Special Pricing Practices

Chapter 11
Special Pricing Practices

Managerial Economics: Economic Tools for Todays Decision Makers, 4/e B P By Paul l Keat K t and d Phili Philip Young Y
Special Pricing Policies

Introduction Cartel Arrangements Revenue Maximization Price Discrimination N Nonmarginal i l Pricing Pi i Multiproduct Pricing Transfer Pricing Other Pricing Practices
Managerial Economics, 4/e Keat/Young
2003 Prentice Hall Business Publishing
Introduction Examine pricing decisions made in specific situations. Imperfectly Competitive Markets
Managerial Economics, 4/e
Keat/Young
Cartel Arrangements
Monopoly profits are the largest profits available in an industry. A cartel arrangement occurs when the firms in an industry cooperate and act together as y were a monopoly. p y if they Cartel arrangements may be tacit or formal Illegal in the U.S.
Sherman Antitrust Act, 1890
OPEC
2003 Prentice Hall Business Publishing Managerial Economics, 4/e Keat/Young
Cartel Arrangements Conditions that influence the formation of cartels

Small S ll number b of f firms fi in i the th industry i d t Geographical proximity of the firms Homogeneous products Stage of the business cycle Difficult entry Uniform cost conditions
Cartel Arrangements
In order to maximize profits, the cartel as a whole should behave as a monopolist. monopolist To accomplish this, the cartel determines the output q marginal g revenue with the marginal g which equates cost of the cartel as a whole. The marginal revenue is determined in the usual way (Ch t 9) (Chapter The marginal cost of the cartel as a whole is the horizontal summation of the members members marginal cost curves. , consider a cartel formed by y two firms. To illustrate, The situation is shown in the next graph.
Cartel Arrangements
MCT is the horizontal sum of MC1 and MC2 QT is found at the intersection of MRT and MCT Price is found from the demand curve at QT This is the price that maximizes total industry profits.
Cartel Arrangements
In order to determine how much each firm should produce, draw a horizontal line back from the MRT/MCT intersection. Where this line intersects each individual firms MC determines that firms output, Q1 and Q2. Note that the firms may produce different outputs. The key point is that the marginal cost of the last unit produced is equated across both firms.
Cartel Arrangements
P Profits fit for f each h firm fi are shown h in i blue. bl We W assume that th t each firm earns profits only from its own sales. Firms may y earn different levels of profit. p Combined profits are maximized. Incentive for firms to cheat on agreement. Cartels are unstable.
Cartel Arrangements Additional costs facing the cartel

Formation Costs Monitoring Costs Enforcement Costs
Weigh the benefits of collusion (increased profits) against these additional costs.
Price Leadership Barometric Price Leadership

One firm in an industry will initiate a price i change h in i response to t economic i conditions. The other firms may or may not follow this leader. Leader may change.
Price Leadership Dominant Price Leadership

One firm is recognized as the industry l d leader. Dominant firm sets price with the realization that the smaller firms will follow and charge the same price. Determining the optimal price is illustrated in the following g graphs. g p
Price Leadership
DT is the demand curve facing the entire industry. industry MCR is the summation of the g cost curves of all of marginal the follower firms. You can think of MCR as a supply curve for these firms firms. In choosing its price, the dominant firm has to consider the amount supplied by the follower firms.
Keat/Young
Price Leadership
For any y price p chosen by y the dominant firm, some of the market demand will be satisfied by b the follower follo er firms. The residual is left for the dominant firm. The demand curve facing the dominant firm is found b subtracting by bt ti MCR from f DT. This residual demand curve cu ve is s labeled abe ed DD.
Price Leadership
To determine price, the dominant firm equates its marginal cost with the marginal revenue from its residual demand curve. The dominant firm sells A units and the rest of the d demand d (QT A) i is supplied by the follower firms firms.
Follower Supply
Follower Supply
Keat/Young
Revenue Maximization Baumol Model

Firms may maximize revenue subject to maintaining i t i i a specific ifi level l l of f profits. fit Reasons
A firm will become more competitive when it achieves a large size (in terms of revenue). Management remuneration may be more closely related to revenue than profits.
Price Discrimination Price discrimination means

Products with identical costs are sold in diff different t markets k t at t diff different t prices. i
Senior citizen or student discounts
The ratio of price to marginal cost differs for similar products.

