Managerial economics and organizational architecture 5e ch007

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 Managerial Economics and Organizational Architecture, 5e Pricing with Market Power $ Price (in dollars) Consumer surplus Demand MC Q Quantity 7-4 Managerial Economics and Organizational Architecture, 5e The Benchmark Case: single price per unit Intuit data: • Purchases software from manufacturer for $10 • Demand curve is P = 85 - 0.5Q (Q in 1000s of units) • What is the profit-maximizing price? • Set MR = MC • 85-Q=10 • Q=75, P= $47.50 • Profit is $2,812.50 (000s) 7-5 Managerial Economics and Organizational Architecture, 5e Single Price per Unit $ Checkware With MC=10, the optimal output is 75 with a price of $47.50 Price (in dollars) 85.00 P*= 47.50 Demand 10.00 MR Q* = 75 Quantity of Checkware MC 170 Q 7-6 Managerial Economics and Organizational Architecture, 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, η, is a measure of price sensitivity • Optimal price is P=MC/[1-1/ η] • For MC = 10, if η = 2, then • P = 10/[1 ẵ] = 20 For MC = 10, if η = 3, then • P = 10/[1 – 1/3] = 15 7-8 Managerial Economics and Organizational Architecture, 5e Price Sensitivity and Optimal Markup Price (in dollars) $ $ 85.00 P*= 47.50 10.00 The optimal markup is higher for the less elastic demand 85.00 42.50 Demand MR Q* = 75 MC 170 Quantity of Checkware Less elastic demand P*= 26.25 10.00 Q Demand MC Q* = 65 MR Q 170 Quantity of Illustrator More elastic demand 7-9 Managerial Economics and Organizational Architecture, 5e Price Sensitivity • • • • In the original example η = 1.267 P = 10/[1 – 1/1.267] = 47.5 For Illustrator, η = 1.615 P = 10/[1 – 1/1.615] = 26.25 7-10 Managerial Economics and Organizational Architecture, 5e Estimating Profit-Maximizing Price • In theory, MC=MR, but in practice, manager may not know demand curve and therefore MR • Cost-plus or mark-up pricing may be useful approximations • Such pricing should be product specific and based on awareness of price sensitivity 7-11 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, 5e Linear Approximation • • • • • • • • Slope = (65-70)/(40-30) = -0.5 the intercept is calculated using P = a - 0.5Q When price is $70, the intercept is $70 = a - 0.5(30) a = 85 Demand is estimated as: P=85 – 0.5Q 7-13 Managerial Economics and Organizational Architecture, 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, 5e Mark-Up Pricing • Optimal mark-up rule of thumb: • P*=MC*/(1-1/η*) • where * indicates estimated value • Requires some knowledge or awareness of both marginal costs and elasticity - 15 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, 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, health clubs, college football 7-18 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, $42.50 Demand Charge a price of $1 per unit and sell units MC $1 Quantity Q*=9 Q 7-19 Managerial Economics and Organizational Architecture, 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, 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 Managerial Economics and Organizational Architecture, 5e Group Pricing • If two groups have different elasticities of demand, the charge a higher price to the group with the more inelastic demand • Us the markup rule: P*=MC*/(1-1/η*) • Apply it for each elasticity to get the different prices • If the elasticities are 2.33 and 1.55 and MC=$10, then markup the price to $17.50 and $30, respectively 7-22 Managerial Economics and Organizational Architecture, 5e Optimal Pricing at Snowfish different demand elasticities Price (in dollars) $ 50.00 50.00 η* = 1.50 P*= 30.00 25.00 η* = 2.33 P*=17.50 10.00 MC MR Q* = 200 Quantity of passes for out-of-town skiers MC 10.00 MR Q* = 150 Quantity of passes for local skiers 7-23 Managerial Economics and Organizational Architecture, 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, basic, etc • Coupons and rebates – users likely more price sensitive – users who are new customers may stick with product 7-24 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 ... pay and what the consumer actually pays 7-3 Managerial Economics and Organizational Architecture, 5e Pricing with Market Power $ Price (in dollars) Consumer surplus Demand MC Q Quantity 7-4 Managerial. .. $42.50 Demand Charge a price of $1 per unit and sell units MC $1 Quantity Q*=9 Q 7-19 Managerial Economics and Organizational Architecture, 5e Price Discrimination heterogeneous consumer demands •... • Coupons and rebates – users likely more price sensitive – users who are new customers may stick with product 7-24 Managerial Economics and Organizational Architecture, 5e Bundling and Other