1. 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

2. 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
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3. 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
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4. Pricing with Market Power$
Consumer surplus
Price (in dollars)
Demand MC Q
Quantity
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5. The Benchmark Case: single price per unit
Intuit data:
Purchases software from manufacturer for $10
Demand curve is P = Q (Q in 1000s of units)
What is the profit-maximizing price?
Set MR = MC
85-Q=10
Q=75, P= $47.50
Profit is $2, (000s)
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6. Single Price per Unit Checkware$
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
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7. Cost Issues Relevant costs sunk costs are irrelevant
current opportunity costs are relevant
historical costs are irrelevant
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8. 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
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9. 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
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10. Price Sensitivity In the original example  = 1.267
For Illustrator,  = 1.615
P = 10/[1 – 1/1.615] = 26.25
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11. 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.
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12. 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
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13. 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
$70 = a - 0.5(30)
a = 85
Demand is estimated as:
P=85 – 0.5Q
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14. Cost-Plus Pricing
Add a markup to average total cost to yield target return
Must account for price sensitivity
Consistently bad pricing policies are not good for the firm’s long-term fiscal health
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15. where * indicates estimated value
Mark-Up Pricing
Optimal mark-up rule of thumb:
P*=MC*/(1-1/*)
where * indicates estimated value
Requires some knowledge or awareness of both marginal costs and elasticity
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16. Potential for Higher Profits$
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
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17. Block Pricing Declining price on subsequent blocks of product
Takes advantage of consumers’ lower marginal value for additional units
Seen in product packaging
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18. 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
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19. 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
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Q*=9
Quantity

20. 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
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21. 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…)
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22. 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 $30, respectively.
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23. Optimal Pricing at Snowfish different demand elasticities$
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
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24. 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
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25. 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
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