Pricing Chapter 7• Collect Assignment 2• Pricing to capture maximum value

– Linear Approximation

– Cost-plus Pricing

– Mark-up pricing

– Price Discrimination• SnowCity Ski Resort - Question 7-9 - Page 186

• A Mickey Mouse Solution for a Disneyland Dilemma

• Block booking and bundling • Why are Hotel Minibars So Expensive?

Questions?• How does pricing contribute to profits?

• Why does Disneyland charge $249 for a 5 day pass instead of pricing each ride?– They used to charge a price for each ride. (let’s

say $8 per ride)

• Why did movie studios want to engage in block-booking (bundling)?

• Why are Hotel Minibars So Expensive?

• How can firms make money selling commodity memory on the internet?

Linear approximation

Requirements: estimates of current price (P1), quantity sold (Q1), possible new price (P2), quantity sold with price change (Q2), and marginal cost

A linear demand curve is approximated by

P1=a-( )Q1

solve for a

More generally, P=a-bQ

Q1-P1/Q2-P2

Purple Man Project Problem: • At Purple Man Project – Vegas, the audience is entertained

by purple performers in Sin City. • The Project has experimented with two prices: $50 and

$70. They carefully tried to hold all other factors constant during the experiment.

• At the $50 price they averaged an audience of 500. At the $70 price the averaged an audience of 450.

• The marginal cost of filling another theater seat is zero.

• What is the demand curve facing the Purple Man Project ?• What is the optimal price and quantity of tickets to sell for

the Purple Man Project?

Cost-plus pricing

• Add a markup to average total cost to yield target return

• Does this ignore incremental costs and price sensitivity?– not if managers have a fundamental understanding of

their markets

– consistently bad pricing policies are not good for the firm’s long term fiscal health

Mark-up pricing

• Optimal mark-up rule of thumb:

where * indicates estimated value• Requires knowledge or awareness of both marginal

costs and elasticity

*

11

**

MC

P

Problem:

• As an internet memory sales company Glenn Ellison has told you your own-price elasticity of demand for low quality 128MB PC100 memory modules is 25 in absolute value.

• Why is your demand so elastic for the low quality 128MB PC100 memory modules?

• What is your optimal markup???

Price discrimination

• Different prices charged to different customers for essentially the same product– examples

• Demand curve shows willingness to pay = subjective valuation

• Price discrimination tries to turn willingness-to-pay into profit

Price discriminationheterogeneous consumers

• Necessary conditions– identify submarkets– no transfers across submarkets

• Degrees of discrimination– Group pricing (market segmentation)– Personalized pricing

Optimal pricing at Snowfishdifferent demand elasticities

Snow City Ski Resort

• Page 186 Question 7-9

• Snow City Ski Resort

• Out of town: Qo = 600 - 10PP=60- (1/10) *Qo

• Local: Ql = 600 - 20P P=30- (1/20 )*Ql

Combined: Qt = 1200 – 30P

P=40 – (1/30)*Qt

a. Marginal revenue (40 –1/30Q) equal to marginal cost ($10).

Price can be found by substituting this quantity into the demand curve. The optimal

quantity is 450 tickets (100 local; 350 nonlocal), price = $25, and profits = $6,750.

Snow City Ski Resort

b. The local skiers have more elastic demand. The point elasticity for the local-skier market is 5 versus .714 for the out-of-town market.

Hint: point elasticities are covered in the appendix to chapter 4

Snow City Ski Resort

714.0350

250

350

2510

5100

500

100

2520

townersofout

Q

PB

Q

PBlocal

Snow City Ski Resortc. What are the optimal price and quantity for

each market segment???• Snow City should charge $35 to out-of-town

skiers and sell 250 tickets. • The price and quantity for local skiers are $20 and

200 tickets. • Total Revenue from OT =PQ=$35*250=$8750• Total Revenue from Locals=$20*200=$4000• Total cost = $10*450=$4500• Total profits are $8750+$4000-$4500=$8,250 d. What techniques might the resort use to

implement such a pricing policy?

A Mickey Mouse Solution for a Disneyland Dilemma• Two-part tariffs

– up-front (entry) fee for the right to purchase– additional fee per unit purchased equal to marginal cost

• At Disneyland MC=0 per ride approximately– best when customers have relatively homogenous demand for

product– Must be able to prevent resale!!!! So it works for the Mouse!

Entry Fee

Price

0 Quantity

Demand

Per unit price =Marginal cost

Quantity sold

EA Sports: “Its in the game.”• Consider the following information about the demand for last

year’s video games. There are an equal number of consumers in each group. This table shows that maximum that each type of consumer is willing to pay for each game:

a. Why is EA Sports still selling old versions of its video games? b. As Vice-President for EA Sports explain your optimal bundling and

pricing strategy to maximize EA Sports profits from the sale of 2002 games. Be sure to explain why your strategy is optimal.

Product Group 1 consumers

Group 2 consumers

Madden 2004 $20 $14

Tiger Woods 2004 $13 $18

Application:Smart Pricing Case

• What is smart pricing?

• Any similarities to price discrimination?

• How does it capture willingness-to-pay?

• Infrastructure needs

• Benefits & costs

Add-on Pricing

– Glenn Ellison’s cool research– Why are Hotel Minibars So Expensive?– How can firms facing vigorous price competition mark-up prices

above marginal cost to stay in business???– Even in the face of highly elastic demand for commodity

products (computer memory) on the internet??

Looking Forward

• Return and Review Assignment 2• Readings – Game Theory

Managerial Economics Chapter 9• Holland Sweetener versus Monsanto, p.

245

• Please bring lots of change to next week’s class for fun and games