ECW2731

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ECW2731
Managerial Economics
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Structure
Weeks 7-8 Competition, market structures and
business decisions
Week 9 Pricing strategies and practices
Week 10 Business and Government.
Weeks 5 - 6 Production and Costs
Managerial Economics
Week 11 Capital budgeting
Weeks 3-4 Demand analysis and estimation
Week. 12 Research question Business and current
economic situation.
Week 2 Basic economics principles demand and
supply.
Week1 Introduction. The nature of managerial
economic decision making
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What prices should be set?
Mark-up pricing
Price discrimination.
Two part pricing
Tying
Multiple and joint product pricing.
Transfer pricing
4
Introduction. The nature of managerial economic
decision making
Reading
Hirschey, Chapter 15
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What prices should be set?
Markup Pricing And Profit Maximization

• Competitive Markets
• Profit maximization always requires setting Mp
  MR - MC 0, or MRMC, to maximize profits.
• In competitive markets, PMR, so profit
  maximization requires setting PMR MC.
• Imperfectly Competitive Markets
• With imperfect competition, P gt MR, so profit
  maximization requires setting MRMC.

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How companies discover the level of customer
demand?
Mark-up pricing

• Regular prices
• Discounts
• Rebates
• Coupon promotions
• Regional pricing
• Other pricing strategies

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Markup on cost
Mark-up pricing

• The difference between price and cost (profit
  margin or markup) is expressed as a percentage
  of cost
• Two steps
• The firm estimates the cost per unit of output of
  the product
• The firm adds a markup to the estimated average
  cost

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Markup on price
Mark-up pricing

• The difference between price and cost (profit
  margin or markup) is expressed as a percentage
  of price

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Target Return Figure
Mark-up pricing
P L M K F/Q (PA)/Q where P is
price L is unit labor cost M is unit
material cost K is unit marketing cost F is
fixed cost Q is units of output A is total
gross operating assets P is desired profit
rate on assets
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The role of cost in markup pricing
Mark-up pricing

• Standard costs based on historic accounting can
  be misleading if not adjusted to reflect
  opportunity costs.
• During peak periods of full capacity usage fully
  allocated costs is relevant.
• P L M K F/Q (PA)/Q
• During off-peak periods only incremental costs
  are relevant.
• P L M K

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Price discrimination.

• Where a firm exercises market power, the
  opportunity may exist to further increase profits
  by charging different prices to different
  consumers, or to different groups of consumers
  for reasons other than costs
• In so doing the firm will appropriate all or part
  of the consumer surplus.

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General Principle
Price discrimination.

• General Principle Profit-Making Criteria
• Price discrimination exists if P1/P2 ? MC1/MC2.
• Ability to segment the market.
• Multiple markets with no reselling.
• Price elasticity of demand differs across
  submarkets.

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Types of price discrimination
Price discrimination.

• First-degree the firm is aware of each buyers
  demand curve
• Second-degree the firm charges a different
  price, depending on the quantity each buyer
  purchases
• Third-degree the firm breaks buyers into groups
  based upon their price elasticity of demand

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First Degree Price Discrimination(Perfect Price
Discrimination)
Price discrimination.

• Each consumer is charged the price he/she is
  willing to pay.
• Producer takes all the consumer surplus

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1st. degree price discrimination
Price discrimination.
Price
P1
PL
Demand
Q1
Q
Quantity
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1st. degree price discrimination
Price discrimination.
Price
P1 P2
PL
Demand
Q1 Q2
Q
Quantity
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1st. degree price discrimination
Price discrimination.
Price
P1 P2 P3
PL
Demand
Q
Q1 Q2 Q3
Quantity
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1st. degree price discrimination
Price discrimination.
For each consumer price chargedprice willing
to pay Monopolist appropriates all consumer
surplus
Price
P1 P2 P3 P4 . .
PL
Demand
Q
Quantity
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2nd Degree Price Discrimination(non-linear
pricing)
Price discrimination.

