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Pricing Strategy

Pricing Strategy. C. t'. R. c’. t. Profits = R - C. c. Example of Profit Maximization. $. Slope of R curve is MR. 400. 300. Slope of C curve is MC. 200. 150. 100. 50. Quantity. 0. 5. 10. 15. 20. Profit  (Q) = Revenue - Cost = R(Q) - C(Q)

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Pricing Strategy

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  1. Pricing Strategy

  2. C t' R c’ t Profits = R - C c Example of Profit Maximization $ Slope of R curve is MR 400 300 Slope of C curve is MC 200 150 100 50 Quantity 0 5 10 15 20

  3. Profit  (Q) = Revenue - Cost = R(Q) - C(Q) Maximum when = 0, i.e., = Here: = MR = marginal revenue = MC = marginal cost Profit Maximization d dQ dR dC dQ dQ dR dQ dC dQ

  4. So profits are maximized at the price/output level at which marginal revenue = marginal cost

  5. MC P1 P* AC P2 Lost profit from lower output Q1 Q* Q2 Maximizing Profit When Marginal Revenue Equals Marginal Cost $ per unit of output D = AR MR Quantity

  6. Monopoly The Monopolist’s Output Decision • An Example Note – here fixed cost = 50

  7. Monopoly The Monopolist’s Output Decision • An Example

  8. Monopoly The Monopolist’s Output Decision • An Example

  9. Monopoly The Monopolist’s Output Decision • An Example • By setting marginal revenue equal to marginal cost, profit is maximized at P = $30 and Q = 10. • This can be seen graphically:

  10. C t' R c’ t Profits c Example of Profit Maximization Question – how does a change in fixed costs affect the best price? $ 400 300 All costs above $50 are variable. 200 150 100 50 Quantity 0 5 10 15 20 Fixed cost is $50. Changing fixed cost changes the intercept only.

  11. C $ t' R 400 300 c t 200 150 Profits 100 50 c 0 5 10 15 20 Quantity Example of Profit Maximization • Observations • Slope of rr’ = slope cc’ and they are parallel at 10 units • Profits are maximized at 10 units • P = $30, Q = 10, TR = P x Q = $300 • AC = $15, Q = 10, TC = AC x Q = 150 • Profit = TR - TC • $150 = $300 - $150

  12. MC AC Profit AR MR Illustration of Profit Maximization $/Q 40 30 20 15 10 0 5 10 15 20 Quantity

  13. $/Q 40 MC 30 AC Profit 20 AR 15 MR 10 0 5 10 15 20 Quantity Illustration of Profit Maximization • Observations • AC = $15, Q = 10, TC = AC x Q = 150 • Profit = TR = TC = $300 - $150 = $150 or • Profit = (P - AC) x Q = ($30 - $15)(10) = $150

  14. Markup Rules Two models of pricing – Markup over costs and What the market will bear. In fact they come together in a demand-based approach to markup pricing. How should price relate to cost to maximize profits?

  15. dQ P dP Q • PED = Ep = • Revenue = R = P(Q)Q • Marginal Revenue = MR = = [P(Q)Q] • MR = Q + P • MR = P [ + 1] • MR = P [ + 1] dR dQ d dQ dP dQ dP Q dQ P 1 Ep

  16. For maximum profits, MR = MC so P + P = MC Or 1 Ep P - MC = - 1 P Ep

  17. Another way of saying the same thing: P - MC = - P Ep

  18. Plot the ratio of price to marginal cost as a function of the demand elasticity: Epp/MC - 1  - 2 2 - 3 3/2 - 4 4/3 - 5 5/4 - 6 6/5  1

  19. The more elastic is demand, the less the markup. P* MC MC P* AR P*-MC MR AR MR Q* Q* Elasticity of Demand and Price Markup $/Q $/Q Quantity Quantity

  20. Summary This is a model of price setting as a markup over costs with the markup reflecting what the market will bear.

  21. These are the costs to consumers of switching from one producer or brand to another They make demand for the first brand less elastic - less responsive to lower prices by competitors Switching costs associated with your competitors’ brands make your selling costs higher Switching costs ( “lock-in”)

  22. Frequent flier bonuses and other rewards for loyalty Emphasis on “relationships” rather than “transactions”. Valid for banking, computer systems (custom jobs vs. off-the-shelf software), consulting, legal services Emphasis on “uniqueness” of product Examples of switching costs:

  23. IBM with mainframes ATT with PBXs Microsoft with Windows Examples of Switching Costs

  24. Can be high for widely-used software because of need to retrain, modify file formats, maintain links to other applications, etc. Hence incoming products will attempt to maintain compatibility and reduce these costs. Switching Costs

  25. In general, a major role of marketing strategy and image building is to increase the costs of switching from your product, so as to make demand less elastic. Switching costs are reflected in the PED. Being an industry standard raises switching costs.

