Chapter 7: Pricing with Market Power

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Chapter 7 Pricing with Market Power

• Brickley, Smith, and Zimmerman, Managerial
  Economics and Organizational Architecture, 4th ed.

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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 selected pricing techniques consistent with
  maximum profit

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Beyond.com

• Please read Beyond.com case study, pages 184,185
• Pricing is a key managerial decision. These
  examples illustrate some of the complexities
  associated with product pricing.
• For example, how should managers set their basic
  prices?

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Beyond.com

• Why do firms use coupons and rebates?
• Why some customers are charged higher prices
  than others for the same product?
• Why do firms bundle products?
• Why would a firm ever give its product away for
  free?
• Why do some firms offer volume discounts?

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Beyond.com

• In this chapter we present a basic analysis of
  pricing with market power and provide answers to
  these and related questions
• First, we will discuss the underlying objective
  of pricing decisions.
• Next, we will analyze a benchmark case where the
  firm charges the same price to all customer

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Beyond.com

• Subsequently, we consider more complex pricing
  policies.
• The chapter ends with a brief discussion of
  several other issues, including multiperiod
  considerations, strategic interactions, and legal
  and implementation issues.

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Pricing objective

• A firm has market power if
• it faces a down sloping demand curve.
• Firms with market power can raise price without
  losing all customers to competitors.
• The demand curve reflects
• consumer willingness and ability to buy.
• The firms pricing objective is
• to maximize shareholder value.

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Consumer surplus

• Consumer surplus is defined as the difference
  between what the consumer is willing to pay for a
  product and what the consumer actually pays when
  buying it.
• Managers, in maximizing profits, try to devise a
  pricing policy that captures as much of the gains
  from trade as possible.
• Thus, they try to capture potential consumer
  surplus as company profit.

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Consumer and Producer Surplus

• Consumer Surplus

Consumer Surplus
Equilibrium Price 8
P1
Price (Per Bag)
D
Q1
Quantity (Bags)
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Consumer and Producer Surplus

• Producer Surplus

S
Equilibrium Price 8
P1
Price (Per Bag)
Producer Surplus
Q1
Quantity (Bags)
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Consumer and Producer Surplus

• Efficiency Revisited

S
Consumer Surplus
Equilibrium Price 8
P1
Price (Per Bag)
Producer Surplus
D
Q1
Quantity (Bags)
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Consumer and Producer Surplus
Efficiency Losses (Deadweight Losses)
S
Efficiency
Losses
P1
Price (Per Bag)
D
Q3
Q1
Q2
Quantity (Bags)
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Pricing with market power - firm should never
price below MC since it can do better by not
producing the product
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Single Price Per Unit - Benchmark Case

• In the benchmark case, the firm chooses a single
  per-unit price for all customers.
• Profits are maximized at the price and output
  level where marginal revenue equals marginal
  cost.
• In this case, the firm captures some, but not
  all, of the potential gains from trade because we
  are not utilizing complex pricing structures
  which allow us to capture some or most of the
  consumer surplus

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Single Price Per Unit - Benchmark Case

• Four simplifying assumptions
• 1. All consumers are charged the same unit price
  regardless of quantities purchased
• 2. The firm sells only one product consumer
  interactions are thus ignored
• 3. The demand curve is for single period
  longer-term focus on increase demand and profits
  are not considered
• 4. The price of competing products are the same
  no matter what beyond.com charges

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Single price per unitCheckware
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Relevant Costs- Benchmark Case

• Fixed and sunk costs are irrelevant only
  incremental costs matter in the pricing decision.
  
• Also as discussed earlier, it is important for
  managers to focus on opportunity costs (costs
  associated with the next best alternative) not
  accounting costs

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Price Sensitivity

• The optimal price markup over marginal cost
  depends on the elasticity of demand.
• The optimal markup decreases as demand becomes
  more elastic
• It is optimal to charge high prices when
  customers are not very price-sensitive.

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Price sensitivity and optimal markup - price
sensitivity for the left panel is 1.27 (higher
markup) and the right panel is 1.62 (lower
markup)
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Estimating the Profit-Maximizing Price

• Economic theory suggests that managers should
  price so that marginal revenue equals marginal
  cost. (MR MC)
• One practical problem in applying this principle
  is that managers often do not have precise
  information about their demand curves and thus
  their marginal revenue

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linear approximation

• The linear approximation technique can be used
  when the demand curve is roughly linear and the
  manager has basic information about current
  price-quantity, price sensitivity, and marginal
  cost.
• Markup pricing is a technique that managers can
  use when they have limited information and reason
  to believe that price elasticity varies little
  (isoelastic same elasticity) across the demand
  curve.

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Cost-Plus Pricing

• One of the most common pricing methods used by
  firms is cost-plus pricing.
• Managers using this technique calculate average
  total cost and mark up the price to yield a
  desired rate of return.
• Cost-plus pricing appears inconsistent with
  profit maximization since it includes fixed and
  sunk costs and does not consider consumer demand
  explicitly.

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Cost-Plus Pricing - problems

• We have stressed how profit maximizing pricing
  considers only incremental costs and depends on
  the price sensitivity of customers.
• Cost-plus pricing appears to ignore both of these
  considerations by using average total costs which
  includes fixed cost and then using targeted
  markup ignoring price elasticity of consumers.

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Cost-Plus Pricing So why use it?

• Cost-plus pricing is more useful when the rate of
  return that yields the profit-maximizing price on
  the product is relatively stable over the
  relevant range of cost variation for a given
  product and varies little across a related set of
  products.
• It is also easy to use.

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Cost-Plus Pricing

• Managers, however, can consider consumer demand
  implicitly by choosing appropriate target returns
  (lower target returns are chosen when demand is
  more elastic).
• The widespread use of this pricing policy
  suggests that it can be a useful rule of thumb in
  some settings.

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Potential for higher profits Figure 7.4, page
192

• In the benchmark case of a single unit price, the
  firm captures some, but not all, of the potential
  gains from trade.
• Firms profits are displayed by the shaded
  rectangle, and the associated consumer surplus is
  labeled abc.

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Potential for higher profits Figure 7.4, page
192
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Potential for higher profits Figure 7.4, page
192

• The triangle, labeled def, shows additional
  potential gains from trade that would accrue from
  selling to customers who value the product above
  its marginal cost, but who do not buy the product
  at the higher unit price P
• Below we discuss how a firm might increase
  profits through more complicated pricing
  strategies that allow it to capture some of the
  gains from trade displayed by these two triangles

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Homogenous Consumer Demands block pricing

• The benchmark policy charges the same price to
  all customers independent of the quantity
  purchased. Sometimes a firm can do better with
  more complicated pricing policies.
• With block pricing a high price is charged for
  the first block and declining prices for
  subsequent blocks.

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Homogenous Consumer Demands - block pricing

• Block pricing either can be used to extract
  additional profits from a set of customers with
  similar demands or can be used to
  price-discriminate. Please see an example of
  block pricing at page 193 (T-shirts)

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Homogenous Consumer Demands two-part tariff

• With a two-part tariff, the customer pays an
  up-front fee for the right to buy the product and
  then pays additional fees for each unit of the
  product consumed amusement parks, golf and tennis
  clubs, telephone service providers
• Two-part tariffs tend to work best when customer
  demand is relatively homogeneous please see
  example on page 194 relative to Figure 7.5

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Two-part tariffcapturing consumer surplus
Figure 7.5, page 194
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Price Discrimination Heterogeneous Consumer
Demand

• Potential customers often vary materially in
  their willingness to pay for a product
• In our benchmark case, the firm charges the same
  price to all potential customers.
• With a heterogeneous customer base, the company
  can make higher profits if it is able to charge
  higher prices to those customers who are willing
  to pay more for the product

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Price Discrimination Heterogeneous Consumer
Demand

• Price discrimination occurs whenever a firm
  charges differential prices across customers that
  are not related to differences in production and
  distribution costs.
• With price discrimination, the markup or profit
  margin realized varies across customers because
  potential customers often vary materially in
  their willingness to pay for a product

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Price Discrimination Heterogeneous Consumer
Demand

• We begin our examination of price discrimination
  by considering the case where the manager has
  good information about individual demands.
• We then consider the case where the manager has
  information only about the distribution of
  demands

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Price Discrimination - Heterogeneous Consumer
Demands

• Two conditions are necessary for profitable price
  discrimination.
• First, different price elasticities of demand
  must exist in various submarkets for the product
  (customers must be heterogeneous).
• Second, the firm must be able to identify
  submarkets and restrict transfers among consumers
  across different submarkets.

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Personalized pricing - first degree price
discrimination

• Personalized pricing extracts the maximum amount
  each customer is willing to pay for the product
  reservation price
• Each consumer is charged a price that makes him
  or her indifferent between purchasing and not
  purchasing the product the firm extracts all the
  potential gains from trade. Also called first
  degree price discrimination. This form is rare
  and is only possible when number of customers is
  small and resale is impossible. More common today
  due to technology (Virtual Vineyards, page 197)

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Group pricing - third degree price discrimination

• Group pricing results when a firm separates its
  customers into several groups and sets a
  different price for each group based on age,
  income, time of purchase, dress and sensitivity
  observations are very common
• A firm that can segment its market maximizes
  profits by setting marginal revenue equal to
  marginal cost in each market segment higher
  prices are charged to the less price-sensitive
  groups, examples include utility companies,
  airlines, theaters, computer companies,
  (educational discounts)

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Using information about the Distribution of
Demands

• Both personalized and group pricing require
  relatively good information about individual
  customer demands.
• Even if the manager does not have detailed
  information such as income levels of all
  customers about individual demands, price
  discrimination still is possible with sufficient
  information about the distribution of individual
  demands.

