CHAPTER 15|Pricing Strategy Chapter Summary and Learning Objectives 15.1 Pricing Strategy, The Law of One Price, and Arbitrage (pages 494–496) Define the law of one price and explain the role of arbitrage. According to the law of one price, identical products should sell for the same price everywhere. If a product sells for different prices, it will be possible to make a profit through arbitrage: buying a product at a low price and reselling it at a high price. The law of one price will hold as long as arbitrage is possible. Arbitrage is sometimes blocked by high transactions costs, which are the costs in time and other resources incurred to carry out an exchange or because the product cannot be resold. Another apparent exception to the law of one price occurs when companies offset the higher price they charge for a product by providing superior or more reliable service to customers. 15.2 Price Discrimination: Charging Different Prices for the Same Product (pages 496–505) Explain how a firm can increase its profits through price discrimination. Price discrimination occurs if a firm charges different prices for the same product when the price differences are not due to differences in cost. Three requirements must be met for a firm to successfully practice price discrimination: (1) A firm must possess market power; (2) some consumers must have a greater willingness to pay for the product than other consumers, and firms must be able to know what customers are willing to pay; and (3) firms must be able to divide up—or segment—the market for the product so that consumers who buy the product at a low price cannot resell it a high price. In the case of perfect price discrimination, each consumer pays a price equal to the consumer’s willingness to pay. 15.3 Other Pricing Strategies (pages 505–510) Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. In addition to price discrimination, firms also use odd pricing, cost-plus pricing, and two- part tariffs as pricing strategies. Firms use odd pricing—for example, charging $1.99 rather than $2.00— because consumers tend to buy more at odd prices than would be predicted from estimated demand curves. With cost-plus pricing, firms set the price for a product by adding a percentage markup to average cost. Using cost-plus pricing may be a good way to come close to the profit-maximizing price when marginal revenue or marginal cost is difficult to measure. Some firms can require consumers to pay an initial fee for the right to buy their product and an additional fee for each unit of the product purchased. Economists refer to this situation as a two-part tariff. Sam’s Club, cell phone companies, and many golf and tennis clubs use two-part tariffs in pricing their products. Chapter Review Chapter Opener: Getting into Walt Disney World: One Price Does Not Fit All (page 493) Walt Disney World charges different consumers different prices for admission based on their willingness to pay. When Disneyland opened in 1955, Disney charged different prices for admission into the park and had a separate charge for rides. Today, there is a high price for admission to Disneyland and Walt Disney World but once a customer is in the park the rides are free. This change in strategy was designed to increase profits. ©2010 Pearson Education, Inc. Publishing as Prentice Hall 390 CHAPTER 15 | Pricing Strategy 15.1 Pricing Strategy, The Law of One Price, and Arbitrage (pages 494–496) Learning Objective: Define the law of one price and explain the role of arbitrage. Firms sometimes increase their profits by practicing price discrimination, charging different prices to different consumers for the same product when the price differences are not due to differences in cost. The development of information technology has made it possible for firms to gather information on consumers’ preferences and their responsiveness to price changes. This practice, called yield management, is particularly important to airlines and hotels. To practice price discrimination, firms must prevent arbitrage. Arbitrage is the process of buying a product in one market at a low price and reselling it in another market at a higher price. Arbitrage explains the law of one price: Identical products should sell for the same price everywhere. The law of one price holds only if transactions costs are zero. Transactions costs are costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. 15.2 Price Discrimination: Charging Different Prices for the Same Product (pages 496–505) Learning Objective: Explain how a firm can increase its profits through price discrimination. Charging different prices to different consumers for the same product when the price differences are not due to differences in cost is called price discrimination. Successful price discrimination has three requirements. 1. A firm must possess market power. 2. Some consumers must have a greater willingness to pay for the product than others, and the firm must know the prices consumers are willing to pay. 3. The firm must be able to segment the market so consumers who buy the product at a low price cannot resell it at a high price. Firms will charge a higher price to consumers whose demand is less elastic than other consumers. Airlines have a strong incentive to use price discrimination to manage their prices because airline seats are a perishable product, and the marginal cost of flying one additional passenger is low. Airlines divide their customers into two main categories: business travelers who are not very sensitive to changes in price, and leisure passengers who are sensitive to changes in price. Airlines use yield management to make frequent price adjustments in response to fluctuations in demand. Firms sometimes engage in price discrimination over time. These firms charge a higher price for a product when it is first introduced and a lower price later. This pattern was followed by firms that sold products such as HD-DVD players and digital cameras. Book publishers routinely use price discrimination over time to increase their profits. Hardcover editions of novels have much higher prices and are published months before paperback editions. The Robinson-Patman Act of 1936 outlawed price discrimination if its effect is to reduce competition in an industry. In recent years, the courts have interpreted Robinson-Patman to allow firms to use common types of price discrimination. ©2010 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 15 | Pricing Strategy 391 Study Hint Don’t Let This Happen to YOU! on page 496 in the textbook explains the difference between price discrimination and other types of discrimination, such as discrimination based on race or gender. Keep in mind that not all price differences are price discrimination, which refers to charging different prices for the same product where the price differences are not due to differences in cost. Making the Connection, “How Colleges Use Yield Management,” on page 501 in the textbook describes an example of price discrimination you should find interesting: offering different financial aid packages to college students based on differences in the price elasticity of demand. 15.3 Other Pricing Strategies (pages 505–510) Learning Objective: Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. In addition to price discrimination, firms can use the strategy of odd pricing. Odd pricing refers to charging prices just less than even dollar amounts—for example, $3.98 instead of $4.00—to give the appearance that the price is less than it really is. Some evidence supports the effectiveness of odd pricing in increasing profits, but this evidence is not conclusive. Another pricing strategy is cost-plus pricing. Cost-plus pricing involves adding a percentage markup to average cost to determine prices. This technique may be a good way to approximate the profit- maximizing price when marginal cost or marginal revenue are difficult to estimate. A two-part tariff is another pricing strategy. This is a situation in which consumers pay one price (or tariff) for the right to buy as much of a related good as they want at a second price. An amusement park that charges an admission fee and also separate fees for rides is using a two-part tariff. Extra Solved Problem 15-3 Tennis Anyone? Supports Learning Objective 15.3: Explain how some firms increase their profits through the use of odd pricing, cost-plus pricing, and two-part tariffs. The Topeka (Kansas) Racquet Club charges club members a monthly membership fee as well as an hourly fee to use its indoor tennis courts. The following graph illustrates the Racquet Club’s demand, marginal revenue and marginal cost curves. Because marginal cost is constant, it is also equal to average cost ($2). The graph shows that if the Club charges a fee of $11 per hour, Club members will use the tennis courts a total of 9,000 hours in a month. This is the quantity where marginal revenue equals marginal cost. The Club’s profit from its court fees for one month is equal to area A in the diagram ($11 – $2) × 9,000 = $81,000. ©2010 Pearson Education, Inc. Publishing as Prentice Hall 392 CHAPTER 15 | Pricing Strategy a. What is the maximum amount the Club can charge as a monthly fee if it charges an $11 per hour court fee? b. Is it possible for the Club to charge a different hourly court fee and increase its profit? SOLVING THE PROBLEM Step 1: Review the chapter material.