MANAGERIAL th ECONOMICS 11 Edition

By Mark Hirschey

Pricing Practices
Chapter 15

Chapter 15 OVERVIEW

Pricing Rules-of-thumb Markup Pricing And Profit Maximization Price Discrimination Price Discrimination Example Multiple-product Pricing Joint Products Joint Product Pricing Example Transfer Pricing Global Transfer Pricing Example

Chapter 15 KEY CONCEPTS

competitive market pricing rule-of-thumb imperfectly competitive pricing rule-of-thumb markup on cost profit margin optimal markup on cost markup on price optimal markup on price Lerner Index of Monopoly Power price discrimination

market segment first-degree price discrimination second-degree price discrimination third-degree price discrimination by-product common costs vertical relation vertical integration transfer pricing

Pricing Rules-of-thumb

Competitive Markets

Profit maximization always requires setting M

= MR - MC = 0, or MR=MC, to maximize profits. In competitive markets, P=MR, so profit maximization requires setting P=MR= MC. With imperfect competition, P > MR, so profit maximization requires setting MR=MC.

Imperfectly Competitive Markets

MR = P[1 + (1/P)] Optimal P* = MC/[1 + (1/P)]

Markup Pricing And Profit Maximization

Optimal Markup on Cost

Markup on cost uses cost as a basis. Markup pricing is an efficient means for achieving the profit maximization objective. Optimal markup on cost = -1/(P + 1)
Markup on price uses price as a basis. Optimal markup on price = -1/P

Optimal Markup on Price

Price Discrimination

Profit-Making Criteria

Price discrimination exists if P1/P2 MC1/MC2. Ability to segment the market. Multiple markets with no reselling. Price elasticity of demand differs across submarkets.
First degree: Different prices for each consumer.

Degrees of Price Discrimination

Creates maximum profits for sellers.

Second degree: Block-rates or quantity discounts. Third degree: Different prices by customer age, sex, income, etc. (most common).

Price Discrimination Example

Price/Output Determination

Maximizes profits by setting MR=MC in each market segment.

Without price discrimination, MR=MC for customers as a group. With price discrimination, MR=MC for each customer or customer segment. Profitable price discrimination benefits sellers at the expense of some customers.

One-price Alternative

Graphic Illustration

Multiple-product Pricing

Demand Interrelations

Cross-marginal revenue terms indicate how product revenues are related to another.
Joint products may compete for resources or be complementary. A by-product is any output customarily produced as a direct result of an increase in the production of some other output.

Production Interrelations

Joint Products

Joint Products in Variable Proportions

If products are produced in variable proportions, treat as distinct products. For joint products produced in variable proportions, set MRA=MCA and MRB=MCB. Common costs are joint product expenses.

Allocation of common costs is wrong and arbitrary.

Joint Products in Fixed Proportions

Some products are produced in a fixed ratio. If Q=QA=QB, set MRQ=MRA+MRB=MCQ.

Joint Product Pricing Example

Joint Products Without Excess By-product

Profit-maximization requires setting MRQ=MRA+MRB=MCQ. Marginal revenue from each byproduct makes a contribution toward covering MCQ.

Joint Production With Excess By-product (Dumping)

Profit-maximization requires setting MRQ=MRA+MRB=MCQ.

Primary product marginal revenue covers MCQ. Byproduct MR=MC=0.

Transfer Pricing

Transfer Pricing Problem

Products Without External Markets

Pricing transfer of products among divisions of a single firm can become complicated.
Marginal cost is the appropriate transfer price. Market price is the optimal transfer price.

Products With Competitive External Markets

Products With Imperfectly Competitive External Markets

Optimal transfer price is the marginal revenue derived from combined internal and external markets.

Global Transfer Pricing Example

Profit Maximization for an Integrated Firm

Optimal transfer price is profit maximizing.

Optimal transfer price balances supply/demand.

Transfer Pricing with No External Market

Competitive External Market with Excess Internal Demand

Firm employs own and external inputs.

Competitive External Market with Excess Internal Supply

Firm supplies inputs to internal and external markets.