1. Pricing Policy & Strategic Thinking
MBA NCCU
Managerial Economics
Jack Wu

2. Pricing Policy

3. Case: Emirates Airline, Dubai-Mumbai, Economy class, May 2004
Fare
Restrictions
Price
Year KRTAE1
None
AED 2250
(US$ 613)
Special Excursion QEE4MAE1
Min. 7 days, max. 4 mths stay
AED 1900
Basic Season Special Excursion LLE4MAE1
Low season; min. 7 days, max. 4 mths stay
AED 1550
Basic Season Special Excursion VLE4MAE1
AED 1200

4. Emirates Airline, Mumbai-Dubai, Economy class, May 2004
Fare
Restrictions
Price
Economy unrestricted LRT
None
INR 25,600
(US$ 557)
Economy restricted LRTIN1
INR 22,700
Regular Excursion LEE3M1
Min. 7 days, max. 3 mths stay
INR 20,100
Special Excursion VEE3MIN1
Max. 3 mths stay.
INR 17,000

5. Emirates Airline
Why does Emirates charge lower fare for passengers originating from Mumbai?
How is this discrimination possible?

6. Pricing Policy uniform pricing complete price discrimination
direct segment discrimination
indirect segment discrimination
bundling

7. UNIFORM PRICING marginal cost demand marginal revenue 80
Price (Thousand Yen per unit) 55
marginal cost 30
demand
marginal revenue
2500
5000
Quantity (Units a year)

8. Uniform Pricing: Profit Maximum
MR = MC
Equivalently, set the incremental margin percentage equal to the inverse of absolute value of price elasticity of demand,
(price - MC) / price = -1/e

9. Price Elasticity e = -1.5  IM% = 2/3
always set price so that demand is elastic
if demand more elastic, then lower incremental margin percentage (IM%) e = -2  IM% = 1/2
e = -1.5  IM% = 2/3

10. Pricing Private-Label Cola
Suppose that WalMart learns that demand for private-label cola is less elastic than the demand for Coca Cola. Should WalMart set a higher price for private-label cola?

11. Uniform Pricing: Shortcomings
marginal cost
price
buyer surplus
potential buyers $
quantity
leaves buyers with a lot of surplus
does not sell to every potential buyer
A new picture from IP’s presentation

12. Complete Price Discrimination
price each unit at buyer’s benefit and sell quantity where MB = MC
maximum profit -- theoretical ideal
different from MR = MC
implementation: must know entire marginal benefit and marginal cost curves

13. Complete Price Discrimination: Practice
bargaining
auctions

14. Direct Segment Discrimination, I
price by segment
implementation
fixed identifiable characteristic --- basic for segmentation
no re-sale

15. Direct Segment Discrimination, II
simple case: uniform price within each segment
within each segment IM% = -1/e
for segment with more elastic demand, then lower incremental margin percentage (IM%)

16. DIRECT SEGMENT DISCRIMINATION, III
(a) Men’s demand
(b) Women’s demand
demand 80
Price (Thousand Yen per unit)
Price (Thousand Yen per unit) 55 50
marginal
revenue
marginal
cost 40
marg.
cost 30 30
demand
marginal revenue
2500
3000
1000
Quantity (Units a year)
Quantity (Units a year)

17. NYNEX Telephone Service
New York City
residential -- $16/month
business -- $23/month
How is discrimination possible?

18. Asian Wall Street Journal
Price for annual subscription, May 2006
Print: Hong Kong (HK$ 2,700)
US$ 348
Print: Singapore (S$ 525)
US$ 331
Print: Tokyo (Yen 94,500)
US$ 845
Interactive: Worldwide
US$ 99
p.241, IP
Why different prices for print edition but not interactive edition?

19. Indirect Segment Discrimination
structure choice to earn different incremental margins from each segment
implementation
seller controls some variable to which segments are differentially sensitive
buyers cannot circumvent the variable

20. AIR TRAVEL: BENEFITS
Air Travel: Indirect Segment Discrimination

21. AIR TRAVEL: INDIRECT SEGMENT DISCRIMINATION
*MC=200

22. Chinese Embassy: Visa Fees
Application period
1 day
3 days
7 days
Single entry
$75
$60
$25
Double entry
$85
$70
$35
Source: Chinese Embassy, Singapore, September 2000

