Two+part+pricing,+Block+pricing,+peak+load+pricing,+cross+subsidies,+price++matching,+randomized+pricing

=**Two-Part Pricing, Block Pricing, Peak Load Pricing, Cross Subsidies, Price Matching, and Randomized Pricing**=

//By: Trevor J. Moore//
Firms with market power tend to employ several pricing strategies in order to maximize profits. Since firms with market power have a downward sloping demand curve, they are forced to balance the trade-off between selling a lot of goods at a low price or fewer goods at a higher price. The ideal price to charge all customers is a situation at which marginal revenue equals marginal cost. However, competitive firms with market power can choose to utilize the following pricing strategies in order to maximize profits: two-part pricing, block pricing, peak load pricing, cross subsidies, price matching, and randomized pricing. The subsequent is a comprehensive list of these pricing strategies and their definitions.


 * Two-Part Pricing** – A pricing strategy in which consumers are charged a fixed fee for the right to purchase a product, plus a per-unit charge for each unit purchased.


 * Block Pricing** – A pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-or-none decision to purchase.


 * Peak Load Pricing** – A pricing strategy in which higher prices are charged during peak hours than during off-peak hours.


 * Cross Subsidies** – A pricing strategy in which profits gained from the sale of one product are used to subsidize sales of another product.


 * Price Matching** – A pricing strategy in which a firm advertises a price and a promise to match any lower prices offered by a competitor.

(Baye, 2006)
 * Randomized Pricing** – A pricing strategy in which a firm intentionally varies its price in an attempt to “hide” price information from consumers and rivals.

**Two-Part Pricing**
The way a firm enhances profits using this strategy is by charging a per-unit price that equals the marginal costs and then adding a fixed fee that is equal to the consumer surplus each consumer receives at the per-unit price (Baye, 2006). Some traditional examples of two-part pricing are health clubs or golf courses. Historically, they have charged a fixed initiation fee plus a periodically assessed fee to use the facilities. This can either be a per-month fee or a per-use fee. A strange example of this pricing strategy is being contemplated by General Motors and their anticipated release of its electric car, the Chevy Volt. GM may allow buyers of this vehicle to “rent the vehicle’s battery as a way of pricing the vehicle at a comparable level to a traditional, petrol-driven family [sedan]” (Quinn, 2007). While this two-part pricing example might not be aligned with the pricing principle discussed, it proves that using a two-part pricing strategy might persuade consumers to make the initial purchase (at a lower price) if they are able to delay some of the costs until a later time. These “two-part tariffs,” as they are sometimes called, are when “the good being sold is divided up—part is sold for a fixed amount, the other part sold per-unit” (Quinn, 2007). Quinn uses the example of razors. First consumers buy the handle and then pay for the razor after buying the blades. “The handle purchases our access to the usage of the razor as a whole” (Quinn, 2007). The important thing to note about two-part pricing is that it allows a firm to extract all consumer surplus from consumers. “Two-part pricing allows a firm to earn higher profits than it would earn by simply charging a price for each unit sold. By charging a fixed fee, the firm is able to extract consumer surplus, thus enhancing its profits” (Baye, 2006).

Block Pricing
“If you have purchased toilet paper in packages of four rolls or cans of soda in six-packs, you have had firsthand experience with block pricing” (Baye, 2006). When a firm packages units and sells them as one package, the firm will earn more than “by posting a simple per-unit price” (Baye, 2006). “The profit-maximizing price on a package is the total value the customer receives for the package, including consumer surplus” (Baye, 2006). A firm uses this in order to get the consumer to pay the full value of the total amount of units purchased. If a company packages their product in a package of eight units, the consumer has to decide if they want to purchase all eight units or none of the units. If the total value of the eight units is $50, the consumer will find it in his/her best interest to purchase the package as long as the price does not exceed this value. This prevents the consumer from purchasing only a few of the units, which would decrease the firm’s profits from this consumer.

Peak Load Pricing
With peak-load pricing, a firm may enhance profits by charging a higher price during peak times than the price they charge during the off-peak times. The peak times are characterized by the times when the demand is higher. This is common practice for electric companies, toll roads, and airlines. Toll roads usually have more traffic during rush hour; utility companies (especially electric companies) have higher demand during the day than late at night; airlines usually have higher demand during the week than on the weekends (Baye, 2006). Peak load pricing usually occurs when the demand during this peak time is too high for the company to meet the entire demand at the normal price. Although it seems that firms at peak times would not have MC = MR, they still meet this profit maximizing principle. The marginal cost is usually horizontal until it reaches a certain quantity, then it becomes vertical. With two different levels of demand and marginal costs, this equilibrium prices is a different level. Many electric companies are finding that the peak load is becoming earlier in the morning that it has been historically. Over the past five years is has been shown that more people are watching TV between the hours of 5:00AM and 7:00AM, while many stores are now opening at 7:00AM instead of 8:00AM (Morning peaks, 2006). In 2003, Southern Company’s peak winter usage was at 8:00AM and is now at 7:00AM. This shows that electric companies that utilize peak load pricing strategies will have to reassess their pricing models in order to take advantage of this change and maximize profits.

