Transcript No Slide Title

Pricing Techniques and Analysis
Chapter 16
• Value-based more than cost-based pricing often
helps build profits.
• Firms charge different customers different
prices, which is known as price discrimination.
• This chapter also looks at pricing within a firm
called transfer pricing.
• Pricing techniques that are used by many multiproduct firms, such as full-cost pricing and
target return pricing.
2002 South-Western Publishing
Slide 1
Proactive Value-based Pricing
• If the price doesn’t fit what customers are willing
to pay, then the product may not be profitable.
» Customer value is the focus for pricing, not just the
costs associated with the product.
» Apple Computer lost market share by ignoring this.
» The Ford Mustang was a success, as Ford found that
people wanted a sports car, but didn’t want it to be
too expensive. The started with a price and designed
the product.
• The Mustang used value-based, not cost-plus pricing
Slide 2
Differential Pricing
• If at peak rush hour, the toll is higher than at
the off-peak, we are using different prices at
different time periods.
• The peak toll can encourage shifting travel
patterns to off-peak times or discourage
some commuting altogether.
• Differential pricing appears more frequently
than one thinks. This we call price
discrimination.
Slide 3
Price Discrimination
 Price Discrimination -- Goods which are
NOT priced in proportion to their marginal cost,
even though technically similar
 Some
Necessary Conditions:
1. Some Monopoly Power
• In Perfect Competition, P = MC
2. Ability to Arbitrage
• Separate Customers and Prevent Reselling
Slide 4
Arbitrage -
Buy Low to Sell Higher
• Arbitrage of Goods is Easy
» Price discrimination of goods is ineffective
» Little price discrimination of grocery items
• Arbitrage of Services is Difficult
» Price discrimination of services is effective
» Price discrimination at restaurants by age, a service
» Lawyers charge different prices for wills, based on
ability to pay
Slide 5
Many Ways to Separate Customers for
Price Discrimination
1.
2.
3.
4.
5.
Geography
Income
Gender
Age
Time
6. Race
7. Language
8. Transient /
Resident
9. Ability to
Haggle
Slide 6
Why Practice Price Discrimination?
• In Simple Monopoly,
there is only one price
• Consumers receive a
consumer surplus
• In Price
Discrimination,
monopolists can
SCOOP OUT all
consumer surplus
MC
Simple
Monopoly
PSM CS
D
QSM
Q
Slide 7
First Degree Price Discrimination
• Charge the MOST
that a person is
willing to pay for
each good
• Zero consumer
surplus
• Produce MORE than
in Simple Monopoly
• Output the same as in
Competition
Price Discriminating MC
Monopoly
D
Q
Q1st
Slide 8
Car Sales as First Degree Price Discrimination
“How much do you
plan to pay a
month?”
you inadvertently reply:
“Only $200 per
month, but I have
$3,000 down
payment!”
Ahh, that is
$9,887 for 60
months at our
7.9% financing,
plus $3,000
Here’s one for only
$12,887. It’s swell.
Slide 9
Notice: Incentives to Understate
One’s True Willingness to Pay
• The conditions
for First Degree
price
discrimination
are seldom met
• Hence, some
close
approximations
exist
Second Degree Price
Discrimination:
Units are Grouped
• There are are a variety
of ways to group units
to attempt to scoop out
consumer surplus
Slide 10
Second Degree Price
Discrimination Methods
We look at four examples:
• Block rate setting
• Two part pricing
• Unlimited access
• Bundling methods
Slide 11
Second Degree Price Discrimination:
Block Rate Pricing
• Price declines as the quantity
purchased increased
• Examples:
»
»
»
»
P
D
Tri-State Gas Company example
(page 632)
TJ Maxx, second pair half price
telephone charges
foreign film festivals
• Price declines similar to the
demand curve
Q
Slide 12
Another Second Degree Price Discrimination:
Two-Part Pricing:
• A price for the
privilege of buying
items
• And a price per item
• Examples:
» Country Club Dues
MC
and Greens Fees
» Cover Charge to
Enter and a Price Per
Drink
Cover
Charge
Q
Slide 13
If P = 4.50 - Q and MC = .50
Find Optimal Cover Charge
• At P = $.50, he/she
buys 4 mugs of
Cover
root beer
Charge
$4.50 $8.00
• Biggest cover
charge is the area
PM=$2.50
of a triangle
Cover
» Height is 4
Charge $8
$.50
» Base is 4
» (1/2)Height•Base
• Max cover charge
is $8.00
QM
Monopoly: QM = 2 & PM = $2.50
4
Slide 14
Q
Second Degree Price Discrimination:
Unlimited Access
or All-You-Can-Eat Pricing
A specified price for an unspecified quantity:
Example: AOL unlimited access for $19.95/month
Examples: Salad Bars, Legal Retainers, HMO’s
P
Area under demand
curves represent most
willing to pay for an
AYCE offer
ounces
Slide 15
Second Degree Price Discrimination:
Bundling (or Block Booking)
Often the pricing arrangement includes purchasing
groups of dissimilar products. The products are
bundled or sold as a block, as in theatrical or
sporting tickets.
