Pricing+Strategies

**PRICING STRATEGIES By Tiffany Mack**

 * THE BASICS**

When looking at firms with market power, we can determine that in order to maximize profits we must charge the price where marginal revenue (MR) equals marginal cost (MC). Example: If the firm should charge a higher price they will sell less, if the firm should charge a lower price they will sell more. Therefore to help settle this problem, managers will set output where MR=MC. Then the managers determine what the highest price is that they can charge in order to sell all that they produced.


 * TAKING A DEEPER LOOK**

How exactly do the managers estimate how much to produce and what people are willing to pay? Most managers have access to data revealing the overall cost of their product. They know exactly how much materials, labor, etc goes into each product. After they know the cost, they can determine how much they want to mark up from the cost. Next they have to determine how elastic their product is. If there are many substitutes available for their product then they will have a lower markup. (Baye) In a case where they are perfectly elastic, then we already know that price should be set equal to MC.


 * OTHER STRATEGIES THAT PRODUCE GREATER REVENUE**

//Price Discrimination// is a way that firms can produce greater revenue. (Baye) They do this by selling the same product to one customer at a different price than they sell it to another. The simple fact is some people are willing to pay more or less for a product than another. This technique allows managers to determine what the highest possible price is a specific customer is willing to pay for that specific good.

//Two Part Pricing// allows firms to charge a fixed fee for each purchase plus a price per unit sold in addition. (Baye) Managers do so by setting the fixed fee equal to MC. Therefore, they set the price per unit equal to consumer surplus. This allows the firm to maximize profits.

//Block Pricing// creates a situation where customers have to decide "all or nothing." (Baye) It groups two identical products together in one package which forces the customer to buy at least two products in a single order. The firm earns more this way, versus each customer only purchasing one product at a time.

//Commodity Bundling// is similar to block pricing because it groups products together in one package. (Baye) The difference is unlike block pricing, commodity bundling groups several different products together. This requires that the customer must purchase "all or nothing" again. The firm maximizes profits this way instead of allowing the customer to purchase one item at a time. Many personal product manufacturers will group different products together such as toothbrushes, mouth wash, and toothpaste.

//Peak-Load Pricing// is a strategy that allows the firm to charge a higher price during peak and a lower price during an "off season". (Baye) An example of this would be the price of gas over the holidays versus all other times of the year. When the customer really needs the product the most it is forced to pay a higher price.

//Cross-Subsidy// occurs when a firm has two products. (Baye) They price one higher and one lower in order to accomodate for the cost of each other. If a firm sells body wash and lotion in the same fragrance. They can charge a higher price for the body wash and a lower price for the lotion in order to accomodate for the cost of each other.

Price Matching allows a firm to encourage purchases by giving customers an incentive. (Baye) The firm advertises that it will match any lower price offered by a competitor for the same product. Many grocery stores will use price matching on products such as Coke or Pepsi products.


 * QUIZ**

//If a firm with market power charges a higher price://

a. they will sell more.

b. they will sell less.

c. they will sell the same amount.

d. they will sell equal to output.

answer: b. If a firm with market power charges a higher price they will sell less because price should be set MR=MC.

//A product that is perfectly elastic should set price equal to://

a. output.

b. marginal revenue.

c. marginal cost.

d. cost of materials.

answer: c. A product that is perfectly elastic should set price equal to MC because there are many substitutes available.

//An example of block pricing is://

a. grouping several different products together in one package.

b. advertising to match any price offered by competitors for the same product.

c. charging a higher price for one item and a lower price for another.

d. grouping two or more of the same items together in one package.

answer: d. An example of block pricing is grouping two or more of the same items together in one package which forces the customer to buy more in a single purchase.

//Price Discrimination is://

a. selling the product at the same price no matter what.

b. setting the price based on the season.

c. selling the product only to people willing to pay more.

d. setting the price equal to the maximum each specific person is willing to pay.

answer: d. Price Discrimination allows the firm to adjust the price according to what each specific person is willing to pay.

//An example of two part pricing is://

a. Sam's Club

b. Walmart

c. K-mart

d. Target

answer: a. Sam's Club charges a fixed price (membership) in order to purchase from their store. In addition they charge for each item purchased.

Sources: Baye, Michael R., "Managerial Economics and Business Strategy", Fifth Edition, Mc-Graw Hill, 2007