Pricing

A firm has control over the prices only if it has some market power.

Pricing decisions are simple in the perfectly competitive markets: just

sell at the market price.

Can a firm get more than monopoly profits?

• Monopoly profit is the maximum profit a firm can make if it charges the same price for all consumers

• The profits can be increased if the firm could charge higher prices to the consumers that are willing to pay more.

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The simplest example of why price discrimination is profitable. Slide 1

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There are three consumers in the market willing to pay 1, 2, and 3 dollars for an apple. What price would a monopoly seller set to maximize profits? Imagine that the marginal cost is zero.

The price will be set at $2 because at this price the monopolist can sell 2 apples and make $4 in profit which is greater than $3 that the monopolist could make by setting the price at $1 or $3.

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The simplest example of why price discrimination is profitable. Slide 2

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What if the monopolist knew exactly how much each consumer is willing to pay for an apple? Then the monopolist could charge different prices to different consumers and sell 3 apples.

The profit could reach $3+$2+$1=$6

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A paradox of price discrimination.

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Given MC=0, what is the socially optimal level of output?

Socially optimal level of output is 3. This level would be achieved if there was perfect competition in the market of apples.

This is also the level of output when a single monopolist can perfectly price-discriminate!

Price discrimination is socially optimal! But (and it is a big one) all the surplus goes to the producer.

Three types of price discrimination

1. First degree price discrimination.

2. Second degree price discrimination.

3. Third degree price discrimination.

The practice of charging different prices to consumers for the same good or service.

First degree price discrimination.The practice of charging each consumer the

maximum amount she is willing and able to pay.

Examples:

- The manager of Suez Canal charges different prices to different ships depending on their cargo, alternative routes, and other characteristics.

-Car dealers.

- Amazon tried to use cookies to charge different prices

Second degree price discrimination.The practice of posting a discrete schedule of declining prices for different ranges of quantities.

Examples:

- Family size boxes of cereals

- Anytime minutes in wireless plans

- Volume discounts

Intertemporal price discrimination.

The first consumers to buy the product might like the new goods or know how to use it more efficiently.

Examples:

- First USB Flash Drives, Laptops, and Digital Cameras were extremely expensive.

- First computer were very expensive but there were firms and agencies who bought it because their benefits were larger than the cost.

- Recall how the price of USB flash drives was changing over time (the technology was there almost all the time)

Third degree price discrimination.Practice of charging different prices for different

groups of consumers based on an observable characteristic.

Example:

-Why is the ticket from Chicago to Ukraine with a change of plane in Frankfurt, Germany, cheaper than a ticket from Chicago to Frankfurt?

-Income per capita is higher in Germany and therefore average German is willing and able to pay more for the air fare. This characteristic is perfectly observable by the destination of the trip

-Why is the one-way ticket to Ukraine is twice more expensive than a round trip?

How to identify groups?

Coupons

Office and Office-Pro

DELL Inspiron for home users and DELL Latitude for business users.

Insurance rates vary with the number of traffic violations.

Red cars are sometimes more expensive to insure.

Reverse auctions at www.priceline.com

Professional handbooks: none else can actually understand them.

Firm should be able to prevent resales.

High transaction costs: far remote markets.

Services: it is very difficult to resale a haircut.

Government barriers to resale: tariffs make resale more costly.

Students are required to show a student ID to enter a football game with a student ticket.

It is very difficult to buy a car in Canada and bring it into the US.

The European Honda Accord is Acura in the US.

Is third degree price discrimination bad?

Example:

Drug companies have very low marginal cost of producing drugs. They could increase profits by selling to developing nations at lower price if reimportation of those drugs back to the US could be prevented.

The drug companies and the consumers in the developing countries would be better off.

Why does the price of brand name drugs often rise when equivalent generic brands enter the market?

(Perloff,2004)

Grabowski and Vernon (1992):

- A study of 18 major orally administered drugs that faced entry of generic brands

- Generic brands captured 35% of sales in the first year after introduction.

- The price of brand name drugs increased by 7%

Is any difference in price a sign of price discrimination?

No, only difference in prices that cannot be explained by the difference in costs.

