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Pricing with market power
McGraw-Hill/Irwin
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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.
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Pricing with market power
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Single price per unitCheckware
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Price sensitivity and optimal markup
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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!
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Potential for higher profits
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Two-part tariffcapturing consumer surplus
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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…)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Optimal pricing at Snowfish
different demand elasticities
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.