Product Pricing &

Market Structure

ECU_07306 Managerial Economics

Department of Economics
 Pricing and its Objectives
Price
– the amount of money that has to be paid to
acquire a given product/ service.
– the act of establishing a value for a product or
service
Pricing Strategy – Managers’
Role?
 How does a company decide what price to
charge for its products and services?
 What is “the price” anyway? doesn’t price
vary across situations and over time?
 Some firms have to decide what to charge
different customers and in different
situations
 They must decide whether discounts are
to be offered, to whom, when, and for what
reason
Why is Pricing Important?
In a company with average economics*,
 1% increase in volume = 3.3% increase in
profit
 1% increase in price = 11.1% increase in profit
 Improvements in price typically have 3-4
times the effect on profit as proportionate
increases in volume.

*Based on average of 2,463 companies

Price vs. Nonprice Competition
 In price competition, a seller regularly offers
products priced as low as possible and
accompanied by a minimum of services
 In non price competition,
competition a seller has stable
prices and stresses other aspects of
marketing
 With value pricing,
pricing firms strive for more
benefits at lower costs to consumer
 With relationship pricing, customers have
incentives to be loyal-- get price incentive if
you do more business with one firm
Nonprice Competition
 Some firms feel price is the main competitive
tool, that customers always want low prices
 Other firms are looking for ways to add value,
thereby being able to avoid low prices
 Sometimes prices have to be changed in
response to competitive actions
 Many firms would prefer to engage in non
price competition by building brand equity
and relationships with customers
 Steps for Determining Prices
 Establish Pricing Objectives
 Increase sales volume?
 Prestigious image?
 Increase market share?

 Study Costs
 Can you make a profit?
 Can you reduce costs without affecting quality or
image?
 Steps for Determining Prices
 Estimate Demand
 What do customers expect to pay?
 Prices usually are directly related to demand.

 Study Competition
 Decide on a Pricing Strategy
 Price higher than the competition because your product
is superior
 Price lower, then raise it once your product is accepted

 Set Price
 Monitor and evaluate its effectiveness as conditions in
the market change
Assessing and responding to a competitor’s price cut (depending on
the market structure)
Pricing & Market Structure
Market Structure – Internal rivalry

 Market structure and pricing decisions are closely

related. But how to define the market?
 The degree to which the firm gets to choose price is
determined in large part by market structure
 There are two extreme cases: perfect competition
and monopoly
Perfect Competition

 Conditions necessary:

 Large numbers of buyers and sellers

 Homogeneous product
 Free entry and exit
 Perfect information
Perfect Competition
 Demand curve for any given firm is
horizontal. Price is set by market at Pe

P P D
e e
D

 Firm can sell as much or as little as desired

at market price, but nothing if they raise P.
Monopoly
 Conditions necessary
 Single seller of product
 No close substitutes
 Significant barriers to entry
 There are few examples of perfect
competition and pure monopoly.
 Most firms have a differentiated product, and
there are substitutes.
Pricing in Perfect Competition

 Do not choose price.

 Choose output quantity. Total Cost includes
opportunity cost of capital invested.
 What will be our profit (loss) from our output
decision?
 Should we produce now? (Short Run)
 Should we stay in the industry? (Long Run)
 Costs at different levels of production

Cost per unit at different levels of production

Pricing in a Monopoly

 Profit maximization will be achieved by

setting price so that MC=MR.
 It is not reached by setting price as “high as
possible.”
 Like any firm, the monopolist is constrained
by their demand curve.
 One cannot choose both P and Q.
The Shut-Down Rule
 At what point should the firm cease
production of a certain item?
 When might it pay to produce at a loss?
 In SR, many costs are fixed. Just because a
firm is making losses, it does not necessarily
mean it should shut down (short run), or even
go out of business (long-run).
 The Shut-Down Rule cont.

 Profit = TR – TC; TR=P*Q, TC = VC + FC

 (TR - VC) - FC = [(P - AVC)Q] – FC
 Separate out fixed costs, focus on variable elements
 As long as P>AVC, there is a positive contribution to fixed
costs.
 If firm shuts down (Q = 0), then Profit = - FC
 If shut down: Firm has a loss of fixed costs.
 The Shut-Down Rule cont.

 In SR, firm may minimize losses by continuing to

produce.
 If losses are expected permanently, get out.

