Pricing Strategy
Pricing Strategy
Pricing Strategy
INTRODUCTION
In this research we deal with pricing strategies of firms that have some market power:
firms in monopoly, oligopoly and monopolistic competition. Firms in perfect competition
are price takers and they don’t have a pricing strategy of their own. This research goes as
far as providing practical advice on implementing pricing strategies for those firms with
market power, typically using information that is readily available to managers, including
publicly available information such as the price elasticity of demand.
The optimal pricing strategies for firms with market power vary depending on the
underlying market structure and the instruments (e.g., advertising) available & the nature
of product whether it has elastic or inelastic demand (i.e. whether it is luxury or necessary
good). To account for that, this research presents some sophisticated pricing strategies
that enable a manger to extract greater profits from the consumers.
Demonstration 1:
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Suppose the inverse demand equation is given by
P=10-2Q (downward sloping demand=market)
and the cost function is
CQ=2Q
Formula: Marginal Revenue for a firm with Market Power (Monopoly and Monopolistic
Competition):
MR=P1+EfEf where Ef=%∆Q%∆P=∆Q∆P*PQ
where Ef is the firm’s own direct price elasticity of demand. Substitute this in the profit-
maximization rule
P1+EfEf=MC
Solve for the price:
P=1+EfEfMC
or
P=(K)MC
where K=Ef1+Efcan be viewed as the profit maximization (optimal factor) markup
factor.
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Example: The clothing store’s best estimate of elasticity is -4.1 and this is known. Thus,
the optimal markup is
K = -4.1/(1- 4.1) = 1.32.
Then the optimal price
P = (K)MC = 1.32*MC
(That is, 1.32 times marginal cost).
The manger should note two things about this price elasticity: First, the more
elastic the price is, the lower the markup factor and the price (if Ef = -infinity, then K= 1
and P = MC as is the case in perfect competition); the lower MC is, lower the price.
Demonstration 2:
Suppose the manger of a convenience store competes in a monopolistically competitive
market and buys Soda at a price of $1.25 per liter. The price elasticity of demand for the
typical grocery is -3.8. The manger of this convenience store believes that demand is
slightly more elastic than -3.8. Let the price elasticity of the convenience store is -4. What
is the profit maximizing price for this store?
P = [-4/(1-4)]MC = 1.3 MC
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formula for a firm in a Cournot Oligopoly. First, it can be shown that if products are
similar then
Ef = N*EM
Where Ef is the price elasticity of demand for the typical firm, EM is the industry’s price
elasticity of demand and N is the number of firms in the industry. Recall that the markup
pricing rule under monopoly and monopolistic competition is given by
P = [Ef /(1+Ef)]MC
where MC is the individual firm’s marginal cost. Upon substitution for Ef from above, the
profit maximizing price for a firm under Cournot is given by:
Demonstration 3:
Suppose a Cournot industry has three firms, with market elasticity Em equal -2 and the
individual firm’s MC is $50. What is the firm’s profit maximizing price under Cournot
oligopoly
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All the above four strategies aim at extracting consumer surplus and turn it into profit for
the producers.
I. Price Discrimination
Price discrimination is the practice of charging different prices to different consumers for
the same good or service sold. There are three types of discrimination; each requires that
the manager have different types of information about consumers.
P
P1
P2
Actual P
If monopoly single pricing strategy is used and the monopoly price is P*M, then
consumer surplus (CS) in the graph below is the yellow triangle above the P*M-
line and below the D-curve.
CS MC
P*M M
PC
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Q*M MR
If 1st degree price discrimination is practiced then: Consumer surplus (rectangle area) =
0, (because the price is the maximum price the consumer is willing to pay).
Fig. 11-1a below shows the firms’ total (operating) profit (CS + PS) when the firm
charges the maximum price. It is the area below the demand curve and above the MC
curve up to Q*M. Note that the area below the MC curve and below the price line P*M up
to the quantity Q*M is the producer surplus (PS).
First-degree price discrimination is also called perfect price discrimination because it
requires identifying the reservation price for each consumer under alternative quantities.
