Managerial Economics

PRICING STRATEGIES

Price
A financial expression of the value of the product
Concept of value: Perceived value = perceived benefits perceived costs
Customers motivation to purchase product,
first from need/want (I need/want food);
second comes from perception of value (I really fancy a McDonalds)

Perception of value varies with customers, and can be increased by either

increasing the perceived benefits or reducing the perceived costs

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What the Consumer Pays?

Includes:
Physical good/service
Assurance of quality
Repair facilities
Packaging
Credit
Warranty
Delivery

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Pricing Objectives
Companies concerned about pricing objectives (one of the 4 Ps) as
it directly affects sales/earnings and competitiveness
Pricing objectives fit companys overall marketing strategy
Types of pricing objectives:
Profit-oriented: using target return objective
Sales-oriented: to get specified share of the market
Status quo-oriented: maintain stable prices/competitor activity (especially if
satisfied with present situation)

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Influences on Pricing
Costs: need to recover most of the time
Competitors: Need to accept market price in conditions nearing perfect
competition
Customers: what the customers are willing to pay; need to match desired sales
(market share) with price-demand curve realities
Business Objectives maximise profits, make target return, achieve sales
target, get/maintain market share, match competition, etc

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Standard Pricing and Profits

P = 10 - 2Q
C(Q) = 2Q
If the firm must charge a single price to all
consumers, the profit-maximizing price is
obtained by setting MR = MC

Price

Profits from standard pricing

= $8

10
8
6

10 - 4Q = 2, so Q* = 2

P* = 10 - 2(2) = 6

MC
P = 10 - 2Q

Profits = (6)(2) - 2(2) = $8

1

Quantity

MR = 10 - 4Q

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A Simple Markup Rule

Suppose the elasticity of demand for the firms product is E F
MR = P[1 + EF]/ EF
Setting MR = MC and simplifying yields this simple pricing formula:
P = [EF/(1+ EF)] MC
The optimal price is a simple markup over relevant costs!
More elastic the demand, lower markup.
Less elastic the demand, higher markup.
Example:
Elasticity of demand for Kodak film is -2
P = [EF/(1+ EF)] MC
P = [-2/(1 - 2)] MC
P = 2 MC
Price is twice marginal cost
Fifty percent of Kodaks price is margin above manufacturing costs.
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First-Degree or Perfect Price Discrimination

Practice of charging each consumer
the maximum amount he or she will
pay for each incremental unit
Permits a firm to extract all surplus
from consumers
Caveats:
In practice, transactions costs and
information constraints make this is
difficult to implement perfectly (but car
dealers and some professionals come
close).
Price discrimination wont work if
consumers can resell the good.
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Price $
Profits:
.5(4-0)(10 - 2)
= $16

10
8
6
4

Total Cost

MC
D
1

Quantity
8

Second Degree Price Discrimination

The practice of posting a discrete schedule of
declining prices for different quantities.

Price

Example: Electric utilities

$10

Firms typically charge a higher rate on the first hundred

kilowatt hours of electricity used than on subsequent units.
The primary advantage of this strategy is that the firm can
extract some consumer surplus from consumers without
needing to know beforehand the identity of the consumers
who will choose to purchase small amounts (and thus are
willing and able to pay a higher price per unit).
Given the posted schedule of prices, consumers sort
themselves according to their willingness to pay for
alternative quantities of the good. Thus, the firm charges
different prices to different consumers, but does not need
to know specific characteristics of individual consumers

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MC

$8
$5

D
2

Quantity
9

Third Degree Price Discrimination

The practice of charging different groups of consumers different prices for the
same product
Examples include student discounts, senior citizens discounts, regional &
international pricing
Suppose the total demand for a product is comprised of two groups with
different elasticities, E1 < E2
Notice that group 1 is more price sensitive than group 2
Profit-maximizing prices?
P1 = [E1/(1+ E1)] MC
P2 = [E2/(1+ E2)] MC
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Third Degree Price Discrimination: An

Example
Assume two market demand curves:
P1 = 30 - Q1; P2 = 40 - Q2 and MC = 10
Find the profit-maximizing price and quantity in both markets.

Market 1 Q1 = 10 and P1 = 20, e1=-2 More elastic situation

Market 2 Q2 = 15 and P2 = 25, e2=-1.66 Less elastic situation

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Two-Part Pricing
When it isnt feasible to charge
different prices for different units
sold, but demand information is
known, two-part pricing may permit
you to extract all surplus from
consumers.
Two-part pricing consists of a fixed
fee and a per unit charge.
Example: Athletic club memberships

1. Set price at marginal cost.

Price

2. Compute consumer surplus.

10

3. Charge a fixed-fee equal to consumer

surplus.

