Download MANAGERIAL ECONOMICS NOTES Pricing Strategies: Pricing

MANAGERIAL ECONOMICS NOTES
Pricing Strategies: Pricing Models
PRICING ANALYSIS AND DECISION
Price is the amount of money paid for a unit or quantity of the good or service under consideration.
A “package” of other services goes with the physical commodity and include time and place of
delivery, time payment is expected by the seller, cash and quantity discounts, guarantees that go
with the product, or any rights of return of goods. If changes occur in any of these things, even
though money paid per unit remains unaltered, the true price has changed. The quoted and list
prices may be no guide to the price actually paid, as concessions may be given to particular groups of
individuals. Price is the only element in the marketing mix that creates sales revenues, other
elements are costs.
The setting of prices involves three areas of information- costs, competition and consumer demand.
Costs information is derived from internal sources whereas information on competition and
consumer demand involves the external environment. In any business a great deal of information is
potentially available about its external environment from the operations of its own staff. Reports
from salesmen in the field will convey information about the strategy of competitors, the emergence
of new competition and reaction of customers. This can be very effective if salesmen are given
guidance on what to look for, and reporting should be restricted to statement of observable fact.
PRICING STRATEGY
This is the task of defining the initial price range and planned price movement through time that the
company will use to achieve its marketing objectives in the target market.
1. COST ORIENTED PRICING STRATEGIES
(a) Mark up pricing or cost plus pricing- also called Average Cost pricing or full cost pricing. It
is the most common method of pricing a product by manufacturing firms. The term cost plus is
often used to describe the pricing of jobs that are non-routine and difficult to “cost” in advance,
such as construction and military weapon development. Under the cost plus pricing, the firm
calculates or estimates its AVC , and then sets its price by adding on a percentage mark-up that
includes a contribution towards the firm’s fixed costs, and a profit margin. The general practice
under the mark-up pricing method is to add a fair percentage of profit margin to the AVC. The price
is set as:
P= AVC+ x% (of AVC) where x is the mark-up percentage chosen. Or
P=AVC + AVC x (m) = (1+m)AVC or (1+m)C where m is the mark-up percentage fixed so as to
cover AFC and net profit margin. The size of mark up depends on the willingness of consumers to
pay the maximizing and this level varies inversely with the value of price elasticity. Products with
higher price elasticities of demand should be expected to have relatively lower percentage mark ups
in order to make the maximum total contribution to overheads and profits. Firms find their “best”
mark up by trial and error or by adopting the same mark up that is applied by other firms or by the
price leader in the industry.
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Firms usually apply higher mark-ups to products facing less elastic demand than to products with
more elastic demand. It can also be shown that cost-plus pricing leads to approximately the profit –



maximising price. If we take MR  P1 
1
Ep

 where Ep is the price elasticity of demand. Solving


 Ep 
 .Since profits are maximised where MR=MC, we can substitute MC
 E 1
p


for P we get P  MR
 Ep 
 . If the firm’s MC is constant and equal to C
 E  1
 p

for MR in the above equation and get P  MC 
 Ep 
 Ep 
 Ep 
 . We can then set P =(1+m)C  C 
 or 1+m  
 . Thus
 E 1
 E 1
 E 1
p
p
p






