Transcript MANAGERIAL ECONOMICS An Analysis of Business Issues

MANAGERIAL ECONOMICS
An Analysis of Business Issues
Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall
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Chapter 14:
Pricing in Theory
Objectives:
To examine theoretical aspects of the pricing decision,
including
basic rules for optimal pricing
pricing and market structures
pricing and entry conditions - the pre-game theory
approach
price discrimination
pricing and the product life cycle
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The Basic Rule for ProfitMaximization
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(Price - Marginal Cost)/Price = 1/-Ed
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Not an operational decision rule - a
statement of the condition required for
maximum profit
Can be re-stated in an “average cost
plus margin” format - see p.292
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Pricing and Market Structures
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Review Chapter 10
Under perfect competition, firms are pricetakers
Under monopoly, firms are price-makers (but
still constrained by the requirement to make
maximum profit)
Under monopolistic competition, prices settle
at the ‘excess capacity’ level where P=AC
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Pricing in Oligopoly
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Review Chapter 13 on Cournot,
Bertrand and von Stackelberg
competition
The ‘conjectural variation’ approach
– P - MC = (-) si(1+a)
•P
Ed
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Where si = firm’s market share;
a =conjectural variation
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Entry Conditions and Pricing
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Entry may be ‘blockaded’, ‘effectively
impeded’ or ‘uneffectively impeded’
Entry barriers are advantages held by
incumbent firms, arising from:
– absolute cost advantages
– economies of scale
– product differentiation
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Limit Pricing
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The ‘limit price’ is the highest price that can
be charged without inducing new entry
Can it be determined?
Game theory is the current approach - review
Chapter 13
The traditional, pre-game theory approach
was based on the Bain-Sylos-LabiniModigliani model
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Limit Pricing
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The Bain-Sylos-Labini-Modigliani model
Entry will take place if the entrant believes
that the post-entry situation will be profitable
Entrants believe that if entry takes place,
incumbents will keep their output constant
– (a rather restrictive assumption)
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Limit Pricing
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Figure 14.2: Demand for an Entrant’s product
Price
P1
P2
Dindustry
X
X
Dentrant
Quantity
Q1
Q2
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Limit Pricing
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Figure 14.3: The Case of Absolute Cost
Advantages
PH
ATC entrant
PL
ATCincumbent
Dentry encouraged
Dentry deterred
Quantity
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Limit Pricing
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If the limit price is known, should incumbent
firms set that price or not?
Limit pricing might mean less profit in short
term but less erosion of profit in the long term
Therefore depends upon:
– how much extra profit can be made in the short
run by setting price above the limit price
– how long can that extra profit be enjoyed before
entry takes place
– what is the firm’s discount rate?
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Price Discrimination
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Price discrimination exists when the same product is
sold for different prices, that are not attributable to
differences in the cost of supply
Two conditions are needed:
– the market must be divisible into sub-markets
between which there cannot be any arbitrage
– demand conditions (elasticity) must be different in
the sub-markets
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Third Degree Price
Discrimination
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A number of sub-markets, each containing a
number of potential customers
These markets may be separated by:
– distance ( car prices differ between Europe and
the UK - but is it really price discrimination?)
– time (for non-storable commodities) - peak versus
off-peak journeys
– age and status - Student Railcards, Old Person
Railcards
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See p 304 for a graphical analysis
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First Degree Price Discrimination
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Every buyer is charged the maximum they
are willing to pay (the demand curve
becomes the marginal revenue curve)
Can be difficult to evaluate willingness to pay
but first degree discrimination may be
possible in personal, household or
commercial services
Note that the socially optimal level of output
will be produced but all the surplus accrues to
the producer
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Second Degree Price
Discrimination
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Customers are charged one price for
the first block of units they purchase,
then a different price for the second
block
– electricity, water, gas tariffs
– the producer appropriates part of the
consumer surplus
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Pricing and the Product Life
Cycle
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Given;
– the basic formula linking Price, Marginal
Cost and Elasticity
– the likelihood that Elasticity rises and
Marginal Cost falls throughout the PLC
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The most straightforward prediction is
that price falls continuously
But is the PLC really valid?
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Pricing and the Product Life Cycle
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Sales
Maturity
Decline
Volume
Growth
Introduction
Time
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What Happens to Elasticity of Demand
and Marginal Cost Over the Product Life Cycle?
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Introduction - product is new. Elasticity may be low because there are no
substitutes or high if buyers need to be persuaded to try the new product.
Marginal cost is relatively high. Appropriate price will reflect high MC combined
with high/low elasticity
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Growth - imitation begins, and learning takes place. Elasticity rises, MC falls.
Price falls?
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Maturity - competition from many locations, substitutes and next-generation
products have been invented, elasticity high, MC low
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Decline - fierce competition for a declining market, very low margins
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BEWARE THE POTENTIALLY SELF-FULFILLING NATURE OF
THE PLC THEORY!!!!!
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Pricing New Products
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For new products, there is a significant amount of uncertainty
about demand conditions. Two strategies have been suggested
(Dean 1950)
SKIMMING - set an initially high price. IF that produces a high
level of profits, leave the price high until conditions change and
demand becomes more elastic. Do this when:
–
–
–
–
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there is a significant group of buyers prepared to pay high prices
when demand is inelastic
when the high price will not induce entry
when the cost penalty for low volume is small
PENETRATION - set a low price from the beginning in order to
build a large market share quickly. Do this when:
– demand is elastic
– low volume is very high cost
– entry is a major danger
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Is Skimming v Penetration Just an Application
of the Simple Model?
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YES - set a high price when elasticity is low and MC is high, set a
low price when the opposite is true
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BUT – skimming may have another benefit. If experience shows it is the
wrong strategy, the price can be cut without much customer
resistance. If the penetration approach is used but it becomes clear
that skimming would be better, it is more difficult to raise price than to
lower it
– skimming may provide a means of price discrimination through time.
If a market contains a group of ‘trendsetters’ or ‘first-adopters’ who
must have, or like to have, a product first and are willing to pay more
for it. Skimming allows them to be charged a higher price.
– E.g new major dictionaries, new types of mobile phone
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