MANAGERIAL ECONOMICS NOTESPricing Strategies: Pricing Models

PRICING ANALYSIS AND DECISIONPrice is the amount of money paid for a unit or quantity of the good or service under consideration. A “package” of other services goes with the physical commodity and include time and place of delivery, time payment is expected by the seller, cash and quantity discounts, guarantees that go with the product, or any rights of return of goods. If changes occur in any of these things, even though money paid per unit remains unaltered, the true price has changed. The quoted and list prices may be no guide to the price actually paid, as concessions may be given to particular groups of individuals. Price is the only element in the marketing mix that creates sales revenues, other elements are costs.The setting of prices involves three areas of information- costs, competition and consumer demand. Costs information is derived from internal sources whereas information on competition and consumer demand involves the external environment. In any business a great deal of information is potentially available about its external environment from the operations of its own staff. Reports from salesmen in the field will convey information about the strategy of competitors, the emergence of new competition and reaction of customers. This can be very effective if salesmen are given guidance on what to look for, and reporting should be restricted to statement of observable fact.

PRICING STRATEGYThis is the task of defining the initial price range and planned price movement through time that the company will use to achieve its marketing objectives in the target market.1. COST ORIENTED PRICING STRATEGIES

(a) Mark up pricing or cost plus pricing- also called Average Cost pricing or full cost pricing. It is the most common method of pricing a product by manufacturing firms. The term cost plus is often used to describe the pricing of jobs that are non-routine and difficult to “cost” in advance, such as construction and military weapon development. Under the cost plus pricing, the firm calculates or estimates its AVC , and then sets its price by adding on a percentage mark-up that includes a contribution towards the firm’s fixed costs, and a profit margin. The general practice under the mark-up pricing method is to add a fair percentage of profit margin to the AVC. The price is set as:

P= AVC+ x% (of AVC) where x is the mark-up percentage chosen. Or

P=AVC + AVC x (m) = (1+m)AVC or (1+m)C where m is the mark-up percentage fixed so as to cover AFC and net profit margin. The size of mark up depends on the willingness of consumers to pay the maximizing and this level varies inversely with the value of price elasticity. Products with higher price elasticities of demand should be expected to have relatively lower percentage mark ups in order to make the maximum total contribution to overheads and profits. Firms find their “best” mark up by trial and error or by adopting the same mark up that is applied by other firms or by the price leader in the industry.

Firms usually apply higher mark-ups to products facing less elastic demand than to products with more elastic demand. It can also be shown that cost-plus pricing leads to approximately the profit –

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maximising price. If we take where Ep is the price elasticity of demand. Solving for

P we get .Since profits are maximised where MR=MC, we can substitute MC for MR

in the above equation and get . If the firm’s MC is constant and equal to C we can

get . We can then set P =(1+m)C or 1+m . Thus we get

. From this if Ep=-1.5, m=2, or 200%; if Ep=-2, m=1 or 100%. It can then be concluded

that the optimal mark-up is lower the greater is the price elasticity of demand of the product. Firms in practice have been found to apply a higher mark-up to products with inelastic demand than to products with elastic demand, and when increased competition has increased the price elasticity of demand, they have been found to reduce their mark-up. It can thus be concluded that cost-plus pricing does lead to approximately profit-maximizing prices. In a world of inadequate and imprecise data on demand and costs, firms may simply utilize cost-plus pricing as the rule-of-thumb method for determining the profit-maximising prices.

The advantages of mark-up pricing are:

(i) by pinning the price to unit costs, sellers simplify their own pricing task considerably and they do not have to make frequent adjustments as demand conditions change.

(ii) There is also generally less uncertainty about costs than about demand. (iii) It requires less information and less precise data than in MC=MR case. (iv) It results in stable prices when costs do not vary much. (v) It provides a justification for price increases when costs rise. (vi) It is easy and simple to use (may be misleading since difficulty of projecting TVCs and

overheads allocation).

Limitations(i) Assumes firm’s resources are optimally allocated and the standard cost of production is

comparable with the average for the industry.(ii) Uses historical cost rather than current cost data- this may lead to underpricing under

increasing cost conditions and to overpricing under decreasing cost conditions.(iii) If VC fluctuates frequently and significantly, cost plus pricing may not be an appropriate

method of pricing.(iv) It is “alleged” that cost plus pricing ignores the demand side of the market and is solely

based on supply conditions (“alleged” because firms determine the markup on the basis of what the market can bear.).

