Pricing Techniques and Analysis

Chapter 16
• Value­based more than cost­based pricing 
often helps build profits.
• Firms charge different customers different 
prices, which is known as price discrimination. 
• This chapter also looks at pricing within a firm 
called transfer pricing.  
• Pricing techniques that are used by many multi­
product firms, such as full­cost pricing and 
target return pricing.  
2002 South-Western Publishing Slide 1
 Proactive Value-based Pricing
• If the price doesn’t fit what customers are willing 
to pay, then the product may not be profitable.
» Customer value is the focus for pricing, not just the 
costs associated with the product.  
» Apple Computer lost market share by ignoring this.
» The Ford Mustang was a success, as Ford found that 
people wanted a sports car, but didn’t want it to be 
too expensive.  The started with a price and designed 
the product.

• The Mustang used value­based, not cost­plus pricing
Slide 2
Differential Pricing
• If at peak rush hour, the toll is higher than
at the off-peak, we are using different prices
at different time periods.
• The peak toll can encourage shifting travel
patterns to off-peak times or discourage
some commuting altogether.
• Differential pricing appears more frequently
than one thinks. This we call price
discrimination. Slide 3
 Price Discrimination
● Price Discrimination -- Goods which are
NOT priced in proportion to their marginal cost,
even though technically similar
● Some Necessary Conditions:
1. Some Monopoly Power
• In Perfect Competition, P = MC
2. Ability to Arbitrage
• Separate Customers and Prevent Reselling

Slide 4
 Arbitrage - Buy Low to Sell Higher

• Arbitrage of Goods is Easy

» Price discrimination of goods is ineffective
» Little price discrimination of grocery items
• Arbitrage of Services is Difficult
» Price discrimination of services is effective
» Price discrimination at restaurants by age, a service
» Lawyers charge different prices for wills, based on
ability to pay

Slide 5
 Many Ways to Separate Customers for
Price Discrimination

1. Geography 6. Race
2. Income 7. Language
3. Gender 8. Transient /
Resident
4. Age
9. Ability to
5. Time
Haggle

Slide 6
 Why Practice Price Discrimination?
MC
• In Simple Monopoly, Simple
there is only one price Monopoly
• Consumers receive a
PSM CS
consumer surplus
• In Price
Discrimination,
monopolists can
SCOOP OUT all D
consumer surplus
QSM Q
Slide 7
 First Degree Price Discrimination

• Charge the MOST Price Discriminating MC

that a person is Monopoly
willing to pay for
each good
• Zero consumer
surplus
• Produce MORE than
in Simple Monopoly
• Output the same as in
D
Competition Q
Q1st Slide 8
Car Sales as First Degree Price Discrimination
Ahh, that is
“How much do you $9,887 for 60
plan to pay a months at our
7.9% financing,
month?”
plus $3,000

you inadvertently reply: Here’s one for only

$12,887. It’s swell.
“Only $200 per
month, but I have
$3,000 down
payment!”
Slide 9
 Notice: Incentives to Understate
One’s True Willingness to Pay
• The conditions Second Degree Price
for First Degree Discrimination:
price Units are Grouped
discrimination
are seldom met • There are are a variety
• Hence, some of ways to group units
to attempt to scoop out
close consumer surplus
approximations
exist
Slide 10
 Second Degree Price
Discrimination Methods
We look at four examples:

• Block rate setting

• Two part pricing
• Unlimited access
• Bundling methods
Slide 11
 Second Degree Price Discrimination:
Block Rate Pricing
• Price declines as the quantity
purchased increased P D
• Examples:
» Tri-State Gas Company example
(page 632)
» TJ Maxx, second pair half price
» telephone charges
» foreign film festivals
• Price declines similar to the Q
demand curve Slide 12
 Another Second Degree Price Discrimination:
Two-Part Pricing:
• A price for the
privilege of buying
items
• And a price per item
• Examples: Cover
» Country Club Dues Charge
MC
and Greens Fees
» Cover Charge to
Enter and a Price Per
Drink Q
Slide 13
 If P = 4.50 - Q and MC = .50
Find Optimal Cover Charge
• At P = $.50, he/she
buys 4 mugs of Cover
root beer Charge
• Biggest cover $4.50 $8.00
charge is the area
of a triangle PM=$2.50

» Height is 4 Cover
Charge $8
» Base is 4 $.50
» (1/2)Height•Base
• Max cover charge Q
is $8.00
QM 4
Monopoly: QM = 2 & PM = $2.50 Slide 14
 Second Degree Price Discrimination:
Unlimited Access
or All-You-Can-Eat Pricing
A specified price for an unspecified quantity:

Example: AOL unlimited access for $19.95/month

Examples: Salad Bars, Legal Retainers, HMO’s
Area under demand
P curves represent most
willing to pay for an
AYCE offer

ounces Slide 15
 Second Degree Price Discrimination:
Bundling (or Block Booking)
Often the pricing arrangement includes purchasing
groups of dissimilar products. The products are
bundled or sold as a block, as in theatrical or
sporting tickets.

