Download - Chapter 7: Pricing with Market Power
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Chapter 7: Pricing with Market Power
Brickley, Smith, and Zimmerman, Managerial Economics and
Organizational Architecture, 4th ed.
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Pricing with market power learning objectives
• Students should be able to• Explain the role of elasticity in optimal
pricing• Identify circumstances appropriate for
price discrimination• Apply selected pricing techniques
consistent with maximum profit
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Pricing objective
A firm has market power if…it faces a downsloping demand curve.
The firm’s pricing objective is…to maximize shareholder value.
The demand curve reflects…consumer willingness and ability to buy.
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Pricing with market power(Figure 7.1)
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Single price per unitFigure 7.2
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Other single pricing issues• Relevant costs
– sunk costs are irrelevant– current opportunity costs are relevant
• Price sensitivity– price elasticity, , is a measure of price
sensitivity– Optimal price is P*=MC*/[1-1/ *]– A firm with market power should never
operate on the inelastic portion of the demand curve
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Price sensitivity and optimal markup
(Figure 7.3)
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Estimating profit-maximizing price
• In theory, MC=MR, but in practice, manager may not know demand curve and therefore MR.
• Cost-plus or mark-up pricing may be useful approximations.
• But they must reflect awareness of price sensitivity!
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Cost-plus pricing• Add a markup to average total cost to yield
target return• Does this ignore incremental costs and price
sensitivity?– not if managers have a fundamental
understanding of their markets– consistently bad pricing policies are not good
for the firm’s long-term fiscal health
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Mark-up pricing
• Optimal mark-up rule of thumb:P*=MC*/(1-1/*)
where * indicates estimated value• Requires some knowledge or
awareness of both marginal costs and elasticity
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Potential for higher profits(Figure 7.4)
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Homogenous consumer demand
• Block pricing– declining price on subsequent blocks of product– product packaging
• Two-part tariffs– up-front fee for the right to purchase– additional fee per unit purchased– best when customers have relatively homogenous
demand for product
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Two-part tariffcapturing consumer surplus
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Price discriminationheterogeneous consumer demands
• Price discrimination occurs when firm charges different prices to different groups of customers for the same product– not related to cost differences
• Necessary conditions– different price elasticities of demand– no transfers across submarkets
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Using information about individuals
• Personalized pricing– “first degree” price discrimination– possible only with small number of buyers
• Group pricing– “third degree” price discrimination– very common (utilities, theaters, airlines…)
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Optimal pricing at Snowfishdifferent demand elasticities
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Using information about the distribution of demands
• Menu pricing– “second degree” price discrimination– consumers select preferred package
• Coupons and rebates– users likely more price sensitive– users who are new customers may stick
with product
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Bundling and other concerns• Bundling may yield a higher price than if
each component is sold separately– theater season tickets– restaurant fixed price meals
• Multiperiod pricing– low initial price can “lock-in” customers
• Strategic considerations– low price may be barrier to entry