we can get P  C 
we get m 
Ep
Ep 1
 1 . From this if Ep=-1.5, m=2, or 200%; if Ep=-2, m=1 or 100%. It can then be
concluded that the optimal mark-up is lower the greater is the price elasticity of demand of the
product. Firms in practice have been found to apply a higher mark-up to products with inelastic
demand than to products with elastic demand, and when increased competition has increased the
price elasticity of demand, they have been found to reduce their mark-up. It can thus be concluded
that cost-plus pricing does lead to approximately profit-maximizing prices. In a world of inadequate
and imprecise data on demand and costs, firms may simply utilize cost-plus pricing as the rule-ofthumb method for determining the profit-maximising prices.
The advantages of mark-up pricing are:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
by pinning the price to unit costs, sellers simplify their own pricing task considerably and
they do not have to make frequent adjustments as demand conditions change.
There is also generally less uncertainty about costs than about demand.
It requires less information and less precise data than in MC=MR case.
It results in stable prices when costs do not vary much.
It provides a justification for price increases when costs rise.
It is easy and simple to use (may be misleading since difficulty of projecting TVCs and
overheads allocation).
Limitations
(i)
Assumes firm’s resources are optimally allocated and the standard cost of production is
comparable with the average for the industry.
(ii)
Uses historical cost rather than current cost data- this may lead to underpricing under
increasing cost conditions and to overpricing under decreasing cost conditions.
(iii)
If VC fluctuates frequently and significantly, cost plus pricing may not be an appropriate
method of pricing.
(iv)
It is “alleged” that cost plus pricing ignores the demand side of the market and is solely
based on supply conditions (“alleged” because firms determine the markup on the basis
of what the market can bear.).
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(b) Marginalist Pricing .There are three main ways of practicing marginalist pricing under
uncertainty:
(i) Given estimated demand and MC curves. MR has the same intercept value and
twice the slope value as compared with the demand curve and thus we can quickly
derive an estimate of MR. Setting the expression for MR equal to that of MC, we can
solve for the quantity level that preserves the equality. This method of price
determination involves inserting the result back into the demand curve to give us
the price that will maximize contribution and hence profit.
(ii) Given estimated price elasticity and MC- involves using the elasticity value and
the current price and output levels to find an expression for the demand curve and
then proceed to equate estimated marginal revenue and marginal cost.
(iii) Given estimates of incremental costs and revenues- is a marginalist approach
since it is concerned with changes in both total revenues and total costs. Where
demand contains indivisibilities or discontinuities we cannot construct the marginal
revenue function, since the total revenue curve is not continuous and therefore is
not differentiable. Instead we must compare the incremental costs and incremental
revenue at each price level and choose the price that allows the maximum
contribution to be made.
(c) Target Pricing- also cost oriented pricing approach in which the firm, tries to
determine the price that would give it a specified target rate of return on its total
costs at an estimated standard volume e.g. pricing of good X so as to achieve an
average rate of return of 15 to 20% on a firm’s investment. The breakeven chart can
be used to illustrate target pricing. The total cost curve (TC) and total revenue (TR)
curve have to be worked out. Target pricing has a major conceptual flaw- the
company uses an estimate of sales volume to derive the price but price is a factor
that influences the sales volume.
2. DEMAND ORIENTED PRICING STRATEGIES
This calls for setting a price based on consumer perceptions and demand intensity rather than
on cost.
(a) Perceived value pricing or prestige pricing-deliberately setting high prices to attract
prestige-oriented consumers (goods have a snob appeal. An increasing number of companies
are basing their price on the product’s perceived value. They see the buyers’ perception of
value as the key to pricing. Price is set to capture the perceived value. A company develops a
product for a particular target market with a particular market positioning in mind with respect
to price, quality and service. Market research has to be carried out to establish the market’s
perceptions.
(b) Demand Differential pricing- is another of demand oriented pricing. It is also called price
discrimination. It takes many forms (i) Customer basis- different customers pay different
amounts for same product/service. (ii) Product form basis- different versions of the product are
priced differently but not proportionately to their respective marginal costs. (iii) Place basisdifferent locations are priced differently although there is no difference in MC. (iv) Time basis3
different prices charged seasonally by the day, by the hour, etc. For effectiveness the market
must be segmentable and have different demand elasticities, no resale to segment paying the
higher price. The cost of segmenting and policing the market should not exceed the extra
revenue derived from price discrimination the practice should not breed customer resentment
and turning away.
Price discrimination types
There are three types
First degree Discrimination – involves charging the maximum possible price for each unit of output.
It involves making the price per unit of output depend on the identity of the purchaser and on the
number of units purchased. Thus the consumer who attaches the greatest value to the product is
identified and charged a price of P1 (this being individual 1’s reservation price) Similarly, the
consumers willing to pay P2 for the second unit (this being individual 2’s reservation price) and P3 for
the third are identified and required to pay P2 and P3 respectively. each customer is being charged
different prices. Each unit of product is charged separately. All consumer surplus is extracted.
First degree
P1---P2 ------P3-------------Pc
Second Degree
P1
P2
MC=AC
P3
D
Q1 Q2 Q3 QD
O
Q1
Q2
Q3
With first degree price discrimination , the profit maximising output rate is where the MC and
Demand curves intersect. Any sale in excess of QD would reduce profits because price would have
been less than MC. First degree Price discrimination is uncommon because it requires that the seller
have complete knowledge of the market demand curve and also of willingness of individuals to pay
for the product, In addition the market must be segmentable and also that resale is not possible.
