Transcript lecture 1 - Vanderbilt University

Any Questions from Last
Class?
Chapter 10
More Realistic and Complex
Pricing
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Thomson South-Western, a part of The Thomson
Corporation. Thomson, the Star logo, and South-Western
are trademarks used herein under license.
Chapter 10 – Take Aways
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After acquiring a substitute product, raise price
on both products to avoid each product
cannibalizing the sales of the other product.
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After acquiring a substitute product, raise price
more on the low-margin (more elastic demand)
product.
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After acquiring a substitute product, reposition
the products so that there is less substitutability
between them.
Chapter 10 – Take Aways
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After acquiring a complementary product, reduce price on
both products to increase demand for both products.
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If fixed costs are large relative to marginal costs, and
capacity is fixed, price to fill available capacity.
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If the costs of underpricing are smaller than the costs of
overpricing, then underprice, on average, and vice versa.
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If promotional expenditures make demand more elastic,
then reduce price when you promote the product, and vice
versa.
Review of Chapter 9
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Competitive firm earns positive or negative profits only in the shortrun
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Indifference principle
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Entry and imitation eventually erode profits
Strategy is plan to slow profit erosion
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Compensating wage differentials
Risk premia on stocks
Monopoly firms can earn positive profits for longer period of time
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In long run, profits exhibit mean reversion
IO view focuses on industry; RBV focuses on firm resources
Generic strategies
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Cost reduction
Product differentiation
Control competition
Another Pricing Anecdote
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Las Vegas Casinos
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Similar to grocery store loss leader concept
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Offer both rooms and gaming
Prices on rooms are often set at “sub-optimal”
levels
Plan to more than make up room profit shortfall
with gaming profits
Get people in the door
Goal is to maximize total profit, not individual
product profit
Pricing Commonly Owned Products
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First case to consider is when the products are substitutes for each
other
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Use marginal analysis
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Discussion: Purchasing adjacent video store
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Common ownership makes analysis more complex
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Reducing price at one store steals sales from the other (reduces MR at both)
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With MR falling, raise price to maximize profits
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Consider your product portfolio as a bundle of goods
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Demand for a bundle of substitutes is less elastic than demand for the
individual products
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Less elastic demand means raise price
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Raise price more on the more elastic product (try to push price sensitive
customers to higher margin product)
Pricing Commonly Owned Products (cont.)
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Next case to consider is when the products are complements of each
other
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Use marginal analysis
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Discussion: Purchasing parking lot adjacent to video store
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Common ownership makes analysis more complex
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Reducing price at one increases demand at the other (increases MR at both)
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With MR rising, reduce price to maximize profits
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Consider your product portfolio as a bundle of goods
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Demand for a bundle of complements is more elastic than demand for the
individual products
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More elastic demand means reduce price
Revenue or Yield Management
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Example industries: cruise ships, hotels, stadiums,
commercial parking lots, etc.
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Costs of building capacity are mostly fixed or sunk
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Firms face capacity constraints
Initial decision is how much capacity to build
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Keep adding capacity until LRMR = LRMC
Once built, must decide on pricing
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Relevant costs are now short-run MR and MC
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If MR>MC at capacity, price to fill available capacity
Revenue or Yield Management (cont.)
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When demand is difficult to predict, pricing to fill
capacity is very challenging
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Balances the cost of over-pricing (lost profit on
unsold capacity) against the cost of under pricing
(lower margins on capacity sold)
Optimal price minimizes the expected costs of these
two mistakes.
In general, if the lost profit from over-pricing (unused
capacity) is bigger than the lost profit from underpricing (lower margins), then price lower than would
fill capacity, and vice-versa.
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Advertising and Promotional Pricing
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Combines two of the Four P’s (Pricing and Promotion)
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Promotional spending affects demand in different ways
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Price-related promotions (coupons, end-of-aisle displays, etc.)
tend to make demand more elastic
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Product-related promotions (quality advertising, celebrity
endorsements, etc.) tend to make demand less elastic
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If you are making demand more elastic, it makes sense to reduce
price concurrently
If you are making demand less elastic, it makes sense to raise
price concurrently
Caveat: Prices can affect customer perception of quality
Alternate Intro Anecdote
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American Airlines pioneered the development of
sophisticated reservation management systems, launching
SABRE in 1968
Without overbooking practices like those instituted through
SABRE, AA estimates that 15% of the seats on sold out
flights would be unused.
This overbooking process was the first element in
developing a yield management system.
With additional industry changes in the 1970’s, AA moved
to develop a yield management system with the goal of
"selling the right seat to the right customer at the right
time."
Alternate Intro Anecdote (cont.)
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The yield management system helps determine
 How many seats to allocate initially to each fare category
 How to dynamically adjust this allocation as reservations
come in and the date of the flight approaches.
 Accurate forecast of demand and cancellations are
critical
The complexity of the problem eventually led to the
development in 1988 of an automated system for yield
management, DINAMO. The system's net impact was
estimated be $1.4 billion in additional revenues over a three
year period.