11 - Pricing Strategies Flashcards
Perfect Competition Pricing
Firms have no control over pricing and must charge whatever other firms charge.
Market power pricing
Simple rule for monopoly and monopolistic competition.
Firms have some influence that varies from firm to firm and by degree of instruments (advertising) and nature of industry.
Must master techniques and proper selection for circumstances.
Basic Pricing Strategy
MON and MC
Simply set price and qty where MR = MC for profit-maximizing price.
Applicable in any market that faces a downward demand curve.
Rough demand and cost function estimates.
MON and MC
Short of professional economic analysis, estimates are possible but albeit crude by comparison.
MC estimates based on capital inputs tend to be understated by not fully reflecting sales, marketing and administrative overhead.
Public industry reports are available that can guide demand estimates. However these are broad and may not accurately describe niche markets.
Straight Markups and Rules of Thumb
MON and MC
May fall short of profit maximizing price and qty. May fall short of optimal sales volume.
Tent to learn through trial and error or market observation.
Specialty products with fewer substitutes tend to get higher markups
Profit maximizing price calculation
MON and MC
Begin with Marginal Revenue Formula for own price and recall that at optimal price, MR = MC
Thus: MR = P[(1+E)/E] = MC
Solve for P in terms of MC (that are more readily known)
P=[E/(1+E)]MC or P=K•MC as K=E/(1+E)
K is the profit maximizing markup factor
Optimal markup factor implications
MON and MC
And Cournot Oligopoly
The more elastic the demand, the lower the markup factor. With many substitutes, and nearing perfect competition, the markup factor nears 1 with P nearly equal to MC.
In perfect competition K=1 This occurs when E = -infinity.
The higher the MC, the higher P must be.
In Cournot, when many firms produce homogeneous a product, price will = MC
Optimal Markup factor caveats
MON and MC
For a linear demand function elasticity is different at different prices so changing price will move elasticity which will change formula output leading to different optimal price.
If demand function is available, more accurate to compute MR and equate to MC to find P.
For log-linear demand function, elasticity is constant so price estimates are stable.
Profit maximizing price calculation for a Cournot Oligopoly
Few firms - many customers
Differentiated or homogeneous
Each firm believes others will hold output constant
Optimal price where MR = MC
To calculate P requires full information about all competitor demands and costs and the firm’s MR depends on outputs by all other firm’s.
To simplify:
P=[NE/(1+NE)]MC
N is the # of firms and E is market elasticity
Cournot Elasticity relation to Market Elasticity
For homogeneous product markets: Efirm = NEmarket
N = # firms in market
N = 1 is monopoly
N > 1 is Cournot
So further simplify P=[E/(1+E)]MC
Which is the same formula for monopoly and monopolistic competition!
Just use E of firm just like MON/MC formula
Use NE/(1+NE) if given market elasticity
First Degree Price Discrimination
The firm charges each customer the maximum threat are willing to pay. No customer surplus exists in the market.
Manager must somehow know what each customer is willing to pay.
Second Degree Price Discrimination
Prices staggered in discreet steps. Firms can extract some but not all surplus and customers sort themselves out according to tolerance to pay and desire for product volume or service level.
Firms do not need to know in advance spending tolerance of customers.
Third Degree Price Discrimination
Pricing groups based on demographic divisions. Senior citizen or kids eat free discounts.
Each group is charged a price reflecting its unique elasticity while equating MR to MC.
Firm must able to identify each group E
- age verification, etc.
Low price buyers can not be allowed to resell to high price group. That creates a perfect substitute!
Two-Part Pricing
A flat fixed fee for “right” to purchase goods and a per unit charge.
Set a per unit charge that equals MC plus a fixed fee equal to the consumer surplus each customer receives at the per unit price.
Two-part pricing extracts 100% of consumer surplus.
Block Pricing
Sell items in lots as one package. The price in the package includes price/qty combination total price (which in bulk is quite low) plus the entire surplus value the customer will receive.
This technique extracts 100% of the customer surplus.
Customers are forced to make all-or-nothing decision.