 Case of multiple products:

 C = FC + VC1 + VC2
 The Shut-Down Rule
1.  = (TR1 - TVC1) + (TR2 - TVC2) - FC
2.  = (P1*Q1 - AVC1*Q1) + (P2*Q2 - AVC2*Q2) - FC
3.  = [(P1 - AVC1)*Q1]+ [(P2 - AVC2)*Q2] - FC
 Results:
1. SR - each product should be produced if Pi>AVCi
2. In LR, the firm should continue operating only if
expected 0 (Profits are non-negative)
Price Discrimination
 Selling the same good to different people at
different prices
 Conditions necessary:
 Identifiable customer groups with differing
price elasticities
 Maintain separation of groups--prevent resale.
Types of Price Discrimination
 First degree
 Identify and charge each customer
what they are willing to pay
 Limit: D = MR, no consumer
surplus.
 Second degree
 Quantity discounts. Volume
purchases are given lower prices.
Need to measure goods and
services bought by consumers.
Types of Price Discrimination
 Third degree
 Segment markets in some way. Charge
all in the segment the same prices.
 Treat each segment as a separate
market– then do MR=MC in each
 Are coupons as a price discrimination
mechanism?
 Oligopoly Strategies
 Common theme - Rivalrous behavior
 Pricing - limit pricing - set prices low as signal
to possible entrants or other competitors your
willingness and ability to defend your market
share.
 Must have credibility.
 Trading SR profit for more profits later
Oligopoly Strategies
 Use the legal / regulatory systems
 File patent application
 Challenge business charter application
 File regulatory challenge
Oligopoly Strategies
 Capacity and production

 Announce capacity expansion

 Revise/modify products - more
difficult to copy
 Advertising

 Raise cost of entry for others

Oligopoly and Monopolistic
Competition
 Oligopoly
 Few sellers - usually large ones
 Recognized interdependence in
pricing and output decisions
 Need to consider response of rivals in
pricing decisions
 Typically significant barriers to entry
Oligopoly and Monopolistic
Competition
 Monopolistic Competition

 Large number of interdependent

sellers
 Differentiated product
 Good substitutes
 Easy entry and exit
Oligopoly and Monopolistic
Competition
 Most industries are one or the other
 Oligopoly: many heavy manufacturing
Autos, steel, chemicals, pharmaceuticals
 Monopolistic Competition
Service companies, retail stores, large
corporations (McDonald’s, Wendy’s)
The important point is that demand is downward
sloping
Cartels
 Illegal in most countries – but encouraged in
others
 Conditions helpful:
 Small number of firms
 Homogeneous product
 Entry barriers
 Similarity of members
Cartels
 Problems with cartels:
 Cheating on agreement
 Price cutting behaviour
 Tend to fall apart
 Note: When might firms in an industry ask for
(demand) regulation?
Pricing Strategies

Price-Based

Optimization

Skimming

Penetration
1. Penetration Pricing
 Price set to ‘penetrate the market’

 ‘Low’ price to secure high volumes

 Typical in mass market products – chocolate bars,

food stuffs, household goods, etc.

 Suitable for products with long anticipated life cycles

 May be useful if launching into a new market
2. Market Skimming
 High price, Low volumes

 Skim the profit from the market

 Suitable for products that have short life cycles or which will face
competition at some point in the future (e.g. after a patent runs
out)

 Examples include: Playstation, jewellery, digital technology – Flat

Screens, new DVDs, etc.
3. Value Pricing
 Price set in accordance with
customer perceptions about
the value of the product /
service

 Examples include status

products/exclusive products

Companies may be able to set prices

according to perceived value.

Title: BMW At The Frankfurt Auto Show. Copyright: Getty Images,

available from Education Image Gallery
4. Loss Leader
 Goods/services deliberately sold below cost to
encourage sales elsewhere

 Typical in supermarkets, e.g. at Christmas, selling

bottles of gin at £3 in the hope that people will be
attracted to the store and buy other things

 Purchases of other items more than covers ‘loss’ on

item sold
 e.g. ‘Free’ mobile phone when taking on contract
package
5. Psychological Pricing
 Used to play on consumer perceptions

 Classic example - $9.99 instead of $10.00!

 Odd-even: $5.95, $.79, $699 OR $12, $50

 Multiple Unit-3 for !1.00 better than $.34 each

5. Psychological Pricing
 Odd-Even Pricing
 Odd numbers convey a bargain image
-- $.79, $9.99, $699

 Even numbers convey a quality image

-- $10, $50, $100
5. Psychological Pricing
 Prestige Pricing – sets a higher than average
price to suggest status
5. Psychological Pricing
 Multiple-Unit Pricing – 3 for $.99
 Suggests a bargain and helps
increase sales volume.
 Better than selling the same items
at $.33 each.
6. Going Rate (Price Leadership)
 In case of price leader, rivals have difficulty in competing on
price – too high and they lose market share, too low and the
price leader would match price and force smaller rival out of
market

 May follow pricing leads of rivals especially where those rivals

have a clear dominance of market share

 Where competition is limited, ‘going rate’ pricing may be

applicable – banks, petrol, supermarkets, electrical goods – find
very similar prices in all outlets
7. Tender Pricing
 Many contracts awarded on
a tender basis

 Firm (or firms) submit their

price for carrying out the
work

 Purchaser then chooses

which represents best value

 Most government contracts

 8. Price Discrimination
 Charging a different price for
the same good/service in
different markets

 Requires each market to be

impenetrable

 Requires different price

elasticity of demand in each
market
Prices for rail travel differ for the same journey  Air/rail
at different times of the day  First class
 Business class
 Economy class
9. Discounts and Allowances
 Cash Discounts – offered to buyers
to encourage them to pay their bills
quickly.