Preferences are uncorrelated
A
1
2
Preferences are correlated
B
150
80
100
190
A
250
270
160
200 = 360
simple monopoly
500
80
B
100 180
360
165
175 340
165
200 = 365
simple monopolySlide 16
Third Degree Price Discrimination
East
West
Market
PM
MC
MR
Example with a Simple Monopoly
Price in both markets
Slide 17
Third Degree Price Discrimination
East
West
Market
PE
PM
PW
MC
MR
MR
MR
Example with Different Prices in Each Market
Slide 18
Pricing In Segmented Markets
• Segment markets by
price sensitivity
• Charge higher prices
in the markets that are
the most inelastic
• Then P1 = $150 and
• P2 = $120
P ( 1 + 1/ EQ•P ) = MC
Suppose MC = $100 in 2 markets
and E1 = - 3 and E2 = - 6
Why are
haircuts for
kids cheaper
than for
adults?
Slide 19
Pricing of Multiple Product
• Products are INDEPENDENT when changes in
price and quantity of one product do not alter
revenues or cost in the others
• Products are INTERDEPENDENT, when
changes DO affect other products
• Ex: Procter & Gamble makes both Luvs and
Pampers
» TR = TRA + TRB
Slide 20
Substitutes & Complements
• Look for interdependencies in marginal
revenues:
» MRA = TRA / QA + TRB / QA
» MRB = TRA / QB + TRB / QB
• Substitutes when cross terms are negative
» Erosion or Cannibalism are terms used
• Complements when cross terms are
positive
» BASE sells tapes and tape head cleaners
Slide 21
Decision Rule for Multiple Product Firms
• Do NOT use the rule to produce where
MR=MC, as in MRA = MCA
• INSTEAD:
» Produce where the FULL MR = FULL MC
» For a Two Product Firm of A & B
» Produce where:
TRA /QA + TRB /QA = TCA /QA + TCB /QA
Include all relevant revenue and cost effects
Slide 22
Pricing Example in Supermarkets
• Turkey prices fall during Thanksgiving
» Yet we would expect DEMAND to be greatest?!
• Loss Leader Pricing
» Consider T as turkey
» and A as all other food
• TRstore = TRT + TRA
MRstore for turkey = TRT /QT + TRA /QT
• Complementarity with other food explains the
apparent conundrum
Slide 23
Pricing of Joint Products
• Interdependencies in costs occur in products
that are produced simultaneously
• E.g., Beef & Hides; Wool & Mutton; Natural
Gas & Crude Oil
• Suppose FIXED PROPORTIONS in
production: 500 lbs. of Beef + 10 sq. yards of
Hide for 1 steer.
• Two cases: No Excess of Hides, and Excess
Hides case
Slide 24
Steers: No Excess Case
Two Demand
Curves:
Hides & Beef
Two MR Curves:
Hides & Beef
MRB
MRH
DH
DB
steers (T)
Slide 25
Steers: No Excess Case 2
MRT
Find where
MCT
MRT = MCT
to find the
optimal of
steers.
DH
MRH
DB
steers (T)
Slide 26
Steers: No Excess Case 3
MRT
At the optimal
number of
steers, find
the prices of beef &
hides on their
respective
demand curves
MCT
PB
PH
DH
T
MRH
if demand for beef
rises, the price
DB of hides will
fall !
steers (T)
Slide 27
Excess of One of the Joint Products
• Excess means the price would be
ZERO
• The solution is to hold back some of
the excess to reach the Unit Elastic
Point on the Demand Curve.
• This Maximizes Total Revenue.
Slide 28
Multi-Divisional Firms
and the Economics of Transfer Pricing
Transfer Pricing serves two functions:
1.
Measure of the marginal value of the
resource
2.
Provides a performance measures of
resources used
For international firms, transfer pricing may assist in
reducing worldwide taxation, but the ability to reduce
taxation is limited because the IRS requires arm’s
length prices.
Slide 29
Create Transfer Prices Similar to
Competitive Market Prices
• Disagreements across divisions are common
» “Selling” Division wants a HIGH transfer price
» “Buying” Division wants a LOW transfer price
• When External Markets exists, use those prices for
transfer (a market-based competitive price)
sell to others @ “P”
motor assembly
final car
assembly
purchase motors from others @ “P”Slide 30
Transfer Pricing
With No External Markets
• When no external markets exist, use the
MC of the transferred good.
• Often, however, the MC is a function of
output.
