Pricing Strategies Successful Pricing in Practice

Lecture 8. Pricing and Business Strategy (2)

1. Economic theory vs practice

2. Model- Efficient pricing

3. Pricing strategies Successful pricing in practice

The ”right” Price to The ”right” Customer at The ”right” Time Economic theory vs practice

- Demand is usually unknown ex ante. There are many determinants of demand which makes it difficult to make accurate estimations.

QA= f (PA, AA, DA, LA, IC,TC, EC, PB, AB, DB, LB, G, M, O)

Strategic variables Consumer variables Competitor variables Other variables (Controllable) (Uncontrollable) (Uncontrollable) (Uncontrollable) How to estimate/measure the demand: Interviews, simulations or regression analysis.  Concepts: Demand Elasticity and Price Elasticity

- Marginal cost is often hard to distinguish. - Profit maximization seldom the only objective Economic theory vs practice

 Concepts: Price elasticity of demand measures the sensitivity of the quantity demanded to changes on the price. Two goods: Price elasticity of demand measures the sensitivity of the quantity demanded of a good to changes in the price of complementary or substitute products. Q P Ep   P Q The income increases as the price decreases

Two products

The income decreases as the price drops

Epij > 0: Epij < 0: Complementary Substitute products products Economic theory vs practice

Most common practice because COST BASED PRICING the demand is difficult to estimate.

Product Cost Price Value Customer

VALUE BASED PRICING

Customer Value Price Cost Product The three cornerstones of pricing

Demand

EFFICIENT Competitive PRICE conditions

Cost Structure Efficient pricing – A Model

Demand / Cost Competition

Data Data (Customer) Collection

Demand Cost (Customer) Competition

Analyses Analyses Analyses

analyses Strategic

PRICE STRATEGY

Strategic formulation Efficient pricing – A Model Strategic questions: Are not… What price is needed to cover our cost and earn a profit? What price is the customer willing to pay? But instead… What costs can we afford to incur and still earn a profit? Wat price is motivated by customer value?

Definition and measurement How communicate? Efficient pricing – A Model Strategic questions: Are not… What price is needed to cover our cost and earn a profit? What price is the customer willing to pay? But instead… What costs can we afford to incur and still earn a profit? Wat price is motivated by customer value?

Definition and measurement

The ”economic value” of a product/service equals the price of customer’s best alternative ( = reference value) + The value of any differentiation from this alternative ( = differentiation value)

Customer value is created when economic value is in accordance with customer preference, expectations and ultimately explicit and implicit need (customer benefit) Efficient pricing – A Model Strategic questions: Are not… What price is needed to cover our cost and earn a profit? What price is the customer willing to pay? But instead… What costs can we afford to incur and still earn a profit? Wat price is motivated by customer value?

How communicate? - Avoid to much emphasis on product characteristics - Avoid to much emphasis on customer advantatges - Emphasize advantatges in accordance with customer needs and expectations Which customers are/can be profitable?

SEGMENTATION

Customer Market Product

PRICE PRICE DIFFERENTIATION DISCRIMINATION

- It should be possible to separate different segments in practice. - There must be differences in price sensitivity - Product homogeneous Non-Price competition

• Advantages of Non-price Competition – Non-price competition can be an effective means for growing market share and profitability. – Nonprice competition can be difficult to imitate. • Optimal Level of Advertising – Profit-maximizing level of non-price competition is found by setting activity MR = MC.

– Set MRA = MCA to determine optimal advertising. Non-Price competition

A firm will expand the level of advertising up to the point where the net marginal revenue generated just equals the marginal cost of advertising. Pricing rules-of-thumb

• Competitive Markets • Profit maximization always requires setting Mπ = MR - MC = 0, or MR=MC, to maximize profits. • In competitive markets, P=MR, so profit maximization requires setting P=MR= MC. • Imperfectly Competitive Markets • With imperfect competition, P > MR, so profit maximization requires setting MR=MC.

MR = P[1 + (1/εP)]

• Optimal P* = MC/[1 + (1/εP)] Markup Pricing and Profit Maximization

•Optimal Markup on Cost – Markup pricing is an efficient means for achieving profit maximization. – Markup on cost uses cost as a basis.

– Optimal markup on cost = -1/(εP + 1). •Optimal Markup on Price – Markup on price uses price as a basis.

– Optimal markup on price = -1/εP Multiple-product Pricing

•Demand Interrelations – Cross-marginal revenue terms indicate how product revenues are related to another. •Production Interrelations – Joint products may compete for resources or be complementary. – A by-product is any output customarily produced as a direct result of an increase in the production of some other output. Multiple-product Pricing: Joint Products

• Joint Products in Variable Proportions • If products are produced in variable proportions, they are distinct outputs. • For joint products produced in variable

proportions, set MRA= MCA and MRB= MCB. • Allocation of common costs is wrong and arbitrary. • Joint Products in Fixed Proportions • Some products are produced in a fixed ratio.

