Understanding Pricing Strategies and Practices

Learning objectives:
 At the end of this chapter students should be able to

▪ Explain the importance of competitive advantage in
pricing strategies and practices
▪ Discuss the meaning, uses, basis and requirements to
market segmentation, targeting and positioning
▪ Explain the meaning, uses and the conditions necessary
for price discrimination
▪ Explain and evaluate the potential costs and benefits of
price discrimination to both firms and consumers
▪ Explain the role of prices in the marketing mix
5.1. Introduction
 Price is just one of many decision variables that managers
have to determine. And pricing strategies and practices are
often treated as being the core of managerial economics.
 Pricing strategy refers to the policy a firm practices to
determine what it will charge for its products and services.
5.1. Introduction … continued
 We have thus far discussed output and pricing decisions
under some very simplistic assumptions:
➢The firm is a profit maximizer,
➢The firm produces and sells a single good or service
➢All production takes place in a single location
➢The firm operates within a well-defined market structure
➢Management has precise knowledge about the firm’s
production, revenue, and cost functions.
➢The firm sells its output at the same price to all
consumers in all markets.
 These conditions, however, are rarely observed in reality:
that is, there is no universally agreed pricing strategy that
works with all these assumptions.
 Most real world pricing practices take us away from the
standard assumption in theory of the firm that there is a
single profit-maximizing price for the same good or service.
Strategic pricing approaches
 Strategic pricing approaches fall broadly into three categories :
a) Cost-based pricing: setting prices based on the costs for
producing, manufacturing, distributing, and selling the
product. The firm normally adds a fair rate of return to
compensate for its efforts and risks
b) Competition-based pricing: setting prices in relation to the
prices of competitors
c) Value-based pricing: setting prices primarily, but not
exclusively, based on a consumer's perceived or estimated
value of a product or service rather than according to the
cost of the product or historical prices. This is customer-
focused pricing approach.
5.2. Competitive Advantage
 Competitive advantage refers to internal factors that allow a
firm to produce goods or services better or more cheaply than its
competitors. The factors that define competitive advantages of a
firm determine its ability to create more value than its rivals.
 Competitive advantage is, thus, what makes a firm’s products or
services more desirable to customers than that of any other rival.
 Competitive advantages are attributed to a variety of factors
including cost structure, the quality of product offerings, the
distribution network, branding, intellectual property, and
customer service. These factors allow the firm to generate more
sales or superior margins compared to its market rivals.
 Competitive advantages can be broken down into two:
1) Comparative advantages and
2) Differential advantages.
5.2. Competitive Advantage … Continued
Comparative advantage
 Comparative advantage refers to a firm’s ability to produce
goods or services more efficiently than its competitors.
 Rational consumers will choose the cheaper of any two perfect
substitutes offered.
 Economies of scale, efficient internal systems, and geographic
location are the factors that can create a comparative advantage.
 Comparative advantage does not imply a better product or
service, though. It only shows the firm can offer a product or
service of the same value at a lower price.
 For example, a firm that manufactures a product in China may
have lower labor costs than a company that manufactures in the
U.S.A., so it can offer an equal product at a lower price.
5.2. Competitive Advantage … Continued
Differential advantage
 A differential advantage is when a firm’s products or
services are seen as superior (both unique and higher
quality) relative to its competitors.
 Advanced technology, patent-protected products or
processes, superior personnel, and strong brand identity are
all drivers of differential advantage. These factors
support wide margins and large market shares.
 Example: Apple is famous for creating innovative products,
such as the iPhone, and supporting its market leadership
with savvy marketing campaigns to build an elite brand.
5.3. Market Segmentation, Targeting and Positioning
Market Segmentation
 Market refers to people or institutions with sufficient
purchasing power, authority, and willingness to buy
 Market segmentation is a process of dividing large
markets into distinct groups on the basis of certain distinct
needs, characteristics, or behaviour of the customers.
 Through market segmentation, companies or firms divide
large, heterogeneous markets into smaller, relatively
homogeneous groups that can be reached more efficiently
and effectively with products and services that match their
unique needs. Segmented markets must be homogeneous
within and heterogeneous between markets.
The importance of market segmentation
 Markets have a variety of product needs and preferences.
 Marketers can better define customer needs.
 Decision makers can define objectives and allocate
resources more accurately.
Basis for segmenting consumer markets
 Characteristics of individuals, groups, or organizations used
to divide a total market into segments.
 Some of the characteristics used to segment markets are:
 Geographic characteristics
 Demographics characteristics
 Psychographics characteristics
 Behavioural characteristics
 These characteristics are described on the next slides
Basis for segmenting consumer markets …
 Geographic segmentation: based on location characteristics