Examples:

-Hardcover vs. paperback books

-International edition of M.Baye “Managerial Economics”

-Business class travel. The difference in prices can be larger than the difference in costs

-PC with 128Mb of RAM and 512Mb of RAM. The price often differs by more than the difference in component price.

-Optional umbrellas in the trunk of a Bentley will cost you $450 apiece.

-Volume discounts that do not reflect economies of scale

-Why restaurants can sell large drinks when refills are free?

Additional pricing strategies.

1.Two part pricing: Six flag pricing.

2. Block pricing: 6-packs.

3. Commodity bundling: PC and a monitor.

4. Peak-load pricing: anytime/weekend minutes in cell phone plans

5. Randomized pricing: weekly sales.

6. Inducing brand loyalty: coupons for first time users of spin-brush

7. Cross-subsidization: free wireless in coffee shops

8. Price matching: Best buy vs. Circuit City

1.Two part pricing.

Examples:

- Disney Land

- Sam’s Club

- Coffee mugs with discounted refills

1.Why two part pricing is profitable?

If Six Flags can charge $8 to enter the park and then let the visitors ride for free, the profits will be $8

instead of $4 if Six Flags charged monopoly price $2 of per ride.

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2. Block pricing.

Examples:

- 6-packs

- 12-24 rolls of toilet tissues in one package

2. Why block pricing works?

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What if the firm sold in packs of 2 only? You can’t buy one

unit.

3. Commodity bundling.

Examples:

- Microsoft Office

- Dell’s PC with a monitor

- Amazon’s free shipping

3. The rationale behind commodity bundling.

There are two consumers with the following reservation prices for Word and Excel.

Their reservation prices for Office is the sum of the two reservation prices.

$100 $60

$70 $80

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Word Excel

Maximum Profits

Office

$160

$150

$140 $120 $300

To maximize profits monopolist will charge

$70 $60 $150

3. Is commodity bundling always optimal?

Similarly the reservation price of the two consumers for a flash-light and for batteries are in the table below.

However, in this case profits from a bundle are smaller.

$5 $2

$4 $0.5

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Flash light 2 batteries

Maximum Profits

Bundle

$7

$4.5

$8 $2 $9

To maximize profits monopolist will charge

$4 $2 $4.5

3. A more general case of commodity bundling.

There are two goods: word processor and spreadsheet. You are considering whether your firms should bundle them and sell as office.

Their demands are given by the two curves below.P

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Demand for word

Demand for spreadsheet

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3. A more general case of commodity bundling.

The combined demand curve will show how much consumers are willing to pay for a unit of “word processor +spreadsheet”. Therefore the two curves have to be added up vertically to get the demand curve for the “office”.

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Demand for offi

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4. Peak-load pricing.

Examples:-Airlines charge holiday premiums on airline travel

-Hotels are more expensive in the summer

-Roses around Valentines

Peak-load pricing is widely used because the demand of all consumers increases at the same time. The firm does not have to be able to single out consumes with different demands.

4. Peak-load pricing.

Why we do not see peak-load pricing during Christmas sales?

- Higher prices can be hidden behind low-priced door busters

- At Christmas there are more people willing to buy the good who are not necessarily willing to pay more

- Most of the goods are durables and can be purchased in advance

5. Randomized pricing.

Randomized pricing allows for the firms to make producer’s “shop” for the better price.

One store has a sale this week while the other one a sale next week. This way the consumers are encouraged to check out the sales.

Example:

Best Buy vs. Circuit City

Pay Less vs. Marsh

6. Inducing brand loyalty.(Experience goods)

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7. Cross-subsidization.

Examples:

- free wireless in coffee shops

- Adobe’s free Acrobat Reader

- P&G and Black&Decker combine to provide low cost coffee makers in order to boost sales of ground coffee

8. Price matching.

Examples:

- BestBuy matches the price of any competitor

- Meijer’s price matching policy

8. Price matching.

How do we know if the firms are engaging a fierce price competition or they are just watching each other?

- It is difficult because both involve price matching.

- Some times the price matching includes a clause about identical product. If Best Buy carries Centon brand memory and Circuit City carries PNY memory they do not have to price match.

So. Why is popcorn more expensive in the movie theaters?