PRICING

PRACTICES
COMPETITIVE MARKET PRICING RULE-OF-THUMB for profit
maximization
- set P= MR = MC for profit maximization
-firms price their products in a manner consistent with
profit maximization
IMPERFECTLY COMPETITIVE MARKETS
-products produced by firms in monopolistic competition,
oligopoly, and monopoly markets all have elements of
uniqueness that give rise to downward-sloping firm demand
curves.
-P>MR and the competitive market pricing rule-of-thumb for
profit maximization does not apply
-must find the price-output combination that will set
MR=MC
- when P=f(Q), set P= MC/[1+(1/Ɛp)] for maximum profits
 MARKUP PRICING AND PROFIT
MAXIMIZATION

Optimal markups are low when the underlying price

elasticity of demand is low; optimal markups are high
when the price elasticity of demand is high
 OPTIMAL MARKUP ON COST
MARKUP ON COST
is the profit margin for an individual product expressed as
a percentage of marginal cost

Markup on Cost = (P-MC)/MC= -1/ (Ɛp + 1)

MARKUP ON PRICE
the difference between price and cost, measured relative
to price, expressed as a percentage.

Markup on Price = (P-MC)/P= -1/Ɛp

OPTIMAL PRICES can vary from one market to
another, or among customers in a single
market, because of differences in relevant
marginal costs.

PEAK PERIODS
When facilities are fully utilized

OFF-PEAK PERIODS
Periods of excess capacity
 OPTIMAL MARKUPS also vary between
markets, or between customers in a single
market depending upon differences in the
price elasticity of demand.

In COMPETITIVE MARKET, P=MC, so the

markup on price tends to converge toward
zero as competitive pressures increase.

In MONOPOLY MARKETS, P>MC, so the

markup on price can be expected to rise as
competitive pressures decrease.
Table 1 Optimal Markups at Various Price Elasticity Levels
 LERNER INDEX OF MONOPOLY POWER
- proposed by an American economist
ABBA LERNER
- an interpretation of the optimal markup
on price as an indicator of monopoly power.

Lerner Index = (P – MC) / P = -1/ Ɛp

 PRICE DISCRIMINATION
A pricing practice that sets prices in different
markets that are not related to differences in costs.
 MARKET SEGMENT
A division or fragment of the overall market with
essentially unique characteristics.

DEGREES OF PRICE DISCRIMINATION

FIRST-DEGREE PRICE DISCRIMINATION

Charging different prices to each customer.
SECOND-DEGREE PRICE DISCRIMINATION
Charging different prices based on use rates or
quantities purchased.
THIRD-DEGREE PRICE DISCRIMINATION
Charging different prices to each customer class.
 PRICE-OUTPUT DETERMINATION
PRICE DISCRIMINATION is profitable because it
allows sellers to enhance revenues without
increasing costs. It is an effective means for
increasing profits because it allows firms and
other sellers to more closely match marginal
revenues and marginal costs. A firm that can
segment its market maximizes profits by
operating at the point where marginal revenue
equals marginal cost in each market segment
 TWO- PART PRICING
Customers are sometimes charged a lump sum amount plus a
usage fee to extract the maximum amount they are willing to
pay for various goods and services.
 ONE-PRICE POLICY AND CONSUMER SURPLUS
The total area under the demand curve , as shown in Figure 15.3,
captures the value obtained from consumption. This area is
comprised of two parts: the shaded triangle that reflects consumer
surplus and the rectangle that represents total revenue. Recall that
surplus arises because individual consumers place different values on
goods and services. At high prices, only customers that place
relatively high value on the product are buyers al low prices, both
high- value and low-value customers are buyers. As one proceeds
downward along the demand curve in Figure 15.3, customers that
place a progressive lower marginal value on the product enter the
market. Similarly, if the value placed upon consumption by given
customer declines as usage increases, that customer also faces
downward- sloping demand curve.
 CAPTURING CONSUMER SURPLUS WITH TWO-PART
PRICING
TWO-PART PRICING
A per unit fee equal to marginal cost, plus a fixed fee equal
to the amount of consumer surplus generated at that per
unit fee.

CONSUMER SURPLUS AND BUNDLE PRICING

BUNDLE PRICING
When significant consumer surplus exists, profits can be
enhanced if products are purchased together as a single
package or bundle of goods or services.
 MULTIPLE-PRODUCT PRICING
Requires the same basic analysis as for single product, but the
analysis is complicated by demand and production
interrelations
DEMAND INTERRELATIONS
It arises because of substitute or complementary relations
among various products or product lines. If product are
interrelated, either as substitutes or as complements, a
change in the price of one affects demand for the other.
Multiple-product pricing decisions must reflect such
influences. In the case of a two-product firm, the marginal
revenue functions for each product can be written as
MRA= ƏTR/ƏQA = ƏTRA/ƏQA + ƏTRB/ƏQA
MRB= ƏTR/ƏQB = ƏTRB/ƏQB + ƏTRA/ƏQB
 ƏTRB/ƏQA
Shows the effect on product B revenues of an additional unit sold of
product A.
ƏTRA/ƏQB
Represents the change in revenues received from product A when an
additional unit of product B is sold.

CROSS-MARGINAL REVENUE TERMS that reflect demand interrelations can

be positive or negative.
COMPLEMENTARY PRODUCTS
Positive because increased sales for one product will lead to increased
revenues from another.
SUBSTITUTE PRODUCTS
Negative because increased sales of one product reduce demand for
another.
 Accurate price determination in the case of
multiple products requires a complete analysis
of pricing decision effects. This often means that
optimal pricing requires an application of
incremental analysis to ensure that the total
implications of pricing decisions are reflected.
 PRODUCT INTERRELATIONS
are sometimes so strong that the joint nature of
production is relatively constant.

BY-PRODUCT is any output that is customarily

produced as a direct result of an increase in the
production of some other output. Also generated in the
process of providing services.

Appropriate pricing and production decisions are

possible only when such interrelations are accurately
reflected.
 JOINT PRODUCTS
Optimal pricing practices depends upon whether joint
products are produced in variable or fixed proportions.

JOINT PRODUCTS IN VARIABLE PROPORTIONS

The marginal costs of joint products produced in variable
proportions equals the increases in total costs associated with a 1-
unit increase in that product, holding constant the quantity of the
other joint product produced.

Optimal price-output determination for joint products in this case

requires simultaneous solution of marginal cost and marginal
revenue relations.

Impossible to determine their individual average costs.

 COMMON COST
Expenses that are necessary for manufacture of a joint
product.
JOINT PRODUCTS IN FIXED PROPORTIONS
When by-products are jointly produced in fixed proportions,
all costs are common, and there is no economically sound
method of cost allocation.

Optimal price-output determination in fixed proportions

requires analysis of the relation between marginal revenue
and marginal costs for the combined output package.

As long as the sum of marginal revenues obtained from all by-

products is greater that the marginal cost of production, the
firm gains by expanding output.