Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Managerial Economics &
Chapter 11
Pricing Strategies for Firms with
Market Power
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Overview
I,Basic Pricing Strategies
? Monopoly & Monopolistic Competition
? Cournot Oligopoly
II,Extracting Consumer Surplus
? Price Discrimination ? Two-Part Pricing
? Block Pricing ? Commodity Bundling
III,Pricing for Special Cost and Demand Structures
? Peak-Load Pricing ? Price Matching
? Cross Subsidies ? Brand Loyalty
? Transfer Pricing ? Randomized Pricing
IV,Pricing in Markets with Intense Price Competition
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Standard Pricing and Profits
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1 2 3 4 5
MC
MR = 10 - 4Q
Profits from standard pricing
= \$8
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
An Algebraic Example
? 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
? 10 - 4Q = 2,so Q* = 2
? P* = 10 - 2(2) = 6
? Profits = (6)(2) - 2(2) = \$8
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
A Simple Markup Rule
? Suppose the elasticity of demand for the firm’s
product is EF
? 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,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
An 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 Kodak’s price is margin
above manufacturing costs,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Markup Rule for Cournot
Oligopoly
? Homogeneous product Cournot oligopoly
? N = total number of firms in the industry
? Market elasticity of demand EM
? Elasticity of individual firm’s demand is given
by EF = N EM
? P = [EF/(1+ EF)] ? MC,so
? P = [NEM/(1+ NEM)] ? MC
? The greater the number of firms,the lower the
profit-maximizing markup factor
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
An Example
? Homogeneous product Cournot industry,3 firms
? MC = \$10
? Elasticity of market demand = - 1/2
? Profit-maximizing price?
? EF = N EM = 3 ? (-1/2) = -1.5
? P = [EF/(1+ EF)] ? MC
? P = [-1.5/(1- 1.5] ? \$10
? P = 3 ? \$10 = \$30
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Perfect Price Discrimination
Price \$
Quantity
D
10
8
6
4
2
1 2 3 4 5
Profits,
.5(4-0)(10 - 2)
= \$16
Total Cost
MC
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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 won’t work if consumers can
resell the good,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Second Degree
Price Discrimination
? The practice of posting
a discrete schedule of
declining prices for
different quantities,
? Example,Electric
utilities
Price
MC
D
\$5
\$10
4 Quantity
\$8
2
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Third Degree Price Discrimination
? The practice of charging different groups
of consumers different prices for the same
product
? Examples include student discounts,senior
citizen’s discounts,regional &
international pricing
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Implementing Third Degree
Price Discrimination
? 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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
An Example
? Suppose the elasticity of demand for Kodak film in
the US is EU = -1.5,and the elasticity of demand in
Japan is EJ = -2.5
? Marginal cost of manufacturing film is \$3
? PU = [EU/(1+ EU)] ? MC = [-1.5/(1 - 1.5)] ? \$3 = \$9
? PJ = [EJ/(1+ EJ)] ? MC = [-2.5/(1 - 2.5)] ? \$3 = \$5
? Kodak’s optimal third-degree pricing strategy is to
charge a higher price in the US,where demand is
less elastic
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Two-Part Pricing
? When it isn’t 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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
How Two-Part Pricing Works
1,Set price at marginal cost,
2,Compute consumer surplus,
3,Charge a fixed-fee equal to
consumer surplus,
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC
Fixed Fee = Profits = \$16
Price
Per Unit
Charge
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
An Algebraic Example
? Typical consumer’s demand is P = 10 - 2Q
? C(Q) = 2Q
? Optimal number of units in a package?
? Optimal package price?
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Quantity To Package,4
Units
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC = AC
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Price for the Package,\$24
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC = AC
Consumer’s valuation of 4
units =,5(8)(4) + (2)(4) = \$24
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Costs and Profits with Block Pricing
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
MC = AC
Profits = \$16
Costs = \$8
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
An Example that Illustrates
Kodak’s Moment
? Total market size is 4 million consumers
? Four types of consumers
? 25% will use only Kodak film
? 25% will use only Kodak developing
? 25% will use only Kodak film and use only Kodak
developing
? 25% have no preference
? Zero costs (for simplicity)
? Maximum price each type of consumer will
pay is as follows,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Reservation Prices for Kodak Film
and Developing by Type of
Consumer
T y p e F ilm D e v e lo p in g
F \$8 \$3
FD \$8 \$4
D \$4 \$6
N \$3 \$2
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Film Price?
