Theory of Pricing Policy

Pricing Policy:
 
Chapter Summary:

The easiest way to set price is via uniform pricing. At profit-maximizing uniform price, the incremental margin percentage equivalents the reciprocal of absolute value of the price elasticity of demand. The most gainful pricing policy is complete price discrimination, where each and every unit is priced at the benefit which the unit gives to its buyer. To implement this policy, though, the seller should know each potential buyer’s individual demand curve and be capable to set different prices for each and every unit of the product.

The next most gainful pricing policy is direct segment discrimination. For this policy, the seller should be capable to directly recognize the different segments. The third most gainful policy is indirect segment discrimination. This includes structuring a set of selections around some variable to which the different segments are differentially sensitive. Uniform pricing is the least gainful way to set a price.

A commonly employed basis for direct segment discrimination is place. This exploits a difference among free on board and cost comprising freight prices. A generally used technique of indirect segment discrimination is bundling. Sellers might apply either pure or mixed bundling.

Key Concepts:

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General Chapter Objectives:

A) Examine uniform pricing and understand its restrictions relative to price discrimination.

B) Understand that cost-plus pricing drops to maximize gain.

C) Examine complete price discrimination and its informational needs.

D) Examine direct segment discrimination and its informational and implementation needs.

E) Describe how position can be employed as a basis for direct segment discrimination.

F) Evaluate indirect segment discrimination and its informational and implementation needs.

G) Elucidate how bundling serves to consequence indirect segment discrimination.

H) Describe how the discriminating variable must be set.

I) Appreciate the hierarchy of pricing policies in terms of information requirement and profitability:

i) Complete price discrimination;
ii) Direct segment discrimination;
iii) Indirect segment discrimination; and
iv) Uniform pricing.

Notes:

1) Uniform pricing:

a) Uniform pricing: It is a pricing policy where a seller charges similar price for each and every unit of the product.

b) Profit maximizing price (or incremental margin percentage rule): It is a price where the incremental margin percentage (that is, price less marginal cost divided by price) is equivalent to the reciprocal of absolute value of the price elasticity of demand. This is the rule of marginal revenue equivalents the marginal cost.

i) Price elasticity might vary all along a demand curve, marginal cost modifies with scale of production. The above process usually includes a series of trials and errors with distinct prices.

ii) Intuitive factors which underlie price elasticity: indirect and direct substitutes, buyer’s preceding commitments and search cost.

c) Price adjustments following modifications in demand and cost.

i) To maximize gains, a seller must consider both demand and costs.

ii) A seller must adjust its price to modifications in either the marginal cost or the price elasticity.

iii) It should consider the consequence of price change on the quantity demanded.

iv) When demand is more elastic (that is, price elasticity will be a bigger negative number), the seller must aim for a lower incremental margin percentage, and not essentially a lower price, and similarly,

v) When demand is less elastic, the seller must aim for a higher incremental margin percentage, and not essentially a higher price.

vi) A seller must not essentially adjust the price by similar amount as a change in the marginal cost.

D) Special notes:

i) Simply the incremental margin percentage (that is, price less marginal cost divided by the price) is relevant to the pricing.

  • Contribution margin percentage (that is, price less average variable cost divided by price) is not relevant to the pricing.
  • Variable costs might raise or reduce with the scale of production, and therefore, marginal cost will not be similar as average variable cost.

ii) Setting price by just marking up average cost will not maximize the profit. Troubles of cost plus pricing:

  • In businesses with economies of scale, average cost based on scale, however scale depends on price. This is a circular exercise.
  • Cost plus pricing provides no guidance as to markup on the average cost.

e) Limitations of uniform pricing (or incremental margin percentage rule).

i) The inframarginal buyers do not pay as much as they will be ready to pay. A seller could raise its profit by taking some of the buyer excess.

ii) Economically incompetent quantity of sales. By giving the product to everyone whose marginal benefit surpasses marginal cost, the seller could earn more gain.
 
2) Price discrimination: It is a pricing policy where a seller sets distinct incremental margins on different units of the same or alike product.

a) To earn a bigger incremental margin from buyers with high benefit and a smaller margin from buyers with lower benefit.
 
3) Complete price discrimination: It is the pricing policy where a seller prices each unit of output at buyer’s benefit and sells a quantity where the marginal benefit equivalents the marginal cost.

a) All buyer surpluses are removed. Each and every buyer is charged the maximum she is willing for pay for each and every unit.

b) Economically proficient quantity: All the opportunity for extra profit via modifications in sales is exploited.

c) Extracts a higher price for units which would be sold beneath uniform pricing and extends sales by selling extra units which would not be sold.

d) Needs information regarding each potential buyer’s whole individual demand curve.  
 
4) Direct segment discrimination: The pricing policy where a seller charges a dissimilar incremental margin to each and every identifiable segment (with uniform pricing in each segment). A segment is an important group of buyers in a big market.

a) Profit maximizing price: Set prices and hence the incremental margin percentage of each segment equivalents the reciprocal of the absolute value of that segment’s price elasticity of demand; that is, applies the rule for uniform pricing to find out the profit maximizing prices for each segment.

b) Whenever marginal cost is rising, any change in price for one segment which affects sales will influence marginal cost and the incremental margin percentage for other segment. Accordingly, the seller should conduct the trial and errors search for the prices to both segments at similar time.

c) A seller can distinguish on the basis of a buyer’s position

i) Free on board (or FOB) price is a price which does not comprise delivery.