Second degree price discrimination- this involves pricing based on the quantities of output
purchased by individual consumers.. That is it involves making the price per unit of output depend on
the number of units purchased. The monopolist designs a menu of prices and quantities (or use rates
of quantities purchased) such that each consumer chooses a price –quantity combination that allows
the monopolist to discriminate profitably between consumers. The price does not depend on the
identity of the purchaser. It involves charging uniform prices per unit for a specific quantity or block
of the product sold to each customer, a lower price per unit for an additional batch or block of the
product and so on.. This is easy where there are meters as in electricity and water. Another version
is discriminating among groups of buyers on a time or urgency basis. This probably applies to new
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products. For example first 10 units at 15cents, next 20 units at 10 cents and all additional at 5cents
each. In other words blocks are charged at different prices. Examples include the charging of
electricity, whereby there is a two-part tariff, requiring the payment of a fixed fee if the consumer
wishes to make any purchases at all, plus an additional uniform price per unit purchased. It also
involves charging different prices in two or more different markets at the same point in time (until
MR of the last unit of product sold in each market equals the MC of producing the product). This
implies that MR1=MR2=MC. The market is segmentable e.g. student versus nonstudent.
Third Degree price discrimination - most common. The price per unit depends on the identity of the
purchaser. The price does not depend on the number of units purchased. Involves separating
consumers or markets in terms of their price elasticity of demand. The monopolist charges a relatively
high price to consumers whose demand is price inelastic, and a relatively low price to consumers
whose demand is price elastic. Segmentation can be based on several factors e.g. geographical
location (selling of books outside US at lower prices), telephone users may be residential or
commercial (nature of use), usage of electricity ( industrial or residential) or during certain times),
can be according to age (personal characteristics).
Forms of price discrimination used in practice
These include:
 Intertemporal price discrimination, whereby the supplier segments the market by the point in
time at which the product is purchased.
 Branding, whereby different prices are charged for similar or identical goods differentiated
solely by a brand label.
 Loyalty discounts for regular customers.
 Coupons that provide price discounts discriminate between consumers on the basis of
willingness to make the effort to claim the discount.
 Stock clearance sales involving successive price reductions are a form of intertemporal price
discrimination.
 Free-on-board pricing involving the producer or distributor absorbing transport costs, and
representing a form of price discrimination favouring buyers in locations where transport
costs are higher.
3. COMPETITION ORIENTED PRICING
This is when a company sets its price chiefly on the basis of what its competitors are charging. It is
not necessary to charge the same price as the competition. The firm may seek to keep its prices
lower or higher than the competition by a certain percentage. The distinguishing characteristic is
that it does not seek to maintain a rigid relation between its price and its own costs or demand.
Conversely the same firm will change its price when competitors change theirs, even if its costs or
demand have remained constant.
Going rate pricing- the firm tries to keep its price at the average level charged by the industry. The
pricing primarily characterizes pricing practice in homogeneous product markets, although the
market structure itself may vary from pure competition to pure oligopoly.
Sealed Bid pricing- also called competitive tendering or competitive bidding. In this there is only one
buyer in the market whose requirements are individual to himself. In other words a number of
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sellers compete for the business of a single buyer. Confronting him is a number of suppliers each of
whom is capable of doing the work e.g. building a ship, an office block, or building a nuclear power
station. The buyer, wishing to secure the benefits of competition, puts his contract up for tender. It
may be open to all comers or may be restricted to a select group which the buyer judges to have the
competence and resources to undertake the work successfully. Normally the contract will go to the
bidder quoting the lowest price but, with a view to protecting his own interest, the buyer will usually
reserve the right to accept any tender – or none. Competitive bids may also occur where Services of
a product may not be identical hence combination of price and quality also matter. Examples are in
the service sector.
Normally buyer has budgeted expenditure whilst bidders do not know of it. Too low a price leads to
loss or loss of tender. Too high a price may be rejected. A firm can win a tender but may incur losses
due to rising costs- the ‘winner’s curse’.
Types of Bids
There are three types of bids
(1) Fixed price bids.
(2) Cost plus fee bids.
(3) Incentive bids.
Fixed Price Bids
This is when suppliers tender for a price bid regardless of variation of costs. Supplier tenders a bid
price or price quote and undertakes to complete the job for that price regardless of any variation of
costs from expected levels.
Pb   t  Ct where Pb is the bid price;  t is target profit and C t is supplier’s target cost. The
actual profit  a =  t + ( C a  Ct ) where C a is actual cost. (NB. If Ct > Ca  a falls)
Cost Plus Fee Bids
In these the entire risk is borne by the buyer who agrees to meet the actual cost plus what supplier
stated was their profit.
Pb  Ca   t   a   t where Pb is the bid price. (NB.  t is the fee)The buyer expects to audit
the costs. The contract is unfair to the buyer because of the problems of conducting the audit.
Incentive BidsThese are also called risk sharing bids. The buyer and seller (supplier) agree before hand on a bid
price but agree to share any deviation from expected costs level in a given way.
More formally mathematically if  = supplier’s share of cost variation where 0<  <1 then
For the buyer Pb  Ct   t  (1   )(Ca  Ct )...............................(1)
Pb is the bid price , C t is supplier’s target cost,  t is target profit.
For the Seller  a =  t +  ( C a  Ct ).
If  =1 then Pb  Ct   t and this becomes fixed price bids. All risk goes to the seller.
 a =  t + C a  Ct .
On the other hand if  =0, Pb   t  C a . In this case the buyer is bearing the burden.
 a =  t . This is the cost plus fee bid. All risk goes to the buyer.