T y p e F ilm D e v e lo p in g
F \$8 \$3
FD \$8 \$4
D \$4 \$6
N \$3 \$2
Optimal Price is \$8,to earn profits of \$8 x 2 million = \$16 Million
At a price of \$4,only first three types will buy (profits of \$12 Million)
At a price of \$3,all will types will buy (profits of \$12 Million)
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Optimal Price for Developing?
T y p e F ilm D e v e lo p in g
F \$8 \$3
FD \$8 \$4
D \$4 \$6
N \$3 \$2
Optimal Price is \$3,to earn profits of \$3 x 3 million = \$9 Million
At a price of \$6,only,D” type buys (profits of \$6 Million)
At a price of \$4,only,D” and,FD” types buy (profits of \$8 Million)
At a price of \$2,all types buy (profits of \$8 Million)
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Total Profits by Pricing Each Item
Separately?
T y p e F ilm D e v e lo p in g
F \$8 \$3
FD \$8 \$4
D \$4 \$6
N \$3 \$2
\$16 Million Film Profits + \$9 Million Development Profits =\$25 Million
Surprisingly,the firm can earn even greater profits by bundling!
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Pricing a,Bundle” of Film and
Developing
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Valuations of a Bundle
T y p e F ilm D e v e lo p in g V a l u e o f B u n d l e
F \$8 \$3 \$11
FD \$8 \$4 \$12
D \$4 \$6 \$10
N \$3 \$2 \$5
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
What’s the Optimal Price for a
Bundle?
T y p e F ilm D e v e lo p in g V a l u e o f B u n d l e
F \$8 \$3 \$11
FD \$8 \$4 \$12
D \$4 \$6 \$10
N \$3 \$2 \$5
Optimal Bundle Price = \$10 (for profits of \$30 million)
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
? When demand during
peak times is higher
than the capacity of the
firm,the firm should
pricing,
? Charge a higher price (PH)
during peak times (DH)
? Charge a lower price (PL)
during off-peak times (DL)
Quantity
Price MC
MRL
PL
QL QH
DH
MRH
DL
PH
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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?
? An Example,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Wholesaler’s 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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Retailer’s Problem
? Demand for the final product P = 10 - 2Q
? Retailer’s 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
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
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 wholesaler’s profits are \$6 ? 1 - 2(1) = \$4
instead of the monopoly profits of \$6 ? 2 -
2(2) = \$8
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Wholesaler’s,Monopoly
Profits”
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1 2 3 4 5
MC = AC
MR = 10 - 4Q
\$8
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Wholesaler’s Profits when
Retailer Marks price up to \$8
Price
Quantity
P = 10 - 2Q
10
8
6
4
2
1 2 3 4 5
MC = AC
MR = 10 - 4Q
\$4 Retail
Price
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Solutions for the Wholesaler?
? Force retailers to charge \$6,How?
?,Suggested retail prices?”
? Vertical price restraints?
? Vertical quantity restraints?
? Integrate into retailing?
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Pricing in Markets with Intense
Price Competition
? Price Matching
? Advertising a price and a promise to match any lower price offered
by a competitor,
? No firm has an incentive to lower their prices,
? Each firm charges the monopoly price and shares the market,
? Randomized Pricing
? A strategy of constantly changing prices,
? Decreases consumers’ incentive to shop around as they cannot
learn from experience which firm charges the lowest price,
? Reduces the ability of rival firms to undercut a firm’s prices,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Recap of Pricing Strategies
? First degree price discrimination,block pricing,and
two part pricing permit a firm to extract all
consumer surplus,
? Commodity bundling,second-degree and third
degree price discrimination permit a firm to extract
some (but not all) consumer surplus,
? Simple markup rules are the easiest to implement,
but leave consumers with the most surplus and may
result in double-marginalization,
? Different strategies require different information,