(b) Marginalist Pricing .There are three main ways of practicing marginalist pricing under uncertainty:

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(i) Given estimated demand and MC curves. MR has the same intercept value and twice the slope value as compared with the demand curve and thus we can quickly derive an estimate of MR. Setting the expression for MR equal to that of MC, we can solve for the quantity level that preserves the equality. This method of price determination involves inserting the result back into the demand curve to give us the price that will maximize contribution and hence profit.

(ii) Given estimated price elasticity and MC- involves using the elasticity value and the current price and output levels to find an expression for the demand curve and then proceed to equate estimated marginal revenue and marginal cost.

(iii) Given estimates of incremental costs and revenues- is a marginalist approach since it is concerned with changes in both total revenues and total costs. Where demand contains indivisibilities or discontinuities we cannot construct the marginal revenue function, since the total revenue curve is not continuous and therefore is not differentiable. Instead we must compare the incremental costs and incremental revenue at each price level and choose the price that allows the maximum contribution to be made.

(c) Target Pricing- also cost oriented pricing approach in which the firm, tries to determine the price that would give it a specified target rate of return on its total costs at an estimated standard volume e.g. pricing of good X so as to achieve an average rate of return of 15 to 20% on a firm’s investment. The breakeven chart can be used to illustrate target pricing. The total cost curve (TC) and total revenue (TR) curve have to be worked out. Target pricing has a major conceptual flaw- the company uses an estimate of sales volume to derive the price but price is a factor that influences the sales volume.

2. DEMAND ORIENTED PRICING STRATEGIESThis calls for setting a price based on consumer perceptions and demand intensity rather than on cost.(a) Perceived value pricing or prestige pricing-deliberately setting high prices to attract prestige-oriented consumers (goods have a snob appeal. An increasing number of companies are basing their price on the product’s perceived value. They see the buyers’ perception of value as the key to pricing. Price is set to capture the perceived value. A company develops a product for a particular target market with a particular market positioning in mind with respect to price, quality and service. Market research has to be carried out to establish the market’s perceptions.

(b) Demand Differential pricing- is another of demand oriented pricing. It is also called price discrimination. It takes many forms (i) Customer basis- different customers pay different amounts for same product/service. (ii) Product form basis- different versions of the product are priced differently but not proportionately to their respective marginal costs. (iii) Place basis- different locations are priced differently although there is no difference in MC. (iv) Time basis- different prices charged seasonally by the day, by the hour, etc. For effectiveness the market must be segmentable and have different demand elasticities, no resale to segment paying the higher price. The cost of segmenting and policing the market should not exceed the extra

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revenue derived from price discrimination the practice should not breed customer resentment and turning away.

Price discrimination typesThere are three typesFirst degree Discrimination – involves charging the maximum possible price for each unit of output. It involves making the price per unit of output depend on the identity of the purchaser and on the number of units purchased. Thus the consumer who attaches the greatest value to the product is identified and charged a price of P1 (this being individual 1’s reservation price) Similarly, the consumers willing to pay P2 for the second unit (this being individual 2’s reservation price) and P3 for the third are identified and required to pay P2 and P3 respectively. each customer is being charged different prices. Each unit of product is charged separately. All consumer surplus is extracted.

First degree Second Degree

P1---- P1

P2 ------- P2

P3-------------- Pc MC=AC P3

D Q1 Q2 Q3 QD O Q1 Q2 Q3

With first degree price discrimination , the profit maximising output rate is where the MC and Demand curves intersect. Any sale in excess of QD would reduce profits because price would have been less than MC. First degree Price discrimination is uncommon because it requires that the seller have complete knowledge of the market demand curve and also of willingness of individuals to pay for the product, In addition the market must be segmentable and also that resale is not possible.