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Auctions
There are four basic auction formats.
1. English Auction- also called the ascending bid auction and involves the price being set
initially at a very low level which many bidders would be prepared to pay, and then raised
successively until a level is reached which only one bidder is willing to pay. The last
remaining bidder secures the item at the final price and the auction stops.
2. The Dutch auction- also known as the descending bid auction, is the exact opposite of the
English. Price is set initially at a very high level which no bidder would be prepared to pay,
and is then lowered successively until a level is reached which one bidder is prepared to pay.
The first bidder who is prepared to match the current price secures the item at that price, and
the auction stops.. normally used to sell agricultural produce.
3. First price sealed bid auction- each bidder independently submits a single bid, without seeing
the bids submitted by other bidders. The highest bidder secures the item, and pays a price
equal to his or her winning bid. This has been used by governments to sell drilling rights for
gas and oil, and the rights to extract minerals from state owned land.
4. The second price sealed bid auction- sometimes known as a Vickrey auction after the seminal
paper on auction theory by Vickrey in 1961. The bidding process works in the same manner
as a first price sealed bid auction: each bidder independently and [privately submits a single
bid. Again the highest bidder secures the item, but pays a price equal to the second-highest
submitted bid. Has been used occasionally in practice.
There is a Sealed bid auction and an open auction.
Sealed Bid- all bidders have to submit their bid in a sealed envelope at the same time. The most
striking difference with open auction is that you do not learn about the private information of the other
bidders during the auction process. In sealed bid auctions, the private valuations of all players remain
unobservable. In situations of uncertainty regarding the true value of the auctioned object, all private
valuations must be based on estimates.
If you are the winner, there may be good news and bad news in the outcome. The good news is that
you have got the deal. The bad news may be that you have based your calculations on the most
optimistic calculations of all competitors. This is called the winner’s curse in game theory.
Open Bid- the bids of all parties are observable. In an ‘increasing bid’ competition the optimal
strategy for the individual bidder is to remain in the bidding competition until the price rises to his
own valuation of the item. If all bidders are rational and execute this strategy, the item, the item will
be transferred to the buyer with the highest private valuation of the item. As the bidding process
unfolds one is able to observe the private valuations by noticing who remains in the competition and
who drops out. The bidding process forces the players to reveal their preferences. In the ‘Dutch
auction’ instead of an increasing bid competition, the auctioneer starts off from a very high price. The
auctioneer cries out loudly prices which slowly decrease.
4 PRICING WITHOUT COMPETITION
Cases exist where there may be only one source of supply in the market, for example, in the
provision of defence equipment. If there is only one source of supply but an exact specification can
be laid down- as where the same equipment has been supplied before- the supplier can be asked to
quote a firm price on the basis of which the order can be placed. The fairness of the price quoted
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can be judged in the light of previous experience. Thus contracts under such circumstances are
stated “price to be agreed”. Such prices are to be agreed contracts based on costs. They may be
based on estimates of costs made either before or during production. Alternatively they may be
founded on actual costs which are ascertained after production has finished.
NEW PRODUCT AND ITS PRICING
The term new product has many meanings. It may refer to a product of distinctive novelty- the first
TV set or the first ball point pen. On the other hand it may be a product new to the market in the
sense of a new brand of detergent or beer where guidelines to price already exist in the form of
established brands.
In the case of a pioneering product, the first stage is that of deciding the degree of market
acceptance of the new product. This is partly a question of the price at which it can be sold, but
other considerations may well be prominent. Price is likely to be more prominent at the early stages
of introduction in cases where the product has no more than a small degree of novelty. If there are
no close substitutes, price may well be a secondary factor at the early stages of introduction to the
market. Trendsetters may buy the product because they are usually people with surplus income and
may not look closely at price.
The producer of a pioneering product is faced is faced with a dynamic competitive situation – at first
he enjoys a degree of freedom because he is alone in the market- he may have protection of a
patent, and if rewards look high enough, ways can usually be found to evade the patent without
infringing his legal rights. Thus as the market develops, changes in the pricing strategy must be
made. At the outset he has a choice between a skimming price and a penetration price.
Price Skimming- It involves setting a relatively high initial price for a new product when it is first
introduced, to capture customers with high purchasing power, with the intent of getting as much
profit from the product as possible. This is a short term intent. This may be similar to first degree
price discrimination and can somewhat be compared to prestige pricing. Here the product pioneer
takes advantage of any price insensitivity which exists at the early stages of marketing and charges a
high “monopoly” price. In this way he secures a relatively high cash flow at an early stage which
helps to minimize his losses if, in the end, the product fails to “take off”. If however demand builds
up according to his hopes and expectations then he will be seen to be earning high returns. The
conditions to encourage competitors to try to enter the market are strongly established. As
competition builds up, he reduces his price in an attempt to check their (competitors) inroads on his
market. He may get credit for pioneering price reductions. The firm may also lower its price to draw
in the more price elastic elements of the market.
Rationale for price skimming
(1) it is difficult to know the demand curve when entering a market, which market is unknown.
Demand elasticity is unknown.
(2) Production of the new product is at small scale. Low plant size will limit output. Maximize
revenue through higher prices which will generate high initial cashflows.