23. PRICING POLICIES: RANKING

24. Bundling
strategy
pure bundling
mixed bundling

25. Cable Television: Benefits

26. Pure or Mixed Bundling What is the profit-maximizing pricing policy if
marginal cost per channel = 0
marginal cost per channel = $5
Generally,
if item is costless, no loss from giving it to every consumer --> pure bundling;
if item is costly, then should avoid providing it to low-benefit users --> use mixed bundling to screen out low-benefit users.
Mixed bundling is form of indirect segment discrimination
structured choice between bundle and separates

27. Pure or Mixed Bundling Generally,
if item is costless, no loss from giving it to every consumer --> pure bundling;
if item is costly, then should avoid providing it to low-benefit users --> use mixed bundling to screen out low-benefit users.
Mixed bundling is form of indirect segment discrimination
structured choice between bundle and separates

28. Strategic Thinking

29. Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9%
Case: Coke vs. Pepsi, 1999
Nov. 16: Coca-Cola raised price 7%
Nov. 22: Pepsi raised price 6.9%
“Coke and Pepsi will move now from price-based competition to marketing-based competition”,
Andrew Conway, Morgan Stanley 2

30. What should Coke do? Competitive Dilemma 5
Nash equilibrium: for both parties, “raise price” is dominated by “discount”.
but discounting is bad for both -- if only they could agree somehow to raise price.
Coke and Pepsi stuck in this situation for four years until November 1999.
What should Coke do? 5

31. Strategic Situations
parties actively consider the interactions with one another in making decisions
game theory -- set of ideas and principles to guide strategic thinking
simultaneous actions: strategic form
sequential actions: extensive form

32. Dominated Strategy
generates worse consequences than another strategy, regardless of the choices of the other parties
never use dominated strategy

33. Nash Equilibrium
Given that the other players choose their Nash equilibrium strategies, each party prefers its own Nash equilibrium strategy
No one is willing to deviate unilaterally from a Nash equilibrium

34. Solving for Nash Equilibrium
eliminate dominated strategies, then check remaining cells
“arrow” technique

35. Nash equilibrium: Competitive dilemma
Pepsi
Raise price
Discount
Coke
C: 3,
P: 3
C: 0,
P: 5
C: 5,
P: 0
C: 1,
P: 1
From [IP] 10strt-ap-wo
What should Coke do?

36. Coke and Pepsi Game
Nash equilibrium: for both parties, “raise price” is dominated by “discount”.
but discounting is bad for both -- if only they could agree somehow to raise price.
Coke and Pepsi stuck in this situation for four years until November 1999.

37. Nash equilibrium: Prisoners’ dilemma
Sam
Do not confess
Confess
Ian
Do not confess
I: 0,
S: 0
I: -10,
S: -10
I: -5,
S: -5
From [IP] 10strt-ap-wo
What should Sam do?

38. No Nash equilibrium in pure strategies
WHERE TO ADVERTISE?
No Nash equilibrium in pure strategies 8

39. Randomized Strategies
choose among pure strategies according to probabilities
must be unpredictable
Example: where to advertise
_ We.com: ½ NBA and ½ NHL
_ Competitor.com: ½ NBA and ½ NHL

40. Randomized strategies: Retail price competition
Pricing trade-off:
high price to extract buyer surplus of loyal customers
low price to get store switchers
Solution: randomized discounts
From [IP] 10strt-ap-wo

41. Coordination/competition: Evening news
Delta
7.30pm
8.00pm
Zeta
A: 1,
B: 1
A: 3,
B: 4
A: 4,
B: 3
A: 2.5,
B: 2.5
From [IP] 10strt-ap-wo

42. Coordination and Competition
Prime time for news is 8:0pm; second best is 7:30pm;
since audience is limited, get maximum viewership if two channels schedule at different times.
Question: which station gets 8:0pm? Situation has elements of
coordination -- avoiding same time slot
competition -- getting the 8:0pm slot

43. Zero/Positive Sum
zero-sum games: pure competition -- one party better off only if other is worse off
positive-sum games: coordination -- both can be better off or both worse off
co-opetition: competition and coordination

44. Coordination/competition: Future DVD standard
Consumers
Blu-ray
HD-DVD
DVD player manuf- acturers
M: 1,
C: 1
M: -1,
C: -1
Similar problem in mid-1990s: adoption of new 56kbps modem for data communications.
New technology assumed that ISP connected to exchange by digital circuit; economized on conversion, so offers higher speed;
Market was frozen: for technology to work, both IAP (Internet access provider) and end-user must acquire matching modems;
IAP and end-users daren’t buy modems for fear of buying the wrong technology – needed to coordinate
Eventually settled: 3Com (belonging to Rockwell alliance) bought US Robotics;
Two standards harmonized as ITU standard

