1. BUS7500 Managerial Economics Week 5 Dr. Jenne Meyer

2. Group Work  Break into teams and answer the following:  What are all of the pricing strategies your company does?  Are their similarities/differences between companies?  How does this impact the business strategy?

3. Advertising and promotional pricing  Combines two of the “Four P’s of marketing,” Pricing and Promotion  Promotional spending affects demand in different ways  Price-related promotions (coupons, end-of-aisle displays, etc.) tend to make demand more elastic  If promotion makes demand more elastic, it makes sense to reduce price concurrently  Product-related promotions (quality advertising, celebrity endorsements, etc.) tend to make demand less elastic  If promotions make demand less elastic, it makes sense to raise price concurrently  Caveat: Prices can affect customer perception of quality – i.e. higher price equals higher quality in the mind of the consumer

4. Psychological Pricing  Biases can affect optimal pricing decisions.  Example: Airline snacks In 2008, some airlines began charging for snacks It seems like a good idea because those who value an in-flight snack could buy one and those who didn’t didn’t have to buy. Many passengers, though, viewed the change negatively and changed airlines as a result.  Research in the field of behavioral economics says that this reaction was predictable using “prospect theory”  The way a decision is framed matters a great deal to the decisions that consumers make, i.e. consumers feel losses more than gains – so decisions should be framed in such a way to highlight a gain not the loss of an in-flight snacks.

5. Psychological pricing (cont.)  Consumers are also very sensitive to fairness.  Many retailers make deliberate pricing decisions so as not to appear unfair  Home Depot didn’t raise prices after Katrina, though demand did increase; hardware stores don’t increase the price on snow shovels following a big winter blizzard  In 2008, when gas prices rose to meet consumer demand, many US citizens were outraged and heavily criticized oil companies for profiting “unfairly.”  To avoid looking unfair, companies must come up with creative solutions.  In the music industry, performers set concert ticket prices below the market price. People buy up the low priced tickets and sell them on secondary markets, which consumers don’t subject to rules of fairness.  Often, artists also sell tickets on secondary sites, sharing in the profits but avoiding the label of “unfair”

6. Another pricing anecdote  Las Vegas Casinos  Offer both hotel rooms and gaming  Prices on rooms are often set at “sub-optimal” levels  Casinos plan to more than make up for the room profit shortfall with gaming profits  Similar to grocery store loss leader concept  Get people in the door  Goal is to maximize total profit, not individual product profit

7. Chapter 13: Direct Price Discrimination

8. Summary of main points  If a seller can identify two groups of consumers with different demand elasticities, and it can prevent arbitrage between two groups, it can increase profit by charging a higher price to group with the less-elastic demand.  Price discrimination is the practice of charging different people or groups of people different prices that are not cost-justified. Typically more people are served under price discrimination than under a uniform price.  Arbitrage can defeat a price discrimination scheme if enough of those who purchase at low prices re-sell to high-value consumers. This can force a seller to go back to a uniform price.

9. Summary of main points (cont.)  A direct price discrimination scheme is one in which we can identify members of the low-value (more price elastic) group, charge them a lower price, and prevent them from re-selling their lower- priced goods to the higher-value group.  It can be illegal for business to price discriminate when selling goods (not services) to other businesses unless  price discounts are cost-justified, or  discounts are offered to meet competitors’ prices.  Price discrimination schemes may annoy customers who know they’re paying more than others and can make them less willing to buy because they know someone else is getting a better price. If you can, keep them secret.

10. Warning: only schmucks pay retail  Consumers do not like knowing they are paying higher prices than others.  For example, when shown a box for a promotional code on a website, click- through rates decline.  Online shoppers were less likely to complete their transactions once they realized a coupon existed that they didn’t have.  People don’t like knowing they are schmucks  So, if you are price discriminating, it is important to keep the scheme secret if you can.

11. Anecdote: conference pricing  The American Association for Clinical Chemistry (AACC) sponsors 3-day conferences  90% of the attendees from same city or surrounding region  Foreign participants  Greater travel costs  Longer travel times  Applying and interviewing for travel visas  The majority attend conferences in own countries  To increase attendance, the AACC proposed reducing price to foreign participants  QUESTION: HOW DID THEY PREVENT ARBITRAGE?

12. Chapter 14: Indirect Pricing Discrimination

13. Summary of main points  When a seller cannot identify low- and high-value consumers or cannot prevent arbitrage between two groups, it can still discriminate, but only indirectly, by designing products or services that appeal to groups with different price elasticities of demand, who identify themselves based on their purchasing behavior.  Metering is a type of indirect discrimination that identifies high-value consumers by how intensely they use a product (e.g., by how many cartridges they buy). In this case, charge a big markup on the cartridges and a lower markup on the printer.  If you offer a low-value product that is attractive to high-value consumers, you may cannibalize sales of your high-price product.

14. Summary of main points (cont.)  When pricing for an individual customer, do not bargain over unit price. Instead, you should  Offer volume discounts;  Use two-part pricing; or  Offer a bundle containing a number of units.  Bundling different goods together can allow a seller to extract more consumer surplus if willingness to pay for the bundle is more homogeneous than willingness to pay for the separate items in the bundle.