(3) High R and D to be recouped as quickly as possible.
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(4) Skimming may also enable firm to identify different market segments for the product, each
prepared to pay progressively lower prices. If there is product differentiation it may be
possible to continue to sell at higher prices to some market segments.
(5) There is presently a sufficient number of buyers having high current demand.
(6) The high price creates an impression of a superior product.
(7) The high initial price will not attract more competitors.
Skimming can also be maintained by :
(1) barriers.
(2) Quality of product. Demand is expected to be maintained.
PENETRATION PRICING
This is the opposite strategy to price skimming strategy and has the aim of discouraging competition.
This type of policy is likely to be followed when the producer is likely to be followed when the
producer is of the opinion that the period of exclusive occupation of the market is likely to be of
short duration. Competition will arise quickly and his aim is to try to make this as unattractive as
possible by setting a low price and a fine margin of profit. The motive for so doing will be
strengthened if the market is one which is not easily segmented and where it is considered that the
sales volume of the product will be very sensitive to price even when it is first introduced. An added
inducement in support of such a policy is to be found in those cases where an increased volume of
output is subject to marked economies of scale. The policy requires faith in the speedy realization of
a high volume of sales and will almost certainly need to be associated with a considerable sales
promotion effort.
Circumstances favouring this strategy
(1) wish to discourage rivals from entering.
(2) Firm wishes to shorten initial period of PLC in order to enter growth and maturity stages
quickly.
(3) Significant economies of scale to be realized from large output may build larger capacity and
then reduce prices further.
Other Pricing Practices
These include:
Price lining-this refers to the setting of a price target by a firm and then developing a product that
would allow the firm to maximise total profits at that price. Thus instead of deciding first on the type
of product to produce and then on the price to charge so as to maximise the firm’s total profits (as
usual), the order is reversed with price lining. (Cart before horse strategy).
Value Pricing- refers to the selling of quality goods at much lower prices than previously. The
manufacturers are also redesigning the product to keep or enhance quality while lowering costs so
as to still earn a profit.
Ramsey Pricing
No product should be supplied by a firm unless its incremental revenues are expected to exceed its
incremental cost. If there are common costs managers must decide which products will be priced
above incremental cost and how much above. According to the Ramsey pricing, for an enterprise to
cover its total cost at least one of its two goods must be priced above its marginal cost. In its simplest
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form, Ramsey pricing requires that price deviations from marginal costs be inversely related to the
elasticity of demand. That is, for goods with very elastic demand, the price should be set close to
marginal cost. Conversely for goods with relatively inelastic demand, the price should deviate more
from marginal cost. The rationale for Ramsey rule is that if demand is elastic, increasing the price
causes a substantial reduction in quantity demanded. . But if demand is highly inelastic , large changes
in price will result in little change in the quantity demanded. In the extreme, if demand were totally
inelastic (a vertical demand curve), there would be no change in quantity demanded as price
increased. Hence , if deviations from marginal cost pricing are greatest for those goods with inelastic
demand, the resource misallocation will be minimized.
Ramsey pricing
P’y
P’x
Px
MCx
Py
MCy
Dx
Q’x
Dy
Q’y Qy
Qx
Good X
Good Y
Prices charged for X and Y are respectively P’x and P’y.
PRODUCT LIFE CYCLE (PLC)
The product life cycle concept draws an analogy between biological life cycles and the pattern of
sales growth exhibited by successful products. In doing so it distinguishes four basic stages in the life
of a product- introduction, growth, maturity and decline. The concept in other words derives from a
biological metaphor namely that all “living things” go through a cycle of birth, growth, maturity and
inevitable decline and death. Product forms, product classes and brands are likened to living things
in this context.
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Product Life Cycle
Product
Sales
Growth or
Expansion
Maturity
Decline
Introduction
Stage 1
Stage 2
Stage 3
Stage 4
Time
Stage 1 Introduction Stage or introductory stage- this is the most hazardous stage of all, when the
product has to prove its value and find a market. Preproduction costs are also high at this stage.
Pursuing the life cycle analogy, infant mortality is very high and most products do not survive this
stage. The initial price will be relatively high compared with later stages in the life cycle. The aim is to
recover development costs as quickly as possible. Some consumer goods may be sold at an
introductory price offer which is withdrawn when the selling momentum picks up. In pricing the
new product, the appropriate strategies are skimming price or penetration price. The product being
new lacks information and hence a degree of uncertainty. Skimming pricing can be used on the
product, this being accompanied by heavy sales promotion expenditure. Price can also be of a
penetrating the market by charging lower prices which can then be increased over time.
Stage 2 Expansion, growth, or breakthrough period. The product receives general acceptability,
rapid growth as more cautious buyers enter the market. Other firms are joining in. Production costs
are likely to fall. Prices are also likely to fall. The post skimming strategy can be used in situations
where the product is losing its distinctiveness or exclusiveness hence a series of small price
reductions would be more appropriate.
Stage 3 Maturity stage- the product is now well established, existing in a variety of forms to suit
different needs and different markets. The uniqueness of the product (characteristic of stage 1) has
gone and the rapid period growth of stage 2 has disappeared. The original firm may be on the point
of withdrawing. Costs including advertising and promotional costs are likely to fall as the momentum
of sales gathers strength. Manufacturers in this stage should reduce real prices as soon as the
system of deterioration appears. This does not mean that the manufacturer should declare open
price war in the industry but rather move in the direction of product improvement and market