  • FOB pricing ignores the differences among the price elasticity of demand in different markets.
  • The differences among prices at different locations equivalent the differences in the costs of delivery.

ii) Delivered pricing is the pricing policy, where the seller’s price comprises delivery. Cost comprising freight (or CF) price is one that comprises delivery.

The seller can apply direct segment discrimination, aim for various incremental margin percentages in each and every market, and gain higher profit.

The differences among prices at different locations are the result of different incremental margin percentages and the various marginal costs of supplying different markets, and might be bigger or smaller than the costs of delivery.

d) Requirements:

i) Should directly recognize the members of each and every segment. The identifiable buyer characteristic should be fixed.

ii) Should prevent buyers from reselling the product between them.

  • Usually, resale of services is harder than resale of goods; therefore there is more price discrimination in the services than goods.
  • Sellers can limit the resale of goods by limiting warranty service to the position of purchase.

e) Limitations: For each segment, similar limitations as uniform pricing.  
 
5) Indirect segment discrimination: It is a pricing policy where a seller (who can’t directly recognize the customer segments) structures a selection for buyers and hence to earn various incremental margins from each segment.

a) Profit maximizing price:

i) There is no simple rule to determine the profit maximizing prices.
ii) Buyers may substitute among different selections.

Accordingly, the seller should analyze how modifications in the price of one product influence the demand for other selections, and set the prices of all products at similar time.  The seller should not price any product in isolation.

b) Requirements:

i) Buyers should be differentially sensitive to several variables that the seller can control.  The seller then utilizes this variable to structure a set of selections which will discriminate among the segments.

ii) Buyers should not be able to circumvent the differentiating variable. The seller should strictly enforce all situations of sale to prevent switching.

iii) Cannibalization takes place whenever the sales of one product decrease the demand for other with a higher incremental margin.

  • Mitigate cannibalization by reducing the quality of the low margin product.

c) Less gainful than direct price discrimination.

i) Products give less benefit than those with the direct discrimination.
ii) Includes comparatively higher costs.
iii) Leakage: It is an indirect discrimination relies on different segments to voluntarily recognize them via the structured choice. However consumers in one segment might buy the item aimed at the other segment.

6) Profit ranking:

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7) Bundling:

a) Bundling: It is one technique of indirect segment discrimination which deliberately limits buyer selections. This is the combination of two or more products into one package with single price.

i) Pure bundling: It is the pricing policy where the seller gives the products simply as a bundle.
ii) Mixed bundling: In this, the seller gives the products as a bundle and as well separately.

b) There is no simple common rule to set the prices.

c) Bundling is more gainful where:

i) The advantages of segments from the products are negatively correlated, that is, a product which is very beneficial to one segment gives relatively little benefit to the other (that is, the benefit from the bundle will be comparatively less disparate across the segments than the advantages from the separate products); and

ii) The marginal cost of product is low (comparatively little economic inefficiency will ensue from giving the bundle to all buyers).

d) Whenever marginal cost is substantial, mixed bundling must be considered. By structuring a selection among the bundle and separate products, different segments will recognize themselves by their product selection. The economic inefficiency of giving a product for which the marginal cost is less than the buyer’s advantage can be avoided.

Question-Answer:

Magazines are distributed via both subscriptions and newsstands. They derive revenue from both advertising and selling the publication. Many as well publish their content via the World Wide Web.

a) The bigger a title's circulation, the more its publisher can charge for advertising. How ought to a publisher take account of this aspect in setting the cover price of a magazine?

b) From the reader's point of view, what are the differences among buying at a newsstand and via subscription? How must publisher price subscriptions relative to the newsstand sales?

c) The Web edition is specifically beneficial to business executives who travel often and subscribers in positions which are poorly served by mail delivery from the magazine printers.   Must a magazine give the Web edition free to subscribers or levy an extra charge for it?

Answer:

a) The publisher must consider marginal revenue in two forms-magazine sales and advertising. In setting the cover price, the publisher must balance the marginal revenue from both advertising and sales with the marginal cost of producing and delivering the publication.

b) For reader, subscription is more suitable as it comprises delivery. On the other hand, a subscription locks in the reader and hence he can’t pick and select according to the content of specific issues. These two factors encompass conflicting consequences on the reader’s willingness to pay for subscriptions in relation to newsstand purchases.

c) There emerge to be some segments in the demand for the Web edition:

i) Business executives who travel frequently;
ii) Subscribers in positions which are poorly served by mail delivery from magazine printers; and
iii) Non-business subscribers in positions well-served by the mail delivery. The magazine can directly recognize segment and offer them the Web edition at no charge. Though, the magazine can’t directly recognize segment. It can indirectly distinguish by levying a charge for the Web edition.

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