• If Q = QA= QB, set MRQ= MRA+ MRB = MCQ. Joint Products

For joint product produced in fixed proportions, the optimal activity level occurs at the point where the marginal revenues derived from both products

(MRT) = the marginal cost of production Joint Product pricing Example

• Joint Products Without Excess By-product

• Profit-maximization requires setting MRQ= MRA+MRB = MCQ. • Marginal revenue from each byproduct makes a contribution toward covering MCQ.

• Joint Production With Excess By-product (Dumping)

• Profit-maximization requires setting MRQ= MRA+MRB= MCQ. • Primary product marginal revenue covers MCQ. • Byproduct MR=MC=0. Pricing strategies beyond the single-Price-per-unit Model

Pricing strategies to Pricing strategies to Pricing strategies extract surplus from enhance efficiency and competition customers

- Price discrimination (first, second and third - Price differentiation degree). (peak-load pricing). - Price matching.

- Price bundling. - Multi-part pricing - Limit pricing (second-best pricing). - Two-part pricing. - Predatory pricing - Network pricing - Block pricing. Pricing strategies beyond the single-Price-per-unit Model

Pricing strategies to Pricing strategies to Pricing strategies extract surplus from enhance efficiency and competition customers

- Price discrimination (first, second and third - Price differentiation degree). (peak-load pricing). - Price matching.

- Price bundling. - Multi-part pricing - Limit pricing (second-best pricing). - Two-part pricing. - Predatory pricing - Network pricing - Block pricing. Pricing strategies to extract surplus from customers

Price discrimination (first, second and third degree)

• Profit-Making Criteria • Price elasticity of demand must differ in submarkets. • Must have ability to prevent reselling.

• Price discrimination exists if P1/P2 ≠ MC1/MC2. • Degrees of Price Discrimination • First degree creates different prices for each customer (maximum profits). • Second degree gives quantity discounts. • Third degree assigns different prices by customer age, sex, income, etc. (most common). Price discrimination (first, second and third degree)

Sellers with market power want to capture as much customer surplus for themselves as possible Price discrimination (first, second and third degree)

Until now, we have considered a single market Price. But now, we can consider that the firm can charge different prices for the same product (homogenous)

To be able to charge a different price it is necessary that: 1) The firm has market power (e.g. monopolist) 2) Perfect information about the characteristics of consumers 3) Resale between consumers is impossible. Price discrimination (first degree)

Monopoly with discrimination

MC MC

D D = MR MR

q q

Different prices depending on consumers’ willigness to pay More efficient but less equitative Price discrimination (second degree)

P Example: Decreasing: Enhance the consumption

CMg

2 6 q Q1 Q2 Q3

Different prices depending on the consumption Price discrimination (third degree)

Different prices depending on the consumers’ characteristics EXAMPLE: Flight tickets.

The airlines assume that, when demanding a round-trip flight during the week, it is a business trip and the ticket price is higher than weekend. Generally, airlines use “the Saturday night stay’s criterion” as a consideration of a pleasure trip, which usually corresponds to a lower price. Price discrimination (third degree) Market segmentation: It is necessary to know information from consumers in order to group them into segments and apply a differentiated commercial policy. Student D

D Pensioner

D Tourist q Price discrimination (Example)

•Price/Output Determination – To maximize profits, set MR=MC in each market.

•One-price Alternative – Without price discrimination, MR=MC for all customers as a group. – With price discrimination, MR=MC for each customer or customer group. – Profitable price discrimination benefits sellers at the expense of some customers. Pricing strategies to extract surplus from customers

Price bundling Based on Economies of scale  Low price strategy Based on Economies of scope  Value Based pricing (Price Bundling)

Strategies: 1. Pure bundling (tie-in sales): Products/services cannot be purchased separately 2. ”Mixed bundling” (add-on sales) Product/services can be purchased separately 2.1. Mixed-leader: Discount on the product/service when another one is purchased 2.2. Mixed-joint: Common reduced price when two (or more) products/services are purchased Price bundling (example 1. mixed-joint strategy)

Excel Access Office

(A) 120 130 250

(B) 100 150 250

Selling products (separate)  Profits: 100 * 2 + 130 *2 = 460 Selling products (together)  Profits: 250 *2 = 500 Price bundling (example 2. mixed-joint strategy)

Assume the following reservation prices on product/service A and B:

Reservation Customer 1 Customer 2 Customer 3 Customer 4 Price (RP)

RP (A) 1400 600 1600 900

RP (B) 600 1400 1000 400

RP (A+B) 2000 2000 2600 1300

With single prices, P(A)=1400 and P(B)=1000 would max revenue= 4800 in total revenue (2A*1400 + 2B*1000) But a price bundle of 2000 would generate 6000 in revenue (everyone but customer 4 would purchase the bundle)  Profitability?? Pricing strategies to extract surplus from customers