45. Coordination/Competition: Focal Point
Single Nash equilibrium - clear focal point
Multiple Nash equilibria - look for focal point to see which one to play *

46. nodes branches outcomes Sequencing
Game in extensive form – sequence of moves:
nodes
branches
outcomes
In some strategic situations, players act in sequence;
examples: takeover bidding; tennis; Sotheby’s bidding; tic-tac-toe;
use different model to analyze sequential moves -- game in extensive form: explicitly shows
timing of moves
node -- where party must choose an action
branches leading from a node represent the possible choices
outcome after each move

47. Extensive Form: Equilibrium
backward induction
final nodes  intermediate nodes  initial node

48. Sequencing: Extensive Form - TV News
Fig.2 17

49. Strategic Move credibility first mover advantage
Action to influence beliefs or actions of other parties in a favorable way
credibility
first mover advantage
second mover advantage

50. Examples
Examples:
Evening TV news -- both stations want to move first: which one can?
Use strategic move, eg, contracts with advertisers to deliver news at 8pm.
Famous Chinese general: after crossing a river, burnt his ships -- strategic move to force soldiers to fight harder.
Issue: Is the move credible? Will it convince the other players?
Advantage doesn’t always go to first mover;
In war, better to see opponent’s move, and then take action, eg is enemy moving south or north?
new product category -- let competitor test the market and educate the customers

51. (2) destroying the plate (3) other solution?
Lithographer
Make more prints
Buy
Litho
Make prints
consumer
Do not
Do not
Litho
(1) serial number
(2) destroying the plate
(3) other solution?
Do not 20

52. Conditional Strategic Moves
Threats – if it succeeds, then it needn’t be carried out
Promises – if it succeeds, then it needn’t be carried out
Ideal strategic move doesn’t impose costs
Strategic move may be very costly, eg,
upon arriving in Mexico, Cortes dismantled his ships;
similar example in Chinese history
lithographer destroys plates
Ideal -- strategic move that doesn’t impose costs:
threat: if it succeeds, then needn’t be carried out
promise: if it succeeds, then needn’t be carried out
Examples of promises:
Lithographer: put money in escrow, and offer to buy back prints from dissatisfied customers. If successful, then no buybacks.
United States Federal Deposit Insurance Corporation (FDIC) guarantees deposits of up to $100,000 at participating banks. FDIC’s promise aims to forestall bank runs. If successful, then FDIC doesn’t spend anything. 22

53. MORGAN STANLEY: “SHAREHOLDER RIGHTS PLAN”
If any party acquires 10% or more of company’s shares, other shareholders get right to buy additional shares at 50% discount.
Impact on hostile bidder? 23

54. Shareholder Rights Plan
This shareholder rights plan is a threat to potential bidders:
most hostile bidders begin with small stake;
with shareholder rights plan, if bidder acquires more than 10%, then rights triggered, and bidder will be diluted.
Nickname: poison pill.
Actually works against shareholder rights -- by entrenching existing management.

55. Poison Pill Hilda loses on initial stake + cost of takeover rises
activates rights
acquires 100,000
shares
Sharon
Hilda
does not
doesn’t bid 25

56. American professional football?
Strike
Lose current wage
and possibly gain in
future wage
strike
reject union
demand
Union
do not
Maintain current
wage
Employer
accept
Why are strikes rare in
American professional football? 27

57. Conditional strategic move: Without deposit insurance
bank insolvent
bank remains solvent
principal + interest
zero
depositor
depositor
maintains deposit
withdraws deposit
principal
bank remains solvent
bank insolvent
For depositor, no dominant strategy:
maintain deposit
benefit -- small amount of interest
risk – lose entire principal
withdraw deposit – no interest, but safety of principal
critical factor– perceived probability that bank will become insolvent
if probability sufficiently high, depositor would withdraw immediately on hearing rumors
Next transparency: deposit insurance
if there is a bank run, depositor will only suffer inconvenience
working back to initial node, depositor would not withdraw immediately on hearing rumors

58. Conditional strategic move: With deposit insurance
bank insolvent
bank remains solvent
principal + interest
principal
depositor
depositor
maintains deposit
withdraws deposit
principal
bank remains solvent
bank insolvent
With deposit insurance
if there is a bank run, depositor will only suffer inconvenience
working back to initial node, maintaining deposit is dominant strategy
depositor would not withdraw immediately on hearing rumors
Good example of promise
U.S. Federal Deposit Insurance Corporation (FDIC) guarantees deposits of up to $100,000 at participating banks.
FDIC’s promise aims to forestall bank runs.
If successful, then FDIC doesn’t spend anything.