Pricing with market power

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Pricing with market power learning objectives

• Students should be able to• Explain the role of elasticity in

optimal pricing• Identify circumstances appropriate

for price discrimination• Apply selected pricing techniques

consistent with maximum profit

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Pricing objective

A firm has market power if…...it faces a downsloping demand curve.

The firm’s pricing objective is……to maximize shareholder value.

The demand curve reflects……consumer willingness and ability to

buy.

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Pricing with market power

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The benchmark case:single price per unit

Beyond.com data:• Purchases software from manufacturer for

$10• Demand curve is P = 85-.5Q (Q in 000s 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)

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Single price per unitCheckware

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Other single pricing issues• Relevant costs

– sunk costs are irrelevant– current opportunity costs are relevant

• Price sensitivity– price elasticity, , is a measure of price

sensitivity– Optimal price is P*=MC*/[1-1/ *]– A firm with market power should never

operate on the inelastic portion of the demand curve

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Price sensitivity and optimal markup

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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.

• But they must reflect fundamentals!

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Linear approximation

Requirements: estimates of current price (P1), quantity sold (Q1), possible new price (P2), quantity sold with price change (Q2), and marginal cost

A linear demand curve is approximated byP1=a-(P2-P1/Q2-Q1)Q1; solve for a

More generally, P=a-bQ

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Cost-plus pricing

• Add a markup to average total cost to yield target return

• Does this ignore incremental costs and price sensitivity?– not if managers have a fundamental

understanding of their markets– consistently bad pricing policies are not

good for the firm’s long term fiscal health

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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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Potential for higher profits

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Homogenous consumer demand

• Block pricing– declining price on subsequent blocks of

product– product packaging

• 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

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Two-part tariffcapturing consumer surplus

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Price discriminationheterogeneous 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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Using information about individuals

• Personalized pricing– “first degree” price discrimination– possible only with small number of

buyers

• Group pricing– “third degree” price discrimination– very common (utilities, theaters,

airlines…)

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Group pricingexample

Snowfish Ski Resort demand curvesOut of town: Qo=500-10P

Local: Ql=500-20P

Total: Q=1000-30POne-price profit: P*=$21.66, Q*=350,

Qo*=283, Ql*=67, Profit=$4,081

Two-price profit: Po*=$30, Qo*=200, Pl*=17.50, Ql*=150, Profit=$5,125

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Optimal pricing at Snowfish

different demand elasticities

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Using information about the distribution of

demands• Menu pricing

– “second degree” price discrimination– consumers select preferred package

• Coupons and rebates– users likely more price sensitive– users who are new customers may

stick with product

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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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