Managerial Economics and Organizational Architecture, 5e Chapter 7: Pricing with Market Power Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved. McGraw-Hill/Irwin

Pricing Objective Pricing is key to managerial decision making Firms with market power can raise prices without losing all customers to competitors A firm has market power when it faces a downward sloping demand curve 7-2

Pricing Assume profit maximization Implies single period pricing strategies Firms wish to capture as much consumer surplus as possible Consumer surplus is the difference between what the consumer is willing to pay and what the consumer actually pays 7-3

Pricing with Market Power $ Consumer surplus Price (in dollars) Demand MC Q Quantity 7-4

The Benchmark Case: single price per unit Intuit data: Purchases software from manufacturer for $10 Demand curve is P = 85 - 0.5Q (Q in 1000s 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) 7-5

Single Price per Unit Checkware $ 85.00 With MC=10, the optimal output is 75 with a price of $47.50 P*= 47.50 Price (in dollars) Demand 10.00 MC MR Q Q* = 75 170 Quantity of Checkware 7-6

Cost Issues Relevant costs sunk costs are irrelevant current opportunity costs are relevant historical costs are irrelevant 7-7

Pricing Strategy price elasticity, , is a measure of price sensitivity Optimal price is P=MC/[1-1/ ] For MC = 10, if  = 2, then P = 10/[1 – ½] = 20 For MC = 10, if  = 3, then P = 10/[1 – 1/3] = 15 7-8

Price Sensitivity and Optimal Markup The optimal markup is higher for the less elastic demand $ $ 85.00 85.00 Price (in dollars) P*= 47.50 42.50 Demand P*= 26.25 Demand MC 10.00 MC 10.00 MR Q MR Q Q* = 75 Q* = 65 170 170 Quantity of Checkware Quantity of Illustrator Less elastic demand More elastic demand 7-9

Price Sensitivity In the original example  = 1.267 For Illustrator,  = 1.615 P = 10/[1 – 1/1.615] = 26.25 7-10

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. Such pricing should be product specific and based on awareness of price sensitivity. 7-11

Linear Approximation Suppose firm currently sells 30 units at $70 Firm estimates that by lowering price to $65 it will sell 40 units This information can be used to approximate a linear demand curve 7-12

Linear Approximation Slope = (65-70)/(40-30) = -0.5 the intercept is calculated using P = a - 0.5Q When price is $70, the intercept is $70 = a - 0.5(30) a = 85 Demand is estimated as: P=85 – 0.5Q 7-13

Cost-Plus Pricing Add a markup to average total cost to yield target return Must account for price sensitivity Consistently bad pricing policies are not good for the firm’s long-term fiscal health 7-14

where * indicates estimated value 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 7 - 15

Potential for Higher Profits $ Consumer surplus b Firm profits a c Unrealized gains from trade P* e Price (in dollars) Demand d f MC MR Q Q* 170 Quantity of Checkware 7-16

Block Pricing Declining price on subsequent blocks of product Takes advantage of consumers’ lower marginal value for additional units Seen in product packaging 7-17

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 Used at country clubs, health clubs, college football 7-18

Two-Part Tariff capturing consumer surplus $ $10 Charge an upfront fee equal to consumer surplus Profits will equal the area of the consumer surplus, $42.50 Price (in dollars) Demand Charge a price of $1 per unit and sell 9 units MC $1 Q 7-19 Q*=9 Quantity

Price Discrimination heterogeneous 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 7-20

Using Information About Individuals Personalized pricing “first degree” price discrimination Extract maximum amount each customer is willing to pay possible only with small number of buyers Group pricing “third degree” price discrimination very common (utilities, theaters, airlines…) 7-21

Group Pricing If two groups have different elasticities of demand, the charge a higher price to the group with the more inelastic demand. Us the markup rule: P*=MC*/(1-1/*) Apply it for each elasticity to get the different prices If the elasticities are 2.33 and 1.55 and MC=$10, then markup the price to $17.50 and $30, respectively. 7-22

Optimal Pricing at Snowfish different demand elasticities $ 50.00 50.00 η* = 1.50 Price (in dollars) P*= 30.00 25.00 η* = 2.33 P*=17.50 10.00 MC 10.00 MC MR MR Q* = 200 Q* = 150 Quantity of passes for out-of-town skiers Quantity of passes for local skiers 7-23

Using Information About the Distribution of Demands Menu pricing “second degree” price discrimination consumers select preferred package Companies often use different versions of their product – deluxe, basic, etc. Coupons and rebates users likely more price sensitive users who are new customers may stick with product 7-24

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 7-25