Preferences are uncorrelated Preferences are correlated

A B A B

1 150 100 250 80 100 180

500 360
80 190 270 165 175 340
2
160 200 = 360 165 200 = 365
simple monopoly simple monopolySlide 16
 Third Degree Price Discrimination

East West Market

PM

MC
MR

Example with a Simple Monopoly

Price in both markets Slide 17
 Third Degree Price Discrimination
East West Market

PE
PM
PW
MC
MR
MR

MR
Example with Different Prices in Each Market
Slide 18
 Pricing In Segmented Markets
• Segment markets by • Then P1 = $150 and
price sensitivity
• P2 = $120
• Charge higher prices
in the markets that are
the most inelastic

P ( 1 + 1/ EQ•P ) = MC
Why are
haircuts for
Suppose MC = $100 in 2 markets kids cheaper
and E1 = - 3 and E2 = - 6 than for
adults?
Slide 19
 Pricing of Multiple Product
• Products are INDEPENDENT when changes in
price and quantity of one product do not alter
revenues or cost in the others
• Products are INTERDEPENDENT, when
changes DO affect other products
• Ex: Procter & Gamble makes both Luvs and
Pampers
» TR = TRA + TRB
Slide 20
 Substitutes & Complements
• Look for interdependencies in marginal
revenues:
» MRA = ∂TRA / ∂QA + ∂TRB / ∂QA
» MRB = ∂TRA / ∂QB + ∂TRB / ∂QB
• Substitutes when cross terms are negative
» Erosion or Cannibalism are terms used
• Complements when cross terms are
positive
» BASE sells tapes and tape head cleaners Slide 21
Decision Rule for Multiple Product Firms
• Do NOT use the rule to produce where
MR=MC, as in MRA = MCA
• INSTEAD:
» Produce where the FULL MR = FULL MC
» For a Two Product Firm of A & B
» Produce where:

∂TRA /∂QA + ∂TRB /∂QA = ∂TCA /∂QA + ∂TCB /∂QA

Include all relevant revenue and cost effects Slide 22

 Pricing Example in Supermarkets
• Turkey prices fall during Thanksgiving
» Yet we would expect DEMAND to be greatest?!
• Loss Leader Pricing
» Consider T as turkey
» and A as all other food
• TRstore = TRT + TRA
MRstore for turkey = ∂TRT /∂QT + ∂TRA /∂QT
• Complementarity with other food explains the
apparent conundrum
Slide 23
 Pricing of Joint Products
• Interdependencies in costs occur in products
that are produced simultaneously
• E.g., Beef & Hides; Wool & Mutton; Natural
Gas & Crude Oil
• Suppose FIXED PROPORTIONS in
production: 500 lbs. of Beef + 10 sq. yards of
Hide for 1 steer.
• Two cases: No Excess of Hides, and Excess
Hides case
Slide 24
Steers: No Excess Case
Two Demand
Curves:
Hides & Beef

Two MR Curves:
Hides & Beef

MRB DH DB

MRH steers (T) Slide 25

Steers: No Excess Case 2
MRT
Find where
MCT
MRT = MCT
to find the
optimal of
steers.

DH DB

MRH steers (T) Slide 26

 Steers: No Excess Case 3
MRT At the optimal
MCT number of
steers, find
PB the prices of beef &
hides on their
respective
demand curves
PH
if demand for beef
rises, the price
DH DB of hides will
fall !
T MRH steers (T) Slide 27
 Excess of One of the Joint Products

• Excess means the price would be

ZERO
• The solution is to hold back some of
the excess to reach the Unit Elastic
Point on the Demand Curve.
• This Maximizes Total Revenue.

Slide 28
 Multi-Divisional Firms
and the Economics of Transfer Pricing
Transfer Pricing serves two functions:

1. Measure of the marginal value of the

resource

2. Provides a performance measures of

resources used
For international firms, transfer pricing may assist in
reducing worldwide taxation, but the ability to reduce
taxation is limited because the IRS requires arm’s
length prices.
Slide 29
 Create Transfer Prices Similar to
Competitive Market Prices
• Disagreements across divisions are common
» “Selling” Division wants a HIGH transfer price
» “Buying” Division wants a LOW transfer price
• When External Markets exists, use those prices for
transfer (a market-based competitive price)

sell to others @ “P”

final car
motor assembly assembly
purchase motors from others @ “P”Slide 30
 Transfer Pricing
With No External Markets
• When no external markets exist, use the
MC of the transferred good.
• Often, however, the MC is a function of
output.
• Marketing and Production steps (M & P)
• Transfer price is PT = MC P on following
figure