such as country, city, density, language, climate, population, etc.
 Demographic segmentation: based on demographic
characteristics such as age, gender, household size, stage in the
family life cycle, income, occupation, education, religion,
ethnicity, generation, nationality, and so on.
 Psychographic segmentation: based on life-style, social class,
personality and other related variables of interest.
 Behavioural segmentation: based on variables such as
occasions, benefits, user status, usage rate, loyalty status,
readiness stage, attitude toward product and other related factors.
No Market Segmentation
Segmented by Gender
Segmented by Age
Requirements for effective market segmentation:
 Measurable: size, purchasing power, profiles of segments
 Accessible: segments can be effectively reached and served
 Substantial: large or profitable enough to serve
 Actionable: effective programs can be designed to attract
and serve the segments
 Differentiable: conceptually distinguishable.
Targeting
 Targeting is the selection of the target market: choosing one or
more segments for which to design your marketing operations.
 Target market consists of a set of buyers who share common needs or
characteristics that the company decides to serve.
 Market targeting strategies:
a) Undifferentiated (mass) marketing: whole market one offer (or
single marketing mix): ignore segments
b) Differentiated (segmented) marketing: decide to target several
market segments, separate offers for each
c) Concentrated (niche) marketing: concentrate on one or a few
segments or niches
d) Micromarketing:
◦ Local marketing: cities, neighborhoods, specific stores
◦ Individual marketing: person practice of tailoring products
Strategies for Reaching Target Markets
• No single, best choice strategy suits all firms
• Choosing a targeting strategy depends on:
– Company resources
– Product homogeneity (or product or market variability)
– Competitors’ marketing strategy
– Product life-cycle stage,
Target Marketing Process
 Linking customer needs to marketing action follows
sequence of processes
1) Segmentation: identify and describe market segments
2) Targeting: evaluate segments and decide which to go
after
3) Positioning: design a product or service to meet a
segment’s needs and develop a marketing mix that will
create a competitive advantage in the minds of the
selected target market.
Market Positioning
 Positioning starts with a product, but it is not what you
do to a product.
 It is what you do in the target market’s or target
customer’s mind (perceptions, feelings, and impressions).
 Positioning refers, therefore, to the place that a brand
occupies in the minds of the customers and how it is
distinguished from the products of the competitors and
different from the concept of brand awareness.
5.4. Price Discrimination
 For firms with market power, price discrimination refers to
the practice of selling the same good or service at different
prices for the purpose of extracting maximum profit.
 Price discrimination may involve
▪ Charging different buyers different prices for the same
product or
▪ Charging the same consumer different prices for different
quantities of the same product.
 Thus, in price discrimination, a firm sells identical products in
two or more markets at different prices.
 Price discrimination takes us away from the standard
assumption in theory of the firm that there is a single profit-
maximizing price for the same good or service.
5.4. Price Discrimination … Continued
 Main aims of price discrimination:
◦ To increase revenue
◦ To extract the maximum profit
◦ To improve cash flow
 Conditions for price discrimination
a) Sufficient monopoly (market) power. Monopolist firms
always have pricing power- price makers not takers
b) Identifying different market segments; i.e., consumers with
different price elasticities of demand
c) Ability to separate different groups. Requires information
(or sufficient market intelligence).
d) Ability to prevent re-sale (arbitrage). No secondary
markets where arbitrage can take place at intermediate prices.
Example: limiting sales, age-restrictions, use of ID cards
5.4. Price Discrimination … Continued
Types of price discrimination
 There are several types (forms) of price discrimination.
 Economists have identified three degrees of price
discrimination; namely:
a) First-degree price discrimination,
b) Second-degree price discrimination, and
c) Third-degree price discrimination.
5.4.1. First-degree Price Discrimination
 First-degree price discrimination (also called perfect price
discrimination) occurs when a firm (or a seller) charges
each consumer his reservation price, the maximum amount
that he is willing to pay, for each unit.
▪ A firm charges each buyer a different price for each
individual unit of a given product purchased.
▪ The producer charges different prices for different units
▪ The price charged for each unit purchased is based on
the seller’s knowledge of each buyer’s demand curve.
5.4.1. First-degree Price Discrimination … Continued
 First degree price discrimination is the extreme form of
charging different prices to different consumers, and makes
use of the concept of “reservation price”.
 A consumer’s maximum willingness to pay is defined to be
their reservation price. Reservation Price is the maximum
price that a consumer is willing to pay for a good. Each
consumer pays its own willingness to pay for each unit
 First-degree price discrimination is potentially the most
profitable of the three types of price discrimination.
 In first-degree price discrimination, a firm tries to maximize
profits by extracting the buyer’s consumer surplus.
 Because it is virtually impossible to satisfy its informational
requirements, it is extremely rare in practice.
Figure 5.1: First-degree price discrimination