• Marketing and Production steps (M & P)
• Transfer price is PT = MC P on following
figure
Slide 31
Find Where MCM+P = MR
MCM+P
P
MCP
MCM
PT
D
MR
Slide 32
Pricing in Practice
• In practice, pricing strategy involves
the whole life-cycle of the product.
• Managers report wide use of cost-plus
pricing methods because it:
» Streamlines pricing of multiple products
» Streamlines pricing of retail prices
Slide 33
Cost-Plus and Full Cost Pricing
P = ACn + Markup
or
P = ACn(1 + m)
where ACn is average cost at a normal output
and m is a percentage markup
• Notice: Little reliance on MC pricing or use of
elasticities, as in: P( 1 + 1/Ep ) = MC
Slide 34
Cost-Plus Pricing: Illustrated
Manufacturing pricing illustrated: One Good
P
}
ATC
markup
ACn
AVC
AFC
Qn
Qcapacity
Slide 35
Cost-Plus Pricing: Illustrated
D1
P
quantity
varies as
demand
varies
D2
}
markup
ACn
AVC
AFC
Qn
Qcapacity
Slide 36
Cost-Plus Pricing: Illustrated
D1
P
quantity
varies as
demand
varies
D2
}
markup
ACn
AVC
AFC
Q1
Qn Q2 Qcapacity
Slide 37
Full Cost Pricing
• Full Cost-» Covers all Costs at the standard or normal output
» Plus a return on the investment
• P = AFCn + AVCn + p K / Qn
» where p K is the target amount of profit
» and p is the desired profit rate and K is gross operating
assets
• Example: Low Tech Security
FC = 200,000, Qn = 3000, VC = 90,000
p = 20% and K=$500,000. Find Full Cost Price!
Slide 38
Full Cost Pricing
• Answer
» P = AVC + AFC + (.20)(500,000)/Q
» P = 30 + 66.67 + 33.33
= $130
• Also, suppose a 35% markup on cost
» P = [ ACn] (1.35)
» P = [ 30 + 66.67 ](1.35)
» P = $130.50
Slide 39
Cost-Plus Pricing
Advantages
Disadvantages
• Cost-plus is simple
• But cost-plus ignores
demand changes
• It is easy to delegate to
others
• Pricing may be based on
poor cost data
• Easy to apply to
thousands of items
• Output varies in business
cycle
» Can use categories
of markups for
different classes of Hybrid Method: Variable
Cost-Plus Pricing -- the
products
markup can vary over the
season or business cycle
Slide 40
Optimal Markups in Practice
• Grocery stores have
• Demand is therefore
low markups
highly elastic
• Many close substitutes -- • Optimal markup would
at other grocery stores
consequently be small
(bread varieties and
qualities are
standardized)
• Frequent purchase, so
customers are
knowledgeable about
prices & quality
1999 South-Western College Publishing
Slide 41
Markups on Jewelry
• Jewelry Markups are known to be large
• Difficult to make comparisons across
jewelry stores
• Little repeat purchases, so knowledge
about prices is low
• Consequently, lower price elasticity for
jewelry
• The optimal markup is larger
1999 South-Western College Publishing
Slide 42
Skimming
a form of block rate pricing over time
• Price declines over time
• Those who wish to get it first
pays the highest price, others
are willing to wait
• Examples:
» Hardcover & Paperback
Books
» New electrical & Computer
Products
1999 South-Western College Publishing
P
D
TIME
Slide 43
Revenue Management: Appendix 16A
• Revenue Management is the problem of the
disappearing inventory.
• Managers must be flexible to change their
predicted sales by market segment as information
arrives.
• Airlines price discriminates between business and
non-business travelers. If too few business
travelers have booked tickets compared to the
amount expected, then more non-business tickets
should be released.
Slide 44
Optimal Overbooking
• Managers may authorize reservation clerks to
sell more seats (rooms) than are available.
• The greater the overbooking, the lower are the
costs of spoilage.
• Spoilage is an inventory NOT sold. If capacity
is large, an airline or hotel will have high
spoilage.
• The greater the overbooking, the greater are the
costs of spillage, making customers unhappy by
finding that they have no seat or reservation.
Slide 45
Spillage
• Spillage is the excess demand that cannot
be met.
• If the service industry has low capacity, the
spillage will be great
• Customers leave the hotel or airline unable
to get a room or an airplane seat.
Slide 46
Optimal Overbooking
• Spillage and spoilage costs go in
opposite directions, the sum of
these costs has a minimum with
the optimal amount of
overbooking.
• Since business travelers tend to a
large extent to be repeat
customers, the cost of spillage
(oversells) may be very high.
• The optimal amount of
overbooking for this market
segment may well be lower than
for non-business clients.
Spillage
Total
Cost
optimal
Spoilage
100% 110% 120% ...
Percent Overbooked
Slide 47