Second degree price discrimination- this involves pricing based on the quantities of output purchased by individual consumers.. That is it involves making the price per unit of output depend on the number of units purchased. The monopolist designs a menu of prices and quantities (or use rates of quantities purchased) such that each consumer chooses a price –quantity combination that allows the monopolist to discriminate profitably between consumers. The price does not depend on the identity of the purchaser. It involves charging uniform prices per unit for a specific quantity or block of the product sold to each customer, a lower price per unit for an additional batch or block of the product and so on.. This is easy where there are meters as in electricity and water. Another version is discriminating among groups of buyers on a time or urgency basis. This probably applies to new products. For example first 10 units at 15cents, next 20 units at 10 cents and all additional at 5cents each. In other words blocks are charged at different prices. Examples include the charging of electricity, whereby there is a two-part tariff, requiring the payment of a fixed fee if the consumer

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wishes to make any purchases at all, plus an additional uniform price per unit purchased. It also involves charging different prices in two or more different markets at the same point in time (until MR of the last unit of product sold in each market equals the MC of producing the product). This implies that MR1=MR2=MC. The market is segmentable e.g. student versus nonstudent.

Third Degree price discrimination - most common. The price per unit depends on the identity of the purchaser. The price does not depend on the number of units purchased. Involves separating consumers or markets in terms of their price elasticity of demand. The monopolist charges a relatively high price to consumers whose demand is price inelastic, and a relatively low price to consumers whose demand is price elastic. Segmentation can be based on several factors e.g. geographical location (selling of books outside US at lower prices), telephone users may be residential or commercial (nature of use), usage of electricity ( industrial or residential) or during certain times), can be according to age (personal characteristics).

Forms of price discrimination used in practiceThese include:

Intertemporal price discrimination, whereby the supplier segments the market by the point in time at which the product is purchased.

Branding, whereby different prices are charged for similar or identical goods differentiated solely by a brand label.

Loyalty discounts for regular customers. Coupons that provide price discounts discriminate between consumers on the basis of

willingness to make the effort to claim the discount. Stock clearance sales involving successive price reductions are a form of intertermporal price

discrimination. Free-on-board pricing involving the producer or distributor absorbing transport costs, and

representing a form of price discrimination favouring buyers in locations where transport costs are higher.

3. COMPETITION ORIENTED PRICINGThis is when a company sets its price chiefly on the basis of what its competitors are charging. It is not necessary to charge the same price as the competition. The firm may seek to keep its prices lower or higher than the competition by a certain percentage. The distinguishing characteristic is that it does not seek to maintain a rigid relation between its price and its own costs or demand. Conversely the same firm will change its price when competitors change theirs, even if its costs or demand have remained constant. Going rate pricing- the firm tries to keep its price at the average level charged by the industry. The pricing primarily characterizes pricing practice in homogeneous product markets, although the market structure itself may vary from pure competition to pure oligopoly.

Sealed Bid pricing- also called competitive tendering or competitive bidding. In this there is only one buyer in the market whose requirements are individual to himself. In other words a number of sellers compete for the business of a single buyer. Confronting him is a number of suppliers each of whom is capable of doing the work e.g. building a ship, an office block, or building a nuclear power station. The buyer, wishing to secure the benefits of competition, puts his contract up for tender. It may be open to all comers or may be restricted to a select group which the buyer judges to have the

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competence and resources to undertake the work successfully. Normally the contract will go to the bidder quoting the lowest price but, with a view to protecting his own interest, the buyer will usually reserve the right to accept any tender – or none. Competitive bids may also occur where Services of a product may not be identical hence combination of price and quality also matter. Examples are in the service sector.

Normally buyer has budgeted expenditure whilst bidders do not know of it. Too low a price leads to loss or loss of tender. Too high a price may be rejected. A firm can win a tender but may incur losses due to rising costs- the ‘winner’s curse’.

Types of BidsThere are three types of bids

(1) Fixed price bids.(2) Cost plus fee bids.(3) Incentive bids.

Fixed Price BidsThis is when suppliers tender for a price bid regardless of variation of costs. Supplier tenders a bid price or price quote and undertakes to complete the job for that price regardless of any variation of costs from expected levels.

where is the bid price; is target profit and is supplier’s target cost. The actual

profit = + ( ) where is actual cost. (NB. If Ct > Ca falls)

Cost Plus Fee BidsIn these the entire risk is borne by the buyer who agrees to meet the actual cost plus what supplier stated was their profit.

where is the bid price. (NB. is the fee)The buyer expects to audit the costs. The contract is unfair to the buyer because of the problems of conducting the audit.Incentive Bids- These are also called risk sharing bids. The buyer and seller (supplier) agree before hand on a bid price but agree to share any deviation from expected costs level in a given way.More formally mathematically if = supplier’s share of cost variation where 0< <1 then For the buyer

is the bid price , is supplier’s target cost, is target profit.For the Seller = + ( ).If =1 then and this becomes fixed price bids. All risk goes to the seller.