 The purpose of first-degree price discrimination is to extract the
total amount of consumer surplus from each individual
customer. The concept of consumer surplus is crystal clear.
 It represents the ETB value of benefits received per unit of
output consumed minus the product’s selling price (Figure 5.2).
 If we assume that the individual’s demand function is linear, i.e.,

 Then consumer surplus is approximated as
 Equation (5.3) suggests that the smaller the change in Q, the

better the approximation of the consumer surplus: the value of
the consumer surplus may be calculated as
 The application of integral can be applied to calculate the

actual value of consumer surplus. Defining the demand curve as
P = f(Q), consumer surplus may be defined as
 Where Pn and Qn are the equilibrium price and quantity,

respectively.
 Substituting Equation (5.2) into the integral equation (5.5) yields,
𝑛
2 𝑛
𝐶𝑆 = 𝑎 + 𝑏𝑄𝑖 𝑑𝑄 − 𝑃𝑛 𝑄𝑛 = 𝑎𝑄 + 0.5𝑏𝑄𝑖 − 𝑃𝑛 𝑄𝑛
0
0
= 𝑎𝑄𝑛 + 0.5𝑏𝑄𝑛 2 − 𝑎 0 + 0.5𝑏 0 2

− 𝑃𝑛 𝑄𝑛
= 𝑎𝑄𝑛 + 0.5𝑏𝑄𝑛 2 − 𝑃𝑛 𝑄𝑛
Figure 5.2: Consumer Surplus

 If we assume that the demand equation is linear (P = a + bQ) and

that the firm is able to extract consumer surplus, total revenue
for a profit-maximizing firm is
TR(Q) = PQ + CS = PQ + 0.5(a – Pn)Qn …… (5.6)
 If we assume that total cost as an increasing function of output,
then the total profit function is
Π(Q) = TR(Q) – TC(Q) = [PQ + 0.5(a – Pn)Qn] – TC(Q) … (5.6)
 Substituting Equations (5.4) and (5.6) into Equation (5.7) yields
𝜋 𝑄 = 𝑎 − 𝑏𝑄 𝑄 + 0.5 𝑎 − 𝑎 + 𝑏𝑄 𝑄 − 𝑇𝐶 𝑄
= 𝑎𝑄 + 0.5𝑏𝑄 2 − 𝑇𝐶 𝑄 … … … … … (5.9)
 The first- and second-order conditions for profit maximization

are respectively
𝑑𝜋
= 0 → 𝑎 + 𝑏𝑄 − 𝑀𝐶 = 0 … … … . (5.10)
𝑑𝑄
𝑑2 𝜋 𝑑𝑀𝐶
= 𝑏 − < 0 … … … . (5.11)
𝑑𝑄 2 𝑑𝑄
 Solving Equation (5.10) for output yields

𝑀𝐶 − 𝑎
𝑄∗ = … … … . (5.12)
𝑏
 Substituting Equation (5.12) into Equation (5.2) yields
𝑀𝐶 − 𝑎
𝑃∗ = 𝑎 + 𝑏 = 𝑎 + 𝑀𝐶 − 𝑎 = 𝑀𝐶 … … … … (5.13)
𝑏
 The firm attempting to extract consumer surplus does
not actually charge a price equal to marginal cost, which
is the case of a profit-maximizing condition for a firm
operating in a perfectly competitive industry.
 Instead, the firm will calculate consumer surplus by
substituting Equation (5.13) into Equation (5.4).
 Of course, P > MC for a profit-maximizing firm facing a
downward-sloping demand curve for its product.
Numerical example (consumer surplus): Assume that a

firm’s demand equation is given by P = 20 – 2Q. Suppose
that the market price of the product is P = ETB 6. What is
the actual value of consumer surplus?
 Solution: P = ETB 6 implies Q = 7. The actual value of the
individual’s consumer surplus is given by the expression
CS = 0.5(a – Pn)Qn
 Substituting into this expression we obtain
CS = 0.5(20 – 6)7 = ETB 49
 Alternatively, a definite integral can be applied to calculate
the actual value of consumer surplus.
7
7
𝐶𝑆 = 20 − 2𝑄 𝑑𝑄 − 𝑃𝑛 𝑄𝑛 = 20𝑄 − 𝑄 2 − 𝑃𝑛 𝑄𝑛
0
0
= 20𝑄𝑛 − 𝑄𝑛 2 − 20 0 − 0 2
− 𝑃𝑛 𝑄𝑛
𝐶𝑆 = 20𝑄𝑛 − 𝑄𝑛 2 − 𝑃𝑛 𝑄𝑛
 Since P = ETB 6 implies Q = 7, we have
𝐶𝑆 = 20(7) − (7)2 − 6 7 = 140 − 49 − 42 = 𝐁𝐢𝐫𝐫 𝟒𝟗

