BM1704
PRICING TECHNIQUES
Pricing Strategies
Pricing Decisions under the Market Structures
• Perfect competition – The market price of a commodity is beyond the control of individual
buyers and sellers. With many firms selling homogenous products, no individual firm is in a
position to influence the price of a product. The market price is determined by the equilibrium
between supply and demand in the market period during a very short run.
• Monopoly – A monopoly firm is a price maker. It also has market power, which means that it
can take the best of the demand and cost conditions without fear of new firms entering to take
away its profits.
• Oligopoly – Under an oligopoly, the number of competing firms is small. Each firm controls an
important proportion of the total supply. Therefore, the effect of a change in the price or output
of one (1) firm upon the sales of another firm is noticeable and significant.
Marginal Revenue and the Relationship with Elasticity of Demand
• Remember that marginal revenue is the measurement of the change in total revenue (TR) as
quantity sold (Q) changes by one (1) unit.
• In a perfect competition, MR = P, because the firm can sell all it wants at the going market price.
The demand for the firm is perfectly elastic. If a firm in a perfect competition raises its price, it
would be easy for customers to go to someone else because all goods are homogenous and can
be substitutable for each other. Buyers in the perfect competition are very sensitive to price
changes.
• For a monopoly, the firm has to reduce price to sell more. It is a price maker, and the demand
for the product is inelastic. If the buyer chooses not to buy the monopoly firm’s product because
of a price increase, he/she cannot get the product anywhere else. Therefore, buyers may just
choose to still buy the product despite changes in price, because of its uniqueness.
• Oligopoly lies between these two (2) extremes. Demand for its product is more inelastic because
there are only a few firms in the market that the buyer can get the product from.
• MR and elasticity of demand are important in managerial decisions on price and quantity. For
example, if a manager understands the elasticity of demand for its product, he or she will be
able to make an informed decision on how consumers will react to a price increase or decrease.
If a manager decides to raise the price of a product with an elastic demand, consumers would
likely purchase less of the product.
• The relationship between MR and elasticity can also be expressed using an equation:
1
𝑀𝑀𝑀𝑀 = 𝑃𝑃 �1 + �
𝐸𝐸𝐷𝐷
Where: P = price, and E D = Elasticity of demand
• If demand is elastic, an increase in price will lead to a decrease in total revenue.
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General Objectives in Pricing
• Profit maximization – This strategy ignores market share and tries to work out the price where
profit is maximized. In theory, this occurs where MR = MC.
• Sales maximization – This strategy aims to maximize sales while making normal profit or break
even profit. This involves selling at a price equal to average cost.
• Market share – Some firms may have a target to increase market share. Pricing for this strategy
also means setting the price equal to average cost.
Pricing Strategies to Maximize Sales and Profit
• Pricing for a new product
o Skimming price – In this pricing strategy, companies tend to charge a higher price in the
initial stages of the product. Setting high prices initially would help the firm identify the
buyers who are not very price sensitive/price elastic.
o Penetration price – In penetration pricing, the firm initially offers the product at a low
price to encourage buyers to try the product. This is also a useful strategy for a new firm
entering the market.
• Pricing for special cost and demand structures
o Peak-load pricing – Many markets have periods in which demand is high and periods in
which demand is low. This is a pricing strategy wherein higher prices are charged during
peak hours rather than off-peak hours. If the firm charges a high price at all times of the
day, no one would purchase during low-peak periods. By lowering the price during low-
peak periods, the firm increases its chances of selling to some customers using low-peak
periods. Similarly, if the firm charges a low price during all times of the day, it would lose
money during peak times, when customers are willing to pay more.
o Price matching – This is a strategy in which a firm advertises a price and a promise to
match any lower price offered by a competitor. However, if all firms in the market
announce such a policy, they can actually all set a high price. No one would be
motivated to lower their price because the other firms would just match the price. It is
up to the consumer to show the firm that some rival is offering a better deal. The
consumers who have not found a better deal continue to pay the higher price. Thus,
even if some firms charged a lower price, the firm using the price matching strategy
would get to price discriminate between those consumers who found the lower price
and those who did not.
Pricing Strategies to Increase Market Share
• Limit pricing – This occurs when a firm sets a price lower than profit maximization to discourage
entry. This enables the firm to make a supernormal profit, but the price is still low enough to
discourage new firms to enter the market.
• Predatory pricing - In this strategy, a firm uses a selling price below marginal cost to try and
force a rival out of business. After the rival leaves the market, the remaining firm raises price to
increase its profit. This practice is illegal.
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Other Pricing Strategies to Help Determine Price
• Average-cost pricing – This happens when a firm sets a price equal to average cost plus a
certain profit margin. One (1) of the primary reasons average-cost pricing is so popular is its
simplicity.
• Market-based pricing – This happens when the firm sets a price depending on supply and
demand.
• Markup pricing – This involves setting a price equal to marginal cost of production plus a profit
margin a firm wants to make on each sale.