= + .On the other hand if =0, . In this case the buyer is bearing the burden.

= . This is the cost plus fee bid. All risk goes to the buyer.

AuctionsThere are four basic auction formats.

1. English Auction- also called the ascending bid auction and involves the price being set initially at a very low level which many bidders would be prepared to pay, and then raised

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successively until a level is reached which only one bidder is willing to pay. The last remaining bidder secures the item at the final price and the auction stops.

2. The Dutch auction- also known as the descending bid auction, is the exact opposite of the English. Price is set initially at a very high level which no bidder would be prepared to pay, and is then lowered successively until a level is reached which one bidder is prepared to pay. The first bidder who is prepared to match the current price secures the item at that price, and the auction stops.. normally used to sell agricultural produce.

3. First price sealed bid auction- each bidder independently submits a single bid, without seeing the bids submitted by other bidders. The highest bidder secures the item, and pays a price equal to his or her winning bid. This has been used by governments to sell drilling rights for gas and oil, and the rights to extract minerals from state owned land.

4. The second price sealed bid auction- sometimes known as a Vickrey auction after the seminal paper on auction theory by Vickrey in 1961. The bidding process works in the same manner as a first price sealed bid auction: each bidder independently and [privately submits a single bid. Again the highest bidder secures the item, but pays a price equal to the second-highest submitted bid. Has been used occasionally in practice.

There is a Sealed bid auction and an open auction.

Sealed Bid- all bidders have to submit their bid in a sealed envelope at the same time. The most striking difference with open auction is that you do not learn about the private information of the other bidders during the auction process. In sealed bid auctions, the private valuations of all players remain unobservable. In situations of uncertainty regarding the true value of the auctioned object, all private valuations must be based on estimates.

If you are the winner, there may be good news and bad news in the outcome. The good news is that you have got the deal. The bad news may be that you have based your calculations on the most optimistic calculations of all competitors. This is called the winner’s curse in game theory.

Open Bid- the bids of all parties are observable. In an ‘increasing bid’ competition the optimal strategy for the individual bidder is to remain in the bidding competition until the price rises to his own valuation of the item. If all bidders are rational and execute this strategy, the item, the item will be transferred to the buyer with the highest private valuation of the item. As the bidding process unfolds one is able to observe the private valuations by noticing who remains in the competition and who drops out. The bidding process forces the players to reveal their preferences. In the ‘Dutch auction’ instead of an increasing bid competition, the auctioneer starts off from a very high price. The auctioneer cries out loudly prices which slowly decrease.

4 PRICING WITHOUT COMPETITIONCases exist where there may be only one source of supply in the market, for example, in the provision of defence equipment. If there is only one source of supply but an exact specification can be laid down- as where the same equipment has been supplied before- the supplier can be asked to quote a firm price on the basis of which the order can be placed. The fairness of the price quoted can be judged in the light of previous experience. Thus contracts under such circumstances are stated “price to be agreed”. Such prices are to be agreed contracts based on costs. They may be

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based on estimates of costs made either before or during production. Alternatively they may be founded on actual costs which are ascertained after production has finished.

NEW PRODUCT AND ITS PRICING

The term new product has many meanings. It may refer to a product of distinctive novelty- the first TV set or the first ball point pen. On the other hand it may be a product new to the market in the sense of a new brand of detergent or beer where guidelines to price already exist in the form of established brands.

In the case of a pioneering product, the first stage is that of deciding the degree of market acceptance of the new product. This is partly a question of the price at which it can be sold, but other considerations may well be prominent. Price is likely to be more prominent at the early stages of introduction in cases where the product has no more than a small degree of novelty. If there are no close substitutes, price may well be a secondary factor at the early stages of introduction to the market. Trendsetters may buy the product because they are usually people with surplus income and may not look closely at price.

The producer of a pioneering product is faced is faced with a dynamic competitive situation – at first he enjoys a degree of freedom because he is alone in the market- he may have protection of a patent, and if rewards look high enough, ways can usually be found to evade the patent without infringing his legal rights. Thus as the market develops, changes in the pricing strategy must be made. At the outset he has a choice between a skimming price and a penetration price.