 Therefore, the actual value of consumer surplus is ETB 49.
 Numerical example (optimal price and output determination):
Let’s consider a firm whose demand curve and marginal revenue
curve are given by the following equations:
P = 150 – 5Q
MR = 150 – 10Q
 Let’s assume that the firm’s marginal cost is given by 5Q with
no fixed cost
a) Calculate the profit-maximizing price, output and profit of
the firm without price discrimination.
b) Calculate the profit-maximizing price, output and profit of
the firm with price discrimination.
c) Calculate the demand elasticities of the two segments at
their profit-maximizing prices.
Solution
a) If there is no price discrimination, the profit-maximizing
output for a firm facing a downward-sloping demand
curve occurs at a point at which its MR = MC.
150 – 10Q = 5Q → Q = 10
▪ The demand curve tells us that the firm should set price at
P = 150 – 5(10) = ETB 100
▪ Since there is no price discrimination, ETB 100 is charged
for each of the 10 units. Thus, the total revenue is
TR = 100 (10) = ETB 1,000
▪ The total cost is
TC = ETB 275
▪ The total profit is ETB 725 (ETB1,000 – ETB 275).
b) The demand curve tells us that the reservation price, the
maximum price that consumers will pay, is different
from marginal revenue as shown in the table below:
Marginal Reservation
Q Marginal Cost
Revenue Price
1 5 140 145
2 10 130 140
3 15 120 135
4 20 110 130
5 25 100 125
6 30 90 120
7 35 80 115
8 40 70 110
9 45 60 105
10 50 50 100
 With price discrimination, each customer is charged a
price that corresponds to the demand function.
 So, the optimal output level occurs when the marginal
cost curve intersects the demand curve (or the reservation
price instead of the marginal revenue curve).
MC = P → 5Q = 150 – 5Q → Q = 15
 As the reservation price curve intersects marginal cost
curve at Q = 15 units, optimal output is 15 units and total
revenue is the sum of prices charged for those 15 units
TR = P1 + P2 + P3 + … + P15 = ETB 1650
 Since total cost for 15 units is ETB 600, profit when there is
price discrimination is ETB 1,050 (= 1,650 – 600).
 This example shows that by engaging in perfect price
discrimination, a company or a firm earns an additional
profit of ETB 325 (= 1,050 - 725).
 This arises from the firm’s ability to charge a price of
ETB145 for the first unit, ETB140 for the second unit and
so on instead of a single price of ETB100 for each unit
and due to increase in the optimal output from 10 to 15.
 The difference between reservation price and the market
price represents consumer surplus.
 Through perfect price discrimination, the producer has
effectively captured all of the consumer surplus.
c) Elasticities of demand at the two segments of profit-
maximizing prices.
 Defining elasticities of demand 𝛆i
𝛆i = (dQi/dPi) (Pi/Qi)
 Since P = 150 – 5Q implies Q = 30 – 0.2P,
𝛆i = -0.2 (Pi/Qi)
 Thus, elasticities of demand at the two segments of profit-
maximizing prices are
 At P = 100,
𝛆 = -0.2 (100/10) = -2
 At Q = 15, P = 75,
𝛆 = -0.2 (75/15) = -1
5.4.2. Second-degree Price Discrimination
 Second-degree price discrimination sometimes referred to
as volume or quantity discounting. Second-degree price
discrimination occurs when firms sell their product in
“blocks” or “bundles” rather than one unit at a time.
 Second degree price discrimination is a common form of
pricing and packaging.
 In second-degree price discrimination, therefore,
▪ Different prices are charged for different blocks of units, or
▪ Different products are bundled and sold at a package price.
 Second degree price discrimination takes advantage of
preference differences between consumers.
5.4.2. Second-degree Price Discrimination
 Two or more different sized packages of a good with
different prices per unit is an example of second-degree price
discrimination strategy: A 12-units and a 24-units pack of
exercise book is a practical example of this strategy.
 This strategy is effective only when the consumers have
different preferences for different sized packages, and different
demand curves reflect this difference.
 In the case of second-degree price discrimination, however,
sellers attempt to maximize profits by selling product in
blocks or bundles rather than one unit at a time.
 Therefore, second-degree price discrimination differs from
first-degree price discrimination in the manner in which the
firm attempts to extract consumer surplus.
5.4.2. Second-degree Price Discrimination … Continued
 Common forms of second-degree price discrimination:
1) Block pricing and
2) Commodity bundling.
Block pricing
 Block pricing involves selling a product in fixed
quantities. There are different prices for different blocks
of goods and services.
 The rationale behind block pricing is to charge a price
for the package that approximates, but does not exceed,
the total benefits obtained by the consumer.
Block pricing …
 Block pricing is similar to first-degree price discrimination
in that the seller is trying to maximize profits by
extracting all or part of the buyer’s consumer surplus.
 Suppose, for example, that the estimated demand equation of
the average consumer for good Q is P = 0.3 - 0.0125Q.
 Suppose, further, that the marginal cost of producing a good Q is
constant at ETB 0.10. This situation is illustrated in Figure 5.3.
➢With block pricing the firm will attempt to get the
consumer to pay for the full value received for the 8 units
of good Q by charging a single price for the package.
➢If 8 units of good Q were sold for ETB 0.10 each, the total
expenditure by the typical consumer would be ETB 0.80.
Block pricing …
Figure 5.3: Block pricing