segmentation.
Stage 4 Decline- this marks the old age and virtual death of the product in its original form. There
are many causes of decline but two main ones are (1) Change in fashion. (2) a technical
breakthrough may render the original product obsolete. The strategy in this stage is to reduce the
price of the product. The product should be reformulated so as to suit the consumers’ preferences.
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It is a common practice in book trade. When the sale of hard-bound edition reaches saturation,
paperback editions are brought to the market.
PRICE POSITIONING
Price setting is a very challenging task because reaction of consumers and competitors is very
difficult to ascertain. Apart from cost considerations other factors, particularly in the consumer fields
ought to be considered as they play an important role.
(i)
Possible existence of a traditional price range for the product. Unless the product
embodies something entirely new most consumers and producers know instinctively
what a “reasonable” price ought to be and a decision to move outside this band involves
not merely finding a new market segment but possibly also a new marketing strategy.
(ii)
Prevailing attitude of mind of the customers towards switching. If there is a strong brand
loyalty, the situation is particularly difficult for the newcomer. In this situation a
dramatic break with the existing price structure, either a substantially cheaper product
or improved mark ups for the distributors, may be required.
In established product markets, firms can be classified as price makers or price takers, that is, they
are either price leaders of followers. Price leaders normally choose the price that they feel best
fulfills their objectives, perhaps subject to the constraint that the chosen price must lie within a
range that is acceptable to the price followers.
In established product markets, the general price level may be regarded as being historically
determined, in the sense that it has gravitated to a specific level (in real terms) over a prolonged
period of time , and to the general satisfaction or acquiescence of the firms involved. The firm must
therefore position its price correctly in relation to its competitors.
Product Line Price Strategy
Almost all firms have more than one product in their line of production. These multiple models or
sizes of a product produced by the same company may be considered as different products or
perfect substitutes for each other. Each has different AR and MR curves. The pricing under these
conditions is known as multiproduct pricing or product line pricing.
A frequent procedure is to apply a common mark up percentage to the per unit variable costs of
each item in the product line. This is not optimal pricing since some products have relatively smaller
price elasticities while others have relatively higher price elasticities. Higher price elasticities result
from a product’s having a variety of substitutes and / or being relatively expensive. There are 3 basic
decisions to be made in product line pricing:
(1) Choose the price of the basic or bottom of the line item. The “loss leader” considerations must be
weighed against connotations of lower quality that may be attached to lower prices, in order to
achieve maximum contribution from the entire production line.
(2) Choose the price of the top of the line item with an eye to the impact of that price on sales of the
whole line. A high mark up prestige item at the top of the line may confer status and quality
connotations on all other items in the line. Alternatively a price too high could give the impression
that other items are overpriced as well and could cause total sales and contribution to be reduced.
12
(3) Choose the price intervals for the remaining items in the line. These price differentials should
reflect the presence, absence, or degree of perceived attributes and should be chosen after
observation of rival firms’ chosen differentials.
13
MODIFIED BEHAVIOURAL PRICING MODELS AND MODIFIED STRUCTURAL PRING MODELS
MODIFIED BEHAVIOURAL PRICING MODELS
These are models which incorporate one or more of the appropriate behavioral as assumptions
(profit maximizing) It looks at several more complex models of pricing behaviour in imperfectly
competitive markets. They include:
(a) Price Leadership models- these are mostly under oligopoly where there is upward
adjustment of prices. One firm leads the way and will be followed within a relatively short
period by all or most of the other firms adjusting their prices to a similar degree. The leader
is a firm willing to take the risk of being the first to adjust price, and usually has good reason
to expect that other firms will follow suit. The risk here is if the firm raises price and is not
followed by other firms, it will experience an elastic demand response and lose profits. Price
leadership is possible under both product homogeneity and product differentiation; where
there is a small number of firms; restricted entry; inelastic demand for industry and firms
have almost similar cost curves.
(1) Barometric Price Leader- the leader possesses an ability to accurately predict when
climate is right for a price change e.g. following a generalized increase in labour or
materials costs, or a period of increased demand, the barometric firm judges that all
firms are ready for a price change and takes the risk of sales losses by being the first
to adjust its price. If the other firms trust the firm’s judgement they adjust prices to
the extent or if they do not they may adjust to a lesser degree, the leader reviewing
the price to that level. It does not have to be the same firm functioning as leader
always. It does not have to be the same firm functioning as leader always.
(2) Low Cost Price Leadership- is a firm that has a significant cost advantage over its
rivals and inherits the role of price leader largely due to the other firms’ reluctance
to incur the wrath of the lower cost firm. In the event of a price war, the other firms
would incur greater losses and be more prone to the risk of bankruptcy than would
be the lower cost firm.
(3) Dominant Firm Price Leadership- the dominant firm is large relative to its rivals and
its market. It is large and has several smaller firms competing with it in the industry.
Large firm may have achieved its position by being the first seller in the industry,
because it has lower costs resulting from scale economies, or by virtue of superior
management skill. If the small firms in an industry look to the dominant firm to
establish price, they can be viewed as price takers. As such their behaviour is similar
to firms in perfect competition. If they can sell all they produce at the market price,
they maximise profit by producing until P=MC. Total output supplied by all the small
firms is the sum of their marginal cost curves ( M C F ) in the diagram The smaller

