C.  Pricing Practices

1.  Pricing of multiple products

• Firms produce more than one product

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a.  Products with interrelated demands

• Goods could be related to one another - substitutes and complements

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• Need to take into account or too much or too little of product is produced

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b.  Plant capacity utilization

• Produce more than one product to better utilize plants

• Introduce new products as long as MR > MC

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• Profitable for firm to introduce other products until price of last product equals its marginal cost

• Production facilities can easily be adapted to the production of other products

• Assumes demands are independent

• Firm may produce a product where little or no profit is made because it wants to:

(1) offer a full range of products

(2) use product as a loss leader - to attract customers

(3) retain customers' goodwill

(4) keep channels of distribution open

(5) keep resources in use while waiting for more profitable opportunities

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2.  Price discrimination

• Charge different prices to different customers

• Goal is increase profits by converting consumer surplus to producer surplus

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a. Required conditions

(1)  Firm has some control over price

(2)  Different market segments with different price elasticities

(3)  Market segments are separable - no reselling between groups

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b.  Forms of price discrimination

(1)  First-degree price discrimination

• Charge different price to each customer

Ex. -

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(2)  Second-degree price discrimination

• Different price schedules, usually based on volume

• Also called block pricing

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(3)  Third-degree price discrimination

• Charge different prices to different segments of the market

Ex. -

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• Algebraic approach

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3.  Transfer pricing

• What price should be charged when selling products to a division within the same company?

• Affects output and profitability of each division

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a.  No external market for intermediate product

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b.  External market for intermediate product

(1)  Perfectly competitive market for intermediate product

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(2)  Imperfectly competitive market for intermediate product

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4.  Cost-plus pricing

• Also called markup or full-cost pricing

• Fully allocated average cost - AVC plus a percentage for overhead

• Apply percentage markup to that

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a.  Advantages

(1)  Requires less information and less precise data

(2) Simple and easy to use

• Difficult to estimate total variable costs

• May be impossible to allocate overhead charges when there are multiple products

(3) Results in relatively stable prices when costs don't change much over time

• Costly to change prices

(4)  Provides clear justification for price increases when costs increase

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b.  Problems

(1)  Based on accounting and historical costs, not replacement and opportunity costs

• Criticism of how cost-plus pricing is implemented, not the concept itself

(2)  Based on average, not marginal costs

• Not a problem if marginal cost is constant

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c.  Relationship to demand

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5.  Special situations

a.  Peak-load pricing

• Charge different prices during different time periods - more during peak periods

Ex. -

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b.  Two-part tariff

• Initial fee paid for right to buy product, then a price per unit purchased

• Must balance revenue from initial fee and price per unit

Ex. -

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c.  Tying

• Someone buying a product must also buy product needed in use of the first

Ex. -

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d.  Bundling

• Products sold together as a package

• Customers have different tastes but price discrimination can't be used

Ex. -

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6.  Other pricing practices

a.  Prestige pricing

• Set high price to attract prestige-oriented customers

• Occurs when it is difficult to obtain objective information about the quality of a product

Ex. - Cars, luxury products

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b.  Price lining

• Set price, design product to maximize profits

Ex. - Cars

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c.  Skimming

• Set high price when product is introduced, gradually reduce price

• Difficult to determine demand and price, get people who are willing to pay high price first

Ex. - Durable goods

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d.  Value pricing

• Sell quality goods at much lower prices than previously

• Redesign product to keep or enhance quality while lowering costs

Ex. - Fast food

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e.  Price matching

• Offer to match competitors' prices

• Discourages competitors from cutting prices, consumers may not search for alternatives

Ex. - Retailing

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f.  Auction pricing

• Buyers make bids for products

Ex. - eBay, Priceline