Block pricing …
 The firm will add the value of consumer surplus to the
package of 8 units of good Q, as follows:
Block Price = TR = PQ + CS = PQ + 0.5(a – Pn)Qn
= 0.1(8) + 0.5(0.3 – 0.1)8
= 0.8 + 0.8
= ETB 1.6
 The profit earned by the firm is
Π = TR – TC = PQ + CS – (MC * Q) = 1.6 – 0.8 = ETB 0.8
 If this firm operated in a perfectly competitive industry and
8 units of good Q were sold individually, the selling price
would be ETB 0.10 per unit and the firm would break even.
Block pricing …
Numerical Example: Suppose a hypothetical Park has estimated
the demand for the average yearly visits as Q = 27 -3P where Q
represents the number of visits by each visitor and P the price
per visit in ETB. Assume the total cost of providing a visit is
characterized by TC = 1 + Q. Suppose the park is a profit
maximizer considering two different pricing schemes: charging
on a per-visit basis or charging a one-time admission fee and
allowing park visitors to visit as often as they like.
a) How much should the park charge on a per-visit basis, and what is
the total profit to it per customer?
b) If the park decides to extract the consumer surplus of the average
park visitor, how much should it charge as a one-time admission
fee? What is the estimated average profit per park visitor? What is
the amount of consumer surplus of the average park visitor?
Block pricing …
Solution:
a) Solving the demand equation for P yields:
P = 9 – (Q/3)
 The per-customer total revenue equation is
TR = PQ = [9- (Q/3)]Q = 9Q – (Q2/3)
 The per-customer total profit equation is
Π = TR – TC = 9Q – (Q2/3) – (1 + Q) = -1 + 8Q - (Q2/3)
 The first-order conditions for profit maximization is
d Π/dQ = 0 → 8 – (2Q/3) = 0 → Q = 12 units
Block pricing …
 The second-order condition for profit maximization is
d2Π/dQ2 < 0 → – (2/3) < 0
The second-order condition for a maximum is satisfied.
 The profit-maximizing output level and price are, therefore,
Q* = 12 Units
P* = 9 – (Q*/3) = 9 – (12/3) = ETB 5
 The estimated average profit per visit is
Π = -1 + 8Q - (Q2/3) = -1 + 8(12) - (122/3) = ETB 47
Block pricing …
b) If the park charges a one-time admission fee, it will
attempt to extract the total amount of consumer surplus.
Since the demand equation is linear, the estimated
consumer surplus per average visitor is given by the
equation CS = 0.5(a – P)Q. From Equation (5.8) the profit
equation for the park is given by
Π = TR – TC = (a + bQ)Q + 0.5(a – (a + bQ)Q) – (1 + Q)
= (9 – (Q/3))Q + 0.5 [(9 – (9 – (Q/3))]Q – (1 + Q)
= 9Q - (Q2/3) + 0.5 (Q/3)Q – (1 + Q)
= 9Q - (Q2/3) + (Q2/6) – 1 – Q
= 8Q - (Q2/6) – 1
Block pricing …
d Π/dQ = 0 → 8 – (2Q/6) = 0 → Q = 24 visits
 The second-order condition for profit maximization is
d2Π/dQ2 < 0 → – (2/6) < 0
 The second-order condition for a maximum is satisfied.
 The profit-maximizing output level and price are, therefore,
Q* = 24 visits
P* = 9 – (Q*/3) = 9 – (24/3) = ETB 1 = MC
 Total profit is, therefore,
Π = 8(24) - (242/6) – 1 = ETB 95
Block pricing …
 The one-time admission fee should equal the total cost per
visitor of providing 24 visits plus the total amount of
consumer surplus, that is,
One-time admission fee = (MC * Q) + CS
= (MC * Q) + 0.5(a – MC)Q
= 1(24) + 0.5(9 – 1)24
= 24 + 96
= ETB 120
 Thus, the estimated consumer surplus of the average park
visitor is ETB 96.
Commodity Bundling
 Commodity bundling involves combining two or more
different products into a single package, which is sold at
a single price.
 Like block pricing, this is done to enhance the firm’s
profits by extracting at least some consumer surplus.
 Example: a resort hotel that sells weekly vacation

packages. Suppose that the package includes room, board,
and entertainment. Let us further suppose that the MC cost
to the resort hotel of providing the package is ETB 1,000.
Commodity Bundling …
 Suppose management of the resort hotel has identified two
groups of individuals that would be interested in the
vacation package. To keep the example simple, assume that
there are an equal number of members in each group.
 To further simplify the example, assume that total
membership in each group is a single individual.
 Table 5.1 illustrates the maximum amount that each group
will willingly pay for the components of the package.
Table 5.1 Commodity bundling and vacation packages
Group Room and board Entertainment
1 ETB 2,500 ETB 500
2 ETB 1,800 ETB 750