firms accept the firm’s price leadership perhaps simply because they are unwilling
to risk being the first to change prices or perhaps out of fear that the dominant firm
could drive them out of business, by forcing raw materials suppliers to boycott a
particular small firm on pain of losing the order of the larger firm for example. In
such a situation the smaller firms accept the dominant firm’s choice of the price
level and simply adjust output to maximize their profits. They are more like pure
competitors. Knowing how much the smaller firms will supply at each price level,
the dominant firm can subtract this from the market demand to find how much
demand is left over at each price level. The dominant firm will choose the price level
in order to maximize its own profits from this assured or residual demand.
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If the dominant firm is content to set a price and let its small rivals supply as much
as they want, the large firms can be thought of as supplying the residual demand.
 MC
Price
Cost
per unit
F
DT
DL
Po
MCL
PL
MRL
O
DL
QL
QT
DT
Quantity per period
If the dominant firm is content to set a price and let its small rivals supply as much as they
want, the large firm can be thought of as supplying the residual demand. The leader’s
demand curve is DLDL. Total demand is DTDT. MCL is dominant firm’s MC while MRL is
dominant firm’s MR. If price is set at Po, the small firms will meet total market demand and
the dominant firm will have no sales because there is no residual demand. So prices will be
set below Po. The demand curve faced the industry leader can easily be determined for any
price level (it is the horizontal distance between DTDT and
 MC
F
) Output for the price
leader is QL. Output of small firms is QT-QL. The price setting by the leader assumes that the
dominant firm has complete information regarding its own demand and cost functions as
well as those of its smaller competitors. The firm sets the price , and other firms follow
passively, whether through convenience, ignorance or fear. In fact there is no oligopoly
problem as such, since interdependence is absent.
(b) Sales Maximisation Model-having determined the minimum acceptable level of profits the
firm will wish to maximize its sales subject to this profit constraint.
(c) Limit pricing models- the limit pricing involves choosing the price level such that it is not
quite high enough to induce entry of new firms. Established firms may choose a price that
does not allow the potential entrant to earn even a normal profit at any output level. These
existing firms’ future market shares and profitability are protected from incursions from this
quarter at least.
MODIFIED STRUCTURAL PRING MODELS
These deal with theories of firm behaviour that rest upon structural assumptions different from
those employed in the basic spectrum of market forms. Firms are allowed to have differing cost
15
structures. The models here look at the multiplant firms and how they choose price and output such
that the MC in each plant is equal to the MR of the last unit sold.
Multiplant Firms and cartels
The firm may have two or more plants in which its product may be produced. The two or more
plants are due to mergers and takeovers. The standard profit maximizing rule that MC equals MR
applies. The firm nominates the plant that can produce the incremental unit at the lowest marginal
cost.
Plant A
Plant B
Firm
MC
P
P
P
MC
C
MC
SAC
SAC
MC=MR
MR
Q1
Q2
Q
The firm’s profit will be maximized at output level where the combined MC=MR. This analysis of
multiplant firm applies to any market situation where a firm envisages a negatively sloping demand
curve (monopoly, monopolistic competition or oligopoly.). The analysis also applies to cartels where
firm A and firm B replace plants A and B above. They allocate quantities Q1 and Q2 to maximize their
joint profitability.
Price discrimination for multi market firms- price discrimination can be involving discrimination
among groups of buyers on time or urgency basis or also where the firm can charge different prices
in two or more different markets, at the same point of time.
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Plant A
Plant B
Firm
MC
P
P
P
MC
C
MC=MR
MC
SAC
SAC
MR
Q
Q1
Q2
Plant A
Plant B
Firm
P
P
MC
P2
SAC
D1 P3
MR
MC=MR
MRA
QA
MRB
QB
Q=QA +QB
Dorfman Steiner Conditions for profit maximisation
For profit maximisation the ratio of advertising expenditures to sales revenue should be equal to the
ratio of advertising elasticity of demand to price elasticity of demand. The model illustrates the
importance of advertising elasticity as a determinant of the profit maximising advertising budget.
E
A
 A
PQ  E D
Given that Quantity sold is a function of the price and Advertising expenditure and also that cost is a
function of quantity.
17
  P  Q  CQ  A  P  Q ( P, A)  C[Q ( P, A)]  A
d
dQ dC dQ