Per Unit Charge

Fixed Fee = Profits = $16

4
MC

2
D
1

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Quantity
12

Block Pricing
The practice of packaging multiple units of a product together and selling them
as one package.
Examples
Paper
Six-packs of drinks
Different sized of cans of green beans

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13

Commodity Bundling
The practice of bundling two or more products together and charging one price
for the bundle
Examples
Vacation packages
Computers and software
Film and developing

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Peak-Load Pricing
When demand during peak times is higher than the capacity
of the firm, the firm should engage in peak-load pricing.

Price

MC

Charge a higher price (PH) during peak times (DH)

Charge a lower price (PL) during off-peak times (DL)

Q: Malls typically charge a higher price for parking during

weekend than they do during other days of the week. Why?
A: It pays for malls to engage in peak-load pricing. Since the
demand for parking is much higher during weekend, when
shoppers spend extended periods with families, parking lots
tend to fill up during that time. If malls charged a high price
whole week, they would have empty spaces most of the
time. If they charged low prices weekend, they would lose
out on the additional amount consumers are willing to pay
during weekend. Thus, with peak-load pricing, malls earn
higher profits.
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PH

DH

PL

MRH

MRL
QL

DL
QH Quantity
15

Cross-Subsidies
Prices charged for one product are subsidized by the sale of another product
May be profitable when there are significant demand complementarities effects

Examples
Browser and server software
Drinks and meals at restaurants

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Transfer Pricing
The internal price at which an upstream division sells inputs to a downstream
division in order to maximize the overall profits of the firm.
In order to maximize profits, the upstream division produces such that its
marginal cost, MCu, equals the net marginal revenue to the downstream division
(NMRd):
NMRd = MRd - MCd = MCu
This permits the firm to avoid double-marginalization.

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Example
Suppose that the (inverse) demand for Boeings single engine planes is given
by P = 15,000-Q.
Its upstream division produces engines at a cost Cu(Qe)=2.5Qe2 of and the
downstream divisions cost of assembling planes is Cd(Q) = 1,000Q.
What could be the optimal transfer price when there is no external market for
engines?
The optimal transfer price is set where the firms net marginal revenue from
engine production equals the upstream divisions marginal cost of producing the
engines, NMRd=MRd-MCd=MCu
NMRd=15000-2Q-1000=5Qe, Q=Qe=2000?
PT=MCu=5Qe=10,000
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Double Marginalization
A wholesaler (or upstream firm) marks up its price when selling to a retailer (or
downstream firm)
The retailer (or downstream firm), in turn, further marks up price.
Double marginalization results in lower profits for the wholesaler. Why?
Wholesalers Problem

Retailers Problem

Demand for the final product P = 10 - 2Q

C(Q) = 2Q
Suppose the wholesaler sets MR = MC to
maximize profits
10 - 4Q = 2, so Q* = 2
P* = 10 - 2(2) = $6, so wholesaler charges the
retailer $6 per unit

Demand for the final product P = 10 - 2Q

Retailers marginal cost is the $6 charged by
the wholesaler
Retailer sets MR = MC to maximize profits
10 - 4Q = 6, so Q* = 1
P* = 10 - 2(1) = $8, so retailer charges $8 per
unit

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Analysis
This pricing strategy by the wholesaler results in less than optimal profits!
Wholesaler needs the price to be $6 and the quantity sold to be 2 units in order
to maximize profits. Unfortunately,
The retailer sets price at $8, which is too high; only 1 unit is sold at that price.
The wholesalers profits are $6 1 - 2(1) = $4 instead of the monopoly profits of
$6 2 - 2(2) = $8

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Retailers Problem
Demand for the final product P = 10 - 2Q
Retailers marginal cost is the $6 charged by the wholesaler
Retailer sets MR = MC to maximize profits
10 - 4Q = 6, so Q* = 1
P* = 10 - 2(1) = $8, so retailer charges $8 per unit

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Surge Pricing
Ubers pricing algorithm automatically detects situations of high demand and
low supply and hikes the price in increments, depending on the scale of the
shortage.
Those higher prices are supposed to make drivers more likely to bite, putting
more Uber cars on the road when theyre most needed.
Surge pricing is used to encourage more drivers to come online and pick up
passengers from the area

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