the price of all other close substitutes constant.

•  The firm’s profit is defined as the difference between total revenue of the firm and the total cost of production.

•  With revenue and cost information, a firm will produce output at levels that yield the highest profits.

•  To induce consumers to purchase the profit- maximizing output, the firm will use demand information to price its products.

Example

What pricing and output decisions will maximize profits? www.mbs.edu

The MR = MC Pricing Rule •  In Perfect Competition, price is determined by

the market forces of demand and supply. •  A company can use demand and cost data to

maximize its profits by applying the Marginal Revenue (MR) = Marginal Cost (MC) Pricing Rule whereby the profit maximizing price (P) and quantity (Q) will be when MR=MC.

•  Profit maximization requires setting P = MR = MC.

Competitive Market Pricing Competition among buyers forces the market price up to the maximum demand price on the demand curve.

Competition among the sellers forces the market price down to the minimum supply price on the supply curve.

Imperfect Market •  An imperfect market is a situation where individual firms

have some measure of control or discretion over the price of the commodity in an industry

–  This imperfect competition does not necessarily mean that a firm can arbitrarily put any price on its commodity

–  an imperfect competitor does not have absolute power over price

•  Aside from discretion over price, imperfect competitors may or may not have product differentiation/variation

Elasticity and Pricing

•  In reality, firms have only a limited knowledge of their demand and marginal revenue curves. Thus, it is difficult to apply the rule of MR=MC to determine the optimal level of production and the price per unit.

•  However, if the firm knows its MC of production and the elasticity of demand (e) then it can use the following rule for setting its pricing policy

P = MC / [ 1 + ( 1 / e )

Imperfectly Competitive Pricing •  Pricing under Monopoly

-It is true that a firm with monopoly has price-setting power and will look to earn high levels of profit. -However the firm is constrained by the position of the demand curve. Ultimately a monopoly cannot charge a price that the consumers in the market will not bear. -The position and elasticity of the demand curve acts as a constraint on the pricing behavior of the monopolist.

•  Pricing under Oligopoly -A market structure characterized by competition among a small number of large firms that have market power, but that must take their rivals’ actions into consideration when developing their competitive strategies.

Imperfectly Competitive Pricing

How Prices are Determined

•  Interdependent Pricing – Each firm keeps a close eye on the activities

of other firms in the industry. Because firms engage in competition among the few, decisions made by one firm affect others.

How Prices are Determined

•  Price Wars – Assumes that oligopolistic is able to predict

the counter moves of his rivals and they provide a determinant solution to the price and output problem.

– The objective of price wars: •  To seize major part of total sales •  To expand towards monopoly •  To threaten rivals to accept leadership

How Prices are Determined

•  Price Leadership – Firms in an oligopoly would accept one firm as

a leader and would follow in setting prices. – Such a leader firm may be dominant or low-

cost firm producing a very large proportion of the total production and having a great influence over the market.

How Prices are Determined

•  Formal Agreement: Cartel – A group of firms that collude to limit

competition in a market by negotiating and accepting agreed-upon price and market shares.

– Two models of imperfect cartels: •  Joint-Profit Maximizing Cartels •  Market-sharing cartels

Kinked Demand Curve

•  According to the kinked demand curve hypothesis, the demand curve facing the oligopolistic has a kink at the level of the prevailing price.

•  The kink is formed because the segment of the demand curve above the prevailing price level is highly elastic and the segment of the demand curve below the price level is inelastic.

Optimal Pricing of Multiple Products

•  We have considered pricing by the firms of a single product. In reality firms produce multiple products.

•  Such multiple products create 4 different kinds of relationships. – Demand relationships – Cost relationships – Production relationships – Capacity relationships

Optimal Pricing of Multiple Products

•  4 different kinds of relationships. – Demand relationships: products are complements

or substitutes – Cost relationships: multiple products produced in

some facility. Cost sharing results. – Production relationships: more than one product

results from a single production process. – Capacity relationships: firms can use excess or idle

capacity to produce one or more additional products.

Pricing Products with Interrelated Demands •  For a two product (A and B) firm, marginal

revenue functions of the firms are:

! If the 2nd term on the right hand side of each equation is > 0, the two products are complementary

! If the 2nd term on the right hand side of each equation is < 0, the two products are substitutes.

Plant Capacity Utilization and Optimal Product Pricing

•  Firms produce more than one product to make fuller use of their plant and production capacities.

•  Example:

Plant Capacity Utilization and Optimal Product Pricing

JOINT PRODUCTS

•  Joint Products in Fixed Proportions – Products should be thought of as a single

production package. – Jointly produced products may have

independent demands and marginal revenues.

–  If Q=QA=QB, set MRQ =MRA + MRB = MCQ

Joint Products in Fixed Proportions

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.

Joint Products in Variable Proportions

PRICE DISCRIMINATION

•  The situation where a firm sells identical products in two or more markets at different prices.

•  3 degrees of price discrimination – First-degree price discrimination

•  Occurs when a firm charges each buyer in the market a different price based on what the consumer is willing to pay.

Price discrimination

– Second-degree price discrimination •  Involves charging different prices for different

blocks of units or bundling different products and sold at a package price

•  Often referred to as volume discounting – Third-degree price discrimination

•  Firms segment the market for a particular good or service into easily identifiable groups and then charging each group a different price.

•  Market segregation may be based on factors like geography, age, product use, income, etc.

First-Degree Price Discrimination

If a firm that practices first-degree price discrimination charges $2 and sells 40 units, then total revenue will be equal to $160 and consumers’ surplus will be zero.

Bahan Kuliah

Second-Degree Price Discrimination

If a firm that practices second-degree price discrimination charges $4 per unit for the first 20 units and $2 per unit for the next 20 units, then total revenue will be equal to $120 and consumers’ surplus will be $40.

Bahan Kuliah

Third-Degree Price Discrimination

Examples of Price Discrimination

•  business vs. tourist airfares

•  business vs. residential telephone service

•  and senior discounts.

International Price Discrimination & Dumping

• Dumping is defined as the act of a firm in one country exporting a product to another country at a price which is either below the price it charges in its home market or is below its costs of production.

Other forms of Dumping

•  Predatory Dumping – the practice of cutting prices abroad in an attempt to drive a rival out of business

•  Strategic Dumping – if a firm has a monopoly in its home market but has strong competition in a foreign market, it charges a higher price in the home market

Other forms of Dumping

•  Sporadic Dumping – selling at low price because of over capacity due to downturn in demand

•  Market Expansion Dumping – selling at lower price for export than domestically in order to gain market share