Two-Part pricing

• One-price Policy and Consumer Surplus • A single price policy creates bargains for avid buyers; they enjoy consumer surplus. • Consumer surplus reflects unpaid benefit. • Capturing Consumer Surplus With Two-part Pricing • Lump-sum prices plus user fees capture consumer surplus for producers, e.g., club memberships. • Consumer Surplus and Bundle Pricing • When significant consumer surplus exists, profits can be enhanced if products are purchased together. Two-Part pricing

The idea is to create a price with two parts: a fixed fee (A) that entitles them to buy a product and a usage fee (p) that depends on each unit they wish to consume. Ex: Mobile phone tariffs, gym. Price = A + p x q

The alternative is to create a Flat rate (Fix)

Price = F Two-Part pricing

A+p q

q Two part pricing Fix rate

Consumers can chose depending on their preferences and firms get information from consumers. Two-Part pricing

A firm with market power charges a fixed fee for the right to purchase its goods, plus a per-unit charge for each unit purchased. Pricing strategies to extract surplus from customers

Block Pricing

Pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-or-none decision to purchase.

The profit- maximizing price on package is the total value the customer receives for the package. Pricing strategies beyond the single-Price-per-unit Model

Pricing strategies to Pricing strategies to Pricing strategies extract surplus from enhance efficiency and competition customers

- Price discrimination (first, second and third - Price differentiation degree). (peak-load pricing). - Price matching.

- Price bundling. - Multi-part pricing - Limit pricing (second-best pricing). - Two-part pricing. - Predatory pricing - Network pricing - Block pricing. Pricing strategies to enhance efficiency

Price differentiation (peak-load pricing)

Under nonstorable service…

- Distinguish between short run and long run marginal costs

- Price should be based on short run marginal cost

- Capacity expansion should be based on long run marginal cost Price differentiation (peak-load pricing)

Applied in capital intensive industries (large infrastructure) where variable costs are low and fixed costs are high.

Example:

Electricity, telecomunications, travel/transport, etc. Pricing strategies to extract surplus from customers

Network pricing

Consist of links that connect different points (nodes) in geographic/economic space.

- One – way networks

- Two-way networks: link users exhibit positive externalities called direct network externalitites: Pricing strategies beyond the single-Price-per-unit Model

Pricing strategies to Pricing strategies to Pricing strategies extract surplus from enhance efficiency and competition customers

- Price discrimination (first, second and third - Price differentiation degree). (peak-load pricing). - Price matching.

- Price bundling. - Multi-part pricing - Limit pricing (second-best pricing). - Two-part pricing. - Predatory pricing - Network pricing - Block pricing. Pricing strategies and competition

Product life cycle…

…new products Pricing strategies and competition

Price Matching

Pricing strategy in which a firm adverises a price and a promise to match any lower price offered by a competitor.

- Used to mitigate the stark outcome associated with firms competing in a homogenous-product (Bertrand)

- Outcome: If all firms in the market adopt a price matching policy, all firms can set the monopoly price and earn monopoly profits; instead of a zero profits it would earn in the usual one-shot Bertrand model.

Potential issues:

- Dealing with false consumer claims of low prices.

- Competitor’s with lower cost structures. Pricing strategies and competition

• Limit Pricing • Limit pricing strategy sets less than monopoly prices to deter entry by competitors • Predatory pricing is pricing below marginal cost (rare). • Limit pricing is often confused with predatory pricing. • Market Penetration Pricing • Market penetration pricing sets very low (or zero) prices to create a new market or grab market share. • Objective is to gain a critical mass of customers, make network effects, and generate viable business. Pricing strategies and competition

With limit pricing, a monopoly firm gives up current profits to forestall entry Pricing strategies and competition

Limit Pricing

If a business is success, then, it can be attractive for potential competitors so, the incumbent firm may consider to limit pricing.

Under this situation, the entrant is assumed to have perfect information about the incumbent’s demand and costs. However, it could have a problem:

- The strategy does not ”hide” information about the profitability of the incumbent’s business.

- The low price charged by the incumbent may not prevent entry; the entrant stays out only if it belives that the incumbent would produce at

least QL, if it entered.

A revised pricing strategy is to set the monopoly price (PM), and produce the monopoly output (QM), and threaten to expand output to QL, if entry occurs. Pricing strategies and competition

Predatory Pricing

Pricing strategy where a firm temporarily prices below its marginal cost to drive existing competitors out of the market.

- Involves a trade-off between current and future profits, so it is profitable only when the present value of the higher future profits offsets the lossess required to drive rivals out of the market.

- A firm engaging in predatory pricing must have ”deeper pockets” (greater financial resources) than the prey in order to outlast it.