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Chapter 10
Special Pricing Policies
Chapter Ten
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
1
Overview
Cartel arrangements
Price leadership
Revenue maximization
Price discrimination
Nonmarginal pricing
Multiproduct pricing
Transfer pricing
Chapter Ten
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
2
Cartel arrangements

A cartel is an arrangement where firms in
an industry cooperate and act together as
if they were a monopoly
• cartel arrangements may be tacit or
formal
• illegal in the US: Sherman Antitrust Act,
1890
• examples: OPEC
Chapter Ten
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
3
Cartel arrangements

Conditions that influence the formation of
cartels
 small number of large firms in the
industry
 geographical proximity of the firms
 homogeneous products that do not
allow differentiation
 stage of the business cycle
 difficult entry into industry
 uniform cost conditions, usually defined
by product homogeneity
Chapter Ten
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Cartel arrangements
In order to maximize profits, the cartel as
a whole should behave as a ‘monopolist’
 the cartel determines the output which
equates MR = MC of the cartel as a whole
 the MC of the cartel as a whole is the
horizontal summation of the members’
marginal cost curves
 price is set in the normal monopoly way,
by determining quantity demanded where
MC=MR and deriving P from the demand
curve at that Q

Chapter Ten
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Cartel arrangements
MCT is the horizontal sum of MCI and MCII
QT is found at the intersection of MRT and MCT
 price is found from the demand curve at QT …
this is the price that maximizes total industry
profits
Chapter Ten
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Cartel arrangements
 to determine how much each firm should produce, draw a
horizontal line back from the MRT/MCT intersection
 where this line intersects each individual firm’s MC
determines that firm’s output, QI and QII. Note that the
firms may produce different outputs
Key point: the MC of the last unit produced is equated
across both firms
Chapter Ten
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Cartel arrangements
Profits for each firm are shown as rectangles in blue
Firms may earn different levels of profit, though
combined profits are maximized
Chapter Ten
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Cartel arrangements

Problem: incentive for firms to cheat on
agreement, thus cartels are unstable
Additional costs facing the cartel
 formation costs
 monitoring costs
 enforcement costs
 cost of punishment by authorities
 weigh the benefits against these costs

Chapter Ten
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Cartel arrangements

Examples: price fixing by cartels
GE, Westinghouse
 Archer Daniels Midland Company
 Sotheby’s, Christie’s
 Roche Holding AG, BASF AG

Chapter Ten
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Price leadership

Barometric price leadership
one firm in an industry will initiate a
price change in response to economic
conditions
 the other firms may or may not follow
this leader
 leader may vary

Chapter Ten
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Price leadership

Dominant price leadership
one firm is the industry leader
 dominant firm sets price with the
realization that the smaller firms will
follow and charge the same price
 can force competitors out of business or
buy them out under favorable terms
 could result in investigation under
Sherman Anti-Trust Act

Chapter Ten
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Price leadership
DT = demand curve
for entire industry
MCD = marginal cost
of the dominant firm
MCR = summation of
MC of follower firms
 in setting price,
dominant firm must
consider the amount
supplied by all firms
Chapter Ten
Copyright 2009 Pearson Education, Inc.
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Price leadership
Demand curve facing
the dominant firm is
found by subtracting
MCR from DT
 dominant firm
equates its MC with
MR from its ‘residual
demand curve’ DD
 the dominant firm
sells A units and the
rest of the demand
(QT – A) is supplied by
the follower firms
Chapter Ten
Copyright 2009 Pearson Education, Inc.
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Revenue maximization

Baumol model: firms maximize revenue
(not profit) subject to maintaining a
specific level of profits
Rationale
 a firm will become more competitive
when it achieves a large size
 management remuneration may be
related to revenue not profits
Implication: unlike the profit maximization
case, a change in fixed costs will alter
price and output (by raising the cost curve
and lowering the profit line)
Chapter Ten
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Price discrimination

Price discrimination: products with
identical costs are sold in different
markets at different prices
 the ratio of price to marginal cost
differs for similar products
Conditions for price discrimination
 the markets in which the products are
sold must by separated (no resale
between markets)
 the demand curves in the market must
have different elasticities
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Price discrimination

First degree price discrimination
seller can identify where each consumer
lies on the demand curve and charges
each consumer the highest price the
consumer is willing to pay
 allows the seller to extract the greatest
amount of profits
 requires a considerable amount of
information