 If the resort hotel could identify the members of each group,
it might engage in first-degree price discrimination and
charge members of the first group ETB 3,000 and members
of the second group ETB 2,550 for the vacation package.
 Since the MC of providing the service to each group is ETB
1,000, the hotel’s profit would be ETB 3,550 per group.
 Since the hotel is not able to identify members of each
group, what price should the hotel charge for the package?
 Suppose the hotel decides to price each component of the
package separately.
▪ If it charges ETB 2,500 for room and board, it would sell
only to the first group, and its total revenue would be ETB
2,500. Members of the second group will not be interested
because the price is above what the value they attach to
room and board.
▪ If the hotel were to charge ETB 1,800 for room and board,
it would sell to both groups for total revenue of ETB
3,600. Clearly, then, the hotel will charge ETB 1,800.
 The same scenario holds true for entertainment.
▪ If the hotel charges ETB 750, then only members of the
second group will purchase entertainment, and the hotel
will generate revenue of only ETB 750.
▪ If the hotel charges ETB 500, both groups will purchase
entertainment and generate revenues of ETB 1,000.
 Thus, whether the hotel charges per item or a package price
of ETB 1,800 + ETB 500 = ETB 2,300, the profit from each
group will be ETB 1,300and the total profit is ETB 2,600.
 Although a package price of ETB 2,300 appears to be reasonable from
the point of view of the hotel’s profit, the hotel can do even better if
it charges a package price of ETB 1,800 + ETB 750 = ETB 2,550.
 The reason is simple. Management knows that the value of the
package to the first group is ETB 2,500 + ETB 500 = ETB 3,000 and
that of the second group is ETB 1,800 + ETB 750 = ETB 2,550.
 By bundling and selling the package for ETB 2,550, the hotel will sell
both components of the package to members of both groups.
 At a package price of ETB 2,550, the hotel earns a profit of ETB
1,550, instead of ETB 1,300, from each group.
 Again, since we have assumed that there is only one person in each
group, the hotel’s total profit is now ETB 3,100.
 Although a package price of ETB 2,300 appears to be
reasonable from the point of view of the hotel’s profit, the
hotel can do even better if it charges a package price of
ETB 1,800 + ETB 750 = ETB 2,550.
 The reason is simple. Management knows that the value of
the package to the first group is ETB 2,500 + ETB 500 =
ETB 3,000 and that of the second group is ETB 1,800 +
ETB 750 = ETB 2,550.
 By bundling room, board, and entertainment and charging
the package for ETB 2,550, the hotel will sell both
components of the package to members of both groups.
 At a package price of ETB 2,550, the hotel earns a profit of
ETB 1,550, instead of ETB 1,300, from each group.
 Again, since we have assumed that there is only one person
in each group, the hotel’s total profit is now ETB 3,100.
 Therefore, by commodity bundling, the hotel has enhanced
its profits by ETB 250 per group member.
 The hotel has extracted the entire amount of consumer
surplus from members of the second group and some
consumer surplus from members of the first group.
 Numerical example: A car dealership offers power steering
and a compact disc stereo system as options in all new
models. Suppose that the dealership sells to members of
three different groups of new car buyers and that there are
five individuals in each group as illustrated in Table 5.2.
Table 5.2: Commodity bundling and new car option
Group Power steering CD stereo system

1 ETB 1,700 ETB 300
2 ETB 1,600 ETB 320
3 ETB 1,500 ETB 340
 Suppose that the per-unit cost of providing power steering
and a CD stereo system is ETB 1,200 and ETB 250,
respectively.
a) If the dealership sold each option separately, how much
profit would it earn from each group member?
b) If the dealership cannot easily identify the members of
each group, how should it price a package consisting of
power steering and a CD stereo system? What will be
the dealership’s profit on each package sold?
Solution
a) If the dealership sells each item separately, and
▪ If the dealership sells power steering for ETB 1,500, it
will make a profit of $300 per sale. Given that there
are five members in each group, the dealership’s total
profit will be ETB 4,500.
▪ If it sells power steering for ETB 1,600, it will earn a
profit of ETB 400 per sale. In this case, however, only
members of the second and third groups will purchase
power steering. As a result, the dealership’s total profit
will only be ETB 4,000.
▪ Similarly, if the dealership sells compact disc stereo
systems for ETB 300, it will make a profit of ETB 50
per sale. Again, since there are five members in each
group, the dealership’s total profit will be ETB 750.
▪ By contrast, if it sells pact disc stereo systems for ETB
320 it will earn a profit of ETB 70 per sale. In this
case, however, only members of the first and second
group will opt for the CD stereo system at this price.
So, the dealership’s total profit will be ETB 700.
b) If the dealership sells power steering and a CD stereo
system at a package price of ETB 1,800, as suggested in
the answer to part a, the total profit will be ETB 4,700.
 However, if it sells the package for ETB 1,840, it will
appeal to members of all three groups. In this way, the
dealership will extract total consumer surplus from
members of the third group, and at least some
consumer surplus from the remaining two groups.
Then the dealership’s total profit will be ETB 5,850.
5.4.3. Third-degree Price Discrimination
 Third degree price discrimination is a practice of charging different
prices to different consumer groups.
 It occurs when a company or a firm segments the market for a
particular good or service into easily identifiable groups and then
charges each group a different price.
 Such market segregation may be based on such factors as geography,
age, product use, or income.
 Third-degree price discrimination is by far the most frequently
practiced type of price discrimination.
 It is a common practice for theaters, restaurants, and parks, for
example, to offer senior citizen, student, and youth discounts. For
example, a theater may divide moviegoers into seniors, adults, and
children, each paying a different price when seeing the same movie.
5.4.3. Third-degree Price Discrimination … Continued
 The rationale behind third-degree price discrimination is
straightforward. Different individuals or groups of
individuals with different demand functions will have
different marginal revenue functions.
 The firm will maximize profits by setting the marginal
revenue for each consumer group equal to the marginal cost
of production.
 Since the marginal cost of producing the good is the same,
regardless of which group purchases the good, the profit-
maximizing condition must be
MC = MR1 = MR2 = … = MRn,
where n is the number of identifiable and separable groups.
Figure 5.4: third-degree price discrimination