Price Skimming- It involves setting a relatively high initial price for a new product when it is first introduced, to capture customers with high purchasing power, with the intent of getting as much profit from the product as possible. This is a short term intent. This may be similar to first degree price discrimination and can somewhat be compared to prestige pricing. Here the product pioneer takes advantage of any price insensitivity which exists at the early stages of marketing and charges a high “monopoly” price. In this way he secures a relatively high cash flow at an early stage which helps to minimize his losses if, in the end, the product fails to “take off”. If however demand builds up according to his hopes and expectations then he will be seen to be earning high returns. The conditions to encourage competitors to try to enter the market are strongly established. As competition builds up, he reduces his price in an attempt to check their (competitors) inroads on his market. He may get credit for pioneering price reductions. The firm may also lower its price to draw in the more price elastic elements of the market.

Rationale for price skimming

(1) it is difficult to know the demand curve when entering a market, which market is unknown. Demand elasticity is unknown.

(2) Production of the new product is at small scale. Low plant size will limit output. Maximize revenue through higher prices which will generate high initial cashflows.

(3) High R and D to be recouped as quickly as possible.

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(4) Skimming may also enable firm to identify different market segments for the product, each prepared to pay progressively lower prices. If there is product differentiation it may be possible to continue to sell at higher prices to some market segments.

(5) There is presently a sufficient number of buyers having high current demand. (6) The high price creates an impression of a superior product.(7) The high initial price will not attract more competitors.

Skimming can also be maintained by :(1) barriers.(2) Quality of product. Demand is expected to be maintained.

PENETRATION PRICINGThis is the opposite strategy to price skimming strategy and has the aim of discouraging competition. This type of policy is likely to be followed when the producer is likely to be followed when the producer is of the opinion that the period of exclusive occupation of the market is likely to be of short duration. Competition will arise quickly and his aim is to try to make this as unattractive as possible by setting a low price and a fine margin of profit. The motive for so doing will be strengthened if the market is one which is not easily segmented and where it is considered that the sales volume of the product will be very sensitive to price even when it is first introduced. An added inducement in support of such a policy is to be found in those cases where an increased volume of output is subject to marked economies of scale. The policy requires faith in the speedy realization of a high volume of sales and will almost certainly need to be associated with a considerable sales promotion effort.Circumstances favouring this strategy

(1) wish to discourage rivals from entering.(2) Firm wishes to shorten initial period of PLC in order to enter growth and maturity stages

quickly.(3) Significant economies of scale to be realized from large output may build larger capacity and

then reduce prices further.

Other Pricing PracticesThese include:Price lining-this refers to the setting of a price target by a firm and then developing a product that would allow the firm to maximise total profits at that price. Thus instead of deciding first on the type of product to produce and then on the price to charge so as to maximise the firm’s total profits (as usual), the order is reversed with price lining. (Cart before horse strategy).Value Pricing- refers to the selling of quality goods at much lower prices than previously. The manufacturers are also redesigning the product to keep or enhance quality while lowering costs so as to still earn a profit.

Ramsey PricingNo product should be supplied by a firm unless its incremental revenues are expected to exceed its incremental cost. If there are common costs managers must decide which products will be priced above incremental cost and how much above. According to the Ramsey pricing, for an enterprise to cover its total cost at least one of its two goods must be priced above its marginal cost. In its simplest

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form, Ramsey pricing requires that price deviations from marginal costs be inversely related to the elasticity of demand. That is, for goods with very elastic demand, the price should be set close to marginal cost. Conversely for goods with relatively inelastic demand, the price should deviate more from marginal cost. The rationale for Ramsey rule is that if demand is elastic, increasing the price causes a substantial reduction in quantity demanded. . But if demand is highly inelastic , large changes in price will result in little change in the quantity demanded. In the extreme, if demand were totally inelastic (a vertical demand curve), there would be no change in quantity demanded as price increased. Hence , if deviations from marginal cost pricing are greatest for those goods with inelastic demand, the resource misallocation will be minimized.

Ramsey pricing

P’y

P’x

Px MCx Py MCy

Dx Dy

Q’x Qx Q’y Qy Good X Good Y

Prices charged for X and Y are respectively P’x and P’y.

