Transcript No Slide Title
Pricing Techniques and Analysis
Chapter 16 • • • •
Value-based
more than
cost-based
helps build profits.
pricing often 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
full-cost 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 value-based, not cost-plus 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
1
Many Ways to Separate Customers for Price Discrimination
.
Geography
2.
Income
3.
Gender
4.
Age
5.
Time 6. Race 7. Language 8. Transient / Resident 9. Ability to Haggle
Slide 6
Why
Practice Price Discrimination?
• • • In Simple Monopoly, there is only one price Consumers receive a consumer surplus In Price Discrimination, monopolists can
SCOOP OUT all
consumer surplus
P SM CS Q SM Simple Monopoly MC
Q
D
Slide 7
First Degree Price Discrimination
• • • • Charge the
MOST
that a person is willing to pay for each good Zero consumer surplus Produce MORE than in Simple Monopoly Output the same as in Competition
Price Discriminating Monopoly MC Q 1st D
Q Slide 8
Car Sales as First Degree Price Discrimination “
How much do you plan to pay a month?”
you inadvertently reply:
“Only $200 per month, but I have $3,000 down payment!” Ahh, that is $9,887 for 60 months at our 7.9% financing, plus $3,000
Here’s one for only
$12,887
. It’s swell.
Slide 9
Notice: Incentives to Understate One’s True Willingness to Pay
• The conditions for First Degree price discrimination are seldom met • Hence, some close approximations exist
Second Degree Price Discrimination
:
Units are Grouped
• There are are a variety of ways to group units to attempt to scoop out consumer surplus 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 • Examples: » Tri-State Gas Company example (page 632) » TJ Maxx, second pair half price » telephone charges » foreign film festivals • Price declines similar to the demand curve P
D
Slide 12
Q
Another Second Degree Price Discrimination
:
Two-Part Pricing:
• • • A price for the privilege of buying items And a price per item Examples: » Country Club Dues and Greens Fees » Cover Charge to Enter and a Price Per Drink
MC
Cover Charge
Q
Slide 13
If P = 4.50 - Q and MC = .50
Find Optimal Cover Charge
• • • At P = $.50, he/she buys 4 mugs of root beer Biggest cover charge is the area of a triangle » Height is 4 » » Base is 4 (1/2)Height•Base $4.50
P M =$2.50
$.50
Cover Charge $8.00
Cover Charge
$8
Max cover charge is
$8.00
Q M
Monopoly: Q M = 2 & P M = $2.50
4
Slide 14
Q
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 P
Examples :
Salad Bars, Legal Retainers, HMO’s Area under demand 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.
1 2 Preferences are
uncorrelated
Preferences are
correlated A B A B 150
80 100
190 250 270 160 200
=
360 simple monopoly 500
80
100
180 165
175
340 360
165 200
=
365
P M
MC
Third Degree Price Discrimination
East West Market Example with a
Simple Monopoly Price
in both markets Slide 17
MR
P E
P M
MC
Third Degree Price Discrimination
East West Market
MR P W MR MR
Example with
Different
Prices in Each Market Slide 18
Pricing In Segmented Markets
• • Segment markets by price sensitivity Charge
higher prices
in the markets that are the most
inelastic
• • Then P 1 = $150 and P 2 = $120
P ( 1 + 1/ E Q•P ) = MC Suppose MC = and E 1 $100 in 2 markets = - 3 and E 2 = - 6 Why are haircuts for kids cheaper 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 = TR A + TR B
Slide 20
Substitutes & Complements
• • Look for
interdependencies
in marginal revenues: » MR A » MR B = TR A / Q A +
TR B /
Q A
=
TR A /
Q B
+ TR B / Q B
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 MR A = MC A INSTEAD
:
» Produce where the
FULL MR = FULL MC
» For a Two Product Firm of A & B » Produce where:
TR A /
Q A +
TR B /
Q A =
TC A /
Q A +
TC B /
Q A 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 TR store = TR T + TR A MR store for turkey = TR T / Q T + TR A / Q T 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
MR B MR H D H D B steers (T)
Slide 25
Steers:
No Excess Case 2
MR T MC T
Find where
MR T = MC T
to find the optimal of steers.
MR H D H D B steers (T)
Slide 26
P B P H
Steers:
No Excess Case 3
MR T T MR H MC T
At the optimal number of steers, find the prices of beef & hides on their respective demand curves
D H D B if demand for beef rises, the price of hides will fall !
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”
motor assembly final car 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 P figure T = MC P on following Slide 31
P T P
Find Where MC
M+P
= MR
MC M+P MC P MC M MR D
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
or
P = AC n + Markup P = AC n (1 + m)
where AC n 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/E p ) = MC
Slide 34
Cost-Plus Pricing
:
Illustrated
Manufacturing pricing illustrated: One Good
P AC n } markup ATC AVC Q
n
AFC Q
capacity Slide 35
P AC n
Cost-Plus Pricing
:
Illustrated
D 1 D 2 } markup
quantity varies as demand varies
AVC Q
n
AFC Q
capacity Slide 36
P AC n
Cost-Plus Pricing
:
Illustrated
D 1 D 2 } markup quantity varies as demand varies AVC Q 1 AFC Q
n
Q 2 Q
capacity Slide 37
Full Cost Pricing
• • Full Cost » » Covers all Costs at the standard or normal output Plus a return on the investment P = AFC n » where p
K
+ AVC n + p
K
/ Q n is the target amount of profit » and p is the desired profit rate and K is gross operating assets • Example: Low Tech Security FC = 200,000, Q n p = 3000, VC = 90,000 = 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 = [ AC n ] (1.35) » P = [ 30 + 66.67 ](1.35) » P = $130.50
Slide 39
Cost-Plus Pricing
• • •
Advantages
Cost-plus is simple It is easy to delegate to others Easy to apply to thousands of items » Can use categories of markups for different classes of products • • •
Disadvantages
But cost-plus ignores demand changes Pricing may be based on poor cost data Output varies in business cycle
Hybrid Method
:
Variable Cost-Plus Pricing --
the markup can vary over the season or business cycle Slide 40
Optimal Markups in Practice
• Grocery stores have low markups • Many close substitutes - at other grocery stores (bread varieties and qualities are standardized) • Frequent purchase, so customers are knowledgeable about prices & quality 1999 South-Western College Publishing • • Demand is therefore
highly elastic
Optimal markup would consequently be small 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 pays the highest price, others are willing to wait •
Examples:
» Hardcover & Paperback Books » New electrical & Computer Products
D 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 non-business
travelers. If too few business and 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 large, an airline or hotel will have high spoilage.
is an inventory NOT sold. If capacity 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
be met. is the excess demand that cannot 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
the optimal amount of overbooking.
go in opposite directions, the sum of these costs has a minimum with Since business travelers tend to a large extent to be repeat customers, the cost of spillage (oversells) may be very high. The optimal amount of overbooking for this market segment may well be lower than for non-business clients.
Spillage
Total Cost
optimal
Spoilage
100% 110% 120% ...
Percent Overbooked Slide 47