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Using information about the Distribution of Demand

• Nonetheless, the manager might have enough
  information about the range or distribution of
  individual demands to engage in profitable price
  discrimination.
• Two prominent methods that can be used in this
  setting. Both rely on the principle of
  self-selection consumers are provided with
  options. They then reveal information about their
  individual price sensitivity by their choices

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Optimal pricing at Snowfishdifferent demand
elasticities out of town elasticity 1.50 and
2.33 for local skiers
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Menu Pricing - second degree price discrimination

• With menu pricing all potential customers are
  given the same menu of options
• The classic example involves block pricing, where
  the price per unit depends on the quantity
  purchased cell phone companies, please also
  review Table 7.1 Example of Menu Pricing

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Menu Pricing - second degree price discrimination

• Customers use their private information to select
  the best option for them.
• By carefully constructing the menu of options,
  the firm makes more profits than if it simply
  offered the product at one price to all potential
  customers.

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Coupons and Rebates

• Coupons and rebates offer price discounts to
  customers.
• Price discrimination is one reason why firms use
  coupons and rebates to make price discounts
  rather than simply lowering the price.
• Price-sensitive customers are more likely to use
  coupons and rebatesand thus are charged lower
  effective pricesthan customers who are less
  price sensitive.

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Coupons and Rebates

• Similar to menu pricing, customers self-select,
  depending on private information about their
  personal characteristics.
• Coupon and rebate programs are expensive to
  administer. These costs have to be compared to
  the benefits in deciding whether to adopt such a
  program.

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Bundling

• To this point, we have considered the case where
  the firm sells a single product.
• This section extends the analysis by providing an
  introduction to the case of multiple products

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Bundling

• Firms frequently bundle products for sale.
• One reason for bundling products is to extract
  additional profits from a customer base with
  heterogeneous product demands Please review Table
  7.2 Product Bundling for an example as well as
  Bundling Videogames
• Bundling can be more profitable than selling the
  products separately when the relative values that
  the customers place on the individual products
  vary theater season tickets,

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Other Concerns

• This chapter focuses on a single-period pricing
  problem, in which managers face a fixed demand
  curve and cost structure. The prices of competing
  products are held constant.
• In some situations, concerns about future demand
  and costs, as well as the reactions of
  competitors, can motivate managers to choose
  pricing policies that would not be appropriate in
  the simple single-period analysis.

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Multiperiod Considerations

• Managers are concerned with sales not only in the
  current period as in the benchmark case but in
  the future periods as well
• Giving the product away after rebates etc. can
  attract new customers it lowers the full cost of
  consuming the good below that of competing
  products.

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Future Demand

• Offering a product at a price below marginal cost
  is a more effective pricing strategy if
  information costs are higher software such as
  Encarta.
• Once customer has invested time in learning the
  new software he/she is likely to stay with it
  rather than switch (lock-in effect) and hopefully
  will buy future upgrades, new editions and other
  complement products.

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Future Demand

• Other reasons for charging lower than profit
  maximizing price today are
• Maintaining customer goodwill
• Reactions of public interest groups and
• Government regulators
• Future lower costs due to learning effects
• Storable Goods

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Strategic Interaction

• Reactions of competitors must be taken into
  consideration unlike our benchmark case
• Legal Issues There are laws that restrict the
  ability of firms to charge different prices to
  different customers Robinson-Patman Act for
  retailers.
• Tying Contracts are also illegal under Antitrust
  Laws managers are advised to check the legality
  of their pricing decision within a particular
  jurisdiction

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Implementing a Pricing Strategy

• Actual implementation of any pricing strategy is
  far more complicated due to these and other
  factors
• First, pricing policies presented here are not
  mutually exclusive many companies use combination
  of pricing policies
• Second, we have used a single product pricing
  where as most companies sell variety of products
  therefore it is

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Implementing a Pricing Strategy

• Important to consider the interactions of demands
  and costs of multiple products in developing a
  pricing strategy.
• Third, Optimal pricing policies can change over
  time
• Fourth, firms have to give more detailed
  consideration to the legal and strategic issues
  in formulating pricing strategies.

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The End

• Please remember to do the following
• 1. Online Quiz
• 2. Concepts Related Questions
• 3. Current Event Questions
• Thank you!