This is not possible in the real world.
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Second Degree Price Discrimination (discrimination based on quantity)
This type of price discrimination leaves the consumer with some consumer surplus. Thus
relative to the first degree price discrimination, the total profit under the second degree is
lower. This discrimination practice is based on giving discount for buying extra quantities
of the good.
In Fig. 1b, the firm charges the consumers $8 a unit for the first two units. In this case it
extracts [1/2*(8-5)*2= $3] of the consumer surplus which would have gone to the
consumers under single pricing. It also extracts some more by charging $5 per unit of on
the units from 2 to 4. This is an additional extraction of CS. The firms cannot extract all
consumer surpluses; some consumer surplus will be left to the consumers under the 2 nd
degree-price discrimination.
Example: Electric companies: it works by charging different prices for different
quantities or blocks of the same good or service (KWH). This is the case of natural
monopoly (economies of scale) where both AV and MC curves are declining all the way.
Natural Monopoly: MR = MC
Breakeven: P = AC or TR = TC
P1
PM*
P2
Break even
P3 EM AC
MC
MR D
Q1 QM* Q2 Q3
1st block 2nd block 3rd block
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Fig. 1(b) above shows how much of the consumer surplus is extracted by the firm when
the second-degree practice is used.
Where MRT is the horizontal sum of all groups MRi , i = 1,…, n. That is, fix MRi at a
certain level then add up the corresponding quantities Q1, Q2,. ..,Qn. Then repeat this
process by fixing MRi at a different level and so on. You will get MRT.
Then equate MR1 = MR2 = --- = MRN = MCT to divide the total output among the n
customer groups.
If MRi > MCT for all groups i, then profit will increase by increasing total output and
lowering prices.
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MRi < MCT then profit will increase by decreasing total output and increasing prices.
Total
Group 1 Group 2
output
Q1 Q2
QT = Q1 + Q2
P1 P2
Total cost function C = C (QT)
TR1 = P1Q1
TR2 = P2 Q2
MR1 – MC = 0
MR1 = MC
MR2 = MC
MR1 = MR2 = MC (which is the condition allocating total output Q* among the two
groups).
This is the condition for profit maximization under third degree monopoly.
Monopolists practicing this price discrimination may find it easier to think in terms of
the relative prices that should be charged to each group and to relate these prices to
elasticity.
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Recall MR2 = P2 + P2(1 / EP2D2) = P2(1+1/EP2D2)
P1[(1+E1)/E1] = MC
P2[(1+E2)/E2] = MC
Therefore from 1st profit max ruler under 3rd price discrimination:
MR1 = MR2
P1(1+1/EP1D1) = P2(1+1/EP2D2)
P1 = [1+(1/EP2D2)]
P2 [1+(1/EP1D1)]
The higher price will go to the consumers with the lower elasticity.
Or P1 = 1.5P2
Demonstration 4:
During the day only students eat there, while at night faculty members eat. If student’s
elasticity of demand is -4 and of faculty is -2, what should be the pricing policy be to
maximize profit?
Answer:
P1[(1+E1)/E1] = MC
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P2[(1+E2)/E2] = MC
PL[(1-4)/-4] = $6
PD [(1-2)/-2] = $6
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Fig. 2: Comparison of Standard Monopoly Pricing and Two-Part Pricing
Fig. 2(a) gives the profit maximization for a firm with market power using single pricing
which based on the rule:
MR =MC.
Suppose that the demand curve is given by
Q = 10- P.
Then the inverse demand is given by
P = 10 –Q
And, thus,
MR = 10 – 2Q.
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Suppose that the total cost function is given by:
C(Q) = 2Q,
Which implies that MC = 2 (in this case MC = AC and constant).
The firm’s equilibrium output and price based on single pricing are determined by
10 -2Q = 2.
Then Q* = 8/2= 4 units and P* = $6.
Total profit = (P – MC)*MC = (6 – 2)*4 = $16
Consumer surplus = (1/2)*(10 -6)* 4 = $8
Now let us use the two-part pricing strategy. Suppose the demand function in Fig. 11-2
(a) be for a single consumer. The firm can use the following two-part pricing strategy: the
fixed initiation fee for the right to purchase units $32 and that the price per unit is $2.
