Pricing Strategies for the Firm Chapter 10

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Markup Pricing Calculating the price of a product by determining the average cost of producing the product and then setting the price a given percentage above that cost. Optimal markup: m = -1 ÷ (1 + ep), where, m = markup and ep = price elasticity of demand Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Optimal Markups Elasticity Calculation Markup -2.0 m = -[1/(1 - 2)] = +1.00 1.00 or 100% -5.0 m = -[1/(1 – 5)] = +.25 0.25 or 25% -11.0 m = -[1/(1 - 11)] = +0.10 0.10 or 10% ∞ m = -[1/(1 - ∞)] = 0 0.00 (no markup) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Studies of Markup Pricing The 1958 Lanzillotti study concluded that the goal of the companies studied was to earn a predetermined target rate of return on their investment. In 1988, Kenneth Elzinga updated the Lanzillotti study and found that most of the 20 original firms earned a lower rate of return in subsequent years compared with the original study period. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Markup Pricing Examples Restaurant Industry. The divergence between the prices restaurants charge and the costs of producing the menu items goes far beyond the traditional view that the markup on liquor is much greater than the markup on food items. Markups on mussels can reach 650 percent, while those on salmon can exceed 900 percent. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Price Discrimination Price discrimination is the practice of charging different prices to various groups of customers that are not based on differences in the costs of production. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Requirements for Successful Price Discrimination Firms must possess some degree of monopoly or market power that enables them to charge a price in excess of the costs of production. Firms must be able to separate customers into different groups that have varying price elasticities of demand. Firms must be able to prevent resale among the different groups of customers. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

First Degree Price Discrimination A pricing strategy under which firms with market power are able to charge individuals the maximum amount they are willing to pay for each unit of the product. The Internet offers many opportunities for first degree price discrimination. Amazon.com tracks the purchases of its customers, adjusts prices, and recommends additional related books in subsequent sessions. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Second Degree Price Discrimination A pricing strategy under which firms with market power charge different prices for different blocks of output. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Third Degree Price Discrimination A pricing strategy under which firms with market power separate markets according to the price elasticity of demand and charge a higher price (relative to cost) in the market with the more inelastic demand. Dell Computer Corporation has made extensive use of this pricing strategy. In June 2001, its Latitude L400 ultralight laptop was listed at $2,307 on the company’s Web page directed to small businesses, at $2,228 for sales to health care companies, and at $2,072 for sales to state and local governments. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination - Versioning Offering different versions of a product to different groups of customers at various prices, with the versions designed to meet the needs of the specific groups. Book publishers have long used versioning when they publish a hardcover edition of a book and then wait a number of months before the cheaper paperback edition is released. Astro Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination - Bundling Bundling involves selling multiple products as a bundle where the price of the bundle is less than the sum of the prices of the individual products or where the bundle reduces the dispersion in willingness to pay. Microsoft Office bundles its products together, but also sells them separately. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination: Coupons and Sales - Promotional Pricing Using coupons and sales to lower the price of the product for those customers willing to incur the costs of using these devices as opposed to lowering the price of the product for all customers. Those individuals who clip coupons or watch newspaper advertisements for sales are more price sensitive than consumers who do not engage in these activities, and they are also willing to pay the additional costs of the time and inconvenience of clipping the coupons and monitoring the sale periods. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall

Price Discrimination: Two - Part Pricing Charging consumers a fixed fee for the right to purchase a product and then a variable fee that is a function of the number of units purchased. This is a pricing strategy used by buyers clubs, athletic facilities, and travel resorts where customers pay a membership or admission fee and then a per-unit charge for the various products, services, or activities as members. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall