Pricing Technique

Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/IrwinManagerial Economics, 9e

Managerial Economics ThomasMauriceninth edition

Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/IrwinManagerial Economics, 9e

Managerial Economics ThomasMauriceninth edition

Chapter 14

Advanced Pricing Techniques

Managerial EconomicsManagerial Economics

14-2

Advanced Pricing Techniques

• Price discrimination• Multiple products• Cost-plus pricing


14-3

Capturing Consumer Surplus• Uniform pricing

• Charging the same price for every unit of the product

• Price discrimination• More profitable alternative to uniform

pricing• Market conditions must allow this

practice to be profitably executed• Technique of charging different prices for

the same product• Used to capture consumer surplus

(turning consumer surplus into profit)


14-4

The Trouble with Uniform Pricing (Figure 14.1)


14-5

Price Discrimination

• Exists when the price-to-marginal cost ratio differs between two products:

A B

A B

P PMC MC


14-6

Price Discrimination

Three conditions necessary to practice price discrimination profitably:

1) Firm must possess some degree of market power

2) A cost-effective means of preventing resale between lower- and higher-price buyers (consumer arbitrage) must be implemented

3) Price elasticities must differ between individual buyers or groups of buyers


14-7

First-Degree (Perfect) Price Discrimination• Every unit is sold for the maximum

price each consumer is willing to pay• Allows the firm to capture entire

consumer surplus• Difficulties

• Requires precise knowledge about every buyer’s demand for the good

• Seller must negotiate a different price for every unit sold to every buyer


14-8

First-Degree (Perfect) Price Discrimination (Figure 14.2)


14-9

Second-Degree Price Discrimination

• Lower prices are offered for larger quantities and buyers can self-select the price by choosing how much to buy

• When the same consumer buys more than one unit of a good or service at a time, the marginal value placed on additional units declines as more units are consumed


14-10

Second-Degree Price Discrimination• Two-part pricing

• Charges buyers a fixed access charge (A) to purchase as many units as they wish for a constant fee (f) per unit

• Total expenditure (TE) for q units is:TE A fq

A fq

TE A fqpq q

Average price ( ) is:p


14-11


• When consumers have identical demands, entire consumer surplus can be captured by:• Setting f = MC• Setting A = consumer surplus (CS)

• Optimal usage fee when two groups of buyers have identical demands is the level for which MRf = MCf


14-12

Inverse Demand Curve for Each of 100 Identical Senior Golfers (Figure 14.3)


14-13

Demand at Northvale Golf Club (Figure 14.4)


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• Declining block pricing• Offers quantity discounts over

successive discrete blocks of quantities purchased


14-15

Block Pricing with Five Blocks (Figure 14.5)


14-16

Third-Degree Price Discrimination

• If a firm sells in two markets, 1 & 2• Allocate output (sales) so MR1 = MR2

• Optimal total output is that for which MRT = MC

• For profit-maximization, allocate sales of total output so that MRT = MC = MR1 = MR2


14-17

Third-Degree Price Discrimination

• Equal-marginal-revenue principle• Allocating output (sales) so MR1 =

MR2 which will maximize total revenue for the firm (TR1 + TR2)

• More elastic market gets lower price

• Less elastic market gets higher price


14-18

Allocating Sales Between Markets (Figure 14.6)


14-19

Constructing the Marginal Revenue Curve (Figure 14.7)


14-20

Profit-Maximization Under Third-Degree Price Discrimination (Figure 14.8)


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Multiple Products• Related in consumption

• For two products, X & Y, produce & sell levels of output for which

MRX = MCX and MRY = MCY

• MRX is a function not only of QX but also of QY (as is MRY) -- conditions must be satisfied simultaneously


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Multiple Products• Related in production as substitutes

• For two products, X & Y, allocate production facility so that

MRPX = MRPY

• Optimal level of facility usage in the long run is where MRPT = MC

• For profit-maximization: MRPT = MC = MRPX = MRPY


14-23

Multiple Products• Related in production as complements

• To maximize profit, set joint marginal revenue equal to marginal cost:

MRJ = MC• If profit-maximizing level of joint

production exceeds output where MRJ kinks, units beyond zero MR are disposed of rather than sold

• Profit-maximizing prices are found using demand functions for the two goods


14-24

Profit-Maximizing Allocation of Production Facilities (Figure 14.9)


14-25

Profit-Maximization with Joint Products (Figure 14.11)


14-26

Cost-Plus Pricing• Common technique for pricing when

firms do not wish to estimate demand & cost conditions to apply the MR = MC rule for profit-maximization

• Price charged represents a markup (margin) over average cost: P = (1 + m)ATC Where m is the markup on unit cost


14-27

Cost-Plus Pricing• Does not generally produce profit-

maximizing price• Fails to incorporate information on

demand & marginal revenue• Uses average, not marginal, cost


14-28

Practical Problems with Cost-Plus Pricing (Figure 14.13)

Pricing Technique

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