This situation is depicted in Fig. 11-2(b).With a price of $2 per unit, the consumer will
purchase
Q = 10 – P = 10 -2 = 8 units.
The consumer surplus with 8 units is
CS = (1/2)*(10 - 2)*8 = $32.
To implement this pricing strategy, the firm can charge a fixed initiation fee (whether as
membership fee or an entrance fee) of $32. This fee will extract the entire consumer
surplus.
Note that at $ 2/ unit, revenue will equal cost (net of fixed cost). That is,
(Variable) Profit = (P – MC)*Q = (2-2)*8 = $0.
But the firm receives $32 as a fixed payment which is greater than the $18 profit which
receives by charging a single price
Demonstration 5:
Suppose the total demand for golf services is Q = 20 – P and MC =$1. The total demand
function is based on individual demands of 10 golfers. What is the optimal two part
pricing strategy for this golf services firm? How much profit will the firm earn?
Answer:
The optimal per unit charge is marginal cost. At this price, 20-1 = 19 rounds of golf will
be played each month. The total consumer surplus received by all 10 golfers at this price
is thus: ½[(20-1)19] = $180.50
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Since this is the total consumer surplus enjoyed by all 10 consumers, the optimal fixed
fee is the consumer surplus enjoyed by an individual golfer ($180.50/10 = $18.05 per
month). Thus, the optimal two part pricing strategy is for the firm to charge a monthly fee
to each golfer of $18.05, plus greens fee of $1 per round. The total profits of the firm thus
are $180.05 per month, minus the firm’s fixed costs.
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Fig. 11-3: Block pricing
Then the profit maximizing price for the package of eight units = $48
Demonstration 6:
Suppose a consumer’s (inverse) demand for gum produced by a firm with market power
is given by
P = 0.2 – 0.04 Q
And the marginal cost is zero. What price should the firm charge for a package
containing five pieces of gum?
Answer
When Q = 5, P = 0.2 – 0.04 * (5) = 0
When Q = 0, P = $0.2 . The linear demand is graphed in Fig. 11-4 (optimal Block Total
Pricing with zero marginal cost)
Value of the five units = C5
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= ½ ($0.2 - $0) * 5 = $ 0.50
The firm extracts all consumer surplus and charges a price if $0.50 for a package of five
pieces.
The manager does not know the identity of those two groups, and thus cannot practice
price discrimination. Suppose the cost is constant and equals to zero to simplify matters.
The manager can separately sell one computer and total profit equals
TR – TC = 2,000 – 0 = $2,000
If it sells it at $1,500, then
TP = 3,000 – 0 =3,000
Moreover, it can also sell monitors separately. At $300 it can sell one. At $200, it can sell
two and then total profit equals
= $3,000 + 2 * $200 = $3,400
If the manager bundles the computers and the monitors and sell them at $1,800 a bundle
then
Total profits = 2 * $1,800 = 3,600
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which $200 more than selling the computers and the monitors separately. Thus
commodity bundling can hence profit.
Demonstration 7:
Suppose there are three purchasers of a new car that has the following valuations of two
options: air conditioner and power brakes.
Consumer Air Conditioner Power brakes
1 $1000 $500
2 $800 $300
3 $100 $800
Suppose the costs are zero
1. If the manager knows the valuations and consumer identities what is the optimal
pricing strategy?
Profit from consumer 1 = 1,000 + 500 = 1,500
Profit from consumer 2 = 800 + 300 = 1,100
Profit from consumer 3= 100 + 800 = 900
Total Profit = $3,500
2. Suppose the manager does not know the identities of the buyers. Hoe much will the
firm make if the manager sells brakes and air conditioners for $800 each but offers a
special options, package (power brakes and an air conditioner) for $1,100.
Consumer 1 and 2 will buy the bundle
Profit = 2 * $1,100
Consumer 2 will buy power brakes at $800
Total Profit = $3,000
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