 Quantity Discounts – offered for

placing large orders

 Trade Discounts – the way

manufacturers quote prices to
wholesalers and retailers.
10. Promotional Pricing - Used with
sales promotion
 Loss Leader Pricing – offering very
popular items for sale at below-cost
prices
 Special-Event
 Back-to-school specials
 Dollar days
 Anniversary sales
 Rebates and Coupons
11. Discounts and Allowances

Seasonal Discount – offered

outside the customary buying
season
11. Discounts and Allowances
 Allowances – go directly to the
buyer. Customers are offered a
price reduction if they sell back an
old model of the product they are
purchasing
12. Destroyer/Predatory Pricing
 Deliberate price cutting or offer of ‘free gifts/products’ to force
rivals (normally smaller and weaker) out of business or prevent
new entrants

 Anti-competitive and illegal if it can be proved

 Typical of oligopoly with collusion

Unfair Trade Practice Acts

Laws that prohibit

wholesalers and retailers from
selling below cost
Price Fixing

An agreement between two or

more firms on the
price they will charge
for a product (usually in oligopolistic
markets)
Predatory Pricing

The practice of charging a

very low price for a product
with the intent of driving
competitors out of business
or out of a market.
Discussion: Impact of Ethics on
Pricing
 How should you price if your product is a life-
saving drug?
 What are the ethical considerations?
 Customers have no choice
 Need to pay for the research
 When cheaper options doesn’t work
 Competition decides

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Some other pricing strategies
Absorption/Full Cost Pricing

 Full Cost Pricing – attempting to set price to

cover both fixed and variable costs

 Absorption Cost Pricing – Price set to

‘absorb’ some of the fixed costs of production
Marginal Cost Pricing
 Marginal cost – the cost of producing ONE extra or ONE fewer
item of production
 MC pricing – allows flexibility
 Particularly relevant in transport where fixed costs may be
relatively high

 Allows variable pricing structure – e.g. on a flight from London

to New York – providing the cost of the extra passenger is
covered, the price could be varied a good deal to attract
customers and fill the aircraft
 Marginal Cost Pricing
 Example:

Aircraft flying from Bristol to Edinburgh – Total Cost (including normal

profit) = £15,000 of which £13,000 is fixed cost*
Number of seats = 160, average price = £93.75
MC of each passenger = 2000/160 = £12.50
If flight not full, better to offer passengers chance of flying at £12.50 and
fill the seat than not fill it at all!
*All figures are estimates only
Contribution Pricing
 Contribution = Selling Price – Variable (direct costs)
 Prices set to ensure coverage of variable costs and a
‘contribution’ to the fixed costs
 Similar in principle to marginal cost pricing
 Break-even analysis might be useful in such
circumstances
Target Pricing
 Setting price to ‘target’ a specified profit level
 Estimates of the cost and potential revenue at
different prices, and thus the break-even have
to be made, to determine the mark-up
 Mark-up = Profit/Cost x 100

 This strategy is used by many clothes retailers

where they can add upto 60% mark-up on the
basic cost of the clothes. So even with a 50%
sales offer they still make a profit!
Cost-Plus Pricing
 Calculation of the average cost (AC) plus a
mark up

 AC = Total Cost/Output
Influence of Elasticity
 Price Inelastic:
 % change in Q < % change in P

 e.g. a 5% increase in price would be met by a

fall in sales of something less than 5%

 Revenue would rise

 A 7% reduction in price would lead to a rise in

sales of something less than 7%
Influence of Elasticity
 Any pricing decision must be mindful of the impact of
price elasticity
 The degree of price elasticity impacts on the level of
sales and hence revenue
 Elasticity focuses on proportionate (percentage)
changes

 PED = % Change in Quantity demanded

% Change in Price
Influence of Elasticity
 Price Elastic:
 % change in quantity demanded > % change in price

 e.g. A 4% rise in price would lead to sales falling by

something more than 4%

 Revenue would fall

 A 9% fall in price would lead to a rise in sales of

something more than 9%

 Revenue would rise

Select a Pricing Method
Now that you know various Pricing Strategies, its
time to select your preferred pricing method!
 Mark-up Pricing - “Cost Plus”
 Target Return Pricing
 Value Pricing
 Going Rate Pricing (market price)
 Reference Pricing (comparison/substitutes)
 Sealed-Bid Pricing

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