Chapter 7: Pricing With Market Power: Managerial Economics and Organizational Architecture, 5e

Managerial Economics and Organizational Architecture, 5e
Managerial Economics and

Organizational Architecture, 5e
Chapter 7: Pricing with

Market Power
McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Pricing Objective
Pricing is key to managerial decision
making
Firms with market power can raise prices
without losing all customers to competitors
A firm has market power when it faces a
downward sloping demand curve
7-2
Pricing
Assume profit maximization
Implies single period pricing strategies
Firms wish to capture as much consumer

surplus as possible
Consumer surplus is the difference
between what the consumer is willing to
pay and what the consumer actually pays
7-3
Pricing with Market Power

$
Price (in dollars)
Consumer surplus
Demand
MC
Q
Quantity
7-4
The Benchmark Case:

single price per unit
Intuit data:
Purchases software from manufacturer for $10
Demand curve is P = 85 - 0.5Q (Q in 1000s of
units)
What is the profit-maximizing price?
Set MR = MC
85-Q=10
Q=75, P= $47.50
Profit is $2,812.50 (000s)
7-5
Single Price per Unit

$
Checkware
With MC=10,
the optimal output is 75
with a price of $47.50
Price (in dollars)
85.00
P*=
47.50
Demand
10.00
MR
Q* = 75
Quantity of Checkware
MC
170
Q
7-6
Cost Issues
Relevant costs
sunk costs are irrelevant
current opportunity costs are relevant
historical costs are irrelevant
7-7
Pricing Strategy
price elasticity, , is a measure of price
sensitivity
Optimal price is P=MC/[1-1/ ]
For MC = 10, if = 2, then
P = 10/[1 ] = 20
For MC = 10, if = 3, then
P = 10/[1 1/3] = 15
7-8
Price Sensitivity and Optimal Markup
Price (in dollars)
85.00
P*=
47.50
10.00
The optimal markup

is higher for the less
elastic demand
85.00
42.50
Demand
MR
Q* = 75
MC
170
Less elastic demand
P*=
26.25
10.00
Q
Demand
MC
Q* = 65
MR
Q
170
Quantity of Illustrator
More elastic demand

7-9
Price Sensitivity
In the original example = 1.267

P = 10/[1 1/1.267] = 47.5
For Illustrator, = 1.615
P = 10/[1 1/1.615] = 26.25
7-10
Estimating Profit-Maximizing Price

In theory, MC=MR, but in practice,
manager may not know demand curve
and therefore MR.
Cost-plus or mark-up pricing may be
useful approximations.
Such pricing should be product specific
and based on awareness of price
sensitivity.
7-11
Linear Approximation
Suppose firm currently sells 30 units at
$70
Firm estimates that by lowering price to
$65 it will sell 40 units
This information can be used to
approximate a linear demand curve
7-12
Linear Approximation
Slope = (65-70)/(40-30) = -0.5

the intercept is calculated using
P = a - 0.5Q
When price is $70, the intercept is
$70 = a - 0.5(30)
a = 85
Demand is estimated as:
P=85 0.5Q
7-13
Cost-Plus Pricing
Add a markup to average total cost to
yield target return
Must account for price sensitivity
Consistently bad pricing policies are not
good for the firms long-term fiscal health
7-14
Mark-Up Pricing
Optimal mark-up rule of thumb:
P*=MC*/(1-1/*)
where * indicates estimated value
Requires some knowledge or awareness
of both marginal costs and elasticity
7 - 15
Potential for Higher Profits

$
Consumer surplus
b
Price (in dollars)
Firm profits
P*
Unrealized gains from trade
c
e
Demand
MR
Q*
MC
170
Q
7-16
Block Pricing
Declining price on subsequent blocks of
product
Takes advantage of consumers lower
marginal value for additional units
Seen in product packaging
7-17
Two-Part Tariffs
Up-front fee for the right to purchase
Additional fee per unit purchased
Best when customers have relatively
homogenous demand for product
Used at country clubs, health clubs,
college football
7-18
Two-Part Tariff
$
capturing consumer surplus
$10
Charge an upfront fee equal to consumer surplus
Price (in dollars)
Profits will equal the area of the consumer surplus, $42.50
Demand
Charge a price of $1 per unit and
sell 9 units
MC
$1
Quantity
Q*=9
7-19
Price Discrimination
heterogeneous consumer demands
Price discrimination occurs when firm
charges different prices to different groups
of customers
not related to cost differences
Necessary conditions
different price elasticities of demand
no transfers across submarkets
7-20
Using Information About Individuals

Personalized pricing
first degree price discrimination
Extract maximum amount each customer is
willing to pay
possible only with small number of buyers
Group pricing
third degree price discrimination
very common (utilities, theaters, airlines)
7-21
Group Pricing
If two groups have different elasticities of
demand, the charge a higher price to the
group with the more inelastic demand.
Us the markup rule: P*=MC*/(1-1/*)
Apply it for each elasticity to get the
different prices
If the elasticities are 2.33 and 1.55 and
MC=$10, then markup the price to $17.50
and $30, respectively.
7-22
Optimal Pricing at Snowfish

different demand elasticities
Price (in dollars)
$
50.00
50.00
* = 1.50
P*=
30.00
25.00
* = 2.33
P*=17.50
10.00
MC
MR
Q* = 200
Quantity of passes
for out-of-town skiers
MC
10.00
MR
Q* = 150
Quantity of passes
for local skiers
7-23
Using Information About the

Distribution of Demands
Menu pricing
second degree price discrimination
consumers select preferred package
Companies often use different versions of
their product deluxe, basic, etc.
Coupons and rebates

users likely more price sensitive
users who are new customers may stick with
product
7-24
Bundling and Other Concerns

Bundling may yield a higher price than if
each component is sold separately
theater season tickets
restaurant fixed price meals
Multiperiod pricing
low initial price can lock-in customers
Strategic considerations
low price may be barrier to entry
7-25

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Managerial Economics and Organizational Architecture, 5e

Managerial Economics and