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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.

Managerial Economics and Organizational Architecture, 5e

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

Managerial Economics and Organizational Architecture. 5e 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 .

5e Pricing with Market Power $ Price (in dollars) Consumer surplus Demand MC Q Quantity 7-4 .Managerial Economics and Organizational Architecture.

812. 5e The Benchmark Case: single price per unit Intuit data: • Purchases software from manufacturer for $10 • Demand curve is P = 85 .Managerial Economics and Organizational Architecture.0.50 (000s) 7-5 . P= $47.50 • Profit is $2.5Q (Q in 1000s of units) • What is the profit-maximizing price? • Set MR = MC • 85-Q=10 • Q=75.

50 Price (in dollars) 85.00 MR Q* = 75 Quantity of Checkware MC 170 Q 7-6 .50 Demand 10.00 P*= 47.Managerial Economics and Organizational Architecture. 5e Single Price per Unit $ Checkware With MC=10. the optimal output is 75 with a price of $47.

5e Cost Issues • Relevant costs – sunk costs are irrelevant – current opportunity costs are relevant – historical costs are irrelevant 7-7 .Managerial Economics and Organizational Architecture.

5e Pricing Strategy • price elasticity. if  = 3. then • P = 10/[1 – 1/3] = 15 7-8 . is a measure of price sensitivity • Optimal price is P=MC/[1-1/ ] • For MC = 10. if  = 2. then • P = 10/[1 – ½] = 20 • For MC = 10.Managerial Economics and Organizational Architecture. .

00 Q Demand MC Q* = 65 MR Q 170 Quantity of Illustrator More elastic demand 7-9 .00 42.00 The optimal markup is higher for the less elastic demand 85.50 Demand MR Q* = 75 MC 170 Quantity of Checkware Less elastic demand P*= 26.Managerial Economics and Organizational Architecture. 5e Price Sensitivity and Optimal Markup Price (in dollars) $ $ 85.50 10.00 P*= 47.25 10.

25 7-10 . 5e Price Sensitivity • • • • In the original example  = 1.267 P = 10/[1 – 1/1.Managerial Economics and Organizational Architecture.5 For Illustrator.267] = 47.615 P = 10/[1 – 1/1.  = 1.615] = 26.

• Such pricing should be product specific and based on awareness of price sensitivity. 7-11 . but in practice. MC=MR. 5e Estimating Profit-Maximizing Price • In theory. manager may not know demand curve and therefore MR. • Cost-plus or mark-up pricing may be useful approximations.Managerial Economics and Organizational Architecture.

5e 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 .Managerial Economics and Organizational Architecture.

5Q 7-13 .5(30) a = 85 Demand is estimated as: P=85 – 0.0.0.Managerial Economics and Organizational Architecture.5 the intercept is calculated using P = a . the intercept is $70 = a . 5e Linear Approximation • • • • • • • • Slope = (65-70)/(40-30) = -0.5Q When price is $70.

5e 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 firm’s long-term fiscal health 7-14 .Managerial Economics and Organizational Architecture.

15 . 5e 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 .Managerial Economics and Organizational Architecture.

5e Potential for Higher Profits $ Consumer surplus b Price (in dollars) Firm profits P* a Unrealized gains from trade c e Demand d f MR Q* Quantity of Checkware MC 170 Q 7-16 .Managerial Economics and Organizational Architecture.

5e 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 .Managerial Economics and Organizational Architecture.

college football 7-18 . health clubs.Managerial Economics and Organizational Architecture. 5e 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.

$42.50 Demand Charge a price of $1 per unit and sell 9 units MC $1 Quantity Q*=9 Q 7-19 .Managerial Economics and Organizational Architecture. 5e 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.

5e 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 .Managerial Economics and Organizational Architecture.

Managerial Economics and Organizational Architecture. 5e 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 .

7-22 . the charge a higher price to the group with the more inelastic demand.55 and MC=$10.50 and $30.33 and 1. 5e Group Pricing • If two groups have different elasticities of demand.Managerial Economics and Organizational Architecture. then markup the price to $17. • Us the markup rule: P*=MC*/(1-1/*) • Apply it for each elasticity to get the different prices • If the elasticities are 2. respectively.

00 η* = 1. 5e Optimal Pricing at Snowfish different demand elasticities Price (in dollars) $ 50.50 P*= 30.00 η* = 2.50 10.33 P*=17.00 MC MR Q* = 200 Quantity of passes for out-of-town skiers MC 10.00 50.Managerial Economics and Organizational Architecture.00 MR Q* = 150 Quantity of passes for local skiers 7-23 .00 25.

etc. basic.Managerial Economics and Organizational Architecture. • Coupons and rebates – users likely more price sensitive – users who are new customers may stick with product 7-24 . 5e 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.

Managerial Economics and Organizational Architecture. 5e 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 .