PRODUCT LIFE CYCLE (PLC)

The product life cycle concept draws an analogy between biological life cycles and the pattern of sales growth exhibited by successful products. In doing so it distinguishes four basic stages in the life of a product- introduction, growth, maturity and decline. The concept in other words derives from a biological metaphor namely that all “living things” go through a cycle of birth, growth, maturity and inevitable decline and death. Product forms, product classes and brands are likened to living things in this context.

Product Life Cycle

Product

Sales Growth or Expansion Maturity Decline

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Introduction

Stage 1 Stage 2 Stage 3 Stage 4

Time

Stage 1 Introduction Stage or introductory stage- this is the most hazardous stage of all, when the product has to prove its value and find a market. Preproduction costs are also high at this stage. Pursuing the life cycle analogy, infant mortality is very high and most products do not survive this stage. The initial price will be relatively high compared with later stages in the life cycle. The aim is to recover development costs as quickly as possible. Some consumer goods may be sold at an introductory price offer which is withdrawn when the selling momentum picks up. In pricing the new product, the appropriate strategies are skimming price or penetration price. The product being new lacks information and hence a degree of uncertainty. Skimming pricing can be used on the product, this being accompanied by heavy sales promotion expenditure. Price can also be of a penetrating the market by charging lower prices which can then be increased over time.

Stage 2 Expansion, growth, or breakthrough period. The product receives general acceptability, rapid growth as more cautious buyers enter the market. Other firms are joining in. Production costs are likely to fall. Prices are also likely to fall. The post skimming strategy can be used in situations where the product is losing its distinctiveness or exclusiveness hence a series of small price reductions would be more appropriate.

Stage 3 Maturity stage- the product is now well established, existing in a variety of forms to suit different needs and different markets. The uniqueness of the product (characteristic of stage 1) has gone and the rapid period growth of stage 2 has disappeared. The original firm may be on the point of withdrawing. Costs including advertising and promotional costs are likely to fall as the momentum of sales gathers strength. Manufacturers in this stage should reduce real prices as soon as the system of deterioration appears. This does not mean that the manufacturer should declare open price war in the industry but rather move in the direction of product improvement and market segmentation.

Stage 4 Decline- this marks the old age and virtual death of the product in its original form. There are many causes of decline but two main ones are (1) Change in fashion. (2) a technical breakthrough may render the original product obsolete. The strategy in this stage is to reduce the price of the product. The product should be reformulated so as to suit the consumers’ preferences. It is a common practice in book trade. When the sale of hard-bound edition reaches saturation, paperback editions are brought to the market.

PRICE POSITIONINGPrice setting is a very challenging task because reaction of consumers and competitors is very difficult to ascertain. Apart from cost considerations other factors, particularly in the consumer fields ought to be considered as they play an important role.

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(i) Possible existence of a traditional price range for the product. Unless the product embodies something entirely new most consumers and producers know instinctively what a “reasonable” price ought to be and a decision to move outside this band involves not merely finding a new market segment but possibly also a new marketing strategy.

(ii) Prevailing attitude of mind of the customers towards switching. If there is a strong brand loyalty, the situation is particularly difficult for the newcomer. In this situation a dramatic break with the existing price structure, either a substantially cheaper product or improved mark ups for the distributors, may be required.

In established product markets, firms can be classified as price makers or price takers, that is, they are either price leaders of followers. Price leaders normally choose the price that they feel best fulfills their objectives, perhaps subject to the constraint that the chosen price must lie within a range that is acceptable to the price followers.

In established product markets, the general price level may be regarded as being historically determined, in the sense that it has gravitated to a specific level (in real terms) over a prolonged period of time , and to the general satisfaction or acquiescence of the firms involved. The firm must therefore position its price correctly in relation to its competitors.

Product Line Price StrategyAlmost all firms have more than one product in their line of production. These multiple models or sizes of a product produced by the same company may be considered as different products or perfect substitutes for each other. Each has different AR and MR curves. The pricing under these conditions is known as multiproduct pricing or product line pricing.A frequent procedure is to apply a common mark up percentage to the per unit variable costs of each item in the product line. This is not optimal pricing since some products have relatively smaller price elasticities while others have relatively higher price elasticities. Higher price elasticities result from a product’s having a variety of substitutes and / or being relatively expensive. There are 3 basic decisions to be made in product line pricing:

(1) Choose the price of the basic or bottom of the line item. The “loss leader” considerations must be weighed against connotations of lower quality that may be attached to lower prices, in order to achieve maximum contribution from the entire production line.