• Profit maximization – In this strategy, the firm sets price and quantity so MR = MC.
Price Discrimination
Conditions for Pricing Discrimination
• The firm can segment the market into customers who have different price elasticities of
demand.
• The firm possesses some degree of monopoly power and can set the price.
• The customers can’t resell the good. If customers are able to resell the good, those who pay a
lower price can buy the good and sell it for a higher price, but not as high as the firm charges.
This process is called arbitrage, and it limits the firm’s ability to benefit from price
discrimination.
Impact of Price Discrimination
• Increase in output – Because the firm is able to charge different prices to different groups of
customers, it can attract more buyers who are willing to pay a lower price without sacrificing
revenue from buyers willing to pay a higher price. By selling to both groups at different prices
the firm increases the quantity of goods it sells.
• Increase in profit – By charging different prices, the firm is able to capture more consumer
surplus – the difference between the price a consumer is willing to pay and the price the
customer actually pays. The additional consumer surplus adds to the firm’s producer’s surplus.
First Degree Price Discrimination
• This type of price discrimination is also referred to as perfect price discrimination. It exists when
a firm charges a different price for each unit of the good sold – each customer pays a different
price for each unit of the good sold. This degree is the ultimate extreme in price discrimination.
• When this type of price discrimination exists, the firm is able to extract all surplus from
consumers and this earns the highest possible profits.
• A graph can show how first degree price discrimination works. Each point on the market
demand curve reflects the maximum price that consumers would be willing to pay for each
additional unit of output. Customers can start out with zero units of the good, and firms can sell
the first unit of output for the highest price.
• Since the demand (marginal revenue) curve slopes downward, the maximum price the firm can
charge for each additional unit declines. The difference between each point on the demand
curve and the firm’s marginal cost represents the firm’s profit on each additional unit of output
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sold. Thus, the shaded area between the demand curve and the firm’s marginal cost curve
reflects the total contribution to the firm’s profit when it charges the customer the maximum
price.
• First degree price discrimination is virtually impossible to implement. First, the firm must know
exactly the maximum price each consumer will pay for each unit of the good purchased, which
isn’t likely. In addition, the firm must negotiate separately with each individual consumer, and
be able to prevent resale between consumers. The cost of these negotiations is likely to be
greater than the benefits of first degree price discrimination. Still, the closer the firm gets to first
degree price discrimination, the greater the benefits.
Second Degree Price Discrimination
• In situations where the firm does not know the maximum price that each consumer will pay for
the good, a firm might be able to employ second degree price discrimination. The primary
advantage of this strategy is that the firm can extract some consumer surplus without needing
to know beforehand the identity of the consumers who want to purchase in small amounts and
those who want to buy larger quantities. As long as the consumers know this information, they
can sort themselves out according to their willingness to pay for alternative quantities of the
good. Thus, the firm charges different prices to different consumers but does not need to know
specific characteristics of individual consumers.
• This type of discrimination is seen in bulk discounting.
Third Degree Price Discrimination
• This type of price discrimination exists when the firm partitions the market into two (2) or more
different groups of consumers based on different price elasticities of demand. The differences in
elasticities enable you to charge customers in each group different prices.
• Groups possess different price elasticities of demand for any number of reasons. Differences in
income, tastes, or availability of substitutes can account for variation in elasticities. Examples of
third degree price discrimination include different prices for senior citizens, student discounts,
variations in airline ticket prices depending upon when the ticket is purchased.
• After the firms determine that they can separate potential consumers into two (2) or more
groups with different price elasticities of demand, the firm must determine the quantity of
output to sell to each group and the good’s price for each group.
• Coupons are also a way to price discriminate. Customers who are very responsive to price
changes and have very elastic demand are likely to take time to find coupons that effectively
lower than the good’s price. On the other hand, customers who are less responsive to price
changes because of their less elastic demand aren’t as likely to take the time to find coupons.
Bundling
• Bundling refers to a situation where the firm packages two (2) or more goods together and sell
them as a single unit. Firms use bundling to increase profit.
• Firms would be better able to increase profit by bundling goods that have large differences in
prices customers are willing to pay. The reservation price is the price where the consumer is
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indifferent between purchasing the good or continuing to search for a lower price. In essence,
the reservation price is the maximum price the consumer is willing to pay.
• Effective bundling requires firms to package goods that are negatively correlated across
consumers. Therefore, for some consumers, good A has a high reservation price, and good B has
a low reservation price. For other consumers, good A has a low reservation price, and good B
has a high reservation price. This reverse relationship or negative correlation across consumers
enables the firm to bundle the goods A and B and have both sets of consumers purchase the
bundle consisting of bundle goods A and B. The result is all customers buy both goods instead of
having only the consumers with high reservation prices buying the good.
• Customers only add another good to the bundle if the actual price difference between the
bundle and buying an item separately is less than the additional item’s reservation price.
References:
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https://www.economicshelp.org/blog/1021/business/pricing-strategies/
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https://www.tutor2u.net/economics/reference/business-pricing-strategies.
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