Figure 5.3: third-degree price discrimination
 If MR1 > MC, it would pay for the firm to produce one
more unit of the good or service and sell it to group 1.
 As more of the good or service is sold to group 1, marginal
revenue will fall until MR1 = MC is established.
 The pricing rule for the third-degree price discriminating
firm is to charge the highest price to the consumer group
with the smallest (most inelastic) price elasticity of demand.
 For third-degree price discrimination to be effective, a
number of conditions must be satisfied.
1) The firm must be able to estimate each group’s demand function.
The degree of price variation will depend on differences in each
group’s price elasticity of demand. In general, groups with higher
price elasticities of demand will be charged a lower price.
2) The members of each group must be easily identifiable by
some distinguishable characteristic, such as age; or perhaps
groups can be identified in terms of the time of the day in which
the good or service, such as movie tickets, is purchased.
3) Firms must be able to prevent resale of the good or service
across segregated markets. That is, it must not be possible for
groups purchasing the good or service at a lower price to be able
to resell that good or service to groups changed the higher price.
 Numerical example: ABC Company sells its product in
two separable and identifiable markets. The company’s total
cost equation is give by TC = 6 + 10Q. The demand
equations for its product in the two markets are Q1 = 10 –
0.2P1 and Q2 = 15 – 0.5P2, respectively, where Q = Q1 + Q2
and P1 and P2 are the prices charged for products in the first
and second market, respectively.
a) Assuming that the second-order conditions are satisfied, calculate
the profit-maximizing price and output level in each market.
b) Verify that the demand for ABC Company’s product is less elastic
in the market with the higher price.
c) Give the firm’s total profit at the profit-maximizing prices and
output levels.
Solution
a) Solving the demand equations in both markets for price
yields the inverse-demand.
P1 = 50 – 5Q1
P2 = 30 – 2Q2
 The corresponding total revenue equations are
TR1 = P1Q1 = (50 – 5Q1)Q1 = 50Q1 – 5Q12
TR2 = P2Q2 = (30– 2Q2)Q2 = 30Q2 – 2Q22
The Company’s total profit equation is

Π = TR1 + TR1 - TC = 50Q1 – 5Q12 + 30Q2 – 2Q22 - 6 – 10(Q1 + Q2)
= 40Q1 – 5Q12 + 20Q2 – 2Q22 - 6
dΠ/dQ1 = 0 → 40 – 10Q1 = 0 → Q1 = 4 units
→ P1 = 50 – 5Q1 = 50 – 5(4) = ETB 30
dΠ/dQ2 = 0 → 20– 4Q2 = 0 → Q2 = 5 units
→ P2 = 30 – 2Q2 = 30– 2(5) = ETB 20
b) The relationships between the selling price and the price
elasticity of demand in the two markets are
 Substituting these results into the equations presenting the
relationships between the selling price and the price
elasticity of demand in the two markets, we have
 This verifies that the higher price is charged in the market

