MANAGERIAL ECONOMICS

An Analysis of Business Issues

Howard Davies and Pun-Lee Lam

Published by FT Prentice Hall

Chapter 14:

Pricing in Theory
Objectives:
To examine theoretical aspects of the pricing decision, including basic rules for optimal pricing pricing and market structures pricing and entry conditions - the pre-game theory approach price discrimination pricing and the product life cycle
2

The Basic Rule for ProfitMaximization

(Price - Marginal Cost)/Price = 1/-Ed

Not an operational decision rule - a statement of the condition required for maximum profit Can be re-stated in an average cost plus margin format - see p.292
3

Pricing and Market Structures

Review Chapter 10 Under perfect competition, firms are pricetakers Under monopoly, firms are price-makers (but still constrained by the requirement to make maximum profit) Under monopolistic competition, prices settle at the excess capacity level where P=AC

Pricing in Oligopoly

Review Chapter 13 on Cournot, Bertrand and von Stackelberg competition The conjectural variation approach
P - MC = (-) si(1+a) P Ed

Where si = firms market share; a =conjectural variation

5

Entry Conditions and Pricing

Entry may be blockaded, effectively impeded or uneffectively impeded Entry barriers are advantages held by incumbent firms, arising from:
absolute cost advantages economies of scale product differentiation
6

Limit Pricing

The limit price is the highest price that can be charged without inducing new entry Can it be determined? Game theory is the current approach - review Chapter 13 The traditional, pre-game theory approach was based on the Bain-Sylos-LabiniModigliani model
7

Limit Pricing

The Bain-Sylos-Labini-Modigliani model Entry will take place if the entrant believes that the post-entry situation will be profitable Entrants believe that if entry takes place, incumbents will keep their output constant
(a rather restrictive assumption)

Limit Pricing

Figure 14.2: Demand for an Entrants product

Price

P1
P2

Dindustry X X Dentrant
Quantity Q1 Q2
9

Limit Pricing

Figure 14.3: The Case of Absolute Cost Advantages

PH

ATC entrant
PL

ATCincumbent

Dentry encouraged

Dentry deterred
Quantity

10

Limit Pricing

If the limit price is known, should incumbent firms set that price or not? Limit pricing might mean less profit in short term but less erosion of profit in the long term Therefore depends upon:
how much extra profit can be made in the short run by setting price above the limit price how long can that extra profit be enjoyed before entry takes place what is the firms discount rate?
11

Price Discrimination

Price discrimination exists when the same product is sold for different prices, that are not attributable to differences in the cost of supply Two conditions are needed: the market must be divisible into sub-markets between which there cannot be any arbitrage demand conditions (elasticity) must be different in the sub-markets

12

Third Degree Price Discrimination

A number of sub-markets, each containing a number of potential customers These markets may be separated by:
distance ( car prices differ between Europe and the UK - but is it really price discrimination?) time (for non-storable commodities) - peak versus off-peak journeys age and status - Student Railcards, Old Person Railcards

See p 304 for a graphical analysis

13

First Degree Price Discrimination

Every buyer is charged the maximum they are willing to pay (the demand curve becomes the marginal revenue curve) Can be difficult to evaluate willingness to pay but first degree discrimination may be possible in personal, household or commercial services Note that the socially optimal level of output will be produced but all the surplus accrues to the producer
14

Second Degree Price Discrimination

Customers are charged one price for the first block of units they purchase, then a different price for the second block
electricity, water, gas tariffs the producer appropriates part of the consumer surplus

15

Pricing and the Product Life Cycle

Given;
the basic formula linking Price, Marginal Cost and Elasticity the likelihood that Elasticity rises and Marginal Cost falls throughout the PLC

The most straightforward prediction is that price falls continuously But is the PLC really valid?
16

Pricing and the Product Life Cycle

Sales Volume

Maturity

Decline

Growth

Introduction

Time 17

What Happens to Elasticity of Demand and Marginal Cost Over the Product Life Cycle?

Introduction - product is new. Elasticity may be low because there are no substitutes or high if buyers need to be persuaded to try the new product. Marginal cost is relatively high. Appropriate price will reflect high MC combined with high/low elasticity
Growth - imitation begins, and learning takes place. Elasticity rises, MC falls. Price falls? Maturity - competition from many locations, substitutes and next-generation products have been invented, elasticity high, MC low

Decline - fierce competition for a declining market, very low margins

BEWARE THE POTENTIALLY SELF-FULFILLING NATURE OF THE PLC THEORY!!!!!

18

Pricing New Products

For new products, there is a significant amount of uncertainty about demand conditions. Two strategies have been suggested (Dean 1950) SKIMMING - set an initially high price. IF that produces a high level of profits, leave the price high until conditions change and demand becomes more elastic. Do this when:
there is a significant group of buyers prepared to pay high prices when demand is inelastic when the high price will not induce entry when the cost penalty for low volume is small

PENETRATION - set a low price from the beginning in order to build a large market share quickly. Do this when:
demand is elastic low volume is very high cost entry is a major danger
19

Is Skimming v Penetration Just an Application of the Simple Model?

YES - set a high price when elasticity is low and MC is high, set a low price when the opposite is true BUT skimming may have another benefit. If experience shows it is the wrong strategy, the price can be cut without much customer resistance. If the penetration approach is used but it becomes clear that skimming would be better, it is more difficult to raise price than to lower it skimming may provide a means of price discrimination through time. If a market contains a group of trendsetters or first-adopters who must have, or like to have, a product first and are willing to pay more for it. Skimming allows them to be charged a higher price. E.g new major dictionaries, new types of mobile phone
20