Identical products sold with different packaging.
Price Discrimination To be successful successful, price discrimination requires that

The markets in which the product is sold must by separated. I.e., no resale between markets. The demand curves in the market must have different elasticities.
Price Discrimination Three types of price discrimination

First Degree Price Discrimination
Seller can identify where each consumer lies on the demand curve and charges each consumer the highest price the consumer is willing to pay. pay Allows the seller to extract the greatest amount of profits profits. Requires a considerable amount of information.

Second Degree Price Discrimination
Differential Diff ti l prices i charged h d by b blocks bl k of f services. Block pricing Requires metering of services.
Keat/Young

Third Degree Price Discrimination
Customers C t are segregated t d into i t different diff t markets k t and charged different prices based on each groups group s elasticity of demand Segmentation can be based on any characteristic such as age, geographic location, gender, income, etc. Illustrated g graphically p y in the following g figures. g
Assume the firm operates p in two markets, , A and B. The demand in market A is less elastic than the demand in market B. The entire market faced by the firm is described by the sum of the demand and marginal revenue curves curves. This is illustrated in the graph at the far right.
The firm finds the total amount to produce by equating the marginal revenue and marginal cost in the market as a whole. This is labeled as QT. If the h firm fi were forced f d to charge h a uniform if price, i it i would ld find fi d the h price i by b examining the aggregate demand DT at the output level QT. This is represented by point C in the graph. However the firm can increase its profits by charging a different price in However, each market.
In order to find the optimum price to charge in each market, draw a horizontal line back from the MRT/MCT intersection. Where this horizontal line intersects each submarkets MR curve determines the amount that should be sold in each market; QA and QB. These quantities are then used to determine the price in each market using the demand curves DA and DB.
Price Discrimination
Are tying arrangements a form of price discrimination?
A tying arrangement exists when a buyer of one product is obligated to also by a related product from the same supplier. Illegal Ill l in i some cases. One explanation: firms with market power in one market will use tying y g arrangements g to extend monopoly p yp power into other markets. Other explanations of tying
Quality control Efficiencies in distribution Evasion of price controls
Nonmarginal Pricing Types of nonmarginal pricing

Cost-Plus Pricing Incremental Pricing and Costing Analysis
Keat/Young
Nonmarginal Pricing Cost Cost-Plus Plus Pricing

Price is set by first calculating the variable cost, cost adding an allocation for fixed costs, and then adding a profit percentage p g or markup. p Are there similarities between cost-plus pricing p g and using g the MR=MC rule? When MC=AC, the MR=MC rule and p p pricing g yield y the same results. cost-plus
Nonmarginal Pricing
Incremental Pricing and Costing Analysis
Similar to marginal analysis Incremental analysis deals with changes in total revenue and total cost resulting from a decision to change prices, introduce a new product, di discontinue ti an existing i ti product, d t improve i a product, or acquire additional capital equipment. q p Only the revenues and costs that will change due to the decision are considered.
Multiproduct Pricing More often than not, not firms produce multiple products that may be related either on the demand side or on the cost side.
Keat/Young
Multiproduct Pricing Four types of relationships:

1. Products are complements in terms of demand
An increase in the quantity sold of one will bring about an increase in the quantity sold of the other. A fast-food restaurant sells both hamburgers and soft drinks. An increase in the quantity sold of one will bring about an decrease in the quantity sold of the other. Honda produces both Preludes and Accords
2. Products are substitutes in terms of demand

Multiproduct Pricing Four types yp of relationships: p

3. Products are joined in production
Products produced from one set of inputs Soybean meal and soybean oil, beef and leather Using resources to produce one product takes those resources away from producing other products. Honda may use steel to produce either Preludes or Accords.
4 Products compete for resources 4.
Transfer Pricing
Modern companies p are subdivided into several groups or divisions. Each of these divisions may be charged with a profit objective. bj i As the product moves through these divisions on the way to the consumer it is sold sold or transferred from one division to another at a transfer price. each c division d v s o is s allowed owed to o choose c oose its s own ow transfer se If e price without any coordination, the final price of the product to consumers may not maximize profits for th firm the fi as a whole. h l
Transfer Pricing
Firms must pay special attention toward designing a transfer pricing mechanism that is geared toward maximizing g g total company p y profit. Design g of the optimal p transfer pricing p g mechanism is complicated by the fact that
each division may be able to sell its product in external markets as well as internally. each division may be able to procure inputs from external markets as well as internally. internally
Transfer Pricing E Examples amples Assume that a firm has two divisions
Division C manufactures components Division A assembles the components into a final product and sells it.
Keat/Young
Transfer Pricing Case 1: No External Markets