 1  0............................(i )
dA dQ dA
dQ
dQ
P ( )  MC 
1
dA
dA
dQ
( P  MC )  1................................................................(ii )
dA
FOC : ..
dA
 P
Multiply both sides of (ii) by
A
PQ
dQ
A
A
( P  MC ) 

dA
PQ PQ
dQ A P  MC
A
 {
}
dA Q
P
PQ
P  MC
A
EA (
)
..........................................................(iii )
P
PQ
P  MC
A 1

( )..........................................................(iv )
P
PQ E A
Second FOC
d
dQ
dC dQ
 P
Q

.  0...............(i )(b)
dP
dP
dQ dP
dQ
dQ
P
 Q  MC 
 0.............................................(ii )
dP
dP
rearrangin g
FOC : ........
dQ
dQ
 MC 
 Q.
dP
dP
divide both sides by P
P
dQ P  MC
Q
(
)   ...............................................(iii )
dP
P
P
P  MC
Q dP
1
 

........................................(iv )
P
P dQ
EP
From this....

P  MC
Q dP
1
A 1
 


( )
P
P dQ
E P PQ E A
E
E
A
 A  A ...................
PQ  E p
Ep
, The Dorfman-Steiner condition implies that for profit maximisation, the ratio of advertising
expenditure to total revenue, or advertising to-sales ratio should be proportional to the ratio of
18
advertising elasticity of demand to price elasticity of demand. The intuition behind this result is that
when the advertising elasticity is high relative to the price elasticity, it is efficient for the monopolist
to advertise (rather than cut price) in order to achieve any given increase in quantity demanded.
Accordingly, the monopolist spends a relatively high proportion of its sales revenue on advertising.
On the other hand, when the price elasticity is high relative to the advertising elasticity, it is efficient
to cut price (rather than advertise) in order to achieve any given increase in quantity demanded.
Accordingly , the monopolist spends a relatively low proportion of its sales revenue on advertising. It
can also be inferred that the oligopolist has an additional incentive to advertise: not only does
advertising increase total industry demand, but it also increases the advertising firm’s share of
industry demand.
The Dorfman –Steiner condition provides a justification for the assertion that there is no role for
advertising under perfect competition. The demand function of the perfectly competitive firm is
horizontal, and the firm’s price elasticity of demand is infinite. Accordingly, the ratio of the firm’s
advertising elasticity of demand to its price elasticity of demand is zero. The profit-maximising
advertising to sales ratio is also zero. If the firm can sell as much as it likes at the current market
price, there is no point in advertising.
The Dorfman Steiner condition can also be reformulated as profit-maximising advertising –to-sales
ratio equals the product of the Lerner index an d the advertising elasticity of demand. For the
perfectly competitive firm, the Lerner index is zero because price equals marginal cost. Therefore
the profit maximising advertising –to-sales ratio is also equal to zero,
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