Download ECON 202: Principles of Microeconomics

ECON 202: Principles
of Microeconomics
Chapter 15
Pricing Strategy
Pricing Strategy
1.
2.
3.
4.
5.
Pricing Strategy, the Law of One Price, and Arbitrage.
Price Discrimination.
Odd Pricing and Cost-Plus Pricing.
Pricing with Two-Part Tariffs.
Pricing with Different Types of Customers and
Asymmetric Information.
ECON 202: Princ. of Microeconomics
Princing Strategy
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Introduction


Until now, we have assumed that firms charge a single
price for the good they are selling.
However, in real world, many times firms:




Charge different prices to different consumers.
Charge two-part prices.
Offer only fixed bundles.
We will analyze those cases and see what is the
economic rationality guiding these decisions.
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Princing Strategy
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1. Pricing Strategy, the Law of One Price,
and Arbitrage

Law of one price:


When law of one price does not hold, opportunities for
arbitrage appear.



Buy cheap and sell more expensive in a different “location”.
Arbitrage will make almost all price differences in price in
different locations disappear.
Even with arbitrage, some price difference can persist
among locations because of transaction costs.


Identical products should sell for the same price everywhere.
Law of one price holds exactly only if transaction costs are zero.
Differences in prices among firms can be explained by
monopolistic competition model.

Differentiated products.
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Princing Strategy
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2. Price Discrimination

Price discrimination:



Charging different prices to different customers for the same
product.
Price differences are not explained by differences in cost.
Requirements for successful price discrimination:



Market power.
Different types of customers (willingness to pay).
Ability to separate types of customers (no arbitrage).
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Princing Strategy
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2. Price Discrimination


Less elastic demand pays a higher price.
More elastic demand pays a lower price.
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Princing Strategy
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2. Price Discrimination

Perfect price discrimination

If monopolist know the willingness to pay of all the customers, it
can charge exactly this willingness to pay to them.
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Princing Strategy
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2. Price Discrimination

With perfect price discrimination





Economic efficiency is improved (no DWL).
Profits increase.
Consumer surplus disappear.
Hard to find real world cases.
Price discrimination across time.



When new products are introduced, firms can discriminate
consumers according to when they buy the new product.
Early adopters will likely have a less elastic demand.
Hardcover vs. paperback editions.
ECON 202: Princ. of Microeconomics
Princing Strategy
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3. Odd Pricing and Cost-Plus Pricing

Odd pricing


Odd pricing creates the illusion of a cheaper price.


80%-90% of products sold in supermarkets have prices ending
in “9” or “5”, rather that “0”.
Higher than actual discount.
Experiment using odd pricing in different products
showed that increases in demand were higher than
expected given previously estimated demand curves.
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Princing Strategy
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3. Odd Pricing and Cost-Plus Pricing

Cost-Plus Pricing



Cost-plus pricing maximizes profit only when are equal:




Adding a percentage markup to average cost.
At an average cost of $10 add a markup of 20%: price $12.
Cost-plus price, and
Price that corresponds to the quantity where MR=MC.
Problem with this approach is that ignores information
from demand curve and only focuses on costs.
Cost-plus pricing may be the best way to determine the
optimal price if:


Marginal Cost and Average Cost are roughly equal.
Demand curve is hard to estimate.
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Princing Strategy
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4. Pricing with Two-Part Tariffs

Two-part tariffs


When consumers pay one price (or tariff) for the right to buy as
much of a related good as they want at a second price.
Disneyland, Ipods.
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Princing Strategy
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4. Pricing with Two-Part Tariffs



With optimal two-part tariff:
Outcome is economically efficient: price equals marginal
cost at the level of output supplied.
All consumer surplus is transformed into profit.
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Princing Strategy
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5. Pricing with Different Types of Customers
and Asymmetric Information

In many cases, firms offer different quantities at different
prices, such that the price per unit is smaller as quantity
increases



Firms know that customers have different willingness to
pay for goods, but their identification is difficult.
They try to have customers reveal their type:



Cable, internet, sodas.
High-value customers to order the higher priced offer.
Low-value customers to order the lower priced offer.
Suppose a cable monopolist have 2 customers with
different types (high and low), but does not know their
identity.
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Princing Strategy
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5. Pricing with Different Types of Customers
and Asymmetric Information
Total Utility
35
30
25
20
15
10
5
0
0
2
4
6
High-value customer
8
10
12
Number of channels
Low-value customer
ECON 202: Princ. of Microeconomics
High-value customer
Numer of
Marginal
Total Utility
channels
Utility
0
0
-1
5.25
5.25
2
10.00
4.75
3
14.25
4.25
4
18.00
3.75
5
21.25
3.25
6
23.50
2.25
7
25.50
2.00
8
27.25
1.75
9
28.75
1.50
10
30.00
1.25
11
30.00
0.00
12
30.00
0.00
Princing Strategy
Low-value customer
Marginal
Total Utility
Utility
0
-5
5
9
4
12
3
14
2
15
1
15
0
15
0
15
0
15
0
15
0
15
0
15
0
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5. Pricing with Different Types of Customers
and Asymmetric Information

Cable company wants to maximize profit by:


Charging the highest possible price for each customer.
Suppose that the utility is expressed in dollars and
marginal cost of channels is $1.
High-value customer
Marginal
Numer of Total Utility
Utility
channels
Revenue
Revenue
0
0
-1
5.25
5.25
2
10.00
4.75
3
14.25
4.25
4
18.00
3.75
5
21.25
3.25
6
23.50
2.25
7
25.50
2.00
8
27.25
1.75
9
28.75
1.50
10
30.00
1.25
11
30.00
0.00
12
30.00
0.00
ECON 202: Princ. of Microeconomics
Low-value customer
Marginal
Total Utility
Utility
Revenue
Revenue
0
-5
5
9
4
12
3
14
2
15
1
15
0
15
0
15
0
15
0
15
0
15
0
15
0
Princing Strategy
Marginal
Cost
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
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5. Pricing with Different Types of Customers
and Asymmetric Information

Monopoly will offer two packages:



Customers utility:



High-value utility: $30 - $30 = $0
Low-value utility: $15 - $15 = $0
Monopoly profit:


10 channels for $30 dollars (for the high-value).
5 channels for $15 dollars (for the low-value).
($30+$15) – ($10+$5) = $30
However, high-value can buy the low-value package:

High-value utility: $21.25 - $15 = $6.25
making cable company profit fall:

($15+$15) – ($5+$5) = $20
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Princing Strategy
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5. Pricing with Different Types of Customers
and Asymmetric Information

How can the cable company make more profit?



New high-value pack: 10 channels for $23.75
High-value customer utility: $30 - $23.75 = $6.25



High value customer obtain same utility with both packs, then will
buy high-value pack.
No changes for low-value customer.
New monopoly profit:


Cable company can reduce the price charged to high-value such
that her utility from high-value pack is the same than from the
low-value pack.
($23.75 + $15) – ($10+$5) = $23.75
Cable company increased profit.
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Princing Strategy
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5. Pricing with Different Types of Customers
and Asymmetric Information




Can the cable company increase profit even further?
Firm can make less attractive the low-value pack for the
high-value customer.
New-new low-value pack: 4 channels for $14.
Utility from buying new low-value pack:





Low-value customer:
High-value customer:
$14 - $14 = $0
$18 - $14 = $4
Monopoly can increase price of high-value pack, making
the high-value customer gain $4 (instead of $6.25).
New-new high-value pack: 10 channels for $26
New-new monopoly profit: ($26+$14) – ($10+$4) = $26.
ECON 202: Princ. of Microeconomics
Princing Strategy
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5. Pricing with Different Types of Customers
and Asymmetric Information
Packages offered
Original
New
New-new
Utility
High-value Low-value
customer customer
Type
Channels
Price
High-value
10
30
0
-15
Low-value
5
15
6.25
0
High-value
10
23.75
6.25
-8.75
Low-value
5
15
6.25
0
High-value
10
26
4
-11
Low-value
4
14
4
0
ECON 202: Princ. of Microeconomics
Princing Strategy
Cable
company
profit
20
23.75
26
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5. Pricing with Different Types of Customers
and Asymmetric Information

Because of difficulty to identify each type of customer,
cable company ends up:




Giving some extra benefit to high-value customer in order to
make her reveal her identity.
Selling a quantity to low-value customer that is lower than
efficient level.
Price per channel is higher for the low value customer
($14 / 4 = $3.5) than for the high value customer ($26 /
10 = $2.6).
Quantity discounts are not only explained by differences
in cost, but also by pricing strategies of firms.
ECON 202: Princ. of Microeconomics
Princing Strategy
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ECON 202: Principles
of Microeconomics
Chapter 15
Pricing Strategy