Managerial Economics and Organizational Architecture, Chapter 7
Pricing with market power learning objectives
Students should be able to
• Explain the role of elasticity in optimal pricing
• Identify circumstances appropriate for price discrimination
• Apply slected pricing techniques consistent with maximum profit
Managerial Economics and Organizational Architecture, Chapter 7
Pricing objective
A firm has market power if…
...it faces a downsloping demand curve.
The firm’s pricing objective is…
…to maximize shareholder value.
The demand curve reflects…
…consumer willingness and ability to buy.
Managerial Economics and Organizational Architecture, Chapter 7
The benchmark case:single price per unit
Beyond.com data:• Purchases software from manufacturer for $10• Demand curve is P = 85-.5Q (Q in 000s of units)
What is the profit-maximizing price?• Set MR = MC• 85-Q=10• Q=75, p=$47.50• Profit is $2,812.50 (000s)
Managerial Economics and Organizational Architecture, Chapter 7
Other single pricing issues• Relevant costs
– sunk costs are irrelevant– current opportunity costs are relevant
• Price sensitivity– price elasticity, , is a measure of price
sensitivity– Optimal price is P*=MC*/[1-1/ *]– A firm with market power should never operate
on the inelastic portion of the demand curve
Managerial Economics and Organizational Architecture, Chapter 7
Price sensitivity and optimal markup
Managerial Economics and Organizational Architecture, Chapter 7
Estimating profit-maximizing price
• In theory, MC=MR, but in practice, manager may not know demand curve and therefore MR.
• Cost-plus or mark-up pricing may be useful approximations.
• But they must reflect fundamentals!
Managerial Economics and Organizational Architecture, Chapter 7
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-(P2-P1/Q2-Q1)Q1; solve for a
More generally, P=a-bQ
Managerial Economics and Organizational Architecture, Chapter 7
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
Managerial Economics and Organizational Architecture, Chapter 7
Mark-up pricing
• Optimal mark-up rule of thumb:
P*=MC*/(1-1/*)
where * indicates estimated value
• Requires some knowledge or awareness of both marginal costs and elasticity
Managerial Economics and Organizational Architecture, Chapter 7
Homogenous consumer demand
• Block pricing– declining price on subsequent blocks of product– product packaging
• Two-part tariffs– up-front fee for the right to purchase– additional fee per unit purchased– best when customers have relatively
homogenous demand for product
Managerial Economics and Organizational Architecture, Chapter 7
Two-part tariffcapturing consumer surplus
Managerial Economics and Organizational Architecture, Chapter 7
Price discriminationheterogeneous consumer demands
• Price discrimination occurs when firm charges different prices to different groups of customers– not related to cost differences
• Necessary conditions– different price elasticities of demand– no transfers across submarkets
Managerial Economics and Organizational Architecture, Chapter 7
Using information about individuals• Personalized pricing
– “first degree” price discrimination– possible only with small number of buyers
• Group pricing– “third degree” price discrimination– very common (utilities, theaters, airlines…)
Managerial Economics and Organizational Architecture, Chapter 7
Group pricingexample
Snowfish Ski Resort demand curves
Out of town: Qo=500-10P
Local: Ql=500-20P
Total: Q=1000-30P
One-price profit: P*=$21.66, Q*=350, Qo*=283, Ql*=67, Profit=$4,081
Two-price profit: Po*=$30, Qo*=200, Pl*=17.50, Ql*=150, Profit=$5,125
Managerial Economics and Organizational Architecture, Chapter 7
Optimal pricing at Snowfishdifferent demand elasticities
Managerial Economics and Organizational Architecture, Chapter 7
Using information about the distribution of demands
• Menu pricing– “second degree” price discrimination– consumers select preferred package
• Coupons and rebates– users likely more price sensitive– users who are new customers may stick with
product
Managerial Economics and Organizational Architecture, Chapter 7
Bundling and other concerns• Bundling may yield a higher price than if
each component is sold separately– theater season tickets– restaurant fixed price meals
• Multiperiod pricing– low initial price can “lock-in” customers
• Strategic considerations– low price may be barrier to entry