Managerial Economics & Business Strategy Chapter 11 Pricing Strategies for Firms with Market Power

Standard Pricing and Profits Price Profits from standard pricing = $8 10 8 6 4 2 MC=AC P = 10 - 2Q 1 2 3 4 5 Quantity MR = 10 - 4Q

Price Discrimination Defined as: Purpose: Caveat: the practice of charging different prices to consumers for the same good or service Purpose: to extract consumer surplus and increase firm profits. Caveat: in order for price discrimination to work consumers who pay a lower price are not able to resell the good to consumers willing to pay a higher price (i.e., no arbitrage possibilities)

First-Degree or Perfect Price Discrimination Practice of charging each consumer their maximum willlingness-to-pay Permits a firm to extract all surplus from consumers Nearly impossible Examples: car salesman who is able to “perfectly size up” his customers

Perfect Price Discrimination Profits: .5(4)(10 - 2) = $16 10 8 6 4 Total Cost 2 MC D 1 2 3 4 5 Quantity

Second Degree Price Discrimination The practice of charging different prices for different quantities of the same good. Examples: soup, electricity, items sold in bulk, and block pricing which is encouraged when scale economies exist $10 D $8 $5 $3 AC MC 2 4 MR Quantity

Third Degree Price Discrimination The practice of charging different groups of consumers different prices for the same product Based on Time, Consumer Characteristics, or geographic location Examples include student discounts, senior citizen’s discounts, coupons, rebates, matinees, long-distance telephone service, best-selling novels (hard vs. soft), new technologies (e.g., DVD players)

Third Degree PD To maximize profits, the firm should equate MR from selling Q to each group to MC MR1=MC and MR2=MC; thus firm should allocate Q among the 2 groups such that MR1=MR2=MC. Suppose E1 < E2 Thus, group 1 will be charged a lower price than group 2. Senior citizen or student discounts Those who clip coupons Matinees

An Example BMW can produce any quantity of cars at a constant MC equal to $15,000, and a FC of $20 million. You are asked to advise the CEO as to what prices and quantities BMW should set for sales in Europe and in the US. The demand for BMW’s in each market is given by QE=18,000 – 400PE QU=5500 – 100PU Assume that BMW can restrict US sales to authorized dealers only.

Two-Part Pricing Two-part pricing consists of a fixed fee and a per unit charge. Works well when consumer demands are relatively homogeneous. Examples: golf club memberships, Costco, cell phone services, Gillette razors.

How Two-Part Pricing Works Price 1. Set price at marginal cost. 2. Compute consumer surplus. 3. Charge a fixed-fee equal to consumer surplus. 10 8 6 Fixed Fee = Profits = $16 Per Unit Charge 4 2 MC D 1 2 3 4 5 Quantity

An Example As the owner of the only tennis club in an isolated wealthy community, you must decide on membership dues and fees for court time. There are 2 types of tennis players (serious and occasional) with the following demands QS = 6 – PS QO = 3 – 0.5PO where Q is court hours per week, and P is the fee per hour for each individual player. Assume that there are 1000 players of each type, the MC of court time is zero, FC are $5000 per week, and serious and occasional players look alike so you must charge the same price. You only want S players. What should you charge for annual dues and court fees? Could you increase profits by selling to both types?

Commodity Bundling The practice of bundling two or more products together and charging one price for the bundle. Mixed Bundling the practice of selling goods separately or as a bundle Good when: Heterogeneous consumer demands Can’t PD Consumer demands are negatively correlated Examples Vacation packages Computers and software Film and developing McDonald’s

An Example that Illustrates Kodak’s Moment Total market size is 4 million consumers Four types of consumers 25% will use only Kodak film 25% will use only Kodak developing 25% will use only Kodak film and use only Kodak developing 25% have no preference Zero costs (for simplicity) Maximum price each type of consumer will pay is as follows:

Reservation Prices for Kodak Film and Developing by Type of Consumer

Optimal Film Price? Optimal Price is $8, to earn profits of $8 x 2 million = $16 Million At a price of $4, only first three types will buy (profits of $12 Million) At a price of $3, all will types will buy (profits of $12 Million)

Optimal Price for Developing? At a price of $6, only “B” type buys (profits of $6 Million) At a price of $4, only “B” and “FD” types buy (profits of $8 Million) At a price of $2, all types buy (profits of $8 Million) Optimal Price is $3, to earn profits of $3 x 3 million = $9 Million

Total Profits by Pricing Each Item Separately? $16 Million Film Profits + $9 Million Development Profits =$25 Million Let’s see if the firm can earn even greater profits by bundling

Consumer Valuations of a Bundle

What’s the Optimal Price for a Bundle? Optimal Bundle Price = $10 (for profits of $30 million)

Cross-Subsidies Prices charged for one product are subsidized by the sale of another product May be profitable when there are significant demand complementarities Example Adobe Reader and Adobe Acrobat

Pricing in Markets with Intense Price Competition Price Matching Advertising a price and a promise to match any lower price offered by a competitor. Such strategies weaken the incentives for rivals to undercut any given store’s price, thus Each firm charges the monopoly price and shares the market. Randomized Pricing A strategy of constantly changing prices. Decreases consumers’ incentive to shop around as they cannot learn from experience which firm charges the lowest price. Reduces the ability of rival firms to undercut a firm’s prices.