Slide 31
 Find Where MCM+P = MR
MCM+P
MCP

P
MCM

PT
D

MR Slide 32
 Pricing in Practice
• In practice, pricing strategy involves
the whole life-cycle of the product.
• Managers report wide use of cost-plus
pricing methods because it:
» Streamlines pricing of multiple products
» Streamlines pricing of retail prices

Slide 33
 Cost-Plus and Full Cost Pricing
P = ACn + Markup
or P = ACn(1 + m)
where ACn is average cost at a normal output
and m is a percentage markup
• Notice: Little reliance on MC pricing or use of
elasticities, as in: P( 1 + 1/Ep ) = MC

Slide 34
 Cost-Plus Pricing: Illustrated
Manufacturing pricing illustrated: One Good

P
} markup ATC
ACn AVC

AFC

Qn Qcapacity Slide 35
 Cost-Plus Pricing: Illustrated
quantity
varies as
D1 D2
demand
P varies
} markup
ACn AVC

AFC

Qn Qcapacity Slide 36
 Cost-Plus Pricing: Illustrated
quantity
varies as
D1 D2
demand
P varies
} markup
ACn AVC

AFC

Q1 Qn Q2 Qcapacity Slide 37
 Full Cost Pricing
• Full Cost--
» Covers all Costs at the standard or normal output
» Plus a return on the investment

• P = AFCn + AVCn + π K / Qn
» where π K is the target amount of profit
» and π is the desired profit rate and K is gross operating
assets
• Example: Low Tech Security
FC = 200,000, Qn = 3000, VC = 90,000
π = 20% and K=$500,000. Find Full Cost Price!
Slide 38
 Full Cost Pricing
• Answer
» P = AVC + AFC + (.20)(500,000)/Q
» P = 30 + 66.67 + 33.33
= $130
• Also, suppose a 35% markup on cost
» P = [ ACn] (1.35)
» P = [ 30 + 66.67 ](1.35)
» P = $130.50
Slide 39
 Cost-Plus Pricing
Advantages Disadvantages
• Cost-plus is simple • But cost-plus ignores
• It is easy to delegate to demand changes
others • Pricing may be based on
• Easy to apply to poor cost data
thousands of items • Output varies in business
» Can use categories cycle
of markups for
Hybrid Method: Variable
different classes of
Cost-Plus Pricing -- the
products
markup can vary over the
season or business cycle
Slide 40
 Optimal Markups in Practice
• Grocery stores have • Demand is therefore
low markups highly elastic
• Many close substitutes -- • Optimal markup would
at other grocery stores consequently be small
(bread varieties and
qualities are
standardized)
• Frequent purchase, so
customers are
knowledgeable about
prices & quality
1999 South-Western College Publishing Slide 41
 Markups on Jewelry
• Jewelry Markups are known to be large
• Difficult to make comparisons across
jewelry stores
• Little repeat purchases, so knowledge
about prices is low
• Consequently, lower price elasticity for
jewelry
• The optimal markup is larger

1999 South-Western College Publishing Slide 42

 Skimming
a form of block rate pricing over time
• Price declines over time
• Those who wish to get it first P D
pays the highest price, others
are willing to wait
• Examples:
» Hardcover & Paperback
Books
» New electrical & Computer
Products TIME
1999 South-Western College Publishing Slide 43
 Revenue Management: Appendix 16A
• Revenue Management is the problem of the 
disappearing inventory. 
• Managers must be flexible to change their 
predicted sales by market segment as information 
arrives.  
• Airlines price discriminates between business and
non-business travelers. If too few business
travelers have booked tickets compared to the
amount expected, then more non-business tickets
should be released.
Slide 44
 Optimal Overbooking
• Managers may authorize  reservation clerks to 
sell more seats (rooms) than are available.  
• The greater the overbooking, the lower are the 
costs of spoilage. 
• Spoilage is an inventory NOT sold.  If capacity 
is large, an airline or hotel will have high 
spoilage.
• The greater the overbooking, the greater are the 
costs of spillage, making customers unhappy by 
finding that they have no seat or reservation.
Slide 45
 Spillage
• Spillage is the excess demand that cannot 
be met.  
• If the service industry has low capacity, the 
spillage will be great
• Customers leave the hotel or airline unable 
to get a room or an airplane seat.

Slide 46
 Optimal Overbooking
• Spillage and spoilage costs go in  Spillage
opposite directions, the sum of 
these costs has a minimum with 
Total
the optimal amount of 
Cost
overbooking.
• Since business travelers tend to a 
large extent to be repeat  optimal
customers, the cost of spillage 
(oversells) may be very high.  
• The optimal amount of  Spoilage
overbooking for this market 
segment may well be lower than 
100% 110% 120% ...
for non­business clients.
Percent Overbooked
Slide 47