PRICING POLICY & STRATEGIC THINKINGMBA NCCU

Managerial Economics

Jack Wu

PRICING POLICY

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

Low season; min. 7 days, max. 4 mths stay

AED 1200

EMIRATES AIRLINE, MUMBAI-DUBAI, ECONOMY CLASS, MAY 2004

Fare Restrictions Price

Economy unrestricted LRT

None INR 25,600

(US$ 557)

Economy restricted LRTIN1

None 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

EMIRATES AIRLINE

Why does Emirates charge lower fare for passengers originating from Mumbai?

How is this discrimination possible?

PRICING POLICY

uniform pricing complete price discrimination direct segment discrimination indirect segment discrimination bundling

0

30

55

80

2500 5000

marginal revenue

marginal cost

demand

Quantity (Units a year)

Pri

ce (

Thousa

nd Y

en p

er

unit

)

UNIFORM PRICING

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

PRICE ELASTICITY

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

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?

UNIFORM PRICING: SHORTCOMINGSSHORTCOMINGS

leaves buyers with a lot of surplus

does not sell to every potential buyer

marginal cost

price

buyer surplus

potential buyers

$

0quantity

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

COMPLETE PRICE DISCRIMINATION: PRACTICE

bargaining auctions

DIRECT SEGMENT DISCRIMINATION, I

price by segment implementation

� fixed identifiable characteristic --- basic for segmentation

� no re-sale

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%)

0

30

55

80

25003000

Quantity (Units a year)

Pri

ce (

Thousa

nd Y

en p

er

unit

)

(a) Men’s demand

0

30

50

Quantity (Units a year)

Pri

ce (

Thousa

nd Y

en p

er

unit

)

(b) Women’s demand

marginal revenue

demand

40

1000

marginal revenue

demand

marginalcost

DIRECT SEGMENT DISCRIMINATION, III

marg.cost

NYNEX TELEPHONE SERVICE

New York City residential -- $16/month business -- $23/monthHow is discrimination possible?

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

Why different prices for print edition but not interactive edition?

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

Traveler

Segment

Unrestricted Travel ($)

Restricted Travel ($)

Maria Business 1000 200 Tom Business 900 180 Robin Vacation 500 400 Leslie Vacation 280 224

AIR TRAVEL: BENEFITS

Product

Fare ($)

Sales

Total Rev. ($)

Total Cost ($)

Profit ($)

Unrestricted

900 2 1800 400 1400

Restricted 399 1 399 200 199

*MC=200

AIR TRAVEL: INDIRECT SEGMENT DISCRIMINATION

CHINESE EMBASSY: VISA FEES

Application period

1 day 3 days 7 days

Single entry $75 $60 $25

Double entry $85 $70 $35

Profitability Policy Information Requirement

Highest Complete price discrimination

Highest

Direct segment discrimination

Indirect segment discrimination

Lowest Uniform pricing Lowest

PRICING POLICIES: RANKING

BUNDLING strategy

pure bundling mixed bundling

CABLE TELEVISION: BENEFITS

“if every segment … was wild about one thing and hated the rest, they have done their job” (Economist) Segment Education

channel Music channel

Conservatives $20 $ 2

Middle of road $11 $11

PURE OR MIXED BUNDLING

What is the profit-maximizing pricing policy if marginal cost per channel = 0 marginal cost per channel = $5

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

STRATEGIC THINKING

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

CASE: COKE VS. PEPSI, 1999

COMPETITIVE DILEMMA

Pepsi

Raise price Discount

Raise price

C: 3, P: 3

C: 0, P: 5

Coke Discount C: 5,

P: 0 C: 1, P: 1

What should Coke do?

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

DOMINATED STRATEGY

generates worse consequences than another strategy, regardless of the choices of the other parties

never use dominated strategy

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

SOLVING FOR NASH EQUILIBRIUM

eliminate dominated strategies, then check remaining cells

“arrow” technique

NASH EQUILIBRIUM: COMPETITIVE DILEMMACOMPETITIVE DILEMMA

Pepsi

Raise price Discount

Coke

Raise priceC: 3,

P: 3

C: 0,

P: 5

DiscountC: 5,

P: 0

C: 1,

P: 1

What should Coke do?

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.

NASH EQUILIBRIUM: PRISONERS’ DILEMMAPRISONERS’ DILEMMA

Sam

Do not confess

Confess

Ian

Do not confess

I: 0,

S: 0

I: -10,

S: 0

ConfessI: 0,

S: -10

I: -5,

S: -5

What should Sam do?

No Nash equilibrium in pure strategies

Competitor.com

NBA NHL

NBA W: 4, C: 3

W: 3, C: 4

We.com NHL W: 3,

C: 4 W: 4, C: 3

WHERE TO ADVERTISE?

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

RANDOMIZED STRATEGIES: RETAIL PRICE COMPETITIONRETAIL PRICE COMPETITION

Pricing trade-off: high price to extract buyer surplus of loyal

customers low price to get store switchers

Solution: randomized discounts

COORDINATION/COMPETITION: EVENING EVENING NEWSNEWS

Delta

7.30pm 8.00pm

Zeta

7.30pmA: 1,

B: 1

A: 3,

B: 4

8.00pmA: 4,

B: 3

A: 2.5,

B: 2.5

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

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

COORDINATION/COMPETITION:FUTURE DVD STANDARD

Consumers

Blu-ray HD-DVD

DVD player manuf-acturers

Blu-rayM: 1,

C: 1

M: -1,

C: -1

HD-DVDM: -1,

C: -1

M: 1,

C: 1

COORDINATION/COMPETITION: FOCAL FOCAL POINTPOINT

Single Nash equilibrium - clear focal point

Multiple Nash equilibria - look for focal point to see which one to play

SEQUENCING

Game in extensive form – sequence of moves:

nodesbranchesoutcomes

EXTENSIVE FORM: EQUILIBRIUM

backward induction final nodes intermediate nodes initial node

SEQUENCING: EXTENSIVE FORMEXTENSIVE FORM - TV NEWS- TV NEWS

STRATEGIC MOVE

Action to influence beliefs or actions of other parties in a favorable way

• credibility– first mover advantage– second mover advantage

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

consumer

Litho

LithoMake prints

Do not

Buy

Do not

Make more prints

Do not

(1) serial number (2) destroying the plate(3) other solution?

LITHOGRAPHER

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

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?

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.

Sharon

Hilda

acquires 100,000shares

doesn’t bid

does not

activates rights

Hilda loses on initial stake + cost of takeover rises

POISON PILL

Union

Employer

reject union demand

accept

do not

strike Lose current wageand possibly gain infuture wage

Maintain current wage

Why are strikes rare inAmerican professional football?

STRIKE

CONDITIONAL STRATEGIC MOVE: WITHOUT DEPOSIT INSURANCE

depositor

maintains deposit

withdraws deposit

bank insolvent

bank remains solvent

principal + interest

zero

depositor

principal

principal

bank remains solvent

bank insolvent

CONDITIONAL STRATEGIC MOVE: WITH DEPOSIT INSURANCE

depositor

maintains deposit

withdraws deposit

bank insolvent

bank remains solvent

principal + interest

principal

depositor

principal

principal

bank remains solvent

bank insolvent