Managerial economics Business strategy Chapter 11 Pricing Strategies for Firms with Market power Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Managerial Economics & Business Strategy Chapter 11 Pricing Strategies for Firms with Market Power
Overview I. Basic Pricing Strategies a Monopoly monopolistic Competition Cournot Oligopoly IL. Extracting Consumer Surplus Price discrimination Two-Part Pricing a Block pricing Commodity Bundling IlL. Pricing for Special Cost and Demand Structures Peak-Load Pricing Price Matching Cross subsidies Brand loyalty Transfer Pricing a Randomized pricing IV. Pricing in Markets with Intense Price Competition Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Overview I. Basic Pricing Strategies Monopoly & Monopolistic Competition Cournot Oligopoly II. Extracting Consumer Surplus Price Discrimination Two-Part Pricing Block Pricing Commodity Bundling III. Pricing for Special Cost and Demand Structures Peak-Load Pricing Price Matching Cross Subsidies Brand Loyalty Transfer Pricing Randomized Pricing IV. Pricing in Markets with Intense Price Competition
Standard Pricing and profits Price Profits from standard pricing 10 $8 8 MC P=10-2Q 2345 Quantity MR=10-4Q Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Standard Pricing and Profits Price Quantity P = 10 - 2Q 10 8 6 4 2 1 2 3 4 5 MC MR = 10 - 4Q Profits from standard pricing = $8
An Algebraic Example P=10-2Q C(Q=2Q If the firm must charge a single price to all consumers, the profit-maximizing price is obtained by setting MR= MC 10-4Q=2,s0Q*=2 P*=10-2(2)=6 Profits=(6(2)-2(2)=$8 Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 An Algebraic Example • P = 10 - 2Q • C(Q) = 2Q • If the firm must charge a single price to all consumers, the profit-maximizing price is obtained by setting MR = MC • 10 - 4Q = 2, so Q* = 2 • P* = 10 - 2(2) = 6 • Profits = (6)(2) - 2(2) = $8
A Simple markup rule Suppose the elasticity of demand for the firms product iS EF MR=P1+ElEF Setting MR= MC and simplifying yields this simple pricing formula P=[EF/(1+EF×MC The optimal price is a simple markup over relevant costs More elastic the demand, lower markup Less elastic the demand higher markup Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 A Simple Markup Rule • Suppose the elasticity of demand for the firm’s product is EF • MR = P[1 + EF ]/ EF • Setting MR = MC and simplifying yields this simple pricing formula: • P = [EF /(1+ EF )] MC • The optimal price is a simple markup over relevant costs! • More elastic the demand, lower markup. • Less elastic the demand, higher markup
An example Elasticity of demand for Kodak film is-2 P=[EF(1+EF)ⅹMC P=[-2/(1-2)×MC P=2×MC Price is twice marginal cost Fifty percent of Kodaks price is margin above manufacturing costs Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 An Example • Elasticity of demand for Kodak film is -2 • P = [EF /(1+ EF )] MC • P = [-2/(1 - 2)] MC • P = 2 MC • Price is twice marginal cost • Fifty percent of Kodak’s price is margin above manufacturing costs
Markup rule for Cournot Oligopoly Homogeneous product Cournot oligopoly n=total number of firms in the industry Market elasticity of demand EM Elasticity of individual firm's demand is given by EF=NEM P=[EF/(1+EF)×MC,So P=NE/(1+NEM)×MC The greater the number of firms the lower the profit-maximizing markup factor Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Markup Rule for Cournot Oligopoly • Homogeneous product Cournot oligopoly • N = total number of firms in the industry • Market elasticity of demand EM • Elasticity of individual firm’s demand is given by EF = N EM • P = [EF /(1+ EF )] MC, so • P = [NEM/(1+ NEM)] MC • The greater the number of firms, the lower the profit-maximizing markup factor
An Example Homogeneous product Cournot industry 3 firms ·MC=$10 Elasticity of market demand=-1/2 Profit-maximizing price? °EF=NEM=3×(-12)=-1.5 P=[EF/(1+EF)×MC P=[-1.5/(1-1.5]×$10 P=3×$10=$30 Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 An Example • Homogeneous product Cournot industry, 3 firms • MC = $10 • Elasticity of market demand = - 1/2 • Profit-maximizing price? • EF = N EM = 3 (-1/2) = -1.5 • P = [EF /(1+ EF )] MC • P = [-1.5/(1- 1.5] $10 • P = 3 $10 = $30
First-Degree or Perfect Price discrimination Practice of charging each consumer the maximum amount he or she will pay for each incremental unit Permits a firm to extract all surplus from consumers Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 First-Degree or Perfect Price Discrimination • Practice of charging each consumer the maximum amount he or she will pay for each incremental unit • Permits a firm to extract all surplus from consumers
Perfect price discrimination Price S Profits 10 5(4-0(10-2) $16 8 Total Cost MC 2 3 4 5 Quantity Michael R Baye, Managerial Economics and Business Strategy, 3e. CThe McGraw-Hill Companies, Inc, 1999
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999 Perfect Price Discrimination Price $ Quantity D 10 8 6 4 2 1 2 3 4 5 Profits: .5(4-0)(10 - 2) = $16 Total Cost MC