where the price elasticity of demand is less elastic. The firm
will charge the same price in the two markets only if the
price elasticity of demand in the two markets are equal.
c) The firm’s total profit at the profit-maximizing prices and
output levels is
Π = 40Q1 – 5Q12 + 20Q2 – 2Q22 – 6
= 40(4) – 5(4)2 + 20(5) – 2(5)2 – 6
= 160 – 80 + 100 – 50 - 6
= ETB 124
5.5. Pricing and the Marketing Mix
 Many firms do not handle pricing decisions well so the
pricing strategy needs more attention.
 Common mistakes when developing a pricing strategy
▪ Firms set prices that are too cost-oriented
▪ Firms fail to revise prices to reflect market changes
▪ Firms fail to take the rest of the marketing mix into account
and fail to set prices that are varied enough for different
products, market segments and purchase decisions
 No matter how good the product, how creative the promotion, or
how efficient the distribution is, unless the price covers the
costs, the firm will make a loss.
 However, in advanced markets where technology and innovation
are the main drivers in the market, cost structure frequently
evolve to support the pricing strategy of the company.
 A good marketing strategy starts with setting good pricing
objectives:
▪ Survival of the business
▪ Maximization of current profit, cash flow or rate of return
▪ Maximum sales growth
 Pricing strategies marketers can use in relation to the
product offer include:
▪ Skimming pricing
▪ Penetration pricing
▪ Demand pricing
▪ Predatory pricing
▪ Discount and allowance based pricing
▪ Value based pricing
Skimming pricing
 Skimming pricing strategy is based on a high initial price
for a product and used when:
▪ The nature of demand is uncertain
▪ Large amounts of money is expected on research and
development of the new product
▪ When the competition is expected to develop and
launch a similar product
 The decision about how high a skimming pricing should be
depends on the level of competition in the market
Penetration pricing
 Penetration pricing strategy is to enter a market with a low
initial price so that a greater share of the market can be
captured and used when:
▪ Dealing with markets that are price sensitive
▪ When selected market does not exist and demand
seems to be elastic over the entire demand curve
▪ To discourage competitors from entering the market or
a particular market segment
▪ Marketing new products to existing markets.
 Thus, penetration pricing reflects a long-term perspective in
which short-term profits are sacrificed in order to establish a
sustainable viable advantage.
Demand strategy
 Demand is the quantity of product or service that will be
sold in the market at various prices for a specified period.
 The quantity of a product or service that a consumer will
buy depends on the price.
 Before setting the price marketers must understand the
relationship between the price and demand for the product
in the market
 Pure competition can be described as a market of buyers
and sellers trading their products in financial terms.
Predatory pricing
 The predatory company first lowers its price until it is
below average costs of its competitors in order to force
out competition
 The theory of predatory pricing has always assumed that a
dominant company will be able to manipulate its
smaller competitors to such an extent that even the
potential use of predatory strategies by the smaller rivals is
likely to be successful.
Discounts and allowances
 Marketing managers use various forms of discounts and
allowances to encourage customers to purchase more of
their companies’ products
 Types of discounts and allowances
▪ Quantity discount: consumers receive this discount for
buying more of a certain product
▪ Cumulative quantity discount: a customer is not
allowed a discount until consecutive purchases have been
reached a specified total
▪ Cash discount: when the seller reduces the price of a
product in return for a cash payment.
Discounts and allowances …
▪ Functional discount: to compensate distributor channel
intermediaries for performing a service or function for the
manufacturer
▪ Seasonal discount: when a price reduction is granted to
customers buying merchandize out of season
▪ Promotional (trade) allowance: payment to a dealer for
promoting the manufacturer’s products.
▪ Rebates: cash refunds given to the purchaser of a product
during a specified period.
Summary
▪ Price of a product must be set according to a set
parameters that will assist marketing managers in setting
up the right price
▪ Price has to be considered according to goals, costs,
profits to be made, research and development, innovation,
competition and may more parameters that may influence
the price.
▪ The price should be consistent with the overall strategy of
the product
▪ Price should match the design of the product, the quality,
the message it is carrying and the media, the distribution
channels and the sales method among others.

Understanding Pricing Strategies and Practices

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Understanding Pricing Strategies and Practices

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Learning objectives:

 At the end of this chapter students should be able to

• Choosing a targeting strategy depends on:

Figure 5.1: First-degree price discrimination

 If we assume that the individual’s demand function is linear, i.e.,

 Equation (5.3) suggests that the smaller the change in Q, the

 The application of integral can be applied to calculate the

 Where Pn and Qn are the equilibrium price and quantity,

 Substituting Equation (5.2) into the integral equation (5.5) yields,

= 𝑎𝑄𝑛 + 0.5𝑏𝑄𝑛 2 − 𝑎 0 + 0.5𝑏 0 2

Figure 5.2: Consumer Surplus

 If we assume that the demand equation is linear (P = a + bQ) and

 The first- and second-order conditions for profit maximization

 Solving Equation (5.10) for output yields

Numerical example (consumer surplus): Assume that a

 Since P = ETB 6 implies Q = 7, we have

𝐶𝑆 = 20(7) − (7)2 − 6 7 = 140 − 49 − 42 = 𝐁𝐢𝐫𝐫 𝟒𝟗

Figure 5.3: Block pricing

 Example: a resort hotel that sells weekly vacation

Group Room and board Entertainment

1 ETB 2,500 ETB 500

2 ETB 1,800 ETB 750

Table 5.2: Commodity bundling and new car option

Group Power steering CD stereo system

Figure 5.4: third-degree price discrimination

The Company’s total profit equation is

 This verifies that the higher price is charged in the market

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