15. Introductory anecdote: iPhone  In July 2007, Apple released two versions of the iPhone: 8-GB for $599 and 4-GB for $499. In the first weekend alone Apple sold around half a million iPhones  Two months later, however, Apple discontinued the 4-GB model and cut the 8-GB model’s price to $399  Why cut prices when demand is so high?  Apple used the lower price to attract additional customers.  This would have been a great pricing move, BUT many loyal Apple customers were upset by the price cut, suddenly early purchasers found themselves “the schmucks,” and Apple had to give $200 rebates to early customers to avoid negative publicity

16. Hewlett-Packard printers  HP identifies high- and low-value consumer groups by the number of ink cartridges purchased  To charge high-value customers higher prices, HP charges a 50% markup over MC on ink cartridges while only charging a 15% markup on printers.  In 2003, HP sold $10 billion worth of printers and $12 billion in ink cartridge sales, HP’s actual profit off of ink cartridges was three times greater than the profit from printer sales.  The low margin on printers and high margin on ink cartridges is similar to pricing schemes used for many complementary products: razor blades and razors, movies and popcorn, etc.

17. Chapter 15: Strategic Games

18. Summary of main points  A Nash equilibrium is a pair of strategies, one for each player, in which each strategy is a best response against the other.  When players act rationally, optimally, and in their own self-interest, it’s possible to compute the likely outcomes (equilibria) of games. By studying games, we learn not only where our strategies are likely to take us, but also how to modify the rules of the game to our own advantage.  Equilibria of sequential games, where players take turns moving, are influenced by who moves first (a potential first-mover advantage, or disadvantage), and who can commit to a future course of action. Credible commitments are difficult to make because they require that players threaten to act in an unprintable way—against their self-interest.  In simultaneous-move games, players move at the same time.

19. Summary of main points  In the prisoners’ dilemma, convict and cooperation are in tension—self- interest leads to outcomes that reduce both players’ payoffs. Cooperation can improve both players’ payoffs.  In a repeated prisoners’ dilemma, it is easier for players to learn to cooperate. Here are some general rules of thumb:  Be nice: No rest strikes.  Be easily provoked: Respond immediately to rivals.  Be forgiving: Don’t try to punish competitors too much.  Don’t be envious: Focus on your own slice of the port pie, not on your competitor’s.  Be clear: Make sure your competitors can easily interpret your actions.

20. Introductory anecdote: Blu-ray  In February 2002, nine electronics companies, led by Sony, announced plans for the next big video recording format: Blu-Ray  By August of that same year, Toshiba and NEC announced plans for a rival technology: HD-DVD  A common standard among all competitors (rather than two rival technologies) would have best benefited consumers.  With a common standard, demand for the new technology would have grown more rapidly and all producers would have benefited.  But some producers would benefited more than others: Sony would have profited from the choice of Blu-ray while Toshiba would have preferred HD-DVD.  Both sides waged a “standards” war, recruiting big name entertainment groups (such as Disney, Paramount Pictures, HBO, etc.) to take sides. In the end, Blu-Ray won after Wal-Mart announced it would sell only Blu-Ray disc players.

21. Introductory anecdote (cont.)  In a standards war, the profit of one firm depends on the actions of other firms, rivals, consumers, and suppliers.  This type of interdependence is characteristic of games, and we analyze it using game theory.  A “game,” has three elements: players, options/moves available and the payoffs resulting from each combination of moves.  Assuming that each player acts optimally, rationally and selfishly, the likely outcomes, or equilibria, of the game can be computed.

22. Introduction: Game theory  Aside from telling firms where competition is likely to lead them, game theory can also offer advice to change the rules of the game to one or both player’s advantage.  For Sony and Toshiba, both realized there were two potential equilibria to their game (Blu-ray vs. HD-DVD):  Consumers, retailers, manufacturers, content providers, etc. would coordinate on one of these standards  The standards war was the result of each firm attempting to convince the market participants and public that their respective technology would become the standard (competition “for the market”)  Game theory also suggest strategies to reduce competitive intensity to increase profit (“strategy” from ch. 11)

23. Sequential-move games  In game theory, there are two types of games. The first of which is known as sequential-move games.  For a sequential-move game, players take turns.  Each competitor is given the opportunity to evaluate their rival’s move before selecting how to proceed.  To analyze sequential games, use the “extensive-” or “tree-form” of a game, and look ahead and reason back.  For example, a two-move, two-player game. Player One (moving first) must anticipate the reaction of Player Two to each of One’s possible moves to determine One’s best move  Equilibrium is when each player chooses a best available move, anticipating how the other will react.

24. Nash Equilibria  Named for John Nash, mathematician and Nobel laureate in economics.  Nash is known as the "father" of non-cooperative game theory  He proved the existence of equilibrium in all well-defined games in his doctoral dissertation at Princeton.  Definition  A set of strategies, one for each player, such that no player has incentive to unilaterally change her action.  Players are in an equilibrium if a change in strategies by any one of them would lead that player to earn less than if she remained with her current strategy.  Practice (the only way to learn this material)  http://www.5stone.net/en/ http://www.5stone.net/en/  http://www.gametheory.net/Mike/applets/PDilemma/Pdilemma.html http://www.gametheory.net/Mike/applets/PDilemma/Pdilemma.html

25. Discussion  Key learnings?  Next weeks assignments.