Transcript Chapter 7: Pricing with Market Power Brickley, Smith, and Zimmerman,

Brickley, Smith, and Zimmerman,
Managerial Economics and
Organizational Architecture, 4th ed.
Chapter 7: Pricing with
Market Power
Pricing with market power
learning objectives
• Students should be able to
• Explain the role of elasticity in optimal
pricing
• Identify circumstances appropriate for
price discrimination
• Apply selected pricing techniques
consistent with maximum profit
Pricing objective
A firm has market power if…
it faces a downsloping demand curve.
The firm’s pricing objective is…
to maximize shareholder value.
The demand curve reflects…
consumer willingness and ability to buy.
Pricing with market power
(Figure 7.1)
Single price per unit
Figure 7.2
Other single pricing issues
• Relevant costs
– sunk costs are irrelevant
– current opportunity costs are relevant
• Price sensitivity
– price elasticity, , is a measure of price
sensitivity
– Optimal price is P*=MC*/[1-1/ *]
– A firm with market power should never
operate on the inelastic portion of the
demand curve
Price sensitivity and optimal markup
(Figure 7.3)
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.
• But they must reflect awareness of price
sensitivity!
Cost-plus pricing
• Add a markup to average total cost to yield
target return
• Does this ignore incremental costs and price
sensitivity?
– not if managers have a fundamental
understanding of their markets
– consistently bad pricing policies are not good
for the firm’s long-term fiscal health
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
Potential for higher profits
(Figure 7.4)
Homogenous consumer demand
• Block pricing
– declining price on subsequent blocks of product
– product packaging
• 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
Two-part tariff
capturing consumer surplus
Price discrimination
heterogeneous consumer demands
• Price discrimination occurs when firm
charges different prices to different
groups of customers for the same
product
– not related to cost differences
• Necessary conditions
– different price elasticities of demand
– no transfers across submarkets
Using information about individuals
• Personalized pricing
– “first degree” price discrimination
– possible only with small number of buyers
• Group pricing
– “third degree” price discrimination
– very common (utilities, theaters, airlines…)
Optimal pricing at Snowfish
different demand elasticities
Using information about the
distribution of demands
• Menu pricing
– “second degree” price discrimination
– consumers select preferred package
• Coupons and rebates
– users likely more price sensitive
– users who are new customers may stick
with product
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