Cross Subsidies
“Whenever the demands for two products produced by a firm are interrelated through costs or demand, the firm may enhance profits by cross-subsidization: selling one product at or below cost and the other product above cost” (Baye, 2006). A good example of this strategy is the practices of some software companies. For instance, Adobe produces products such as Adobe Acrobat and Adobe Flash, but provides a form of these products free of charge to consumers. Adobe Reader and Adobe Flash Player are available for free, but do not allow the user to create files with them. The full versions of these programs are available at a cost that pays for the development of both the free versions and the full versions. With the increased number of people demanding Adobe Reader, there will be a proportional increase in demand for Adobe Acrobat. This will eventually help to increase the total profits of the company.

Price Matching
With this strategy, not only does a firm advertise their own price for a good, but they also advertise that they will be willing to meet the price of a competitor. An advertisement of this kind might read, “our price is $34.99, but if you find a better price at another retailer, we will match that price.” This statement alone could cause some consumers to flock to this retailer just because they believe that they will always have the lowest price. If all of the firms in a market employ this pricing strategy, they can actually set the price to the high monopoly price and earn higher profits than the zero profits they would normally earn (Baye, 2006). It seems that if one of these retailers lowered their price, they would be able to gain market share. However, if they lower their price, a consumer will simply shop at the retailer with the higher price and get the same deal they would at the cheapest retailer. Therefore, lowering their price does not increase their share of the market. The primary concern with this strategy is getting into a situation where you are competing with a firm that has a lower marginal cost. If you promise the same price, but have higher costs, you are in jeopardy of suffering lower profits, or even losses.

Randomized Pricing
When a firm randomly changes the prices of their goods, consumer cannot learn from experience which firm charges the lowest price in the market. Sometimes firm A might be lowest and sometimes firm B might be lowest. Since consumers do not have an understanding of where a company stands on pricing, they have less incentive to shop for the best price. The other advantage a firm gets with this strategy is it discourages other firms from trying to undercut their prices. Other firms cannot accurately predict the price set by a randomly priced good, so they are forced to ignore it when they are setting their prices. According to Beard and Sweeney, “a profitable price randomization creates an attractive price gamble for consumer that induces favorable consumer commitments, thus increase average firm profits above those obtainable through deterministic pricing” (Beard & Sweeney, 1994). This can best be shown with airlines changing their pricing randomly. If Southwest knew that United had a daily flight from Chicago to New York at a price of $200, they could set their price at $190 and steal a great deal of business. However, since airlines randomly change prices throughout the course of a day, consumers are forced to buy when they think the price is low and they cannot shop around for the best price. At one time, Southwest might be cheapest and at another time United might be cheapest. This randomized pricing strategy helps firms maximize profits by creating a feeling of uneasiness from both competitors and consumers.

Multiple Choice Questions
1) Which of the following pricing strategies does not maximize profits? a) Two-Part Pricing b) Peak Load Pricing c) Block Pricing d) None of the above The correct answer is D. All of these pricing strategies maximize a firm’s profits.

2) Which of the following makes up a firm’s profits in a two-part pricing system? a) The fixed fee b) The per-unit fee c) The total cost to the consumer d) The marginal cost plus consumer surplus The correct answer is A. The firm sells each unit at its marginal cost and thus makes no profit on each unit sold at this price. But the firm also receives the fixed payment, which is pure profit.

3) ____________ is a pricing strategy in which profits gained from the sale of one product are used to subsidize sales of another product. a) Two-Part Pricing b) Block Pricing c) Peak Load Pricing d) Cross Subsidies The correct answer is D. Cross subsidies is a pricing strategy in which profits gained from the sale of one product are used to subsidize sales of another product.

4) Packaging soda into packages of 12 is an example of which type of pricing? a) Peak Load Pricing b) Cross Subsidies c) Price Matching d) None of the above The correct answer is D. Block pricing is a pricing strategy in which identical products are packaged together in order to enhance profits by forcing customers to make an all-or-none decision to purchase.

5) The following is an example of peak load pricing: a) Trucks transporting goods at full capacity b) Charging a higher price at times of the highest demand c) A firm deciding to make less profit at times of the highest demand in order to satisfy the demand d) A firm maximizing profit by keeping their manufacturing facilities running at full capacity at all time The correct answer is B. Peak-load pricing is a pricing strategy in which higher prices are charged during peak hours than during off-peak hours