(2) Choose the price of the top of the line item with an eye to the impact of that price on sales of the whole line. A high mark up prestige item at the top of the line may confer status and quality connotations on all other items in the line. Alternatively a price too high could give the impression that other items are overpriced as well and could cause total sales and contribution to be reduced.

(3) Choose the price intervals for the remaining items in the line. These price differentials should reflect the presence, absence, or degree of perceived attributes and should be chosen after observation of rival firms’ chosen differentials.

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MODIFIED BEHAVIOURAL PRICING MODELS AND MODIFIED STRUCTURAL PRING MODELS

MODIFIED BEHAVIOURAL PRICING MODELSThese are models which incorporate one or more of the appropriate behavioral as assumptions (profit maximizing) It looks at several more complex models of pricing behaviour in imperfectly competitive markets. They include:

(a) Price Leadership models- these are mostly under oligopoly where there is upward adjustment of prices. One firm leads the way and will be followed within a relatively short period by all or most of the other firms adjusting their prices to a similar degree. The leader is a firm willing to take the risk of being the first to adjust price, and usually has good reason to expect that other firms will follow suit. The risk here is if the firm raises price and is not followed by other firms, it will experience an elastic demand response and lose profits. Price leadership is possible under both product homogeneity and product differentiation; where there is a small number of firms; restricted entry; inelastic demand for industry and firms have almost similar cost curves.

(1) Barometric Price Leader- the leader possesses an ability to accurately predict when climate is right for a price change e.g. following a generalized increase in labour or materials costs, or a period of increased demand, the barometric firm judges that all firms are ready for a price change and takes the risk of sales losses by being the first to adjust its price. If the other firms trust the firm’s judgement they adjust prices to the extent or if they do not they may adjust to a lesser degree, the leader reviewing the price to that level. It does not have to be the same firm functioning as leader always. It does not have to be the same firm functioning as leader always.

(2) Low Cost Price Leadership- is a firm that has a significant cost advantage over its rivals and inherits the role of price leader largely due to the other firms’ reluctance to incur the wrath of the lower cost firm. In the event of a price war, the other firms would incur greater losses and be more prone to the risk of bankruptcy than would be the lower cost firm.

(3) Dominant Firm Price Leadership- the dominant firm is large relative to its rivals and its market. It is large and has several smaller firms competing with it in the industry. Large firm may have achieved its position by being the first seller in the industry, because it has lower costs resulting from scale economies, or by virtue of superior management skill. If the small firms in an industry look to the dominant firm to establish price, they can be viewed as price takers. As such their behaviour is similar to firms in perfect competition. If they can sell all they produce at the market price, they maximise profit by producing until P=MC. Total output supplied by all the small firms is the sum of their marginal cost curves in the diagram The smaller firms accept the firm’s price leadership perhaps simply because they are unwilling to risk being the first to change prices or perhaps out of fear that the dominant firm could drive them out of business, by forcing raw materials suppliers to boycott a particular small firm on pain of losing the order of the larger firm for example. In such a situation the smaller firms accept the dominant firm’s choice of the price level and simply adjust output to maximize their profits. They are more like pure competitors. Knowing how much the smaller firms will supply at each price level, the dominant firm can subtract this from the market demand to find how much demand is left over at each price level. The dominant firm will choose the price level in order to maximize its own profits from this assured or residual demand.

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If the dominant firm is content to set a price and let its small rivals supply as much as they want, the large firms can be thought of as supplying the residual demand.

Price DT Cost per unit DL

Po MCL PL

MRL DL DT

O QL QT Quantity per period

If the dominant firm is content to set a price and let its small rivals supply as much as they want, the large firm can be thought of as supplying the residual demand. The leader’s demand curve is DLDL. Total demand is DTDT. MCL is dominant firm’s MC while MRL is dominant firm’s MR. If price is set at Po, the small firms will meet total market demand and the dominant firm will have no sales because there is no residual demand. So prices will be set below Po. The demand curve faced the industry leader can easily be determined for any

price level (it is the horizontal distance between DTDT and ) Output for the price

leader is QL. Output of small firms is QT-QL. The price setting by the leader assumes that the dominant firm has complete information regarding its own demand and cost functions as well as those of its smaller competitors. The firm sets the price , and other firms follow passively, whether through convenience, ignorance or fear. In fact there is no oligopoly problem as such, since interdependence is absent.

