Module 11 - Pricing strategies

Question 1

Outline the factors that influence the firm’s power over prices

Answer 1

Perfect competition: firms are price takers.

Imperfect markets: control will typically be greater

• the fewer rivals the firm has
• the greater the difference between its products and those of its rivals.

Oligopolistic markets: pricing will reflect the interaction between firms. (low prices if they compete, high prices if they collude)

Monopoly: firms consider the possible entry of new firms when setting their prices. (low prices make entry more difficult, high prices encourage new entrants)

Question 2

Limit pricing

Answer 2

Where a business strategically sets its price below the level that would maximise its profits in the short run in an attempt to deter new rivals entering the market. This enables the firm to make greater profits in the long run.

Question 3

Average cost or mark-up pricing

Answer 3

A pricing strategy adopted by business in which a profit fixed percentage mark-up is added to average costs.
price = average fixed cost + average variable cost + mark-up

Question 4

Reverse capacity

Answer 4

A range of output over which business costs will tend to remain relatively constant.
(the average variable cost curve is saucer-shaped)

Question 5

Outline the factors affecting the price mark-up

Answer 5

The mark-up and output level can be adjusted by trial and error, having regard to:

• sales and profit targets
• the possible response of rival firms
• how the firm wishes to spread overheads across different products.

In general the mark-up will be larger:

• in growing markets
• where there are fewer rival firms

Question 6

Distinguish between and illustrate the three types of price discrimination

Answer 6

First degree price discrimination:
The firm charges each consumer the maximum price that he or she is prepared to pay for a good or service.

Second degree price discrimination:
The firm offers the customers a range of different pricing options for the same or similar product. Consumers are then free to choose whichever option they wish, but the price is often dependent on the quantity of the product purchased.

Third degree price discrimination:
A firm divides the consumers into different groups based on some characteristics that is relatively easy to observe and acceptable to the consumer. The firm then charges a different price to consumers in different groups, but the same price to all consumers within a group.

Question 7

Describe the three main types of second-degree price discrimination

Answer 7

1. Discounts for bulk purchases
   - Buy one get one free
   - 3 for the price of 2
2. Coupons/Vouchers
   Enables to buy the product for a lower price. Only the price-sensitive consumers will be bothered to spend time searching for the vouchers.
3. Inter-temporal pricing
   This occurs when the price charged varies over time. This happens because the price elasticity of demand varies over time. For example, some people will be prepared to pay a high price for a new version of a mobile phone, but the more price-sensitive will wait until the price falls.

Question 8

Outline the conditions necessary for price discrimination

Answer 8

1. The firm has a degree of market power, ie it faces a-sloping demand curve.
2. It is not possible to buy in one market and resell the product for a higher price in another market, eg haircuts, restaurant meals, goods with high transport costs.
3. The elasticity of demand differs between consumers at any given price.

Question 9

Discuss whether or not price discrimination is in the public interest

Answer 9

1. Distribution effects
   The consumer surplus gained by the consumers who are able to purchase a good that they would otherwise not be able to buy, or who pay a lower price than would otherwise be the case, could be compared with the consumer surplus lost by the consumers who have to pay more than would otherwise be the case.
2. Effect on output
   Price discrimination may lead to additional output.
3. Misallocation effects
   The introduction of TDPD could lead to misallocation of resources. If total sales remain constant and the product is reallocated from those who were prepared to pay a higher price to those with a lower willingness to pay, then assuming that price reflects utility, total welfare would fall.
4. Anti-competitive effects
   Predatory pricing. Although consumers gain from lower prices in the short run, prices will rise once the competitors have been driven from the market.

Question 10

Inter-temporal pricing

Answer 10

Where the price the firm charges for a product varies over time. It occurs where the price elasticity of demand for a product varies at different points of time.

Question 11

Predatory pricing

Answer 11

Where a firm sets its average price below average cost in order to drive competitors out of business.

Question 12

Peak-load pricing

Answer 12

The practice of charging higher prices at times when demand is highest because the constraints on capacity lead to higher marginal cost.

Question 13

Two-part tariff

Answer 13

A pricing system that requires customers to pay both an access and a usage price for a product.

Question 14

Loss leader

Answer 14

A product whose price is cut by the business in order to attract custom. The idea is that once in the store, consumers will also buy lots of full-price products.

Question 15

Full-range pricing

Answer 15

A pricing strategy in which a business, seeking to improve its profit performance, assesses the pricing of its goods as a whole rather than individually.

Question 16

By product

Answer 16

A good or service that is produced as a consequence of producing another good or service.

Question 17

Explain what is meant by transfer pricing

Answer 17

The pricing system used within a business organisation to transfer intermediate products between the business’s various divisions.

Individually, each division may attempt to maximise its own profits, by charging higher prices, at the expense of other divisions. However this may not be to the benefit of the organisation as a whole.

Question 18

Describe the four stages of the product life circle

Answer 18

1. Launch
2. A period of rapid sales growth
3. A levelling off in sales - maturity
4. A period of decline - as the market becomes saturated with alternatives or the product becomes obsolete.

Question 19

Explain and illustrate how pricing varies with each stage in the life of a product

Answer 19

Consumer demand, competition and the other factors affecting the pricing decision will generally vary between these stages.

1. Launch
   The lack of substitutes and resulting inelastic demand, may enable the firm to charge high prices and make large profits, particularly for a new product that is unlike existing products.
   However, if the firm is worried about possible competition from new entrants, then it may charge a lower price to get as large a market share and as much brand loyalty as possible before new firms enter.
   The two key factors to consider are:
   - the current price elasticity of demand
   - the likelihood of new entrants
2. Growth stage
   Rapid sales growth is likely to attract new entrants, possible leading to an oligopolistic market in which firms may compete by offering slightly different products.
3. Maturity stage
   As more firms enter the market, competition is more intense and any collusion might begin to break down. Price wars might break out and firms may innovate to try and prolong the life of the product.
4. Decline stage
   Competition may increase further as firms struggle to retain sales and some firms may be driven from the market. Eventually sales will level out at the replacement level, or even fall to zero if the product becomes obsolete.