• Different price is charged for a different
  quantity bought (but not across consumers).
• set one price for a 1st bundle, a lower price for
  a 2nd bundle, ....
• extract some, but not all of consumer surplus
• Note
• In 1st deg casegtdifferent prices charged for
  different consumers
• In 2nd deg casegtdifferent prices charged for
  different quantities (for same consumer)

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2nd Degree Price Discrimination(non-linear
pricing)
Price discrimination.

• Examples
• Telephone companies charging different prices for
• different quantities

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3rd Degree Price Discrimination
Price discrimination.
P
P
MC
DT MRT
D2
D1
MR2
MR1
Q
Q
Q
QT
Market 2 flatter D more elastic
Mkt1Mkt2 QTQ1Q2
Market1 steeper D less elastic
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3rd Degree Price Discrimination
Price discrimination.

P
P
MC
DT MRT
D2
D1
MR2
MR1
QT
Q
Q
Q
Mkt1Mkt2 QTQ1Q2
Market 2
Market1
How much to sell in each Mkt (Q1? Q)2? what
prices (P1? P2)?
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3rd Degree Price Discrimination
Price discrimination.
P
P
MC
DT MRT
D2
D1
MR2
MR1
QT
Q2
Q
Q
Q1
Market 2 MR2MC More elastic demand
Mkt1Mkt2 QTQ1Q2 MR1MR2MC
Market1 MR1MC Less elastic demand

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3rd Degree Price Discrimination
Price discrimination.
P
P
MC
P1
P2
DT MRT
D2
D1
MR2
MR1
QT
Q2
Q
Q
Q1
Market 2 MR2MC More elastic Demand - Higher
Price
Mkt1Mkt2 QTQ1Q2 MR1MR2MC
Market1 MR1MC Less elastic Demand - Lower price


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Two part pricing
100
Per-unit fee is equal to marginal costs plus a
fixed fee equal to to the amount of consumer
surplus (membership fee, Service fee)
80
Consumer surplus 800
60
Monopoly Price
Profits 1,600
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MC AC
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Demand
Q
MR
0
0
120
20
100
40
80
60
(a) Monopoly Per Unit Pricing
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Tying

• Occurs when a firm sells a product, the use of
  which requires the consumption of a complementary
  product
• The consumer is required to buy the complementary
  product from the firm selling the product itself

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Multiple-product Pricing

• Demand Interrelations
• Cross-marginal revenue terms indicate how product
  revenues are related to another.
• Production Interrelations
• Joint products may compete for resources or be
  complementary.
• A by-product is any output customarily produced
  as a direct result of an increase in the
  production of some other output.

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Joint Products in Variable proportions

• Joint Products in Variable Proportions
• If products are produced in variable proportions,
  treat as distinct products.
• For joint products produced in variable
  proportions, set MRAMCA and MRBMCB.
• Common costs are joint product expenses.
• Allocation of common costs is wrong and
  arbitrary.
• Joint Products in Fixed Proportions
• Some products are produced in a fixed ratio.
• If QQAQB, set MRQMRAMRBMCQ.

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Joint product pricing.
Joint products produced in fixed proportions
Some products are produced in a fixed
ratio QQAQB MRTMRA MRB MCQ
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Transfer pricing
Transferring an intermediate product from one
division to another in a vertically integrated
firm

• Financial autonomy of divisions
• Marginal cost opportunity cost
• Three cases
• Products Without External Markets
• Products With Competitive External Markets
• Products With Imperfectly Competitive External
  Markets

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Transfer pricing
No external markets

• Financial autonomy of divisions
• Economic profit of one division is a cost of
  another division.
• Profit cant be made
• Pricing at marginal cost covering opportunity
  costs.

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Transfer pricing
There is an external market alternative

• Financial autonomy of divisions
• Two cases
• The external market is perfectly competitive
• Pricing at the external market price
• The external market is not perfectly competitive
• Pricing at the marginal revenue of the combined
  external and internal markets