Chapter Ten
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Price discrimination

Second degree price discrimination
differential prices charged by blocks of
services
 requires metering of services consumed
by buyers

Chapter Ten
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Price discrimination

Third degree price discrimination
 customers are segregated into different
markets and charged different prices in
each
 segmentation can be based on any
characteristic such as age, location,
gender, income, etc
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Price discrimination
Third degree discrimination:
• assume the firm operates in two markets, A and B
• the demand in market A is less elastic than the demand in
market B
• the entire market faced by the firm is described by the horizontal
sum of the demand and marginal revenue curves …
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Price discrimination
•
•
•
the firm finds the total amount to produce by equating the
marginal revenue and marginal cost in the market as a whole: QT
if the firm were forced to charge a uniform price, it would find the
price by examining the aggregate demand DT at the output level
QT
the firm can increase its profits by charging a different price in
each market …
Chapter Ten
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21
Price discrimination
•
•
•
in order to find the optimum price to charge in each market, draw
a horizontal line back from the MRT/MCT intersection
where this line intersects each submarket’s MR curve determines
the amount that should be sold in each market: QA and QB
these quantities are then used to determine the price in each
market using the demand curves DA and DB
Chapter Ten
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Price discrimination

Examples of price discrimination
•
doctors
•
telephone calls
•
theaters
•
hotel industry
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Price discrimination

Tying arrangement: a buyer of one
product is obligated to also buy a related
product from the same supplier
illegal in some cases
 one explanation: a device to ‘meter’
demand for tied product
 other explanations of tying
 quality control
 efficiencies in distribution
 evasion of price controls

Chapter Ten
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Nonmarginal pricing

Cost-plus pricing: price is set by first
calculating the variable cost, adding an
allocation for fixed costs, and then adding
a profit percentage or markup
Problems with cost-plus pricing
 calculation of average variable cost
 allocation of fixed cost
 size of the markup
Chapter Ten
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Nonmarginal pricing

Incremental pricing (and costing)
analysis: deals with changes in total
revenue and total cost resulting from a
decision to change prices or product
Features:
• incremental, similar to marginal analysis
• only revenues and costs that will change
due to the decision are considered
• examples of product change: new
product, discontinue old product,
improve a product, capital equipment
Chapter Ten
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Multiproduct pricing

When the firm produces two or more
products
Case 1: products are complements in terms
of demand  an increase in the quantity
sold of one will bring about an increase in
the quantity sold of the other
Case 2: products are substitutes in terms of
demand  an increase in the quantity sold
of one will bring about a decrease in the
quantity sold of the other
Chapter Ten
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Multiproduct pricing

When the firm produces two or more
products
Case 3: products are joined in production 
products produced from one set of inputs
Case 4: products compete for resources 
using resources to produce one product
takes those resources away from
producing other products
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Transfer pricing

Internal pricing: as the product moves
through these divisions on the way to the
consumer it is ‘sold’ or transferred from
one division to another at a ‘transfer price’
Rationale:
• firm subdivided into divisions, each may
be charged with a profit objective
• without any coordination, the final price of
the product to consumers may not
maximize profits for the firm as a whole
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Transfer pricing

Design of the optimal transfer pricing
mechanism is complicated by the fact
that
each division may be able to sell its
product in external markets as well as
internally
 each division may be able to procure
inputs from external markets as well
as internally

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Transfer pricing

Case A: no external markets
 no division can buy from or sell to an
external market
 the selling division will produce exactly
the number of components that will be
used by the purchasing division
 one demand curve and two MC curves
 MC curves are summed vertically
 set production where MR = Total MC
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Transfer pricing

Case B: external markets
 divisions have the opportunity to buy or
sell in outside competitive markets
 if selling division prices above the
external market price, the buying
division will buy from outside
 if selling division cannot produce enough
to satisfy buying division demand, the
buying division will buy additional units
from the external market
Chapter Ten
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Other pricing practices

Price skimming
 the first firm to introduce a product may
have a temporary monopoly and may
be able to charge high prices and obtain
high profits until competition enters

Penetration pricing
 selling at a low price in order to obtain
market share
Chapter Ten
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Other pricing practices

Prestige pricing


demand for a product may be higher at a
higher price because of the prestige that
ownership bestows on the owner
Psychological pricing

demand for a product may be quite inelastic
over a certain range but will become rather
elastic at one specific higher or lower price
Chapter Ten
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34