ECON 202: Principles of Microeconomics Chapter 15 Pricing Strategy

Pricing Strategy Pricing Strategy, the Law of One Price, and Arbitrage. Price Discrimination. Odd Pricing and Cost-Plus Pricing. Pricing with Two-Part Tariffs. Pricing with Different Types of Customers and Asymmetric Information. ECON 202: Princ. of Microeconomics Princing Strategy

Introduction Until now, we have assumed that firms charge a single price for the good they are selling. However, in real world, many times firms: Charge different prices to different consumers. Charge two-part prices. Offer only fixed bundles. We will analyze those cases and see what is the economic rationality guiding these decisions. ECON 202: Princ. of Microeconomics Princing Strategy

1. Pricing Strategy, the Law of One Price, and Arbitrage Identical products should sell for the same price everywhere. When law of one price does not hold, opportunities for arbitrage appear. Buy cheap and sell more expensive in a different “location”. Arbitrage will make almost all price differences in price in different locations disappear. Even with arbitrage, some price difference can persist among locations because of transaction costs. Law of one price holds exactly only if transaction costs are zero. Differences in prices among firms can be explained by monopolistic competition model. Differentiated products. ECON 202: Princ. of Microeconomics Princing Strategy

2. Price Discrimination Price discrimination: Charging different prices to different customers for the same product. Price differences are not explained by differences in cost. Requirements for successful price discrimination: Market power. Different types of customers (willingness to pay). Ability to separate types of customers (no arbitrage). ECON 202: Princ. of Microeconomics Princing Strategy

2. Price Discrimination Less elastic demand pays a higher price. More elastic demand pays a lower price. ECON 202: Princ. of Microeconomics Princing Strategy

2. Price Discrimination Perfect price discrimination If monopolist know the willingness to pay of all the customers, it can charge exactly this willingness to pay to them. ECON 202: Princ. of Microeconomics Princing Strategy

2. Price Discrimination With perfect price discrimination Economic efficiency is improved (no DWL). Profits increase. Consumer surplus disappear. Hard to find real world cases. Price discrimination across time. When new products are introduced, firms can discriminate consumers according to when they buy the new product. Early adopters will likely have a less elastic demand. Hardcover vs. paperback editions. ECON 202: Princ. of Microeconomics Princing Strategy

3. Odd Pricing and Cost-Plus Pricing 80%-90% of products sold in supermarkets have prices ending in “9” or “5”, rather that “0”. Odd pricing creates the illusion of a cheaper price. Higher than actual discount. Experiment using odd pricing in different products showed that increases in demand were higher than expected given previously estimated demand curves. ECON 202: Princ. of Microeconomics Princing Strategy

3. Odd Pricing and Cost-Plus Pricing Adding a percentage markup to average cost. At an average cost of $10 add a markup of 20%: price $12. Cost-plus pricing maximizes profit only when are equal: Cost-plus price, and Price that corresponds to the quantity where MR=MC. Problem with this approach is that ignores information from demand curve and only focuses on costs. Cost-plus pricing may be the best way to determine the optimal price if: Marginal Cost and Average Cost are roughly equal. Demand curve is hard to estimate. ECON 202: Princ. of Microeconomics Princing Strategy

4. Pricing with Two-Part Tariffs When consumers pay one price (or tariff) for the right to buy as much of a related good as they want at a second price. Disneyland, Ipods. ECON 202: Princ. of Microeconomics Princing Strategy

4. Pricing with Two-Part Tariffs With optimal two-part tariff: Outcome is economically efficient: price equals marginal cost at the level of output supplied. All consumer surplus is transformed into profit. ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information In many cases, firms offer different quantities at different prices, such that the price per unit is smaller as quantity increases Cable, internet, sodas. Firms know that customers have different willingness to pay for goods, but their identification is difficult. They try to have customers reveal their type: High-value customers to order the higher priced offer. Low-value customers to order the lower priced offer. Suppose a cable monopolist have 2 customers with different types (high and low), but does not know their identity. ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information Cable company wants to maximize profit by: Charging the highest possible price for each customer. Suppose that the utility is expressed in dollars and marginal cost of channels is $1. ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information Monopoly will offer two packages: 10 channels for $30 dollars (for the high-value). 5 channels for $15 dollars (for the low-value). Customers utility: High-value utility: $30 - $30 = $0 Low-value utility: $15 - $15 = $0 Monopoly profit: ($30+$15) – ($10+$5) = $30 However, high-value can buy the low-value package: High-value utility: $21.25 - $15 = $6.25 making cable company profit fall: ($15+$15) – ($5+$5) = $20 ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information How can the cable company make more profit? Cable company can reduce the price charged to high-value such that her utility from high-value pack is the same than from the low-value pack. New high-value pack: 10 channels for $23.75 High-value customer utility: $30 - $23.75 = $6.25 High value customer obtain same utility with both packs, then will buy high-value pack. No changes for low-value customer. New monopoly profit: ($23.75 + $15) – ($10+$5) = $23.75 Cable company increased profit. ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information Can the cable company increase profit even further? Firm can make less attractive the low-value pack for the high-value customer. New-new low-value pack: 4 channels for $14. Utility from buying new low-value pack: Low-value customer: $14 - $14 = $0 High-value customer: $18 - $14 = $4 Monopoly can increase price of high-value pack, making the high-value customer gain $4 (instead of $6.25). New-new high-value pack: 10 channels for $26 New-new monopoly profit: ($26+$14) – ($10+$4) = $26. ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information ECON 202: Princ. of Microeconomics Princing Strategy

5. Pricing with Different Types of Customers and Asymmetric Information Because of difficulty to identify each type of customer, cable company ends up: Giving some extra benefit to high-value customer in order to make her reveal her identity. Selling a quantity to low-value customer that is lower than efficient level. Price per channel is higher for the low value customer ($14 / 4 = $3.5) than for the high value customer ($26 / 10 = $2.6). Quantity discounts are not only explained by differences in cost, but also by pricing strategies of firms. ECON 202: Princ. of Microeconomics Princing Strategy

ECON 202: Principles of Microeconomics Chapter 15 Pricing Strategy