(b) Sales Maximisation Model-having determined the minimum acceptable level of profits the firm will wish to maximize its sales subject to this profit constraint.

(c) Limit pricing models- the limit pricing involves choosing the price level such that it is not quite high enough to induce entry of new firms. Established firms may choose a price that does not allow the potential entrant to earn even a normal profit at any output level. These existing firms’ future market shares and profitability are protected from incursions from this quarter at least.

MODIFIED STRUCTURAL PRING MODELS

These deal with theories of firm behaviour that rest upon structural assumptions different from those employed in the basic spectrum of market forms. Firms are allowed to have differing cost

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structures. The models here look at the multiplant firms and how they choose price and output such that the MC in each plant is equal to the MR of the last unit sold.

Multiplant Firms and cartels

The firm may have two or more plants in which its product may be produced. The two or more plants are due to mergers and takeovers. The standard profit maximizing rule that MC equals MR applies. The firm nominates the plant that can produce the incremental unit at the lowest marginal cost.

Plant A Plant B Firm

MC

P P P

MC MC

C SAC SAC MC=MR

MR

Q1 Q2 Q

The firm’s profit will be maximized at output level where the combined MC=MR. This analysis of multiplant firm applies to any market situation where a firm envisages a negatively sloping demand curve (monopoly, monopolistic competition or oligopoly.). The analysis also applies to cartels where firm A and firm B replace plants A and B above. They allocate quantities Q1 and Q2 to maximize their joint profitability.

Price discrimination for multi market firms- price discrimination can be involving discrimination among groups of buyers on time or urgency basis or also where the firm can charge different prices in two or more different markets, at the same point of time.

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Plant A Plant B Firm MC

P P P MC MC

C SAC SAC MC=MR MR Q1 Q2 Q

Plant A Plant B Firm

MC P2 P P SAC

D1 P3 MC=MR MR MRA MRB

QA QB Q=QA +QB

Dorfman Steiner Conditions for profit maximisation

For profit maximisation the ratio of advertising expenditures to sales revenue should be equal to the ratio of advertising elasticity of demand to price elasticity of demand. The model illustrates the importance of advertising elasticity as a determinant of the profit maximising advertising budget.

Given that Quantity sold is a function of the price and Advertising expenditure and also that cost is a function of quantity.

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Multiply both sides of (ii) by

Second FOC

, The Dorfman-Steiner condition implies that for profit maximisation, the ratio of advertising expenditure to total revenue, or advertising to-sales ratio should be proportional to the ratio of advertising elasticity of demand to price elasticity of demand. The intuition behind this result is that when the advertising elasticity is high relative to the price elasticity, it is efficient for the monopolist to advertise (rather than cut price) in order to achieve any given increase in quantity demanded. Accordingly, the monopolist spends a relatively high proportion of its sales revenue on advertising. On the other hand, when the price elasticity is high relative to the advertising elasticity, it is efficient to cut price (rather than advertise) in order to achieve any given increase in quantity demanded.

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Accordingly , the monopolist spends a relatively low proportion of its sales revenue on advertising. It can also be inferred that the oligopolist has an additional incentive to advertise: not only does advertising increase total industry demand, but it also increases the advertising firm’s share of industry demand.

The Dorfman –Steiner condition provides a justification for the assertion that there is no role for advertising under perfect competition. The demand function of the perfectly competitive firm is horizontal, and the firm’s price elasticity of demand is infinite. Accordingly, the ratio of the firm’s advertising elasticity of demand to its price elasticity of demand is zero. The profit-maximising advertising to sales ratio is also zero. If the firm can sell as much as it likes at the current market price, there is no point in advertising.

The Dorfman Steiner condition can also be reformulated as profit-maximising advertising –to-sales ratio equals the product of the Lerner index an d the advertising elasticity of demand. For the perfectly competitive firm, the Lerner index is zero because price equals marginal cost. Therefore the profit maximising advertising –to-sales ratio is also equal to zero,

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