The two divisions must deal with equal quantities. titi Division C will produce exactly the number of components that will be used by division A. One demand curve and two marginal cost curves.
Transfer Pricing
The firm firms s total marginal cost is found by y vertically y summing g the marginal costs from the two divisions. divisions Production should g occur where marginal revenue equals the firms total marginal cost Point B. cost. B
Transfer Pricing
The final price is determined from the demand curve at this quantity. The optimal transfer price i is i given i by b division Cs marginal cost at the optimal p output level. Thus, the optimal transfer f price i is i PC.
Transfer Pricing Case 2: External Markets

Division C has the opportunity to sell its i t intermediate di t product d t in i a competitive titi market. Division A has the opportunity to purchase the intermediate product in the same market as well as directly from division C.
Transfer Pricing
Division C produces at the point where MCC intersects DC ( l MRC since (also i competitive market). QC The transfer price should reflect the competitive price PC.
Transfer Pricing
Division As total marginal cost becomes MC=MCA + PC. Optimal production of f the h firms fi final fi l output is found by equating MC with MR in the market for the final p product. Qt
Other Pricing Practices Price Skimming

The first firm to introduce a product may h have a temporary t monopoly l and d may be b able to charge high prices and obtain high profits fit until til competition titi enters t
Penetration Pricing
Selling at a low price in order to obtain market share
Other Pricing Practices

Prestige P ti Pricing Pi i
Demand for a product may be higher at a higher price i because b of f the th prestige ti that th t ownership hi bestows on the owner.
Psychological P h l i l Pricing Pi i
Demand for a product may be quite inelastic over a certain t i range but b t will ill become b rather th elastic l ti at t one specific higher or lower price.

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Chapter 11

Special Pricing Practices

Special Pricing Policies

2003 Prentice Hall Business Publishing

2003 Prentice Hall Business Publishing

Managerial Economics, 4/e

Cartel Arrangements Conditions that influence the formation of cartels

2003 Prentice Hall Business Publishing

2003 Prentice Hall Business Publishing

2003 Prentice Hall Business Publishing

Cartel Arrangements Additional costs facing the cartel

Price Leadership Barometric Price Leadership

Price Leadership Dominant Price Leadership

2003 Prentice Hall Business Publishing

Managerial Economics, 4/e

Managerial Economics, 4/e

Revenue Maximization Baumol Model

Price Discrimination Price discrimination means

The ratio of price to marginal cost differs for similar products.

Price Discrimination To be successful successful, price discrimination requires that

Price Discrimination Three types of price discrimination

Price Discrimination Three types of price discrimination

2003 Prentice Hall Business Publishing

Managerial Economics, 4/e

Price Discrimination Three types of price discrimination

Third Degree Price Discrimination

2003 Prentice Hall Business Publishing

Third Degree Price Discrimination

2003 Prentice Hall Business Publishing

Third Degree Price Discrimination

2003 Prentice Hall Business Publishing

Nonmarginal Pricing Types of nonmarginal pricing

2003 Prentice Hall Business Publishing

Managerial Economics, 4/e

Nonmarginal Pricing Cost Cost-Plus Plus Pricing

2003 Prentice Hall Business Publishing

Managerial Economics, 4/e

Multiproduct Pricing Four types of relationships:

2. Products are substitutes in terms of demand

2003 Prentice Hall Business Publishing

Multiproduct Pricing Four types yp of relationships: p

4 Products compete for resources 4.

2003 Prentice Hall Business Publishing

2003 Prentice Hall Business Publishing

Managerial Economics, 4/e

Transfer Pricing Case 1: No External Markets

Transfer Pricing Case 2: External Markets

Other Pricing Practices Price Skimming

Other Pricing Practices

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