  26. Consumer Surplus • With a downward sloping demand curve, and uniform price for all buyers, some buyers will be paying less than they are willing to pay for the good (for example, the buyers at the top left hand end of the demand curve)

  27. The difference between what a buyer is willing to pay for the units of a good which she buys, and the amount she actually pays, is called the buyer’s consumer surplus

  28. One of the main aims of pricing strategy is to find a way of charging for goods which brings this consumer surplus to the seller. To quote the marketing SVP of American Airlines, “Why sell a seat for $200 to someone who is willing to pay $500 for it?”

  29. Consumer surplus & demand curve • Buyer’s consumer surplus is area beneath her demand curve and above horizontal line whose height is the price. • Example - buyer is willing to pay $10 for 1st unit, $9 for 2nd, $8 for 3rd, $7 for 4th, etc. • Construct demand curve.

  30. Area under D curve here is about 55, = total willingness to pay. Demand curve

  31. Consumer Surplus • Suppose price is zero. She will buy 10 units and consumer surplus is $(10+9+8+7+6 … ) which is $55. • Area beneath demand curve and above P=0 is 1/2x10.5x10.5 which is 55.125. • Try second example: price is just less than $6, so she buys 5 units. Pays $5x6 = $30.

  32. Area under D curve here is about 55, = total willingness to pay. Demand curve

  33. Consumer surplus • Area beneath demand curve and above P=6 is 1/2x4.5x4.5 = 10.125. • Total value attributed to first 5 units is $(10+9+8+7+6) = $40. Subtract payment of $30 and consumer surplus is $10. • So - CS is area beneath D curve and above horizontal line with vertical coordinate of price.

  34. Three main tools: Price discrimination, two-part pricing and bundling (1) Price discrimination: charging different prices for essentially the same good to different buyers. Charge each what they are willing to pay. Tools of pricing strategy

  35. Charging a different price to every buyer. Examples: Reuters Info Services, car sales Segmenting the market. Airlines with business vs. vacation travel, railroads with time-of-day pricing, phone companies with time-of-day pricing, retail stores pricing by location. price discrimination over time: introduce a product at a high price and reduce the price over time. Sell at a high price to the aficionados - e.g. high fi systems, new and more powerful computers Different types of price discrimination

  36. Two market segments, with demand curves P1 = P1 (Q1) and P2 = (Q2) Marginal cost curve is MC = MC (Q1 + Q2)

  37. Market Segmentation • Choose price, output so that MR same in each segment • Common MR should equal MC

  38. Third-Degree Price Discrimination $/Q Consumers are divided into two groups, with separate demand curves for each group. MRT = MR1 + MR2 D2 = AR2 MR2 D1 = AR1 MR1 Quantity

  39. MC = MR1 at Q1 and P1 • QT: MC = MRT • Group 1: P1Q1 ; more elastic • Group 2: P2Q2; more inelastic • MR1 = MR2 = MC • QT control MC P1 MC P2 Q1 Q2 QT=Q1+Q2 Third-Degree Price Discrimination $/Q D2 = AR2 MR MR2 D1 = AR1 MR1 Quantity

  40. MC Third-Degree Price Discrimination $/Q MR2 MR1 Q1 Quantity Q2 QT=Q1+Q2

  41. Market Segmentation • Choose price, output so that MR same in each segment • Common MR should equal MC

  42. Sales, Coupons, Random Discounts All of these are frequently forms of price discrimination. People who won’t pay the full price wait for sales. Coupon users typically have low incomes.

  43. Price Elasticity Product Nonusers Users Price Elasticities of Demand for Users Versus Nonusers of Coupons Toilettissue -0.60 -0.66 Stuffing/dressing -0.71 -0.96 Shampoo -0.84 -1.04 Cooking/salad oil -1.22 -1.32 Dry mix dinner -0.88 -1.09 Cake mix -0.21 -0.43

  44. Price Elasticity Product Nonusers Users Price Elasticities of Demand for Users Versus Nonusers of Coupons Cat food -0.49 -1.13 Frozen entrée -0.60 -0.95 Gelatin -0.97 -1.25 Spaghetti sauce -1.65 -1.81 Crème rinse/conditioner -0.82 -1.12 Soup -1.05 -1.22 Hot dogs -0.59 -0.77

  45. Airlines Cost Structure Consulting studies: costs are 12 cents/available passenger mile (a.p.m.). Is this AC or MC? Focus on AC vs. MC distinction and on SR vs. LR MC 12 cents/a.p.m. is AC LR MC is AC SR MC is close to zero

  46. Demand PED for Business Class = -1.25 PED for Economy in range -1.5 to -5 depending on category

  47. Passengers and fares on UAL # 815

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